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EXAM COVER SHEET


EXAM DETAILS
Course Code: ECON1085
Course Description: International Monetary Economics
Exam Date
Exam Start time: Exam Duration: 2 hours + 15 min reading time
Total number of pages (incl. this cover sheet) 10 pages + MCQ answer sheet
ALLOWABLE MATERIALS AND INSTRUCTIONS TO CANDIDATES
Students must not write, mark in any way any exam materials, read any other text other than
1.
the exam paper or do any calculations during reading time

2. This is a CLOSED BOOK EXAM

Commence each question on a new page. Carry out the instructions on the front cover of this
3.
paper
Complete all student and course information on the Multiple Choice Answer Sheet. You must
4. write your student number in the spaces provided AND fill in the corresponding bubbles
(omitting any letters)
All multiple choice responses MUST be recorded on the Multiple Choice Answer Sheet. DO
5.
NOT record these answers in the exam script book.

6. Calculators ALLOWED (if non-programmable)

7. Dictionaries NOT ALLOWED

This exam contains Two sections A& B. Attempt ALL questions in Section A and any three of
8.
five questions in Section B
This exam paper adds to 100 marks and comprises 50% of the total marks allocated in this
9. course. To obtain a pass in this course, you must achieve at least 50 % overall in course
assessment
All mobile phones must be switched off and placed INSIDE your bag. You are in breach of
10.
exam conditions if it is on your person (i.e. pocket)

11. NOTE: This EXAM paper CANNOT be RETAINED by the student

ECON1085, (SIM), Semester 1, 2016 Page 1 of 11


SECTION A
MULTIPLE CHOICE QUESTIONS
REQUIRED: COMPLETE ALL 25 QUESTIONS - EACH QUESTION = 1 MARK

QUESTION 1
A current account surplus
(a) Corresponds to an exactly equal accumulation of net financial assets by domestic residents
on the rest of the world.
(b) Corresponds to an exactly equal accumulation of net financial liabilities to the rest of the
world.
(c) Has no implications for a countrys wealth.
(d) Increases the countrys net debt to the rest of the world.

QUESTION 2
A nations current account balance can be expressed
(a) As a nations export receipts and income received from abroad minus import expenditure and
income paid to foreign residents
(b) As the difference between national savings and investment
(c) In terms of inter-temporal trade
(d) All of the above

QUESTION 3
If the sum of the financial account and current account is less than zero, there will be
(a) A reduction in international reserves under a flexible exchange rate regime
(b) A reduction in international reserves under a fixed exchange rate regime.
(c) An increase in international reserves under a fixed exchange rate regime.
(d) None of the above.

QUESTION 4
If a New Zealand company purchases a factory in Vietnam it will be reflected in the New Zealand
balance of payments as
a A credit in the current account and a debit in the financial account.
b A credit in the current account and a credit in the financial account.
c A debit in the financial account and a credit in the financial account.
d A debit in the current account and a credit in the financial account.

QUESTION 5
Which of the following statements is incorrect?
a The level of net foreign debt is determined by the current account of the Balance of Payments.
b A debit item on the financial account may be counterbalanced by a credit item on the same
account.
c If a current account deficit is financed by the Central Bank the economys net foreign assets
remain unchanged.
d None of the above.

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QUESTION 6
In the context of an inter-temporal model, let rA be the closed economy real interest rate of a large
country A, rB be the closed economy real interest rate of a large country B and rW be the common
real interest rate when these two countries are open to each other. If rA < rW < rB , then:
a A will import current consumption and B will export future consumption
b A will export current consumption and B will export future consumption
c A will import current consumption and B will import future consumption
d A will import future consumption and B will export current consumption

QUESTION 7
Assuming an economy is initially experiencing internal balance, a reduction in the real exchange
rate will
a Result in an excess supply of non-tradeables
b Result in an excess demand for non-tradeables
c Result in a balance of trade deficit
d Result in a balance of trade surplus

