Econ 402, Winter 2017

Lecture 19 review questions

1. One USD bought 26 Russian rubles in March 2007 and 56 Russian rubles in March 2017.

Calculate the annual appreciation rate of USD against the Russian ruble. Assuming interest

rate parity (IRP) holds, what should be the average difference in risk-adjusted nominal interests

between the two countries?

2. Suppose that a foreign country has restrictions on capital flows to/from abroad. Which

approach would be more appropriate for forecasting this country’s future exchange rate:

purchasing power parity (PPP) or IRP? Explain your reasoning.

3. What are some of the reasons for a small open economy to pursue a fixed exchange rate policy

with the US dollar? Give examples.

4. Currently, 10-year US Treasury bonds pay an annual interest rate of 1%, 10-year bonds of the

State of New Jersey pay 2.5%, and 10-year bonds of the State of Illinois pay 3.5%. How do

you explain this difference through interest rate parity? Assuming that US Treasury bonds are

safe (0% chance of default), can you estimate the chances of default within a year in Illinois

and in New Jersey?

5. What are the endogenous variables in the Fleming-Mundell model when prices are fixed in the

short run?

6. Why is the ? line in the Fleming-Mundell model vertical rather than upward-sloping? 7. In the Fleming-Mundell model, the ? line relates which two endogenous variables? 8. Suppose that the government is considering putting a restriction on flows of capital in/out of

the country. Then, after the policy is implemented, the interest rate will _____ if the country’s

current account is _____. Draw a diagram illustrating your reasoning.

a) rise, positive

b) fall, positive

c) fall, negative

9. How is the equilibrium real exchange rate determined in an open economy with restricted

capital flows? How is the equilibrium interest rate determined an open economy with restricted

capital flows? Draw diagrams showing your reasoning.

10. According to the Fleming-Mundell model, what is the relation between government

expenditure and nominal exchange rate in the short run? Draw a diagram to illustrate your

reasoning.

11. Consider a small open economy described by the Fleming-Mundell model. Suppose that the

government pursues a fixed exchange rate policy. How can this policy be implemented with

changes in money supply? Draw a diagram showing how money supply is determined under

fixed nominal exchange rate regime. 12. Would a fixed exchange rate regime make sense for the US? Why or why not? Explain. Page 1 of 1