Examples Questions With Guided Answers

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Franco Bruni
International Monetary Economics from Krugman-Obsfeld-Melitz, Chapters 13-19
EXAMPLES OF EXAM QUESTIONS WITH GUIDELINES FOR ANSWERS
Note that only guidelines are noted below: students answers are usually supposed to be more explicit ,
though in some parts more concise (when the guidelines written here go beyond the essential answer,
when they repeat the answer in different ways, when they help the student to place the question in the
context of the relevant section of the program and thus recall certain explanations behind the answers).
Students answers must normally contain the relevant formulas and graphs that are often avoided here
(to show how much of the reasoning in the program can be conducted without algebra and geometry)
but that often can save words and allow quicker and more direct comments. Moreover answers can differ
according to the ability of each student to go to the point with synthetic, clear but personal wording, to
be somewhat original in shaping the requested reasoning and, sometimes, to include personal
comments.
February 2014
AN INDEX
10 examples of exam texts are reported here, always consisting in 3 questions, often divided in
sub-questions. As in the real exams, in each example and to answer each question the material
of various chapters of the KOM textbook is required and somewhat mixed. To help students in
using this material to review the individual chapters, an index is provided where each chapter is
associated with the question or sub-question specifically referred to what is taught in that
chapter. Obviously to answer questions on a chapter, also previous ones have to be studied.
Questions are indicated in this index by specifying first the number of the example and then the
number of the question in the example: therefore, for instance: 5, 3a means question 3a in
example 5.
Chapter 13: 2, 1a; 3, 1a; 5, 1a&b; 7, 1a; 9, 2a&b; 10, 1c

Chapter 14: 1, 1a; 10, 1a&b; 10, 3a
Chapter 15: 1, 1b; 3, 3a; 4, 1a; 6, 1c; 7, 1b; 7, 3; 8, 1a
Chapter 16: 1, 2; 2, 1b; 2, 3; 3, 1b; 4, 2; 5, 3c; 6, 1a&b; 6, 2; 6, 3; 8, 1b; 9, 1b
Chapter 17: 1, 3; 2, 1c; 2, 2; 3, 2a&b; 4, 1c; 4, 3; 5, 2; 7, 2; 8, 2; 9, 1c; 10, 3b&c
Chapter 18: 3, 2c; 3, 3b; 4, 1b; 5, 3a; 7, 1c; 9, 1a; 9, 2c; 9, 3a
Chapter 19: 1, 1c; 3, 1c; 5, 1c; 5, 3b; 8, 1c; 8, 3; 9, 3b; 10, 2
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Example 1 - Closed books. One hour and 15 minutes, all the three questions have the same weight in the grading.
Question 1
Are the following three statements TRUE or FALSE? Motivate your answer in a brief way, but showing that
you are applying the right theory and/or using the correct and relevant information. It can happen that the
statement is neither totally true nor totally false: if you really think this is the case, clearly explain why.
(a) The forward exchange rate between two currencies can always be interpreted as a good estimator of
the future expected spot rate.
False. The crucial concept here (appendix to ch. 14, the only appendix which was part of the
programme) is that F = Ee only if both the Open Interest Parity and the Covered Interest Parity are
holding. The proof is immediate by writing OIP and CIP. Additional comments could list potential
causes of deviation from OIP (imperfect asset substitutability) and/or CIP (imperfect capital mobility).
(b) A permanent monetary restriction does not cause overshooting of the exchange rate in case perfect
price flexibility prevails.
True. Overshooting is caused by price stickiness as the change in nominal money supply is not
immediately matched by a proportional decrease in prices, thus resulting in a decrease of the real
money supply. The short-run overshooting is what allows the interest rate to increase and the money
demand to decrease, preserving money market equilibrium. [To avoid money market disequilibrium
the real demand for money must change: as in the long run and in full employment Y cannot change,
this can happen only if R changes. But R=R* if there are no expected changes in E. These expected
changes must be such as to move R in the right direction. With monetary restriction real money
demand must decrease, therefore R must increase: according to OIP this requires overshooting, i.e. E
immediately stronger than its long run expected equilibrium value. Obviously all this path is not
required in case P immediately adjusts to the changed Ms]. The type of comment written in
parenthesis is not required for a fully satisfactory answer.
(c) Several reasons can justify the fact that macroeconomic policies try to avoid excessive and prolonged
current account deficits.
True. First of all the deficits can result from excessive private and/or public consumption, with no
corresponding accumulation of productive assets to enable the country to reimburse, in the future,
the debts incurred to finance the deficits. Sometimes it can even become difficult to pay the interest
costs of those debts. The accumulation of debts can also cause a sudden stop in lending by
international markets to the deficit country. Moreover, when deficits are financed running down
official reserves of foreign currencies, reserves can be exhausted, it can become impossible to borrow
more of them and the country can be troubled by the sudden need to let the exchange rate
depreciate in an uncontrolled way, with undesired consequences on price and financial stability.
Question 2
Consider a long-run exchange rate model based on PPP and on money market equilibrium equations.
(a) Starting from a long-run equilibrium position, suppose a country increases its money supply. Will
this policy move have consequences for the equilibrium level of its real interest rate?
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Here, as in the following (2b), the crucial point for answering is to pick the right model! The longrun exchange rate model based on PPP and on Money market equilibrium equations is the
monetary approach model of Ch. 16. To answer part (a) it is sufficient to recall that, with PPP,
the real interest rate cannot change if the foreign rate does not change (as PPP implies constant q
and the real interest parity states that r=r*+e%q). Students that do not concentrate on the right
model might try to answer with a short-run approach (the double graph reporting the forex
and the money market) where it is difficult to show the path towards the long-term equilibrium
with PPP.
(b) According to this model, what is the effect of a decrease in the domestic nominal interest rate on
the equilibrium nominal exchange rate? Can you give an intuitive explanation of the answer that
results from the analytical formulation of the model?
The domestic nominal interest rate enters the formula of E of the model in the denominator, as it
influences negatively the domestic demand for money. Therefore a decrease in R, by increasing
Md, decreases (appreciates) E. Which is counterintuitive as a lower yield on the domestic currency
should make it less attractive thus causing a depreciation. The intuitive explanation is that, with
PPP (one of the basis of the model), q is constant, therefore r is constant (according to the real
interest parity): a change in R=r+ inflation (by definition) can be triggered only by a change in
inflation. A decrease in R is therefore associated with a decrease in inflation, which, intuitively, is
in accord with a strengthening value of the domestic currency. Students can mention the Fisher
effect (that r is constant, so that R follows inflation levels) but this is not required and cannot
substitute the correct reasoning based on the formula for E in the monetary approach model.
Question 3
Provide three synthetic definitions, each followed by a short explanation and comment, of the following
three expressions:
(a) J curve
The J curve describes the behaviour of the current account of the balance of payments over time
following a change in the exchange rate. A depreciating (appreciating) E causes a negative
(positive) value-effect *more (less) expensive imports and lower(higher)-unit-value exports]
together with a positive (negative) volume-effect *more (less) exports and less (more) imports+.
In the very short run the volume effect is weak, as export and import contracts must be changed
and re-directed, while the value effect is immediate. Therefore in the short run a depreciation
(appreciation) causes a worsening (improvement) of the current account, turning into an
improvement (worsening) over time, thus describing a J-shaped time profile.
(b) Pass-though from the exchange rate to import prices
This is the ratio of the change in import prices (when expressed in domestic currency) caused by a
change in the nominal exchange rate. The ratio stays between 0 and 1. When it is <1 the reason is
the strategic behaviour of foreign importers that might decide, when for instance the
domestic currency gets depreciated, to lower their selling prices in foreign currency to avoid
losing market share in the devaluing country, thus giving up part of their profits to keep their
clients. With lower (higher) P*, import prices will not fully reflect the higher (lower) E: which, by
definition, is a pass-through lower than 1.
(c) Liquidity trap.
The liquidity trap is a situation where standard monetary policy (based on a transmission
mechanism where interest rates changes are crucial) does not function, as the interest rate is so
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low that the demand for money is infinite and adding liquidity, for instance, results in larger
money balances with lower velocity of circulation and no effect on interest rates and spending.
This happens (often following economic crises with very low Y) when R is zero (and cannot
become negative) or so low that nobody expects it to become lower. In the AA/DD graph the
liquidity trap causes a flat segment in the AA line, when approaching the vertical axis. The
nominal exchange rate cannot be further devalued because the nominal interest rate cannot be
further lowered (and given the open interest parity: where the trap is at R=0, E cannot go higher
than Ee=(1-R*) ). When the DD crosses the AA in the flat segment the system is in the liquidity
trap: monetary expansion would simply lengthen the flat segment, with no effect on the
equilibrium point: only a substantial shift in the DD (due, for instance, to an expansionary fiscal
policy) can get the macro-equilibrium out of the trap. Note that, while expanding money in the
trap is ineffective, restrictive monetary policy becomes effective when the flat segment of the AA
is shortened enough, beyond the crossing point with the DD.
