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NANYANG TECHNOLOGICAL UNIVERSITY

SEMESTER 2 EXAMINATION 2008-2009

HE206 International Monetary Economics

April 2009 Time Allowed: 2 hours

INSTRUCTIONS

1 This paper contains SIX(6)questions and comprises FIVE(5)pages.2 Answer FOUR(4)questions only:-

Section A - any THREE(3)questions

Section B - any ONE(1)question

3 The number of marks allocated is shown at the end of each question.4 Begin your answer to each question on a separate page of the answer book.5 Answers will be graded for content and appropriate presentation.

SECTION A Answer any THREE(3)questions from this section.

Question 1

Consider a small open economy with a flexible exchange rate system and free capital

mobility. Suppose the economy is best described by the following DDAA framework:

AA curve: M/P = L (R*+E

e/E-1, Y) with L1< 0 and L2> 0

DD curve: Y = Y (EP*/P, A0) with Y1> 0 and Y2> 0

where the AA curve represents asset market equilibrium and the DD curve represents goods

market equilibrium, M is domestic money supply, P is domestic price level, R* is world

interest rate, E is the exchange rate (i.e., domestic currency per unit of foreign currency), Ee

the expected value of E, Y is domestic output, L(.) is the domestic real money demand

function, L1and L2are the first and second derivatives of the L(.) function, P*is foreign price

level, A0 is the term containing all autonomous expenditures, Y(.) is a function related to

aggregate demand, and Y1, and Y2are the first and second derivatives of the Y(.) function.

Note: Question No. 1 continues on page 2.

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Question 1 (continued)

(a) Suppose price only adjusts gradually while exchange rate adjusts instantaneously.Discuss the short run and long run effects of a permanent reduction in domestic

money supply on the exchange rate, output, price and interest rate.(10 marks)

(b) Now suppose price is perfectly flexible in the short run. What would be the short runand long run effects of the permanent reduction in domestic money supply on the

exchange rate, output, price and interest rate?

(5 marks)

(c) Use the modified monetary approach to discuss the long-run effect of each of thefollowing changes on the nominal and real exchange rates of the domestic economy:

(i) A 20% rise in domestic money supply; and(ii) A rise in worlds demand for domestic product.

(10 marks)

(TOTAL: 25 marks)

Question 2

Consider a small open economy with a fixed exchange rate system and free mobility of

capital. Suppose domestic investment is now a negative function of domestic interest rate so

that the economy is best described by the following DDAA framework:

AA curve: M/P = L (R*+E

e/E-1, Y) with L1< 0 and L2> 0

DD curve: Y = Y (EP*/P, R

*+E

e/E-1, A0) with Y1> 0, Y2< 0 and Y3> 0

where the AA curve represents asset market equilibrium and the DD curve represents goods

market equilibrium, M is domestic money supply, P is domestic price level, R* is world

interest rate, E is the exchange rate (i.e., domestic currency per unit of foreign currency), Ee

the expected value of E, Y is domestic output, L(.) is the domestic real money demand

function, L1and L2are the first and second derivatives of the L(.) function, P*is foreign price

level, A0 is the term containing all autonomous expenditures, Y(.) is a function related to

aggregate demand, and Y1, Y2and Y3are the first, second and third derivatives of the Y(.)

function.

(a) Suppose the economy is originally at its natural level of output Yn. Now consider a

permanent rise in world interest rate R*. Will the rise in R*cause a shift in the AA,

DD and/or Yncurves?

(5 marks)

Note: Question No 2. continues on page 3.

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Question 2 (continued)

(b) Suppose the economy is able to maintain the fixed exchange rate. What will be the

effect of the rise in R* on domestic output in the short run? Use also the money

market and foreign exchange market diagrams to discuss its impacts on domesticinterest rate and money supply in the short run.

(7 marks)

(c) What will be its long run effect on domestic output, price, interest rate and money

supply?

