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1 Continued Overleaf
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2 Continued Overleaf
You must answer ONE question from this section. Answers to each sub-question
should adhere to the reported word limit. Anything you write once you have reached
the word limit will not be marked. All questions are of equal weighting.
Question 1
Suppose that the demand function for real money balances in the domestic country is in logarithmic form as follows:
𝑚𝑑 − 𝑝 = 𝜂𝑦 + 𝛾𝑤 − 𝜎𝑅 , 𝑡𝑡𝑡𝑡𝑡
with 𝜂 > 0, 𝛾 > 0, and 𝜎 > 0. 𝑚𝑑 denotes the logarithm of nominal money demand, 𝑝 the 𝑡𝑡
logarithm of the price level, 𝑦𝑡 the logarithm of real income, 𝑤𝑡 the logarithm of real wealth, and 𝑅𝑡 the nominal interest rate. The corresponding real money demand function in the foreign country is as follows:
𝑚𝑑∗ −𝑝∗ =𝜂𝑦∗ +𝛾𝑤∗ −𝜎𝑅∗, 𝑡𝑡𝑡𝑡𝑡
where * denotes magnitudes in the foreign country.
Using the flexible-price monetary model of the exchange rate answer the following questions:
1.1 Show that the current exchange rate of the domestic currency depends on the expected exchange rate. Comment on your findings (maximum 400 words).
1.2 Discuss how changes in the domestic money supply can influence the current exchange rate (maximum 400 words).
1.3 Discuss whether in an economy experiencing very strong economic growth and a persistent current account surplus, and in which the domestic nominal interest rate is equal to the foreign nominal interest rate, it is possible to observe both a higher growth of the domestic nominal money supply relative to the foreign one and an appreciating domestic currency (maximum 700 words).
(20%) (Total 50%)
3 Continued Overleaf
Question 2
In the context of the Dornbusch model of inflexible goods prices and assuming that the foreign nominal interest rate, foreign nominal money supply, foreign goods prices, and foreign real income remain constant, please answer the following questions:
2.1 Assuming in addition that the domestic real income remains constant, discuss what happens to the exchange rate of the domestic currency in both the short-run and the long-run if the domestic central bank decreases the money supply (maximum 600 words).
2.2 Assuming now that the domestic nominal supply remains constant, discuss what happens to the exchange rate of the domestic currency in both the short-run and the long-run if domestic real income increases (maximum 600 words).
Question 3
You must answer ONE question from this section. Answers to each sub-question
should adhere to the reported word limit. Anything you write once you have reached
the word limit will not be marked. All questions are of equal weighting.
Consider a two-country open economy, consisting of United Kingdom (home country) and the United States (foreign country) and answer the following questions:
3.1 Define the Uncovered Interest Rate Parity (UIP) condition by explaining every term and discuss its economic implications. (maximum 500 words)
3.2 Critically evaluate Carry Trade and discuss how it relates to the UIP. (maximum 400 words)
3.3 If the interest rate on UK bonds is 𝑖𝑡 = 4% and the interest rate on US bonds is
𝑖∗ = 2%, discuss the expected exchange rate movements, under which a Carry Trade
strategy would be profitable. (maximum 600 words)
(20%) (Total 50%)
4 Continued Overleaf
(30%) (Total 50%)
Question 4
In the context of Currency Crises answer the following questions:
Define Currency Crises and comment on their frequency. Then present and briefly explain all their different categories. (maximum 450 words)
Critically discuss the ERM (European Exchange Rate Mechanism) Crisis of 1992 and present the sequence of events as it unfolded. (maximum 450 words)
Critically access the role of contagion in the so called “Twin’’ Crises by also providing historical examples. (i.e. jointly financial sector and currency crises) (maximum 600 words)
(20%) (Total 50%)
5 End of Paper
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