International Finance

CAS EC 392 Problem Set 2

February 28, 2014


1. Suppose the Fed increases the money supply and markets believe that the increase is
temporary. Assume that prices are sticky in the short run. What will be the short run
effect on US interest rates, US prices, UK interest rates, and the dollar price of a pound
(E
$
)? Use well labeled diagrams of the US money market and foreign exchange
market to explain your answer. [10 points]

2. Feenstra & Taylor, Ch 4, Q 2. [15 points]

3. Feenstra & Taylor, Ch 4, Q 3. [5 points]

4. Feenstra & Taylor, Ch 4, Q 6. [15 points]

5. Use well labeled diagrams money market, FX market, Keynesian cross, IS-LM) and
words to explain what happens to interest rates, aggregate demand and its components
(C, I, G, and X
n
), output, and the nominal exchange rate in the short run when prices are
sticky when there is an [15 points]
a. Increase in government spending
b. Temporary increase in the money supply that markets expect to be reversed.
c. When both the money supply and government spending rise temporarily.
d. In the long run if the money supply increase is permanent and prices are not sticky.

6. What are the advantages of fixed vs flexible exchange rates? [10 points]

7. Suppose the US Fed temporarily increases the US money supply. [10 points]
a. What will happen to the spot rate and to aggregate demand and its components in
Mexico? Treat Mexico as the domestic country. Assume that its does not restrict
capital flows and that it was at full employment before the Fed acted. Use diagrams
and words.

b. What policy responses should Mexico consider to offset any undesirable effects?

c. Suppose the Bank of Mexico increases the Mexican money supply instead of the US
Fed. What effect would that have on the spot rate and on US aggregate demand?

8. Intervention [10 points]
a. What is the difference between sterilized and unsterilized intervention? Explain what a
central bank would do to keep its currency from depreciating, using each of these two
kinds of intervention.
b. Write and explain an equation that must be true for sterilized intervention to work.
c. What is the evidence for whether unsterilized and sterilized intervention work?

9. What is a J curve? Draw a diagram to explain it. [5 points]

10. What is the Marshall-Lerner condition? Explain its significance. [5 points]