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Example 2 - Closed books. One hour and 15 minutes, all the three questions have the same weight in the grading
Question 1
(a) In an economy where private saving is 50, the public sector deficit is 30 and aggregate investment
is 20, 60 is the deficit of the current account of the balance of payments.
False. As CA = Sp+SG I = Sp (G-T) I = 50 30 20 = 0 : the current account is in equilibrium.
(b) The validity of the law of one price for all goods and services is a necessary and sufficient condition
for absolute PPP to hold.
False. It can be considered a necessary condition (if, for instance, transport costs prevent
equalizing individual prices in different currencies, no PPP will result in aggregate) but it is not
sufficient. The main reason is that price indexes are calculated with baskets of goods and services
that reflect consumption patterns, that can differ across countries, thus preventing aggregate PPP
to hold. The issue of traded vs non-traded goods can also be cited: no arbitrage is possible with
non traded goods in different countries, so that PPP can be violated for them also in the long run.
(c) If the sensitivity of the demand for money to an increase in output is small, the AA curve is rather
flat (when drawn, as usual, with the exchange rate on the vertical axis).
True. To answer it is crucial to show that the method to derive the AA line is well understood. In
the usual double graph, where the money and the forex markets are represented, an increase in
output shifts the money demand to the right thus increasing the interest rate and (in the upper
part of the graph where the OIP is represented) strengthening the exchange rate. Therefore,
when Y goes up, E goes down and this explains the slope of the AA line. But when the sensitivity
of Md to Y is small, a given increase in Y will result in a small increase in R: therefore, for any
given OIP curve, the corresponding decrease of E will also be small. This means that the AA line is
flatter than when the sensitivity is higher.
Question 2
After a deep change in the political scenario, the level of aggregate private productive investment in a
country decreases substantially and the medium-long term expectations are such that the change is
considered permanent. The exchange rate is freely floating.
(a) Suppose first that there are no monetary and fiscal policy reactions. Use the AA-DD model to show
the short and long term effects of this abrupt event on the nominal and real exchange rate as well
as on the levels of economic activity and prices. What happens to the real interest rate?
The answer is exactly like in the case of a permanent fiscal restriction. The DD line shifts to the
left but also the AA line shifts up and to the right, given the depreciation of Ee , due to the
expected permanent nature of the decrease in investment. The latter shift will be such as to avoid
any change in the price level, a change that would prevent the long term re-equilibrium of the
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money market: this means that also Y will not change in the short run (otherwise it would differ
from the full employment level and prices would change) and that the new short-term
equilibrium will be also a long-term equilibrium, with both lines shifted up and a resulting
nominal and real depreciation. The latter plays a crucial role in re-equilibrating the macroeconomy as it triggers an increase in net exports to substitute the lower level of investment while
keeping the full employment level of aggregate demand. As far as the real interest rate is
concerned: R=R* (unchanged by hypothesis) will keep holding in the new equilibrium where,
obviously, inflation will be absent : therefore both the nominal and real interest rates will be
unchanged.
(b) Is it possible for monetary and/or fiscal policies to reproduce the original equilibrium in the short
and/or in the long run?
The most obvious, short, and elegant answer - exploiting the idea that the consequences of the
shock to investment can be dealt with like those of fiscal policy - is that YES, it is possible to
immediately restore the initial equilibrium with a permanent fiscal expansion that compensates
the shrinking private investment pushing back both the DD and the AA lines towards their
original positions. DD shifts as new aggregate demand originates from the government budget,
while the AA shift follows the return of Ee to its original level in view of the permanent nature of
the fiscal expansion.
Question 3
Provide three synthetic definitions, each followed by a short explanation and comment, of the following
three expressions:
(a) Fisher effect
It is the effect of a change in inflation (expectations) on the nominal interest rate when, by
hypothesis, the real interest rate is constant (for instance because PPP holds). The increase in R
will be exactly equal to the increase in (expected) inflation.
(b) Relative PPP
It is PPP expressed with dlogs, % changes, stating that the change in the nominal exchange rate
equals the difference between inflation rates of two countries.
(c) Real international interest rate parity.
States that the difference between the domestic and the foreign real interest rates equals the
expected depreciation of the real exchange rate. This parity can be obtained combining the OIP
with relative PPP.
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Question 1
(a) The current account of the balance of payments does not include only exports and imports of
goods and services.
True. Besides exports and imports the main items included in the current account are incomes
from factors (like interest and dividends earned on foreign financial assets owned by domestic
citizens, as well as interest and dividends paid to foreigner owners of domestic assets) and
unilateral transfers (like international development aid received or transferred abroad).
(b) The real interest parity condition implies that, if the foreign real interest rate is constant, also
the domestic real rate cannot change.
False. The condition equates the difference between the domestic and the foreign real interest
rate to the expected change of the real exchange rate of the domestic economy. Therefore, if the
latter changes (depreciates/appreciates), the domestic real rate changes (increases/decreases)
also if the foreign real rate remains constant.
(c) Fixed exchange rates are worse (than floating) for macro-stability when the main shocks come from
the goods and services market (i.e. from DD shifts).
True. It can easily be proved showing on a AA-DD graph the extent of the change in Y caused by a
shift in the DD when AA does not move, which implies a change in E, and then showing that a
fixed exchange rate policy would imply a contemporaneous shift of the AA as well, which
amplifies the change in Y. The question does not require (but allows) to complete the answer
by showing that, on the contrary, when the shock to the initial equilibrium is caused by a shift in
the AA, a fixed exchange rate regime would completely stabilize Y by bringing back the AA to its
initial position.
Question 2
Consider the AA-DD-XX model, with a purely floating exchange rate.
(a) Show the short run effects of an increase in the foreign price level on the level of income, the exchange
rate and the balance of payments.
Suggestion: start from a long run equilibrium point with zero current account of the balance of
payments (the three lines AA, DD and XX crossing in the same point), even if the question does not
say that this is the case. An increase in P* increases the competitiveness of domestic products, thus
increasing net exports and aggregate demand. The effect is a rightward shift of DD and of XX as well.
The two lines shift by the same vertical amount: after they have shifted, along both lines the same Y
values (including the full employment long term equilibrium Y from which the system has been
displaced by the change of P*) correspond to values of E appreciated by the same % of the increase in
P*. In other words: along both lines any level of Y will correspond to the same real exchange rate as
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before the change in P*, as aggregate demand and net exports depend on the real exchange rate. No
reason, in the short run, to shift the AA. The new short term equilibrium is at the crossing of the nonshifted AA with the shifted DD: therefore Y is higher and, as the DD is steeper than the XX for
reasons well explained in the textbook , it is immediately evident from the graph that this new short
term equilibrium is above the shifted XX, resulting in an improvement of the current account balance
of payments. One could add a comment like: the nominal exchange rate appreciates but in the
short run, when domestic prices cannot change by definition! not as much as P* increases: therefore
the real exchange rate improves, increasing net exports.
(b) Show the effect on the same variables of a transitory decrease of the domestic demand for money (for
every level of income and of the interest rate) .
A decrease in the domestic demand for money, ceteris paribus, exactly like an equivalent increase in
the supply of money, shifts the AA to the right (one can prove this with the double graph picturing the
money and forex markets together, i.e. the graph from which the AA line is constructed), causing a
increase in Y, a depreciation and a trade surplus (a new short run equilibrium where AA and DD cross
above the unchanged XX).
(c) How would your answers to (a) and (b) change in case the exchange rate is kept fixed by the central
bank?
To keep a fixed exchange rate the monetary authorities must intervene in the forex market causing a
change of the money supply and a corresponding shift of the AA line sufficient to keep E constant. In
the case of (a) a rightward shift of the AA is needed further increasing Y and the surplus (as the
appreciation is avoided). In the case of (b) the story is simpler, as the AA will go back to its initial
position and all the values of the variables will be as before the decrease of M d which the central
banks has matched by an equal decrease of Ms to avoid the depreciation.
Question 3
Suppose an economy in long term equilibrium with a given exchange rate (Eo), an interest rate and a real
money demand and supply, suitably described in a double graph featuring both the forex and the domestic
money markets.
(a) Show what happens to the short-term equilibrium in case the future expected exchange rate
suddenly appreciates, with no reaction by monetary authorities.
Simply recall the equation of the open interest parity (OIP) pictured in the upper part of the graph
and observe that a decrease in Ee shifts down the OIP line. With no reaction of monetary policy
(i.e. no change in the domestic interest rate) the shift causes an appreciation of the market
determined value of E equal to the appreciation of the expected exchange rate.
(b) Suppose there is imperfect asset substitutability between domestic and foreign currency
denominated assets. Suppose also that the central bank wants to try and push the exchange rate
back towards the original Eo level without changing the money supply. What type of sterilised
intervention should the central bank operate?
