1 Macroeconomics (Econ G25T) Open Economy Macroeconomics SOME GUIDELINES As has already been announced, there will be tests for both sections of Econ G25 The following remarks relate to the test for the open economy macroeconomics section of the course (taught by Domenico Moro) only. The test for the open economy macroeconomics section will be a multiple-choice test of 16 questions + 4 short essay questions of max 150 words. The test is intended to test whether students have a good knowledge and understanding of the material covered in my section of the course. Extensive calculations and derivations in order to answer the questions will not be required, and there is no need to remember complicated mathematical formulae. It would be reasonable to assume that all the major topics covered in the course before the date of the test will feature in the test, although there are no guarantees. To prepare for the test, it would be advisable to look over the lecture handouts, to do some reading, of both of the text books. The ‘bottom line’ is that if you have a reasonable understanding of the material we covered in the lectures, there should be absolutely no reason to worry about the test. Have a Happy Christmas and I’ll look forward to seeing you in the New Year. 2 Some sample questions (and answers) are given below: Essay – Type “Currency depreciation is always and everywhere a monetary phenomenon”. Without using equations and / or graphs and using a maximum 150 words, provide an intuitive explanation of whether this is a fair summary of the Monetary Model? ANS Not really. The (domestic) currency also depreciates, according to the Monetary Model, when domestic real income falls (or foreign real income rises), or when the foreign price level falls, even if money stocks are constant. However, it is true that currency depreciation is always the result of an excess supply of domestic money/excess demand for foreign money (in both cases, of course, excess implies an imbalance between supply and demand for money). Multiple-choice test – Type 1. According to local currency pricing (LCP), when a country’s currency depreciates, then (a) the domestic currency price of its exports rises; (b) the domestic currency price of its exports stays constant; (c) the foreign currency price of its exports stays unchanged; (d) the domestic currency price of its imports rises; (e) both (a) and (c). The correct answer is (e). Although (a) and (c) are also ‘correct’, it should be clear that (e) is better than either (a) or (c), so no marks would be given to students who choose either (a) or (c). LCP means that firms keep the nominal price of goods constant in the currency of the country in which they are sold, so the foreign currency price of a country’s exports stays constant in the face of a devaluation, but this means that the domestic currency price (of exports) must rise. 2. If the foreign interest rate is 3% and the currency is expected to depreciate by 4%, then, according to the uncovered interest parity condition, in the absence of a risk premium, the domestic interest rate is (a) 1%; (b) 3%; (c) 4%; (d) 7%; (e) 10%. The correct answer is (d). The uncovered interest parity condition states that the domestic interest rate equals the foreign interest rate (3%) plus expected exchange rate depreciation (4%) so 7% must be the answer. 3 3. In the Dornbusch overshooting model (with exogenous output) after a permanent unanticipated increase in the money supply, on the saddlepath to the new steady-state equilibrium, (a) prices are rising and the exchange rate is depreciating; (b) prices are rising and the exchange rate is appreciating; (c) prices are falling and the exchange rate is depreciating; (d) prices are falling and the exchange rate is appreciating; (e) interest rates are above their steady-state level. The correct answer is (b). After the money supply increase, there is a jump to depreciation of the exchange rate which puts the economy on the saddlepath associated with the new dynamic system. The saddlepath is downward sloping. The economy then moves along this saddlepath to the new steady state, with the exchange rate appreciating and the price level rising. (So answers (a), (c) and (d) are ruled out.) Also, the interest rate falls below its steady- state level when the money supply increases, and stays at this steady-state level until it reaches the new steady state, so (e) cannot be right. 4. In the Krugman model of speculative attacks, a speculative attack occurs in a country running a budget deficit when (a) its foreign exchange reserves start to decline; (b) it imposes controls on capital account transactions; (c) its rate of inflation is higher than that of its major competitors; (d) the central bank ceases to perform its role of lender of last resort; (e) its shadow exchange rate equals the actual pegged exchange rate. The correct answer is (e). See the lecture notes for more discussion of this condition. The other answers are incorrect statements about what the Krugman model predicts, although some of them may be true statements about when a speculative account may occur. 5. Which of the following is not a plausible criticism of the Mundell-Fleming model? (a) Behaviour of economic agents is not based on intertemporal optimisation. (b) It assumes a constant price level, and hence does not take into account the effects of inflation. (c) It is an extremely aggregative model, assuming just one good and only two financial assets. (d) It is a static model. (e) It assumes rational expectations. The correct answer is (e) – the Mundell-Fleming model does not assume rational expectations, so this cannot be a plausible criticism. All the other criticisms are plausible criticisms of the model.
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