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ECN209 International Finance - 2016
Section A
Question 1 If a country’s investments are lower than its savings, then the country runs a current
account deficit. [10 marks]
FALSE.
When a country runs a current account deficit, its saving (the sum of changes in tangible assets and
changes in net financial assets) is less than its investment (I - S = CAD). That is, a country experiences
a negative transfer of financial wealth across borders when purchases of goods and services from
abroad and the income paid to non-residents exceeds the amounts residents receive from the
outside world.
Since Y = C + I + G + NX, and Y – C – T = S (savings), then S = G – T + NX + I. This simplifies to the
sectorial balance identity; (S – I) + (T – G) = (NX). Therefore, it can be seen when net exports are
positive (such that the country is running a current account surplus), then this is when the country’s
investments are lower than its savings.
Question 2. Central banks can only influence the exchange rate by altering the nominal money
supply. [10 marks]
TRUE.
There are a number of key factors which influence the exchange rate.
1. Differentials in Inflation: Typically, a country with a consistently lower inflation rate exhibits
a rising currency value, as its purchasing power increases relative to other currencies.
2. Differentials in Interest Rates: By manipulating interest rates, central banks exert influence
over both inflation and exchange rates, and changing interest rates impact inflation and
currency values. Higher interest rates offer lenders in an economy a higher return relative to
other countries. Therefore, higher interest rates attract foreign capital and cause the
exchange rate to rise.
3. Current Account Deficits: A deficit in the current account shows the country is spending
more on foreign trade than it is earning, and that it is borrowing capital from foreign sources
to make up the deficit. The excess demand for foreign currency lowers the country's
exchange rate until domestic goods and services are cheap enough for foreigners, and
foreign assets are too expensive to generate sales for domestic interests.
4. Public Debt: Nations with large public deficits and debts are less attractive to foreign
investors. A large debt encourages inflation, and if inflation is high, the debt will be serviced
and ultimately paid off with cheaper real dollars in the future.
5. Terms of Trade: The terms of trade is related to current accounts and the balance of
payments. If the price of a country's exports rises by a greater rate than that of its imports,
its terms of trade have favorably improved. Increasing terms of trade shows' greater
demand for the country's exports. This, in turn, results in rising revenues from exports,
which provides increased demand for the country's currency (and an increase in the
, FOR MORE HIGH-QUALITY PAST PAPER MODEL ANSWERS, ONLINE TUTORING AND
ECONOMICS HELP, visit LondonEconomicsTutors.co.uk.
Discounted prices compared to all other websites
currency's value). If the price of exports rises by a smaller rate than that of its imports, the
currency's value will decrease in relation to its trading partners.
6. Strong Economic Performance: Foreign investors inevitably seek out stable countries with
strong economic performance in which to invest their capital. A country with such positive
attributes will draw investment funds away from other countries perceived to have more
political and economic risk. Political turmoil, for example, can cause a loss of confidence in a
currency and a movement of capital to the currencies of more stable countries.
The two of these which the central bank can influence are differentials in inflation and differentials
in interest rates. However, the method by which the central bank is able to influence these is
through changes in the nominal money supply. Therefore, this statement is true.
Question 3. After a permanent increase in the money supply, the overshooting of the exchange
rate would not manifest if prices were perfectly flexible in the short run. Use the Uncovered
Interest Rate Parity Condition and the asset model of exchange rate determination to motivate
your answer. [10 marks]
When prices are fully flexible, an increase in the money supply produces an immediate increase in
prices in the same proportion. Hence, the real money balances M/P remain unchanged and the
interest rate remains at its initial level. In the foreign exchange market, the increase in the money
supply produces an increase in the expected exchange rate Ee and hence the current exchange rate E
jumps instantly to its new equilibrium. This is to maintain the uncovered interest rate parity
condition.
Since there is no interest rate differential there is no need for the exchange rate to overshoot its
long-run value. The diagram below shows the effect of the monetary shock in the two-sided
diagram, where it shows that the exchange rate jumps immediately from E0 to E1, and the real
money supply remains fixed.
