1 Chapter 12: The Global Macroeconomy

1. Let H stand for the country, F for the foreign country. Using the price
notation of exchange rate, we know that EH=F de…nes the nominal ex-
change rate as the price of the ___-currency. It expresses how many
units of the ____-currency need to be paid for one unit of the ____-
currency. That is, from the viewpoint of the H-country, and increase in
EH=F is a depreciation of the _____-currency, and an appreciation of
the _____-currency.
2. According to the text in chapter 12 and as discussed in class, there are two
reasons we care so much about exchange rates: they are the relative prices
of goods, and the relative prices of assets. Explain in your own words and
give example for each.
3. What is an exchange rate crisis, and what are the characteristics of an
exchange rate crisis?
4. Explain why/how a fall in the exchange rate of a country, especially for an
emerging country whose country’s liabilities are denominated in a foreign
currency, can lead to default?

5. Explain what is meant by the globalization of …nance, and describe the

trends in this area since 1970. Be sure to distinguish between the trends
in advanced, emerging, and developing countries.

6. What is the relationship between income, expenditure, current account

and external wealth?

7. What are the di¤erences between a policy, a regime, and an institution?

8. What are the six characteristics of “good” institutions, and why are they
considered good (i.e., what are the bene…ts of good institutions?)?

2 Chapter 13: Introduction to Exchange Rates

and the Foreign Exchange Market
1. Table 13-1 lists exchange rate quotations as often found in newspapers.
Be sure that, based on the information

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 TABLE 13-1

Exchange Rate Quotations This table shows major exchange rates as they might appear in
the financial media.
Columns (1)to (3) show rates on December 31, 2015. For comparison, columns (4) to (6) show
rates on December 31, 2014.
For example, column (1) shows that at the end of 2015, one U.S. dollar was worth 1.501
Canadian dollars, 6.870 Danish krone,
0.921 euros, and so on. The euro–dollar rates appear in bold type.
EXCHANGE RATES ON
EXCHANGE RATES ON DECEMBER 31, 2014
DECEMBER 31, 2015 ONE YEAR PREVIOUSLY
(1) (2) (3) (4) (5) (6)
Currency
Country (currency) Symbol Per $ Per € Per £ Per $ Per € Per £
Canada (dollar) C$ 1.501 1.389 2.047 1.158 1.402 1.806
Denmark (krone) DKr 6.870 7.463 10.13 6.154 7.446 9.595
Eurozone (euro) € 0.921 — 1.357 0.826 — 1.289
Japan (yen) ¥ 120.3 130.7 177.3 119.9 145.1 187.0
Norway (krone) NKr 8.851 9.612 13.05 7.498 9.072 11.69
Sweden (krona) SKr 8.431 9.158 12.43 7.828 9.473 12.21
Switzerland (franc) SFr 1.001 1.087 1.485 0.994 1.202 1.549
United Kingdom (pound) £ 0.679 0.737 — 1.559 0.776 —
United States (dollar) $ — 1.086 1.474 — 1.210 1.559

Data from: ft.com.

on the years of 2014 and 2015 below, report the bilateral exchange rate for
both years, indicate if the exchange rate has appreciated or depreciated,
and by how many percent (recall, the percentage home depreciation is
2015 2014
EH=F EH=F
given by 2014
EH=F
100) of the following country pairs:

(a) US Dollar to Euro

(b) Japanese Yen to US Dollar
(c) Euro to Swiss France

2. Explain in your own words the e¤ective exchange rate and why policy
makers pay more attention to it than the bilateral exchange rate.

3. Suppose a country trades with three countries: Brazil (20% of trade),

China (45%), and France (35%). Over the last year, the currency of this
country has depreciated by 4% against the Brazilian real, appreciated by
3% against the Chinese yuan, and depreciated by 7% against the euro.
What has happened to the e¤ective exchange rate of the country?

4. What are the similarities and di¤erences between a currency union and
dollarization?

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5. Explain two of the four main types of derivatives used in the foreign ex-
change market, and why they are used.

6. What role(s) might the government play in the foreign exchange markets?
Explain. Comment on the Chinese-US exchange rate in panel (a) of the
…gure below, and explain in detail how the Chinese Central Bank may
have intervened in foreign exchange market and why?

7. Is it possible to engage in arbitrage under the following scenario? The

exchange rate in New York is E = $1:25=euro, and it is E = $1:35=euro
in London. Explain how you would do it.

8. Explain the di¤erence between risky and riskless arbitrage. State the for-
mulas of covered and uncovered interest rate parity and explain them.

