Please do not put any identifying information (i.e, your name) on the exam! ECON 3347 International.

Please do not put any identifying information (i.e, your name) on the exam! ECON 3347 International Finance – Spring 2021 Midterm Exam Blackboard Submission Deadline: Wednesday, March 17, at 11:30 AM EDT Note: This exam consists of three (3) questions. Please read the questions carefully and completely before answering them. When using a diagram (or math) to answer a question, it has to be accompanied by a verbal explanation (complete sentences!) – including economic intuition when and where necessary – for what is going on in the diagram (or for what you are deriving). Explicitly state any

Please do not put any identifying information (i.e, your name) on the exam! ECON 3347 International Finance – Spring 2021 Midterm Exam Blackboard Submission Deadline: Wednesday, March 17, at 11:30 AM EDT Note: This exam consists of three (3) questions. Please read the questions carefully and completely before answering them. When using a diagram (or math) to answer a question, it has to be accompanied by a verbal explanation (complete sentences!) – including economic intuition when and where necessary – for what is going on in the diagram (or for what you are deriving). Explicitly state any additional assumptions you make. Full credit will only be awarded if your explanations are complete, you show your work (i.e., calculations), and if all your diagrams are labeled properly. Good luck!1. Suppose the two East African islands Comoros and Mauritius are trading with each other. Mauritius uses the Mauritian rupee (MUR) and Comoros uses the Comorian franc (KMF). Suppose the MUR-USD exchange rate is EMUR/USD = 35.0 MUR USD and the KMF-USD exchange rate is EKMF/USD = 560.0 KMF USD . (a) Assume there exists a foreign exchange market between the Comorian and Mauritian currencies, and the direct exchange rate is EKMF/MUR = 15.0 KMF MUR . The described situation represents an arbitrage opportunity for anyone holding any of the three currencies (MUR, KMF, USD). i. How can somebody starting (and ending) with Mauritian rupees on hand make a (riskless) profit by performing transactions on these foreign exchange markets? Explain briefly. ii. How can somebody starting (and ending) with Comorian francs on hand make a (riskless) profit by performing transactions on these foreign exchange markets? Explain briefly. Page 2iii. How can somebody starting (and ending) with US dollars on hand make a (riskless) profit by performing transactions on these foreign exchange markets? Explain briefly. (b) In reality, the KMF/MUR foreign exchange market will likely not exist due to lack of market depth. What would be the equilibrium exchange rate between Mauritian rupees and Comorian francs, EKMF/MUR, under the scenario described above where the MUR-USD exchange rate is EMUR/USD = 35.0 MUR USD and the KMF-USD exchange rate is EKMF/USD = 560.0 KMF USD ? Calculate and explain briefly. Page 32. This question considers the relationship between the Indian rupee (Rs) and the euro (e). Let India be Home and the European Monetary Union be Foreign. Let the exchange rate be defined as rupees per euro, ERs/e. Assume, for simplicity, that European money supply, M_ , liquidity preferences L _ , price level P _ , nominal and real interest rates, i _ and r _ , and output, Y _ , are fixed throughout at the same constant levels; for India, the real interest rate, r, and liquidity preferences, L, are fixed throughout at the same constant level. All other variables M, P, Y , i, Ee , E are assumed to be steady and at constant levels in the old and new long run, but not necessarily at the same level. Further assume that the Indian price level is fixed (sticky) in the short run. Clearly label your graphs. On all graphs below, the initial equilibrium point is labeled with the letter A. Suppose that technological progress leads to a permanent increase in Indias real output/income Y . (a) With the help of the appropriate equilibrium conditions for the money market and the foreign exchange market, describe (in complete sentences) how and why (or why not) Indias nominal interest rate, iLR, its price level, PLR, and its spot exchange rate, ELR, change in the long run [short run and transition period analysis to follow in parts (c) and (e), respectively]. [Note: Full credit will only be given if you use the appropriate equilibrium conditions combined with economic reasoning to describe what is going on here. There will be no (partial) credit for any diagrams here.] Page 4(b) Use the (linked) money market and foreign exchange (FX) market diagrams to illustrate how a permanent increase in Indias real income affects the money and FX markets in the long run only. Label the long-run equilibrium point C. (c) With the help of the appropriate equilibrium conditions for the money market and the foreign exchange market, describe (in complete sentences) why and how (or why not) Indias price level, PSR, its nominal