Practice Exam 2

ECON 3120

Part 1: Multiple Choice (2*20= 40 points)

1. If UIP holds, the foreign interest rate is 12%, and the foreign currency is expected to
depreciate by 6%, then the home interest rate is:
A) 4%. B) 6%. C) 10%. D) 14%.
2. Given the home interest rate is 7%, the foreign interest rate is 8%, and the foreign currency is
expected to depreciate by 2%, investors will ____ domestic assets, _____ domestic currency,
____ foreign currency, and _____ foreign assets.
A) sell; sell; buy; buy B) sell; buy; sell; buy
C) buy; sell; buy; sell D) buy; buy; sell; sell
3. Assume that the expected spot rate for Canadian dollars (CD, in terms of dollars) = $0.75/CD,
the current interest rate on the Canadian deposits is 3.5%, and the current interest rate on dollar
deposits is 2.5%. If the UIP holds, the current spot rate is ____.
A) $0.7425/CD B) CD 0.7575/$ C) $1.25/CD D) CD 1.30/$

4. The current exchange rate between Mexican peso (MXN) and German Deutsche Mark (DM)
is EMXN/DM = MXN10.0125/DM. All other factors held constant, in response to an expansionary
monetary policy in Germany, investors’ prediction of the future exchange rate is likely to be:
A) EMXN/DM = MXN10.0125/DM, implying that the exchange rate stays the same.
B) EMXN/DM = MXN12/DM, implying that MXN depreciates against the DM.
C) EMXN/DM = MXN9/DM implying that MXN appreciates against the DM.
D) All of the above is a possibility.
5. When policy changes are temporary, then_____.
A) exchange rates do not change
B) expectations about the exchange rates do not change
C) interest rates do not change
D) expectations can change based on the type of policy implemented
6. If there is a temporary increase in the money supply in the Eurozone, ceteris paribus, then,
____________.
A) the money supply in the United States must decrease by the same proportion.
B) the U.S. dollar nominal interest rate will increase.
C) investors will expect the euro to appreciate.
D) the dollar will appreciate against the euro.

7. Trilemma refers to the three policy goals, e.g., ______, _____, and ____ that are not mutually
compatible.
A) a fixed exchange rate; fixed price level; fixed interest rate
B) free flow of capital across borders; a floating exchange rate; setting home interest rate same as
the foreign interest rate
C) monetary policy autonomy; free flow of capital across borders; a fixed exchange rate
D) a floating exchange rate; monetary policy autonomy; setting home interest rate higher than
the foreign interest rate
8. A key assumption to ensure that domestic returns and foreign returns are in equilibrium is:
A) there are perfectly flexible prices.
B) the quantity of money is fixed.
C) there are no capital controls preventing the movement of capital.
D) interest rates are fixed.

9. In the above Figure, if the dollar rate of interest increases from 5% to 7%, the U.S. dollar will
_______, if i€ falls, the U.S. dollar will_____ and if the home currency is expected to appreciate,
the U.S. dollar will________.
A) depreciate; depreciate; depreciate
B) depreciate; depreciate; appreciate
C) appreciate; appreciate; appreciate.
D) appreciate; depreciate; depreciate

10. The higher the exchange rate, the _____ is the return on foreign asset as a higher exchange
rate ______.
A) higher; makes foreign investment more expensive as the home currency appreciates
B) lower; also means a higher expected exchange rate thereby increasing foreign return
C) higher; makes foreign investment less expensive as the foreign currency depreciate
D) lower; makes foreign investment more expensive and in turn results in fewer proceeds from
foreign assets.

11. Appleland’s trade balance with its largest trading partner, Peachland improved. The possible
reasons could be
A) Appleland’s currency depreciated against Peachland’s currency, Appleland’s real income
increased and Peachland’s real income declined.
B) Appleland’s currency depreciated against Peachland’s currency, Appleland’s real income
decreased and Peachland’s real income increased.
C) Appleland’s currency appreciated against Peachland’s currency, Appleland’s real income
decreased and Peachland’s real income increased.
D) Appleland’s currency appreciated against Peachland’s currency, Appleland’s real income
increased and Peachland’s real income declined.
12. 35% of Latvia’s trade is conducted with country A; 30% of trade with country B, 20% of
trade with country C, and 15% trade is conducted with country D. If the Latvian Lats appreciates
15% against country A, depreciates 20% against country B, depreciates 5% against country C,
and appreciates 20% against country D, then Latvia’s effective trade-weighted real exchange rate
experiences a ______.
A) 5.25% appreciation
B) 1.25% depreciation
C) 5.25% depreciation
D) 1.25% appreciation

13. When the real exchange rate increases in the United Kingdom, then there is a(n) ______ in
U.K. demand for U.K. goods, a(n) _________ in U.K. demand for Canadian goods, a(n) ______
in Canadian demand for Canadian goods, a(n) ________in Canadian demand for the U.K. goods.
A) decrease; increase; increase; decrease
B) increase; decrease; decrease; increase
C) increase; increase; decrease; decrease
D) decrease; decrease; increase; increase

14. A family’s annual income is $80,000; if the MPCF is 0.20, MPS is 0.20, and income
increases by $10,000, then the family is likely to:
A) save 20% of their total income of $90,000, and spend 20% of their total income on foreign
goods and services.
B) increase total spending by $6,000 and increase saving by $2,000.
C) save 20% of $10,000, and spend 80% of $10,000 on home produced goods and services.
D) increase spending on home produced goods by $6000, and on foreign produced goods by
$2,000.

