International Finance Math Solving

1. There are 2 sections in this paper. You should answer section A and 3 questions from section B.

2. The page limit is 6 pages including graphs. Format: font size 12, normal margins (2.54 cm) and 1.5 spacing.

3. Paste any required diagrams and graphs for your answers directly onto the answer sheet using software or uploaded photos.

4. If you would like to include references, enter them in the text as a footnote

SECTION A – You must answer this question.

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This question is worth 40 marks.

Question 1

Discuss how the exchange rate regimes adopted in Italy and the UK affect these countries’ ability to use monetary and fiscal policy to mitigate the economic impact of the Coronavirus pandemic. Explain in detail with reference to the models studied in the course and link your answer to the policy measures that are being implemented in these countries.

SECTION B – Answer THREE questions from Section B

Each question is worth 20 marks.

Question 1

Suppose the home country is the UK and the foreign country is the US. The exchange rate is in British pounds per US dollar (𝐸£/$). We want to consider how a change in UK money supply affects the interest rate and the exchange rate.

a) Suppose the Bank of England temporarily increases UK money supply. Use the money market and FX diagrams to illustrate the short-run and the long-run effects of this policy.

b) Now suppose that the increase in UK money supply is permanent.

i. Use the money market and FX diagrams to illustrate the short-run and the long-run effects of this policy.

ii. With time on the horizontal axis, show how the policy affects the UK money supply, real money balances, the price level and the exchange rate 𝐸£/$.

c) What is exchange rate overshooting? Explain whether a temporary or permanent shock to money supply leads to exchange rate overshooting, linking your answer to your findings in parts a) and b).

Question 2

Suppose that domestic firms become more optimistic and decide to increase investment expenditure today in new factories and office space. Use the IS-LM-FX model to explain the effect of this shock on aggregate income, the exchange rate, the trade balance, the interest rate and consumption (Y, E, TB, i and C) under the following conditions:

a) The government allows the exchange rate to float and makes no policy response.

b) The government allows the exchange rate to float and responds by using monetary policy to stabilize output.

c) The central bank responds in order to maintain a fixed exchange rate.

Question 3

In 1992, several European countries had their currencies pegged to the ECU (a precursor to the Euro) in anticipation of forming a common currency area. In practice, this meant that countries were pegged to the German Deutsche Mark (DM).

a) Following the German reunification in 1990, the German government increased spending and the Bundesbank (Germany’s central bank) raised its interest rates to stabilize output. Treating Germany as the home country, use the IS-LM diagram to illustrate the effect on output and interest rates of this combination of expansionary fiscal policy and contractionary monetary policy.

b) Treating the UK as the home country, use the IS-LM and FX diagrams to illustrate the effect on the UK economy of the increase in interest rates by the Bundesbank. Draw a different set of diagrams to show the effects of the following alternative policy choices by the UK government:

i. The peg is maintained. ii. The peg is abandoned, and the Bank of England keeps interest rates at their initial level (before the Bundesbank increased interest rates).

iii. The peg is abandoned, and the Bank of England keeps output at the initial level (before the Bundesbank increased interest rates).

c) Denmark had a similar experience to that of the UK. Suppose Denmark’s prime minister does not want to give up monetary policy autonomy but wants to maintain the exchange rate peg. Is this possible? Explain.

Question 4

Consider the second-generation model of currency crises. The government makes a contingent commitment to defend the peg if the benefits from pegging (which are constant and equal to b>0) exceed the costs of defending the peg (which are equal to the deviation of output from its full employment level). Suppose there is a large adverse shock to domestic demand.

a) Use the IS-LM-FX model to study the effect of the shock on output under the following scenarios:

i. The peg is credible – investors believe the peg will be maintained in the future.

ii. The peg is not credible – investors expect a depreciation in the future.

b) Explain why a shift in investors’ beliefs can cause a peg to break. Illustrate your answer with a diagram comparing the benefit and cost of pegging when the peg is credible and when it is not credible.

The End

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