Practice Exam 3 Fall 2015

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1 Global Macroeconomics ::Solutions:: Practice Exam 3 Fall 2015 Do not open this exam until instructed to do so. You have 75 minutes to complete this exam You may use a calculator; you may not use any other device (cell phone, etc.) You may consult one page of notes (both sides); you may not use books, notebooks, etc. Show your work I understand that the honor code applies: I will not lie, cheat, or steal to gain an academic advantage, nor tolerate those who do. Signature Printed Name

2 For each question below, write the letter of the most correct answer to the left of the question. 1. (3 pts.) Covered interest parity assumes all of the following, except: A. The risk and liquidity characteristics of two assets in two countries are identical B. Currency risk is hedged C. The future spot rate evolves predictably D. There is no arbitrage opportunity 2. (3 pts.) If other things are unchanged, current account deficits typically signal all of the following, except: A. The country has surplus savings B. Net foreign assets are declining C. The country is borrowing from abroad D. The country has investment opportunities at home 3. (3 pts.) The primary deficit includes all of the following, except: A. Military spending B. Government investment C. Interest on government debt D. Government funded social assistance programs 4. (3 pts.) The public debt ratio declines faster: A. The smaller the primary surplus B. The lower the real growth rate C. The lower the inflation rate D. The lower the nominal interest rate 5. (3 pts.) Countries are more likely to run a current account surplus if: A. Their domestic real interest rate is lower than abroad B. Their domestic real interest rate is higher than abroad C. They are more competitive in manufactures D. They have a high rate of investment 6. (3 pts.) Purchasing Power Parity (PPP) is most relevant for: A. A country s debt burden B. The carry trade C. Long-run exchange rate determination D. The price of Big Macs page 2 of 8

3 7. (3 pts.) An overvalued fixed exchange rate is usually associated with A. A depreciating currency B. A failure of covered interest parity C. An increase in foreign reserve assets D. Contractionary monetary policy 8. (3 pts.) The deadweight loss consists of A. The consumer surplus minus the producer surplus B. The producer surplus minus the consumer surplus C. The sum of the consumer and producer surpluses and the revenue from taxation D. None of the above 9. (3 pts.) The efficiency benefits of imposing the lowest possible tax rate on the broadest possible tax base A. Favor the taxation of inelastically demanded goods B. Favor a progressive tax on income C. Favor a steady tax rate over time D. Favor a lower tax on capital gains than on labor income 10. (3 pts.) In a world of strict capital controls, a central bank can A. Peg its exchange rate while keeping control over the size of its balance sheet B. Peg its exchange rate while maintaining monetary policy discretion C. Peg its exchange rate and adjust interest rates flexibly D. All of the above page 3 of 8

4 11. Taxes. (Total: 12 pts.) Consider the market for cigarettes. a. (2 pts.) On the axis below, sketch a supply and demand curve for cigarettes and clearly label the equilibrium price and quantity. Price S p cons p p firm Tax Revenue D Q TAX Q Quantity b. (5 pts.) Let there be a per-unit tax of size t on cigarettes. On your graph above, label the price paid by consumers, the price received by producers, and the new quantity of cigarettes sold. Shade in the revenue earned by the government from this tax. See figure above. c. (5 pts.) Explain what characteristic of the supply and demand for cigarettes might make the deadweight loss from the cigarette tax small. (Note: don t worry if your figure from part a. has a large deadweight loss, this question can be answered independently.) The demand for cigarettes is probably inelastic with respect to price. Since consumers and producers will not alter the quantity of cigarettes demanded and supplied by much in response to price changes, the impact of the tax on the volume of cigarettes sold will be small. The smaller the change, the smaller the deadweight loss. page 4 of 8

