Academic Year: 2022/23 Assessment Period: Spring Module Code: BS3555 Assessment Paper Title: INTERNATIONAL FINANCE Duration: 2 hours Please read the following information carefully: Structure of Examination Paper: ˆ There are 4 questions in total. ˆ The maximum mark for the examination paper is 100% and the mark obtainable for a question or part of a question is shown in brackets alongside the question. Note each question counts for 50% marks. Instructions for completing the examination: ˆ Complete front cover of any answer books used. ˆ Insert your student number in the space provided on this page. ˆ This examination paper must be submitted to an Invigilator at the end of the examination. ˆ Answer ANY TWO questions in FULL 1 Part I. In June 1996, a Korean investor is considering investing in bank deposits in Korea and Japan. The annual interest rate on Korean deposits is 4.00%, versus 3.75% on deposits in Japan. Suppose that the forward rate in June 1996 is equal to Fwon/¥ = 10. For the remainder of this question, please use the linear approximations for uncovered and covered interest rate parity. The spot exchange rate in June 1996 is Ewon/¥ = 8 (a) If you are an investor, which country would you consider depositing your money? (Answer) CIP: iwon = i¥ + (Fwon/¥ − Ewon/¥)/Ewon/¥ * Return on Korean deposits: iwon= 0.04, thus 4% * Return on Japanese deposits (in won, covered by forward contract): i¥ + (Fwon/¥ − Ewon/¥)/Ewon/¥ = 0.0375, thus 28.75% You would invest in Japanese Asset. [10%] (b) ?The presence of foreign exchange risk premium creates a wedge between forward premium and the anticipated change in nominal exchange rate.? Suppose this sentence is particularly true for Korea during 1996: during that period, Korea su?ered a chronic ?nancial dominance problem where monetary authority ultimately had no independence. How would you predict the anticipated change in the nominal exchange rate? Explain your reason. [15%] (Answer) The anticipated change in the nominal exchange rate should be greater than the forward premium due to the risk premium, Ee > Fwon/¥, or Ee = Fwon/¥ + R. When uncovered won/¥ won/¥ investments increase risks in return, the expected returns on the uncovered foreign investments will have to be higher than the returns from covered investments by the amount of the risk premium. Financial market equilibrium will occur at a point where the anticipated rate of domestic currency depreciation exceeds forward premium by the amount of risk premium. Part II. Suppose there are only two countries, Korea and Japan, in the world economy. Suppose that the prior to 1996, the Bank of Korea allowed the money supply to grow by 3% each year, which has been increased to 6% since 1997. In contrast to South Korea, Japan maintained the similar money growth across years at 3%. Assume that growth rate is 0% for both countries. (c) How does the Fisher E?ect anticipate South Korea’s interest rate before and after 1997? Assume that the interest rate on South Korean Assets was 4% and that on Japanese Assets was 3.75 %. (Answer) r1996 = r1996 won ¥ ⇐⇒iwon −πwon =i¥−π¥ ⇐⇒iwon −3=3.75−3 ⇐⇒ iwon = 3.75% r1997 = r1997 won ¥ ⇐⇒ i1997 − π1997 = i1997 − π1997 won won ¥ ¥ 2 [10%] ⇐⇒ i1997 −6 = 3.75−3 won ⇐⇒ i1997 = 6.75% won (d) Using time series diagrams, demonstrate how the relative PPP theorem forecasts the e?ect of changes in Korea’s money growth rate on the country’s money supplyM, prices P, interest rate i, real money supply M/P , and exchange rate E£/Y uan over time. [15%] I simply draw the graph, but you should brie?y discuss the logic in your ?nal exam. 3 2. Part I. Question (a) and (b) consider how the FX market will respond to changes in monetary policy. For these questions, de?ne the exchange rate as British pounds (¿) per euro, E£/euro. Use the FX and money market diagrams to answer them. (a) Suppose the European Central Bank (ECB) permanently increases its money supply. Illustrate the short-run (label the equilibrium point B) and long-run e?ects (label the equilibrium point C) of this policy. Answer: See the following diagram. The foreign return decreases, shifting FR downward. The decrease comes from two sources: (1) the decrease in the Eurozone interest rate and (2) the expected appreciation in the British pound. (b) Suppose the ECB permanently increases its money supply, but investors believe the change is tem- porary. That is, investors don’t adjust their expected exchange rate because they believe the policy will be reversed before prices adjust. Describe how this situation would a?ect the spot exchange rate compared with (a). Answer: In this case, the FR line will not shift as far downward. The Eurozone interest rate declines, but there is no change in expected appreciation in the pound. Therefore, the pound will appreciate, but not by as much as in (a). Use IS-LM-FX curve to answer the following question. (c) The coronavirus pandemic has had a signi?cant impact on the global economy, and central banks around the world have responded by implementing monetary policy measures to support their economies. However, the e?ectiveness of monetary policy has been limited by the zero lower bound. Critically evaluate the following statement: ?Due to the crowding out e?ect, ?scal policy is not likely to have a major e?ect on economic growth.? 