International Monetary Economics, Exam 3, April 14, 2020

Your Name: All questions are worth 1 point.

1. Consider the AA curve and the asset market model. Choose the correct words.
“Let (Y1, E1) and (Y2, E2) be two points on the AA curve. Given a fixed level of MS/P, the equilibrium interest
rate with L(R,Y1) is higher than the equilibrium interest rate with L(R,Y2). So, E1 is (greater / smaller) than
E2. In the model of the asset market, the curve of L(R,Y1) is (above / below) the curve of L(R,Y2). In the figure
of AA-DD, the point (Y1, E1) is in the (lower left / lower right / upper left / upper right) of the point (Y2, E2).”
Answer: The situation of this question is like the one below.
E E
AA
E2
E1
Y
L(R,Y2) Y2 Y1
L(R,Y1)

M/P

2. Consider the AA and DD model. Suppose that PH rose temporarily. This would cause changes in the model.
Choose the correct changes below.
The direction of the shift of AA curve: Left, Right, No shift
The direction of the shift of DD curve: Left, Right, No shift
The type of the change: Contractionary, Expansionary
Answer: Remember that PH is in both asset market and output market. In the asset market, the increase
in PH would reduce the real money supply. This would lower the equilibrium E for any Y in the asset market.
Thus, the AA curve would shift to the left (If you cannot imagine this in your head, draw it on a paper or on
a screen.) In the output market, the increase in PH would real-appreciate Home currency. This would reduce
CA. So, the equilibrium real output for any E in the output market would fall. This would shift the DD curve
to the left. Since both curves would shift to the left, the equilibrium Y in the AA-DD model would fall. So, it
is a contractionary change.

3. Initially, Home economy was in its long-run equilibrium. Then, people’s preference for imports changed;
they became consuming less imports and more domestic products without changing their total consumption
level at any disposal income. Choose the correct effect of the preference change on the equilibrium real output
and the policy response to maintain the full employment after the change.
Effect of the preference change on real output: Decrease, Increase, No change
Type of necessary policy response: Expansionary / Contractionary
The policy: Increasing Tax / Increasing government spending / Increasing nominal money supply
The curve the policy shifts: AA / DD / None
The direction of the shift: Left / Right / No shift
Answer: Although the preference change did not affect the total consumption, since it reduced imports, CA
would increase. So, this would shift the DD curve to the right. Of course, it would increase the real output.
Then, the policy response to maintain the full employment after the change is the contractionary policy. So,
now, the real output was higher than the full-employment output level (remember that the economy was
initially in the long-run equilibrium.) So, the necessary policy response was a contractionary one. Among
three policies above, the only policy which is contractionary is “Increasing Tax”. Of course, “Increasing Tax”
would shift the DD curve to the left.

4. Imagine the output market model, asset market model, and the AA-DD diagram. Initially, Home economy
was in the long-run equilibrium. Then, Home central bank permanently changed nominal money supply.
Because of the change, during the process from the short-run equilibrium to the long-run equilibrium, Home
interest rate fell. Based on this information, choose the correct directions of the shifts of curves in the short-
run and in the long-run.
4.a. Shifts of curves in the short-run.
Asset market side
Real money demand curve: Down / Up / No shift
Real money supply curve: Down / Up / No shift
Foreign rate of return curve: Left / Right / No shift
Home rate of return curve: Left / Right / No shift
AA curve: Left / Right / No shift
Output market side
Aggregate demand curve: Down / Up / No shift
DD curve: Left / Right / No shift
Answer: We use the information that the Home interest rate fell during the process from the short-run
equilibrium to the long-run equilibrium. This implies that the real money supply increased during the
process. The real money supply is MS/P. Since the nominal money supply would not change during the process
because this is after the permanent change, the increase in MS/P was due to the change in P. This means that

∆𝑴𝑺 ∆𝑷
P fell during the process. From 𝑴𝑺
= 𝑷
, we know that the central bank reduced the nominal money supply

permanently.

4.b. Shifts of curves in the long-run.

Asset market side
Real money demand curve: Down / Up / No shift
Real money supply curve: Down / Up / No shift
Foreign rate of return curve: Left / Right / No shift
Home rate of return curve: Left / Right / No shift
AA curve: Left / Right / No shift
Output market side
Aggregate demand curve: Down / Up / No shift
DD curve: Left / Right / No shift
Answer: Since price fell during the process from the short-run equilibrium to the long-run equilibrium, it
would affect both the asset market and the output market.

