Columbia University Instructor: Stephanie Schmitt-Grohé

Final Examination
International Monetary Theory and Policy
Economics W4505
Wednesday, May 14, 2014

Point values are indicated for each question. The exam consists of a total of 120 points,
and you have 120 minutes. Write your name on the exam. Write your answers in the space
provided. This exam has 12 pages. You may use a basic, nonprogrammable calculator. Use
of smart phones is prohibited.

1. (10 points) In a large open economy, a shock that affects only the savings schedule can
give rise to a positive comovement between savings and investment. Explain whether
this statement is true, false, or uncertain.

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2. (10 points) If uncovered interest rate parity holds, then returns to carry trade must
be zero not only on average but period by period. Explain whether this statement is
true, false, or uncertain.

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3. The findings of the 2011 International Comparison Program were released on April 29,
2014. They show that the Price Level Index for China was 54. By comparison the
2005 International Comparison Program showed a price level index for China of 42.
By construction, the Price Level Index for the United States is always 100.

(a) (10 points) Find the percent change in the Yuan-dollar real exchange rate between
2005 and 2011.

(b) (10 points) In 2005 the size of the Chinese economy, at PPP exchange rates, was
43 percent that of the U.S. economy. Ignoring growth in physical output, find the
size of the Chinese economy, at 2011 PPP exchange rates, relative to that of the
U.S. economy.

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(c) (10 points) Suppose the entirety of the observed real exchange rate appreciation
was due to the imposition of import tariffs by China. Assume that in the U.S.
1−α
and China the price level is given by, P = PXα PM , where α = 0.5, PX and PM
denote export and import prices, respectively, and that – absent tariffs — the law
of one price holds. Find the size of the import tariff.

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4. Between October 2009 and March 2012 Brazil imposed a number of capital control
taxes to reduce capital inflows into Brazil. After March 2012 those restrictions were
removed. The cupom cambial, icupom
t , is the 360-day interest rate of U.S. dollar deposits
inside Brazil. It is defined as
St
1 + icupom
t = (1 + it) ,
Ft
where St is the spot exchange rate (that is, the reais price of one U.S. dollar), Ft is
the 360-day forward exchange rate of U.S. dollars, and it the 360-day nominal reais
interest rate in Brazil. Let i∗t denote the 360-day U.S. dollar LIBOR rate and define
the spread as
spreadt = icupom
t − i∗t .

(a) (10 points) Suggest a strategy to use observations on the variable spreadt to test
the effectiveness of the Brazilian capital controls in reducing capital inflows.

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(b) (10 points) This figure shows the variable spreadt from June 2009 to December
2012. What do you conclude from this figure about the effectiveness of the capital
inflow controls imposed by the Brazilian authorities. Be sure to be specific in your
argument.

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5. (50 points) Capital Controls, Downward Wage Rigidity, and Currency Pegs
Consider a two-period, small, open economy with free capital mobility. Households are
endowed with 10 units of tradables in period 1 and 10 units in period 2 (QT1 = 10 and
QT2 = 10). The world interest rate is 0, r∗ = 0, the nominal exchange rate, defined
as the price of foreign currency in terms of domestic currency, is fixed and equal to 1
in both periods (S1 = S2 = 1). Suppose that the foreign-currency price of tradable
goods is constant and equal to one in both periods, and that the law of one price
holds for tradable goods. Nominal wages are downwardly rigid. Specifically, assume
that the nominal wage in periods 1 and 2, measured in terms of domestic currency,
can not fall below the past wage rate, Wi ≥ Wi−1 for i = 1, 2, with W0 = 5 given.
Suppose the economy starts period 1 with no assets or debts carried over from the past
(B0∗ = 0). Suppose that the household’s preferences are defined over consumption of
tradable and nontradable goods in periods 1 and 2, and are described by the following
utility function,
ln C1T + ln C1N + ln C2T + ln C2N ,
where CiT and CiN denote, respectively, consumption of tradables and nontradables in
period i = 1, 2. Let p1 and p2 denote the relative prices of nontradables in terms of
tradables in periods 1 and 2, respectively. Households supply inelastically h̄ = 1 units
of labor to the market each period. Finally, firms produce nontradable goods using
labor as the sole factor input. The production technology is given by

QN α
1 = h1

and
QN α
2 = h2

in periods 1 and 2, respectively, where QN

i and hi denote, respectively, nontradable
output and hours employed in period i = 1, 2. The parameter α is equal to 0.5.

(a) Compute the equilibrium level of consumption of tradables and the trade balance
in periods 1 and 2. Show your work. Interpret your findings.

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(b) Compute the equilibrium levels of employment and nontradable output in periods
1 and 2.

For the remainder of the problem consider the case that the world interest rate falls to
r∗ = −0.5.

(c) Compute the equilibrium level of consumption of tradables and the trade balance
in periods 1 and 2.

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(d) Compute the equilibrium level of nontraded consumption in periods 1 and 2 and
the wage rate in period 1. Provide a discussion of your findings.

(e) Compute the level of welfare.

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 (f) Suppose wages were fully flexible. Find the level of nontradable consumption in
periods 1 and 2. Compute the level of welfare.

Suppose now that the government imposes capital controls that prevent households
from borrowing in international capital markets in period 1, i.e., the government
imposes B1∗ ≥ 0. Continue to assume that the world interest rate is r∗ = −0.5.

(g) Find consumption of tradables and nontradables in periods 1 and 2.

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(h) Find the level of welfare under capital controls. Are capital controls welfare
decreasing? Explain why or why not.

(i) Compare the level of welfare under capital controls and under wage flexibility.

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(j) (Extra Credit) Suppose the only instrument the government has to influence
capital inflows is a proportional capital control tax. In particular, individual
households face an interest rate 1 + r̃ = (1 + r∗ )/(1 − τ ). Any capital control tax
revenue is rebated to households in a lump-sum fashion. Does there exist a value
of τ that implements the flexible wage allocation? If so, what is the value of τ .

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