QUESTION 8
Assuming covered interest parity holds, if i = 8%, i* = 10%, e= 1.7, what does the forward exchange
rate equal?
(a) 1.67
(b) 1.32
(c) 1.18
(d) 1.78

QUESTION 9
Assuming a closed economy, where I= 35-4r and S= r+25, then the cost of one unit of current
consumption in country A equals ___ units of future consumption.
a 0.98
b 1.3
c 1.02
d 1.20

QUESTION 10
Assuming uncovered interest parity holds, if the e = 2.45, i = 6% and i* = 8%, then the expected
spot exchange rate equals
(a) 2.20
(b) 2.40
(c) 2.62
(d) 2.88

QUESTION 11
Assuming covered interest parity holds, if i = 5%, i * = 7%, f = 2.40, then the current spot exchange
rate equals
a 3.55
b 2.40
c 2.70
d 2.45

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QUESTION 12
The forward rate and the expected spot exchange rate
a Must be equal for covered interest parity to hold.
b Must be equal for the international fisher relationship to hold.
c Must be equal for covered interest parity and uncovered interest parity to hold.
d None of the above

QUESTION 13
Relative purchasing power parity asserts
a That the country that has the higher expected rate of inflation will have the currency that is expected
to increase in value.
b That the country that has the higher expected rate of inflation will have a forward rate that equals
the expected spot rate.
c That the country that has the higher expected rate of inflation will have the currency that is expected
to fall in value.
d That a basket of goods will have the same cost in different countries if stated in terms of the same
currency

QUESTION 14
Which of the following is true for the J-curve effect? It:
a Suggests that following an increase in the exchange rate a countrys trade balance will
deteriorate before it improves.
b Suggests that following an increase in the exchange rate a countrys trade balance will
improve before it deteriorates.
c Applies to the interest rate effect of a change in the exchange rate.
d Applies to the income effect of a change in the exchange rate.

QUESTION 15
According to the international fisher relationship the economy that has the higher expected rate of
inflation will
a Have the higher real rate of interest.
b Have a lower real rate of interest.
c Have the higher nominal rate of interest.
d Have the lower nominal rate of interest.

QUESTION 16
According to the Dornbusch model, following an increase in the rate of growth of the domestic
money supply,
(a) The short run response of the exchange rate will be greater than its long run response.
(b) The domestic price level will immediately increase.
(c) Domestic nominal interest rates will increase in the short run to ensure money market
equilibrium is restored.
(d) Domestic nominal interest rates will fall in the long run.

QUESTION 17
According to the monetary approach, an increase in domestic output will lead to in the long-run:
a A lower real money demand, a higher price level, and a proportional depreciation of the
domestic currency.
b A higher real money demand, a lower price level, and a proportional appreciation of the
domestic currency.
c A higher real money demand, an unchanged price level and an unchanged value of
domestic currency.
d None of the above

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QUESTION 18
Suppose expected inflation is 5% in Australia and 3% in Singapore. If interest rates in Singapore are
4% then the interest rate in Australia must be ____% .if expected inflation in Australia increases to
6% then the Australian interest rate would have to be ____ for the Fisher effect to hold.
(a) 4% : 6%
(b) 5% : 6%
(c) 6% : 7%.
(d) 7% : 6%.

QUESTION 19
If the value of a countrys currency decreases and the foreign currency price of its imports
decreases, it must mean
a The country is a price taker.
b Its demand curve for imports is positively sloped.
c It faces a horizontal supply curve of imports.
d None of the above.

QUESTION 20
Which of the following statements is correct?
a A country cannot be a large country in both its export and import markets.
b If a country is a large country in the export market, the effect on the foreign currency value of
export receipts as a result of an exchange rate change is uncertain.
c The flatter the demand curve for exports, the greater the degree of market power the
domestic economy has in the export market.
d Both (b) and (c) are correct statements.

QUESTION 21
The absorption approach
a Ignores the effect of a change in income on the trade balance
b Incorporates the financial account.
c Ignores both the financial account and the effect of a change in income on the trade balance.
d None of the above.

