1.(20 marks) Analyze the result of a permanent devaluation by an economy caught in a liquidity trap of the sort described in Chapter 17.


2. (20 marks)Use the DD-AA model to examine the effects of a one-time rise in the foreign price level, P*. If the expected future exchange rate Ee falls immediately in proportion to P* (in line with PPP), show that the exchange rate will also appreciate immediately in proportion to the rise in P*. If the economy is initially in internal and external balance, will its position be disturbed by such a rise in P*?



3. (25 marks) Under the gold standard,  

3.1 We discuss “rules of the game”: The selling of domestic assets to acquire money when gold exited the country as payments for imports. This decreased the money supply and increased interest rates, attracting financial inflows to match a current account deficit.  

Traditionally, central bank cannot affects the interest rate under fixed exchange rate system. However, in the more realistic imperfect asset substitutability framework , the central bank can affect the interest rate level.  

Use a diagram like Figure 18-7 (in our slides) or 18-6 in our textbook to explain how a central bank can alter the domestic interest rate, while holding the exchange rate fixed, under imperfect asset substitutability.


3.2 Suppose we are talking about two large countries, which are macroeconomic interdependent. Now we have . Appendix 1 of Chapter 18 discusses this possibility. 1) Suppose the country UK government issues extra government bond to finance for the military expenditure, what will happened to the premium of holding USD asset. 2) Suppose the Bank of England follows “rules of the game” to buy domestic asset when gold enters the country, what will happened to the premium of holding USD asset.




Q4. (20 marks) Sovereign Debt Default

The Republic of Delinquia has a non-disaster output level of $100 each year. With 10% probability each year, output falls to a disaster level of $80, and the country will feel so much pain that it will default and pay neither principal nor interest on its debts. The country decides to borrow $20 at the start of the year, and keep the money under the mattress. It will default and keep the money in the event that output is low, but this will entail sacrificing $4 in punishment costs. Otherwise, it pays back principal and interest due. Lenders are competitive and understand these risks fully.

a. What is the probability of default in Delinquia?

b. The interest rate on safe loans is 8% per annum, so a safe loan has to pay off 1.08 times $20. What is the lending rate charged by competitive lenders on the risky loan to Delinquia?

c. What does Delinquia consume in disaster years? In non-disaster years?

d. d. Repeat part (c) for the case in which Delinquia cannot borrow. Is Delinquia better off with or without borrowing?





Q5. (15 marks) RMB exchange rate


In the lecture, we introduce an example to show how to determine the RMB central parity rate against USD, after the reform on Aug 2015,  

The parity rate was based on the formula of ‘the closing rate + the theoretical RMB exchange rate to keep the index of a currency basket unchanged over the previous 24 hours’.

a)With the following information provided,  

Initially, we assume that the US dollar/Japanese yen (USDYEN) is 100 and US dollar/Chinese renminbi (USDRMB) is 6.2. Let it to be the base time.


RMB6.2 = US$0.6 + 0.4 × ¥100.

If divided by 6.2, the equation becomes RMB1 = US$0.097 + ¥6.45

renminbi is measured by a basket of two currencies.