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Discounted prices compared to all other websites
ECN209 International Finance - 2019
Section A
Question 1
“If the exchange rate market is in equilibrium and people expect the relative Purchasing Power
Parity (PPP) to hold, the difference between the domestic and the foreign interest rates is equal to
the difference between the expected inflation at home and the expected inflation abroad.” [10
marks]
TRUE.
The law of one price simply says that the same good in different competitive markets must sell for
the same price when transportation costs and barriers between those markets are not important.
Purchasing power parity is the application of the law of one price across countries for all goods and
services, or for representative groups baskets of goods and services. The relative purchasing power
parity condition requires that changes in exchange rates equal changes in prices (i.e. inflation
between two periods). This can be expressed using the formula:
Here, Ee$/€ is the expected exchange rate between dollars and euros in the next period, and E$/€ is
the exchange rate in the current period, and πeUS is the inflation rate in the next period.
The second factor which makes this statement true is the Fisher effect. The Fisher effect states that
a change in a country's expected inflation rate will result in a proportionate change in the country's
interest rate. Here, i is the nominal interest rate, r is the real interest rate, and E[π] is the expected
inflation rate.
When the inflation rate is low, the term rE[π] will be negligible. This suggests that the expected
inflation rate is approximately equal to the difference between the nominal and real interest rates in
any given country such that
Assuming that the real interest rate is equal across two countries (the US and Germany for example)
due to capital mobility. Then substituting the approximate relationship above into the relative
purchasing power parity condition gives the International Fisher effect.
Question 2
“It is possible for a country to have a current account deficit and at the same time a surplus in its
balance of payments.” [10 marks]
, FOR MORE HIGH-QUALITY PAST PAPER MODEL ANSWERS, ONLINE TUTORING AND
ECONOMICS HELP, visit LondonEconomicsTutors.co.uk.
Discounted prices compared to all other websites
TRUE.
The current account is equal to exports minus import (i.e. the net expenditure by foreigners on
domestic goods and services). Thus, if a country has a current account deficit it is importing more
than it is exporting, such that there is a net outflow of money and a new inflow of goods.
A country’s balance of payments accounts for its payments to and its receipts from foreigners. It has
3 parts:
Current account accounts for flows of goods and services (imports and exports)
Financial account accounts for flows of financial assets (financial capital)
Capital account flows of special categories of assets (typically nonmarket, non-produced, or
intangible assets like debt forgiveness, copyrights and trademarks)
Theoretically, the balance of payments should be zero, meaning that assets (credits) and liabilities
(debits) should balance across these three categories, but in practice, this is rarely the case. This is
because statistical discrepancies arise, and therefore there may be a net surplus which result from a
positive statistical discrepancy.
Question 3
“When domestic and foreign bonds are perfect substitutes, a central bank should be indifferent
between using domestic and using foreign assets to implement its monetary policy.” [15 marks]
FALSE.
Two of the key assets which exist on a central bank’s balance sheet are foreign government bonds
and domestic government bonds. One of the fundamental ways in which the central bank is able to
implement its monetary policy is through changes in the central bank 's balance sheet. This is
because changes in their balance sheet leads to changes in currency in circulation or changes in
deposits of banks, which lead to changes in the money supply. In particular, when the central bank
buys domestic bonds or foreign bonds, the domestic money supply increases.
Quantities of both foreign currency deposits and foreign government bonds that are bought and sold
influence the exchange rate. Therefore, a central bank should not be indifferent between using
domestic and foreign assets to implement its monetary policy as it influences the exchange rate.
Therefore, a central bank that aims to maintain a fixed or stable exchange rate is not completely
indifferent about using domestic or foreign assets to implement monetary policy.
Question 4
“A temporary increase in government spending of a given magnitude causes the current account
to fall by the same amount as a permanent increase in government spending of the same given
magnitude.” Please, use a diagram to illustrate your answer. [15 marks]
FALSE.
There are two determinants of the current account – the real exchange rate and disposable income.
There is a set of output and exchange rates that hold when the output market is in equilibrium,
which is expressed below by the DD curve. In the case when government spending increases, at
every level of consumer spending aggregate demand has increased. This is shown below by a shift
upwards of the AD curve and a shift to the right of the DD curve.
