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ECON 345 Study Guide - Midterm Guide: Exchange Rate, Real Interest Rate, Canadian DollarExam

Course Code
ECON 345
Study Guide

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Department of Economics
Econ 345 Prof. Kasa
International Finance Spring 2016
Questions 1-4. Answer True, False, or Uncertain. Briefly explain your answer. No credit
without explanation (10 points each).
1. According to the Balassa-Samuelson theory, rapid productivity growth causes a coun-
try’s real exchange rate to appreciate.
TRUE/UNCERTAIN. Relatively rapid productivity growth that is concentrated in tradeable
goods industries will cause wages to rise in tradeable goods industries. This will then
cause wages to rise in nontradeable goods industries (due to labor mobility), which then
causes prices to rise in nontraded goods industries (due to zero profit constraint).
2. Exansionary monetary policy produces current account deficits.
FALSE/UNCERTAIN. If the Marshall-Lerner condition is satisfied, then expansionary
monetary policy, which depeciates the domestic currency, will produce a current account
surplus. However, if the ML condition is not satisfied, then expansionary monetary
policy could produce a temporary current account deficit.
3. If a country has a current account deficit, then it is borrowing from foreigners.
TRUE/UNCERTAIN. This is true if a country starts from a balanced current account
position (or a deficit). However, if a country already has a positive net foreign asset
position (e.g., China), then a current account deficit can be financed by reducing your
foreign assets, rather than by borrowing.
4. If Canada’s annual interest rate is 5% and the U.S. annual interest rate is 2%, then
investors must be expecting the Canadian dollar to appreciate by 3% during the next
FALSE/UNCERTAIN. If Uncovered Interest Parity holds, then higher Canadian in-
terest rates compensate for the fact that investors expect the C$to depreciate, not
appreciate. Of course, if UIP doesn’t hold, then it is quite possible for rates to be
higher in Canada, while at the same time investors expect the C$to appreciate.
The following questions are short answer. 20 points each.
5. Last year the Canadian economy experienced slow growth and a depreciating currency.
According to the DD-AA model what sort of ‘shocks’ must have been hitting the Cana-
dian economy? Illustrate your answer with a graph. Provide a ‘real world’ example
that might explain these recent observations. Show how macroeconomic policy could
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