U6018 Practice Midterm Exam, Spring 2022

Closed Book, Note, Calculator

Question 1 [25 points]: Balance of Payments

Review the following information for a given country, the United States of Antarctica, as of 2020

Exports: 200

Imports 350

Income received on foreign assets 200

Income paid to foreign holders of home assets 180

Stock of foreign assets: 3000

Foreign Holding of home assets: 1000

Home private purchases of foreign assets: 170

Foreign private purchases of home assets: 70

Home central bank purchases of foreign assets: 100

National Savings: 1500

Calculate the:

a) Trade Balance? (2 pts)

Trade Balance (TB) = X – M = 200-350 = -150

b) Current Account? (2 pts)

CA = TB + Net Income + Net Unilateral Transfers = -150 + (200-180) + 100 = -30

c) Private capital account balance? (2 pts)

KFAprivate = 70 – 170 = -100

d) Official settlements balance? (2 pts)

CA + KFAprivate + KFAofficial + Any errors/omissions = 0 (Balance of payments)

-30 + -100 + KFAofficial + 0 (E&O) = 0

Official settlements balance = KFAofficial = 130

e) Balance of Payments deficit or surplus? (2 pts)

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Current account + capital account (private) + financial account =

Flows of goods/services + capital transfers and disposal of non-financial assets + investment flows

-30 + -100 = -130 = Deficit

f) National Investment Position? (2 pts)

S – I = CA

1500 – I = -30

I = 1530

g) Net International Investment Position as of January 2020? (4 pts)

Remember that NIIP is a stock variable, unlike the current or capital accounts which measure flows. In
January of 2020, the NIIP = Stock Foreign Assets – Stock Foreign Liabilities = 2000

h) Did this country privately finance its current account balance in 2020? (3 pts)

No, the country did not finance its current account balance with its private financial capital account
(KFAprivate is -100)

i) Was it unable to privately finance its current account balance in 2020? (2 pts)

Yes, it was unable

j) Assuming that there was no change in the exchange rate and no capital gains on foreign or home assets
in 2020, what is the net international investment position on January 1, 2021? (4 pts)

NIIP = FA – FL

The NIIP is a stock as aforementioned; CA = ∆FA-∆FL

KFA = ∆FL - ∆FA

Capital financial account is a flow variable

∆NIIP = ∆ Net Foreign Wealth = ∆ Net Foreign Assets = ∆FA - ∆FL = CA

Therefore, assuming there was no change in the exchange rate and no capital gains, the NIIP in January
2021 is equal to the NIIP from January one year earlier plus the CA balance

NIIP 2021 = NIIP 2020 + CA = 2000+ (-30) = -1970

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Question 2 [25 points]: Currency Options

Here is data for a 1-year call option on the pound that was bought on 10/17/02

a) Draw the graph for the USD cash flow (per unit notional) on this trade when it expired on 10/17/03.
Be sure to label all the relevant points on your graph using the actual numbers on the BB screen. (10 pts)

Strike Price

-0.0823*(1.0182)
1.58
)

b) Was this investor betting on a stronger USD or a weaker US dollar relative to the pound? (7.5 pts)

The investor was betting that the dollar would depreciate relative to the pound (e.g. the pound would be
more expensive if purchased in dollars later on), thus the investor purchased a call option because he/she
would like to use this call option to purchase pounds at a much cheaper price at a future date.

c) Suppose on 10/18/03 the dollar price of a pound was 19.542; did the investor make or lose money? (7.5
pts)

The price of the call option is 19.098.

Spot Rate at expiration (19.542) > Strike price (4.332) (ET > EStrike) including the cost of the call option.

Although the spread between the spot rate at expiration and the strike price is substantial (~15 dollar
difference), the price of the call option exceeds this potential gain and may suggest the option would not
be exercised.

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However, despite the option’s price exceeding the potential gain by exercising, the investor would likely
exercise the call option because the loss by not exercising is the price of the call option, ~$19, whereas
the loss by exercising is ~19-15, or $4

The important thing to remember is: call options as just that: options. An investor would only exercise the
option if he/she stood to gain, either by realizing profit or mitigating loss.

