Monetary Economics (Quiz 4A)

Lahore School of Economics

Monetary Economics

Winter Term, 2012

Quiz 4A: B.Sc. III B Suggested Solutions

Instructions:

Answer all questions in the spaces provided below. For full marks, make sure you write all
relevant points and do all necessary calculations. Pencils, pens, rulers, etc. cannot be shared
and cell phones cannot be used during the session.

Exchange of quiz versions will not be tolerated at any cost and any ONE exchange caught
would lead to cancelation of ALL the quizzes. The case would immediately be reported to the
disciplinary committee.

Total points for the quiz: 40

Question 1

During 2009-2011, the economies of Australia and Switzerland suffered relatively mild effects
from the global financial crisis. At the same time, many countries in the euro area were hit
hard with high unemployment and burdened with unsustainably high government debts.
How should this affect the euro/Swiss franc and euro/Australian Dollar exchange rates?
Focus on the monetary authorities while explaining the change in exchange rates. (5 points)

European monetary authorities would reduce their interest rates to get out of recession and
hence Euro would relatively depreciate against Swiss Fran and Australian Dollar, thereby
decreasing both exchange rates.

Question 2

If the Pakistani authorities unexpectedly announce (assume a credible announcement) that it

will start imposing trade barriers on foreign goods one year from now, what will happen to
the value of PKR today? (5 points)

In current time period, two things can happen. Firstly, hearing this announcement, foreign
authorities can impose barriers on our goods in retaliation. This would depreciate PKR.
Secondly, in the absence of any reaction from foreign government, foreign goods would be
more expensive in the future and demand for foreign currency will fall leading to relative
appreciation of PKR overtime. Right now, PKR might appreciate as investors would shift

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 Monetary Economics (Quiz 4A)
towards local products because foreign goods would be expensive in future. So when barriers
are imposed one year from now, local currency would already have appreciated.

Question 3

The New Zealand Dollar to US Dollar exchange rate is 1.36 (the price of local currency, US 1$)
and the British Pound to US Dollar exchange rate is 0.62. What should be the British pound to
New Zealand dollar exchange rate assuming PPP? If you find that British pound to New
Zealand dollar were trading at 0.49 (0.49/New Zealand $), what would you do to earn
riskless profit? (10 points)

1US$ = 1.36 NZD and 1US$ = 0.62

0.62 = 1.36 NZD

1 NZD = 0.46

If actual exchange rate 1 NZD = 0.49, then American investor should invest in British Pound
as it is cheaper and would appreciate against NZD in the long run. Hence purchase NZD and
convert it to . When NZD depreciates to 0.46 in the long run, the can be converted back to
NZD and then finally to US $ for a riskless profit.

In other words,

1 US$ converted to NZD = 1.36 NZD in = 0.49 x 1.36 = 0.67 when in long run 1 NZD =
0.46, 0.67 = 0.67/0.49 = 1.37 NZD convert it back to US $ = 1.37 NZD/1.36NZD = 1.007US $

The investor makes $0.007 profit.

Question 4

With the help of graphs, explain why monetary policy is effective and independent under
flexible exchange rates? (10 points)

We begin from IS/PC/MR model whereby there is a positive exogenous shock in the IS curve
shifting it rightwards. This introduces an inflationary gap which increases inflationary
expectations and in the long run, we move back to Y* at higher inflation level. Assuming it
crosses the target levels, according to the MR curve, the policy maker will increase interest
rates and deliberately create a recessionary gap. This will lower inflationary expectations and
PC curve will shift downwards while to remove recessionary gap, policymaker consistently
reduces interest rates. Economy settles at Point A in the following diagram whereby there is a
BOP surplus. Surplus increases demand for local currency and exchange rate appreciates. We

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 Monetary Economics (Quiz 4A)
observe that under flexible exchange rate system, interest rates can be increased / decreased
as chosen by the policymaker to obtain full employment level.

With appreciated exchange rate at Point A, external demand for local products falls and local
demand for external products increases. This shifts IS curve backwards creating a recessionary
gap which is eliminated by expansionary monetary policy. However, that depreciates the
exchange rate due to capital outflows and BOP deficit which is accepted because exchange
rates are allowed to float freely.

This shows that under flexible exchange rates, any level of interest rates can be chosen and this
makes inflation policy independent and monetary authorities effective.

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 Monetary Economics (Quiz 4A)
Question 5

Assume a country has high interest rates and Balance of Payment deficit. Explain what would
happen to the value of this economys currency according to Asset models of exchange
rates. (10 points)

In the asset market, the demand for foreign currency will increase as import bill is higher than
export revenues. Local authorities would decrease M and B to pay for the rising imports.
Hence the demand curve in the right panel shifts rightwards while the M curve and the B
curve in the left panel will shift leftwards and upwards respectively. The shifts take place in
equal proportion. It can be observed that local currency depreciates (exchange rate increases
numerically).

As long as this BOP deficit remains, demand of foreign currency keeps on increasing. Foreign
currency appreciates and local currency depreciates until and unless the deficit is eliminated.
Hence, in the diagram below, as the deficit reduces, local currency keeps on depreciating and
final change in the exchange rate is from e0 to e1.

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 Monetary Economics (Quiz 4A)
In this model, exchange rate depreciates both in the short and long run but BOP deficit is
eventually equal to zero. With lower value of exchange rate, it can be seen that imports
decrease (b to a) and exports increase (c to a). This eliminates the deficit.

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