International Finance Master PEI Fall 2012 Nicolas Coeurdacier Final exam Non-detailed correction 3 hours

This are indicative directions on how structure the essay questions and what was expected. 1. Multiple choice questions [50 points = 2 per question] You have to select at LEAST one answer from the four proposed answers. You have to select ALL the correct answers, AND ONLY the correct answers to get the maximum number of points (no negative points). 1. In the neoclassical model, a country opening up its capital and financial account should a. export capital if its rate of return is lower than the world rate of return b. grow faster if it has the same technology than the rest of the world c. grow faster if its rate of return to capital is higher than the world rate of return d. run a current account surplus to diversify domestic risk 2. Which of the following sentences are (always) correct? a. Under a fixed-exchange rate regime, a current account deficit necessary leads to a decrease of the official reserves. b. A country running a current deficit is a debtor country. c. If private savings exceed domestic investment, the country can run a fiscal deficit without running a current account deficit. d. The variation of the net foreign asset position of a country is equal to its current account. 3. Here is the external position of the country King-Kong (currency the King-Kong Dollar). Foreign Liabilities (% of GDP) 200% of GDP Of which: In King-Kong Dollar: 100% of GDP In USD: 50% of GDP In Euro: 50% of GDP Foreign Assets (% of GDP) 200% of GDP Of which: In USD: 180% of GDP In Euro: 20% of GDP

a. A depreciation of the Euro with respect to the USD improves the net foreign asset position of King-Kong. b. A depreciation of the Euro with respect to the USD deteriorates the net foreign asset position of King-Kong. c. A depreciation of the Euro with respect to the King-Kong Dollar deteriorates the net foreign asset position of King-Kong. d. A depreciation of the King-Kong Dollar with respect to the Dollar improves the net foreign asset position of King-Kong.

4. Which of the following events does improve the US Balance of Payments (i.e improve the US current account or the US financial account)? a. A purchase of a U.S. Treasury Bill by a foreign resident. b. US investors enjoy large capital gains on their French equity stocks in the CAC40 following the good performance of the French stock index. c. A US consumer sells a Television made in Korea to his neighbour. d. A subsidiary of a US computer manufacturer located in China pays dividends to its US parent. 5. Uncovered interest parity (UIP) implies that a. interest rates should be equal in a currency union abstracting from default risk and/or risk of exit from the union b. low interest rate currencies should not attract foreign investors c. high interest rate countries should have higher inflation d. low interest currencies should appreciate in the future 6. We start from a situation where nominal interest rates are equal in the Eurozone and in the US. According to UIP, if the Federal Reserve lowers interest rates today a. The USD should depreciate if the interest rate change is expected b. The USD should depreciate if the interest rate change is unexpected c. The USD should appreciate immediately and depreciate in the future d. The USD should appreciate in the future 7. Under the gold standard of currency exchange that existed from 1879 to 1914, an ounce of gold cost $20 in U.S. dollars and 4 in British pounds. Therefore, the spot exchange rate between the two currencies under this fixed exchange regime was a. 5 per $. b. 0.20 per $. c. $5 per d. always changing because the price of gold was always changing. 8. One year ago the spot rate of U.S. dollars for Canadian dollars was $1/C$ (read 1 USD per CAN$). Since that time the rate of inflation in the U.S. has been 4% greater than in Canada. Based on the theory of Relative PPP, the current spot exchange rate of U.S. dollars for Canadian dollars should be approximately . a. $0.96/C$ b. $1.4/C$ c. $1.04/C$ d. unchanged if todays interest rates are equal in both countries 9. If Absolute Purchasing Power Parity between two countries holds in the long run then: a. goods have the same price in the two countries once expressed in common currency b. countries with higher domestic inflation should see an appreciation of their currency c. the level of the real exchange rate should be mean-reverting in the long-run d. the growth of money supply has to be the same across the two countries 10. The country Spaghetti is expected to default on its sovereign debt. Investors assess the probability of default to be 20% and expect to be totally expropriated in case of default. Spaghetti is part of a currency union with Wurst. Ten years interest rates on T-bills in Wurst are 4%.

