Problem Set 5 - International Economics F2021 - Solutions
Instructor: Giampiero M. Gallo
Teaching Assistants: Christina S. Hauser and
Robert Schall
December 08, 2021
The due date for this assignment is Wednesday, Dec. 15, 2021, at 11:45PM (Italian time). You are
encouraged to work and discuss the exercises in groups, although answers have to be typed and uploaded
individually. Suggested answers to the exercises will be provided for all exercises after the deadline. Please be
advised that using handouts or solutions to problem sets circulated in any form in previous years or cutting
and pasting any material found on the internet will be considered plagiarism. The aim of the problem set is
to help you in the study of the course material and to get you prepared for the exam. Give short and clear
answers to all the exercises. This problem set only contains six questions. The whole problem set is worth
100 points. Any article or video is accessible by clicking on the title if not stated otherwise. Hand in one
single pdf file named as follows: lastname.firstname.PS5. Typed answers are highly appreciated. If
you have any questions, do not hesitate to send an email.
Problem 1. Equilibrium Interest Rate [8pts]
Using the framework presented in the textbook, determine graphically the effect of the following events on
either money supply or money demand and how it changes the interest rate:
(a) The central bank implements a quantitative easing strategy and buys government bonds.
(b) The central bank increases the reserve requirement.
(c) A drought causes a recession (hint: what measures are taken in the presence of adverse shocks?).
(d) Due to a change in the antitrust law, competition in the transport sector decreases, so that delivery
firms can charge higher markups, and, consequently, prices in all kinds of consumer products rise.
Solution. (a) Money supply shifts to the right (increases). The interest rate falls. [2pt]
(b) Money supply shifts to the left (decreases). The interest rate rises. [2pt]
(c) Money demand shifts down (decreases) as real incomes fall. The interest rate decreases. [2pt]
(d) Money demand shifts up (increases) as the change in law causes inflationary pressure. The interest
rate increases. [2pt]
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Problem 2. Foreign Exchange Markets [16pts]
Imagine you are working for an Italian investment fund, so that Italy is the Euro area country of reference.
Your boss gives you and your colleague 100,000€ to make a profitable investment. The current Turkish
Lira/€ spot exchange rate is 14 Lira for one Euro. Six-month interest rates in the Euro area are at around
1%.
(a) A colleague tells you: ”Look, I found this great investment opportunity in Turkey! There, we can invest
the money at the current six-month interest rate of 15%. This would give us 115,000€ - a profit of
15,000€ in only six months!”
Being an expert on Turkey after solving the last problem set, how would you respond to your colleague’s
idea? [No computations needed, a verbal argument is enough.]
(b) Your colleague stubbornly insisted on investing the money in Turkey, so that you decide that your
colleague goes ahead with her half (€50,000 each) and makes her investment. Six months later, the
spot exchange rate is at 17 Lira/€. Calculate the percentage gain/loss from this investment.
(c) You made yourself familiar with the forward foreign exchange markets and see that the six-month
forward rate is 15.5 Lira/€. Making use of the forward contract, would you invest in Turkey?
(d) What would the six-month forward exchange rate need to be such that investors are indifferent between
investing in the Euro area or Turkey (i.e covered interest parity holds)?
Solution. (a) The investment should not be made without evaluating the exchange rate risk. Although
the investment may yield a high interest rate in Lira within six months, the currency could depreciate
substantially at the same time. [4pt]
(b) The colleague converted 50,000€ into 700,000 Lira. After six months and 15% interest, this yielded
805,000 Lira. Exchanging the amount back to Euros, gives 47,353€. This is a loss of roughly 5.3%.
[4pt]
(c) Denote the spot rate as (S) and the forward rate as (F). Then the investment in Turkey is profitable
if:
50, 000× (1 + iItaly) < 50, 000× S × (1 + iTurkey)× 1
F
That is: 50, 500 < 51, 935.5. Hence, using the forward rate, it makes sense to invest in Turkey. [4pt]
(d) We solve for F in the following equation:
50, 000× (1 + iItaly) = 50, 000× S × (1 + iTurkey)× 1
F
Plugging all other values:
50, 000× (1.01) = 50, 000× 14× (1.15)× 1
F
⇔
F = 50, 000× 14× (1.15)50, 000× (1.01) = 15.94
[4pt]
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Problem 3. Fiscal Policy [28pts]
Figure 1 plots fictional time-series data for two countries. Country A (left), which is a closed economy,
and Country B (right), which is an open economy. Both countries had a balanced budget (neither a budget
deficit nor a budget surplus) from time t = 0 until t = 4. At time t = 5 both countries changed their
fiscal policy in the exact same way. This you can see from the two top panels. Please answer the following
questions:
Figure 1: Fictional time series data on government budget balance (top panel), interest rates (middle panel),
and exchange rates (bottom panel) for two countries - a closed economy (Country A, left column) and an
open economy (Country B, right column)
(a) Looking at the top panel only, did the two countries engage in expansionary or contractionary fiscal
policy from time t = 5?
