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The Global Economy II

Nova SBE – Fall 2018
Miguel Lebre de Freitas, Sharmin Sazedj
Exam 10/12/2018 – Duration: 2h00

I (4.5)

Define three of the following concepts (3-5 lines each):

i. Carry trade

ii. Fix Line

iii. Self-fulfilling currency crisis

iv. Original sin

v. Forward exchange rate

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IV (2.5)
In each question, choose one (correct answer: +0.5; wrong answer: -0.125):
a. The exchange rate overshooting occurs with: (i) a temporary monetary shock when prices are
flexible; (ii) a temporary monetary shock under sticky prices; (iii) a permanent monetary
shock under sticky prices; (iv) a permanent monetary shock when prices are flexible.
b. When the price elasticities of imports and of exports are both equal to zero: (i) a real exchange
rate depreciation has no impact on the trade balance; (ii) a permanent fiscal expansion causes
the real exchange rate to appreciate in the log run; (iii) the Marshal Lerner does not hold; (iv)
all the above.
c. Under flexible exchange rates, the log run impact of a permanent increase in government
expenditures will be: (i) an output expansion; (ii) a nominal exchange rate appreciation (iii)
an increase in the price level; (iv) all the above.
d. The advantage of a pure floating regime as compared to a fixed exchange rate is that: (i) it
avoids large swings in competitiveness; (ii) it delivers higher effectiveness of fiscal policy;
(iii) the money supply is better isolated from monetary shocks abroad; (iv) none of the above.
e. Joining a monetary union is less costly when: (i) output shocks are mostly asymmetrical; (ii)
prices and nominal wages are flexible; (iii) labor is immobile across borders; (iv) none of the
above.

III (3.0)
In each question, choose one (correct answer: +1.0; wrong answer: -0.25):
Suppose that a risk-neutral market participant expects the euro-pound exchange rate to reach 1.05 in
1-year time, and that the spot exchange rate of euros per pound is 1.1. The annual domestic and
foreign interest rates in 1-yr deposits are i=5% and i*=7.5%.

a) Imagine this market participant needs 550 euros to be available in the UK in 1-year time. The
money is available now. Which option is true?

(i) He is indifferent between transferring the money in 12 months and transferring it today; (ii) He
prefers to transfer in 12 months to get an expected relative gain of 12.5 pounds; (iii) He prefers to
transfer in 12 months to get an expected relative gain of 12.5 euros; (iv) None of the above

b) Suppose instead that he needs the money to be available in the UK today. What should he do?

(i) Transfer the money today; (ii) Keep the money in euros and borrow in the UK if the annual
foreign interest in 12-month loans is 9%; (iii) Keep the money in euros and borrow in the UK if
the annual foreign interest in 12-month loans is below 12.5%; (iv) none of the above.

c) Assume that the euro-pound exchange rate is E€/£=1.025-1.075 (euros per pound). How much
should a bank in Portugal set the euro per pound ask 1-yr forward rate?
(i) 1.05; (ii) 1; (iii) 1.03 (iv) none of the above.

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Group II (10 points)

Consider an open economy with sticky prices and floating exchange rate. In this economy,
money supply is equal to M=1250, money demand is given by m D  Y 20i , and full employment
output is Y f  100 . The interest rate parity holds instantaneously, and the foreign interest rate is
equal to i*=5%. The goods market equilibrium is described by Y=2(A+TB), where A=50 and
TB=12.5(E/P-1.92).
a) Assume that the economy is initially at full employment and no policy changes are
expected. Find out: (a1) the price level; (a2) the expressions of the DD and (a3) AA curves;
and the (a4) trade balance.

Now consider a temporary fall in government spending, such that A=49.

b) Without calculations, describe what happens to: (b1) the exchange rate; (b2) the
equilibrium level of income; (b3) the interest rate; (b4) the trade balance. (b5) Explain,
referring to the AA-DD diagram, how real income was impacted, as well as the short-term
dynamics of the exchange rate.

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c) Discuss, using the AA-DD schedule and quantifying, the effectiveness of a temporary move
in monetary policy to restore internal balance. Would the economy meet the external
balance?

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Now consider that the central bank wants to keep the exchange rate fixed at the level found
in a) and that there is a permanent fall in government spending, such that A=49.

d) Describe the implied short-term equilibrium, namely: d1) the new DD curve; d2) the output
level; d3) the money supply; d4) the AA curve and d5) the trade balance. d6) Represent the
adjustment in the AA-DD diagram and d7) explain the central bank intervention to keep the
exchange rate fixed.

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Answer to only one of the following two questions.

e) Describe the adjustment of the economy to the long-run equilibrium, computing: e1) the
price level; e2) the DD curve; e3) the money supply; e4) the AA curve. e5) Represent the
adjustment in the AA-DD diagram and e6) explain how the economy reached full
employment output.
f) Departing from d), could the authorities drive the economy immediately to full employment
through a devaluation? Compute the: f1) new exchange rate; f2) the money supply; f3) the
AA curve. Represent the adjustment in the f4) AA-DD diagram and in the f5) foreign
exchange market. f6) Explain how the economy reached full employment output.

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