Charabia

NAME…………………………………………………… SEMINAR GROUP……..







SOLUTIONS FINAL EXAM

(Thursday March 31st, 2011 – Type 1)

The exam lasts 2 hours. All questions have the same weight in the total score. The last blank page, which cannot be separated from the rest of the exam, is only for your use as scratch paper, nothing that you write there will be graded by your professor.

Question 1In the year 2011 the exchange rate of the euro against the dollar is 1.50 (dollars per euro). Suppose the interest rate is currently (in 2011) 5% on bonds denominated in euros and 12% on bonds denominated in dollars. Forecasts for next year (2012) point to interest rates respectively of 10% on euro bonds and 6% on dollar bonds.
The following table gives us information on the level of consumerprice indexes in the Euro zone and in the US:

2011 2012 2013
P (Euro zone) 100 120 132
P* (US) 100 125 154

1.1. What is the expected future exchange rate of the euro for 2012 and 2013 if the interest parity condition holds? What is the expected annual rate of nominal appreciation or depreciation of the euro for 2012 and 2013?
Interest parity: (1+it) = (1+it*) (Et/ Eet+1) → Eet+1 = (1+it*) Et /(1+it)
Ee2012 = 1.60 Ee2013 = 1.54
∆% Ee2012 = + 6.7 % (appreciation) ; ∆% Ee2013 = - 3.8 % (depreciation)
[or with it ≈ it* - ∆% Eet+1 → ∆% Eet+1 ≈ it* - it = + 7 % in 2012, - 4 % in 2013]

1.2. What will be the evolution of the real exchange rate of the Euro zone (versus the US) in 2012 and 2013? What is the expectedannual rate of real appreciation or depreciation of the euro for 2012 and 2013?
ε = EP/P* → ε 2011 = 1.50 , εe2012 = 1.54 , εe2013 = 1.32
∆% ε = + 2.7 % in 2012, - 14.3 % in 2013

1.3. Explain very briefly the implications of your answers to predict the evolution of the Euro-economy competitiveness versus the US during the period considered.
Euro-economy competitiveness declines in 2012:real appreciation, that is, increase in relative price of Euro-goods, due to nominal appreciation (even if inflation is lower than US). Euro-economy competitiveness improves in 2013: real depreciation, that is, decrease in relative price of Euro-goods, due to nominal depreciation (and relatively lower inflation).



Question 2

Consider an economy where the Central Bank has set a reserveratio of 50% and banks do not keep reserves in excess of the mandatory minimum. The total value of bank deposits is 9,000 millions €, and the currency held by the public is 3,000 millions €.

2.1. Compute the money multiplier, the monetary base (high power money), bank reserves and money supply in this country.
M = CU + D = 3,000 + 9,000 = 12,000 (millions)
R = θ D = 0,50 ∙ 9,000 = 4,500
H =CU + R = 7,500
m = M / H = 1.6 (or m = 1 / [c+ θ (1-c)] , with c = CU / M = 0.25 → m = 1.6 )

2.2. Suppose that money demand is given by the function Md = €Y (0.25 – i), where €Y is nominal GDP, which is equal to 120,000 millions €, and i is the nominal interest rate. Compute the equilibrium nominal interest rate. What happens to the interest rate if the Central Bank buys bonds in an openmarket operation for 3,750 millions €?
Md = M → 120,000 (0.25 – i) = 12,000 → i = 0.15

The Central Bank buys bonds → ΔH = + 3,750 → H’ = 11,250 → M’ = m H’ = 18,000 (or ΔM = 1.6 ΔH = 6,000 → M’ = 18,000) → i = 0.10

2.3. Suppose now there is a change in the money demand and the new function is Md = €Y (0.28 – i). In the initial conditions of monetary policy (that is, before the openmarket operations described in 2.2), how would this change in money demand affect the nominal interest rate?
Md = M → 120,000 (0.28 – i) = 12,000 → i = 0.18

2.4. Draw graphs of the monetary market to show the changes described in 2.2 and 2.3, and explain how would the LM curve shift in each case. Make sure you label the axis, the curves you represent and the equilibrium points.
2.2:...