Economics 3422 Sample Midterm examination. Part A: Multiple-choice questions. Choose the best alternative. The total for Part A is 25 points.

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1 Economics 3422 Sample Midterm examination Instruction: Put your name and PeopleSoft ID on the question sheets and the blue book. Put your answers in the blue book only. Turn in both at the end of the examination. Part A: Multiple-choice questions. Choose the best alternative. The total for Part A is 25 points. 1. Ford Motor Company buys an existing manufacturing plant in Canada and pays for the purchase by giving the shareholders of the existing manufacturing plant an equal value of Ford Motor Company stocks. This transaction is recorded in the U.S. BOP as: a. debit in long-term asset abroad and credit in foreign-owned long-term asset b. credit in long-term asset abroad and debit in foreign-owned long-term asset c. debit in import of goods and services and credit in foreign-owned short-term asset d. debit in long-term asset abroad and credit in foreign-owned short-term asset e. none of the above 2. Futures and forward contracts on foreign currency are bought and sold, respectively, on a. the New York Stock Exchange; the American Stock Exchange b. the Chicago Mercantile Exchange; the New York Options Exchange c. the Philadelphia Exchange; the Chicago Mercantile Exchange d. the Chicago Mercantile Exchange; the forward market of the foreign exchange market e. the spot market; the forward market 3. A foreign currency future contract differs from a foreign currency forward contract in that future contracts a. are traded on an organized exchange b. have four maturity dates per year c. can be for any amount d. all of the above e. only (a) and (b) of the above 4. A contract that gives the owner the right (not the obligation) to buy a Eurodollar time deposit at a fixed interest rate is a. an Eurodollar call option b. an Eurodollar put option c. an Eurodollar interest rate swap d. an European put option 5. According to PPP, if the price level in the U.S. in 1998 is 120, and the price level in Canada is 110, the $/C$ exchange rate for 1998 is approximately a b c d e. none of the above 6. If the inflation rate in the U.S. is 4% in 2005, and the German inflation rate is 6% in 2005, then according to relative PPP a. $ depreciates in 2005 b. depreciates in 2005 c. $ and are trading at par d. none of the above 7. If the domestic and the foreign interest rates are 12% and 10% respectively, then according to uncovered interest rate parity Page 1

2 a. foreign currency is expected to appreciate by 4% b. foreign currency is expected to appreciate by 2% c. foreign currency is expected to depreciate by 4% d. foreign currency is expected to depreciate by 2% 8. Globalization of financial markets allows for a. more independent monetary policy b. more interdependent monetary policy c. a more stable world financial market d. all of the above 9. The LIBOR rate is a. a Eurocurrency deposit rate b. a Eurocurrency lending rate to the bank s best customers c. a Eurocurrency exchange rate d. a Eurocurrency lending rate between Eurobanks 10. The committee most responsible for monetary policy in the U.S. is the a. Federal Reserve Committee b. Interest Rate Committee c. Department of the Treasury d. Federal Open Market Committee e. none of the above 11. An exporter who expects to receive foreign currency payment in three months can hedge against foreign currency by the foreign currency in the forward market. a. appreciation; buying b. appreciation; selling c. depreciation; buying d. depreciation; selling 12. If Y > C + I + G, we can expect the capital account to be a. in a deficit b. in a surplus c. zero d. impossible to tell 13. In the monetary approach to the BOP and the exchange rate, an money will result in a BOP under a fixed exchange rate. a. excess demand for; deficit b. excess supply of money; deficit c. excess demand for; surplus d. excess supply of money; surplus e. both (b) and (c) above 14, In the monetary approach to the BOP and the exchange rate, an money will result in a domestic currency under a floating exchange rate. a. excess demand for; appreciation b. excess supply of money; appreciation c. excess demand for money; depreciation d. none of the above Page 2

3 15. The demand for money function is positively related to a. the price level, the nominal interest rate, and the expected inflation rate b. the price level, the real income level, and the nominal interest rate c. the real income level, the level of real wealth, and the nominal interest rate d. the level of real wealth, the nominal interest rate, and the expected inflation rate e. none of the above 16. The basic balance is also known as the balance on a. goods and services b. short-term capital account c. current account and long-term capital d. none of the above 17. Other things equal, an export of goods from the U.S. as a gift to a foreign country would lead to an improvement in the U.S. but no change in the. a. current account; capital account b. capital account; current account c. merchandise trade balance; current account d. current account; basic balance 18. If the expected $/ spot rate one year from now is $0.50/ and the current spot rate is $0.52/, we expect the current a. U.S. interest rate to be higher than the U.K. interest rate b. U.K. interest rate to be higher than the U.S. interest rate c. both the U.S. and the U.K. interest rates are the same d. insufficient information to tell 19. If the money supply is $400, and the money multiplier is 2, then a. bank reserves = $200 b. bank reserves = $800 c. monetary base = $200 d. monetary base = $ In the Monetary approach, equilibrium in the domestic money market, where money supply equals money demand, determines a. foreign exchange rate b. domestic interest rate c. domestic price level d. domestic real income 21. If the $/ spot rate is $0.50/ and the PPP $/ rate is $0.45/, a. $ is overvalued and is expected to depreciate b. $ is undervalued and is expected to appreciate c. $ is overvalued and is expected to appreciate d. $ is undervalued and is expected to depreciate e. $ is fairly valued 22. The effective exchange rate is a. a bilateral exchange rate b. the same as the real exchange rate c. a multilateral exchange rate against a basket of foreign currencies d. the actual exchange rate that international transactions take place Page 3