5. Government permanently changed its fiscal policy. This policy change was the type that would reduce
CA. Based on this information, choose the correct words and the correct shifts of curves below in the short-
run.
Type of the policy change: Contractionary or Expansionary
The policy change: Increasing T, Increasing MS, Decreasing T, Decreasing MS
Shift of DD curve: Left, Right, No shift
Shift of AA curve: Left, Right, No shift
Change in equilibrium Y in the short-run: Decrease, Increase, No change
Answer: Since the policy change was the type that would reduce CA, it was expansionary (remember what
would happen in imports when Y increased.) So, we consider a permanent expansionary fiscal policy change.
Among 4 policies above, only “Decreasing T” is the expansionary fiscal policy (“Increasing MS” is also
expansionary, but not a fiscal policy.) Since the fiscal policy change was expansionary, the DD curve would
shift to right. However, since the fiscal policy change was permanent, the AA curve would shift to the left so
that the equilibrium real output would not change.

6. Suppose that Home government and central bank wanted to reduce CA and cool down the economy.
Choose the policy from below that can achieve the policy goal.
Policies: Increase MS / Increase G / Decrease MS / Increase T
Answer: The figure below shows the effect of four policies above. Reducing CA requires moving the
equilibrium point below the XX curve. Cooling down the economy requires the moving the equilibrium point
to the left side of the initial equilibrium point. So, the policy that can achieve the policy goal is “Decrease MS”.

E AA
DD
T↑ MS ↑
XX

MS↓ G↑
Y

7. Home central bank did a sterilized intervention in the FX market to appreciate Home currency. The size
of the transaction was 500. The first table below is the initial balance sheet of the central bank. The second
table below is the balance sheet after the sterilized intervention. But it lacks some numbers.
Initial Balance Sheet
Assets Liabilities
Foreign assets 2700 Deposits 3000
Domestic assets 1600 Currency 1300
 Assets Liabilities
Foreign assets Deposits
Domestic assets Currency 1300

Answer the values of Foreign assets, Domestic assets and the deposits in the balance sheet after the sterilized
intervention and how the intervention changed the exchange rate and the Home nominal money supply:
Decrease, Increase, or No change.
Foreign assets: 2200
Domestic assets: 2100
Deposits: 3000
Exchange rate: No change
Home MS: No change
Answer: Since we consider a sterilized intervention, no change in Deposits. Next, since Home central bank
tried to appreciate Home currency (i.e., lowering the value of E), the central bank sold Foreign currency as
you can see in the figure below.
E S
D

cF

So, its Foreign assets would decrease by 500. Then, since Home central bank sterilized it, it would purchase
Domestic assets by 500. Since the sterilized intervention would not change the market, both the exchange
rate and Home nominal money supply would not change.

8. Initially, Home economy was in its long-run equilibrium with Y = 100 and Home central bank fixing the
exchange rate at E = 5 cH/cF. Then, Home government increased its spending temporarily. Home central bank
responded to this increase to keep the exchange rate fixed. Answer how Home central bank responded
(Decrease MS or Increase MS), how the response shifted the AA (leftward, rightward, or No shift). Also, in the
short-run equilibrium after the response, answer if the level of the equilibrium real output would be greater,
smaller, or equal to 100 and if the equilibrium exchange rate would be higher, lower, or equal to 5cH/cF.
Response: Decrease MS or Increase MS
Shift of AA: Leftward, Rightward, or No shift
Equilibrium Y ( < / = / > ) 100
Equilibrium exchange rate ( < / = / > ) 5cH/cF
Answer: Since Home government increased its spending temporarily, the DD curve would shift to the right.
This rightward shift of DD would not only increase the equilibrium real output, but also produce an
appreciation pressure on Home currency at E = 5 cH/cF. To keep the exchange rate fixed, Home central bank
would need to shift the AA curve to the right. See the figure below.
E DD
AA
5cH/cF
 Y
The shift means Home central bank
100 purchased Foreign assets. So, it would increase nominal money supply.

The equilibrium real output after the response would be more than 100 with the exchange rate at 5 cH/cF.