To counteract the appreciation of E the central bank must purchase foreign currency putting
upward pressure on its price in terms of domestic currency. But this move implies an unwanted
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expansion of the domestic money supply which can be avoided by sterilizing the intervention,
i.e. selling domestic bonds (previously in the portfolio of the central bank) to reabsorb the money
used to purchase foreign assets. Given imperfect substitutability, the resulting change in the mix
of domestic and foreign assets in the market will not be without consequences, even if the money
supply is unchanged: the risk premium on domestic bonds will increase (as the amount of them
included in the portfolio of the central bank has decreased: a smaller A in the textbook formula of
the risk premium), which will shift up the open interest parity line and contain or eliminate the
appreciation of E.
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Question 1
Are the following three statements TRUE or FALSE? Motivate your answer in a brief way, but
showing that you are applying the right theory and/or using the correct and relevant information. It
can happen that the statement is neither totally true nor totally false: if you really think this is the
case, clearly explain why.
(a) The overshooting of the exchange rate, when a permanent monetary policy change takes place, is
equal, in percentage points, to the immediate change of the interest rate.
True. The overshooting is needed to match the permanent change in the nominal money supply
Ms (suppose an increase) with a change in Md, before prices adjust and neutralise the nominal
change in money. The needed increase of Md must take place via a reduction of the domestic
interest rate R which (as the OIP holds) equals the foreign one (R*) plus the expected depreciation
of the domestic currency. But with R* constant, to decrease R an expected appreciation
(decrease) of the exchange rate is needed, which contradicts what the market expects when Ms
increases. The only solution to this contradiction is an excessive depreciation immediately
following the monetary expansion, that generates an expected appreciation to bring back E
towards a less depreciated level, rationally expected in the long run, when the price level has
completed its job of re-equilibrating the system. The expression overshooting designates this
excess of the initial depreciation (or appreciation, in case of a monetary restriction). The extent of
the overshooting (and of the corresponding expected appreciation) must be coherent with the
reason that justifies the phenomenon, namely the needed decrease of the interest rate. Therefore
the statement is true. A much shorter (perhaps too short) answer would simply stress that the
open interest parity always holds, so that the interest rate differential must equal the expected
change in the exchange rate and the latter is by definition the difference between the long term
equilibrium exchange rate and the short term level that includes the overshooting.
(b) With a fixed nominal exchange rate, a fiscal restriction causes, in the long run, an appreciation of
the real exchange rate.
False. A long run effect of fiscal policy exists only if the policy is permanent. But (this is a tricky
aspect of the question that should not confuse the well prepared student) the long run effect of a
permanent fiscal policy is immediately reached also in the short run, at least in the model with
rational expectations and other crucial hypotheses that is exposed in the textbook. In that model,
permanent fiscal restrictions cause immediate depreciations of the nominal exchange rate (the
AA line shifting upwards together with the DD) with no impact on the price level (nor on the level
of long term equilibrium real income, while the composition of aggregate demand changes as net
exports increase to compensate for the lower net public demand). Therefore the real exchange
rate depreciates (both in the short and in the long run).
(c) An exchange rate pass-through equal to zero means that a nominal exchange rate depreciation
does not change the price of imports in foreign currency.
False. The pass-through is the percentage change of import prices denominated in domestic
currency divided by the percentage change of the nominal exchange rate. With zero pass-through
foreign exporters decide to sell their products to domestic importers at an unchanged domestic
price, in spite of the fact that this price will be translated into a lower price in foreign currency (in
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proportion to its appreciation). The reason for this behaviour is probably that they prefer to give
up profits (and perhaps suffer temporary losses) than risking to lose clients and market share in
the depreciating country. On the contrary, when the pass-through is one the price in foreign
currency does not change and the price in domestic currency increases by the same percentage as
the exchange rate.
Question 2
Suppose the long-term equilibrium level of the real exchange rate of a country increases
(depreciates).
(a) What can be the cause of such a change?
The textbook offers only one simple theory to explain the equilibrium level of the real exchange
rate: the theory is expressed with a graph where the real equilibrium exchange rate (on the
vertical axis) equates an upward sloping demand for domestic goods (as a proportion of global
demand for goods: the latter tends to shift towards domestic goods as they become cheaper
because of a higher, depreciated real exchange rate) to a vertical supply (assuming for simplicity
that the proportion of goods produced by the domestic country does not depend on prices and
exchange rates but only on the countrys productive capacity). On the basis of this model, an
increase (depreciation) of the real exchange rate can be caused by a decrease in the relative
demand for domestic goods (a leftward shift in the demand line: to sell the unchanged supply a
cheaper international price is needed) and/or by an increase in the relative supply of goods
produced by the country (a rightward shift in the supply line due, for instance to an increased
relative productivity of the domestic country: to sell the result of the increased productivity, for a
given global demand, a larger market share must be conquered with a real depreciation).
(b) If the change was expected, what was the consequence of this expectation on the level of the
countrys long term expected real interest rate?
According to the international real interest parity, international real interest rate differentials
reflect expected changes in the real exchange rates: the domestic real interest rate is higher than
the foreign when the domestic real exchange rate is expected to depreciate. The answer is
therefore that the consequence of the expectation (provided that, obviously, the foreign real
interest rate is assumed to remain constant) is a higher expected real interest rate of the country.
(c) The fact that the real exchange rate has changed contains a message on the validity of the
Purchasing Power Parity (PPP). How would you state this message?
PPP implies by definition a constant real exchange rate, equal to 1, as the domestic price level,
when PPP holds, equals the foreign price level expressed in domestic currency, i.e., multiplied by
the exchange rate. Considering shifts in relative global demand and supply of domestic goods
means that the PPP hypothesis is excluded.
(d) Suppose that the new level of the long term equilibrium real exchange has been reached and will
never change again. Does this mean that PPP will hold from now on also in the short run? For
answering in general terms use the following example: suppose that a temporary money supply
expansion is performed by the central bank and explain whether or not the PPP will hold in the
short term.
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PPP is essentially a long-term hypothesis: in the short term it does not make much sense as prices
are sticky while nominal exchange rates can jump up and down. A temporary money supply
expansion will temporarily depreciate the countrys exchange rate leaving the price level
unchanged (also abroad, obviously). Therefore also the real exchange rate will temporarily
depreciate, decreasing the domestic price level with respect to the foreign price level, both
expressed in the same currency: this means that in the short run PPP will not hold even when it
holds in the long run.
Question 3
The government of a country in full employment-long-term equilibrium announces an expansionary
fiscal policy, a tax cut, for example, to be financed in deficit by selling government bonds. Describe
the impact of the decision on the short and long equilibrium values of the nominal and real
exchange rate, the nominal and real interest rate, the level of economic activity, the price level, in
two different cases:
(a) When the fiscal expansion is expected by the markets to be temporary
Temporary fiscal expansions shift the DD line to the right until they are inverted. The AA does not
shift if they are financed without printing money. The short-term nominal exchange rate
temporarily appreciates as much as the real exchange rate (as prices do not change in the short
term, because they are sticky, nor in the long term, because the inversion of fiscal policy will
eliminate excess demand). In the short term the level of economic activity increases but its
expansion will not survive in the long term, when the fiscal expansion disappears. As for interest
rates, the temporary increase in Y pushes up Md and the equilibrium interest rate (nominal and
real, as prices stay put) but in the long-term equilibrium interest rates are the same as before the
temporary fiscal shock.
(b) When the expansion is expected to be permanent and markets believe that the deficit will in fact
be financed by selling public securities on the open market and not by printing money
In this case, as extensively explained in the textbook, rational expectations anticipate the
exchange rate appreciation and Ee decreases shifting down also the AA line to cross the shifted
DD above the unchanged Y. The only consequence of the permanent fiscal policy has been the
appreciation of the nominal and real exchange rate (implying a changed composition of
aggregate demand with less net exports and, for instance, more private consumption if the tax
cut produces this effect). The price level doesnt change, as aggregate demand never abandons
its long-term equilibrium level. There is no reason for a change in the interest rate.
Consider now your answer to (b) and, in particular, the impact of the fiscal expansion on the price
level. This impact is different if markets expect that the tax cut will end up being financed, at least in
part, with the help of the central bank, increasing the money supply. Can you explain why the
hypothesis on the behaviour of the money supply is so important?
If a permanent increase in money finances part of the tax cut, the long-term price level changes.