(b) Name two policies that could have been implemented to achieve the expansionary/contractionary
pattern depicted in the top panels.
(c) Draw a graph that relates a country’s interest rate to the amount of loanable funds. Using a supply
and demand curve, indicate the equilibrium interest rate that predominated in both countries until
time t = 4.
(d) Looking at the graph for Country A’s interest rate, how can the pattern in the graph be described
using your simple framework from part (c)? To answer this question, extend the graph you drew in (c)
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(using a different color or line style). Provide a short description that relates your graph to the graph
of Figure 1.
(e) Provide a verbal argument on why we see a different evolution of interest rates in Country B.
(f) Draw another graph that pins down the equilibrium exchange rate of the two countries between time
t = 1 and t = 4 as determined by demand and supply of foreign exchange.
(g) By extending the graph of part (f), try to explain the fall of the exchange rate for Country B from
t = 5 onward. Explain the underlying market force in a few words.
(h) If trade was initially balanced up until time t = 4, does Country B have a current account surplus or
deficit after the introduction of the fiscal policy?
Solution. (a) The budget balance for country A and B turn negative. This means that government ex-
penditures are larger than government revenues. In other words, the government spend more than it
receives - the fiscal policy is expansionary. [3pts]
(b) Two examples could be: (i) higher spending due to e.g. a pandemic relief program that pays the
hospitality sector and artists large lump sums to cover forgone revenues during the pandemic and (ii)
lower government revenues due to e.g. a VAT reduction that tries to incentivize consumers to spend
more. [4pt]
(c) Figure 2 establishes the equilibrium interest rate i1−4 at point A. Note that the supply for loanable
funds is perfectly inelastic. [4pt]
Figure 2: Answer to question 3 (c)
(d) As the government adopts an expansionary fiscal policy, the government’s added demand for loanable
funds will cause the demand for loanable funds to increase from D to D′. With only domestic loanable
funds available, the equilibrium would change from A to B and the interest rate rises from i1−4 to
i5−7. In a closed economy, like Country A, an expansionary fiscal policy causes interest rates to rise.
This is what we observe in figure 2. [3pt]
(e) In an open economy, like Country B, with freely flowing international financial capital, the rise in
domestic interest rates causes an inflow of foreign capital as foreign investors see a higher rate of return.
As foreign capital moves into the domestic market, it augments the domestic supply of loanable funds.
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Figure 3: Answer to question 3 (d)
This additional supply of loanable funds from foreigners would shift the supply curve to the right. As
a result, the inflow of foreign capital lowers domestic interest rates from i5−7 back toward i1−4. Thus,
the interest rate again decreases. [3pt]
(f) Figure 4 establishes the equilibrium exchange rate XR1−4 at point A. [4pt]
Figure 4: Answer to question 3 (f)
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(g) When the government adopts an expansionary fiscal policy and domestic interest rates rise, the inflow
of foreign capital requires that foreign investors first sell foreign currency (buy domestic currency). The
effect of the capital inflow is clear. As shown in Figure 5, the supply of foreign exchange increases from
S to S′ and a new equilibrium is established at point B, with an equilibrium exchange rate of XR5−7.
The decline in the exchange rate means that the domestic currency has appreciated in nominal terms.
[4pt]
Figure 5: Answer to question 3 (g)
(h) A current account deficit. It is the difference between imports (point B) and exports (point C) at the
new exchange rate XR5−7. [3pt]
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Problem 4. Fiscal and Monetary Interaction [24pts]
The previous exercise outlined the effects of fiscal policy on the external balance (interest rates, exchange
rates and, hence, the current account) of a country. Using a simple AS-AD framework we would have been
able to assess the effects of fiscal policy on the internal balance (GDP and price levels). Indeed, policymakers
usually have the internal balance in mind when they engage in expansionary or contractionary policies. In
this exercise we add monetary policy to our toolbox and study the interaction with fiscal policy.
Figure 6 provides actual data on the euro area from 2001 until today (the values for 2021 and 2022 are
forecasts). The first panel plots the so-called output gap. It is a measure indicating how the economy deviates
from it’s potential output - comparable to the textbooks notion of full employment output level. Positive
values indicate that the economy is doing good, e.g. is in a boom. Negative values indicate that the economy
is doing bad, e.g. is in a recession. From the graph we can see that the euro area went through two major
crises: (i) the European debt crisis that emerged from the financial crisis starting from 2008 and lasting until
approximately 2016 and (ii) the crisis caused by the Covid-19 pandemic starting in 2020. Panels (2) and (3)
graph the aggregate fiscal policy (measured by the government budget balance) and monetary policy by
the European central bank. These are basically two instruments: the deposit facility (right scale) which is
the interest rate at which banks can lend to each other overnight and monthly asset purchases (left scale)
which are mainly containing the purchase of government bonds. Please answer the questions below.
