Final Exam Questions

Final Exam Questions -- Spring ‘11
Econ 4131: International Finance
1. Explain the complete derivation of the AA (asset market equilibrium) and DD (goods market
equilibrium) curves from Krugman & Obstfeld’s textbook. Use these curves to analyze the effects
of monetary policy and fiscal policy under fixed and under flexible exchange rates. (Ignore the XX
curve)
2. “You may fix the money supply or you may fix the nominal exchange rate, but you can’t do both
simultaneously.” Explain this carefully, with a full explanation of the role of the central bank and
its balance sheet.
3. Explain how the gold standard operated in the classical period (1870-1914). What were the
advantages and disadvantages? Some say the gold standard sacrificed internal balance to external
balance. How? What were the “rules of the game” and what would happen when they were
violated? What would happen when the demand for monetary gold rose faster than the supply, and
why was this a problem?
4. Explain the functioning of the Bretton Woods currency arrangement. Why was it designed as it
was? What strains appeared over time, and what factors led to its collapse? What was “Triffin’s
dilemma”? (Look up Triffin in the index to the textbook). How is Triffin’s Dilemma relevant to
our current payments imbalance with China?
5. Use the interest rate parity condition (underlying the AA curve) to show what effect an expected
devaluation (say 10%) will have on the domestic economy (particularly domestic output) assuming
that the central bank fights to defend the initial fixed parity. What will the consequences be for
internal and external equilibrium? What would be an appropriate policy response to restore internal
and external equilibrium?
6. Consider a country that exports oil, and basically nothing else. Assume that there is a sudden and
apparently permanent collapse of world oil prices. Use a version of the AA-DD model to analyze
and discuss the nature of the macroeconomic shock and adjustment under: i) a flexible exchange
rate regime; ii) a fixed exchange rate regime. Discuss the best policy options in both cases.
7. In the AA-DD model with flexible exchange rates, explain how expansionary fiscal policy
affects the current account and employment, and why. Explain how expansionary monetary policy
affects the current account and employment. Draw a grid with 2 columns (Over employment,
Under-employment) and two rows (CA surplus, CA deficit). In each cell, indicate which policy
should be used (monetary vs. fiscal), and which direction it should take (expansionary vs.
contractionary).
8. A gold-standard is basically equivalent to a fixed exchange rate regime where there is no policy
option of devaluation. Discuss the shock in (6) above, and how the economy would adjust to
internal and external balance if it were following a strict gold standard.
9. Using the AA-DD model from chapter 17, carefully explain how a devaluation affects
employment and the trade balance, starting with a shift in the interest-parity curve. Describe the
transition from the original to the new equilibrium (i.e. what changes immediately, what changes
gradually). Under what circumstances will this policy be superior to expansionary fiscal policy?
10. What is is involved in “sterilization” of a capital flow? Why and under what circumstances
might a country attempt to sterilize capital movements? What factors make sterilization more or
less likely to succeed?

11. In the aftermath of the Mexican peso crisis in the mid 1990s, international investors launched
speculative attacks very selectively against countries with weakened banking systems (i.e. with
high non-performing loan portfolios), and not against countries with healthier banking systems.
What is the logic behind this behavior?
12. Reinhart & Rogoff (2009) discuss patterns of financial crises based on a long historical dataset.
Discuss some of the key features they identify as characteristic of crises. How is the U.S. crisis
(which began in 2007) the same as or different from the comparison group(s)? Since our crisis is
still rolling on, what does the R&R analysis suggest that we have in store for us over the next
couple of years?