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ECS3703 EXAM PACK2014 – 2016 PAPERS
MARCH 26, 2017
PREPARED BY
SHELTON MANDEYA
, FOREWORD
International Finance (ECS3703), quite an interesting, yet
demanding module done at third level. It sums up ECS2602, 2603,
2605 and 3701, and incredibly advanced. It requires student’s
commitment and dedication, as well as zeal and will. Determination
is the way! If you give up, then who will do it?
Nevertheless, it is one of the most passed Economics modules, of
course compared to its predecessors and ‘uncle’ modules.
I hope you will enjoy the pack. It has memos to past papers from
2014 to 2016. Custom-made packs which have answers to
textbook questions, and typical exam questions are also readily
available.
Regards
Shelton
+27 (078) 089 0012
1
, ECS3703 MAY/JUNE 2014 MEMORANDUM
Section A
You must answer ALL questions in this section
1. Explain (with the aid of two diagrams using the IS/LM/BP analysis) the
effectiveness of expansionary fiscal policies as well as ease monetary policies
in an open economy with flexible exchange rates and perfect capital mobility.
(25)
Monetary Policy is effective and Fiscal Policy ineffective.
Fiscal Policy Monetary Policy
i i
LM LM
6.25
E’
LM’
5.0 E F
BP
E 5.0
IS’
BP
IS
0 Y
Yn Yf
Expansionary fiscal policy shifts the IS to Easy monetary policy shifts the LM
IS’. The IS’ and LM intersect at point E curve to LM' and lowers the interest to
due to tendency of the nation’s interest i = 3.5 at point E". The nation reaches
rate to rise to i = 6.25. This leads to full employment Yf. LM' curve
massive capital inflows and appreciation intersects IS curve. This leads to
of the nation’s currency which capital outflow and a tendency of the
discourages exports and encourages nation's currency to depreciate which
imports and shifts the IS’ curve back to shifts the IS curve to the right to IS'
its original position. Thus fiscal policy is (exports are stimulated and imports
ineffective. discouraged).L M' shifts a little to LM"
(due to fall in money supply because
of rising prices in the nation). Final
equilibrium is at F where IS' and LM"
cross on the BP curve at Yf. Thus
monetary policy is effective.
2
, 2. Discuss covered interest arbitrage on the foreign exchange markets. Include
an example in your answer. (25)
Interest arbitrage refers to the international flow of short term liquid funds to earn
higher interest abroad. Can be covered or uncovered.
Covered interest arbitrage
Covered interest arbitrage is the spot purchase of the foreign currency to make
investment and the offsetting simultaneous forward sale (swap) of the foreign
currency to cover foreign exchange risk.
Example:
Assumptions:
Interest rate in the RSA = 10% per year
Interest rate in the USA = 3% per year
Spot exchange rate is $1 = R10,00
One year forward rate is $1 = R10,50
A USA citizen with $100,00 wants to investigate the possibility of arbitrage
profits by investing it in the RSA
To invest in the RSA he will have convert his $100,00 to R1000,00 on the spot
market and invest it in the RSA @10% interest rate (resulting in R1100,00 after a
year) and simultaneously cover it (hedge) using the forward rate. That means the
bank guarantees him that by the end of the year he can convert his money back to $
at the rate of $1,00 = R10, 50 resulting in $104,76 (R1100,00 ÷ R10, 50)
Comparison:
Should he have invested his $100 in the USA it would have grown to only $103,00
by the end of the year. He thus makes an arbitrage profit of $1,76 ($104,76 -
$103,00) by rather investing it in the RSA. At a forward rate of $1,00 = R10,68 no
arbitrage profits will be possible (R1100,00 ÷ R10,68 = $103,00)
The net return from covered interest arbitrage is usually equal to the interest
differential return in favour of the foreign monetary minus the forward discount on the
foreign currency. As covered interest arbitrage continues, the net gain is reduced
and finally eliminated. When the net gain is zero, it is said to be at covered interest
arbitrage parity (CIAP).
3
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