1.(a).

Suppose that UIP (uncovered interest parity) condition holds but the PPP
(purchasing power parity) condition does not hold. In the long run, where
prices are exible, by how much is the real exchange rate (dened as
the foreign price level to the domestic price level in terms of domestic cur-
rency) depreciating or appreciating if the ination dierential between the
domestic and the foreign economy is

= 5%, where = log(P

t
/P
t1
)
and the log interest rate dierential is i i

= 3%, where i(i

) is the log
domestic (foreign) interest rate? (4 marks)
Answer: according to the UIP condition,
e
t
= i
t
i

t
= 3%.
(1 mark) The real exchange rate is q
t
=
EtP

t
Pt
where E, P, P

denote levels
of exchange rate and prices. So the change in (log) real exchange rate is
e
t
+ p
t
p

t
= 3%5% = 2%.
(3 marks). So the real exchange rate is appreciating by 2%.
(b). Now suppose that both the UIP condition and the PPP hold. If the world
real interest rate is 2%, and the ination dierential between home and
foreign is expected to rise from
e

e
= 5% to 7%, = log(P
t
/P
t1
),
by how much should the nominal interest rate change? (4 marks)
Answer: If the UIP and PPP both hold, then we have the real interest
parity,
i
t

e
t
= i

t

e
t
(3 marks for the real interest parity condition), which implies that the
nominal interest rate rises by 2 percent (1 mark).
2. Consider the two-country Balassa-Samuelson model. Suppose that the
two countries, Home and Foreign, produce two goods, one homogenous
tradable good and one nontradable good, with the following production
function
Y
N
= A
N
L
N
Y
T
= A
T
L
T
and The same production function applies to foreign country, whose vari-
ables are denoted with . A
T
and A
N
represent the productivity level in
the tradable sector and nontradable sector of the Home country. Assume
that the price index in Home is
P = P

T
P
1
N
where = 0.5. The same price index holds for the foreign country. Sup-
pose that we know that the domestic exchange rate e depreciates by 5%,
1
the tradable goods price in Home rises by 3% faster than the tradable
goods price in Foreign, i.e. P
T
/P
T
P

T
/P

T
= 3%. We also know
that the productivity in the tradable sector rises by 2 percentage points
faster than the productivity in the nontradable sector at home, that is,
A
T
/A
T
A
N
/A
N
= 2%, and similarly, A

T
/A

T
A

N
/A

N
= 1%.
By how much is the real exchange rate depreciating or appreciating in
the Home country? [Hint: you may use the fact that if A =
BC
D
, then
A
A
=
B
B
+
C
C

D
D
where
A
A
is the growth rate of A. ]
Answer: First recognize that the change in the real exchange rate can be
decomposed into
RER =
eP

T
P
T

(P

N
/P

T
)
1

(P
N
/P
T
)
1
Therefore
RER
RER
= e/e + P

T
/P

T
P
T
/P
T
+ (1 )(P

N
/P

N
P

T
/P

T
)
(1 )(P
N
/P
N
P
T
/P
T
)
= e/e +(P

T
/P

T
P
T
/P
T
) + (1 )(P

N
/P

N
P
N
/P
N
)
Because wages are equalized within a country, we have
A
N
P
N
= A
T
P
T
in both countries, so that (in percentage changes where percentage changes
are omitted)
A
N
+P
N
= A
T
+P
T
P
N
= P
T
+A
T
A
N
Let A
T
A
N
= and similar

in Foreign. Then,
P
N
/P
N
P

N
/P

N
= P
T
/P
T
P

T
/P

T
+(

) = 3%+1% = 4%.
Therefore, the real exchange rate depreciates by 5%0.53%0.54% =
1.5%.
Marking scheme: 2 marks for the decomposition of the real exchange rate,
2 marks for recognizing that the wages must equalize across sectors, and
4 marks for arriving at the nal answer.
3. Consider the Dornbusch model of exchange rates. Suppose that the long
run real exchange rate rises from q to

q

. Does the exchange rate over-

shoot? Explain using simple equations from the model.
Answer: the (log) real exchange is dened by
q = e +p

p
2
and in the long run
q = e +p

p
We know that prices move in proportion to money supply
d p = dm = 0
so it must be that
dq = de,
which implies that the change in real exchange rate can be entirely ac-
commodated by a change in the nominal rate. It does not necessitate any
change in the long-run price level, and there is no overshooting occur-
ring. Adjustment process: domestic currency depreciates immediately to
its new long run level q