a. Ten years interest rates on T-Bills from Spaghetti should be 4% for uncovered interest rate parity to hold and Spaghetti to stay in the currency union. b. Ten years interest rates on T-Bills from Spaghetti should be equal to 5% c. Ten years interest rates on T-Bills from Spaghetti should be equal to 24% d. Ten years interest rates on T-Bills from Spaghetti should be equal to 30% 11. Fill the blanks. According to Uncovered Interest rate Parity, if an investor purchases a five-year U.S. bond that has an annual interest rate of 4% rather than a comparable British bond that has an annual interest rate of 6%, then the investor must be expecting the _________ to ___________ at a rate of at least 2% per year over the next 5 years. a. British pound; appreciate b. British pound; depreciate c. U.S. dollar; appreciate d. U.S. dollar; depreciate 12. The US faces a large fall in aggregate demand. In order to stabilize output, a. the Federal Reserve lowers interest rates b. the Federal Reserve depreciates the value of the dollar c. the government increases tax rates to avoid to run into debt problems d. the government does not need to do anything since automatic stabilizers are high 13. The special liquidity injection by which the Federal Reserve swaps liquidity with high quality security (quantitative easing) is going to be inflationary under what circumstances: a. always and everywhere. b. if the commercial banks will recapitalize. c. if commercial banks will lend that liquidity out to households and businesses and nominal interest rate will be kept at low levels. d. if commercial banks will lend that liquidity out to households and businesses but the central bank will quickly raise interest rates afterwards. 14. The special liquidity injection by which the Federal Reserve swaps liquidity with high quality security (quantitative easing) is likely to depreciate the dollar on impact under what circumstances: a. always and everywhere. b. if inflation raises on impact and investors do not expect the Fed to react by raising interest rates c. if inflation raises on impact and investors expect the Fed to react by raising interest rates d. if inflation does not raise on impact but investors expect this measure to be inflationary in the future 15. A country with a debt to GDP ratio of 100% at the beginning of the year, a total fiscal deficit of 9% of GDP during the year and net interest payment of 6% of GDP during the year a. has a primary fiscal deficit of 3% b. has a primary fiscal surplus of 3% c. pays an average interest rate on its debt of 6% d. will have a debt to GDP ratio of 109% at the end of the year if the GDP is constant 16. The following statements are true: a. countries with high growth rate are likely to see their debt to GDP ratio increasing very fast as the economy overheats b. a country for which the real interest rate r is equal to the growth rate of GDP g can stabilize its debt to GDP ratio by keeping its budget balanced

c. debt sustainability is independent of the real interest rate rate of the economy d. a lower growth rate makes it more difficult for a country to have a sustainable level of debt 17. The Bigstate faces the following fiscal situation. Debt-to-GDP ratio = 100%; Real interest rate = 5%; Real growth rate = 6% a. Bigstate needs a primary surplus of 1% of GDP or above for the debt to be sustainable b. Bigstate needs a primary deficit of 1% of GDP or less for the debt to be sustainable c. If Bigstate runs a primary deficit of 2% of GDP, the debt to GDP ratio will increase (keeping real interest rate and growth rate constant) d. If Bigstate adopt a new constitution that imposed balanced budget, its debt-to-GDP ratio will go to zero (keeping real interest rate and growth rate constant) 18. An unexpected drop of aggregate demand in the eurozone due to the crisis should a. lead to a fall in the demand for money in the eurozone b. lead to a fall in the euro interest rates c. lead to an depreciation of the euro d. be partially offset in the medium term by increasing net exports 19. In the long-term, a permanent increase in rate of growth of money supply should a. lead to depreciation of the currency if GDP growth stays the same b. lead to higher inflation if GDP growth stays the same c. lead to lower inflation if GDP growth falls d. lead to higher trade surpluses 20. According to the Mundell-Fleming model (AA-DD model), fiscal austerity, i.e a reduction in fiscal deficits, in the euro zone should a. lead to an appreciation of the euro b. lead to a fall in output in the euro zone c. improve net exports of the euro zone d. lead to net capital outflows towards the rest of the world. 21. Consider the Mundell-Fleming model (AA-DD model): in a country having a fixed exchange rates, fiscal austerity a. is more costly in terms of output than under flexible exchange rates b. does not affect output since the exchange rate does not adjust c. has a very small Keynesian fiscal multiplier on output d. should lead to a fall in the interest rate 22. The Keynesian fiscal multiplier a. measures the response of output to a fiscal expansion b. measures the response of exchange rates to a fiscal expansion c. is very low if agents are Ricardian d. is higher if the economy is more opened to trade in goods 23. The country Grechen has a fixed exchange rate with the euro. Grechen pays higher interest rates on government bonds than Gernnany, this can mean that: a. Inflation is lower in Grechen b. Capital is not freely mobile between Grechen and Gernnany. c. Investors think the peg is not credible and that the government might devalue. d. Investors think that the peg is credible but the government might default on its debt.

