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ECN209 International Finance - 2017
Section A
Question 1 An increase in the productive efficiency of US labor and capital causes a longrun real
depreciation of the Dollar against the Euro. [10 marks]
TRUE.
Since Americans spend part of their increased income on foreign goods, the supplies of all types of
U.S. goods and services increase relative to the demand for them, the result being an excess relative
supply of American output at the previous real exchange rate. A fall in the relative price of American
products shifts demand toward them and eliminates the excess supply. This price change is a real
depreciation of the dollar against the euro, that is, an increase in q$/€ . A relative expansion of U.S.
output causes a long-run real depreciation of the dollar against the euro (q$/€ rises).
Question 2. Central banks can influence the exchange rate without altering the nominal money
supply. [10 marks]
FALSE.
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
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
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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. A government budget deficit is associated with a current account surplus. [10 marks]
FALSE.
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).
Now, we assume an economy already at potential output, meaning Y is fixed. In this case, if the
government deficit increases (T-G), and saving remains the same (S), then this last equation implies
that either investment (I) must fall, or net exports (NX) must fall, causing a trade deficit. Hence, a
budget deficit can also lead to a trade deficit, causing a twin deficit. Therefore, a government budget
deficit is associated with a current account deficit.
Question 4. According to the DD-AA model, a domestic monetary expansion improves the
domestic current account. [10 marks]
TRUE.
The central bank can attempt to increase the money supply through a purchase of domestic assets.
Under a floating exchange rate, the increase in the central bank’s domestic assets would push the
original asset market equilibrium curve rightward to and would therefore result in a new equilibrium
at point 2 and a currency depreciation (at E2). Under floating rates, the rise in the nominal exchange
rate leads to a rise in the real exchange rate which causes an increase in the current account.
