AMERICAN UNIVERSITY Department of Economics Spring 2015 MIDTERM EXAMINATION IN INTERNATIONAL FINANCE DIRECTIONS: This exam has two (2) sections; be sure to follow the directions for each section. If a question has multiple parts, indicate exactly where you answer each part. I. LONG ANSWER (30 points each) ALL STUDENTS MUST ANSWER QUESTION #1 AND ONE MORE QUESTION, FOR A TOTAL OF TWO (2) OF THE FOLLOWING QUESTIONS. (Ph.D. students should answer the last question.) Expect to fill 5–10 bluebook pages with your answer to each question. LA1. Review the theory and empirics of "purchasing power parity" (PPP). - What do we mean by "absolute purchasing power parity"? Provide sufficent conditions for absolute purchasing power parity to hold, and show they are sufficient. (Give an algebraic analysis, including a discussion of the monotonicity and homogeneity of price indexes.) Which commodities would you expect to satisfy these conditions? - What do we mean by "relative purchasing power parity"? What is the purchasing-power-parity doctrine? Describe the Balassa-Samuelson critique of this doctrine: present this critique algebraically, and discuss its empirical relevance. - Empirically, is purchasing power parity a good characterization of the relationship between exchange rates and relative price levels in the short run? In the long run? (Refer to specific studies or data to support your answers.) LA2. Present and discuss a very simple monetary approach to flexible exchange rates. - What are the assumptions and predictions of this model? (Derive the predictions algebraically.) - Does this very simple model have any empirical relevance? (Mention specific empirical studies that shed light on this.) - Show that imposing rational expectations can lead to a solution for the spot in terms of expected future fundamentals. Be sure to discuss the possibility of bubbles. LA3. Assume an AR(1) data generating process (DGP) for the "fundamentals". - Explain how the DGP informs your guess about the functional form of the observable reduced form. - Use the method of undetermined coefficients to solve the monetary approach model under rational expectations. - What are the short-run and long-run effects on the exchange rate of a positive shock to the process? Offer detailed economic intuition for these effects. - How might you attempt to estimate this model? (Discuss data and methods.) II. MULTIPLE CHOICE (1 point each) ANSWER ALL 50 OF THESE. (Pick the one best answer.) (selected questions) MC2. Suppose a euro currently costs $1.50 but sells for $1.65 one-year forward. Assuming perfect capital mobility, we can conclude that (a) the forward premium on dollars is 15% (b) the forward discount on dollars is 15% (c) the dollar-euro interest differential is 15% (d) a. and c. (e) b. and c. MC6. Which of the following predictions by economists about flexible exchange rates were realized? (a) Floating exchange rates would be as stable as the exchange rate fundamentals. (b) Large trade imbalances would be rare. (c) Instruments for hedging foreign exchange risk would become available. (d) a. and b. (e) all of the above MC10. According to our monetary approach model of floating exchange rates, a country can raise interest rates (a) in the short run, by means of tighter monetary policy. (b) in the long run, by means of tighter monetary policy. (c) in the long run, by means of looser monetary policy. (d) a. and b. (e) a. and c. MC14. Triangular arbitrage is only profitable when (a) a synthetic cross rate yields the same value as the direct exchange rate. (b) a synthetic cross rate does not yield the same value as the direct exchange rate. (c) spatial arbitrage is also involved. (d) spatial arbitrage is not involved. (e) none of the above. MC18. The three-letter ISO currency code for the currency of the United Kingdom is (a) CAD (b) UKP (c) GBP (d) PUK (e) PBR MC22. According to the monetary approach to floating exchange rates, a one-time, permanent, unanticipated increase in the level of the money supply causes a long-run (a) increase in price level. (b) increase in nominal interest rates. (c) decrease in real balances. (d) decrease in money demand. (e) appreciation of the domestic currency. MC29. Our simple (flexprice) monetary approach to exchange rate determination predicts that an increase in expected inflation causes (a) the spot rate to depreciate. (b) the spot rate to appreciate (c) no change in the spot rate. (d) a one period lagged effect on domestic prices. (e) None of the above MC38. Consider the flexprice monetary approach under rational expectations. Given a one-time, permanent, unanticipated increase in the money supply, (a) we see an immediate increase in the domestic price level and a proportional depreciation of the domestic currency. (b) the inflation rate immediately jumps to a new higher rate. (c) the nominal interest rate rises, decreasing money demand, and this increases the equilibrium price level. (d) real balances immediately jump to a new lower level. (e) none of the above. MC39. Consider the flexprice monetary approach under rational expectations. Consider a one-time, permanent, anticipated increase in the money supply. As soon as the increase is anticipated, (a) the inflation rate jumps to a new higher rate. (b) the nominal interest rate rises, decreasing money demand, and this increases the equilibrium price level. (c) we see an increase in the domestic price level and a proportional depreciation of the domestic currency. (d) real balances jump to a new, lower level. (e) All of the above. MC40. Consider our flexprice monetary approach model under rational expectations. Given a one-time, permanent, unanticipated increase in the growth rate of the money supply, (a) At a given level of income, the inflation rate immediately adjusts to equal the new growth rate of money supply. (b) The nominal interest rate rises, decreasing money demand, and this increases the equilibrium price level. (c) We see an immediate increase in the domestic price level and a proportional depreciation of the domestic currency. (d) Inflation and depreciation measured over an interval near the time of the policy change will actually exceed the new growth rate of the money supply. (e) All of the above. MC46. Which of the following properties should characterize any good consumer price index? (a) An increase in the price of any consumption good should increase the price index. (b) A doubling of all prices should double the price index. (c) A rise in real income should case a fall in the price index. (d) a. and b. (e) all of the above MC48. The "Big Mac Standard" constructs a fairly standardized market basket for PPP comparisons, and the basic ingredients are standardized and internationally traded. The result of international comparisons on this standard is (a) clear evidence in favor of absolute PPP. (b) clear evidence in favor of long-run absolute PPP. (c) clear evidence against absolute PPP. (d) b. and c. (e) none of the above.