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ECON 1082 International Monetary Economics Semester 1 2011 Exam

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SECTION A MCQ = 25 Questions = 25 Marks

1.

If Australia purchases web services from an Indian company, and the Indian company deposits
the payments in a branch of an Australian bank, it will be reflected in the Australian balance of
payments as
(a) A debit in the current account and a credit in the financial account.
(b) A debit in the current account and a debit in the financial account.
(c) A credit in the current account and a debit in the financial account.
(d) A credit in the current account and a credit in the financial account.

2.

Which of the following statements is incorrect?

(a)
(b)
(c)
(d)

3.

The level of net foreign debt is determined by the Current Account of the Balance of
Payments.
If a Current Account deficit is financed by the Central Bank the economys level of wealth
remains unchanged.
A debit item on the Financial Account may be counterbalanced by a credit item on the
same account.
None of the above.

If foreigners are accumulating financial claims on the domestic economy the domestic
economy must
(a)
(b)
(c)
(d)

Be running a financial account deficit.

Be running a current account deficit.
Have excess national savings.
None of the above.

4.

If the sum of the financial account and current account is greater than zero, there will be
(a) An excess demand for foreign exchange.
(b) A reduction in international reserves under a fixed exchange rate regime.
(c) Upward pressure on the price of foreign exchange.
(d) None of the above.

5.

If two closed countries have the same real rate of interest

(a) The opportunity cost of one unit of future consumption is the same in both countries.
(b) The opportunity cost of one unit of current consumption is the same in both countries.
(c) There is no incentive to engage in inter temporal trade.
(d) All of the above.

6.

Which of the following statements relating to the closed economy real rate of interest is
correct?

ECON 1082 International Monetary Economics sample exam 2015

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(a)
(b)
(c)
(d)

7.

The lower is the closed economy real rate of interest the lower the opportunity cost of
future consumption.
The lower is the closed economy real rate of interest the greater is the opportunity cost of
current consumption.
The lower is the closed economy real rate of interest the more likely it is that the country
will run a balance of trade deficit when the economy is opened up.
The lower is the closed economy real rate of interest the more likely it is that the country
will run a balance of trade surplus when the economy is opened up.

In the process of inter-temporal trade

(a)
(b)
(c)
(d)

The country that has the higher real rate of interest is worse off.
With everything else being held constant the nation which undertakes relatively more real
investment will run a Balance of Trade deficit.
The country that has the lower real rate of interest will be worse off.
A country can increase its future consumption by reducing its own savings and
investment.

8.

In terms of inter-temporal trade in the context of two large economies, if country B has a
relatively high closed economy rate of interest compared to country A, then it is likely that
(a) Country B will run a financial account surplus.
(b) Country B will run a financial account deficit.
(c) Country B has a comparative advantage in current consumption.
(d) Country A has a comparative advantage in future consumption.

9.

The presence of transportation costs and tariffs is a problem for

(a) Both absolute and relative purchasing power parity.
(b) Absolute purchasing power parity only.
(c) Relative purchasing power parity only.
(d) Covered interest parity.

10.

Relative purchasing power parity asserts

(a) That the country that has the higher expected rate of inflation will have the currency that
is expected to increase in value.
(b) That the country that has the higher expected rate of inflation will have the currency that
is expected to fall in value.
(c) That the country that has the higher expected rate of inflation will have a forward rate
that equals the expected spot rate.
(d) None of the above.

11.

In which of the following relationships between the expected future spot exchange rate and the
forward exchange rate would a speculator have an incentive to sell foreign currency in the
forward market?
(a) E(e) < f
(b) E(e) > f
(c) E(e) = f
(d) E(e) = 1/f

ECON 1082 International Monetary Economics sample exam 2015

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12.

If f = 1.5, e = 1.45, i = 12% and i* = 6%

(a) There will be covered investment overseas.
(b) There will be pressure on e to increase.
(c) There will be pressure on f to decrease.
(d) None of the above

13.

The forward exchange rate and the expected spot exchange rate
(a) Are effectively the same concept.
(a) Will only be equal if the current spot and forward exchange rates are equal.
(b) Are different concepts but could be equal to each other if individuals are risk neutral.
(c) Based on the unbiased expectations theory will always equal the eventual or realized
exchange rate

14.

If covered interest parity holds

(a) The unhedged cost of borrowing overseas will equal the domestic cost of borrowing.
(b) The interest differential on bonds will equal zero.
(c) Domestic and foreign bond rates will be equal.
(d) The overall cost of hedged borrowing overseas will equal the domestic cost of borrowing

15.

