Midterm - Economics 160B, Fall 2014

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1 Name Student ID Section (or TA) Please indicate on your scantron Test Form A. Midterm - Economics 160B, Fall 2014 You will have 75 minutes to complete this exam. Record answers for all multiple choice questions (MC#1-MC#17) on the scantron. There are 5 pages and 61 points total. Good luck. Choose the best answer. Write answer on scantron. (2 points each, 20 points total) MC#1) If a U.S. car manufacturer purchases steering wheels from a Mexican company, using a bank account in Mexico, this will enter the U.S. balance of payments accounts as a in the current account and a in the financial account. a) credit, credit b) credit, debit c) debit, credit d) debit, debit MC#2) When workers from Mexico work in the U.S., their income raises U.S: a) gross domestic product b) gross national income c) current account balance d) net factor income from abroad e) all of the above MC#3) According to the Twin Deficits hypothesis, which of the following could be the cause of the large U.S. current account deficit: a) low investment b) low government saving c) high private saving d) all of the above MC#4) For an open economy, it must be true that a) The country s investment is limited to being equal to its national saving b) current account equals zero c) current account equals saving minus investment d) financial account equals zero MC#5) All of the following contribute to failures in the law of one price and purchasing power parity except: a) arbitrage b) transportation costs c) sticky prices d) tariffs and taxes MC#6) According to the monetary approach to exchange rates, if U.S. money supply rises 5% and U.S. real money demand rises 10%., with no change in money demand or supply in Europe, then the U.S. price level should and the $/euro exchange rate should. a) rise, rise b) fall, rise c) rise, fall d) fall, fall e) not change, not change MC#7) According to the asset approach to exchange rates, a temporary fall in the domestic interest rate should lead to a in the current spot exchange rate (home currency per foreign). a) rise b) fall c) not change d) impossible to tell MC#8) According to the policy Trilemma, how can China have both fixed exchange rates and an independent monetary policy: a) it can t b) only if it holds enough foreign reserves c) only if PPP fails d) only if it restricts financial market openness with capital controls. 1

2 MC#9) Suppose Bulgaria fixes its exchange rate to the euro at a level (Bulgarian lev per euro) that is lower than the exchange rate that would be obtained had the exchange rate been allowed to float freely. This situation will make the Bulgarian money supply and its holdings for foreign currency reserves. (Assume no capital controls.) a) fall, fall b) rise, fall c) fall, rise d) rise, rise MC#10) Since Estonia fixes its exchange rate to the euro, if the European central bank lowers the euro interest rate, this will cause Estonia s interest rate to, and its foreign reserve holdings to. (Assume no capital controls.) a) rise, rise b) fall, rise c) rise, fall d) fall, fall Question 1: Parity Conditions (7 points total, 1 points each item) Answer on scantron. You are a currency speculator trying to forecast the Mexican peso over the next year. Suppose our usual theories hold: uncovered interest rate parity (UIP), covered interest rate parity (CIP), real interest rate parity (RIP), relative purchasing power parity (RPPP), and absolute (levels) PPP. For each of the cases below, use the information in that case to compute the percentage expected appreciation of the peso relative to the dollar ((E e $/peso- E $/peso )/ E $/peso ), and indicate which one parity condition you are using. (Information from one case does not apply to the others.) a) The nominal interest rate for a 1year peso deposit is 4%, and that for a dollar deposit is 2%. What is the expected peso appreciation, and which parity condition used? MC#11) a) -4% b) -2% c) 0% d) 2% e) 4% MC#12) a) CIP b) UIP c) RIP d) RPPP b) Expected inflation over the next year is expected to be 2% in the U.S. and 1% in Mexico. What is the expected peso appreciation, and which parity condition used? MC#13) a) -2% b) -1% c) 0% d) 1% e) 2% MC#14) a) CIP b) UIP c) RIP d) RPPP What is the expected change in the real exchange rate (U.S./Mexico) in this case? MC#15) a) -2% b) -1% c) 0% d) 1% e) 2% c) The forward premium (percentage by which the forward rate is higher than the current spot rate in $/peso) is 3%. What is the expected peso appreciation, and which parity condition used? MC#16) a) -3% b) 0% c) 3% d) none of the above This uses UIP and : MC#17) a) CIP b) RIP c) PPP d)rppp 2

3 Question 2: Parity Conditions Continued (8 points) Suppose you read the following in the newspaper: the dollar interest rate for a one year deposit is 4%, the Chinese yuan interest rate for a one year deposit is 3%, the current exchange rate is 10 yuan/dollar and the forward exchange rate is 8 yuan/dollar. a) (5 points) Explain in several sentences the sequence of trades you would undertake (in theory) to make a profit off of this scenario, assuming you have no dollars or yuan to start, but you have the ability to borrow in either currency. Be specific about which asset or currency you are trading and at what time. You do not need to report any numerical values for any of the transactions, so no computations are needed here. b) (3 points) What parity condition is violated by the numbers above? Explain one reason why this parity condition might not hold in reality. 3

4 Question 3: The Asset Approach and Exchange Rate Overshooting (16 points) Use the overshooting model to explain how a permanent rise in real money demand in the U.S. affects the exchange rate between the British pound ( ) and the U.S. dollar ($), measured as dollars per pound (E $/ ). (Make the usual assumptions: prices are sticky in the short run and flexible in the long run, and that uncovered and covered interest rate parity hold.) a) (10 points) Illustrate this scenario in graphs of the U.S. money market and the foreign exchange market. Label your initial equilibrium point A, label the short-run equilibrium point B, and your long-run equilibrium point C. (You can put short run and long run on the same graphs.) Label all axes, and indicate curve shifts with arrows. Explain the reason for each curve shift briefly. b) (6 points) Using three time diagrams illustrate how the following three variables change over time as implied in your graph above: exchange rate (E $/ ), expected future exchange rate E e $/ and the real exchange rate (US/UK). (You may continue your answer on the next page.) 4

5 Question 4: Monetary Approach to Exchange Rates (10 points) Use the monetary approach to exchange rates to explain and critique in a couple paragraphs the following two claims in an argument at a meeting of G20 government officials (explain the economic logic behind each position, using equations where appropriate, and conclude by discussing which position you agree with more and why): Chinese Premier: the U.S. policy of high money supply growth is exporting inflation to China and other countries, and is partly to blame for inflation in many other countries. U.S. Finance Secretary: the real problem is that China and other countries fix their exchange rates to the dollar; if they let their currency float then U.S. inflation need not be a problem for other countries. 5

6 Nothing below this line will be graded. You may use it for scratch work. 6