24. If Italy is hit by a negative demand shock while Germany is not, the ECB interest rate a. should increase to lower aggregate demand in Germany b. should decrease to increase aggregate demand in Italy c. stays constant to avoid inflation to pick up in the eurozone d. might stay too high for Italy to stabilize its output optimally 25. A country with a fixed exchange rate to the US dollar is more sensitive to a speculative attack if a. the country has small amounts of international reserves b. the country has been mostly borrowing in foreign currency c. the country has a deficit of its financial account d. the country is in recession and US interest rates are rising 2. Short questions/essays [50 points=15+15+20] 1) PPP and the Big Mac Big Mac Prices and (spot) nominal exchange rates with respect to the US dollar and GDP per capita in USD are presented in the table below for few countries (source: The Economist). We focus on Purchasing Power Parity (PPP) based on Big Mac prices.

Country

Big Mac Price in local currency

USA Switzerland Taiwan Russia China

3.22 USD 6.30 SWF 75 TWD 49 RBL 11 CHY

Spot nominal exchange rate (mid-quotes) with respect to the USD (Foreign currency units/USD) (January 31st, 2007) 1.25 32.9 26.5 7.77

Nominal GDP per capita in USD (2007, source IMF)

45,845 58,084 16,606 9,075 2,461

1. According to PPP (absolute and relative), how is determined the nominal exchange rate between two currencies? See class notes 2. According to PPP applied to Big Mac prices, which of the currencies in the table are undervalued/overvalued with respect to the USD? By how much approximately? 3. How is the level of undervaluation (or overvaluation) of the currency related to the GDP per capita of countries? Why? [400 words maximum] Answers: 1. See class notes 2. SWF overvalued, all others undervalued. To see that just compute Big mac prices in a given country in dollars by dividing first column by second. Only in Switzerland, Big macs are more expensive. The % of undervaluation (or overvaluation) is simply deduced by comparing % difference of the Big Mac price in the country expressed in USD compared to the one in the US. For example: in Switzerland, roughly 5USD for a Big Mac, so roughly 60% overvaluation.

3. Richer countries have less undervalued currencies according to PPP based on Big macs. Big macs are non-traded goods. So you were expected to explain the Balassa-Samuelson effect which makes prices lower for non-traded in poorer countries (see class notes). 2) Crisis in Iceland How did the valuation effects on the external position affect Iceland following the sharp depreciation of the Icelandic Krona in October 2008 (see fig. 1 and 2 in the appendix)? How did the structure external debt affect investors decisions before the crisis? [600 words maximum] You were expected to talk about the currency composition of external assets and liabilities for Iceland, investigate the capital losses on the external position associated to a devaluation of the Krona with respect to other currencies and discuss how this aggravates external imbalances of Iceland ex-post. Ex-ante, investors can expect Iceland to be harshly hit in case of a Krona depreciation (financial fragility) which leaves room for multiple equilibria, one where Iceland is hit by a selffulfilling currency crash (see class notes). 3) The global saving glut and the US current account deficit Comment the following remarks of the chairman of the Federal Reserve, B. Bernanke (Sandridge Lecture, Virginia, April 2005): The Changing Pattern of International Capital Flows and the Global Saving Glut