In case this money creation is expected, the AA line, in the short run, does not shift down as much
as required to cross the DD above an unchanged Y: the short-term level of economic activity can
increase, thus causing the change in prices in the long run. If the expected increase in the money
supply does not take place immediately, the higher level of Y could cause an increase in Md and in
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the interest rate. The whole story becomes more complicated and the transition from the short to
the long run depends on the precise behaviour of (still rational?) expectations that one should
specify. The hypothesis on the behaviour of the money supply is very important because an
unchanged Ms anchors the price level and the rational expectations attached to it (the
rationality of expectations is another important hypothesis of the model used to study
permanent fiscal expansions in the textbook). The intuitive reason that justifies the lack of
inflationary consequences of fiscal expansions in full employment is precisely the expectation that
the money required to allow prices to increase will not be created. With no monetary creation the
only effect of permanent fiscal expansions (as of any increase in another component of aggregate
demand) is a crowding out of net exports favoured by an appreciation of the nominal and real
exchange rate.
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Question 1
a) Suppose the current account of the balance of payments of a country has a surplus of 100.
Suppose also that the deficit of the public sector is 10 and that aggregate investment is 50. How
much is private saving?
From the fundamental identity equating the current account surplus to the excess of saving over
investment plus the public sector surplus, CA=(S-I)+(T-G), one can obtain S=100+50+10=160.
b) What is the difference between direct and portfolio investment in the terminology of the
balance of payments?
Direct investment implies the control of the asset abroad that has been acquired by investing: if
I buy an apartment that I fully own, a green field where to build a factory, if I become the
controlling shareholder of a company, etc. A portfolio investment, on the contrary, is the
acquisition of a credit, a security, a minority share-holding, with the sole intention to earn an
interest by holding the asset, or a dividend, or to resell the asset at a higher price realising a
speculative profit.
c) List at least two reasons to justify the idea that a surplus in the current account of the balance of
payments of a country must not last too long; in other words: a sound, sustainable long term
current account must exclude not only excessively lasting deficits but also surpluses.
Too large a current account surplus for too long poses problems (Ch. 19 of KOM textbook, section
on External balance). For a given amount of saving, domestic investment becomes insufficient,
sacrificing domestic employment as well as the benefits of technological spill-over to other
domestic enterprises, decreasing the proceeds of taxes on the returns on capital (as domestic
capital is easier to tax than capital owned abroad). The accumulation of credits on foreign
debtors becomes excessive generating risks of not being repaid which leads to a loss of national
wealth. The country in surplus can be criticized by the rest of the world (for being mercantilist
and the cause of the deficit of other countries) and become a target for discriminatory import
barriers imposed by trading partners with correspondingly growing external deficits.
Question 2
Starting from a long term equilibrium position, with full employment, show
a) that a permanent fiscal restriction, when it is not associated with a change in the money supply, is
not deflationary and causes an improvement of the current account of the balance of payments;
Use the DD-AA-XX model and suppose that the XX corresponding to a balance of payment in
equilibrium crosses the other two lines in the same point. A permanent fiscal restriction shifts the
DD to the left and (via the expectation of depreciation in the long-run) shifts also (immediately, in
the short run) the AA to the right. If there is no change in the money supply prices cannot change,
therefore the AA shift will be as large as needed to cross the shifted DD vertically above the
starting equilibrium Y. If the fiscal restriction does not hit net exports, the XX doesnt shift:
therefore, given that the new point where DD and AA cross (in the short and in the long run as
well) is higher in the graph than before the restriction, it falls above-and-to-the-left of the XX, i.e.
in the surplus region. [Note that the reason why prices do not change is that the real demand for
16
money Md(R,Y), in the long run, does not change because nothing happens to change the long
term equilibrium value of Y and, in the long-run, when the expected change of E is zero, R keeps
being equal to R*: therefore also Ms/P must remain constant and, with no change in M s, this
means no change in P.]
b) the short and long-term effect on the exchange rate, on the level of economic activity and on the
price level, of a permanent decrease in exports.
Graphically, a permanent decrease in exports (as in other autonomous components of aggregate
demand), can be pictured exactly in the same way as the fiscal restriction in a), provided that the
money supply does not change (why should it change? the question does not hypothesize any
change of Ms). Therefore, as above, neither Y nor P change in the short and in the long run. [Note
that the question does not consider the XX nor the impact of the decrease in exports on the
balance of payments; but it easy to conclude that, differently from a), the XX shifts upward and to
the left, crossing the other two lines in their new equilibrium point: the resulting depreciation of
the exchange rate (nominal and real) is what is needed (ceteris paribus, with no other policy
reactions) to neutralise the decrease in exports.
If you deem it useful, add a short comment of your answers to a) and b) stressing what they have in
common.
They both consider changes in one component of real aggregate demand with no associated change
in the money supply. Therefore in both cases P stays constant and the only real effect is a
modification of the nominal and real exchange rate and of the composition of an unchanged total Y.
Question 3
Are the following three statements TRUE or FALSE? Motivate your answer in a brief way, but showing
that you are applying the right theory and/or using the correct and relevant information. It can happen
that the statement is neither totally true nor totally false: if you really think this is the case, clearly
explain why.
a) It is never possible for a central bank to intervene in the foreign exchange market and influence
the exchange rate without changing the money supply.
False. When domestic and foreign currency denominated bonds are imperfect substitutes,
sterilized interventions can influence the exchange rate without changing the money
supply. If the central bank, for instance, buys foreign bonds (thus potentially increasing its
money supply) and, contemporaneously, sells domestic bonds (thus decreasing the money
supply, i.e. sterilizing the consequences of the previous intervention on the money supply),
the market portfolio will contain a larger proportion of bonds denominated in domestic
currency, which arent considered, by hypothesis, perfectly substitutable with bonds
denominated in foreign currency : this will depress the price of the domestic currency, i.e. will
tend to depreciate the exchange rate. The result can be obtained using the double graph
picturing the forex and the domestic money markets: the sterilized intervention, by
decreasing the amount of domestic bonds in the portfolio of the central bank, pushes up the
so called risk premium (B-A), which is positively correlated with the total amount of
domestic public bonds (B) minus those that are kept out of the market and held by the central
bank (A). Increasing pushes up the interest parity line on the forex market allowing a
depreciation even if the money supply (and therefore the domestic interest rate) does not
change.
17
b) Fixed exchange rates tend to create asymmetries in the international monetary system, while
symmetry is an advantage of floating rates.
True. To organise a fixed exchange rate regime an international currency (that can also be
labelled reserve currency) is needed so that each currencys price is fixed in terms of it. If
this international currency is also a national currency, the system is asymmetric as
monetary policy of the country issuing the reserve currency will have an influence on other
countries money supplies (that will change when central banks intervene to keep their
exchange rate fixed). Important examples of this asymmetry are the dollar dominance during
the Bretton Woods system, that died precisely because excessively expansionary US monetary
policy was disliked by countries such as Germany, France and Japan, and the German
dominance during the EMS years, which contributed to the disinflation of Europe as countries
participating in the EMS where obliged to follow the anti-inflation policy of Germany to
keep their exchange rates pegged to the Deutsche Mark. In theory, the gold standard was a
counterexample as the reserve currency was gold and no country had the privilege of issuing
it. But in practice (forgetting about the special situation of countries with gold mines) the
gold standard functioned in a rather imperfect way as British pounds were kept by countries
as reserves without converting them into gold. The system was therefore somewhat
asymmetric with the UK enjoying a special degree of freedom in deciding monetary policy for
itself and influencing other countries money supplies.
c) When PPP holds the difference between domestic and foreign nominal interest rates equals
the difference between domestic and foreign inflation.
True. Market speculation results in the open interest parity, equating the international
nominal interest differential to the expected change in the exchange rate. But the latter, if
PPP holds, equals the difference between domestic and foreign inflation. Note that one
implication of the statement is also that with PPP domestic and foreign real interest rates are
equal.
18
Question 1
(a) Write the expression of the Purchasing Power Parity (PPP), carefully specifying the meaning of the
variables that enter PPP.
Absolute PPP can be written P=EP*, where P and P* are the domestic and foreign price levels
and E in the nominal exchange rate of the domestic currency (units of the domestic currency to
buy one unit of foreign currency). Relative PPP is derived by log-differentiation and can read:
%E = *, where the percentage change in E (rate of depreciation) is equal to the difference
between the rates of inflation, indicating with and * the percentage changes in P and P*.
(b) Assume that price levels are perfectly flexible and put the PPP together with an equation
expressing the equilibrium between the demand and the supply of money. Suppose that Y, real
income, increases. Show how the exchange rate will be affected. Intuitively comment your result.
Has the level of interest rates been affected?
Money market equilibrium equates in the two countries, the real supplies of money (Ms/P and
Ms*/P*) with the real demands for money, which depend positively on the countrys Y and
negatively on its nominal interest rate. Deriving expressions for the price levels P and P* from
these equations and substituting them in the absolute PPP, an expression for E is obtained (a
monetary theory of the exchange rate) where the domestic level of income has a positive
impact on the domestic demand for money in the denominator. Therefore, by increasing the
denominator, an increase in Y causes an appreciation of E. Intuitively, the result can be
understood as the consequence of increasing Y without increasing M when prices are flexible:
there is more demand for the domestic currency (to finance the larger amount of transactions
associated with a higher Y) and an unchanged supply of it, which triggers an increase in its price,
both in terms of foreign currencies (E decreases) and in terms of domestic goods (P decreases).