15. Niceland allows free flow of capital into and out of its border and pegs its currency against
the currency of Peaceland. To recover from an economic recession, Niceland can
A) only increase its money supply
B) only increase government spending or reduce taxes
C) either increase money supply or increase government spending
D) neither increase government spending or money supply

16. According to the IS-LM-FX model, the equilibrium exchange rate is determined by _______.
A) only the fiscal policy of the home country
B) the monetary policies of the home and foreign countries
C) only the monetary policy of the home country
D) the fiscal policy of the home country and the monetary policies of the home and foreign
countries
17) The graph plots the real effective exchange rate (the solid line), and the corresponding trade
balance of a country (the dotted line). Based on the above graph, we know that the trade balance
behaved in accordance with the theory between _____.
A) June 2020 to July 2020, and October 2020 to November 2020
B) November 2020 to December 2020, and April 2021 to May 2021
C) August 2020 to October 2020
D) June 2020 to May 2021

18) Peru’s government reduces taxes to stimulates its economy. As a result, in the short run, the
following variables in Argentina, a large trading partner of Peru, are likely to change
A) money supply, interest rate, price level
B) imports, taxes, interest rate
C) exports, GDP, consumption spending
D) imports, investment, government spending

19) An increase in government spending in an open economy of country A, crowds out

A) only investment by raising the interest rate.
B) only trade balance by appreciating country A’s currency.
C) investment by raising interest rate and also trade balance by appreciating country A’s
currency
D) investment by lowering the interest rate and also trade balance by depreciating country A’s
currency

20) Assume the UIP holds between the Philippines and Singapore and the exchange rate is
allowed to float. The spot exchange rate between the Philippine peso (PHP) and Singapore dollar
(SGD), EPHP/SGD = PHP42/SGD. If the investors expect the exchange rate to change to EPHP/SGD =
PHP45/SGD, then according to the IS-LM-FX model, in the Philippines, GDP_____, Philippine
peso (PHP) ____ and trade balance______.
A) increases; appreciates; stays the same
B) increases; depreciates; may increase/decrease/stay the same
C) decreases; depreciates; improves
D) increases; appreciates; may increase/decrease/stay the same
Part 2: Short Answer

Instruction: Please show all work and write neatly. On the numerical problems. if you only
write the answer but do not show all work, you will not receive full points even if your answer
is correct. Points allocated to each problem are indicated in parenthesis.

You may find the following equations useful!

M H =P H LH ( i H ) Y H

Goods Market equilibrium:

M
Money market equilibrium: = L(i)Y
P

[Use this page if you need more room for your work. Make sure to number your answers]
1. This question considers the relationship between South African Rand and Chinese Yuan. Let
the exchange rate be defined as, ERand/yuan. Suppose to tackle an overheated economy, the South
African monetary authority decreases money supply permanently. (7+5=12 points)
a) Using the FX and money market diagrams, illustrate how the permanent decrease in money
supply affects the money and FX markets in the short run and in the long run. On you graphs,
label the initial equilibrium point A, label your short-run equilibrium point B and your long-run
equilibrium point C. On your graph, show the overshooting of ERand/yuan. Label your graphs
carefully.
b) Illustrate with the aid of graphs how each of the following variables of South Africa is likely
to change over time in response to a permanent decrease in money supply at period T: nominal
money supply M, price level P, real money supply M/P, interest rate iRand, and the exchange rate
ERand/yuan. On the ERand/yuan’s dynamic path, show the overshooting of ERand/yuan.
2) Use the information of the home country presented in the table below to answer the following
questions. (a & b=8 pt., c=3 pt., d= 5 pt., e= 2pt.; Total = 18 points)
Goods Market Money Market FOREX market

C = 100+0.8(Y-T) M = 500 Ee = 5
I = 90-30i L = 0.2Y – 200i i* = 5%
G = 50; T = 30 P=5
TB = 40(1-5/E) – 0.20(Y-200)
πe = 0

a) Find the home economy’s equilibrium interest rate, i, and the equilibrium output, Y. Calculate
consumption, investment, trade balance, and exchange rate at the home economy’s equilibrium.
b) Given that the Home monetary authority implements a contractionary monetary policy to
reduce the money supply to 400, find the home country’s new equilibrium levels of output,
consumption, interest rate, investment, exchange rate and trade balance. Show all work and
report your answers in the following table.