4 The statement is not true. Fiscal policy has played a crucial role in supporting the economy during the coronavirus pandemic, particularly in situations where monetary policy has been constrained by the zero lower bound. The crucial reason that the country does not su?er from the crowding out e?ect is that majority of the major economies used extensive expansionary monetary policy, and encountered into ZLB issue. At this time, the crowding-out e?ect caused by an increase in the interest rate and the appreciated exchange rate will not occur since the interest rate will remain at zero and the exchange rate will not change. (d) Take Argentina, where 97% of exports are invoiced in US dollars and 93% of imports are priced in US dollars. Evaluate critically the following statement: “The expansionary monetary policy is ine?ective to temporarily increase gross output due to its limited in?uence on net export.” It depends. While it is true that the policy may not be able to increase output due to dollarization of trade (and therefore exchange rate depreciation does not aid in raising net export), there is still another avenue for domestic investment. So, we lack su?cient information to determine whether the expansionary monetary policy will have a limited e?ect. 5 3. Consider a non-center home country that is part of a ?xed exchange rate regime. The home country currently has output lower than its desired level. Concerned about depression, central bankers want to boost the economy by devaluing its currency. Using IS-LM diagrams for a home and a foreign country, show how each would a?ect home and foreign output. (a) The foreign country is a center country. Compare a cooperative versus a noncooperative adjustment in exchange rates. [10%] Note that in the pegging system, only center country can use monetary policy. So, when the question asks on (non)cooperative adjustment in exchange rate, this can be done in two di?erent ways: (1) exchange rate adjustment, and (2) interest rate adjustmnt. i. Exchange rate adjustment Non cooperative adjustment is found in point 3,3′; cooperative adjustment is found in point 2,2′. In your answer, you should argue IS curve shifts ?rst due to net export e?ect, and then LM curve follows to maintain pegging system. ii. Interest rate adjustment 6 Non-cooperative adjustment is found in 1,1′; cooperative adjustment is found in point 2,2′. Foreign has monetary policy autonomy. If the center country makes no policy concession, that is when LM1∗ curve does not shift at all. If your answer you should argue LM∗ and LM should simultaneously shift to the right, which will a?ect partner country’s IS curve through net export mechanism. that is, decrease in i∗ will appreciate home country, which then shifts IS curve in through net export mechanism. This holds true in the case of home country’s expansionary monetary policy. (i will decrase, which then appreciate foreign currecy, which then shifts IS∗ curve in through net export mechanism). (b) The foreign country is a non-center country. Compare a cooperative versus a noncooperative adjust- ment in exchange rates. [10%] Note that as both countries are non-center, they can only use exchange rate adjustment. Students should explain the mechanism that moves IS,IS∗,LM,LM∗ curves. 7 (c) Explain how the beggar-thy-neighbor policy plays out in the policy as mentioned above situations. To respond to the question, you should ?rst describe the beggar-thy-neighbor policy and then explain which situations in the preceding questions most apply to the policy. [15%] ?Beggar-thy-neighbor? is an economic policy that seeks to bene?t one country or economic region at the expense of others. In the context of expansionary monetary policy, the term “beggar-thy-neighbor” is often used to describe policies that aim to gain a competitive advantage by deliberately devaluing one’s own currency, and boost up the output. In the case of pegging system where two countries are non-center, a home country can engage in beggar- thy-neighbor policies by devaluing its currency excessively, and equilibrium point 3 in question (b) corre- sponds to the beggar-thy-neighbor policy scenario. When it comes to the relationship between non-center and center countries, we have one more example of ?beggar-thy-neighbor? policy. This is when the center country refuses to cooperate with non-center country and keep their interest rate. This scenario corresponds to the equilibrium point 1 of interest rate adjustment graph (in (a)). Part II. Use the Mendell-Flemming model for analysis for the question. Using IS-LM-FX graph, carefully argue whether expansionary monetary policy or ?scal policy is e?ective to boost the economy. (d) There are two countries that are symmetric in economy sizes. The two countries maintain a ?oating exchange rate system. Please look at the lecture note on MF model. 