International Finance Master PEI Fall 2011 Nicolas Coeurdacier Final exam Non-detailed correction 3 hours 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 in the US and France are 2.85% and 4.85% respectively. This could mean that: a. the dollar is expected to depreciate by 2% against the euro over the next quarter b. the dollar is expected to appreciate by 2% against the euro over the next quarter c. the US is expected to have 2% more inflation than France over the next quarter d. the dollar is expected to stay stable wit respect to the euro but French assets are perceived as more risky 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. In the Dornbush model, an unexpected increase in the money supply should a. lead to depreciation of the currency in the long-run b. lead to a depreciation of the currency in the short-run c. lead to a large depreciation of the currency on impact and then a slow appreciation d. lead to fall in prices in the long-run
6. According to the Mundell-Fleming model (AA-DD model), a fiscal adjustment, 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. deteriorate the current account of the euro zone 7. 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 8. Keynesian fiscal multipliers are larger a. if the economy is not opened to trade b. if the economy has a flexible exchange rate c. if prices and wages are more flexible d. if private savings do not respond to an increase in fiscal deficits 9. In an open economy under flexible exchange rates (AA-DD framework), a fiscal 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 is relying more on internal demand d. if the economy is perfectly integrated to international financial markets 10. 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 11. Asymmetric demand shocks in a currency area can be cushioned a. if the monetary autority of the area raises interest rates b. if fiscal transfers are easily implemented in the area c. if workers mobility is restricted within the area d. if prices and wages are very flexible in the area 12. According to absolute Purchasing Power Parity: a. the rate of change in the nominal exchange rate equals the inflation differential between two countries b. countries with higher domestic inflation should see a depreciation of their currency c. countries with lower domestic inflation should see a depreciation of their currency d. a country s prices are set in a foreign currency
13. Big Mac Prices and (spot) nominal exchange rates with respect to the US dollar and GDP per capita in USD are presented in the table below for few countries (source: The Economist). We focus on Purchasing Power Parity (PPP) based on Big Mac prices. Country Big Mac Price in local currency (Foreign units/usd) USA 3.2 USD - Switzerland 6.30 SWF 1.25 Russia 50 RBL 25 Taiwan 75 TWD 33 Thailand 62 THB 34.7 Spot nominal exchange rate (mid-quotes) with respect to the USD currency a. According to PPP, the Swiss Franc is undervalued with respect to the US dollar b. PPP would be verified if a Big Mac in Taiwan would cost approximately 106 Taiwan Dollars. c. The exchange rate implied by PPP for Russia is close to 15 RBL/USD. d. According to PPP, the Russian rouble is overvalued by roughly 40% with respect to the US dollar. 14. According to the data of the previous table, a. Big Macs are cheaper in poorer countries mainly because meet, tomatoes and ketchup are cheaper in these countries. b. Big Macs are more expensive in richer countries mainly because in rich countries workers are more productive in other sectors (such as manufacturing). c. Big Mac are cheaper in poorer countries mainly because workers in Big Mac restaurants are more productive in poor countries than in rich countries. d. Big Macs are cheaper in poorer countries mainly because wages are lower in these countries 15. According to the neoclassical model, a country opening up its capital and financial account should a. export capital if its rate of return to capital is higher than the world rate of return b. import capital if its rate of return to capital is higher than the world rate of return c. grow faster if its rate of return to capital is higher than the world rate of return b. run a current account deficit if its rate of return to capital is higher than the world rate of return 16. A shortfall in domestic savings to finance domestic investment will lead to a. a current account deficit b. a current account surplus c. (net) capital outflows d. (net) capital inflows 17. Which of the following events will help to reduce the US current account deficit: a. an increase in private savings b. an increase in the fiscal deficit c. an increase in private investment d. a depreciation of the US dollar
18. Here is the external position of the country Ikea (currency the Krona). Foreign Liabilities (% of GDP) Foreign Assets (% of GDP) 100% of GDP 100% of GDP Of which: Of which: In Krona: 50% of GDP In Euro: 80% of GDP In USD: 50% of GDP In USD: 20% of GDP a. A depreciation of the Euro with respect to the USD improves the net foreign asset position of Ikea. b. A depreciation of the Euro with respect to the USD deteriorates the net foreign asset position of Ikea. c. A depreciation of the Euro with respect to the Krona improves the net foreign asset position of Ikea. d. A depreciation of the USD with respect to the Krona deteriorates the net foreign asset position of Ikea. 19. A country with a fixed exchange rate to the US dollar is more sensitive to a speculative attack if a. the country has large amounts of international reserves b. the country has been mostly borrowing in foreign currency c. the country is in recession and US interest rates are rising d. the country is running large current account surpluses 20. The Bigstate faces the following fiscal situation. Debt-to-GDP ratio = 100%; Real interest rate = 3%; Real growth rate = 5% a. Bigstate needs a primary surplus of 2% of GDP or above for the debt to be sustainable b. Bigstate needs a primary deficit of 2% of GDP or less for the debt to be sustainable c. If Bigstate runs a primary deficit of 4% of GDP, the debt to GDP ratio will decrease (keeping real interest rate and growth rate constant) d. If Bigstate wants to reduce its debt-to-gdp ratio below 50%, the country must run permanently a primary deficit of 1% of GDP or less (keeping real interest rate and growth rate constant) 21. The following statements are true a. countries with high growth rate are likely to see their debt to GDP ratio increasing very fast as the economy overheats b. a country for which the real interest rate r is equal to the growth rate of GDP g can reduce its debt to GDP ratio by running a primary fiscal surplus of 1% c. debt sustainability is independent of the growth rate of the economy d. a higher real interest rate makes it more difficult for a country to have a sustainable level of debt 22. Between 1991 and 2001, Argentina maintained a currency board that pegged the value of its currency the peso- against the US dollar. In 2001, it suffered a massive crisis and was forced to devalue and default on its debt. The following factors contributed to the crisis: a. Argentina was running a lax monetary policy and fears of inflation drove investors away b. Argentina s government was running very large fiscal deficits that scared investors away c. Low growth in 2000-01 and high interest rates made the fiscal position unsustainable. d. Argentina was running trade surpluses which reduced its foreign reserves.
