Final exam Non-detailed correction 3 hours

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1 International Finance Master PEI Spring 2013 Nicolas Coeurdacier Final exam Non-detailed correction 3 hours Documents not allowed. Basic calculator allowed. For the Multiple Choice Questions, use the answer sheet at the end of the exam. For the essay questions, please be precise but concise in your answers. This are indicative directions on how structure the essay questions and what was expected. 1. Multiple choice questions [50 points = 2 per question] You have to select at LEAST one answer from the four proposed answers. You have to select ALL the correct answers, AND ONLY the correct answers to get the maximum number of points (no negative points). 1. Uncovered interest parity implies that a. interest rates should converge across countries b. high interest rate currencies should depreciate in the future c. high interest rate countries should have higher inflation d. the exchange rate between two countries is expected to stay constant if the two countries have identical interest rates 2. Annual nominal interest rates on T-Bills in the UK and Italy are 2% and 4 % respectively. This could mean that: a. the euro is expected to depreciate by 2% against the pound the coming year b. growth should be 2% higher in UK in the coming year c. the UK are expected to have 2% more inflation than France in the coming year d. investors think that it is more likely that the Italian government defaults on its debt in the coming year 3. If markets expect an increase in the interest rates by the ECB in the following year, the following should occur: a. The interest rate should increase immediately b. The euro should depreciate immediately c. The euro should appreciate immediately d. The euro exchange rate should not be affected 4. An unexpected expansion of aggregate demand and output in the eurozone should a. lead to a increase in the demand for money in the eurozone b. lead to a fall in euro interest rates c. have no impact on the euro as it is unexpected d. lead to an appreciation of the euro 5. According to the neoclassical growth model, output per capita was expected to grow faster in Spain than in France in the period if the following is true (assume Spain and France share the same long-run steady state): a. Spain was further away from the steady state than France. b. Spain had higher inflation than France. c. Spain had a lower stock of capital per worker than France. d. None of the above because they share the same monetary policy.

2 6. When the Federal Reserve surprise the market by tightening its monetary policy a. the monetary base usually goes up b. T-bill rates usually go down c. the U.S dollar usually appreciates d. inflation usually goes down 7. In the Dornbush model, an unexpected decrease in the money supply in the U.S. should a. lead to depreciation of the dollar in the long-run b. lead to an appreciation of the dollar in the short-run c. lead to a large appreciation of the dollar on impact and then a slow depreciation d. lead to fall in U.S. prices in the long-run 8. According to the Mundell-Fleming model (AA-DD model), fiscal austerity, i.e a reduction in fiscal deficits, in the euro zone should a. lead to a depreciation of the euro b. lead to an appreciation of the euro c. improve the current account of the euro zone d. lead to net capital outflows (out of the euro zone) 9. The recessionary impact of fiscal austerity is larger a. if the economy is not very opened to trade b. if the economy has a fixed exchange rate c. if monetary policy is already at the zero lower bound d. if Ricardian equivalence holds 10. In the Mundell-Fleming model under flexible exchange rates (AA-DD model), an increase in the money supply leads to a. an increase in output and an appreciation of the currency b. a fall in output and an appreciation of the currency c. an increase in output and a depreciation of the currency d. an increase in net exports and a depreciation of the currency 11. In an open economy under flexible exchange rates (AA-DD framework), a monetary expansion is less efficient a. due to the crowding out of investment b. due to the crowding out of net exports c. if the economy has very flexible wages and prices d. if the economy is not very opened to international capital markets 12. The country King-Kong has a fixed exchange rate with the US dollar. Its currency is the King-Kong dollar. Capital is freely mobile between the US and King-Kong. a. Interest rates in King-Kong are lower than in the US to compensate for the devaluation risk. b. Net capital inflows into King-Kong dollars by foreign speculators force the Central Bank to sell US dollar reserves. c. Net capital inflows into King-Kong dollars by foreign speculators increase the supply of King- Kong dollars in the economy. d. An unexpected increase of US rates force the Central Bank to sell US dollar reserves 13. Suppose Spain has a negative shock to aggregate demand but the rest of the Eurozone does not: a. the ECB should raise interest rates to cushion the shock b. the shock would be cushioned because of low fiscal transfers in the euro area c. the shock would be partially cushioned by a depreciation of the euro d. the recession in Spain would be harsher if prices and wages are very rigid in Spain