9. Suppose the U.S. dollar interest rate is 3%, while the interest rate in the
United Kingdom is 6%. Your friend thinks he can convert his dollars,
invest in the United Kingdom and convert his pounds back into dollars
at the end of a year, allowing him to make a lot higher return. Assuming
uncovered Interest parity (UIP), explain why he is incorrect.

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3 Chapter 14: Exchange Rates I: The Monetary
Approach in the Long Run
1. Explain the concepts of the law of one price and the purchasing power
parity. State the formulas describing absolute and relative PPP and ex-
plain the di¤erence between.

2. Absolute PPP doesn’t do a very good job explaining exchange rates in the
short run. Give and fully explain two of the three reasons for this failure.

3. Write down the algebraic expression for the money market equilibrium,
when the demand for money is driven solely by the need to conduct trans-
actions in proportion to nominal income (known as the quantity theory of
money). Explain.

4. Write down all necessary steps to obtain the fundamental equation of the
monetary approach to exchange rate. (Tip: using the quantity theory of
money and (absolute PPP), show how the exchange rate is determined as
depending on relative money supplies and relative nominal incomes across
countries.) Explain.

5. Give an intuitive explanation as to why faster money growth leads to a

depreciating currency.
6. Using the quantity theory of money and the theory of purchasing power
parity, derive the link between the rate of exchange rate depreciation,
In‡ation, and money growth.
7. According to the simple monetary model, if money is growing at 5% in the
United States and 6% in the United Kingdom, while real GDP if rising at
3% in the United States, and at 5% in the United Kingdom. What will
this do to the exchange rate?

8. Absolute PPP doesn’t do a very good job explaining exchange rates in the
short run. Give and fully explain two of the three reasons for this failure.

9. Explain the Fisher e¤ect, both formally and in words. Explain how PPP,
UIP, and the Fisher e¤ect lead to the insight that real interest rates equal-
ize across countries.

10. It has been abundantly demonstrated that nominal interest rates, ex-
change rates, and in‡ation are very tightly linked. In Italy, during the

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 1970s and 1980s, the in‡ation rate of the Italian lira was very erratic,
changing each year in a range of 7% to 20% per year. Predict the e¤ect
on Italy’s nominal interest rates and its exchange rates with other nations
during that period.

4 Chapter 15: Exchange Rates II: The Mone-

tary Approach in the Short Run
1. What happens, ceteris paribus, to the foreign return on assets, as the spot
exchange rate increases (depreciates).

2. Explain why an increase in the European interest rate increases the dollar-
euro exchange rate.

3. Suppose domestic interest rates are at 4.55%, while foreign returns are
bringing 6.38%. According to the asset approach, if the expected future
exchange rate is three dollars per unit of foreign currency, what can we
say about the current spot rate if UIP holds?

4. Write down the money demand and money supply equations in the short
run.
(a) Show graphically (please label all curves and axes) and explain the
intuition for the fact that short-run nominal interest rates fall in re-
sponse to an increase in the money supply.

(b) Explain the intuition for the fact that short-run nominal interest rates
rise in response to an increase in the real income.

5. Give a graphical description of the money market and the foreign exchange
rate market, label all axis and curves in your diagrams. If the money sup-
ply in the United States is temporarily increased from M1 to M2, and
prices are sticky, trace the e¤ects of the change and predict the e¤ect on
the dollar, assuming other variables remain constant.

6. Evaluate the following statement: Higher nominal interest rates are as-
sociated with an appreciating exchange rate. Do you agree, disagree, or
both? In your answers, indicate the time span your arguments are likely
to hold for, i.e. the short run or the long run. Explain.

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7. Describe the e¤ect of a permanent increase in the quantity of money on
exchange rates in both the long and short run.

8. Unifying the monetary and the asset approach of exchange rates:

(a) Use the Money Market and FX Market diagrams below (label all
curves and axes), and use them to study the e¤ects of a monetary
expansion in the short run and the long run, in the case the mone-
tary expansion is known to be permanent. Be clear as to what curves
shifts where, why, and when, and accompany your graphical analysis
with explaining the mechanisms at play in words. Make sure to spec-
ify what the e¤ects of the permanent monetary expansion are for the
future expected exchange rate.

short run:

long run:

(b) What is exchange rate overshooting in this context. Explain why

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 it results. Draw time paths for the money supply, real money bal-
ances, the home price level and the exchange rate in response to the
permanent monetary expansion.

9. What exactly is overshooting and why does it happen? What role does
the Fisher e¤ect play in overshooting?

10. In your own words, explain the essence of the trilemma. Why can’t a
country with …xed exchange rates and capital mobility maintain auton-
omy?

