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Economics 103 Spring 2004

International Monetary Relations

Second Midterm Exam

May 18, 2004

Time:
Total score:

80 minutes
80 points

Exchange Rate Pegging and Monetary Policy Transmission: 10 minutes

Hong Kong fixes the Hong Kong Dollar, its currency, to the US Dollar. If the price level in
the US rises slowly because of slow monetary growth in the US, explain how the monetary
authorities in Hong Kong have to respond (in the absence of any other government intervention). For your argument, use the Uncovered Interest Parity Condition and an appropriate
condition linking interest rates and inflation rates.

Open Economy Trilemma: 10 minutes

The Open-Economy Trilemma relates three macroeconomic objectives to each other. State
the three objectives. The objectives are only pairwise achievable. Provide examples of three
regimes from world monetary history and state which objective the regime sacrificed in order
to achieve the other two.

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Economic Stimulation and the Current Account: 10

minutes

The recent downturn in the US economy was accompanied by a reduction in the current
account balance (a widening current account deficit). Under a pure short-term view of the
economy, what effect did likely dominate: An autonomous shortfall in investment I (due
to gloomier business investment prospects) or an autonomous increase in money demand L
(due to gloomier portfolio investment prospects)? Use an AA-DD diagram to substantiate
your answer.
Both fiscal and monetary authorities share a concern about the sluggish US economy and
consider policies to spur the economys return to its long-term output level. As the recession
sets in, would you recommend a fiscal or a monetary intervention if you wish to raise the
current account balance simultaneously? Add an XX-schedule to your AA-DD diagram to
substantiate your answer.

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Price Shocks and the Current Account: 10 minutes

State the definition of the real exchange rate in terms of the nominal exchange rate and
price levels.
Use an AA-DD-XX diagram to analyze how price changes in petroleum, an important
traded commodity, affect the nominal exchange rate and the current account. A shortfall
in the international supply of petroleum may increase the domestic price level P more
in economies that heavily rely on petroleum, such as the US economy, than P rises in
economies that are less dependent on oil.
How will the nominal exchange rate and the current account respond under this scenario?
To simplify the analysis, suppose that the central bank does not respond to the oil price
shock.

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Defense of an Exchange Rate Peg: 10 minutes

Under a fixed exchange rate, monetary authorities have to stand ready to defend the peg.
Use a joint money market and foreign exchange market diagram to analyze the following case
for a defense: The economy undergoes an output boom, but investors expect the exchange
rate to remain constant. What does the Central Bank have to do in order to defend the
peg and fulfill the investors expectations? If assets are perfect substitutes, does the Central
Bank have to intervene using foreign reserves?

Imperfect Asset Substitutability: 10 minutes

Write down the Adjusted Uncovered Interest Parity condition when assets are imperfect
substitutes. The central bank wants to pursue a monetary expansion to reduce the domestic
nominal interest rate, while keeping the exchange rate at a given level. Use a diagram
showing the domestic money market and the foreign exchange market to document that
such a policy is feasible. [You may ignore commodity market responses.]

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The Rules of the Game: 10 minutes

Argentina in 1900, a country on the gold standard, undergoes an investment boom.

Analyze the automatic economic responses under the price-specie-flow mechanism. How
does Argentinas current account balance respond? Will this response trigger gold inflows
to or outflows from Argentina? How will the price level P in Argentina respond? What does
this response mean for the the DD schedule? Use an AA-DD-XX diagram to substantiate
your answers. [You may ignore the AA schedule, its response depends on whether the central
bank monetizes or demonetizes the gold flows.]
Argentinas central bank plays by the rules of the game and preempts the price-specieflow mechanism. What monetary policy does Argentina pursue? Under fully flexible prices,
what effect does the central bank have on the AA curve? Under fully flexible prices, what
effect does the central bank have on the DD schedule?

Facts and Fallacies: 10 minutes

State whether the following statements are true or false. Provide a brief explanation.
A permanent monetary expansion leads to a lower nominal interest rate in the shortrun but not in the long-run.
Monetary authorities can only accumulate foreign exchange reserves if their countries
run current account surpluses.