If uncovered interest arbitrage holds

(a) The interest differential on bonds will equal zero.
(b) The domestic currency will be expected to increase in value when domestic bond rates
are higher than foreign bond rates.
(c) The foreign currency will be expected to decrease in value when domestic bond rates are
less than foreign bond rates.
(d) Domestic and foreign bond rates will be equal.

16.

According to the International Fisher relationship the economy that has the lower expected
rate of inflation will
(a) Have the higher real rate of interest.
(b) Have a lower real rate of interest.
(c) Have the higher nominal rate of interest.
(d) Have the lower nominal rate of interest.

17.

According to the monetary model of the exchange rate, an increase in the domestic nominal
rate of interest will result in a reduction in the value of the domestic currency, as
(a) The expected rate of inflation has decreased.
(b) The expected rate of inflation has increased.
(c) A domestic price level increase is required to eliminate the resulting excess demand for
money.
(d) A domestic price level decrease is required to eliminate the resulting excess supply of
money.

18.

According to the Dornbusch model

(a) Purchasing power parity holds in the short run
(b) Price flexibility provides an explanation for exchange rate volatility

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(c)
(d)

The money market is cleared in the short run via a change in the price level.
None of the above

19.

Assuming a small country in the export market, if there is an increase in the world price of
exports then the foreign currency value of export receipts will
(a) Increase.
(b) Decrease.
(c) Remain unchanged.
(d) Vary depending on whether the price effect is greater or less than the volume effect.

20.

If a country is a large country in both its import and export market an increase in the exchange
rate
(a) Will reduce foreign currency import expenditure.
(b) Will decrease the quantity of imports and increase the quantity of exports.
(c) Could increase the trade balance measured in foreign currency.
(d) All of the above.

21.

According to the basic absorption approach, a reduction in the value of the domestic currency
(a) Will improve the trade balance through a decrease in income and output if the economy is
above full employment.
(b) Will improve the trade balance through an increase in income and output if the economy
is above full employment.
(c) May improve the trade balance through an increase in direct absorption.
(d) May improve the trade balance through a reduction in direct absorption.

22.

A reduction in the value of the domestic currency

(a) Is more effective at improving the trade balance once the terms of trade effect is
considered.
(b) Is less effective at improving the trade balance once the terms of trade effect is
considered.
(c) May lead to an increase in savings and hence a deterioration in the trade balance.
(d) May lead to an increase in absorption and hence an improvement in the trade balance.

23.

If QT<CT, we can say that:

(a) A trade deficit exists.
(b) A trade surplus exists.
(c) Domestic inflation is present.
(d) None of the above.

24.

Under the Australian model, changes to the level of government spending should be the policy
weapon used
(a) For the objective which has the flattest balance schedule
(b) For the objective which has the steepest balance schedule
(c) To achieve internal balance
(d) To achieve external balance

25.

A reduction in the value of the domestic currency

(a) Is more effective at improving the trade balance once the terms of trade effect is
considered.
(b) Is less effective at improving the trade balance once the terms of trade effect is considered.
(c) May lead to an increase in savings and hence a deterioration in the trade balance.

ECON 1082 International Monetary Economics sample exam 2015

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(d) May lead to an increase in absorption and hence an improvement in the trade balance.

ECON 1082 International Monetary Economics sample exam 2015

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SECTION B COMPLETE ANY 3 QUESTIONS OUT OF GIVEN 5

Question 1
(a) Assume an economy is in internal balance but not external balance. Externally, it is
experiencing a current account deficit. Also assume that the IB schedule is steeper than the
EB schedule. Explain how and why an attempt to restore external balance will disrupt
internal balance and what policy would be used to restore external balance.

To maintain
external balance, an
increase in absorption
must be matched by an
increase in RER.

Initially the economy is situated at point C.

As the EB schedule is relatively flat, policy

makers will increase the nominal exchange rate to increase the RER in order to restore external
balance. An increase in the RER will increase the relative price of tradeable goods, which will
increase the production of tradeables and reduce the consumption of tradeables. The current
account deficit will be eliminated, and external balance restored at point D.

(b)

What has happened in the market for non-tradeables? As the relative price of non-tradeables has
fallen, the consumption of non-tradeables has increased and the production of non-tradeables has
fallen. This has led to excess demand in the market for non-tradeables, and therefore inflation at
point D.
(10 marks)

Assume an economy is in external balance but not internal balance. Internally, it is

experiencing unemployment. Also assume that the IB schedule is steeper than the EB
schedule. Explain how and why an attempt to restore internal balance will disrupt external
balance and what policy would be used to restore internal balance.

o maintain
internal balance, an
increase in absorption
must be matched by a
reduction in RER.

