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Electrical Engineering

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Apr 3, 2024

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Name and BUID: Answer all questions in your blue books, including the multiple choice questions. Turn in this exam sheet with your blue book. Exam answers will be posted on blackboard after grading is complete. (1 + i $ ) = F E (1 + i £ ) i $ ≈ F − E E + i £ (1 + i $ ) = E e E (1 + i £ ) i $ ≈ E e E − E + i £ P US = EP UK ∆ P US P US = ∆ E E + ∆ P UK P UK Figure 1: Figure for asset approach problem

Multiple Choice: 45 points total There are 15 MC questions worth 3 points each for a total of 45 points for the MC section. Write the answers to the MC questions in your blue book. 1. The equation E $ /pound = 2 means that: A. 1 dollar buys 1 2 a pound. B. 1 dollar buys 2 pounds. C. 2 pounds buy 1 dollar. D. 1 dollar buys 1 pound. 2. There is an opportunity for covered interest arbitrage if: A. the domestic interest rate is low relative to the foreign interest rate and the exchange rate is high B. the expected future spot rate is the same as the current spot rate and the interest rates on the two currencies are different from each other C. the forward/spot rate percent difference is larger than the difference in the interest rates on two currencies. D. the domestic interest rate is high relative to the foreign interest rate and the exchange rate is low. 3. The total economic activity in a nation is an important measure. Economists use three approaches to measure key indicators. Which is a method that economists do NOT use to measure economic activity? A. the income approach, measuring income received by factors of production B. the expenditure approach, using the idea that the total economic activity is equal to the combined purchases of the various sectors C. the product approach, which measures GDP from a production standpoint D. the accounting approach, using the idea that total private sales have to equal total private production 4. Adding the value of net transfers from abroad to gross national income (GNI) yields A. gross national disposable income (GNDI) B. gross national expenditure (GNE) C. gross national product (GDP) D. current account (CA) 5. The difference between a spot contract and a forward contract is that: A. the former is a flexible price on the currency, and the latter is a fixed price. B. the former is a derivative, and the latter is not a derivative. C. the former is a contract to be settled immediately, and the latter is a contract to be settled at a future agreed-upon date. D. the former has a fixed price but the contract can be settled at a later date, and the latter is a contract to be settled immediately. 6. In rapidly growing countries in Asia, the presence of large current account surpluses is the result of A. savings rates being less than investment rates B. money growth being less than investment rates C. savings rates being greater than investment rates Page 2

D. money growth being greater than investment rates 7. The US dollar represents one side of over 80% of foreign exchange trades; a small number of other cur- rencies of major industrialized countries account for the majority of remaining trades. These currencies are collectively referred to A. Trading currencies B. Invoicing currencies C. Vehicle currencies D. Dominant currencies 8. An increase in which of the following will cause a decrease in external wealth? A. The financial account B. The capital account C. The current account D. Capital gains on external wealth 9. Since 1990, which of the following has been true of the U.S. current account (CA) and financial account (FA)? A. Both have been positive entries in U.S. balance of payments (BOP) statistics. B. The CA has been a positive entry, and the FA has been a negative entry. C. The CA has been a negative entry, and the FA has been a positive entry. D. Both have been negative entries in BOP statistics. 10. The most common exchange rate arrangement in the world today (used by the most countries) is: A. a floating exchange rate B. a preannounced crawling peg C. a managed exchange rate within a preannounced band D. a fixed exchange rate 11. If the prices of goods in Europe increase while the nominal exchange rate between the euro and the U.S. dollar remains the same, we say that the U.S. dollar has experienced a: A. real depreciation B. real appreciation C. nominal depreciation D. nominal appreciation 12. Empirical evidence suggests that convergence to PPP for non-hyperinflationary countries occurs: A. Very rapidly because of rapid response of asset markets B. Rapidly but not instantly, with convergence occuring in a month or two, because sellers of goods change their prices about that often C. Fairly slowly, with convergence taking a few years, as prices and production and exchange rates adjust and goods are relocated to higher profit locations D. There is not much evidence that there is any convergence to PPP 13. If one nation experiences a gain in its external wealth due to valuation effects only, the other nations in the world combined will experience: A. an equal decline in external wealth Page 3

