ECON 122 INTERNATIONAL FINANCE PROF.

ARIEL BURSTEIN Department of Economics, UCLA, 2013, Winter Quarter Practice longer questions

Question 1
Suppose that consumption is given by C = 2 + 0.75Y , investment is given by I = 2, the current account is given by T B = (1 1/E ) 0.25Y and government expenditures are given by G. Assume that taxes are zero, T = 0. Suppose that the expected exchange rate is E e = 1, and that the foreign interest rate is e E 1 , can be simplied to R = 0.1 + E 1. R = 0.1. Hence, the UIP condition, R = R + E E M Money demand is given by P = 10Y (1 R). We will focus on the short run with P = 1. So the money market equilibrium condition is M s = 10Y (1 R). a. Derive an equation for the aggregate demand for goods, D = C (Y )+ I + G + CA(Y, E ), as a function of Y , E , and G. b. Derive an expression for the DD schedule (an equation with combinations of Y ,E such that goods market equilibrium is satised), for a given value of G c. Derive an expression for the AA schedule (an equation with combinations of Y ,E such that money market equilibrium and UIP are satised). 1. Suppose that R = 0.1 and G = 1. Calculate the equilibrium levels of Y and E , as well as the level of M s consistent with this interest rate level d. Suppose that G increases from 1 to 2 and that the country mantains a xed exchange rate E = 1. What are the new equilibrium levels of Y and R? What is the level of money supply M s that must be chosen consistent with the xed exchange rate E = 1? e. Describe qualitatively (using either a gure or intuition a numerical solution is not required) how, under a oating exchange rate, changes in the money supply M s could be used to stabilize output Y at the level prior to the change in G. Solution: a. Aggregate demand for goods is D = C + I + G + CA = 2 + 0.75Y + 2 + G + (1 1/E ) 0.25Y 1 = 5 + 0.5Y + G E

b. The DD schedule satises the equation Y = 5 + 0.5Y + G or Y = 10 + 2G 2 E 1 E

c. Inserting the UIP condition into the money market equilibrium condition, the AA schedule is given by M s = 10Y (1 R) = 10Y = 10Y 1 0.1 1.9 1 E
2 E

1 +1 E

1. With R = 0.1 and G = 1, from UIP we have E = 1. Hence, Y = 10 + 2G The money supply is M s = 10 Y (1 R) = 10 10 0.9 = 90. d. With E = E e = 1, we have R = R = 0.1. Hence, Y = 10 + 2 2 money supply must increase to M s = 10 12 0.9 = 108.
2 E

= 10.

= 12. The

e. Under a oating exchange rate, a reduction in money supply shifts the AA curve to the left. This contractionary monetary policy appreciate the exchange rate, and hence reduces the increase in output resulting from the rise in G. Note that, under a xed exchange rate, the endogenous rise in Ms exacerbates the rise in Y in response to the rise in G.

Question 2
Suppose that the approximated UIP condition is given by: Uncovered Interest Parity: R = R + Ee E + E

Here, is a risk premium demanded by investors to hold the domestic bond. That is, if e E to be indierent between > 0, then investors require a return higher than R + E E holding the domestic and foreign bond. Suppose a country is under a credible xed -exchange-rate regime. Suppose there is a temporary decrease in (i.e.: domestic bonds become less risky). What are the short-run implications of this shock on output Y , the interest rate R, the nominal exchange rate E , the money supply Ms ? Next, redo this question assuming that the country is under a exible exchange rate in which Ms is xed. Solution:

 Fixed: This is equivalent to a decrease in R under a xed exchange rate regime (i.e. E e = E xed exchange rate regime, and R is constant, so a decrease in is equivalent to a decrease in R ). Under a xed exchange rate, E is xed, and so is P in the short run and the real exchange rate. So from the goods market equilibrium condition Y is constant. R falls one to one with , which increases money demand. Money supply must rise to satisfy this higher money demand. Float: The reduction in , with a xed E e , reduces E for a xed level of R (see UIP condition). That is, the AA schedule shifts down for any given Y . The DD schedule remains unchanged. Hence, in the short run the exchange appreciates (E falls), output falls, and the interest R falls. Given that consumption falls by less than the decline in Y , the current account must fall as well.

Question 3
Explain using the model studied in class why a currency union (i.e.: a set of countries adopting a common currency and thus xing their exchange rates) will be more eective in terms of stabilizing output of the member countries, if the shocks that hit the aggregate demand for goods in these countries (such as changes in G, as in Question 1) are positively correlated (i.e. shocks are symmetric across countries). To answer this question, consider the desired response of monetary policy to stabilize output. Solution: A big downside to xed exchange rates is that it frustrates a central banks ability to deal with aggregate demand shocks using monetary policy. That is, the response of output to negative shocks to aggregate demand is magnied because M s has to fall precisely when the economy is hit by a negative aggregate demand shock (in order to keep E constant). You could get around this, to the extent that you can arrange suitable coordinated monetary policy with your partner countries in the xed exchange rate system. That is, depreciating the common exchange rate whenever a country faces a negative demand shock will mitigate the negative impact of the shock on output. This will be more likely to happen if aggregate demand shocks are positively correlated within countries under the xed exchange rate regime. Then, when all countries are hit by a common negative demand shock, they will want to implement an expansionary monetary policy (hat devalues the common exchange rate) and stabilizes output. Suppose demand shocks were negatively correlated across countries. Then a country that receives a positive demand shock will want to revaluate the currency in order to stabilize output, and the country that receives a negative demand shock will want to devalue the currency. So, in this case it will be dicult to coordinate monetary policy because countries will have dierent preferences in terms of the change in the exchange rate that stabilizes output.