SESS0068 - International Macroeconomics

Section A

Choose the most appropriate answer(s) to each question. No explanation is required. There may be more than one answers for each question. You get no point when your answer is incomplete or wrong.

1. According to absolute purchasing power parity (PPP)

A. countries with lower domestic inflation should see a depreciation of their currency

B. countries with higher domestic inflation should see a depreciation of their currency

C. the rate of change in the nominal exchange rate equals the inflation differential between two countries

D. a country’s prices are set in a foreign currency

2. Uncovered interest rate parity implies that:

A. The interest rates between two countries start in equilibrium, any change in the differential rate of inflation between the two countries tends to be offset over the long-term by an equal but opposite change in the spot exchange rate

B. Interest rates should change by an equal amount but in the opposite direction to the difference in inflation rates between two countries

C. Nominal interest rates in each country are equal to the required real rate plus compensation for expected inflation

D. The difference in interest rates in different currencies for securities of similar risk and maturity should be consistent with the expected changes in future exchange rate for the foreign currency

3. In 2006-2007, the domestic inflation rate in China has been around 6-8%. Which of the following statement is correct?

A. Inflation leads to loss of competitiveness for the Chinese export sector therefore this is bad for the Chinese economy.

B. If the Chinese currency (RMB) was allowed to revalue, the domestic inflation may have been reduced.

C. The US experienced similar level of inflation that year and this is a world problem

D. The average inflation rate in an emerging economy is often higher than in the developed world as what “Balassa-Samuelson model” suggests

4. In an open economy, a shortfall in domestic savings to finance domestic investment will lead to A. a current account deficit and (net) capital inflows

B. a current account deficit and (net) capital outflows

C. a current account surplus and (net) capital inflows

D. a current account surplus and (net) capital outflows

5. The J-curve illustrates which of the following?

A. the short-term effects of depreciation on the trade balance

B. the immediate increase in current account caused by a currency depreciation

C. the effects of depreciation on the home country's output level

D. the gradual adjustment of home prices to a currency depreciation

6. Country A has a current account deficit of $5 billion, and a non-reserve financial account surplus of $5 billion dollars. Which of the following statements is correct?

A. Country A’s net foreign assets decline by 5 billion dollars

B. Country A may have a floating exchange rate

C. Country A’s net foreign assets decline by 5 billion dollars

D. Country A’s net foreign assets decline by 10 billion dollars

7. Which of the following exchange rate systems does/do not require foreign exchange reserves for intervention?

A. floating exchange rates

B. pegged exchange rates

C. managed floating exchange rates

D. dual exchange rates

8. Suppose the central bank of Mexico is pegging its currency, the peso, to the U.S. dollar at a rate of 0.1$ per peso. If on a particular day the demand for pesos exceeds the supply by 1.3 billion pesos, the central bank will

A. Devalue the peso.

B. Use its reserves of U.S. dollars to buy 1.3 billion pesos.

C. Buy 1.3 billion pesos on the open market and sell them to those whose demands are not being met by private supply

D. Prohibit individuals from selling pesos for more than the official rate.

E. Add to its dollar reserves by $130,000,000.

9. The pound-dollar exchange rate is 0.6 pounds to the dollar. The yen-dollar exchange rate is 180 yen to the dollar. The yen-pound exchange rate is 120 yen to the pound. Starting with 10 pound, you can make arbitrage profits of

A. zero

B. 10 pound

C. 15 pounds

D. 20 pounds

10. Due to Japan's high saving rate, suppose that the Japanese invest abroad. This investment may result in a/an ______ of the Japanese yen and therefore a _______ for Japan.

A. appreciation; trade surplus

B. appreciation; trade deficit

C. depreciation; trade surplus

D. depreciation; trade deficit

Section B

Answer ALL the questions. Marks are only awarded for a brief justification (argument, algebra, graphs, etc.) that you provide. Points for each question are indicated below.

Question 1.

A Big Mac costs US$ 6.66 in the United States and Norweigian Krone (NKr) 60 in Norway. The actual nominal exchange rate 8.04 Nkr per US$. If PPP holds in the long-run, using the big Mac index information, please indicate how much is Norweigian Krone overvalued or undervalued? (5 points)

Question 2.