Figure 6: Key Variables of Fiscal and Monetary Policy in the Euro Area. Source: AMECO and ECB
Statistical Data Warehouse.
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(a) Describe the fiscal response of the Euro area during the European debt crisis. When was is expansion-
ary, when was it contractionary? How did the euro area respond to the Covid-19 pandemic?
(b) How did the European Central Bank adjust the deposit facility rate in response to the European debt
crisis? Does this reflect expansionary or contractionary monetary policy? In late 2014 the European
Central Bank intensified their monetary policy by buying large amounts of government bonds (the so-
called quantitative easing). Doe these asset purchases reflect expansionary or contractionary monetary
policy?
(c) When comparing the fiscal and monetary policy between 2012 and 2019, would you say this is a
consistent or inconsistent policy mix? If it is inconsistent, why would officials in the European Union
have chosen to implement it?
(d) According to the graph the output gap was negative up until 2016 meaning that the the euro area
economy did not grow enough for a long time after the financial crisis and during the European debt
crisis. As a policy maker, would you have implemented a different fiscal or monetary policy that could
have increased output as a direct effect (and hence allowed for a faster recovery from the crisis)? Refer
to Table 17.1 of the slides/textbook to explain your policy.
(e) Looking at the fiscal and monetary response to the Covid-19 pandemic, would you say that the policy
mix is consistent?
(f) Read the article ”Can the European Union learn from its fiscal mistakes?”. (Click on the title to access
the article. If you have trouble accessing the link (via NYU library services) you also find a copy in
the weekly readings.) Answer the following questions: Note: In the article the authors refer to the
euro-zone crisis, which is equivalent to what we called the European debt crisis so far.
(i) The European Commission has increased its growth forecast for 2021 and 2022. What reason
does the Commission provide? Is the EU’s GDP expected to have recovered from the pandemic
soon?
(ii) Mario Draghi took office of the ECB in 2011. What famous quote characterizes his time at the
ECB? What was this supposed to signal?
(iii) At one point the authors refer to the example of Greece. How was Greece expected to respond to
the crisis ten years ago? Do the authors think the response was successful?
(iv) Are the authors optimistic that the EU can deal with future crisis more adequately? Use a
maximum of three sentences to explain your impression.
(g) In May 2021 Mario Draghi, former president of the ECB and now prime minister of Italy, said about
the response to the Covid-19 pandemic: ”Monetary policy will continue to remain expansionary [...].
We, and also all Europeans, will only get out from this situation of high debt through higher growth.
Restrictive fiscal policies are unthinkable.” (Financial Times, 2021).
Is his opinion on the optimal response to the current recession in line with the theory discussed in
class? Refer to Table 17.1 of the slides/textbook to explain your reasoning.
Solution. (a) From the graph on the EA’s budget balance we can see that the budget balance was negative
from 2009 to 2011. A negative budget balance means that the governments spent more than they
received in revenues. The fiscal policy was expansionary during that time. However, from 2011 fiscal
policies were contractionary until the end of the European debt crisis. Governments spent less than
they received.
During the Covid-19 crisis, the EA’s fiscal policy response was very expansionary. [3pts]
(b) The ECB decreased the deposit facility rate towards the ”zero lower bound”. This reflects expansion-
ary monetary policy. Lower interest rates allow consumers and firms to borrow money cheaply and,
therefore, increase output due to larger investment and consumption.
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Also the asset purchasing program (quantitative easing) reflects expansionary monetary policy. As
the ECB was already charging negative interest rates (-0.5%), the asset purchasing program amplified
the expansionary monetary response to the European debt crisis. By buying government bonds, the
central bank ”injects” money into the economy which in turn increases investment and consumption
and, hence, GDP. [3pt]
(c) While the ECB engaged in expansionary policy, EA countries engaged in contractionary fiscal policy.
This is an inconsistent policy mix. The effects of such policies can be ambiguous. In the European
Union, the central bank and the government are independent from each other. Hence, it is difficult
to align policies when different opinions on the right response are present (e.g. the austerity debate
during the European debt crisis). [3pt]
(d) An expansionary fiscal policy would have been more promising to boost the economy immediately.
