Marking Scheme Exams Last Year

Marking Scheme 2014/2015
Question 1 (5 marks)
a. What is money?
Anything that is generally accepted in payment for goods or services or in the repayment of debts (2
marks)
b. State the functions of money (3 marks)

Medium of Exchange
Unit of Account
Store of Value
State five functions of the monetary policy committee (MPC) of Bank of Ghana. (5 marks)
Votes on conduct of open market operations
Sets reserve requirements
Sets MPR
Approves bank mergers and applications for new activities
Specifies the permissible activities of bank holding companies
Supervises the activities of banks operating in the country
a. State the theory of Purchasing Power Parity (PPP) (2 marks)
Absolute PPP indicates that the exchange rate between two currencies is equal to the ratio of the two
countries price indexes

The Absolute Purchasing Power Parity relation is: =
where P is the domestic price index, PF the foreign price index, and E is the spot exchange rate (domestic
currency units per unit of the foreign currency).
b. State three reasons why exchange rates deviate from the PPP in the short run (3 marks)
The law of one price does not apply to differentiated products or to globally non-traded goods
Since people in different countries consume different goods, national price indexes may not be
comparable
Another reason for deviations from PPP is that international trade transactions involve time lags
between order and delivery
Transportation costs and tariffs are present

a. What is exchange rate targeting?
The central bank tries to ensure nominal exchange rate stability vis--vis the currency of a so-called
anchor country via interest rate changes and direct foreign exchange interventions, thereby "importing"
price stability from the country
b. State the advantages and disadvantages of exchange rate targeting
Advantages of Exchange-Rate Targeting:
Contributes to keeping inflation under control
Automatic rule for conduct of monetary policy
Simplicity and clarity
Disadvantages of exchange-rate targeting:
Cannot respond to domestic shocks and shocks to anchor country are transmitted
Open to speculative attacks on currency
Weakens the accountability of policymakers as the exchange rate loses value as signal
The Bank of Ghana increases interest rates when it wants to reduce aggregate demand to fight
inflation. How do increases in the interest rate reduce aggregate demand?
Increases in interest rates reduce planned investment. The decrease in investment reduces
equilibrium output by a multiple amount due to the multiplier effect. Also, increases in interest
rates increase the value of the Cedi, reducing net exports, which reduce aggregate demand and
equilibrium output by a multiple amount.
a. Using Keyness Liquidity Preference Theory, show that demand for money is a function
of interest rate and income.
Keynes postulated that individuals hold money for three Motives

a. Transactions motive
b. Precautionary motive
c. Speculative motive
The liquidity preference theory distinguishes between real and nominal quantities of money
Transactions motive
Keynes initially accepted the quantity theory view that the transactions component is
proportional to income
Later, he and other economists recognized that new methods for payment, referred to as
payment technology, could also affect the demand for money
Precautionary motive
Keynes also recognized that people hold money as a cushion against unexpected wants
Keynes argued that the precautionary money balances people want to hold would also be
proportional to income
Similar to transactions demand
As interest rates rise, the opportunity cost of holding precautionary balances rises
The precautionary demand for money is negatively related to interest rates
Speculative motive
Keynes also believed people choose to hold money as a store of wealth, which he called the
speculative motive
Putting all together

= (, )

Where demand for real balances is negatively related to real interest rate and positively related to
income
b. Using Baumol-Tobin Model of Transactions Demand for Money, show that demand for
money is a function of interest rate and income.
The assumptions of the model are as follows:

1. An individual receives income of T0 at the beginning of every period.
2. An individual spends this income at a constant rate, so at the end of the period, all income T0 has
been spent.
3. There are only two assetscash and bonds. Cash earns a nominal return of zero, and bonds
earn an interest rate i.
4. Every time an individual buys or sells bonds to raise cash, a fixed brokerage fee of b is incurred.
Section B: Answer any two questions