3 14. If the U.S. government increase taxes, a. the fiscal deficit usually increases b. the current account deficit usually decreases c. private savings usually fall but aggregate savings usually still increase d. aggregate demand usually falls 15. If GDP exceeds GNI, we know with certainty that a. The country is running a trade deficit b. The country is a borrower with respect to the rest of the world. c. receipts of factor income from the rest of the world exceed payments of factor income to the rest of the world. d. receipts of factor income from the rest of the world are less than payments of factor income to the rest of the world 16. According to Purchasing Power Parity: a. countries with lower interest rates should see a depreciation of their currency b. countries with lower domestic inflation should see a depreciation of their currency c. countries with lower domestic inflation should see an appreciation of their currency d. the real exchange rate should be constant 17. According to the neoclassical model, countries with fast productivity growth in Asia a. export capital to sustain consumption in slow growing countries b. run a current account deficit to finance capital accumulation c. attract more capital than other emerging markets growing at a slower pace, everything else equal b. should have an investment rate larger than their saving rate 18. The following statements are true a. countries with large amount reserves are usually more sensitive to a speculative attacks b. speculative attack usually occurs when the country runs out of reserve c. countries with larger amounts of debt in foreign currency are usually more sensitive to a speculative attack d. a higher U.S. interest rate makes it more difficult for a country with a peg to a the U.S. dollar to have a sustainable level of debt 19. The country of Bratina has initially the following fiscal situation: -debt-to-gdp ratio : 50% -real interest rate: 5% -real growth rate: 3% a. Bratina needs a primary surplus of 1% of GDP or above for the debt to be sustainable b. Bratina needs a primary deficit of 1% of GDP or less for the debt to be sustainable c. Bratina needs a total deficit of 1.5% of GDP or less for the debt to be sustainable d. Bratina needs a total surplus of 1.5% of GDP or above for the debt to be sustainable 20. The country of Bratina sees its fiscal situation deteriorating with (primary) fiscal deficits reaching 2% of GDP. Debt to GDP ratio and real interest rate stay the same -debt-to-gdp ratio: 50% -real interest rate: 5% a. If growth stays at 3%, Bratina s debt over GDP will increase. b. Real growth in Bratina needs to reach 9% to stabilize the debt to GDP. c. If real growth reaches 10%, Bratina s debt over GDP will fall below 50%. d. If expected real growth is 5%, Bratina will need to reach total fiscal balance (zero deficit including interest payments) to stabilize the debt.

4 21. Countries governments have incentives to reimburse their sovereign debt because a. otherwise governments are temporarily replaced by IMF executives to run the country b. otherwise the country can get excluded from international financial markets c. because foreign creditors and foreign banks can make large losses when the government defaults c. because domestic residents and national banks can make large losses when the government defaults 22. The country Bolognese is expected to default on its sovereign debt. Bolognese is part of a currency union with Wurst. Ten years interest rates on T-bills in Wurst are 4%. a. Ten years interest rates on T-Bills from Bolognese should be 4% for uncovered interest rate parity to hold. b. Ten years interest rates on T-Bills from Bolognese should be lower than in Wurst since investors speculate on the potential default of Bolognese c. Ten years interest rates on T-Bills from Bolognese should be lower than in Wurst if investors expect Bolognese to grow at a faster pace in the coming years d. Ten years interest rates on T-Bills from Bolognese should be above 30% if investors assess the probability of default to be at least 20% and expect to be totally expropriated in case of default. 23. Which one of the following sentences is correct a. Under free capital mobility, countries have to decide between targeting the exchange rate and keeping monetary policy autonomy. b. Under capital controls, countries have to decide between targeting the exchange rate and keeping monetary policy autonomy. c. A Central Bank willing to keep the exchange rate fixed with the US dollar can issue money to buy government bonds if it is also buying foreign US dollars. d. A Central Bank willing to keep the exchange rate fixed with the US dollar can issue money to buy government bonds if the country is having net capital inflows into the currency. 24. A real appreciation of the currency in a country a. usually improves the trade balance on impact b. usually improves the trade balance in the medium-term c. generates inflation if foreign imports are invoiced in foreign currency d. reduces the profits of exporting firms in the medium-term 25. Which of the following cases tend to lead to an appreciation of the domestic currency: a. domestic monetary authorities surprise the market by announcing that they will raise interest rate next year b. domestic monetary authorities surprise the market by announcing that they keep interest rate constant while the market the market was expecting a fall. c. domestic monetary authorities surprise the market by announcing that they will keep interest rate constant next year while the market the market was expecting an increase. d. domestic monetary authorities surprise the market by announcing that they increase the inflation target by 1%. Short questions/essays [50 points=25+25] 1. Purchasing Power Parity (PPP) and the Big Mac Index [25 points] This exercise tests the validity of the theory of Purchasing Power Parity (PPP) using data of Big Mac Prices published by The Economist. Big Mac Prices in USD and in Local Currency are presented in the table below for a selection of countries.