9. In this question, assume the imperfect asset substitutability. Home central bank did a sterilized
intervention. Because of the sterilized intervention, Home central bank’s domestic assets increased.
Regarding the effect of the sterilized intervention, choose the correct words below.
Change in risk premium: Decrease, Increase, No change
Change in Home nominal money supply: Decrease, Increase, No change
Shift of foreign rate of return curve: Leftward, Rightward, No shift
Answer: Remember the model of the risk premium:  = (B – A), where A is Home central bank’s domestic
assets (more precisely, Home government bonds). Since Home central bank increased its domestic asset
holdings, B – A would fall, which means  would fall, too. Since we consider a sterilized intervention, Home
nominal money supply would not change. Since  would fall, RH + (Ee – E)/E +  would decrease. So, the
Foreign rate of return curve would shift to the left, and Home currency appreciate.

10. Consider two countries: A and B. Suppose that B's central bank increased nominal money supply and
that the inflation rate in country A was rising. Regarding the exchange rate between A’s and B’s currencies,
consider two cases: the case of the reserve currency standard system with B being the reserve issuing country
and the case of the floating exchange rate system. Answer how A's central bank would change A’s interest
rate in each case:
Reserve currency standard system: Increase, Decrease, No Change
Floating exchange rate system: Increase, Decrease, No Change
Answer: Under the reserve currency system, country A must follow country R’s monetary policy. So, A's
central bank would increase nominal money supply, too. This means A’s interest rate would fall. Under a
floating exchange rate system, A’s central bank can focus on domestic economy. Since the inflation rate was
rising in A, it would need to restrain the economy to avoid higher inflation. So, A’s central bank would raise
interest rate.

11. Home country’s government wanted the floating exchange rate and the effective monetary policy for the
economy. Could Home government allow free international capital flow?
Answer: The trilemma says no country can have the following three simultaneously.
1. Exchange rate stability (i.e., fixed exchange rate)
2. Monetary policy oriented toward domestic goals (i.e., effective monetary policy)
3. Freedom of international capital movements
However, since Home country’s government does not want the exchange rate stability (it wants the floating
exchange rate), it can have the effective monetary policy and the free international capital flow.
A. Yes
12. Consider the price-specie flow mechanism and the rule of the game of the gold standard system. Because
of the mechanism, Home’s exports were decreasing. Based on this information, choose the correct words below.
Home’s balance of payments was in: Deficits, Equilibrium, Surplus
Home’s price level was: Falling, Not changing, Rising
According to the rule of the game, Home central bank had to:
Buy home assets, Sell home assets, Not buy nor sell home assets.
Answer: Remember that the price-specie-flow mechanism works through price changes. Since Home’s
exports were decreasing because of the mechanism, Home price must have been rising (higher price makes
Home outputs less price competitive against Foreign outputs.) This means a surplus in Home’s balance of
payments (Surplus => Gold inflowing => Money supply increase => Price increase). According to the rule of
the game, Home central bank had to buy Home assets to lower Home interest rate.

13. Home economy is under the fixed exchange rate system. The dot in the figure below shows the initial
situation of Home country. Let X be Home’s desired level of the current account (So, the XX curve in the figure
is for X.)

Exchange rate
XX
EII = E0

EXX II

A0 Domestic spending

13.a. Answer Home’s situation on employment and current account at the dot.
Employment: Underemployment | Full employment | Overemployment
CA: Less than X | Equal to X | Greater than X
Answer: Let (A0, E0) be the combination of A and E at the dot. Using the II and XX curves, we can find the
internal balance achieving exchange rate (EII) and the external balance achieving exchange rate (EXX) for A0.
First, consider the internal balance: Employment. As you can see in the figure, actually EII is equal to E0. So,
at the dot, the internal balance was achieved: Full employment.
Next, consider the external balance. Since EXX is lower than E0, Home currency at the dot is more depreciated
than the external balance achieving level. So, the CA would be greater than the desired level, X.

13.b. Choose the best combination of policies from below to achieve the internal and external balances.
(a) Increasing government spending and revaluation
(b) Increasing tax and devaluation
(c) Cutting tax and devaluation
(d) Cutting government spending and revaluation
Answer: Achieving both balances means moving to the intersection of the II and XX curves. So, Home
economy needs to move to the lower right. The lower part means a revaluation. The right part means greater
domestic spending, i.e., an expansionary policy. Among four combinations above, the combination of an
expansionary policy and the revaluation is (a).