ECONOMICS HELP, visit LondonEconomicsTutors.co.uk.
Discounted prices compared to all other websites
ECN209 International Finance - 2019
Section A
Question 1
“If the exchange rate market is in equilibrium and people expect the relative Purchasing Power
Parity (PPP) to hold, the difference between the domestic and the foreign interest rates is equal to
the difference between the expected inflation at home and the expected inflation abroad.” [10
marks]
TRUE.
The law of one price simply says that the same good in different competitive markets must sell for
the same price when transportation costs and barriers between those markets are not important.
Purchasing power parity is the application of the law of one price across countries for all goods and
services, or for representative groups baskets of goods and services. The relative purchasing power
parity condition requires that changes in exchange rates equal changes in prices (i.e. inflation
between two periods). This can be expressed using the formula:
Here, Ee$/€ is the expected exchange rate between dollars and euros in the next period, and E$/€ is
the exchange rate in the current period, and πeUS is the inflation rate in the next period.
The second factor which makes this statement true is the Fisher effect. The Fisher effect states that
a change in a country's expected inflation rate will result in a proportionate change in the country's
interest rate. Here, i is the nominal interest rate, r is the real interest rate, and E[π] is the expected
inflation rate.
When the inflation rate is low, the term rE[π] will be negligible. This suggests that the expected
inflation rate is approximately equal to the difference between the nominal and real interest rates in
any given country such that
Assuming that the real interest rate is equal across two countries (the US and Germany for example)
due to capital mobility. Then substituting the approximate relationship above into the relative
purchasing power parity condition gives the International Fisher effect.
Question 2
“It is possible for a country to have a current account deficit and at the same time a surplus in its
balance of payments.” [10 marks]
, FOR MORE HIGH-QUALITY PAST PAPER MODEL ANSWERS, ONLINE TUTORING AND
ECONOMICS HELP, visit LondonEconomicsTutors.co.uk.
Discounted prices compared to all other websites
TRUE.
The current account is equal to exports minus import (i.e. the net expenditure by foreigners on
domestic goods and services). Thus, if a country has a current account deficit it is importing more
than it is exporting, such that there is a net outflow of money and a new inflow of goods.
A country’s balance of payments accounts for its payments to and its receipts from foreigners. It has
3 parts:
Current account accounts for flows of goods and services (imports and exports)
Financial account accounts for flows of financial assets (financial capital)
Capital account flows of special categories of assets (typically nonmarket, non-produced, or
intangible assets like debt forgiveness, copyrights and trademarks)
Theoretically, the balance of payments should be zero, meaning that assets (credits) and liabilities
(debits) should balance across these three categories, but in practice, this is rarely the case. This is
because statistical discrepancies arise, and therefore there may be a net surplus which result from a
positive statistical discrepancy.
Question 3
“When domestic and foreign bonds are perfect substitutes, a central bank should be indifferent
between using domestic and using foreign assets to implement its monetary policy.” [15 marks]
FALSE.
Two of the key assets which exist on a central bank’s balance sheet are foreign government bonds
and domestic government bonds. One of the fundamental ways in which the central bank is able to
implement its monetary policy is through changes in the central bank 's balance sheet. This is
because changes in their balance sheet leads to changes in currency in circulation or changes in
deposits of banks, which lead to changes in the money supply. In particular, when the central bank
buys domestic bonds or foreign bonds, the domestic money supply increases.
Quantities of both foreign currency deposits and foreign government bonds that are bought and sold
influence the exchange rate. Therefore, a central bank should not be indifferent between using
domestic and foreign assets to implement its monetary policy as it influences the exchange rate.
Therefore, a central bank that aims to maintain a fixed or stable exchange rate is not completely
indifferent about using domestic or foreign assets to implement monetary policy.
Question 4
“A temporary increase in government spending of a given magnitude causes the current account
to fall by the same amount as a permanent increase in government spending of the same given
magnitude.” Please, use a diagram to illustrate your answer. [15 marks]
FALSE.
There are two determinants of the current account – the real exchange rate and disposable income.
There is a set of output and exchange rates that hold when the output market is in equilibrium,
which is expressed below by the DD curve. In the case when government spending increases, at
every level of consumer spending aggregate demand has increased. This is shown below by a shift
upwards of the AD curve and a shift to the right of the DD curve.
