International Economics

1. (20 points) You learned three main types of nominal anchors to control inflation: exchange rate target, money supply target, and inflation target plus interest rate policy. (See Monetary Approach to Exchange Rate Presentation) Assume that you are the central banker for a country that is considering the adoption of a new nominal anchor. When you take the position as chairperson, the inflation rate is 4% and your position as the central bank chairperson requires that you achieve a 2.5% inflation target within the next year. The economy’s growth in real output is currently 3%. The world real interest rate (r*) is currently 1.5%. The currency used in your country is the lira. Assume prices are flexible. (a) What is the growth rate of the money supply in this economy given the current inflation rate of 4%? (Hint: See Money supply target to see the relationship between money supply growth, inflation and growth rate) (b) If you choose to adopt a money supply target, which money supply growth rate will allow you to meet your inflation target? (c) Suppose the inflation rate in the United States is currently 2% and you adopt an exchange rate target relative to the U.S. dollar. Compute the percent appreciation/depreciation in the lira needed for you to achieve your inflation target. Compute the percent appreciation/depreciation in the lira if the central banker allows the inflation rate to remain at 4%. (d) Your final option is to achieve your inflation target using interest rate policy. Using the Fisher equation, compute the current nominal interest rate in your country. What nominal interest rate will allow you to achieve the inflation target? 2. (20 points) Oil prices reached $140 a barrel in 2008. Suppose you were a member of the monetary policy committee of a small open economy, dependent on oil imports, which also wanted to maintain a currency peg to the dollar. This increase in oil prices deteriorated current account balance substantially and raised the question if the current account balance deficit would be sustainable or not. (Hint: Overvalued currency case) (a) Describe the pressures that the currency would face due to the increase in oil prices and current account deficit. How would the central bank have to respond in order to maintain the currency peg? Would this response by the central bank increase or decrease foreign reserves? (b) Describe the impact of the Central Bank actions on the money supply, output, and domestic interest rates. Assume that the economy was already in recession even before oil price hike. What would be the dilemma that policymakers faced? (Hint: Interest rate effect on the economy.) (c) Suppose the central bank kept its exchange rate fixed but decided to sterilize its foreignexchange intervention. Explain how the central banks would sterilize its intervention. 3. (15 points) From 1979 to 1980, Paul Volcker deliberately raised US interest rates to decrease inflation rate. 1 (a) Why did the higher U.S. interest rates make it harder for Latin American nations to repay their debts? (Hint: See the presentation! (b) Why did the U.S. recession make it harder for Latin American nations to pay their debts? (Hint: Demand and see the presentation!) 4. (15 points) The currency crisis led to a recession in Thailand in 1997. In order to restore the economy, the government asked the International Monetary Fund (IMF) for loans. The IMF suggested the Thai government to reduce its expenditures and raise taxes. Why was the IMF often unpopular among the countries that receive rescue loans? Discuss the policies that IMF suggested and critiques of these policies. 5. (15 points) A country is less vulnerable to a financial crisis if its debt is in the form of bank loans rather than foreign direct investment (FDI). Do you agree? Why or why not? (Hint: Hot money) 6. (15 points) Mexico had a fixed exchange rate with a current account deficit. Defaults on loans, political instability, and the increase in the U.S interest rate resulted in some amount of capital outflow. (a) In order to prevent capital outflow and restore confidence, government issued short term debt denominated in dollars (tesobonos). Why did the government issue dollar-based instruments instead of peso-based? (b) Fear of currency devaluation and fear of default on tesobonos increased the capital outflow once again. The central bank had to devalue peso. Why? What is the benefit of currency devaluations in the long-run (Hint: Export)? 2