Economics 161 — Spring 2010International Integration of Latin American EconomiesReview Sheet 3: Financial Crisesand Policy Responses in Latin AmericaMay 20, 2010Instructor: Marc-Andreas MuendlerE-mail: [email protected] Sovereign RiskExplain why higher default risk increases the interest are. Provide a numericalexample to illustrate your verbal explanation.Explain in words the moral hazard problem associated with internationaldebt service and default. Distinguish between ability and willingness to re-pay and explain two scenarios under which lacking willingness to repay can beconcealed as lacking ability.2 Quantity Theory of MoneyExplain why the Quantity Theory of Money implies that the annual rate ofinflation equals the annual rate of money growth. What is required of outputand the velocity of money (the value of transactions per unit of currency) sothat the annual rate of inflation equals the annual rate of money growth?Suppose the foreign country does not change its money supply so that it haszero inflation. Explain why, under this scenario, the annual rate of deprecationof the home currency also equals the annual rate of money growth. Finally,suppose the foreign country change its money supply with a constant growthrate. Explain why, under this final scenario, the annual rate of deprecationof the home currency equals the annual rate of money growth in the homeeconomy less the annual rate of money growth in the foreign economy (theinflation differential).3 Bond Values, Yields and Interest RatesSuppose a 1 dollar bond with 1 year maturity has a 1 dollar face value and istrading at a 33 percent discount. What is the cost of the bond? The contractualinterest rate is 8 percent. What is the effective nominal yield on the bond?What is the real yield on the bond for a domestic resident who cares onlyabout domestic inflation? What is the real yield on the bond for a foreign resi-dent who only cares about exchange rate depreciation (devaluation), regarding1inflation in the investor’s home country as close to zero? What is the real yieldon the bond for a foreign resident who cares about both exchange rate deprecia-tion (devaluation) and inflation in the investor’s home country? Does domesticmonetary policy affect real returns for domestic and foreign investors in thesame way?4 Debt Laffer CurveThe market prize of Mexico’s debt is equal to the average market value, andbelow face value. Would you recommend a debt buyback at the market price?Why or why not? For what set of countries would you recommend debt forgive-ness? Why? Use the Debt Laffer curve to substantiate your verbal explanation.5 Current Account AdjustmentState the main trade-related components of the current account balance and howthey respond to the exchange-rate adjusted terms-of-trade. Distinguish betweenvolume and value effects. State the Marshall-Lerner condition for a country’sexchange-rate adjusted terms of trade. If the value effect dominates the volumeeffects, how will the current account balance respond to a devaluation? If volumeeffects dominate the value effect, how will the current account balance respondto a devaluation? Suppose the value effect dominates initially but volume effectsbecome increasingly important and finally dominate. Depict the time patternof the current account