ECMC61 – Sample Midterm Suggested Answer Key
(Note: This answer key aims at helping you checking your answer. You WILL NOT receive any credit if you do not show your work and provide explanation)

Question 1)
Part (a) (10 points)

FinCity
TradeTown
Gross domestic products
7500
15000
Consumption
5625
9000
Investment
1125
2250
Government spending
1500
3000
Current Account
– 750
750
Non-reserve portion of financial account
450
– 450
Official reserve transactions
300
– 300
Capital account
0
0

Part (b) (5 points)
FinCity runs a current account deficit.
Is it a problem? Depends on the use of foreign borrowing.

Question 2
Part (a)
Yes, it is possible as long as the sum of CA, KAnon-res, and capital account is positive.

Part (b)
Implications: Exports of goods and services < imports of goods and services
Borrowing from abroad
Is it a problem? Depends on the purpose of the borrowing.

Question 3
Uncertain, it depends on what happens to investment.

Question 4
The immediate effect of a fall in Y* on E is DC appreciates.
If the Home central bank wants to keep E at its initial level, it has to use expansionary monetary policy (mention whether it is a temporary or permanent change in MS).

Question 5
Short run: RCAN , PCAN remains unchanged and CAD depreciates.
Long Run: RCAN returns to initial level, PCAN , and CAD depreciates.

Question 6
Short run: DC depreciates.
Long run: DC depreciates.

Question7
Part (a)
Cardland’s price level, PC = 6
Paperland’s price level, PP = 3
Exchange rate: E = 2.2400 or E = 2.3529

Part (b)
Short run:
Cardland’s interest rate, RC = 0.8125
Paperland’s interest rate, RP = 0.4
Exchange rate, E: E = 1.1586 or E = 1.0619
Long run:
Cardland’s price level, PC = 4.5
Paperland’s price level, PP = 3
Exchange rate, E: E = 1.68 or E = 1.7647

Part (c)
Undershooting of C$. (Make sure you provide explanation why the answers are consistent with the asset approach to the exchange rate)

Question 8
Part (a) (7 points)
Return on £-denominated assets: R£ = 0.05 (5%)
Covered £ return on $-denominated assets:R$ + (F£/$ – E£/$)/E£/$ = 0.06 (6%)
There is an arbitrage opportunity by:
Borrow in £ at 5% a year.
Use the borrowed £ to purchase $ in the spot exchange market at 0.55 £ per $.
Invest the $ proceeds in $-denominated assets and earn a return of 3% a year.
Sell $ for £ in the forward exchange market at 0.5665 £per $ (to repay the £ loans).

Part (b) (8 points)
R£ increases
R$ falls
$ appreciates (or £ depreciates) in the spot exchange market
$ depreciates (or £ appreciates) in the forward exchange market

Part (c) (5 points)
E£/$ = 0.5554 or E£/$ = 0.5557

Question 9