ECN209 International Finance 2013 Past Paper Questions and Model Answers

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ECN209 International Finance – 2013
Questions and Answers
Section A
Question 1. A government budget deficit leads to a current account deficit. [10 marks]

A budget deficit might arise from higher government spending and/or a reduction in tax revenues.
This leads to greater aggregate demand, such that the government and/or consumers wish to spend
more on goods and services and greater output overall.

This can be seen by the identity for overall output in the economy:

Y = C + I + G + (X – M)

Rearranging this yields:

(S – I) + (T – G) = (NX)

Therefore as the government runs a deficit (i.e. the left hand side becomes negative) this must lead
to a reduction in the right hand side (i.e. net exports).

Question 2. According to the Purchasing Power Parity theory, if the inflation rate in the US is
higher than the inflation rate in the UK, then the US Dollar should be depreciating against the
British Pound. [10 marks]

FALSE.

The purchasing power parity theory states that:

S = PUS/PUK

Where S is the exchange rate of US dollars to GBP; PUS is the cost of a good in US dollars; and P2 is
the cost of a good in UK GBP.

Therefore if the inflation rate in the US is higher than the inflation rate in the UK, the rate of growth
of the numerator is higher than the rate of growth of the denominator. This means that the
exchange rate of US dollars to GBP is increasing and therefore the US dollar is appreciating.



Question 3. Under fixed exchange rates, fiscal policy becomes less effective at stabilizing output.
[10 marks]

FALSE.

Fiscal policy refers to any change in government expenditures or revenues. Expansionary fiscal policy
occurs when the government increases its spending or when it decreases taxes, and therefore
consumers have more disposable income to spend; this increases aggregate demand. Contractionary
fiscal policy occurs when the government decreases spending or increases taxes, and this decreases
aggregate demand. When the government increases their spending, this results in the DD curve
shifting to the right.

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In the case of a fixed exchange rate, excess demand or little demand for domestic currency will
automatically be relieved by central bank intervention. The central bank will supply or decrease the
quantity of domestic currency by purchasing or selling foreign currency. The shift in the money
supply with cause the AA curve to shift so that the final equilibrium is where the exchange rate is at
its fixed level. This will result in fiscal policy having a larger effect on output as compared to when
exchange rates are able to fluctuate.

Question 4. According to the DD-AA model, a domestic monetary expansion improves the
domestic current account. [10 marks]

TRUE.

The central bank can attempt to increase the money supply through a purchase of domestic assets.
Under a floating exchange rate, the increase in the central bank’s domestic assets would push the
original asset market equilibrium curve rightward to and would therefore result in a new equilibrium
at point 2 and a currency depreciation (at E2). Under floating rates, the rise in the nominal exchange
rate leads to a rise in the real exchange rate which causes an increase in the current account.




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SECTION B