interest rate, iSR, and its current spot exchange rate, ESR, and its (expected) future spot exchange rate, Ee , change in the short run . [Note: Again, full credit will only be given if you use the appropriate equilibrium conditions combined with economic reasoning to describe what is going on here. There will be no (partial) credit for any diagrams here.] Page 5(d) Use the (linked) money market and foreign exchange (FX) market diagrams to illustrate how a permanent increase in Indias real output affects the money and FX markets in the short run only (also using what you know from your answer above for the long run). Label the short-run equilibrium point B. (e) Given your answers in parts (a) and (c), describe (in complete sentences) with the help of the appropriate equilibrium conditions for the money market and the foreign exchange market, why and how (or why not) Indias price level, P, its nominal interest rate, i, and its spot exchange rate, E, change during the transition/adjustment period from the short-run equilibrium to the long-run equilibrium. [Note: Again, full credit will only be given if you use the appropriate equilibrium conditions combined with economic reasoning to describe what is going on here. There will be no (partial) credit for any diagrams here.] Page 6(f) Use the (linked) money market and foreign exchange (FX) market diagrams to illustrate how a permanent increase in Indias real output affects the money and FX markets in the transition/adjustment period (using what you know from your earlier answers). Indicate with small arrows () how equilibrium points in both markets evolve/move between short-run and long-run. (g) Explain (very briefly) whether and how overshooting of the exchange rate does (or does not) apply to this situation. Page 73. This question uses the general monetary model, where real money demand is inversely related to the nominal interest rate. Consider two countries, Japan and South Korea, where the currencies used are the Japanese yen and the Korean won, respectively. In 1996, Japan experienced relatively slow output growth (2%), while Korea had relatively robust output growth (7%). Suppose the Bank of Japan (Japans central bank) allowed the money supply to grow by 3% each year, while the Bank of Korea (South Koreas central bank) chose to maintain slightly higher money supply growth of 5% per year. In addition, bank deposits in Japan paid a nominal interest rate of iJ = 5%. You may further assume that real interest rates were equalized across these two countries. You will find it easiest to treat Korea as the home country and Japan as the foreign country. Please use the approximated version of uncovered interest rate parity (UIP) below. (a) (i) Calculate the inflation rates for both Japan and Korea. (ii) Assuming that relative purchasing power parity (rPPP) holds, what is the expected rate of depreciation of the Korean won? Calculate and explain briefly. (b) Calculate the nominal interest rate on Korean won-denominated bank deposits, iK, assuming that uncovered interest rate parity (UIP) holds. Page 8(c) Suppose the North Korean economy collapses suddenly, leading to re-unification with the South. As a consequence, unified Koreas output growth rate decreases from 7% to 3%. All else equal in Japan, what happens to the inflation rate in Korea, the nominal interest rate paid on Korean deposits, and the expected rate of depreciation of the Korean won due to this drop in output growth? Explain briefly with the help of the appropriate equation(s). (d) How does the change in the nominal interest rate in part (c) affect the price level in Korea and the won-yen exchange rate, respectively, at the time of the re-unification shock? Explain briefly with the help of the respective equilibrium conditions for these two variables. Page 9(e) Using time series diagrams, illustrate how this decrease in the Korean output growth rate affects (i) Koreas money supply, MK; (ii) Koreas (nominal) interest rate iwon; (iii) Korean prices, PK; (iv) Korean real money supply MK PK ; and (v) the exchange rate Ewon/ over time. (Assume that the diagrams are in log scale as they were in class which implies that constant growth rates are represented as straight slopes.) Label the slopes of each graph with the correct percentage growth rates. (Plot each variable on the vertical axis and time on the horizontal axis.) t t P Y t E t M M/P t i t Page 101 Formula Sheet EGBP/EUR = EUSD/EUR EUSD/GBP Mt Pt = LY t or Mt Pt = L(it)Yt _ e t = e t _ g e t with e t = Me t+1 _ Mt Mt and g e t = Y e t+1 _ Yt Yt Et = Pt P _ t and qt = EtP _ t Pt ! Ee t+1 _ Et Et = _ e t _ _ e_ t (1 + it) = (1 + i _ t ) Ee t+1 Et or approximation: it = i _ t + Ee t+1 _ Et Et (1 + it) = (1 + i _ t ) F (t+1) t Et or approximation: it = i _ t + F (t+1) t _ Et Et where F (t+1) t is the forward rate at time t for a forward contract executed at a future time t + 1. it _ _t = i _ t _ _ _ t _ r W t Page 1

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