With perfectly flexible prices there is no difference between short and long term and therefore no
expectation of further changes in E: the domestic interest rate keeps being anchored to the
unchanged foreign R*.
[Note that the question is easy to answer if the right model is picked. PPP + money market
equilibrium is the monetary approach model of Chapter 16 in the KOM textbook. The chapter is
devoted to the long run but it also applies to the short run if, as specified in the question, prices
are perfectly flexible, as they are usually supposed to be in the long run. The mistake to be
avoided is to start reasoning with the double graph where the forex short term market is
graphed together with the money market. This graph is useful to explain changes in the short run
with rigid prices; only after that one can allow prices to change and generate a new long term
equilibrium. The graph, to be sure, can also indicate the right answer to the question, but only
with the following geometrical reasoning, that students arent trained to apply by the textbook:
E0
oip0
oip1
R
E1
M0
M1
M/P
Initial equilibrium in E0 and M0. Increasing Y shifts

the demand for money line to the right. With no
increase in the supply of money, a flexible P
decreases shifting down the real money supply line.
As PPP is expected, also the expected value of E
decreases triggering a shift in the open interest
parity line from oip0 to oip1 . The new equilibrium is
therefore in E1 and M1. It would be a mistake to
look for the new exchange rate starting on the initial
oip line in correspondence to the higher interest rate
at the crossing point of the new demand for money
with the old real supply line. After such a mistake
the new long run equilibrium is difficult to
reconstruct.
19
(c) Assume now that price levels are sticky (rigid in the short run, where PPP does not hold, and fully
flexible in the long run) and show the impact of a permanent increase in Y, on both the exchange
rate and the interest rate, first in the short and then in the long run. (Suggestion: use the double
graph where both the forex and the money markets are represented).
[The model to be used here is the overshooting model of Chapter 15 of the KOM textbook, with
the geometry of Figure 15-12, suitably modified to analyze the case of a permanent increase in
the demand for money instead of the consequences of a permanent increase in the supply. But
the answer is identical to the one to be given in the case of a decrease in the supply (in the
money market an excess demand for money to be readjusted results both from increasing the
demand and from decreasing the supply).] In the double graph like the one on the left of Figure
15-12, referring to the short run, a rightward shift of the money demand line is considered
instead of a downward shift in the money supply line. This causes an increase in the interest rate
and an appreciation of the exchange rate, but not along the initial open interest parity line (OIP),
because an appreciation is expected also in the long run and the expectation causes an
immediate downward shift of the OIP. Therefore in the new short term equilibrium the exchange
rate is much stronger and the interest rate higher. The evolution of the system in the long run is
analogous, mutatis mutandis, to what is described in the right hand side of Figure 15-12. The
excess demand for money, temporarily corrected by the increase in the interest rate, gradually
causes a decrease in the price level, thus pushing down the real money supply line and
decreasing the interest rate, while in the forex market the exchange rate gradually corrects its
initial excess appreciation (overshooting). The system ends with an exchange rate stronger
than before the increase in Y but weaker than in the short run: the new long term equilibrium
exchange rate corresponds to the point, along the lowered OIP, vertically above the initial
interest rate. The latter (call it R0) re-equilibrates also the money market as the lower price level
has driven the real money supply down to cross the demand for money (the rightward shift of
which constitutes the original shock to the system in this exercise) precisely at R0. Intuitively, the
overshooting (excessive appreciation) of the exchange rate in the short run has caused an
expected depreciation and the latter, in the OIP equation, has allowed the interest rate to rise
temporarily, killing the excess demand for money; overtime, prices perform their job, they
decrease and they allow the interest rate to decrease and the exchange rate to correct the
excessive appreciation.
Question 2
(a) When there is freedom of capital movements, the domestic real interest rate is always equal to
the foreign real interest rate. True or false? Why?
False. The freedom of capital movements allows international differences between real interest
rates as long as there are expected changes in real exchange rates that contribute to equalize the
real yield of investments in different countries. The real interest rate parity (RIP) can be written
as follows: r = r*+ %qe , where r and r* are, respectively, the domestic and foreign real interest
rates and the second term to the right of the equal sign is the expected depreciation of the real
exchange rate of the domestic country. If I invest in the latter I will earn a higher real rate but
suffer a real depreciation of the currency in which my investment is denominated: on balance I
will earn, in real terms, as much as I would earn investing abroad, which I am allowed to do by
the hypothesized freedom of capital movements. RIP can be obtained by differentiating
logarithmically the definition of q=EP*/P, thus obtaining %q = %E + *- , substituting the
expected depreciation with the nominal interest rate differential (i.e. using the open interest
parity) and then recognizing that differences between nominal interest rates and inflation rates
are real interest rates.
20
(b) Suppose that the share of domestic goods and services in the global demand for goods and
services is expected to remain constant, for any given level of the exchange rate. While, due to an
increase in productivity, domestic output is expected to become a larger share of the worlds
output. What are the implications of these hypotheses for the relation between the domestic and
the foreign real interest rate?
The question is based on the textbooks very simple graphical theory of the equilibrium level of
the real exchange rate. The latter equates relative the global demand and supply of a countrys
production. Demand increases with a higher real exchange rate (i.e. with a real depreciation,
with a stronger relative price competitiveness of the countrys products) while supply can also be
though as given by the productivity of the countrys resources and independent on the countrys
real exchange rate. With the latter on the vertical axis, the question asks what happens when the
vertical supply line is expected to shift to the right with no shift in the demand schedule. The
answer is obviously that the expected equilibrium level of the real exchange rate increases
(depreciates). From the RIP discussed under a) this implies that the domestic real interest rate is
higher than the foreign r*.
Question 3
On the basis of two hypotheses: the purchasing power parity (PPP) and the international open
interest parity,
(a) show that the difference between the nominal interest rate in the two countries equals their
inflation differential. What do you conclude about the real interest rates in the two countries?
Relative PPP can be written, with the usual symbols, %E = * ; substituting the open
interest to express the depreciation the result is obtained. As in both countries the real
interest rate is defined as the difference between the nominal interest rate and the rate of
inflation, the conclusion is that the two real interest rates are equal. This is an important
implication of PPP.
(b) Substitute the price levels in the PPP with their expression obtained from the equilibrium
relation between the real demand for money and its real supply. Show that, according to the
resulting formula, when the nominal interest rate of a country is increased, its currency
depreciates. This is a counter-intuitive result as we usually think that a higher yield on a
currency strengthens its value. Reconcile the result with intuition: help yourself with the
answer to part a) of the question.
The question is about the monetary approach to exchange rate determination explained in
Chapter 16 of the textbook. The substitution allows to express the exchange rate as the ratio
of the domestic and the foreign nominal money supplies times the ratio of the foreign to the
domestic real demand for money. Both demands for money depend negatively on the
respective nominal interest rates. Therefore when the domestic nominal interest rate is
increased the denominator of the formula decreases, i.e. the exchange rate increases, the
domestic currency depreciates. The opposite happens when the foreign nominal interest rate
increases. The result can be reconciled with intuition considering that with PPP (which holds
by hypothesis in the question) the domestic and the foreign real interest rates are equal;
therefore, when one considers a ceteris paribus increase of a countrys nominal interest rate,
21
the increase can only be the result of higher inflation (as the other component of the real
interest rate remains equal to the foreign real rate, i.e. constant). With higher inflation the
resulting depreciation of the countrys currency is coherent with intuition. A higher nominal
return on a currency increases the demand for it, thus triggering its appreciation, only to the
extent that it is due to an increase in the real part of the interest rate. A nominal interest rate
that is high because of inflation does not increase the attractiveness of a currency: it is a sign
of its weakness, as shown by the monetary approach.
22
Question 1
Are the following three statements TRUE or FALSE? Motivate your answer in a brief way, but showing
that you are applying the right theory and/or using the correct and relevant information. It can happen
that the statement is neither totally true nor totally false: if you really think this is the case, clearly
explain why.
(a) Excessive government deficits, like in many countries of the euro area, always become deficits of
the balance of payments, thus causing a dangerous accumulation of foreign indebtedness.
False. From the fundamental identity CA = (S-I) (G-T) one can see that a high (G-T) results in a
deterioration of the current account only to the extent that private saving net of investment does
not compensate the public deficit with a higher financial balance of the private sector, following
an increase in S and/or a decrease in I. According to a hyper-rational (Ricardo-Barro) approach,
for instance, a higher deficit increases private saving as citizens set aside the money that will be
later taxed away to reimburse the excessive public debt: according to such a theory public
deficits will not result in balance of payment deficits. The theory may be wrong but, in any case,
given the presence of (S-I) in the identity, the statement is false because of the always.