5 12. China s exchange rate. (Total: 17 pts.) Currently, the U.S. dollar price of a Chinese Yuan is around $0.15. Suppose that the equilibrium price that would prevail if the Yuan were allowed to float is $0.20. Assume there are no capital controls. a. (2 pts.) Sketch supply and demand curves for the Yuan on the axis below. Label the floating price of the Yuan and fixed price of the Yuan on the graph. Further, label the amount of Yuan supplied and the amount of Yuan demanded at the fixed exchange rate. s $/Y uan S $0.20 $0.15 D Q S Q D Q Y uan b. (3 pts.) How can the People s Bank of China keep the exchange rate fixed at this rate? What will happen to the level of foreign reserves held by the bank? The PBoC can buy dollars in the foreign exchange market and sell Yuan. PBoC purchases will support the dollar and add to the foreign exchange reserves held by the Bank. c. (6 pts.) What would you expect to happen to the price level in China? Explain why you would expect this. What could the PBoC do to limit this effect? Purchasing dollars expands the PBoC s balance sheet, adding dollars to its assets and Yuan currency or reserves to its liabilities. The increase in the money supply eventually should increase the price level if velocity is constant (that s the quantity theory at work). However, the PBoC can sell other assets (loans or government bonds) to counteract the expansion of (or sterilize) its balance sheet. It also can raise reserve requirements on banks to dampen their lending. Finally, some of China s economic growth reflects rapid gains in productivity, which tends to lower prices. page 5 of 8

6 d. (6 pts.) What would you expect to happen to interest rates in China if the PBoC stopped intervening to keep the Yuan below its equilibrium level? Why? How would this affect the economy and inflation? Unless the PBoC purchased other assets, reduced dollar purchases would slow the increase in the supply of Yuan and thereby increase interest rates in China. The effect would be to dampen aggregate demand and inflation. 13. Government debt. (Total: 10 pts.) On planet Trantor, the budget deficit in 2015 is estimated at 8.0 percent of GDP, the primary deficit at 5.4 percent of GDP, and the end-2014 debt-to-gdp ratio is percent. a. (5 pts.) If nominal GDP growth is 6.1 percent (i.e., nominal GDP is falling) in 2015 and the interest rate on the debt rises to 10%, what will the debt-to-gdp ratio be at the end of 2015? B t = B t 1 + (i t π t ) B t 1 B t 1 g t + D t B t = B t 1 B t 1 + i t (π t + g t ) B t 1 + D t B t = (0.1) ( 0.061) = b. (5 pts.) How large of a primary surplus would planet Trantor need to stabilize its debt-to- GDP ratio under these conditions? Justify your answer by showing an appropriate equation. D t D t = (i t π t g t ) B t 1 1 = (i t (π t + g t )) B t 1 1 D t = ( ) = page 6 of 8

7 14. Interest parity. (Total: 15 pts.) Suppose the return on one-year U.S. Treasury debt is 0.25% and return on one-year Australian Treasury debt is 2% and that both securities are riskless. In the spot market, one Australian dollar (AUD) costs 0.72 U.S. dollars (USD). a. (2 pts.) Suppose the AUD exchange rate one year from now is expected to be 0.71 USD per AUD. Does uncovered interest rate parity hold? Show why or why not. Uncovered interest parity is ( ) s$/aud,t i us = (1 + i au )E t s $/AUD,t and it does not hold with an expected exchange rate of 0.71 USD per AUD < 1.02 (0.71/0.72) = b. (6 pts.) Assume that there are no transaction costs in buying and selling debt or currency. Describe an investment strategy an investor could follow that earns a positive expected return. What is the expected return on this strategy? The investor would borrow in USD, exchange them for AUD and buy Australian debt. When the debt matures, the investor sells the AUD for USD, and pays back the debt. For every USD invested, the investor expects to make USD. This is a pretty small rate of return, and these positions are often highly leveraged. The monthly standard deviation of the exchange rate for the last 5 years is 0.11! c. (7 pts.) Employment in the United States has displayed better than expected growth over the last two months. Explain why this may be a cause of concern for investors following the strategy you outlined in part b. If the positive economic data prompts the Fed to increase the target Federal Funds rate and the central bank in Australia does not also raise its rate the increase in demand for U.S. securities could appreciate the USD, making the strategy in part b. deliver a negative return. Extra practice: by how much would the USD need to appreciate to generate a loss on this investment? page 7 of 8

8 Extra Space Clearly label the question number, and leave a reference to this page near the question. page 8 of 8

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