If the authorities maintained a fixed

exchange rate and attempted to
eliminate the excess supply of non-tradeables by increasing government expenditure
(increasing absorption, which increases the demand for non-tradeables), this would worsen
the trade deficit.

(c)

On the other hand, an increase in the nominal exchange rate (increasing the real exchange rate,
which reduces the production of non-tradeables and increases spending on nontradeables) would be insufficient to restore external balance.
(10 marks)

Critically comment on the following statement.

The external balance schedule is upward sloping as an increase in the real exchange rate
causes an increase in the level of government expenditure.

ECON 1082 International Monetary Economics sample exam 2015

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The EB schedule shows combinations of the RER and absorption that maintain external
balance. To maintain external balance, an increase in absorption must be matched by an
increase in RER.

An increase in RER will increase (decrease) CN (CT) and increase (reduce) QT (QN). An
increase in RER switches spending away from tradeables to non-tradeables (as nontradeables are now relatively inexpensive) and increases profits in the traded goods sector
relative to the non-traded goods sector.

An increase in absorption will increase CN and CT.

(5 marks)

Question 2 (Do we have to include a diagram to obtain full marks in each of the following cases?)
With reference to IS LM BP analysis for a small economy, answer the following questions and
provide the required explanation:
(a) Assuming zero capital mobility, examine the effect that an increase in the level of
government spending has for the domestic economy. Consider both the case of a fixed and
flexible exchange rate.

Fixed exchange rate

With a fixed exchange rate, an increase in G results in a tendency towards a balance of

payments deficit.

There will be a crowding-out effect as fiscal policy is completely ineffective.

Due to the excess demand of foreign currency, there will be pressure for an increase in e as a
result International Reverse will be reduced, which leads to a decrease in Money Supply and
net exports to increase.

Flexible exchange rate

Under a flexible exchange rate fiscal policy is less effective as the degree of capital mobility
increases.

When capital is perfectly immobile (no crowding-out effect) fiscal policy is very effective as
an increase in G results in a tendency towards a balance of payments deficit (due to a current
account deficit), reducing the value of the domestic currency and net exports to increase,
improving the trade balance.

When capital is perfectly mobile fiscal policy has no effect as there is total crowding out due
to the value of the domestic currency increasing causing net exports to be reduced to the same
extent that G increases.
(12.5 marks)

(b) Assuming perfect capital mobility, examine the effect that an increase in the money supply
has for the domestic economy. Consider both the case of a fixed and flexible exchange rate.

Fixed exchange rate

ECON 1082 International Monetary Economics sample exam 2015

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With a fixed exchange rate, an increase in the money supply always results in a tendency
towards a balance of payments deficit whatever the degree of capital mobility.

The central bank under all degrees of capital mobility will have to sell foreign currency and
therefore receive domestic currency reducing the money supply.

Whatever the degree of capital mobility monetary policy never is effective.

Flexible exchange rate

With a flexible exchange rate and perfect capital mobility an increase in the money supply will
lead to a tendency towards a Balance of Payments deficit which will cause the value of the
domestic currency to decrease which in turn will increase net exports causing the IS curve to
shift to the right.

Therefore income does increase due to the increase in net exports, even though the rate of
interest and investment are unchanged.

Whatever the degree of capital mobility monetary policy is effective to some extent.
(12.5 marks)

Question 3
With reference to IS LM BP analysis for a small economy, answer the following questions and
provide the required explanation:
(a) Assuming perfect capital mobility, examine the effect that an increase in the level of money
supply has for the domestic economy. Consider both the case of a fixed and flexible
exchange rate.

Fiscal Policy with Fixed e & Perfect Capital Mobility

Monetary Policy with Fixed e & Perfect Capital Mobility

ECON 1082 International Monetary Economics sample exam 2015

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An increase in MS under a fixed exchange rate

An increase in the money supply always results in a tendency towards a balance of payments
deficit whatever the degree of capital mobility
The central bank under all degrees of capital mobility will have to sell foreign currency and
therefore receive domestic currency reducing the money supply.
Whatever the degree of capital mobility monetary policy never is effective.

Monetary Policy with Flexible e & Perfect Capital Mobility

(12.5 marks)

(b)

Assuming zero capital mobility, examine the effect that an increase in the money supply
has for the domestic economy. Consider both the case of a fixed and flexible exchange rate.

