Economics 103 — Spring 2010International Monetary RelationsProblem Set 2May 4, 2008Due: Tue May 18, before 12:30pmInstructor: Marc-Andreas MuendlerE-mail: [email protected] The Empirics of Purchasing Power Parity andExchange RatesExamine the MXN/USD (peso-dollar) nominal exchange rate and the ratio ofthe Mexican and the US CPI for the period from February 1993 to December2006. What do you observe? Does absolute or relative PPP seem to hold in thelong term? If not, what might be reasons for failure? Repeat the exercise forthe MXN/USD black-market exchange rate for the period from February 1993to December 1998.You may choose not to print the graphs. In that case, draw the stylizedfigures for your answer.Data. Visit http://www.globalfindata.com/ucsd.php3 and display the nom-inal MXN/USD exchange rate (symbol: MXN D), the MXN/USD black-market exchange rate (symbol: XRMXNBM), the consumer price index in Mex-ico (symbol: CPMEXM), and the consumer price in the US (symbol: CPUSAM).To view a series, enter the according symbol in the “GFD file search” windowin the upper left-hand corner. You may want to download the series into fourseparate spreadsheets, then copy and paste the MXN/USD exchange rate andthe two CPI series into one spreadsheet, and copy and paste the MXN/USDblack-market exchange rate and the two CPI series into another spreadsheet. Toplot the ratio between the Mexican and the US CPI, you can divide the MexicanCPI series by the US series directly (e.g. if the first Mexican CPI observationis in cell b2 in Excel and the first US CPI observation in cell c2, you could usethe formula “=B2/C2” for the current cell on line 2) and then plot the resultingseries by highlighting it and clicking the “Chart Wizard” button on the toolbarabove. Select a line chart and then click the “Next” button. In the followingwindow, select the “Series” tab and use the series of dates in the left column asthe “Category (X) axis labels”.2 The DD-AA ModelSmall open economies tend to spend a larger fraction of income on imports thanlarge economies do. Their import volumes are also more responsive to changes1in their national income. Does this imply that the DD-curve in the Netherlands,a smaller and more open economy than the US, is flatter than the DD-curve inthe US?Hint: Your answer depends on what you assume regarding the current-account responsiveness to the real exchange rate in a small open economy. Usethe “Keynesian cross” to derive your answer.Would a temporary monetary expansion in the Netherlands have a strongeror weaker effect on output? Use an AA-DD diagram to substantiate your answer.3 Import Tariffs and the Current AccountTake a commodity-trade perspective of the current account and suppose restric-tions of import volumes do have an effect on values. The government imposes atariff on all imports. Use the DD-AA model to analyze the effects this measurewould have on the economy. Consider both temporary and permanent tariffs.In question 1 of problem set 1, you were asked to take a purely financial viewof the current account with savings and investment decisions dictated by worldreal interest rates. Under that point of view, your answer was different. Why?4 Monetary and Fiscal Policy under DifferentExchange Rate RegimesShow the effects of a temporary and a permanent monetary contraction on thecurrent account, interest rates and output under a floating exchange rate andunder a fixed exchange rate. Do the two policies have different effects under afixed exchange rate? Why or why not?Show the effects of a temporary and a permanent fiscal expansion on thecurrent account, interest rates and output under a floating exchange rate andunder a fixed exchange rate. Do the two policies have different effects under afixed exchange rate? Why or why not?5 Macroeconomic Analysis and InterventionTake the perspective of a South Korean resident. In particular, let E denotethe KRW/USD (Won-US Dollar) exchange rate so that an elevated E meansa depreciated Won. You observe the following simultaneous macroeconomicdevelopments: A fall in Korean output, an appreciation of the KRW, and a fallin the Korean current account.Which of the following temporary shocks is mostly likely to explain thismacroeconomic pattern: A shock to consumer tastes for Korean goods, a shockto money demand, or a shock to investment? Use the DD-AA-XX model toexplain your answer.2The Korean government wishes to restore output to its level before the shock,while retaining the current account balance as close as possible to its pre-shocklevel. Would you recommend monetary or fiscal intervention? What is theeffect of your policy on the KRW exchange rate? Use the DD-AA-XX model tosubstantiate your answer.6 Money Supply, Imperfect Asset Substitutabil-ity and the Nominal Exchange RateThe Adjusted Uncovered Interest Condition can be expressed asR = R∗+Ee−EE+ ρ,where ρ is the risk premium of domestic bonds over foreign bonds. How does anincreased supply of domestic bonds to the private sector affect the risk premiumρ? Redraw the foreign exchange equilibrium diagram, showing the exchangerate and the expected currency returns, under the Adjusted Uncovered InterestCondition.The Federal Reserve System increases aggregate money supply permanently,purchasing domestic bonds in the open market. Use diagrams showing theexchange rate, expected currency returns and money holdings to analyze theshort-term and the long-term effects on the US interest rate, the US price leveland the nominal exchange rate. Compare your answer to question 6 of problemset 1.Hint: Effects on the risk premium are small in practice compared to theFisher