5 Country Big Mac Price in local currency Big Mac in USD Spot nominal exchange rate (2007) PPP exchange rate Under(-)/ overvaluation (+) with respect to USD in % USA 3.22 USD New Zealand 4.60 NZD Switzerland 6.30 SWF United Kingdom 1.99 GBP South Korea 2900 KRW Russia 49 RBL Taiwan 75 TWD Thailand 62 THB Mexico 29 MXP China 11 CHY Source : The Economist (January 2007) 1. What is the Law of One Price? Was the Law of One Price for BigMacs verified in January 2007? LOP implies that BigMac should have the same price across countries once expressed in the same currency. Looking at column 2, large deviations of the LOP in some countries (holds only for NZL and roughly for South Korea). 2. Compute the nominal exchange rate for each country in the table [for question 3 and 4 fill up the table and explain what you are doing] Just divide column 1 by column 2. See table. 3. According to Purchasing Power Parity, how is determined the nominal exchange rate between the US dollar and a foreign currency? Calculate, for each currency, the exchange rate with respect to the USD that would have prevailed in 2007 if the Law of One Price for the Big Mac held with respect to the US (PPP exchange rate)? Deduce the difference between the PPP exchange rate and the spot exchange rate on foreign markets (in percentage terms) in 2007 for each country. Which currency is overvalued (resp. undervalued) with respect to the US dollar according to PPP? Comment. Absolute PPP between the US and a country denoted with (*) at date t implies the following relationship: S t = P* t / P t where: S denotes the Spot Nominal Exchange Rate of country (*) (Currency of (*) per US$) P* denotes the Consumer Price Index in country (*) and P denotes the Consumer Price Index in the US Apply the relationship using the BigMac Price as the Price index. Divide column 1 by See table for results. 4. What are the advantages of using Big Mac prices to compute PPP exchange rates compared to standard price indices (Consumer Price Indices)? What are the limits? Some hints: Advantages

6 - data are reliable, easy to collect - compare an identical product across borders while CPI might not reflect identical consumption baskets Limits - Non traded goods which prevents arbitrage across borders; large share of distribution services. Cf. Balassa Smuleson effect as described below. - Different prices of Big Mac across borders might reflect different tastes across countries rather than deviations of exchange rates from PPP 5. Comment the following graph which gives the prices of Big Mac in USD in a given country as a function of the GDP per capita of the selected countries. Comment. Which currencies are according to you overvalued (resp. undervalued)? Some hints: Balassa-Samuelson effect: countries with expensive Big Macs (and apparently overvalued exchange rates) are those where wages (productivity) in the tradable sector are high. High wages in the tradable (manufacturing) sector implies high wages in the service sector (typically fast-foods) to keep people at work in this sector (even though the sector is less productive). As costs of labour are high in these countries, so are Big Macs. The opposite occurs in less productive countries (e.g China, Thailand ). This explains the strong positive relationship between GDP per capita (a measure of labour productivity in a country) and Big Mac prices. Hence, the Big Mac index reflects more differences in standards of living than misalignments of exchange rates. Currencies of countries above (resp. below) the red line are overvalued once we control for Balassa Samuelson (resp. undervalued). 2. Adjustment in the Eurozone [25 points] Explain the following answer by Mario Draghi (ECB) to a journalist (Feb. 6 th 2014).

7 What does he mean by relative price adjustment? Can you provide some explanations for the weakness of demand in those countries? What are the options ahead? [900 words maximum] [hints: programme countries are Greece, Ireland, Portugal and Spain] Journalist to Mario Draghi: ( ) you have spoken about the unevenness of the recovery. It would be great if you could also speak a little about the unevenness of the disinflationary dynamics. You mentioned that in the four programme countries, it owed something to adjustment, could you elaborate? Mario Draghi: Unevenness of the recovery and, yes, unevenness of disinflation, too. ( ) A good part of the subdued performance of core inflation is due to the subdued, very subdued, performance of core inflation in the programme countries. And some of it certainly is a part of a relative price adjustment that is welcome. And some of it is probably due to the weakness of demand and the high levels of unemployment which are still much higher in the programme, and in the stressed countries, than they are in other parts of the euro area. So, we are looking with great attention at these developments because there is no single clear-cut cause. There are two causes, and one of them would certainly have to be looked at with great, great attention. Twin deficits in Programme countries: fiscal and current account deficit. Unsustainable path for public and external debt. Fiscal and external adjustment necessary. - External adjustment in fixed exchange rate regime. See class notes. Standard trade channel due to exchange rate depreciation cannot operate much for Greece as most trade within Euro zone. Needs competitive disinflation to restore competitiveness. This is the relative price adjustment M. Draghi mentions. - Fiscal adjustment drags down demand in those countries [procyclical fiscal policies]. Fiscal adjustment also more costly if o o fixed exchange rate regime (no crowding in of net exports). See class notes. If monetary policy not accommodative (issue again with being part of a currency union plus monetary policy already at the lower bound). Generating potentially a very severe recession. Vicious circle of low growth and high interest rates as well (high real rates fostered by deflationary pressures). Then discuss options ahead (and risk associated and why this is difficult to reach an agreement on the solutions): - default - massive ECB intervention/debt monetization in the euro zone. - going out of euro