ECON40915 International Finance 2021
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ECON40915-WE01
International Finance
2021
1 a) What is meant by a “credible target zone”? Develop Krugman’s (1991) model and then explain how a credible target zone has a stabilizing effect on the exchange rates. Explain the intuition behind the smooth pasting condition. (60 marks)
b) Use the Balassa-Samuelson model to explain why the purchasing power parity may not hold in the presence of nontraded goods. How is the relative productivity of tradeable goods of nations related to the real exchange rate? Carefully explain the intuitions using the Balassa-Samuelson model. (40 marks)
2 a) Consider the following two country chocolate model. Home country is endowed with
x units of dark chocolates and the foreign country is endowed with y units of white chocolates. Let 
denote the price of home chocolates in home currency and 
denote the price of foreign chocolate in foreign currency, s is the spot exchange rate (home currency/foreign currency). Both countries receive utilities from these two types of chocolates. Let home residents consume 
of home chocolates and 
of foreign chocolates. Let foreigners consume 
of UK chocolates and 
of US chocolates. The utility functions of home and foreign countries are ln
+ 
1 ln
and ln
+ 
2 ln
respectively where 
1 and 
2 are a positive constants.
(i) Set up the maximization problems of home and foreign countries and solve the equilibrium real exchange rate (
/
) showing each and every step. (30 marks)
(ii) What happens to the real exchange rate if 
1 rises? Why? Carefully
interpret your results. (30 marks)
b) Suppose the money stock follows a data generating process (DGP) : m t 
t 
1
t 
1 
2 
t 
2 , where 0 
1 
1 and 0 
2 
1 .
(i) What kind of DGP is it? (20 marks) (ii) Derive an expression for the exchange rate “news.” Carefully interpret
your results. (20 marks)
3 a) Consider the following loglinear Cagan money demand function:
m t 
s t 
[ E ts t 
1 
s t]
where mt = natural log of money stock at date t and st = natural log of the spot exchange rate (home currency/foreign currency), and η>0. Let the money supply follow a process: 
= 
− 
1 
−1 where 0< 
1 <1 and 
is a white noise. Derive the rational expectation solution for 
. What kind of data generating process does the exchange rate follow? How does it differ from a random walk and why?
(50 marks)
b) Using the same Cagan money demand equation, illustrate the distinction between exchange rate fundamental and bubble and comment on the frequently held belief that a bubble necessarily reflects irrational exuberance of investors. (50 marks)
4 Examine whether the following statements are true or false. Give solid support of your reasoning using a relevant model or an example whichever is appropriate.
a) If the unbiased forward rate hypothesis holds, a currency bought at a discount is expected to appreciate in value. (25 marks)
b) If a country’s capital account is in deficit, this country is running a trade deficit. (25 marks)
c) The law of one price is equivalent to the purchase power parity. (25 marks)
d) The carry trade profit opportunity arises due to the failure of uncovered interest parity condition. (25 marks)
2022-05-06