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Eco 365 International Monetary Economics

Midterm Fall 2021


        Part A. Multiple Choice 15 marks: Circle the best answer. Questions 1-5 are worth 3 points each.

        1. Collapse of the Bretton Woods System followed because

a. US trade deficits undermined confidence in the USD.

b. the system created high inflation across Bretton Woods members.

c. both (a) and (b).


        2. Suppose the domestic economy experiences a fall in the range of prod-ucts it manufactures. Then the supply-demand model of exchange rates predicts

a. domestic depreciation and a decrease in X − M.

b. domestic appreciation and an increase in X − M.

c. domestic appreciation and a decrease in X − M.


        3. Suppose the exchange rate is a random walk and initially at its PPP value. If domestic government spending rises then

a. countervailing shocks will return the exchange rate to its PPP value.

b. long term deviations from PPP will likely ensue.

c. deviations from PPP happen in the short run but not the long run.


        4. Suppose investors become convinced that foreign government debt is too high. Then the supply-demand model of exchange rates predicts

a. domestic appreciation and an increase in X − M

b. a leftward shift of the supply curve and leftward shift of the demand curve

c. a rightward shift of the supply curve and leftward shift of the demand curve.


        5. South Africa exports gold, which is priced in U.S. dollars (the foreign currency). The South African currency is the rand. Let the price of gold rise. Then the supply-demand model of the rand-USD exchange rate predicts

a. domestic depreciation and a rise in net exports of goods other than gold.

b. domestic appreciation and a fall in net exports of goods other than gold.

c. decreases in South African gold exports.


        Part B. Numerical Problems 30 marks:

        1. Suppose the Canadian dollar-U.S.dollar rate is 1.25 Canadian dollars (CAD) per U.S. dollar (USD). The Euro-USD rate is 0.7864 euros per U.S. dollar. The Euro-CAD rate is 0.6804 euros per Canadian dollar.

(5) a. Calculate the cross rate between Canadian dollars (CAD) and U.S. dollars (USD) using the euro as an intermediate currency.

(5) b. Suppose an investor has 500,000 CAD. Calculate profits from triangular arbitrage which uses the cross rate between CAD and USD.


        2. Consider the following spot rates for converting U.S. dollars (USD) and Canadian dollars (CAD).

Toronto: bid=1.256 CAD per USD. ask= 1.263 CAD per USD.

New York: bid=0.8114 USD per CAD. ask= 0.8294 USD per CAD.

(10) Consider converting 200,000 USD to CAD in New York and then converting the resulting amount of CAD back to USD in Toronto. Determine if there are there arbitrage opportunities from this trade.


        3. Suppose the Canadian dollar-Euro spot rate is S0 = 1.42 CAD per euro. The one year dollar-Euro forward rate is F0,1 = 1.46 CAD per euro. The one year interest rate in the Canada is 2 percent; in Europe the one year interest rate is 1.5 percent.

(5) a. Suppose an investor has 500,000 Canadian dollars to invest then converts it to euros at the spot rate, invests the resulting capital at the European interest rate for one year and converts the proceeds back to CAD at the forward rate. Determine returns from this trade.

(5) b. Suppose the investor buys one year Canadian Treasury securities with the 500,000 instead. Determine whether this strategy or the one in (a) generates a greater return. Based on this calculation explain in a sentence whether this forward rate is the equilibrium rate.


        Part C: Theoretical Problems 55 marks

        1. Analyze the effect of the following independent shocks on domestic Y and i in the Fleming-Mundell model.

(10) a. A rise in domestic income taxes with imperfect capital mobility and a floating exchange rate. State the long run effect on X − M.

(10) b. A rise in foreign investment I* with perfect capital mobility and a fixed exchange rate. State the long run effect on domestic central bank reserves of foreign currency.

(5) c. Domestic investors decide to hold more of the domestic money supply as cash rather than demand deposits. The exchange rate is fixed and capital is imperfectly mobile.

(5). d Suppose the domestic economy is initially below Yn. With a diagram determine whether a fixed or floating exchange rate is superior for the shock in (b). Also state your finding in a sentence.


        2. Analyze the following independent shocks in the supply-demand model of exchange rates. The exchange rate is floating.

(5) a. Suppose the foreign real estate market experiences sustained falls but the domestic real estate market is rising.

(5) b. Domestic assets are thought to be riskier than before but risk of foreign assets is unchanged.

(10) c. Suppose investors think the exchange rate is above its PPP value but believe PPP deviations are corrected quickly.

(5) 3. In a few sentences analyze the following statement explaining whether it is true, false or uncertain. Points are given for the quality of the explanation.

Frequent money supply shocks will create random walk exchange rates.