, and the economy immediately goes to the new

steady state.
Marking scheme: 7 marks for correctly explaining that all adjustment
takes place through nominal exchange rate, and no overshooting occurs.
8 marks for showing with equations.
4. Consider the Mundell-Flemming IS-LM model with imperfect capital mo-
bility in a oating exchange rate regime. Suppose that suddenly foreigners
tastes shift away from domestic goods.
(a). Illustrate in the IS-LM diagram what happens to the interest rate, ex-
change rate, and output. Explain the mechanism of this change. (4 marks)
(b). What kind of policies should be implemented to restore the output to the
original level? Which policy should be implemented if the country cares
about exchange rate stability? (4 marks)
Answer: (a) See diagram. Mechanism: A fall in the foreigners demand
for domestic goods leads to a deterioration of the current account. For any
given interest rate, this leads to a fall in output (downward shift of the
IS curve). The equilibrium interest rate falls, which leads to a net capital
outow and depreciation of the exchange rate. The depreciation in the net
exports will relieve some fo the initial deterioration in the current account,
and the IS curve will shift back a bit. Thus, the exchange rate depreciates,
the interest rate and output falls compared to before.
Marking scheme: 2 marks for the diagram, full points to show that IS
curve shifts down and LM curve doesnt move; also full marks if they
show that IS curve shifts down and back up again (although not to origi-
nal level).
(b) Expansionary scal policy or monetary policy can restore the econ-
omy back to the original equilibrium. If exchange rate stability is a policy
concern, then expansionary scal policy should be implemented because
expansionary monetary policy woud lead to an interest rate fall, and pres-
sure for the exchange rate to depreciate.
3
[Marking scheme: 1 point for indicating that expansionary policies can re-
store original output; 1 point for answering that it should be expansionary
scal policy if exchange rate stability is concerned.]
5. Consider the model of debt and default analyzed in lecture. Illustrate how
the loan supply and loan demand curves shift when the country experi-
ences higher volatility from V to V

. Also show the corresponding repay-

ment probability graph that plots the probability of repayment against
the level of debt. What happens to the lending rate, default probability
and debt levels?( 8 marks)
See graph attached (3 points for loan supply and demand graph, and 3
points for repayment probability graph). Lending rate rises and defaults
are more likely, the debt levels may rise or fall (ambiguous)[2 points for
these answers].
6. Consider the second-generation exchange rate crisis. Illustrate in a dia-
gram how exchange rate crises can be self-fullling. Make sure you explain
the mechanism carefully.
Answer: See graphs. Mechanism: when e

is in between segment BC
then the condition for an equilibrium in which the government is pegging
the exchange rate is satised. When it is outside the AD region then
the condition for an equilibrium in which the government abandons is
satised. When it is in the AB or the CD region then the governments
actions depend on market expectations: multiple equilibria in which it
either defends or abandons occur.
[Marking scheme: 4 marks for the diagrammake sure the loss function
is clearly indicated,, and 4 marks for explaining the mechanism]
Long Question:
1. Consider the two-period small open economy current account model. In
the rst period, t = 1, the country begins with initial assets B
1
< 0, and
is endowed with output Y
1
. In the second period it is endowed with Y
2
,
where Y
2
= 2Y
1
. Assume that agents in the economy display preferences
U(C) = log(C). The economy ends after period 2, t = 2.
a. Write down the period budget constraints for t = 1, 2 for this country. (2
marks)
Answer:
B
2
B
1
= Y
1
+rB
1
C
1
B
3
B
2
= Y
2
+rB
2
C
2
where B
3
= 0.
4
b. Show why this country with B
1
< 0 necessarily needs to run either a trade
surplus in period 1 or period 2, that is, either TB
1
> 0 or TB
2
> 0. Partial
credit is given for correctly answering why this is the case. (6 marks)
Answer: the intertemporal budget constraint is
C
1
+
C
2
1 +r
= (1 +r)B
1
+Y
1
+
Y
2
1 +r
which can be rewritten as
(1 +r)B
1
= Y
1
+
Y
2
1 +r

C
1
+
C
2
1 +r

= TB
1
+
TB
2
1 +r
.
If the country is an initial debtor, as implied by B
1
< 0, then by the
intertemporal budget constraint, this country has to either run a trade
surplus in period 1 or in period 2. The reason is that the country needs
to pay o the debt with trade surpluses.
Marking scheme: 3 points for correctly writing the intertemporal budget con-
straint, and 3 marks for the correct interpretation and reasoning
.
c. Solve for the optimal consumption level in period 1, C
1
, and the current
account CA
1
. (6 marks)
Answer: from the Euler equation from the consumer maximization prob-
lem, combining with U(C) = log(C) gives
C
2
= (1 +r)C
1
Plugging this into the intertemporal budget one obtains
C
1
=
1
1 +

(1 +r)B
1
+Y
1
+
2Y
1
1 +r

CA
1
= Y
1
+rB
1
C
1
[marking scheme: 2 points for the Euler equation, 2 points for the nal
answer for consumption, and 2 points for the current account.]
d. Now suppose that the interest rate suddenly rises from r to r

where
r

> r. What happens to C

1
? Explain the intuition behind this change in
consumption. (6 marks)
Consumption will fall today. The reason is both that the country was an
initial debtor, so the increase in intereste rate leads to a negative wealth
eect, inducing consumers to consumer less, and also because the present
value of future income has fallen.
[] Marking scheme: 2 marks for indicating that consumption falls, and 4
marks for the reasoning (if they mention that the country was an initial
debtor and argued that for this reason that the wealth falls, give 3 marks,
and 1 additional mark for the second wealth eect.
5
e. Now suppose that B
1
= 0. Illustrate in a digram the impact of an increase
in the interest rate between period 1 and period 2, from r to r

