Marking Scheme Exams Last Year
Marking Scheme Exams Last Year
Marking Scheme Exams Last Year
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)
Question 3 (5 marks)
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
Cannot respond to domestic shocks and shocks to anchor country are transmitted
Weakens the accountability of policymakers as the exchange rate loses value as signal
Question 5 (5 marks)
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.
Question 6 (5 marks)
a. Using Keyness Liquidity Preference Theory, show that demand for money is a function
of interest rate and income.
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.
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
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.
b. the two nations central banks intervene in the foreign exchange market to fix the
exchange rate between the two currencies.
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
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