QUESTION 22
According to the basic absorption approach, a reduction in the value of the domestic currency
a Will improve the trade balance through a decrease in income and output if the economy is
above full employment.
b Will improve the trade balance through an increase in income and output if the economy is
above full employment.
c May improve the trade balance through a reduction in absorption
d May improve the trade balance through an increase in absorption.

QUESTION 23
Under the Australian model (Swan model), changes to government spending should be the policy
weapon used
a For the objective which has the flattest balance schedule
b For the objective which has the steepest balance schedule
c To achieve internal balance
d To achieve external balance

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QUESTION 24
An increase in the real exchange rate will
(a) Decrease the relative price of tradable goods
(b) Increase the relative price of non-tradable goods.
(c) Increase the production of tradables and reduce the consumption of tradables
(d) Increase the production of non-tradables and reduce the consumption of non-tradables.

QUESTION 25
Which of the following statements are correct?
(a) In response to an excess demand for non-traded goods, producers of these goods would be
expected to increase prices, which will increase the real exchange rate.
(b) An excess demand for tradable goods will reduce the nominal exchange rate under a flexible
exchange rate regime.
(c) An excess demand for tradables will increase international reserves under a fixed exchange
rate, resulting in an increase in the money supply and an expansionary effect on absorption.
(d) None of the above

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SECTION B
STUDENTS ARE REQUIRED TO COMPLETE ANY THREE OF THE FOLLOWING FIVE
QUESTIONS

QUESTION ONE
(a) Assume that Singapore is currently achieving internal balance, but experiencing a trade
deficit. Also assume that Singapore faces a relatively elastic IB schedule and a relatively
inelastic EB schedule. Explain how and why an attempt to restore external balance will disrupt
internal balance and how internal balance would be restored.
(10 marks)

(b) Assume that China is currently achieving internal balance, but experiencing a trade surplus.
Also assume that China faces a relatively elastic IB schedule and a relative inelastic EB
schedule. Explain how and why an attempt to restore external balance will disrupt internal
balance and how internal balance would be restored.
(10 marks)

(c) What automatic mechanisms of adjustment might eliminate an excess demand for non
tradeables?
(5 marks)
(10 + 10 + 5 = 25 Marks)

QUESTION TWO
(a) With reference to the IS-LM-BP analysis of a small economy, answer the following questions
and provide the required explanation
(i) Assuming zero capital mobility, examine the effect that an increase in the level of
government expenditure has for the domestic economy. Consider both the case of a
fixed and flexible exchange rate.
(10 marks)

(ii) Assuming perfect capital mobility examine the effect that an increase in the money
supply has for the domestic economy. Consider both the case of a fixed and flexible
exchange rate
(10 marks)

(b) Consider two countries with perfect capital mobility and flexible exchange rates. Making use
of appropriate diagrams, and assuming the domestic economy is large, examine the effect of
an expansionary domestic fiscal policy on both the domestic and foreign economy.

(5 marks)
(10 + 10 + 5 = 25 Marks)

QUESTION THREE
(a) With reference to the IS-LM-BP analysis of a small economy, answer the following questions
and provide the required explanation
(i) Assuming perfect capital mobility, examine the effect that an increase in the level of
government expenditure has for the domestic economy. Consider both the case of a
fixed and flexible exchange rate.
(10 marks)

ii) Assuming zero capital mobility examine the effect that an increase in the money supply
has for the domestic economy. Consider both the case of a fixed and flexible exchange
rate.
(10 marks)

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(b) Consider two countries with perfect capital mobility and flexible exchange rates. Making use of
appropriate diagrams, and assuming the domestic economy is large, examine the effect of an
expansionary domestic monetary policy on both the domestic and foreign economy.
(5 marks)
(10 + 10 + 5 = 25 Marks)

QUESTION FOUR
(a) Critically comment on the following statement.
the advantages of fixed exchange rate regimes increase with the degree of economic
integration while the advantages of flexible exchange rate regimes diminish.
(10marks)

(b) Why could a system of flexible exchange rates be inflationary?

(7 marks)

(c) Critically comment on the following statement.