8 [15%] 4. For (a)-(c): Consider the ?rst-generation crisis model of inconsistent ?scal policies (Krugman 1979). Suppose that the government of Peru is currently pegging the Peruvian peso to the dollar at E = 1 peso per dollar. In year 1, the country has 2,700 billion pesos in money supply and 1,200 billion pesos in domestic credit. The foreign price level is stable at P∗ = 1 at all times, the Home price is 1 initially (P = 1), and foreign interest is 5% (i∗ = 5%). Initial in?ation is zero. Prices are ?exible, and PPP holds at all times. Real output is ?xed at 2,700, real money balances are M/P = 2700 = L(i)Y , and L is initially 1. To ?nance government spending, B grows by 50% each year. (a) Assume that investors are myopic and do not see the crisis coming. Calculate the central bank’s money supply, domestic assets, foreign reserves, and interest rate for years 1 through 4. Time, t 1 2 3 4 M 2,700 2,700 2,700 4,050 B(domestic asset) 1,200 1,800 2,700 4,050 R i 1,500 5% 900 5% 0 55% 0 55% [10%] (b) Continue to assume myopia. Suppose that at time T, when the home interest rate i increases, then L(i) drops from 1 to 2/3. Recall that Y remains ?xed. Illustrate how real money (M/P), price (P), and exchange rate (EPeso/$) change over time. [15%] (c) Suppose investors know the rate at which domestic credit is growing. Is the path described above consistent with rational behavior? What would rational investors want to do instead? Illustrate how real money (M/P), price (P), and exchange rate (EPeso/$) change over time. [15%] This path is not consistent with rational behavior. If investors have perfect foresight, then in period 1 they know the currency will be forced to ?oat in period 3 and they will incur a loss on their domestic 9 currency holdings. They will sell the peso-denominated assets before the currency ?oats, right before the money demand contracts from 2,700=(1*2700) to 1,800 (2/3*2700)?that is, when R = 900, which occurs at time T = 2. Therefore, the price level and exchange rate will begin a gradual increase at t = 2. Note that the rational investors won’t engage in speculative attack at t = 1. An attack at time 1 implies a discontinuous appreciation of the peso. But if that happened, any individual peso holder would enjoy capital gains from holding on to pesos rather than changing them for reserves at the central bank. They would therefore rather wait, let everyone else attack, and pocket the gains. (d) Compose a brief essay on the rise and fall of the Gold Standard System. What were the advantages and disadvantages of the system, and what ultimately led to its demise? To receive a high grade, your response must be based on Mundell’s trilemma, dis/advantage of ?xed exchange system and ?oating exchange system. [10%] The Gold Standard System was a monetary system where the value of a currency was directly linked to a ?xed amount of gold. It was ?rst established in the 19th century and was widely adopted by many countries around the world. However, the system gradually lost its popularity and ultimately collapsed in the early 20th century. We can use Mundell’s trilemma to explain the rise and falls of the Gold Standard System. According to the trilemma, a country cannot simultaneously have a ?xed exchange rate, free capital ?ows, and an independent monetary policy. If a country chooses to ?x its exchange rate, it must either restrict capital ?ows or give up control over its monetary policy. The Gold Standard System chooses free capital ?ows and ?xed exchange rate, sacri?cing monetary policy autonomy. At the initial period of globalization, with increasing ?ows of trade and capital, the advantage that the gold standard provide was evident: by providing a stable exchange rate between countries, the system facilitated international trade and investment. However, the system also had its disadvantages. It restricted the ability of central banks to pursue monetary policies that could stimulate economic growth. For example, if a country wanted to lower interest rates to encourage borrowing and investment, it would need to have su?cient gold reserves to maintain the exchange rate. If it did not, it would risk depleting its gold reserves, which could lead to a currency crisis. The main events that led to the demise of the Gold Standard System was the Great Depression of the 1930s and two world wars. The wars signi?cantly reduced the amount of trade, and thus the advantage of 10 reducing uncertainties in global transactions. Also, the countries participating in the war needed some way to ?nance their e?orts. The in?ation tax was heavily used, and this implied exit from the gold standard. During the period of the Great Depression, countries competitively devalued their currencies to boost up their economies, sacri?cing others. This series of events the gold standard system unraveled in a largely uncoordinated, uncooperative, and destructive fashion. Policymakers tried to opt out of the system to attain autonomous monetary policy in a di?erent way: Germany and South American countries opted into ?closed capital market/?xed exchange rate? solution. Countries like UK or US opted to abandon the gold peg and moved to the open capital market/?oating exchange rate solution. In conclusion, the Gold Standard System was a monetary system that had both advantages and disad- vantages. While it provided stability and reliability, at the sacri?ce of autonomous monetary policy that could stimulate economic growth. Whereas trade gains and an absence of stability costs helped bring the gold standard into being before 1914, reduced trade gains and increased demand for explansionary monetary policy help explain the ultimate demise of the gold standard in the interwar period. 11