# Assoc. Prof. Dr. Yaprak Gülcan International Economics II spring 2008 Quiz Name: Number

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 Assoc. Prof. Dr. Yaprak Gülcan International Economics II Spring 2008 Quiz Name: Number: In 1973, the GDP deflator was 45.0 in Switzerland and 34.3 in the United States (with 1995=100). In 2001, it was 103.2 in Switzerland and 112.1 in the United States. The exchange rate of Swiss franc was SFr 3.1648 per dollar in 1973 and 1.6876 in 2001. Did the relative PPP theory hold between Switzerland and the United States between 1973 and 2001? Why? Suppose that the velocity of circulation of money is V=5 and the nominal GDP of the nation is \$200 billion. What is the quantity of money demanded by the nation? By how much will the quantitiy of money demanded rise if the nation’s nominal GDP rises to \$220 billion? What happens to the nation’s demand for money if its nominal GDP increases by 10 percent each year? Suppose that the domestic credit created by the nation’s monetary authorities is \$ 8 billion and the nations’s international reserves are \$ 2 billion, and that the legal reserve requirement for the nation’s commercial banking system is 25 percent. How much is the monetary base of the nation? What is the value of the money multiplier? What is hte value of the total supply of money of the nation? Suppose that a nation’s nominal GDP= 100, V=4, and Ms = 30. Explain why this nation has a deficit in its balance of payments. Under the law of one price, the price of an internationally traded commodity in one nation in a two-nation world is equal to the exchange rate times the price of the same commodity in the other nation. Assuming that such a law holds, explain why, if the first nation would otherwise face no inflation at home, it will not be able to maintain in the long run both constant prices and a constant exchange rate in the face of inflation in the other nation. Suppose that the interest rate is i= 10 % in New York and i*= 6 % in Frankfurt, the spot rate is SR = \$1/ €1 today and is expected to be \$1.01/€1 in three months. Indicate why the condition for uncovered interest parity (VIP) is satisfied. Explain what would happen if there was a change in expectations so that the spot rate in three months become \$1.02/ € and the interest rate differantial remained unchanged. Good Luck....... Answers to Problems 1. a. The rate of inflation in Switzerland from 1973 to 1998 was: 101.3-46.6 = 54.7 = 0.739 or73.9% (101.3+46.6)/2 74.0 (percentage change can be obtained by (101.3-46.6 )/46.6. Note that in the above calculations, percentage changes were obtained by the average of the beginning and end values.) On the other hand, the rate of inflation in the United States from 1973 to 1998 was: 107.0 - 29.2 = 77.8 = 1.142 or14.2% (107.0+29.2)/2 68.1 (percentage change can be obtained by (107.0-29.2 )/29.2. Note that in the above calculations, percentage changes were obtained by the average of the beginning and end values.) Thus, the inflation rate in Switzerland minus the inflation rate in the United States from 1973 to 1998 was: 73.9% - 114.2% = -40.3% From 1973 to 1998, the Swiss franc appreciated with respect to the U.S. dollar from 3.1648 Swiss francs per dollar in 1973 to 1.4898 Swiss francs per dollar in 1998 or by 1.4898-3.1648 = -1.6750 - -0.720 or -72.0% (1.4898+3.1648)/2 2.3273 (percentage change can be obtained by (1.4898-3.1648 )/3.1648. Note that in the above calculations, percentage changes were obtained by the average of the beginning and end values.) b. The relative PPP theory did hold only to the extent that since the rate of inflation was lower in Switzerland than in the United States the Swiss franc appreciated with respect to the U.S. dollar between 1973 and 1998. But the percent appreciation of the Swiss franc with respect to the dollar was much greater than that predicted by the relative PPP. 2. a. Md=kPY=(l/V)(PY)=(l/5)(200)=\$40 billion. b. If the nation's nominal GDP rises to \$220 billion, Md=220/5=\$44 billion. c. If the nation's nominal GNP increases by 10 percent each year, Md increases also by 10 per cent each year. 3. a. Monetary base of the nation is, D+F=8+2=\$10 billion. b. The value of the money multiplier is, m=l/LLR= 1/0.25 =4. c. The value of the nation's total money supply is Ms=m(D+F)=4(8+2)=\$40 billion 4. Md=100/4=25 falls short of Ms=30 and there will be an outflow of international reserves (a deficit in the nation's balance of payments). 5. According to the monetary approach, inflation in the second nation is caused by excessive money creation there. As a result, either the first nation's exchange rate has to appreciate to keep its balance of payments in equilibrium or its monetary base will rise (so that inflation will spread to nation 1). 6. The condition for uncovered interest parity is given by i-i*=EA, where EA is the expected appreciation of the pound. That is, since the spot rate of SR=\$2.02/£1 in three months is 1% (4% on an annual basis) higher than SR=\$2.00/£1 today, the condition for UIA is satisfied because 6%-10% = 4% (with all percentage rates expressed on an annual basis). If the spot rate is expected to be SR=\$2.04/£1 in three months, the pound would be expected to appreciate by 2% for the three months (8% on an annual basis). Investors would now earn more by investing in London than by investing in New York and the condition for UIA would no longer be satisfied. As more dollars are exchanged for pounds to increase investments in London, the actual spot rate will increase from SR=\$2.00/£1 to SR=\$2.02/£1. This will leave only an expected appreciation of the pound of about 4% per year (the same as before the change in expectations). This is obtained by comparing the new higher spot rate of SR=\$2.02/£1 today with the new expected spot rate of SR=\$2.04/£1 in three months, so as to return to UIA parity.

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