Second generation crisis models can explain a sharp fall in the exchange value of the
domestic currency even when economic policies are sound.
(8 marks)
(10 + 7 + 8 = 25 marks)

QUESTION FIVE
Financial crises can stem from problems of private or public sectors balance sheets and have
domestic or external origins. Irrespective of its origins, a financial crisis is often an amalgam of
events, including substantial changes in credit volume and asset prices, severe disruptions in
financial intermediation, notably a reduction in the supply of external financing, large-scale balance-
sheet problems, and often a need for substantial government and international support

Reflecting on your learning in this course, in particular the theory of optimum currency areas and
currency crises, critically assess the statement above.
In your answer consider an example / examples of an economy or region that has experienced a
currency crisis.
(25 Marks)

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SUGGESTED ANSWERS TO QUESTION FIVE
Definition of Financial Crisis
A financial crisis for example the Euro Crisis is one that has made it difficult or
impossible for some countries in the euro area to repay or re-finance their government
debt without the assistance of third parties.
Causes of Financial Crisis
Rising household and government debt levels
The adoption of the euro led to many Eurozone countries of different credit
worthiness receiving similar and very low interest rates for their bonds and
private credits during years preceding the crisis, with implicit guarantee by the
stronger euro nations such as Germany. As a result, creditors in countries with
originally weak currencies (and higher interest rates) suddenly enjoyed much
more favourable credit terms, which spurred private and government spending
and led to an economic boom. In some countries such as Ireland and Spain, low
interest rates also led to a housing bubble, which burst at the height of the
financial crisis. Trade imbalances.
During the Global Credit Crunch in 2008-09, governments had to provide large
bailout packages. As a result, the average government debt rose from 66% to
84% of GDP. With the exception of Greece, it was not excessive social welfare
spending that was the cause of the crisis. It was indeed excessive lending by
banks, not deficit spending that created this crisis. Government's mounting debts
are a response to the economic downturn as spending rises and tax revenues
fall, not its cause.
Trade Imbalances
Some have attributed the root cause of the crisis as growing trade imbalances.
From 1999 to 2007, these countries (Portugal, Ireland, Italy and Spain) had
balance of payments deficit positions. In any trade deficit by definition requires a
corresponding inflow of capital to fund it, which can drive down interest rates and
stimulate the creation of bubbles: "For a while, the inrush of capital created the
illusion of wealth in these countries: asset prices were rising, currencies were
strong, and everything looked fine. But bubbles always burst sooner or later, and
yesterdays miracle economies have become todays basket cases, nations
whose assets have evaporated but whose debts remain all too real."
A trade deficit can also be affected by changes in relative labour costs, which
made southern nations less competitive and increased trade imbalances. Since
2001, most EU nations had increases in labour costs greater than Germany's.
Those nations that allowed "wages to grow faster than productivity" lost
competitiveness.
The euro locks countries into an exchange rate amounting to very big bet that
their economies would converge in productivity. If not, workers would move to
countries with greater productivity. Instead the opposite happened: the gap
between German and Greek productivity increased, resulting in a large current
account surplus financed by capital flows. The capital flows could have been
invested to increase productivity in the peripheral nations. Instead capital flows
were squandered in consumption and consumptive investments.
Further, Eurozone countries with sustained trade surpluses (i.e., Germany) do
not see their currency appreciate relative to the other Eurozone nations due to a
common currency, keeping their exports artificially cheap. Germany's trade
surplus within the Eurozone declined in 2011 as its trading partners were less
able to find financing necessary to fund their trade deficits, but Germany's trade