(b) In the short run, a permanent increase in the money supply has stronger effects on the exchange
rate and output than an equal temporary increase.
True. When the money supply increases the AA line shifts to the right, increasing output and
depreciating the exchange rate. The shift of the AA is larger when the money supply change is
believed to be permanent, because a permanent change will also trigger an expected
depreciation (which does not happen with a monetary expansion that is expected to disappear in
the long run), i.e. a higher value of Ee, which acts as an additional factor (besides the increase in
the money supply) in pushing the AA line to the right (as it pushes the open interest parity to the
right). Therefore a permanent change in Ms will cause, in the short run, a larger change in Y and
E.
(c) When the exchange rate is free to float, temporary fiscal expansion increases output more than
when the exchange rate is fixed.
False. With free floating a temporary fiscal expansion shifts the DD to the right while the AA does
not move. The result is an appreciation of the exchange rate. To avoid the latter, a fixed
exchange rule requires an expansion of the money supply (a rightward shift also of the AA). With
both lines shifting a larger increase in output takes place. Intuitively, fixing the exchange rate
requires a monetary expansion to follow the fiscal expansion, thus causing, in the short run, a
larger increase in aggregate demand.
Question 2
With the exchange rate on the vertical axis and output on the horizontal axis, draw the AA,DD, and
XX lines describing a situation where there is full employment and equilibrium in the current
balance of payments. Then explain:
23
(a) Why the DD and XX lines differ in steepness?
Start from the equilibrium point where the lines cross and consider an increase in the level of
economic activity (measured on the horizontal axis) moving along the DD line towards the
right. As an increase in Y is only partially absorbed by an increase in domestic consumption
(in other words: as the marginal propensity to consume is smaller than 1: the crucial
hypothesis in this reasoning and a fundamental hypothesis in the Keynesian macroeconomic
equilibrium theory) aggregate demand does not increase as much as the supply, except if net
foreign demand (CA: the current account of the balance of payments) does not increase. But
along the DD aggregate demand is always equal to aggregate supply, by definition. Which
means that moving to the right along the DD drives the exchange rate higher enough to
improve CA (from equilibrium to a surplus). The surplus area lies to the left-above the XX.
Which proves that the DD is steeper than the XX.
In other words: with a higher aggregate supply (and a positive marginal propensity to save
out of additional income), in order for aggregate demand to increase by the same amount
(has it happens along the DD), the exchange rate must depreciate sufficiently to develop a
current account surplus, i.e. more than what is needed to keep the CA in equilibrium (which is
the depreciation implied by the positive slope of the XX, needed to compensate for the fact
that a higher income increases imports and a depreciation must neutralise this effect also by
stimulating exports). As CA is in equilibrium along the XX, and the depreciation along the DD
must be larger, the DD must be steeper than the XX.
(b) The reason of the sign of the slope of the AA line
The AA line pictures the combinations of E and Y that keep the money market (or, better,
assets markets) in equilibrium. Starting from a point on the AA and considering a higher Y,
the demand for money is higher. For a given supply of money the larger demand triggers a
higher interest rate that, along the open interest parity line, is associated with a stronger
(lower) exchange rate. Therefore the AA associates higher Ys with lower Es: it slopes down.
(c) What happens to the XX line if the foreign price level increases?
An increase in the foreign price level increases the competitiveness of domestic productions:
ceteris paribus, exports increase and imports decrease. For any level of the nominal exchange
rate, a higher Y is required to increase imports and keep the same current account (or, one
could say: for any level of Y a stronger exchange rate is required to neutralize the increase in
net exports). Therefore an increase in the foreign price level shifts the XX down and to the
right.
Question 3
Graph the short run equilibrium of the market of the euro (in terms of dollars) together with the
equilibrium of the European money market. Show the effect on the exchange rate of the euro of reducing
the US interest rate,
(a) When European monetary policy does not change: suppose first that the US monetary policy leaves
the expected future exchange rate unchanged, and then that the US decision influences
expectations;
24
When European monetary policy does not change, nothing changes in the lower part of the
double graph, where the domestic money market is represented crossing the demand and supply
of money. As the foreign interest rate decreases, the open interest parity line, in the upper part of
the graph (where the foreign exchange market is represented), shifts down and to the left.
Vertically, above the unchanged domestic interest rate, the equilibrium exchange rate decreases
(appreciates: in accord with intuition, as investing in domestic assets is now more convenient).
When also the expected future exchange rate depreciates (because, for instance, agents expect
the expansionary move of US monetary policy to be permanent), the shift of the open interest
parity line is larger (because in the expression R = R*+(Ee-E)/E both R* and Ee decrease) and
therefore E appreciates more.
(b) when European interest rates are changed to the same extent as the US; show also the extent of
the required change of the European supply of money.
If the changes in domestic and foreign interest rates are the same, the open interest parity holds
with no change in the exchange rate. This happens when the European money supply is increased
to the extent needed to shift down the Ms line so that it crosses the Md line at the level of R above
which (on the open interest parity shifted by the lower foreign interest rate) the exchange rate is
the same as before the US monetary policy move. Graphically:
E
oip0
oip1
E0
R1
R0
R
Ms
M/P
M is the required change in the European supply of Money, as it brings the equilibrium interest
rate down to R1 from R0 . This change in the domestic interest rate is the same as the change in R*
as one can see from the fact that E does not change from the initial value E0 when the lower R*
shifts the open interest parity line from oip0 to oip1.
25
Question 1
Are the following three statements TRUE or FALSE? Motivate your answer in a brief way, but
showing that you are applying the right theory and/or using the correct and relevant information. It
can happen that the statement is neither totally true nor totally false: if you really think this is the
case, clearly explain why.
(a) The likelihood of observing an exchange rate overshooting following a given permanent change in
domestic money supply, depends on the degree of flexibility of goods prices, with high degree of
price flexibility making the overshooting phenomenon more likely
False. The first part of the sentence is right: the overshooting is required to trigger an expected
change in the exchange rate that allows the interest rate to accommodate the money supply
change in the short period, while in the longer period the price level will do the job gradually
shrinking the change in the real money supply. Therefore price flexibility is crucial to determine
the size and length of the overshooting. But the second part of the sentence is wrong: high
flexibility decreases the need for overshooting, makes it less likely, as prices will soon and quickly
neutralize the initial change in the real money supply, thus rendering superfluous a change in the
interest rate (and the expected change in the exchange rate that, following the overshooting,
causes the change in the interest rate) to change money demand in the short run.
(b) If relative PPP is expected to hold, then domestic and foreign expected real interest rates will be
equal
True. PPP implies that the real exchange rate is constant, by definition. The real interest rate
parity states that international differences between real interest rates are equal to expected
changes in real exchange rates. If the latter are constant, real interest rates are equal.
(c) With a fixed exchange rate, fiscal policy can never improve the position of an economy that
suffers of both internal and the external disequilibrium.
False. An improvement is sometimes possible as can be shown with the graph of the Four Zones
of Economic Discomfort. When there is both underemployment and excessive current account
surplus, for instance, an expanding fiscal policy can improve both external and internal
equilibrium. The same happens when a restrictive fiscal policy is used with both overemployment
and excessive current account deficit. The problem becomes a dilemma when the two
disequilibria are badly combined: underemployments and excessive current account deficit or
overemployment and excessive current account surplus. In these cases fiscal policy can improve
one of the two equilibria but at the cost of worsening the other disequilibrium. In the dilemma
situation the cost of keeping the exchange rate fixed is felt in a special way.
Question 2
A country, with a freely floating exchange rate, has a current account deficit that the authorities want to
correct in the short period. They consider three alternatives: monetary policy, temporary fiscal policy and
26
permanent fiscal policy. For each alternative policy specify the sign of the policy change that is needed:
expansion or contraction? Show the short-run impact, on the output and on the exchange rate, of each
policy that corrects the current account deficit. Conclude with a reasoning that compares the three options.
To answer the question an AA-DD-XX graph can be used, with the AA and DD crossing in a point (the
initial equilibrium of the system) below the XX (the CA=0 line), i.e. in the current account deficit area. To
correct the deficit in the short run that crossing point has to be placed on the XX. Monetary policy alone
can do this with an expansionary move, shifting the AA up and to the right until the point where the
unchanged DD crosses the XX. This will cause a depreciation and an increase in Y, perhaps unsustainable
in the long run if the starting Y is a full employment level of income. Fiscal policy alone, instead, can
correct the current account deficit with a restrictive move, temporary shifting the DD up and to the left
until the point where the unchanged AA crosses the XX. Which causes a depreciation and a decrease of Y
and employment. While the expansionary impact of monetary policy is reinforced by depreciation, the
restrictive effect of fiscal policy is only moderated by depreciation, leaving a negative effect of Y. This can
be avoided with a credibly permanent fiscal restriction which immediately shifts both the DD and the AA
up to cross the XX above the initial level of Y, which is perfect if, as it is convenient to assume, it is a full
employment level. Permanent fiscal restriction seems the best choice when the current account
disequilibrium is believed to be a permanent problem, as it permanently shifts the composition of
demand towards net exports and away of where aggregate demand was pushed by the public budget.