()
The table 1 (see appendix) shows the sharp increase in the U.S. current account deficit, about $410 billion between 1996 and 2003. (Data from the first three quarters of 2004 imply that the current account deficit rose last year by an additional $140 billion at an annual rate.) In principle, the current account positions of the world's nations should sum to zero (although, in practice, data collection problems lead to a large statistical discrepancy, shown in the last row of table 1). The $410 billion increase in the U.S. current account deficit between 1996 and 2003 must therefore have been matched by a shift toward surplus of equal magnitude in other countries. Which countries experienced this change? () As we can infer from table 1, most of the swing toward surplus (in the rest of the world) did not occur in the other industrial countries as a whole (although some individual industrial countries did experience large moves toward surplus). () As table 1 shows, the bulk of the increase in the U.S. current account deficit was balanced by changes in the current account positions of developing countries, which moved from a collective deficit of $88 billion to a surplus of $205 billion--a net change of $293 billion-- between 1996 and 2003. The available data suggest that the current accounts of developing and emerging-market economies swung a further $60 billion into surplus in 2004. This remarkable change in the current account balances of developing countries raises at least three questions. First, what events or factors induced this change? Second, what causal relationship (if any) exists between this change and current-account developments in the United States ()? Third, to the extent that the movement toward surplus in developing-country current accounts has had a differential impact on the United States relative to other industrial countries, what accounts for the difference?

()
What does B. Bernanke mean by a global savings glut? Could you provide some tentative answers to the questions asked in the last paragraph? In what sense, the global savings glut can be seen as a driver of the recent financial crisis in the US? [1000 words maximum]

Some directions for the essay: High savings emerging countries lending to a low savings country= global savings glut. Remember that CA=S-I. Surprising given that emerging markets are growing faster and catching up, should be borrowing. Potential explanations among others (to be developed): lack of development of financial and insurance markets/social security, precautionary motives to prevent sudden-stops in capital flows (in particular after east Asian crisis). Lending to countries with more developed financial markets (+ financial deregulation in some of them, in particular the US). Fast demographic transition is Asia as well (ageing faster than the US). As these emerging markets are getting bigger, larger pool of savings to be allocated towards deficit countries, exerts downward pressure on world interest rates: falling interest rates, gives further incentives for US to borrow (consumption/investment boom in US). Fall in savings (and potentially increasing investment), leading to larger CA deficits in the US (again CA=S-I). And makes asset bubbles there more likely (housing boom). Build up of leveraged position by banks and households which generates financial fragility in the US. See Obstfeld and Rogoffs paper in the readings for the link between global imbalances and the financial crisis.

Appendix: Figures and Tables

Fig. 1: Currency crash in Iceland in October 2008 (nominal exchange rate: Icelandic Krona/Euro)

Foreign currency liabilities of banks and CB forex reserves september 2008

800%

700%

600%

750% GDP

500%

400%

300%

CB forex reserves: 21% GDP

200%

CB swaps and credit lines: 14% GDP

100%

0%

Foreign currency liabilities of the banks

CB forex liquidity

Fig. 2 : Forex exposure of banks liabilities in Iceland before the crash.

Table 1. Global Current Account Balances, 1996 and 2003 (Billions of U.S. dollars) Countries 1996 2003 Industrial United States Japan Euro Area France Germany Italy Spain Other Australia Canada Switzerland United Kingdom Developing Asia China Hong Kong Korea Taiwan Thailand Latin America Argentina Brazil Mexico Middle East and Africa E. Europe and the former Soviet Union Statistical discrepancy 46.2 -342.3 -120.2 -530.7 65.4 88.5 20.8 -13.4 39.6 0.4 12.5 -15.8 3.4 21.3 -10.9 -87.5 -40.8 7.2 -2.6 -23.1 10.9 -14.4 -39.1 -6.8 -23.2 -2.5 5.9 -13.5 41.3 138.2 24.9 4.5 55.1 -20.7 -23.6 25.3 -30.4 17.1 42.2 -30.5 205.0 148.3 45.9 17.0 11.9 29.3 8.0 3.8 7.4 4.0 -8.7 47.8 5.1 137.2