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surplus outside the Eurozone has soared as the euro declined in value relative to
the dollar and other currencies.
Structural problem of Eurozone system
A Eurozone system is a monetary union (common currency) without a fiscal
union (e.g., common taxation, pension, and treasury functions). In the Eurozone
system, the countries are required to follow a similar fiscal path, but they do not
have common treasury to enforce it. That is, countries with the same monetary
system have freedom in fiscal policies in taxation and expenditure. So, even
though there are some agreements on monetary policy and through the
European Central Bank, countries may not be able to or would simply choose not
to follow it. This feature brought fiscal free riding of peripheral economies,
especially represented by Greece, as it is hard to control and regulate national
financial institutions. Furthermore, there is also a problem that the Eurozone
system has a difficult structure for quick response. Eurozone, having 18 nations
as its members, require unanimous agreement for a decision making process.
This would lead to failure in complete prevention of contagion of other areas, as
it would be hard for the Eurozone to respond quickly to the problem.
In addition, as of June 2012 there was no "banking union" meaning that there
was no Europe-wide approach to bank deposit insurance, bank oversight, or a
joint means of recapitalisation or resolution (wind-down) of failing banks. Bank
deposit insurance helps avoid bank runs. Recapitalisation refers to injecting
money into banks so that they can meet their immediate obligations and resume
lending.]
In Europe, hyper connectedness both exposed just how uncompetitive some of
their economies were, but also how interdependent they had become. When
countries with such different cultures become this interconnected and
interdependent when they share the same currency but not the same work
ethics, retirement ages or budget discipline you end up with German savers
seething at Greek workers, and vice versa.
Monetary policy inflexibility
Membership in the Eurozone established a single monetary policy, preventing
individual member states from acting independently. In particular, they cannot
create Euros in order to pay creditors and eliminate their risk of default. Since
they share the same currency as their (Eurozone) trading partners, they cannot
devalue their currency to make their exports cheaper, which in principle would
lead to an improved balance of trade, increased GDP and higher tax revenues in
nominal terms.
In the reverse direction moreover, assets held in a currency which has devalued
suffer losses on the part of those holding them. For example, by the end of 2011,
following a 25% fall in the rate of exchange and 5 % rise in inflation, Eurozone
investors in Pound Sterling, locked into euro exchange rates, had suffered an
approximate 30% cut in the repayment value of this debt.
Loss of confidence
Prior to the development of the crisis, it was assumed by both regulators and
banks that sovereign debt from the Eurozone was safe. Banks had substantial
holdings of bonds from weaker economies such as Greece which offered a small
premium and seemingly were equally sound. As the crisis developed, it became
obvious that Greek, and possibly other countries', bonds offered substantially
more risk. Contributing to lack of information about the risk of European
sovereign debt was conflict of interest by banks that were earning substantial
sums underwriting the bonds. The loss of confidence is marked by rising

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sovereign credit default swaps prices, indicating market expectations about
countries' creditworthiness.
Furthermore, investors have doubts about the possibilities of policy makers to
quickly contain the crisis. Since countries that use the euro as their currency
have fewer monetary policy choices (e.g., they cannot print money in their own
currencies to pay debt holders), certain solutions require multi-national
cooperation. Further, the European Central Bank has an inflation control
mandate but not an employment mandate, as opposed to the U.S. Federal
Reserve, which has a dual mandate.
Heavy bank withdrawals have occurred in weaker Eurozone states such as
Greece and Spain. Bank deposits in the Eurozone are insured, but by agencies
of each member government. If banks fail, it is unlikely the government will be
able to fully and promptly honour their commitment, at least not in euros, and
there is the possibility that they might abandon the euro and revert to a national
currency; thus, euro deposits are safer in Dutch, German, or Austrian banks than
they are in Greece or Spain.
Conclusion
The statement actually summed up what causes the Euro crisis. As explained in
the preceding paragraphs, a financial crisis is indeed an amalgam of events both
internal and external. These was due to "systemic stresses from five interrelated
factors: 1) Tightening credit conditions across the Eurozone; 2) Markedly higher risk
premiums on a growing number of Eurozone sovereigns including some that are
currently rated 'AAA'; 3) Continuing disagreements among European policy makers on
how to tackle the immediate market confidence crisis and, longer term, how to ensure
greater economic, financial, and fiscal convergence among Eurozone members; 4)
High levels of government and household indebtedness across a large area of the
Eurozone; and 5) The rising risk of economic recession in the Eurozone as a whole in
2012.

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