On the contrary, if the current account disequilibrium is expected to disappear in the long run, in order to
fix it in the short run, temporary monetary policy can do the job at a cost of a temporary
overemployment while temporary fiscal restriction causes temporary unemployment.
Question 3
Consider the issue of flexible vs free floating exchange rates: which regime better helps a country to keep
output and employment stable when its economy is hit by an unfavorable disturbance? Answer in three
steps: first show how the two regimes behave when there is a transitory fall in exports; then look at the
case when the fall in exports is expected to be permanent; finally compare the two regimes when, for some
reason (like an increase in investors risk aversion) there is a sudden increase in the demand for money for
any level of income.
A transitory fall in exports, with a floating exchange rate, causes a depreciation and some decrease in Y:
but the depreciation, stimulating net exports, limits the temporary depression of economic activity. If the
exchange rate is kept fixed, on the contrary, the temporary depression is larger. The difference is even
neater when the fall in exports is permanent. In this case a floating exchange rate regime allows the AA
to shift up (incorporating the expected future depreciated exchange rate value) crossing the DD (shifted
because of the fall in exports) above the initial value of Y which therefore stays totally stable. The
conclusion is that floating rates guarantee a more stable output when disturbances come from the DD
side, i.e., when they are caused by changes in the autonomous components of aggregate demand:
intuitively this is the case because exchange rate changes cushion (acting in the opposite sense on net
exports) at least in part the impact of the disturbance on Y. An opposite conclusion can be drawn when
the disturbances come from the asset market side, like a shift in the AA due to a change in the demand
for money. A sudden increase in the demand for money for any level of income shifts the AA to the left,
acting in a restrictive way on Y, which would require more money to be financed. If the exchange rate is
free to float it appreciates, cutting net exports as much as it is required to contain Y. If the authorities
instead keep a fixed exchange rate, they immediately accommodate the increase in the demand for
money providing a larger supply of it, thus totally stabilizing output (shifting the AA to the right towards
its initial position). With disturbances originated on the money market, fixed exchange rates assure a
more stable Y.
27
Question 1
(a) Under imperfect asset substitutability, a country that is fixing the exchange rate of its currency can
at least temporarily use monetary policy to pursue domestic objectives.
True. Consider the double graph containing both the forex and the money market equilibrium. On
the forex market, equilibrium combinations of the exchange rate and the domestic interest rate
are along the open interest parity line and the latter can shift also when the exchange risk
premium changes, which happens when a change takes place in the amount of bonds
outstanding denominated in the domestic currency, net of those held in the portfolio of the
central bank: the higher that amount, the higher the risk premium, the higher-and-more-to-theright the position of the open interest parity in the upper graph. Suppose the authorities want to
expand monetary policy, thus lowering the interest rate, to pursue an expansion in domestic
private spending. The lower interest rate would trigger a depreciation of the exchange rate which
they do not want to happen. But if the monetary policy expansion has been performed by
purchasing domestic government bonds, a smaller ratio of domestic to foreign bonds remains in
the market, decreasing the value of the risk premium on the domestic currency and lowering the
open interest parity line. The equilibrium exchange rate, corresponding to the lowered interest
rate, depreciates less. If this is insufficient to reestablish the initial exchange rate, to be kept
fixed, the central bank can push down further the risk premium with sterilized intervention, i.e. by
purchasing more domestic bonds and selling an equivalent amount of foreign bonds, thus leaving
the money supply and the interest rate at their initially modified, respectively, higher and lower
levels, while pushing the open interest parity line down enough to cross the vertical above the
equilibrium interest rate at the desired fixed exchange level. Intuitively: with imperfect asset
substitutability the central bank can change the mix of domestic and foreign bonds in the market
thus manipulating the risk premium which becomes an additional instrument in its hands: with
the right combination of money supply and risk premium, the exchange rate and the interest rate
become two targets that can be pursued independently.
(b) The BalassaSamuelson theory, by explaining inflation caused by the catchingup process of less
developed countries, provides an explanation of why PPP (Purchasing Power Parity) holds, at least
in the longrun.
Balassa-Samuelson explains why, during the catching-up process, the prices of non-traded goods
increase faster than those of traded goods. PPP holds only for the latter as non-traded have no
reason to have their prices equalized with the corresponding goods abroad and they are traded
only domestically, with no contact with the currency market. In this sense the statement is false:
on the contrary, the Balassa-Samuelson story is one of the reasons to deny PPP between price
indices that include also non-traded goods and services. When the catching-up process is finished,
the ratio between the price index of non-traded and the price index of traded goods and services
is equalized with the same ratio in developed countries. But new shocks are possible and nontraded goods have no reason to fulfill the PPP condition.
28
(c) A degree of shortrun passthrough, from the exchange rate to import prices, smaller than 1,
reinforces the Jcurve effect, making a worsening of the current account the most likely shortrun
outcome of a currency depreciation.
False. With a smaller increase in import prices, the immediate impact of a depreciation on the
import bill (when imported volumes are still unchanged) is smaller and therefore a worsening of
the current account is less likely and, if it happens, it is a smaller worsening.
Question 2
(a) A balance of payments deficit, with a fixed exchange rate, tends to decrease the official reserves of
a countrys central bank and the money supply of the economy. True or false? Explain your answer
carefully, perhaps also with a numerical example.
True. With a balance of payments deficit outgoing payments in foreign currency are larger than
payments received from abroad in foreign currency. Therefore the latter is in short supply and tends to
appreciate. To keep a fixed exchange rate (thus preventing the depreciation of the domestic currency) the
domestic central bank must intervene in the forex market to sell foreign currency while buying domestic
currency. These interventions decrease the official reserves and the outstanding amount of domestic
currency (the money supply) as well. If the balance of payment deficit is valued 50 units of foreign
currency, the effort to keep a fixed exchange rate (at the level of, say, 2 units of domestic currency per
unit of foreign currency) will decrease the official reserves by 50 units of foreign currency and the money
supply by 100 units of domestic currency.
(b) In the sentence above balance of payments deficit means a current account deficit. True or false?
Why?
False. What matters is the overall balance of payments, net of official transactions. The value of the
domestic currency can be pushed down both by current account transactions, like the excess of imports
over exports of goods and services, and by financial account operations such as the excess of portfolio or
direct investment abroad over investments from abroad. When the exchange rate is left freely floating,
the balance of the current account plus the balance of the financial account is zero. But when the central
bank intervenes with official transactions, the sum of the current account balance and of the balance of
the financial account is the change in official reserves.
(c) Answer again part a) of this question considering the case where the countrys central bank
sterilizes its intervention on the foreign exchange market. How can this sterilisation take place?
Can in last for ever?
To sterilize the impact of the foreign exchange intervention on the money supply, the central bank must
reinsert in the market the money absorbed by selling reserves of foreign currency. This can be done, for
instance, with open market purchases of domestic assets such as government bonds. But this cannot last
forever if the balance of payments keeps being in deficit: sooner or later the amount of foreign currency
reserves will be exhausted and it will become impossible for the central bank to borrow more reserves on
international markets or from international organizations such as the IMF. At that point the fixed
exchange rate will have to be abandoned together with forex interventions of the central bank. [On the
contrary, if interventions are not sterilized, the restrictive monetary policy impact that they cause could
help restricting aggregate domestic demand, imports and therefore the balance of payments deficit.
After some time the latter could disappear a no more interventions with sales of forex reserves would be
needed.]
29
Question 3
A country called China is pegging its exchange rate to a fixed level. Markets have been expecting the
pegging to continue successfully in the future. Suddenly, markets expectations change: the expected
future exchange rate of the Chinese currency becomes stronger as markets start thinking that the large
Chinese current account surplus will convince Chinese authorities to abandon the pegged level and
appreciate the currency.
(a) Use the double graph including the currency and the money markets to show how a speculative
attack could follow. Suppose Chinese authorities do not change their mind and keep pegging their
currency to the same fixed level. What are the consequences for the Chinese money supply and
Chinese foreign reserves?
The sudden change in expectations causes an inward (down and to the left) shift of the open interest
parity line in the upper part of the graph. With the same Chinese interest rate the shift would trigger an
appreciation, the expected appreciation. To keep pegging the old exchange rate Chinese authorities must
decrease the interest rate that must now correspond to the starting exchange rate on the new open
parity line. To decrease the interest rate an expansion of the money supply is required as can be shown in
the lower part of the graph. The expansion of the money supply is an automatic result of the
interventions of the Chinese central bank on the forex market: purchasing an equivalent amount of
foreign reserves (which therefore increase by that amount) additional domestic currency is poured into
the money market.