Question 3 [25 points]: Exchange rates and Interest Parity

a) If a hypothetical country, The Crypto Republic, has a currency called the Muskcoin (MUSC), where
a price of the dollar is MUSC 2,000 per 1 USD and the dollar price of the Euro in USD is 0.5 USD
per Euro, what is the MUSC price of the euro (MUSC/EUR)? (5 pts)
2000 (MUSC/USD) * (0.5 USD/EUR) = 1000 (MUSC/EUR)
b) Using your answer to part a, what would happen if the value of the Euro relative to the Muskcoin
increases by 25%? Why? (5 pts)
25% of 1000 = 250
1250 (MUSC/EUR)
You would get more Muskcoins for each Euro if the value of the Euro appreciates by X%
c) Do real exchange rates increase if the nominal exchange rate increases? Why or why not? (3 pts)
Nominal exchange rates tend to be more volatile over the short term than real exchange rates; a nominal
rate is the price of one currency in terms of another. The real exchange rate, however, is the product of the
nominal exchange rate and P*/P, where P* is the price level of the foreign country and P is the price level
of the home economy.
Real exchange rates would change increase if the nominal exchange rate increases if and only if the
respective price levels (ratio of P* to P) remained constant.
d) Explain, in 2-3 sentences, the difference between covered and uncovered interest parity. (3 pts)
Covered interest parity involves being ‘covered’ from potential deviations from what the expected and
actual forward exchange rate is by using forward contracts to ‘cover’ any potential risk/change. Uncovered
interest rate parity is based on the assumption that the forward rate will equal what the expected spot rate
is; there are no forward contracts used (e.g. expected returns on deposits of any two currencies in their
respective countries are equal).
e) A recent WSJ article documented the possibility of an interest rate increase in the near future by
the US Federal Reserve System. An economist suggested that this could mean substantial outside
capital will flow into the United States from countries with lower interest rates. Is he correct? Why
or why not? (9 pts)
Differences in real interest rates between two countries will likely result in a temporary flow of financial
capital from the country with a lower interest rate to a higher one. However due to interest rate parity,

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currency exchange rates would eventually factor the difference in interest rates between any two countries.
Remember Professor Clarida’s mention: there is no such thing as a free lunch!

Question 4 [25 points]: The AA-DD Model

Equation for your reference: CA = S – I = Y(1 – b(1-t)) – G – (I0 – d(R* + θ))

Using the AA-DD model developed in class, show and explain in words (and when appropriate graphs)
the short run effect of a rise in the money supply on

a) Gross Domestic Product (3 pts)

An increase in the money supply will eventually decrease the interest rate, leading to a depreciation of the
domestic currency. Holding all other factors constant, depreciating the nominal exchange rate will then
depreciate the real exchange rate, making exports cheaper and imports more expensive. As a result, GDP
will increase.

b) The Exchange Rate (3 pts)

Exchange rate would depreciate (think intuitively about the greater supply of money)

c) Tax Revenues and The Budget Balance (3 pts)

Tax revenues increase because GDP also increases; higher output means there is more income to be taxed

d) Exports (2 pts)

Exports would also increase because they are cheaper for foreigners to buy now

You may hold constant the price level P0 and the expected long run exchange rate Ee as well as the world
interest rate R* and the sovereign spread θ.

e) Explain, in 5-6 sentences, the utility of the AA-DD Model as a monetary tool to someone (e.g. an
infant) with no experience with or knowledge of economics or monetary policy. (14 pts)

The AA-DD model graphs the overall economic output of countries against exchange rates. This singular
model allows monetary policymakers or thinkers to understand the effects of events or shocks (exogenous
variables to use Professor Clarida’s favorite term) on the level of a country’s output (GDP) and its
exchange rate.

Examples of such events or shocks might be a financial crisis or global pandemic.

There are two components of this graph:

1) The DD (demand) curve, which plots the equilibrium for output and every possible exchange rate in
the goods/services market. This curve is sloped upward because a decrease in the value of the dollar (e.g.
an increase in the exchange rate) raises the GDP (at least temporarily, remember there is no free lunch).

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2) The AA (asset) curve, which plots the equilibrium for output and every possible exchange rate in the
money/foreign exchange markets. This curve is sloped downward because an increase in GDP would
lower the equilibrium exchange rate in the money/forex market model.