Fiscal Policy with Fixed e & Zero Capital Mobility

ECON 1082 International Monetary Economics sample exam 2015

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Fiscal Policy with Flexible e & Zero Capital Mobility

An increase
in G under a flexible exchange rate

When capital is perfectly immobile fiscal policy is very effective as an increase in G causes the
value of the domestic currency to decrease and net exports to increase.
When capital is perfectly mobile fiscal policy has no effect as there is total crowding out due
to the value of the domestic currency increasing causing net exports to be reduced to the
same extent that G increases.
Therefore under a flexible exchange rate the greater the degree of capital mobility the less
effective is fiscal policy.

Monetary Policy with Fixed e & Zero Capital Mobility

ECON 1082 International Monetary Economics sample exam 2015

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Monetary
Policy with Flexible e & Zero Capital Mobility

An increase in
MS under a
flexible exchange rate

Whatever the degree of capital mobility monetary policy is effective to some extent
(12.5

marks)

Question 4
(a) Critically comment on the following statement.

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A country that does not share a currency unions business cycle should keep its own currency.

Currency union: The currency that circulates domestically is the same as that circulating in one or
more major neighbours or partners. Firmest commitment to a fixed exchange rate possible.

The costs and benefits of joining a currency union is the degree of economic symmetry.

If a home country and its potential currency union partners are economically similar or
symmetric (they face more symmetric shocks and fewer asymmetric shocks), then a common
monetary policy is appropriate.

If members of a currency union do not share similar business cycles, a common monetary policy
would be destabilising. When different shocks hitting different parts of the currency union, a
common monetary policy would leave the potential for one part of the currency union to experience
high unemployment while another enjoyed a strong economy.
(10 marks)

(b) If an economy is experiencing a tendency towards a balance of payments deficit its real
exchange rate will have to increase. Compare and contrast the way that this is brought about
under a fixed and a flexible exchange rate regime.

It is argued that if there is a flexible exchange rate and the country experiences a tendency
towards a balance of payments deficit the value of the currency will automatically go down
leading to a correction in the balance of payments, avoiding the painful adjustment process that is
required under a fixed exchange rate.

If there is a fixed exchange rate and the country is experiencing a tendency towards a balance of
payments deficit there are a number of things that are likely to happen that will in time restore
external balance.

Since it is a fixed exchange rate the money supply will be reduced as a result of the deficit this
will cause interest rates to increase. The decrease in money supply and increase in interest rates is
likely to lead to Capital inflow, which will improve the Financial Account.

The reduction in the money supply will also lead to income being reduced, which in turn will lead
to a reduction in imports. It is also likely to lead to wages and prices decreasing as a result of
deflation, which should improve the economys competitiveness and the current account.

It is argued that this deflationary process will not work as fast or as uniformly as the flexible
exchange rate adjustment process.
(10 marks)

(c) Why could a system of flexible exchange rates be inflationary?

It is argued that countries that have flexible exchange rates do not worry about inflation as much
as countries that have fixed exchange rates. It is argued that countries that have fixed exchange
rates are going to be vigilant to ensure that inflation does not undermine the viability of the fixed
exchange rate (given that, according to purchasing power parity, countries that fix their exchange
rates should have similar inflation rates over the long run). On the other hand countries that have
flexible exchange rates may not worry as much about inflation because if inflation does break out
a decrease in the value of the currency will ensure external balance.
(5 marks)

Question 5
Financial crises can stem from problems of private or public sectors balance sheets and have
domestic or external origins. Irrespective of its origins, a financial crisis is often an amalgam of
events, including substantial changes in credit volume and asset prices, severe disruptions in
financial intermediation, notably a reduction in the supply of external financing, large-scale
balance-sheet problems, and often a need for substantial government and international support

ECON 1082 International Monetary Economics sample exam 2015

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Reflecting on your learning in this course, in particular the theory of optimum currency areas and
currency crises, critically assess the statement above.
In your answer consider an example / examples of an economy or region that has experienced a
currency crisis.

An optimum currency area (OCA) can be defined as the optimal geographical area for a single
currency, or for several currencies, whose exchange rates are irrevocably pegged. The single currency,
or the pegged currencies, fluctuate jointly vis--vis other currencies. The borders of an OCA are
defined by the sovereign countries choosing to participate in the currency area.

Optimality is defined in terms of various OCA properties, such as price and wage flexibility, financial
integration, etc. Some other meta properties, looking at the similarity of shocks and monetary
transmission mechanisms, surfaced later.

Sharing these OCA properties reduces the usefulness of nominal exchange rate adjustments within the
currency area by lessening the impact of some types of shocks or facilitating their adjustment
thereafter. Countries forming a currency area expect benefits to exceed costs.
(25 Marks)

ECON 1082 International Monetary Economics sample exam 2015

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