23. The country Grechen is expected to default on its sovereign debt. Investors assess the probability of default to be 25% and expect to be totally expropriated in case of default. Grechen is part of a currency union with Gernanny. Ten years interest rates on T-bills in Gernanny are 5%. a. Ten years interest rates on T-Bills from Grechen should be 5% for uncovered interest rate parity to hold. b. Ten years interest rates on T-Bills from Grechen should be equal to 30% c. Ten years interest rates on T-Bills from Grechen should be equal to 40% d. We cannot answer this question since we do not know the inflation differential between Grechen and Gernanny. 24. 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. 25. A real depreciation of the currency in a country a. improves the trade balance on impact b. 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 since the price of exports is falling Short questions/essays [50 points=10+15+25] 1) Exchange rates in Paf Paf is a small country. Its currency is the pif and the exchange rate with the U.S. dollar is 1 pif per dollar in 1980. Purchasing Power Parity (PPP) holds in 1980. The price indexes in 1980 are equal to 100 in the United States and in Paf. Today, the price indexes are equal to 400 in the United States and 300 in Paf. The current exchange rate is 0.6 pifs per dollar. (a) What should the current exchange rate be if PPP prevailed? Is the Pif over/undervalued according to PPP? (b) One-year nominal interest rates in the US and in Paf are both equal to 5%. If you think that the spot exchange rate will revert back towards its PPP value (calculated in (a)) within a year, what would you do as a currency trader? What are the risks associated with this strategy? (a) According to the purchasing power parity relation which states that spot exchange rate adjusts perfectly to inflation differential between two countries, the expected value for the exchange rate, twenty years from now, is given by : Use relative PPP: S1/ S0 = (P1/ P0)/ (P*1/ P*0) = (300/100) / (400/100) S1 = 0.75 According to PPP, the Pif is overvalued (by 25 %). (b) I expect the spot exchange rate in Paf to be equal to 0.75 in one year (and to depreciate by 25%). Since interest rate are equal in both countries, I borrow in Paf to invest in the US for a year (to get the currency return = 25% if reversion back towards PPP within a year) = uncovered arbitrage. Risky
strategy especially since reversion back towards PPP is slow (deviations from PPP can be very persistent). 2) What are the valuation effects on external position due to exchange rate fluctuations? Explain how these valuation effects operate and can facilitate the adjustment of global imbalances in the US case. [note: table (1) can help you to justify your reasoning] [500 words maximum] Table (1): Currency denomination of US foreign assets and liabilities in 2004 see class notes. You were expected to talk about the currency composition of external assets and liabilities for the US and investigates the wealth transfers associated to a devaluation of the dollar with respect to other currencies and discuss how this reinforce the standard trade channel of adjustment. A quantitative exploration based on the data above was very welcome. Some discussion about the role of the dollar, which, as main world currency, can explain a part of the exorbitant privilege of the US was also welcome. 3) Explain the following sentence by Hans-Werner Sinn (University of Munich) and assess the difficulties that Greece is facing in the adjustment process as well as the options ahead. Greece has lost its competitiveness. Its government took on massive debt under the euro, inflating Greek wages and prices. Greece s current-account deficit reached 10.5% of GDP in 2010. Aggregate consumption exceeded national income by 16.5%. In order to solve the competitiveness problem, Greece will have to become 20% to 30% cheaper. [1000 words maximum] Twin deficits in Greece: fiscal and current account deficit. Unsustainable path for public and external debt. Necessary fiscal and external adjustment. Some quantitative discussion about the size of the adjustment was welcome. You were expected to explore the following difficulties regarding the channels of adjustment:
- external adjustment difficult 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. Very costly. - 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). Likely to generate a very severe recession. Vicious circle of low growth and high interest rates as well. 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