International Economics

International Economics
1. (20 points) You learned three main types of nominal anchors to control inflation: exchange
rate target, money supply target, and inflation target plus interest rate policy. (See Monetary
Approach to Exchange Rate Presentation) Assume that you are the central banker for a
country that is considering the adoption of a new nominal anchor. When you take the position
as chairperson, the inflation rate is 4% and your position as the central bank chairperson
requires that you achieve a 2.5% inflation target within the next year. The economy’s growth
in real output is currently 3%. The world real interest rate (r*) is currently 1.5%. The
currency used in your country is the lira. Assume prices are flexible.
(a) What is the growth rate of the money supply in this economy given the current inflation
rate of 4%? (Hint: See Money supply target to see the relationship between money
supply growth, inflation and growth rate)
(b) If you choose to adopt a money supply target, which money supply growth rate will allow
you to meet your inflation target?
(c) Suppose the inflation rate in the United States is currently 2% and you adopt an exchange
rate target relative to the U.S. dollar. Compute the percent appreciation/depreciation
in the lira needed for you to achieve your inflation target. Compute the percent appreciation/depreciation
in the lira if the central banker allows the inflation rate to remain
at 4%.
(d) Your final option is to achieve your inflation target using interest rate policy. Using
the Fisher equation, compute the current nominal interest rate in your country. What
nominal interest rate will allow you to achieve the inflation target?
2. (20 points) Oil prices reached $140 a barrel in 2008. Suppose you were a member of the
monetary policy committee of a small open economy, dependent on oil imports, which also
wanted to maintain a currency peg to the dollar. This increase in oil prices deteriorated
current account balance substantially and raised the question if the current account balance
deficit would be sustainable or not. (Hint: Overvalued currency case)
(a) Describe the pressures that the currency would face due to the increase in oil prices and
current account deficit. How would the central bank have to respond in order to maintain
the currency peg? Would this response by the central bank increase or decrease foreign
reserves?
(b) Describe the impact of the Central Bank actions on the money supply, output, and
domestic interest rates. Assume that the economy was already in recession even before
oil price hike. What would be the dilemma that policymakers faced? (Hint: Interest rate
effect on the economy.)
(c) Suppose the central bank kept its exchange rate fixed but decided to sterilize its foreignexchange
intervention. Explain how the central banks would sterilize its intervention.
3. (15 points) From 1979 to 1980, Paul Volcker deliberately raised US interest rates to decrease
inflation rate.
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(a) Why did the higher U.S. interest rates make it harder for Latin American nations
to repay their debts? (Hint: See the presentation!
(b) Why did the U.S. recession make it harder for Latin American nations to pay their
debts? (Hint: Demand and see the presentation!)
4. (15 points) The currency crisis led to a recession in Thailand in 1997. In order to restore the
economy, the government asked the International Monetary Fund (IMF) for loans. The IMF
suggested the Thai government to reduce its expenditures and raise taxes. Why was the IMF
often unpopular among the countries that receive rescue loans? Discuss the policies that IMF
suggested and critiques of these policies.
5. (15 points) A country is less vulnerable to a financial crisis if its debt is in the form of bank
loans rather than foreign direct investment (FDI). Do you agree? Why or why not? (Hint:
Hot money)
6. (15 points) Mexico had a fixed exchange rate with a current account deficit. Defaults on
loans, political instability, and the increase in the U.S interest rate resulted in some amount
of capital outflow.
(a) In order to prevent capital outflow and restore confidence, government issued short term
debt denominated in dollars (tesobonos). Why did the government issue dollar-based
instruments instead of peso-based?
(b) Fear of currency devaluation and fear of default on tesobonos increased the capital outflow
once again. The central bank had to devalue peso. Why? What is the benefit of currency
devaluations in the long-run (Hint: Export)?
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