Although e-money might be more convenient and efficient than payments system based on
paper, several factors work against the disappearance of the paper system.
Discuss six factors that work against the disappearance of the paper system.
Despite the factors discussed in a above the use of e-money will likely still increase in the future.
Why or why not?
Predictions of a cashless society have been around for decades, but they have not come to
fruition
Although e-money might be more convenient and efficient than payments system based
on paper, several factors work against the disappearance of the paper system
it is very expensive
security and privacy concerns
electronic trail on buying habits
Still, the use of e-money will likely still increase in the future

a. What is an optimum currency area (OCA)
a region just large enough so that the circulation of a single currency maximizes the difference between
the gains from not having to exchange currencies when carrying out transactions within the area and
the losses from having to design a single monetary policy to address the regions employment, growth,
and price stability
b. Using Mundell (1961) model, explain the theory of optimum currency areas (Hint: state
clearly, the assumptions underlying the theory. Discuss how a shock to a region will
affect two countries differently under the assumptions. Discuss the criteria for a single
common currency with a single central bank to two countries)
c. Assumptions
a. there are two separate currency areas that correspond to two nations, A and B.
i. e.g. Ghana and Nigeria
b. the two nations central banks intervene in the foreign exchange market to fix the
exchange rate between the two currencies.
c. prices are sluggish in both countries
d. labor cannot move from A to B
Now, suppose that world product demand shifts from country A to country B
The shift in product demand will cause unemployment in A and inflationary pressure in B.
If capital is mobile (as would be the case for most countries today) each countrys exchange rate
intervention would result in monetary policies that make matters worse!
To prevent depreciation, As central bank would have to buy its currency, thus shrinking its money
supply and worsening its unemployment.
Bs central bank sells its currency to prevent appreciation, thus fueling inflation further.
There are two ways in which this unfortunate scenario can be avoided
First, countries A and B could let the exchange rate float.
With freely floating exchange rates and sluggish prices, the nominal depreciation of As currency relative
to Bs will alter the real exchange rate and balance both countrys international payments
First, countries A and B could let the exchange rate float.
exchange rate depreciation in A will mitigate the unemployment in A by boosting exports

and reducing imports will mitigate the inflation problem in B by increasing imports and
decreasing export demand because they do not have to worry about fixing the exchange
rate, the two countries can also use active monetary policies to address unemployment and
inflation.
They can let the exchange rate do all the necessary adjustment to keep international
payments in balance.
Second, unemployment and inflation can also be avoided in A and B if prices adjust quickly and labor
moves from one country to the other
If prices quickly decline in A and they rise in B, then the real exchange rate effectively
changes in much the same way as in the example of flexible exchange rates.
if labor can move easily from A to B, unemployment will also be reduced in A and inflation
avoided in B.
Based on this the student should show how the countries can be in a monetary union

Using Mundell Fleming (IS-LM-BOP) model, compare the effectiveness of fiscal policy and
monetary policy in an economy with a floating exchange rate regime with some restrictions on
international movement of capital. (Show all curves in the policy transmission process)
Check slides and tutorial sets.

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Marking Scheme 2014/2015

b. State the functions of money (3 marks)

Transportation costs and tariffs are present

b. State the advantages and disadvantages of exchange rate targeting

Advantages of Exchange-Rate Targeting:

Contributes to keeping inflation under control

Automatic rule for conduct of monetary policy

Simplicity and clarity

Disadvantages of exchange-rate targeting:

Open to speculative attacks on currency

Keynes postulated that individuals hold money for three Motives

The assumptions of the model are as follows:

Section B: Answer any two questions

Question 7 (20 marks)

Question 8 (20 marks)

i. e.g. Ghana and Nigeria

c. prices are sluggish in both countries

d. labor cannot move from A to B

First, countries A and B could let the exchange rate float.

exchange rate depreciation in A will mitigate the unemployment in A by boosting exports

Question 9 (20 marks)

Check slides and tutorial sets.

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