(5 marks)

(d) Suppose it takes more than five years for adjustment of price to restore the economy

back to the natural level of output, and the economy is not willing to wait for such a

long adjustment. What monetary and/or fiscal option(s) does the economy has?

(8 marks)

(TOTAL: 25 marks)

Question 3

(a) Consider an economy that is best described by the Swan Diagram with the followinginternal balance (IB) and external balance (EB) curves:

IB curve: Y = Y(EP*/P, A0, Y

*) with Y1> 0, Y2> 0 and Y3> 0

EB curve: CA = CA(EP*

/P, Y-T0, Y*

) with CA1> 0, CA2< 0 and CA3> 0

where E is the exchange rate (i.e., domestic currency per unit of foreign currency), P*

is foreign price level, P is domestic price level, A0 is the term containing all

autonomous expenditures, Y* is world output, Y is domestic output, T0 is the

domestic lump sum tax, Y(.) is a function related to the internal balance, Y1, Y2and

Y3are the first, second and third derivatives of the Y(.) function, CA(.) is a function

related to the current account balance, and CA1, CA2and CA3are the first, second and

third derivatives of the CA(.) function.

(i) Suppose there is a global recession. Will the internal balance curve and/or the

external balance curve be affected by this global recession?

(5 marks)

Note: Question No 3. continues on page 4.

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Question 3 (continued)

(ii) In 2006-2007, China was experiencing a huge current account surplus and a

moderate internal overheating. However, with the global recession, China is

now experiencing a medium-size recession. Meanwhile, Chinas currentaccount surplus continues to be huge, albeit different from that in 2006-2007.

Draw the Swan Diagram and identify a point on the diagram that can best

describe Chinas current internal and external positions.

(4 marks)

(iii) Suppose China chooses to keep its exchange rate stable because of external

political considerations. What would be the effect of the four-trillion yuan

fiscal expansion on Chinas internal balance? Will the fiscal expansion affect

Chinas external balance?

(6 marks)

(b) Briefly explain why there could be a J-curve effect? Suppose a country just

devaluates its currency by 10%, use the J-curve effect discussion to trace the likely

changes in her current account balance in the short run and long run.

(10 marks)

(TOTAL: 25 marks)

Question 4

(a) Briefly explain the restricted choices implied by the doctrine of Impossible Trinity.What has Singapore chosen? Why? What has China chosen? Why?

(6 marks)

(b) Briefly explain why Singapore has been persistently running a huge current account

surplus over the past two decades. If left unattended, this could have caused enormous

monetary growth pressure. How do Singapores CPF system and overseas investment

policy help to avoid the excessive monetary growth pressure? How do they affect

Singapores relative importance in the global economy?

(6 marks)

(c) In recent years, China has also been running a huge current account surplus which has

contributed to the enormous monetary growth pressure in 2006-2007. With theexisting differences between Chinas and Singapores systems, explain to what extent

China can learn from the above Singapore experience. What other monetary policies

has China used to mitigate the monetary growth pressure?

(7 marks)

Note: Question No 4. continues on page 5.

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Question 4 (continued)

(d) Briefly describe Singapores exchange rate system under the normal circumstances

and under extreme economic adversity.

(6 marks)

(TOTAL: 25 marks)

SECTION B Answer any ONE(1)question from this section.

Question 5

What are the similarities and the differences between the Latin American Debt Crisis of the

1980s, the Asian Financial Crisis of 1997-1998, and the US Subprime Mortgage Crisis of

2007? Discuss by focusing on the causes of the crises and the appropriate policy responses to

manage and resolve them.

(TOTAL: 25 marks)

Question 6

On the subject of reforming the international financial architecture, commendable progress

has been made in crisis prevention efforts and some progress has been achieved in crisis

management and resolution. However, very little progress has been made in reforming thegovernance of the International Monetary Fund. Explain by giving examples of selected

reforms.

(TOTAL: 25 marks)

- END OF PAPER -