M =500 M´= 400

Home equilibrium output, Y

Consumption
Home interest rate
Investment
Exchange rate
Trade balance

Work:
c) On an IS-LM-FX graph illustrate how this change in money supply affects the economy. On
your graph, label the following: values of the equilibrium home output, interest rate, exchange
rate, and domestic return both for M = 500, and M´ = 400.
Graph:

d) Use complete and meaningful sentences to provide appropriate economic intuition behind
the direction of changes in home economy’s output, consumption, investment, interest rate, trade
balance, and exchange rate in response to the contractionary monetary policy. Explain if the
changes follow the associated theory taught in class.

e) Circle the correct answer. In response to the contractionary monetary policy in the Home
country, the Foreign country’s
Real GDP will i) increase ii) decrease iii) stay the same/uncertain
Trade Balance will i) increase ii) decrease iii) stay the same/uncertain
Economic Intuition:
3. To answer this question use the fundamental equation from the general monetary approach
P Bolivia M Bolivia /M Brazil
E Boliviano/ Real= =
P Brazil L Bolivia ( i Bolivia ) Y Bolivia / LBrazil (i Brazil )Y Brazil

How will a decrease in the nominal interest in Bolivia affect the variables listed below?
(8 points)
Circle the correct answer.
Bolivian price level, PBolivia i) increases ii) decreases iii) stays the same
Interest rate in Brazil, iBrazil i) increases ii) decreases iii) stays the same
Bolivian real money balance i) increases ii) decreases iii) stays the same
Bolivian Boliviano (in terms of Real) i) Appreciates ii) Depreciates iii) stays the same
Bolivia’s trade balance with Brazil i) increases ii) decreases iii) stays the same

Economic Intuition behind your answer:

4. a) Assume that the interest rates in New Zealand and Australia are constant respectively at 7%,
and at 4%, and the expected exchange rate between New Zealand Dollar (NZD) and Australian

Dollar (AUD) is NZD1.250008/AUD. Use the following table and fill in the blank cells to find
the equilibrium exchange rate. Show your work. (4 points)

Case Spot rate, Expected NZD depreciation Expected NZD

ENZD/AUD rate against AUD return on AUD
deposits

1 1.1983

2 1.2136

3 1.2481

b) Next period the expected exchange rate between New Zealand Dollar and Australian Dollar

changes to NZD1.20005/AUD. On a graph of the foreign exchange market, show the impact of
the change in the expected exchange rate between the currencies on the equilibrium exchange
rate (you may make up a number, but not essential). (Label the initial equilibrium, A (part a) and
the equilibrium after the change in the expected exchange rate, B) (4 points)

c) As a result of the change in the expected exchange rate the following happens (Circle the
correct answer. (0.5+1.5=2 points)
i) NZD appreciates against AUD. ii) NZD depreciates against AUD.
iii) The exchange rate between NZD and AUD will not change.
Economic intuition behind your selected answer:
d. During the global financial crisis of 2008, consumers and investors of Poland and Latvia cut
back their expenditures and the countries’ exports declined as a result of contraction in GDP in
their trading partners. Poland had a floating exchange rate regime and pursued a strong monetary
expansion to stimulate the economy while Latvia had pegged its currency to the euro and had to
pursue a monetary policy to maintain the peg.
i) Draw separate IS-LM-FX graphs for Poland and Latvia and show the equilibrium RGDP of the
countries before the global financial crisis occurred on your graphs. Label the equilibrium point
A. Show, on your graphs, the effects of the global financial crisis, and the equilibrium after the
crisis. Label the equilibrium point B. On your graphs, show the effects of the monetary policies
undertaken in the countries following the financial crisis, and label the new equilibrium point C.
(12 points)

Graph: Poland Graph: Latvia

ii) Report how the variables listed below were likely to change following the policies
implemented in Poland and Latvia in response to the global financial crisis, and provide the
reasoning behind your answer.
In Poland: After the monetary policy was implemented (circle the correct answer)

Home equilibrium output, Y i) increase ii) decrease iii) stay the same iv) uncertain
Economic Intuition:

Consumption i) increase ii) decrease iii) stay the same iv) uncertain
Economic Intuition:

Interest rate i) increase ii) decrease iii) stay the same iv) uncertain
Economic Intuition:
Investment i) increase ii) decrease iii) stay the same iv) uncertain
Economic Intuition:
Exchange rate i) increase ii) decrease iii) stay the same iv) uncertain
Economic Intuition:

Trade balance i) increase ii) decrease iii) stay the same iv) uncertain
Economic Intuition:

In Latvia: After the monetary policy was implemented (circle the correct answer)

Home equilibrium output, Y i) increase ii) decrease iii) stay the same iv) uncertain
Economic Intuition:

Consumption i) increase ii) decrease iii) stay the same iv) uncertain
Economic Intuition:

Interest rate i) increase ii) decrease iii) stay the same iv) uncertain
Economic Intuition:

Investment i) increase ii) decrease iii) stay the same iv) uncertain
Economic Intuition:

Exchange rate i) increase ii) decrease iii) stay the same iv) uncertain
Economic Intuition:

Trade balance i) increase ii) decrease iii) stay the same iv) uncertain
Economic Intuition: