THE UNIVERSITY OF NEW SOUTH WALES

School of Economics

ECON 3104
Practice Questions
1. The forward contract differs from a futures contract in that:

a. the forward contract is to be settled immediately.

b. the futures contract specifies a fixed amount and arranged date, whereas the
forward contract can be for any amount or date.
c. the futures contract cannot be traded in a market, whereas the forward contract can
be bought in the market.
d. forward contracts are standardized, whereas futures contracts are not standardized.

2. Which of the following situations would be consistent with relative PPP?

a. Europe's yearly inflation rate rises from 5% to 7%, ceteris paribus, and the euro-
yen rate depreciates by 7%.
b. Europe's yearly inflation rate rises from 5% to 7%, ceteris paribus, and the euro-
yen rate depreciates by 2%.
c. Europe's yearly inflation rate rises from 5% to 7%, ceteris paribus, and the euro-
yen rate appreciates by 2%.
d. Europe's yearly inflation rate rises from 5% to 7%, ceteris paribus, and the euro-
yen rate appreciates by 5%.

3. The long-run Fisher effect links rises in inflation with rises in nominal interest rates by
the same proportion, resulting in ____ the demand for real money balances.

a. no effect on
b. an increase in
c. a decrease in
d. an increase in the supply of money offsetting the increase in

4. Suppose domestic interest rates are at 4.55%, while foreign returns are bringing 6.38%
interests. According to the asset approach, if the expected future exchange rate is
three dollars per unit of foreign currency, what can we say about the current spot rate
if UIP holds? (Pick the value that is closest to your calculation.)

a. 2.946
b. 3.056
c. 3.064
d. 2.936.
5. A short-run appreciation of the British pound would be consistent with:

a. a temporary fall in the British money supply.

b. a temporary fall in the European money supply.
c. a temporary rise in the European money supply.
d. either a temporary fall in the British money supply or a temporary rise in the
European money supply.

6. During the period 2001–2004, the U.S. Federal Reserve lowered nominal interest rates
on the dollar by more than the European Central Bank (ECB) did on the euro, a move
that most market participants viewed as temporary. What was the effect on the dollar-
euro exchange rate?

a. The dollar depreciated against the euro.

b. The dollar appreciated against the euro.
c. There was no change in the dollar–euro rate because expectations adjusted.
d. There was no change in the dollar–euro rate because real interest rates were
unchanged.

7. When the exchange rate depreciates in the short run and then appreciates slightly in the
long run, it implies that the foreign money supply has:

a. temporarily risen.
b. permanently risen.
c. temporarily fallen.
d. permanently fallen.

8. Why would lowering its own interest rate affect a nation's exchange rate?

a. International interest arbitrage (the ability to borrow in low-rate markets and

deposit in higher-rate markets) would cause investors to sell domestic currency
assets and purchase foreign assets based in other currencies.
b. A nation's central bank controls both interest rates and exchange rates.
Unfortunately, they do not have sufficient funds to take care of both at the same
time.
c. When interest rates fall, borrowing is cheaper, spending and GDP rise and so do
exports, thus causing the exchange rate to appreciate.
d. In the short run, exchange rates have to adhere to PPP; otherwise, traders will
make profits by purchasing in the cheap market and selling in the more expensive
market, thus aligning exchange rates at the proper level.
 9. When calculating the balance of payments, which of the following would NOT result
in a credit (or [+] entry) being made in the balance of payments accounts?

a. a domestic firm signs a contract to buy half of a foreign company headquartered

overseas
b. there is a trade surplus.
c. a domestic firm sells bonds to a foreign firm.
d. other nations come to the aid of starving residents by gifts of cash, food, and
medicine.

(For Questions 10 and 11 only.) Suppose the aggregate production function takes a Cobb-
Douglas form. That is, , where q is GDP per worker, k is capital per worker, A is the
level of productivity, and θ is the share of capital income. For India and the US, we have the
following information:
0.09, 0.04.
Assume that the share of capital income θ is 1/3 in both countries.

10. What are the implied productivity difference between the two countries, , and
the ratio of marginal product of capital between the two countries, ,
respectively?

a. 0.444; 2.25
b. 0.763; 8.55
c. 0.088; 8.55
d. 0.263; 2.25

11. What would be the output per capita ratio, , if the marginal product of capital
were to equalize in the two countries?

a. 1
b. 0.5
c. 0.444
d. 0.135

12. In an open economy, as long as the long-run budget constraint is upheld, a nation
may:

a. run a trade deficit during temporary shocks and run a trade surplus during
temporary gains in output, keeping consumption stable.
b. save during temporary shocks and borrow during temporary gains.
c. forgo borrowing to maintain financial stability, allowing consumption to fluctuate.
d. save even if it is just a little during each period.
13. If there are diminishing marginal returns to capital, such as postulated in economic
production models, what is the marginal product of capital for low-income nations?

a. Their marginal products of capital are lower than in high-income nations.

b. Their marginal products of capital are higher than in high-income nations.
c. Their marginal products of capital are equal to their marginal products of labor.
d. Their marginal products of labor are increasing, causing labor migration.

14. An increase in the home country's income will result in a(n) _________ in the home
country trade balance, and an increase in foreign income will result in a(n) _________
in the home country trade balance
a. fall; fall
b. increase; increase
c. increase; fall
d. fall; increase

15. Under uncovered interest parity, if the domestic interest rate is greater than the foreign
interest rate, then exchange rates are:
a. expected to rise.
b. expected to stay constant.
c. expected to fall.
d. uncertain.
 Written questions

1. What is a beggar-thy-neighbor policy and why would a country engage in such a policy? (6
marks)

2. What is the Fisher Effect? Explain why and how a permanent increase in the Australian
inflation rate would affect the Australian interest rate (6 marks).

3. Use the IS-LM-FX model to illustrate the effects of the following shock: Government
spending increases. For each of the scenarios (listed below), explain the effect of the shock
on the following variables (increase, decrease, no change, or ambiguous): Y, i, E, C, I, and
TB. (12 marks)

a) Assume the government allows the exchange rate to float and makes no policy
response. For your graphical illustration, use A to denote initial equilibrium and B for
the new equilibrium.

b) Assume the government responds by using monetary policy to stabilize output, unlike
part (a), and assume the exchange rate is floating. For your graphical illustration, use
A to denote initial equilibrium and B for the equilibrium in part (a) and C for the
equilibrium in part (b).

c) Assume the central bank responds in order to maintain a fixed exchange rate, unlike
part (a) and (b). For your graphical illustration, use A to denote initial equilibrium and
B for the equilibrium in part (a) and C for the equilibrium in part (c).