4 23. Transactions in categories I, II, III are called, while category IV is called, respectively, a. exogenous items; endogenous items b. exogenous items; autonomous items c. autonomous items; endogenous items d. autonomous items; endogenous items e. autonomous items; accommodating items 24. Suppose starting from an equilibrium situation, i.e., no international capital flow, now you observe capital outflow from Germany into Japan. Based on this observation you may predict: a. a depreciation of the and an appreciation of the b. an appreciation of the and an depreciation of the c. an appreciation of both the and the exchange rates d. a depreciation of both the and the exchange rates 25. In the model (diagram) for the foreign exchange market, demand for foreign currency represents in the BOP, and supply of foreign currency represents in the BOP a. credit; debit b. credit; credit c. debit; debit d. debit; credit d. none of the above Part B: Short answer questions. Make sure you answer all parts of the questions. Questions 1 and 2 are each 5 points. Questions 2 and 3 are 10 points each. The total for Part B is 30 points. 1. Define or give short explanations to the following: a. A net debtor country b. The monetary approach to exchange rate 2. Given that in 2010, the $/ exchange rate is $0.698/, and the German CPI is 119, the U.S. CPI is 117. What is the real $/ exchange rate for 2010? 3. A simple money demand function can be expressed as L f ( P, Y, i, W, E( p )) where P = domestic price level, Y = domestic real income level, i = domestic interest rate W = real wealth, and E( p) = expected inflation. For each of the variables on the right hand side, explain (i.e., how and why) carefully how they are related to money demand. 4. Suppose we have Country A and Country B with a floating exchange rate between them. Suppose further that the Central Bank of Country B (the home country) purchases Country A s (foreign country) currency with its own currency. Discuss carefully how this event affects the exchange rate between countries A and B using the Monetary approach. (i) Draw and label carefully the initial equilibrium in Country B s money market. Page 4

5 (ii) Do you expect the action by the Central Bank of Country B to have any effect on the money market in Country B? Why or why not? (iii) Do you expect the action by the Central Bank of Country B to have any effect on the spot exchange rate market? Why or why not? (iv) Do you expect any capital flow between Countries A and B resulting from the action by the Central Bank of Country B? Explain. In answering this part of the question consider how Country B s Central Bank s action may affect both Country B s interest rate and the spot exchange rate which in turn may affect the expected appreciation term (xa) in the uncovered interest parity condition. Part A: Multiple-choice question. Solution to Sample Midterm Examination 1. A; 2. D; 3. E; 4. B; 5. A; 6. B; 7. B; 8. B; 9. D; 10. D; 11. D; 12. A; 13. E; 14. A; 15. E; 16. C; 17. C; 18. B; 19. C; 20. B; 21. B; 22. C; 23. E; 24. A; 25. D. Part B: Short answer questions. 1. a. A country whose ownership of foreign assets is less than foreign countries ownership of its assets. b. This is an exchange rate theory where changes in the domestic or foreign money markets are the main causes of movements in exchange rates. 2. Use the formula that the RER = nominal exchange in 2010 x (German price level in 2010/U.S. price level in year 2010): x (119/117) = $0.71/. 3. P is positively related to money demand because an increase in the price level requires more money to carry out a given (same) transaction as before. Y is positively related to money demand for two reasons. First, an increase in real income will increase consumption, which will require more money for transaction purposes. Second, an increase in real income will also increase demand for asset where money is an asset. The interest rate, i, is negatively related to money demand, because i represents an opportunity cost of holding money. An increase in the interest rate will lead to a substitution away from money as an asset to bonds. Real wealth, W, is positively related to money demand for the same identical reason that Y is positively related to money demand. Expected inflation is negatively related to money demand for two reasons. First, an increase in expected inflation means that money is expected to lose purchasing power, making it less attractive to hold. Second, with expected inflation, the return of other assets (especially real asset) is expected to increase with inflation. Once again making money less attractive to hold. Page 5

6 4. (i) s M 1 s M 2 i B i 1 i 2 M d M 1 M 2 M B (ii) (iii) (iv) Yes, the purchase of country A s currency by the central bank of country B with its own currency increases the international reserves of country B s central bank. This will increase the money s s supply in country B from M 1 to M 2, causing interest rate in country B to decrease from i 1 to i 2. Yes, when central bank of country B purchases country A s currency with its own, there is increased demand for country A s currency in the foreign exchange market and an increased supply of country B s currency in the foreign exchange market. As a result, country A s currency e B A, t will appreciate against country B s currency. This means that / will increase and xa will decrease. This is difficult to say. Since both i B and xa decrease, if they decrease by the same amount, there will be no capital flow. Or, capital flow can flow from country A to B, or from country B to A. This can be seen from uncovered interest rate parity condition i B i A xa, where Ee xa B / A, t 1 e B / A, t e B / A, t. Page 6

Macroeconomic Theory and Policy

ECO 209Y Macroeconomic Theory and Policy Lecture 6: Introduction to the Open Economy Gustavo Indart Slide 1 The Balance of Payments On the one hand, the home country will export goods and services to other