(b) By avoiding to appreciate the currency Chinese authorities may be underestimating the problems
causes by excessive and too prolonged current account surpluses. Which problems?
The general answer is like for Example 5, Question 1c), from Chapter 19 of KOM. [In the specific case of
China external surplus does not sacrifice domestic investment which is very large, with saving even larger
and therefore CA=S-I strongly positive. The main problem for China is where to invest the surplus abroad,
without risking to loose part of its value when other currencies depreciate, when debtor countries have
difficulties in paying back their debts or when the economies of countries that receive Chinese
investments (even direct investments by the sovereign fund where part of Chinese reserves are
accumulated) are badly managed with poor results in the activities that receive investments from China.
Chinese authorities, for example, have criticized US authorities citing the risk of repeated banking and
financial crises that could endanger Chinese credits with US banks.]
30
Question 1
(a) Instead of expressing the exchange rate of the Turkish lira directly in terms of Chilean pesos, one
can pass through a vehicle currency and get the same result.
One can pass through a vehicle currency like the US dollar: relying on the cross exchange rate
rule stating that the number of pesos required to buy one lira must be equal to the number of
dollars required to buy one lira times the number of pesos required to buy on dollar. The reason
for doing this cross-rate calculation can be the fact that the market for direct exchanges of liras in
pesos is thin and illiquid, with infrequent deals, showing unreliable and unstable exchange rates,
while both currencies have a rich set of transaction with the dollar, expressing meaningful
exchange rate values. The statement is therefore true, except that the same result is obtained
only when arbitrages keep profiting from possible differences between bilateral and cross
exchange rates: for instance, if pesos are cheaper in terms of liras when bought through dollars,
arbitrageurs should rapidly eliminate the difference with indirect purchases of pesos which they
should then use to repurchase liras directly, thus making them cheaper on the direct bilateral
market.
(b) To buy a currency with another I can use a forward contract, which is often called also a future
because they are exactly the same thing.
False, in the sense that they are not exactly the same thing. Both (forex) forwards and futures
express prices (exchange rates) for future delivery (of currencies). But while forwards are
bilateral over the counter contracts that can be tailored to the specific needs (in terms of
quantity of currency purchased as well as of maturity and day of the future delivery), futures
come in standard amounts on organised markets with standard maturities and dates of
execution. To compensate the disadvantage of their standardisation, futures provide a
transparent market where a purchase or a sale can be rapidly undone, relying on continuously
quoted rates. On the contrary, to undo a forward, a new bilateral over-the-counter agreement
must be reached, usually with the same counterpart.
(c) During a given period the only transactions of a country with abroad are the following: import of
raw materials (value: 50 units of foreign currency); interest received on a foreign bond bought in a
previous period (value: 5); reimbursement of a loan that had been granted by a domestic bank to a
foreigner in a previous period (value: 50); purchase of an apartment in the countrys capital by a
foreigner (value: 5). All the transactions are executed by acquiring or selling foreign currency from
or to the domestic central bank, which holds official reserves. Both the current and the official
transactions accounts of the balance of payment of that country in that period are in equilibrium.
To account for the listed transactions one must: write a debit of 50 in the current account (CA) to
express imports while subtracting the same amount from official reserves in the official
transaction account (OT); write a credit of 5 in the CA to express the positive contribution of the
income on the bond received (in a sense it is the price of the services of capital that have been
exported in the past and are now used by foreigners), while adding 5 to official reserves; credit
31
the financial account (FA) for re-importing 50 of capital, while adding the same amount to official
reserves; credit the FA for the direct investment of 5 (the apartment) received from abroad which
have also to be added to the official reserves account. The results are: CA=5-50=-45;
FA=50+5=+55; OT=-50+5+50+5=+10= CA+FA=-45+55. The statement is therefore false: the current
account has a deficit while the financial account has a larger surplus, allowing to account for a
net accumulation of reserves in official transactions. Note that this official accumulation is an
outflow of capital (the country is investing in foreign currency holdings) that compensates the
excess of above the line capital inflows over the CA deficit. In a T account:
Credits
Imports of goods
Incomes from capital
CA balance 5-50 = - 45
Portfolio investments
Direct investments
FA balance (net of OT) 5-(-50)=+55
50
5
- 50
5
Change in reserves
OT balance 0-10= -10
FA balance gross of OT +55-10=+45
Totals
Debits
-50+5+50+5=+10
10
10
Note that the totals balance as, by construction, CA+FA=0, where FA is gross of OT, which can
also be written CA+(FA-OT)=OT
Question 2
Controlling the nominal exchange rate and domestic spending, economic policy can try to reach both
internal and external equilibrium. But when the exchange rate is fixed, the authorities can find
themselves in a zone of economic discomfort and in the dilemma whether or not to move towards one of
the two equilibria while they contemporaneously move further away from the other one. Explain, comment
and illustrate which way out are available from the dilemma.
With the nominal exchange rate on the vertical axis and domestic spending on the horizontal axis,
internal equilibrium is obtained along a downward sloping line where the restrictive impact (on net
external demand) of appreciating the exchange rate is compensated by the expansion of domestic public
spending. Above (and to the right of) the internal equilibrium line there is excess aggregate demand,
inflation and overemployment, below the same line there is unemployment. External equilibrium, on the
contrary, is obtained along an upward sloping line, where depreciation stimulates net exports
compensating the increase in imports following an expansion of domestic spending, which also includes
purchases of imported goods. Above the line there is CA surplus and vice-versa. If the exchange rate is
fixed, the authorities can only move along a horizontal line and both equilibria can be reached only if the
fixed exchange rate is at the level where the two equilibrium lines cross. Suppose this is not the case.
Increasing domestic spending from low to high levels, the authorities can push the system from a point on
the left of both equilibrium lines (where there is unemployment and CA surplus) to points to the right of
32
both lines (where there is overemployment and CA deficit), passing through intermediate points that are
on the left on one line and on the right of the other. In these intermediate zones the dilemma arises:
moving towards one equilibrium causes the system to move further away from the other. The way out
can be a change of the fixed exchange rate or a shift in the equilibrium lines. The latter can be the result
of structural changes in propensities to spend and import or in the ability to export, for a given exchange
rate, but they can also be caused by tariffs or subsidies on imports and exports, spoiling free trade to
reach both equilibria without changing the exchange rate.
Question 3
(a) Given constant levels of the domestic and of the foreign interest rates, the only determinant of the ups
and downs of the nominal exchange rate of a countrys currency are fluctuations in expectations, i.e.
changes in the future expected value of that same exchange rate. True or false? Why?
True. It is an implication of the open interest parity equation (and of the corresponding geometrical
line on the E,R plane).
(b) Describe the effect of a change (ceteris paribus) in the expected exchange rate, in the short run, on the
level of economic activity and on the market exchange rate, using an AA-DD graph and starting from a
long term equilibrium position.
Suppose an expected depreciation, shifting to the right the open interest parity line and, therefore,
the AA. Note that the vertical shifts of both the interest parity line and of the AA are identical to the
increase in the future expected exchange rate. The DD has no reason to move. In the short run the
exchange rate in fact depreciates (not as much as its expected future value) and the level of economic
activity increases.
(c) An increase (depreciation) of the future expected level of the exchange rate can help in driving the
monetary policy of a country out of the so called liquidity trap. Explain and suggest how authorities
could induce such a change in expectations.
Consider the representation of the liquidity trap in the AA-DD graph, with the DD crossing the AA in
the flat segment (with the AA downward sloping part starting only for higher levels of income). An
expected depreciation shifts the whole AA line up (as the intercept of the AA with the E axis is E e/(1R*) ). If the expected depreciation is sufficiently large, the upward shift will cause the unchanged DD
to cross the shifted AA in its downward sloping part, out of the trap, where a monetary expansion can
still expand Y. A change in expectations on the exchange rate could be induced by authorities by
trying to create expectations of inflation (higher than abroad, thus somehow relying on relative PPP)
explicitly targeting a faster increase in the price index than the one which is actually taking place,
and, in any case, preannouncing (the expression forward guidance is often use today to indicate
such an instrument of monetary policy that relies on influencing expectations) a sufficiently
prolonged period of inflationary expansion of the money supply, even if the liquidity trap prevents the
transformation of such an expansion in a lower level of interest rates.

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International Monetary Economics from Krugman-Obsfeld-Melitz, Chapters 13-19

EXAMPLES OF EXAM QUESTIONS WITH GUIDELINES FOR ANSWERS

Chapter 13: 2, 1a; 3, 1a; 5, 1a&b; 7, 1a; 9, 2a&b; 10, 1c

Initial equilibrium in E0 and M0. Increasing Y shifts

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