Since 1992, the UK has a flexible exchange rate and perfect capital mobility. On the day of the Brexit referendum, investors in the foreign exchange market started expecting a gloomy future of the British economy and hence large depreciation of the British Pound in the future. Characterise verbally and graphically the effects on interest rate and exchange rate. (5 points)

Question 3.

Assume Russia and the U.S. are the only two countries in the world. Let Russia be the home country and the US the foreign country and RUBLE/USD is the exchange rate. Suppose the law of one price holds for the traded goods and the share of non-traded goods in price indices is n=0.7 in both countries. Answer the following questions. School of Slavonic and East European Studies LATE SUMMER ASSESSMENT 2020/21 Page 7 of 9 SESS0068

a). Suppose there is 4 % growth per year in tradable sector and 1% per year in non-tradable sector in Russia. In the US productivity growth at 2.5% in both sectors. What is the change in real exchange rate and what happens to Russian Ruble? (5 points)

b). Russia is currently using a floating exchange rate regime. Suppose that there is an inflation rate of 2% per year in Russia and there is a deflation rate of 1% per year in the US. What will happen to the nominal exchange rate of ROUBLE every year if relative PPP holds? (5 points) (Hint: You need to use your answer in section a)

Section C: ESSAY QUESTIONS.

Answer ALL the questions. Points for each question are indicated below. Marks are only awarded for a justification (argument, algebra, graphs, etc.) that you provide. Answer should be structured, coherent and clear. Do not exceed 500 words in each question. You may be penalized if you exceed the limit.

1. Read the following story about Venezuela (obtained from a news website in 2016). Explain the problems Venezuela faced in its export sector and its implication to the country’s government budget deficit and current account. Use one of the crisis models you learned to explain the currency crisis. Cite the key facts in the text to support your view. Also discuss what should be done to solve the country’s currency crisis. (26 points)

“Under former President Hugo Chavez, Venezuela was committed to reining in capitalism. This aim saw most large and medium-sized businesses brought under state control – which critics say stifled innovation and growth. Chavez was able to maintain steady popularity throughout his time in office because of School of Slavonic and East European Studies LATE SUMMER ASSESSMENT 2020/21 Page 8 of 9 SESS0068 huge oil reserves in the country – the profits of which were used to lift citizens out of poverty.

Venezuela’s oil reserves account for 96 percent of its export earnings and half of its federal budget. This was fine when oil was selling for over $100 a barrel, but today – with prices hovering around $50 a barrel – the government has been forced to limit many previously generous social initiatives.

A drought earlier this year has also exacerbated problems in the country, given that over 65 percent of the country’s electricity supply comes from a single hydroelectric power dam.

The current President Maduro’s main solution to the growing crisis has been to print money, but this has simply served to send inflation through the roof. The International Monetary Fund (IMF) reports that inflation in the country will reach 481 percent by the end of the year, and 1,642 percent by next year. Other predictions see it reaching 2,200 percent.

Today a 100 bolivar note is worth around 2 U.S. cents on the black market — meaning people are forced to carry their money round in bags — and the devaluation of the currency has made it close to impossible for the state or private companies to buy supplies. The government has even resorted to trading oil for food with Jamaica. The result is food rations and a burgeoning black market where a bag of pasta can cost the equivalent of $300.” School of Slavonic and East European Studies LATE SUMMER ASSESSMENT 2020/21 Page 9 of 9 SESS0068

2. The current account imbalances between the world deficit countries (e.g. US, UK, the periphery Eurozone countries) and world surplus countries (e.g. China, Japan, Germany and other northern Eurozone countries) have been large in the last 10-15 years (see Figure 1). Some economists have claimed that the current account imbalances are all about spending imbalances and exchange rate policy has nothing to do with it. Please comment on this claim and discuss your view concerning the causes of the current account imbalances. If you are the policy maker, how will you design the policies to reduce the world current account imbalances and ensure a balanced growth? (26 points)