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UNIVERSITY OF TORONTO
DEPARTMENT OF ECONOMICS
ECO365 ± INTERNATIONAL MONETARY ECONOMICS
DURATION: 90 MINUTES
MAY 31, 2010
(i) This test should be answered in BALLPOINT PEN and students who attempt the test in pencil would
surrender their right to request for re-assessment.
(ii) Answer ALL questions ONLY in the designated pages. Clearly LABELED the answer to EACH PART
of every question. Make sure your HANDWRITING is LEGIBLE.
(iii) Do NOT SEPARATE any page from this test.
1. Assume there are only two countries in the world, Canada and U.S., and Canada is a small open economy.
At world real interest rate N
4, Canada has positive net capital outflow. Suppose the Canadian government
suddenly runs a huge deficit that results in negative net capital outflow. Use two properly-labeled
diagrams to help you explain (a) the setup of the model and (b) the step-by-step analysis on the impacts of
this huge government deficit through the loanable funds market and the foreign exchange market
according to lecture discussion. (c) What is the relationship between government budget position and the
current account balance?
Diagrams: 6 marks
Explanation: (a) 8 marks; (b) 8 marks; and (c) 4 marks
2. Suppose China only produces T-shirts and U.S. only produces Microsoft Windows. Assume the price of
T-shirt in China is %0;t and the price of Microsoft Windows in U.S. is 75&tw in which these prices will
remain unchanged throughout the analysis. The exchange rate has been fixed by China at %0;tL75&s
for decades regardless of the significant trade surplus that China has accumulated. When these countries
redeem their foreign exchange reserves, their priority would be to get as much domestic output as possible
first and then they would use the remaining foreign exchange reserves to purchase foreign output. On
December 31, 2009, China had 75&vrr in its foreign exchange reserves while U.S. had %0;urr in its
foreign exchange reserves. (a) What was the real purchasing power of the foreign exchange reserves of
these two countries by the end of 2009? (b) Suppose an agreement is reached today (January 1st, 2010)
between U.S. and China to change the exchange rate to %0;sL75&s. How does this change affect the
real purchasing power of the foreign exchange reserves held by these countries? (c) Explain the economic
intuition for the redistribution effect caused by this exchange rate movement through the concept of net
Explanation: (a) 5 marks; (b) 9 marks; and (c) 6 marks