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B. no change in external wealth. C. an equal gain since all currencies are worth more. D. an increase in the interest they earn. 14. When a domestic investor sells a foreign asset to a foreigner, the financial account: A. falls B. stays the same C. rises D. Not enough information is provided to answer the question. 15. Whenever there is a deficit in the current account, GNDI is: A. less than GNE B. greater than GNE C. can be greater or smaller than GNE D. equal to GNE only if there is no domestic investment spending Longer Questions: 55 points total Write answers in blue books; show your work even if the calculation is simple. Answers alone with no work or explanation will receive no credit. L-1 (5 points) A country is interested in having a fixed exchange rate against the US dollar. What restrictions does the ”trilemma” place on the country’s other policy choices? Solution: The country can choose only one of the following two policy options: (1) independent monetary policy; (2) no capital controls. L-2 (10 points total) An Apple iPad Gen 2 pencil sells for 100 USD in the US and 500 Peruvian Sol (abbreviation: PEN) in Peru. (a) (5 points) What exchange rate is implied by the Law of One Price? (b) (5 points) The market exchange rate between the US and Peru is 4 PEN/USD. Based on the prices of the Apple pencil, is the Peruvian Sol overvalued or undervalued relative to the US dollar? Calculate the percentage over- or under-valuation. Solution: (a) LOP implies 100 = E(500) where E is dollars per sol, so E=0.20 USD/PEN, or E=5 PEN/USD. (b)The sol is overvalued since the market exchange rate requires fewer PEN per USD than the PPP amount. The percent overvaluation is (4-5)/5 = 0.20 or 20%. L-3 (15 points total) Consider two countries, Canada and Mexico. Real output in Mexico grows at 2% per year, while real output in Canada grows at 4% per year. Suppose that the Bank of Canada sets money supply growth at 6% per year, while the Bank of Mexico sets money supply growth at 10% per year. For the following questions, use the simple monetary model in which ”L” is contant, so that real money demand does not depend on the nominal interest rate. Show your work. Page 4

(a) (5 points) What is the inflation rate in Mexico? In Canada? (b) (5 points) What is the expected rate of depreciation of the Mexican peso relative to the Canadian dollar? (c) (5 points) What rate of monetary growth in Mexico would imply a zero rate of appreciation or depreciation vs. Canada? (This is the growth rate needed to maintain a fixed exchange rate) Solution: (a) The inflation rate in Mexico is the money growth rate minus the growth rate of real output, 10%-2% = 8%. The inflation rate for Canada is 6%-4%=2%. (b) The expected rate of depreciation of the peso is the Mexican inflation rate minus the Canadian inflation rate, or 8%-2%=6%. (c) Money growth in Mexico would need to be set so that the Mexican inflation rate is equal to the Canadian inflation rate of 2%. Since the Mexican real growth rate is 2%, the Mexican money supply growth rate would need to be 2%+2%=4%. L-4 (25 points) The graph for this question is on the first page of the exam with the initial equilibrium at point A. The exchange rate is defined as South Korean won per Japanese yen, E won yen . Copy the FX and money market diagrams from the first page of the exam into your blue book to answer the following questions. You do not have to put numbers on the axes, just the axis labels are fine. a. ( 10 points) Suppose the Bank of Korea announces an unanticipated and permanent INCREASE in its money supply. Illustrate the short-run and long-run effects of this policy by shifting the curves as appropriate, placing point B at the new short-run equilibrium on each graph, and placing point C at the new long-run equilibrium on each graph. Ignore the positions of points B and C on the graph given on the first page. There should be a B and C for each graph; you will need to put them in the right place on the graph you draw in your blue book. b. (8 points) What happens to the Korean nominal interest rate in the short run? Why does it change? Be as specific as possible about the mechanism driving the Korean nominal interest rate. Use a graph (a different graph) if you find it easier to explain with a graph, but it’s not needed if your explanation is complete without it. c. (7 points) Does this model display overshooting? Briefly explain your answer, defining what is meant by ’overshooting’ and discuss whether ’overshooting’ is a desirable or undesirable feature of this model. Solution: (a) See the graph. The money market graph must show the M s /P line shifting to the right with the M d /P line unchanged. The initial point A is the new long run point C. The short run in the money market, point B, is where the shifted money supply curve intersects the original money demand curve. The nominal interest rate in S. Korea falls in the short run and returns to its original level in the long run. The FX market analysis will show the FR curve shifting to the right and the DR curve shifting down in the short run, intersecting at point B. The long run position, C, is on the shifted FR curve and the original DR curve. a. The money market graph must show the M s /P line shifting to the left with the M d /P line unchanged. The initial point A is the new long run point C. The short run in the money market, point B, is where the shifted money supply curve intersects the original money demand curve. The nominal interest rate in S. Korea rises in the short run and returns to its original level in the long run. The FX market analysis will show the FR curve shifting to the left and the DR curve shifting up in the short run, intersecting at point B. The long run position, C, is on the shifted FR curve and the original DR curve. b. The S. Korean nominal interest rate falls in the short run because there is more real money Page 5

Figure 2: Graph for Question L-4, Part a supplied than is demanded at the original interest rate. This means there is not equilibrium in the money market. To restore equilibrium, people need to be induced to hold fewer real cash balances. This is accomplished through an increase in the nominal interest rate which is the opportunity cost of holding money. If the opportunity cost of holding money goes down, people hold more of it. This is the key mechanism in this model. c. There is overshooting in this model. The term overshooting pertains to the behavior of the exchange rate, which moves more in the short run (A to B in the FX market) than in the long run (A to C). That is: the short run exchange rate movement ”overshoots” its long run change. This is neither good nor bad from an ethical standpoint or its effect on the economy. But from the point of view of explaining why exchange rates are so much more volatile than changes in money supplies and outputs (the variables that determine exchange rates) this is a ”good thing” in the sense that this model explains high exchange rate variability. As we discussed in class, this feature is one primary reason why this model has remained so important in understanding exchange rate fluctuations. Page 6

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