The Global Economy II Nova SBE Fall 2017 Miguel Lebre de Freitas, Sharmin Sazedj Exam 5/1/2018 Duration: 2h00 I (4.5) Define three of the following concepts (3-5 lines each): i. Foreign exchange put option ii. Peso problem iii. Marshall-Lerner condition iv. Contingent commitment v. FIX line 1
IV (2.5) In each question, choose one (correct answer: +0.5; wrong answer: -0.125): a. The uncovered interest rate parity condition fails if: (i) the domestic and foreign assets are perfect substitutes; (ii) agents are risk neutral; (iii) tax rates on income and on capital gains are equal; (iv) none of the above. b. Under flexible exchange rates and sticky prices, a temporary fall in government expenditures causes: (i) an output contraction and an exchange rate appreciation; (ii) an output expansion and a deterioration of the TB; (iii) an immediate real exchange rate depreciation with no effects on income; (iv) none of the above. c. Under fixed exchange rates and sticky prices, a permanent increase in government expenditures causes: (i) a real exchange rate depreciation; (ii) an increase in the stock of international reserves; (ii) an improvement in the TB; (iv) none of the above. d. The advantage of a pure floating regime as compared to a fixed exchange rate is that: (i) the country is better equipped to deal with symmetric shocks; (ii) it avoids large swings in the real exchange rate; (iii) it delivers higher effectiveness of fiscal policy; (iv) none of the above. e. Joining a monetary union is less costly when: (i) output shocks are mostly asymmetrical; (ii) nominal wages are flexible; (iii) labor is immobile across borders; (iv) none of the above. III (3.0) In each question, choose one (correct answer: +1.0; wrong answer: -0.25): Suppose that a risk neutral market participant expects the euro-pound exchange rate to reach 1.05 in one-year time, and that the annual domestic and foreign interest rates for equivalent assets are i=5% and i*=10%. a) How much should the equilibrium spot exchange rate be? A. 1.2 B. 1.1 C. 1.0 D. none of the above Assume that the euro-pound exchange rate is E / =1.1-1.2 (euros per pound). b) Imagine this same market participant needs 6600 euros to be available in the UK in 12 months. The money is available now. Which option is true? A. He is indifferent between transferring the money in 12 months and transferring it today B. He prefers to transfer in 12 months to get an expected relative gain of 550 pounds C. He prefers to transfer in 12 months to get an expected relative gain of 550 euros D. None of the above c) How much should a bank in Portugal set the euro per pound bid forward rate? A. 0.95 B. 1.05 C. 1.15 D. none of the above 2
Group II (10 points) II.1 (3.5 points) Consider an economy with sticky prices and flexible exchange rates, where the interest rate parity hold instantaneously, and PPP holds in the long run (one year time). The demand for real money balances is given by m D = Y ( 5i), where Y = 250 refers to output (constant). The foreign price level is constant and equal to 0,5. a) Assume that initially the money supply is M = 500, and the domestic interest rate is the same as abroad and equal to i=0,05. (a1) Describe the initial equilibrium, quantifying namely the real money demand, the price level and the nominal exchange rate. (a2) Represent graphically the equilibrium in the (M/P, i) and (e, i) spaces. b) Unexpectedly, the central bank decided to expand the money supply permanently to 1000. Find out: (b1) the new interest rate in the short run and long run; (b2) the expected future exchange rate; (b3) the short run spot exchange rate. 3
(b4) Describe graphically the adjustment in the money market, as well as the time path of the exchange rate from the short run to the long run. II.2 (6.5 points) Consider an open economy, with sticky prices, under flexible exchange rates. Initially, P=1 and the foreign interest rate is i*=0.1. The home money demand is given by m d = 0,1 Y 5i, the nominal money supply is M=24,5, and full employment output is Y f =250. The goods market equilibrium is described by Y = 5( A+ TB), where initially the trade balance is equal to TB = 4( E / P 0,45) and A=50. a) Describe the initial equilibrium. In particular, find out: (a1) the expression for the DD curve; (a2) the expected exchange rate; (a3) the expression for the AA curve; (a4) the equilibrium exchange rate and output. 4
(a5) Describe the initial equilibrium graphically (AA-DD). b) Analyze the effects of a temporary shock in foreign demand causing TB = 4( E / P 0,75). In particular find: (b1) the new DD curve. (b2) The equilibrium levels of output and exchange rate. (b3) Explain the intuition behind the change in the exchange rate. (b4) The interest rate. 5
(b5) Describe the shock and new equilibrium in the AA-DD diagram. (b6) Characterize this equilibrium in terms of internal and external balance. c) Departing from (b), compare, quantifying and analyzing graphically, the following policy options to reach full employment: (c1) temporary monetary shift; (c2) Temporary shift in government consumption. (c3) Will any of these policy options succeed in driving the economy to external balance? 6
DRAFT PAPER 7