ECON 4131, International Finance, Spring 2002, Exam 1

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Midterm Exam

International Finance

April 8, 2002

Answer all questions in examination booklets

1. (10 points) Use the BOP accounts guide on the last page of this exam to indicate where each of the following transactions should be recorded in the U.S. balance of payments (e.g.: “i3”, “e2”, etc.). Bear in mind that each transaction should generate a capital account and a current account entry.

a) The U.S. buys $1m. of lumber from Canada

b) Japan buys $500K of fish from an Alaskan fishing outfit

c) The U.S. contracts a Panamanian flagged vessel for shipping on the Mississippi

d) Mexican migrant workers wire $2m. home for Cinco de Mayo celebrations

e) A Panamanian flagged ship purchases a $100K insurance contract from

a U.S. firm

2. (10 points) The nation of Pecunia had a current account deficit of $2 billion and a nonreserve capital account surplus of $900 million in 1998.

a) What was the “balance of payments” of Pecunia that year? What happened to the country’s net foreign assets?

b) Assume that the foreign central banks neither buy nor sell Pecunian assets. How did the Pecunian central bank’s foreign reserves change in 1998? How would this official intervention show up in the balance of payments accounts of Pecunia?

c) How would your answer to (b) change if you learned that foreign central banks had purchased $1.2 billion of Pecunian assets in 1998? How would these official purchases enter the foreign balance of payments accounts?

3. (15 points) Derive (show your work) the following, and provide a brief explanation:

a) Uncovered interest rate parity

b) Covered interest rate parity

4. (10 points) Define “neutrality of money” and discuss why money is thought to be “neutral” in the long-run.

5. (10) Define “Purchasing Power Parity” and discuss the reasons why it might or might not hold.

6. (15 points) In our formal model of exchange rate determination under “sticky prices”

a) What do the two curves represent?

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b) Explain how and why the model leads to “overshooting”

c) Is the overshooting greater or smaller when we assume long-run “neutrality of money” (as opposed to exogenous long-run exchange rates and prices)? Explain.

d) Carefully explain the trajectory of exchange rates, interest rates, and prices, as this model predicts they would respond to a permanent increase in the money supply

7) (15 points)

a) Why might a firm enter into a contract “selling forward” foreign exchange?

b) What circumstances might make a firm prefer a foreign exchange futures contract to a forward contract?

c) What circumstances might make a firm prefer a foreign exchange options contract to a futures contract?

d) What circumstance might make a firm prefer a currency swap to any of the above alternatives?

8) (15 points)

a) Derive the equation (show your work) for the bilateral dollar/euro exchange rate according to the “monetary approach to the exchange rate.”

b) What does this model predict will happen if domestic real income rises?

c) Why is this thought to be more of a long-run than a short-run theory?

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