ECONOMICS HELP, visit LondonEconomicsTutors.co.uk.
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ECN209 International Finance - 2016
Section A
Question 1 If a country’s investments are lower than its savings, then the country runs a current
account deficit. [10 marks]
FALSE.
When a country runs a current account deficit, its saving (the sum of changes in tangible assets and
changes in net financial assets) is less than its investment (I - S = CAD). That is, a country experiences
a negative transfer of financial wealth across borders when purchases of goods and services from
abroad and the income paid to non-residents exceeds the amounts residents receive from the
outside world.
Since Y = C + I + G + NX, and Y – C – T = S (savings), then S = G – T + NX + I. This simplifies to the
sectorial balance identity; (S – I) + (T – G) = (NX). Therefore, it can be seen when net exports are
positive (such that the country is running a current account surplus), then this is when the country’s
investments are lower than its savings.
Question 2. Central banks can only influence the exchange rate by altering the nominal money
supply. [10 marks]
TRUE.
There are a number of key factors which influence the exchange rate.
1. Differentials in Inflation: Typically, a country with a consistently lower inflation rate exhibits
a rising currency value, as its purchasing power increases relative to other currencies.
2. Differentials in Interest Rates: By manipulating interest rates, central banks exert influence
over both inflation and exchange rates, and changing interest rates impact inflation and
currency values. Higher interest rates offer lenders in an economy a higher return relative to
other countries. Therefore, higher interest rates attract foreign capital and cause the
exchange rate to rise.
3. Current Account Deficits: A deficit in the current account shows the country is spending
more on foreign trade than it is earning, and that it is borrowing capital from foreign sources
to make up the deficit. The excess demand for foreign currency lowers the country's
exchange rate until domestic goods and services are cheap enough for foreigners, and
foreign assets are too expensive to generate sales for domestic interests.
4. Public Debt: Nations with large public deficits and debts are less attractive to foreign
investors. A large debt encourages inflation, and if inflation is high, the debt will be serviced
and ultimately paid off with cheaper real dollars in the future.
5. Terms of Trade: The terms of trade is related to current accounts and the balance of
payments. If the price of a country's exports rises by a greater rate than that of its imports,
its terms of trade have favorably improved. Increasing terms of trade shows' greater
demand for the country's exports. This, in turn, results in rising revenues from exports,
which provides increased demand for the country's currency (and an increase in the
, FOR MORE HIGH-QUALITY PAST PAPER MODEL ANSWERS, ONLINE TUTORING AND
ECONOMICS HELP, visit LondonEconomicsTutors.co.uk.
Discounted prices compared to all other websites
currency's value). If the price of exports rises by a smaller rate than that of its imports, the
currency's value will decrease in relation to its trading partners.
6. Strong Economic Performance: Foreign investors inevitably seek out stable countries with
strong economic performance in which to invest their capital. A country with such positive
attributes will draw investment funds away from other countries perceived to have more
political and economic risk. Political turmoil, for example, can cause a loss of confidence in a
currency and a movement of capital to the currencies of more stable countries.
The two of these which the central bank can influence are differentials in inflation and differentials
in interest rates. However, the method by which the central bank is able to influence these is
through changes in the nominal money supply. Therefore, this statement is true.
Question 3. After a permanent increase in the money supply, the overshooting of the exchange
rate would not manifest if prices were perfectly flexible in the short run. Use the Uncovered
Interest Rate Parity Condition and the asset model of exchange rate determination to motivate
your answer. [10 marks]
When prices are fully flexible, an increase in the money supply produces an immediate increase in
prices in the same proportion. Hence, the real money balances M/P remain unchanged and the
interest rate remains at its initial level. In the foreign exchange market, the increase in the money
supply produces an increase in the expected exchange rate Ee and hence the current exchange rate E
jumps instantly to its new equilibrium. This is to maintain the uncovered interest rate parity
condition.
Since there is no interest rate differential there is no need for the exchange rate to overshoot its
long-run value. The diagram below shows the effect of the monetary shock in the two-sided
diagram, where it shows that the exchange rate jumps immediately from E0 to E1, and the real
money supply remains fixed.
