Monetary Economics (Quiz 4B)

Lahore School of Economics

Monetary Economics

Winter Term, 2012

Quiz 4B: 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

Suppose the president of the Pakistan announces a new set of reforms that includes a new
anti-inflation program. Assuming public believes in that announcement, how will long-run
exchange rate of PKR change? (5 points)

People would expect the interest rates to increase and price levels to fall. E $/Re = P*/P; as P
falls, exchange rate and Re would appreciate in the long run according to PPP.

Question 2

If the Canadian Dollar to US Dollar exchange rate is 1.28 (the price of local currency, US 1$)
and the British Pound to US Dollar exchange rate is 0.62, what must be the Canadian Dollar to
British Pound exchange rate? If actual exchange rate of Canadian Dollar to British Pound is
lower than the value you calculated, what would you do to earn a riskless profit? (10 points)

1US$ = 1.28 CD and 1US$ = 0.62

0.62 = 1.28 CD

1 = 2.06CD

If actual exchange rate 1 = 1.5CD (or any other value less than 2.06), then American
investor should invest in British Pound as it will get expensive against CD in future.

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 Monetary Economics (Quiz 4B)
In other words,

1 US$ converted to 1.28CD (in assuming 1.5CD/ exchange rate) 1.28/1.5 = 0.85
when in long run 1 = 2.06CD, 0.85 = 2.06 x 0.85 = 1.75CD convert it back to US $ =
1.75CD/1.28CD = 1.37 US $

The investor makes $0.37 profit.

Question 3

Explain briefly why might a revaluation of any currency only temporary reduce a Balance of
Payment surplus? (5 points)

Once a currency is revalued, the volume of exports decreases overtime and BOP surplus falls or
disappears. This is because imports become cheaper and exports become expensive. As
decrease in import prices feeds through into wages and local costs of production, inflation
levels decrease leading to expectations of BOP surplus and appreciating currency in the long
run.

Question 4

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 Monetary model of exchange
rates. (10 points)

Dornbusch used the following equation to relate P and e for given values of m, y and i*.

e= 1/ [p m + y i*]

To reduce deficit, local monetary authorities would decrease interest rates to depreciate the
currency lower interest rates expansionary monetary policy. As i' falls, capital outflows
take place depreciates local currency at same price level e2

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 Monetary Economics (Quiz 4B)

e > e (bar) under-valued

With depreciated and undervalued exchange rate, exports rise and imports fall leading to long
run appreciation to e3.

On the vertical axis, price levels rise in the long run because of monetary expansion. Higher
price level should depreciate the exchange rate from e1 to e3 but it depreciates by a higher
amount in the short run and then appreciates to long run value

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 Monetary Economics (Quiz 4B)
Question 5

Is the following statement true or false? Central banks cannot have both fixed exchange rates
and independent inflation policy. (10 points)

This is true statement. Consider the following graph:

Assuming perfect capital mobility, BP curve will be horizontal and local and foreign financial
assets will be considered perfect substitutes. As foreign interest rates rise, there will be huge
capital outflows from local country and thatll put a downward pressure on the currency or
depreciate it. And as depreciation is not allowed, as soon as foreign interest rates rise, local
interest rates would also have to rise in equal proportion. Domestic interest rates follow the
foreign interest rates rendering domestic monetary policies ineffective.

In the following diagram, currently, were at Point A, whereby world interest rates are at r w and
there is recessionary gap in the domestic economy. To eliminate the gap, domestic monetary
authorities can reduce interest rates to rS. However, thatll depreciate the currency due to
capital outflows and to avoid this, domestic interest rates MUST increase to rW. This will bring
the economy back to Y0. Thus, in this case, fiscal policy will be more effective and rise in
government expenditures and corresponding shift in IS curve rightwards would bring the
economy back to Y* at rW.

If the following points can be achieved, interest rates can be reduced without the fear of
depreciating currency. Hence in the following cases, the statement is false.

1. Central Bank could control the capital outflows completely; lower interest rates cannot lead
to depreciating currency as there would be no capital outflows

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 Monetary Economics (Quiz 4B)
2. Secondly, there could be limitations on free trade. As interest rates fall and income levels
increase, imports could increase leading to further depreciation of local currency. However,
trade barriers can solve this problem and lower interest rates would not lead to
depreciation

3. CB could announce an official depreciation: devaluation after lower interest rates are
implemented

Hence, central bank has an independent monetary policy and fixed exchange rate regime if
there is a compromise on full or high capital mobility and free trade (from the inconsistent
quarter). This only applies for weaker country; the stronger country can have independent
monetary policy under any assumption. Hence the statement is false for stronger country.

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