II 4

I. Suppose the dollar interest rate and the pound sterling interest rate are the same, 5 percent per year. What is the relation between the current equilibrium $/ exchange rate and its expected future level? Suppose the expected future $/ exchange rate, $1.52 per pound, remains constant as Britains interest rate rises to 10 percent per year. If the U.S. interest rate also remains constant, what is the new equilibrium $/ exchange rate? ( Total 15 points ) The mainpoints: The current equilibrium exchange rate must equal its expected future level since, with equality of nominal interest rates, there can be no expected increase or decrease in the dollar/pound exchange rate in equilibrium. (5 ) If the expected exchange rate remains at $1.52 per pound and the pound interest rate rises to 10 percent, then interest parity is satisfied only if the current exchange rate changes such that there is an expected appreciation of the dollar equal to 5 percent. 5 This will occur when the exchange rate rises to $ 1.60 per pound (a depreciation of the dollar against the pound). 5

II. Derive Marshall-Lerner Condition. ( 20 points )

Answers suggested: Current account : CA=PEX-P*IMe 4 ) P* is foreign price of import goods E is exchange rateIM is the amount of import goods.E is the amount of export goods. Assume international payment is in balance:

CA = 0 = P EX P * IM e = 0 P EX = P * IM e

dcA = p dEX p* IM P*e dIM de de Pde = P* IM e EX

(6 )

dcA 1 p dEX p * e dIM = 1 de p * IM de p EX de p * IM

d1m 1m = d1m p * = d1m e = Nm the elasticity of import demand: dp * dp * IM IM de p* dEX EX = dEX p = Nx the elasticity of export supply: dp EX dp p
according to ppp

p e p*
(6 )

so :

dcA 1 e dEX e dIM = 1 de p * IM de EX de IM

 Nx ( Nm ) 1 = Nx + Nm 1 because Nm <0,

1 >0, p * IM
dcA >0: Nx + Nm 1 >0that is Nx + Nm > 1 de
(4 )

so: the condition of

III. Imagine that two identical countries have restricted imports to identical levels, but one has done so using tariffs while the other has done so using quotas. After these policies are in place, both countries experience identical, balanced expansions of domestic spending. Where should the demand expansion cause a greater real currency appreciation, in the tariff-using or in the quotausing country? ( Total 15 points ) The main points: The balanced expansion In domestic spending will increase the amount of imports consumed in the country that has a tariff in place, but imports cannot rise in the country that has a quota in place. (5 ) Thus, in the country with the quota, there would be an excess demand for imports if the real exchange rate appreciated by the same amount as in the country with tariffs. 5 Therefore, the real exchange rate in the country with a quota must appreciate by less than in the country with the tariff.5 IV. Economists have long debated whether the growth of dollar reserve holdings in Bretton Woods years was demand determined that is determined by central banks desire to add to their international reserves or supply determined(that is, determined by the speed of U.S. monetary growth).what would your answer be?what are the consequences for analyzing the relationship between growth in the world stock of international reserves and worldwide inflation? (15 points) Main points: A "demand determined" increase in dollar reserve holdings would not affect the world supply of money as central banks merely attempt to trade their holdings of domestic assets for dollar reserves. A "supply determined" increase in reserve holdings, however, would result from expansionary monetary policy in the United States (the reserve center). (7 ) At least at the end of the Bretton Woods era the increase in world dollar reserves arose in part because of an expansionary monetary policy in the United States rather than a desire by other central banks to increase their holdings of dollar assets. Only the "supply determined" increase in dollar reserves is relevant for analyzing the relationship between world holdings of dollar reserves by central banks and inflation.(8 ) V. You observe that a countrys currency depreciates but its current account worsens at the same time. What data might you look at to decide whether you are witnessing a J-curve effect? What other macroeconomic change might bring about a currency depreciation coupled with a deterioration of the current account, even if there is no J-curve? ( Total 20 points ) Main points: A currency depreciation accompanied by a deterioration in the current account balance could be caused by factors other than a J-curve. For example, a fall in foreign demand for domestic products worsens the current account and also lowers aggregate demand, depreciating the currency. (7 ) In terms of the following figure DD and XX undergo equal vertical shifts, to D'D' and X'X', respectively, resulting in a current account deficit as the equilibrium moves from point 0 to point 1. To
2

detect a J-curve, one might check whether the prices of imports in terms of domestic goods rise when the currency is depreciating, offsetting a decline in import volume and a rise in export volume. (7 ) The diagram: (6 )
E A D D X X X X D D 1 0 A Y

VI. As home country carries out an expansion monetary policy, what would happen to the foreign country under fixed exchange rates regime in Two-countrys MundellFleming Model? (15 points)

Main points:
LM Q , i IM Q , i ( 5 )

LM , LM
( 5 )

i , i

Q , Q
Finally ,foreign country will experience growth of output and decrease in interest. AS THE FOLLOWING FIGURE: (5 ) IS2 IS1 LM LM LM2 LM1 IS LM1 IS I0 i i1 I1

Y0 Y1 HOME COUNTRY

Y0

Y1 FOREIGN COUNTRY