According to Table 17.1 both an expansionary fiscal and monetary policy increase the equilibrium
output as a direct effect. This could have helped to recover from the crisis faster. [3pt]
(e) Both monetary and fiscal policy are expansionary. Hence, the policy mix is consistent. [2pt]
(f) [8pt]
(i) One reason is the €750bn recovery fund. The fund has been one of the fiscal tools to implement
expansionary policy. At the end of this year, the EU could be back at its pre-pandemic level.
(ii) ”Whatever it takes”. Through this sentence, he credibly communicated to markets that the ECB
will use the entire toolbox of monetary policy to respond to the crisis.
(iii) Greece was supposed to implement austerity measures i.e. reduce their government spending.
Especially countries like Germany put pressure on the Greek government (”During the previous
crisis common debt was suggested as a necessary step to guarantee the future of the euro, only to
be dismissed by the likes of Angela Merkel, Germany’s chancellor”). This reflects a contractionary
response to the crisis.
The authors say that the approach failed both to reduce debt and to increase output.
(iv) Yes, the authors are optimistic. The political environment in Europe has changed such that fiscal
rules could be relaxed and countries are allowed to engage in more expansionary fiscal policies.
However, the author also see that the recovery fund that helped to issue more debt for fiscal
spending may not be turned into a permanent one, which could set up a ”needless drama about
rebuilding it in the next crisis”.
(g) Yes, he thinks that fiscal policy and monetary policy should be consistent. According to Table 17.1,
both policies can only foster growth when they are expansionary. [2pt]
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Problem 5. Fixed Exchange Rate Regimes [17pts]
Read the article ”Making sense of West Africa’s new currency”. (Click on the title to access the article.
If you have trouble accessing the link (via NYU library services) you also find a copy in the weekly readings.)
(a) Gather some background information. In the first paragraph of the article, the authors introduce ”the
West African and Central African CFA francs, two monetary unions pegged to the euro”. Look up
(i.e. on the Internet) what countries belong to the West African monetary union and what countries
belong to the Central African monetary union. What are their respective ISO currency codes? At
what exchange rate is the CFA franc pegged to the Euro?
(b) The CFA will be replaced by the ECO. What is the connotation of the CFA that the countries want
to get rid off?
(c) How is France continuing to support the ECO peg to the Euro?
(d) What are the described limits on monetary sovereignty when member states want to maintain the
ECO’s peg to the Euro?
(e) What has been (and will still be) the main reason to peg the CFA/ECO to the Euro?
(f) Explain what is meant by the trilemma. Which of the three policy parts that the trilemma is composed
of are the CFA countries willing to give up?
Solution. (a) West African (XOF): Benin, Burkina Faso, Guinea-Bissau, Ivory Coast, Mali, Niger, Senegal,
Togo
Central African (XAF): Cameroon, Central African Republic, Chad, Congo-Brazzaville, Equatorial
Guinea, Gabon
1 euro = 655.957 CFA franc (XOF and XAF have the same exchange rate) [5pt]
(b) CFA is a French acronym for ”French Colonies of Africa”. By getting rid of the cfa, the countries want
to overcome the colonial ties with France. [2pt]
(c) France, in effect, promises to make unlimited transfers from the French treasury if the eco comes under
speculative attack. [2pt]
(d) It is hardly possible to decrease interest rates if needed, as capital would leave to Europe and in order
to maintain the peg the central bank would need to sell a lot of reserves, but eventually it would either
have to raise interest rates or let the exchange rate slide. [3pt]
(e) The peg is, in effect, a commitment to track the anti-inflationary stance of the European Central Bank.
This has produced benefits: inflation has been much lower in Ivory Coast, which uses the CFA franc,
than in neighbouring Ghana, which does not. [2pt]
(f) The trilemma describes the incompatibility of the three policies: perfect capital mobility, fixed exchange
rates, and an effective monetary policy. The cfa countries give up the effective monetary policy as part
(d) showed. [3pt]
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Problem 6. Gold Standard - True or False? [7pts]
Are the following statements about the gold standard true or false? Correct the statement if it is false.
(a) With the gold standard, a balance of payments deficit would lead to inflows of gold.
(b) If a country had a balance of payments imbalance at the current fixed exchange rate, the gold standard
system would automatically set into motion an adjustment process to correct the imbalance. For
example, suppose that a country had a balance of payments deficit at the current fixed exchange rate.
This imbalance in the foreign exchange market would be corrected by gold outflows from the country
to the rest of the world. This exportation of gold would cause a decline in the country’s monetary
base and money supply. Domestic interest rates would decrease and aggregate demand would increase
causing an increase in real GDP and the price level.
Solution. (a) False.
Either: With the gold standard, a balance of payments deficit would lead to outflows of gold.
Or: With the gold standard, a balance of payments surplus would lead to inflows of gold. [3pt]
(b) False.
Domestic interest rates would increase and aggregate demand would decline causing a decrease in real
GDP and the price level. [4pt]