ECON 442 Midterm Exam

ECON 442
Midterm Exam 
Answer all questions clearly in the space provided. Each question carries 20 points. Please make
sure you show all the steps of your reasoning. The exam is due on Thursday 23rd march in class.
All the best!
1. Suppose that home country A has the following transactions with foreign countries
(represented by foreign country B.
(i)

For each transaction, indicate the appropriate debit and credit entry in A's balanceof-payments accounts. ( note each transaction clearly in the form of a balance of
payment entry: eg export, import, reduction in domestically held short term
foreign assets etc)

(ii)

Also indicate whether the ternasaction enters into the Current or the
Financial/Capital account

a) A firm in country A buys $3,000 of textiles from a country B firm. Payment is made by
the firm in A drawing down its checking account in a country B commercial bank.
Debit
Credit
b) Country A citizen earns $800 as interest payments from a Country B bond and deposits
the earnings in his Country B bank .account.
Debit
Credit
c) Country B tourist spends $1,000 on hotel expenditures in Country A. She pays using her
credit card from a Country B bank
Debit
Credit
d) A citizen of country A buys a shares worth $ 1000 of a company in country B by drawing
down his/her checking deposit in a bank in B.
Debit
Credit
e) A investor in Country B purchases $2200 worth of short term Country A government bills
by selling its Country A deposits.
Debit
Credit

Name_______________________________
2. The interest rate on dollar deposits is 4 % and that on euro deposits is 6 %
a) If uncovered interest parity holds do you expect the dollar to appreciate or depreciate?
What is the expected rate of appreciation/depreciation

b) Now suppose that the dollar is trading at $1.20 per euro today. Next year's expected
exchange rate is $1.40 per euro. What is the expected rate of return on dollar and euro
deposits?

c) Does parity hold now? Would investors be investing in dollars or euro deposits?

d) Briefly explain how parity would be restored?

e) Now suppose the current spot rate is $1.40 per euro. What should the forward rate be,
if covered interest parity holds? Is the euro at a premium or a discount?

Name_______________________________

3. 1) Explain clearly (with the help of figures)
a. A situation where a currency depreciates when the domestic interest falls.

b. A situation where the currency appreciates when domestic interest rate rises.

c. Short run effect of a temporary increase in domestic output on the domestic
exchange rate.

d. Short run effect of a permanent increase in output on the domestic exchange rate
(remember to take into account impact on exchange rate expectations).

e. Long run effect of an increase in output on the domestic exchange rate.

Name_______________________________

Name_______________________________
4. a. The price of a Big Mac in South Korea is 2700 won, while that in the US is $3.00.
Using the Big Mac prices as a proxy for price level in the two countries calculate the
“big Mac PPP exchange rate.

b. If the actual spot exchange rate is 990 won per dollar, would you expect the won to
appreciate or depreciate over time, and by how much? Explain your reasoning.

c. What are the possible reasons why the change you expect in part b may not materialize.

d. A treaty negotiated between the US and S. Korea results in a transfer of $200 million
annually, over the next 15 years from the US to S. Korean Government. Explain the
impact of this treaty on the real exchange rate, the nominal exchange rate and the price
level in S. Korea.

Name_______________________________

e. Suppose there is an increase in productivity in S. Korea so that its output rises faster
than that in the US. How would this impact the real exchange rate, the nominal exchange
rate and the price level in S. Korea.

5. Use the AA –DD framework to answer the following questions (with figures) Assume
you are starting from less than full employment equilibrium.
a. The government announces a temporary tax cut plan. What would happen to
output and the exchange rate?

b. The government decides to finance the above tax cut by printing more money.
Would this change the outcome in part a?

Name_______________________________

c. Now suppose that people expect the tax cut in part a to become permanent
because they believe that these tax cuts once in place will be impossible to
remove. What would be the impact on output and employment? (Assume that the
government is NOT financing the deficit by printing money)

d. How would your argument in part c change if the economy was initially at full
employment equilibrium.