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ECON40915 International Finance
Format of Exam Take home exam
Duration: 2 hours
Word/Page Limit: 3000 words
Additional Material provided: None
Expected form of Submission Word Document using template provided or PDF of Handwritten
Work
Your uploaded file should be named with your anonymous ID
and the Exam Code e.g Z0123456ECON11111-WE01
Submission method Turnitin
Instructions to Candidates: Answer any two questions.
Each question carries equal weight.
Revision:
Page 2 of 3 ECON40915-WE01
1 a) What is meant by a “credible target zone”? Develop Krugman’s (1991) model and
then explain how a credible target zone has a stabilizing effect on the exchange
rates. Explain the intuition behind the smooth pasting condition. (60 marks)
b) Use the Balassa-Samuelson model to explain why the purchasing power parity may
not hold in the presence of nontraded goods. How is the relative productivity of
tradeable goods of nations related to the real exchange rate? Carefully explain the
intuitions using the Balassa-Samuelson model. (40 marks)
2 a) Consider the following two country chocolate model. Home country is endowed with
x units of dark chocolates and the foreign country is endowed with y units of white
chocolates. Let denote the price of home chocolates in home currency and
∗
denote the price of foreign chocolate in foreign currency, s is the spot exchange
rate (home currency/foreign currency). Both countries receive utilities from these
two types of chocolates. Let home residents consume of home chocolates and
of foreign chocolates. Let foreigners consume
∗ of UK chocolates and
∗ of US
chocolates. The utility functions of home and foreign countries are ln + 1 ln
and ln
∗ + 2ln
∗ respectively where 1 and 2 are a positive constants.
(i) Set up the maximization problems of home and foreign countries and
solve the equilibrium real exchange rate (
∗ /) showing each and
every step. (30 marks)
(ii) What happens to the real exchange rate if 1 rises? Why? Carefully
interpret your results. (30 marks)
b) Suppose the money stock follows a data generating process (DGP) :
1 1 2 2t t t t
m
, where
1
0 1 and
2
0 1 .
(i) What kind of DGP is it? (20 marks)
(ii) Derive an expression for the exchange rate “news.” Carefully interpret
your results. (20 marks)
Page 3 of 3 ECON40915-WE01
3 a) Consider the following loglinear Cagan money demand function:
][ 1 ttttt ssEsm
where mt = natural log of money stock at date t and st = natural log of the spot
exchange rate (home currency/foreign currency), and η>0. Let the money supply
follow a process: = − 1−1 where 0< 1<1 and is a white noise. Derive
the rational expectation solution for . What kind of data generating process does
the exchange rate follow? How does it differ from a random walk and why?
(50 marks)
b)
Using the same Cagan money demand equation, illustrate the distinction between
exchange rate fundamental and bubble and comment on the frequently held belief
that a bubble necessarily reflects irrational exuberance of investors. (50 marks)
4 Examine whether the following statements are true or false. Give solid support of your
reasoning using a relevant model or an example whichever is appropriate.
a) If the unbiased forward rate hypothesis holds, a currency bought at a discount is
expected to appreciate in value. (25 marks)
b) If a country’s capital account is in deficit, this country is running a trade deficit.
(25 marks)
c) The law of one price is equivalent to the purchase power parity. (25 marks)
d) The carry trade profit opportunity arises due to the failure of uncovered interest
parity condition. (25 marks)