5 Chapter 16: National and International Ac-

counts: Income, Wealth, and the Balance of
Payments
1. The United States has experienced large and growing current account
de…cits for more than 20 years, whereas Japan has experienced large and
growing current account surpluses for roughly the same period. The U.S
economy has grown at faster rates than Japan’s over the past 10 years.
What might explain the di¤erence? Relate your answer to the relationship
between the current account and GDP.

2. Your text authors state that in the long run a nation cannot sustain cur-
rent account de…cits and that every nation must eventually “live within
its means.” What does that mean? What implications are there for the
United States?
3. What is meant by “twin de…cits”?

4. Explain why a nation with a current account de…cit is a net external

borrower, while a nation with a current account surplus is a net external
lender.
5. External Wealth, Current Account and Valuation E¤ects:

(a) What two reasons could cause a change in a nation’s external wealth?
In this context, explain the term "valuation e¤ects".

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 (b) Over the past 30 years, the United States has experienced rising
CA de…cits. What have been the impacts of the de…cits? What
fallout has there been on the U.S. economy? How would one explain
the seemingly contradictory situation existing for the United States,
which, despite a large external debt, enjoys being a net recipient of
interest payments?

6 Chapter 17: Balance of Payments I: The Gains

from Financial Globalization
1. Give an intuitive explanation for the long-run budget constraint.

2. What is a “sudden stop” and what are the consequences?

3. Explain the concept of consumption smoothing in your own words.

4. Explain what is meant by “e¢ cient” investment.

5. What is the Lucas Paradox?

6. In theory, there are three primary bene…ts to …nancial globalization. Brie‡y

explain each. Also comment if these theoretical consideration on the gains
from …nancial globalization are observed empirically. Why and in how far
/ why and in how far not?

7 Chapter 18: Balance of Payments II: Output,

Exchange Rates, and Macroeconomic Policies
in the Short Run
1. Identify the determinants of the trade balance and give a brief intuitive
explanation for each.

2. Explain expenditure switching.

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 3. Explain the J curve.

4. What are the ultimate impacts of temporary expansionary monetary pol-

icy under ‡oating exchange rates on Y, i, E and the TB? . Illustrate using
the IS-LM-FX model. Make sure to label all curves and axes. Brie‡y
explain in words, graphically and formally (stating all equations of the
model)

5. What are the ultimate impacts of temporary expansionary monetary pol-

icy under …xed exchange rates on Y, i, E and the TB? Illustrate using the
IS-LM-FX model. Make sure to label all curves and axes. Brie‡y explain
in words, graphically and formally (stating all equations of the model)

6. What are the ultimate impacts of temporary …scal contraction under ‡oat-
ing exchange rates on Y, i, E, and the TB? Illustrate using the IS-LM-FX
model. Make sure to label all curves and axes. Brie‡y explain in words,
graphically and formally (stating all equations of the model)

7. What are the ultimate impacts of temporary …scal contraction under …xed
exchange rates on Y, i, E, and the TB? Illustrate using the IS-LM-FX
model. Make sure to label all curves and axes. Brie‡y explain in words,
graphically and formally (stating all equations of the model)

8. We have seen that Latvia and Poland have seen their economies perform
quite di¤erently in response to shock to foreign demand at the onset of the
Great Recession. Explain why. Use the IS-LM-FX model to substantiate
your arguments.

8 Chapter 19: Fixed versus Floating: Interna-

tional Monetary Experience
1. In the early 1990s, the German economy experienced a period of strong
economic growth due to the German reuni…cation, i.e., high …scal expen-
diture targeted towards underdeveloped regions in eastern Germany. To
avoid an overheating of the German economy and too high in‡ation rates
the Bundesbank decided to use contractionary monetary policy, raising
interest rates. At the time several core European countries we in an ex-
change rate regime of quasi-…xed exchange rate (tight bands), known as
the Exchange Rate Mechanism (ERM). Use the IS-LM-FX model to ex-
plain, graphically and in words, how the British economy was a¤ected by

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 the German developments. What conclusion did Britain reach in the end
and why? How did other countries fare in this period?

2. Explain why economic similarity is such an important issue for countries

deciding whether to …x or ‡oat.

3. What is the empirical evidence for bene…ts of countries adopting a …xed

exchange rate regime?

4. Explain the concept of liability dollarization.

5. “Original sin”sometimes refers to a nation’s inability to borrow in its own

currency, and therefore is forced to borrow and repay internationally in
other currencies. Why is this the case? What other problems ‡ow from
this inability?

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