?. Be sure
to mark the original consumption and output levels C
1
, C
2
, Y
1
, Y
2
and the
consumption levels after the change C

1
, C

2
, as well as the slope of the
budget constraints.(5 marks)
Answer: This country is an initial borrower Y
1
< C
1
, since income rises
over time. Therefore, a decrease in the interest rate leads to a negative
wealth eect and consumption falls.
Marking scheme: 1 point for recognizing that the country was an initial
borrower, 2 marks for the correct slopes of the budget constraints, and 2
marks for the correct consumption level changes.
2. Consider the Dornbusch model. The real money demand is given by
The new money market equilibrium condition becomes:
m
s
p = ky
d
lr
where m
s
is the log money supply, p is the log domestic price level, y
d
is
log aggregate demand for output, and r is the log interest rate. Aggregate
supply is given by
p = (y
d
y)
and the log exchange rate e adjusts according to
e
e
= (e e)
a.) Suppose money supply is at the initial level m
0
. Compute the long-run
values for domestic prices, the real and the nominal exchange rates as a
function of the exogenous variables. (3 marks)
Answer: In the long-run, y
d
= y so that the long-run equilibrium condi-
tions are the same as in question 1. As before we have
p = m
0
ky +lr

(1)
e =

1
h
k

y +m
0
+lr

(2)
q = e p =
y
h
(3)
b.) Derive the equilibrium in nancial market by using the equilibrium
condition in the money market, the UIP and the expectation rule for the
nominal exchange rate. What is the slope of this curve? (2 marks)
6
Answer: Start by combining UIP with the expectations rule for the nom-
inal exchange rate, as in the previous question. Then substitute this into
our new money market equilibrium equation (23). Also substitute the ag-
gregate demand equation (4) into equation (23). After some rearranging
end up with the modied MM curve:
m
0
= p(1 kh) +e(l +kh) lr

le (4)
The slope of this curve is given by
e
p
=
(1 kh)
l +kh
(5)
Notice that the slope is negative if kh < 1 (case 1) and positive if kh > 1
(case 2). Notice further that in case 2,
e
p
< 1 since
e
p
< 1

(1kh)
l+kh
< 1 1 + kh < l + kh 1 < l which is true since
l, > 1 by assumption.
c. Suppose now that , the sensitivity of market expecations to over-valuation
or under-valuation of the currency relative to the equilibrium exchange
rate, increases. Describe the adjustment mechanism following this unex-
pected change. Illustrate this on the diagram. (10 marks)
Answer: Long run equilibrium conditions does not depend on . Hence
we conclude that there are no long run eects; In the short run, we nd
that the increase in has no eect on the GM line, but will cause the MM
line to become atter. The slope of the MM curve is given by 1/(l), so
that the increase in makes the MM line atter. From graph, we see that
MM curve pivots but the exchange rate and prices do not change.
Intuition: Since the exchange rate is at its equilibrium lelve, the change
in has no eect on the equilibrium. It would only have an impact if we
started from a position of disquilibrium.
d. Describe the adjustment path of the economy following an increase in the
interest rate elasticity of money demand l. Illustrate in a diagram with
the MM and GM curve studied in lecture. Explain the intuition of this
adjustment process. (10 marks)
Again, the long run equilibrium conditions suggest that increase in l causes
an increase in the long run price level p, and an increase in e. In the short
run, GM curve is unchangedl has no eect on the GM line, but the MM
curve shifts outwards and becomes atter (since both e, p have increased.
An increase in l also changes the slope of the MM curve (atter). There
will be a short run exchange rate overshooting (over-depreciation) when
p is xed, but in the long run when p is exible, the domestic currency
starts to appreciate and prices start to rise until it reaches the long run
equilibrium level.
7
Figure 1: Current Account question, graph for change in the world interest rate;
Q denotes output
[] Answer: The increase in the sensitivity of money demand to interest
rates l means that, at any given interest rate, there must be a decrease in
the demand for money, leading to a fall in the interest rate. From the UIP
condition, there must be an expected appreciation of the currency. But we
know that in the long run, equilibrium requires that r = r

. This implies
that in the long run, the supply of real money balances must fall so that
interest rates are equalized across countries. This can only occur through
an increase in the long run level of prices p. Further, given that the long
run output is unchanged, RER must be unchagned in the long run. All
of this implies that it can be consistent with a long run depreciation only
if the exchange rate overshoots (over-depreciates) in the short run.
8