Question 1 (20 points)

The world consists of three countries, Alpha, Beta, and Gamma. The table below provides some

macroeconomic data for these three countries. Additional information about these countries:

• Households in all three countries consume 56% of output.

• The government of Alpha collects one-third of total income as taxes, and it runs a budget surplus of 450.

• Alpha’s sales of goods and services abroad represent 30% of its output, and half of the sales goes to Beta. It also runs a balanced balance of payments.

• In Beta, the government runs budget deficit of 280 while the central bank depletes its holding of foreign assets by 428.

• Beta has a current account deficit of 60 with Alpha.

• The levels of financial assets purchased by the residents of Beta from Alpha and Gamma reach 545 and 1000 respectively.

• Beta’s residents receive asset transfers of 75 and 50 from residents of Alpha and Gamma respectively. No market transactions are involved in these transfers. In addition, these are the

only asset transfers among these three countries.

• Gamma country allocates 17% of its output to build up (physical) capital stock.

• Gamma runs a balanced trade with Alpha, and its stock of official reserves increases by 428.

• Gamma’s residents sell 375 worth of financial assets to Alpha’s residents.

• The central banks of all three countries do not make any transaction with the private sector. In other words, the central banks only make transactions with other countries’ monetary

authorities.

Alpha Beta Gamma

Gross domestic product, GDP 9000 8500

Consumption, C 5600

Investment, I

Government spending, G 4400

Taxes, T

Exports of goods and services, EX

Imports of goods and services, IM 4163

Private saving, SP 2830

Public saving, SG

National saving, S

Net unilateral transfer 0 0 0

Current account, CA – 1445

Sales of country’s financial assets to foreign

residents

1973

Purchases of foreign financial assets by

domestic residents

Official reserve transactions, ORT

Financial account, KA 15

Capital account

MGEC61 Assignment 1 (Winter 2022) 3

Complete the above table. No explanation requires for this part of the question; however, you

should understand the logic behind so that you could work on similar questions in the future.

Note: The table is reprinted on page 6 of this assignment. You MUST submit that page with your

assignment for grading; otherwise, you will be receiving a grade of zero for this question.

Question 2 (20 points)

Suppose you are working for a large, international investment bank, and you observe the annual

interest rate on the German corporate bonds and the British corporate bonds are 1.25% and 2.4%

respectively. In addition, the current (spot) €/£ exchange rate is 1.1900, and the euro is traded at

a forward premium of 1.15% against the British pound.

Note: Assume your bank does not have any funds denominated in both currencies.

a) Is there is an arbitrage opportunity? Yes/No, explain. (4 points) b) Now, suppose the interest rate on the German corporate bonds increases by 35 basis points.

What would you do? Explain. (5 points)

c) (Continued from part b) Suppose your firm can move the markets (i.e., change the spot exchange rate, the forward exchange rate, and the corporate bond yields in both countries),

what happens to these four variables after the transactions you carried in part (a)? Explain in

words. (8 points)

d) (Continued from part b) Fine the annualized forward premium/discount on the British pound such that your bank will be indifferent between holding the German corporate bonds and the

British corporate bonds. (3 points)

Note:

1) Quote the exchange rates as E€/£ and F€/£. 2) Interest rates are expressed in decimal points (i.e., if R = 0.1, then R = 10%). 3) Use the approximate form of covered interest rate parity. 4) Instead of the assumption made in class (individuals are small players and cannot affect the

exchange rates and interest rates), the investment bank in this question is a LARGE player that

has the ability to change the exchange rates and the corporate bond interest rates when it carries

transactions in the spot exchange market, the forward exchange market, and corporate bonds

markets in Germany and Britain.

5) Use the subscripts “G” and “B” to represent all the variables and terms used for Germany and Britain respectively in your written explanation. You must use these notations; otherwise, you

will receive a grade of ZERO for the whole question.

Question 3 (20 points)

Suppose the DC/FC exchange rate (EDC/FC) is determined by the asset approach to the exchange

rate.

Home Foreign

Money demand L(R, Y) = 0.15Y – 5000R L(R, Y) = 0.2Y – 4000R*

Money supply MS = 75000 MS* = 76800

• Note: Interest rates are expressed in decimal forms (i.e., if R = 0.05, then R = 5%). Keep

your answer to 4 decimal places if needed.

MGEC61 Assignment 1 (Winter 2022) 4

The long-run level of output in Home is 45000, which is 5000 units less than output in Foreign.

Both economies have the same (long-run) level of nominal interest rate, which is 10%.

a) Find the initial long-run equilibrium level of exchange rate if the (initial) expected DC/FC exchange rate is given by the ratio of domestic price level to foreign price level. (6 points)

Recently, there are permanent changes in the domestic money market. Domestic money holders

increase the fraction of income held in the form of money increases by 2 percentage points. At

the same time, the central bank of Home lowers its volume of open market purchases and the level

of money supply changes by 4%. When the market revises their expectations, the expected change

rate (Ee) would change by 0.242 DC per FC. (You need to decide the new levels of money supply

and expected exchange rate).

b) Find the short-run equilibrium levels of interest rate in both countries and the DC/FC exchange rate. (8 points)

c) Suppose there is a change in monetary policy such that the central bank of Home wants to keep the short-run exchange rate at 1.5500 via a temporary change in money supply. Can the central

bank achieve this goal? Explain. (6 points)

Question 4 (20 points)

Consider two small open economies, Home and Foreign, and the DC/FC exchange rate is

determined by the asset approach to the exchange rate.

a) “When foreign money holders hold a larger portion of their income in the form of money, there will be an overshooting of domestic currency.” True/False/Uncertain, explain with the aid of

ONE foreign exchange market diagram.

Note: Only the first diagram will be graded and compare your answer to initial equilibrium.

(15 points)

b) Suppose a country’s financial account depends on the interest rate differentials between DC denominated assets and FC denominated assets. Based on your answer in part (a), explain

what happens to Home’s financial account balance in both short run and long run (i.e., a debit

or credit entry). Compare your answer to the initial equilibrium and you can assume the

financial account is in balanced in the initial equilibrium. (5 points)