INTERNATIONAL ECONOMICS—FINAL EXAM

(3-4 pm, July 22, 2005)

Instructor: Professor Kenichi Ohno

l This is a closed book exam. Use your pen and brain only.

l PLEASE WRITE CLEARLY. Poor handwriting will be ignored, resulting in lost points.

l ANSWER ALL QUESTIONS. Use only TWO official answer sheets. Use only FRONT side of each answer sheet. Allocate space carefully.

l Clear and concise answers are preferred. Long answers do not guarantee high points.

l After the exam, model answers will be distributed. Graded exams will be returned to the students a few days later and overall results will be posted in the web.

Answer in any order; each question carries 20 points

Q1. Explain uncovered interest parity (UIP). Does this always hold among advanced economies?

Q2. What is sterilization? Why do some monetary authorities engage in sterilization?

Q3. Explain the syndrome of the ever-higher yen by McKinnon and Ohno (1997).

Q4. List three reasons for the banks’ balance sheet vulnerability at the time of the Asian financial crisis (1997-1998).

Q5. Read the following article by Prof. Kawai and comment on the desirability of adopting a currency basket.

(Note: whether or not you agree with him does not affect your points as long as your idea is consistent. Make sure you answer the question directly instead of discussing other issues.)

Masahiro Kawai (Tokyo Univ. & economic advisor to ADB President) “East Asian Economic Integration and Currency Arrangement,” Japan Economic Journal, July 15, 2005, excerpts:

For mutual currency stability within the East Asian region, each country should stabilize its currency against the G3 currency basket consisting of yen, dollar and euro. Meanwhile, Japan should continue to float the yen against the dollar … The G3 currency basket can also cope effectively with the possible sharp fall of the dollar. As the US continues to have the twin [trade and budget] deficits and the East Asian region continues to accumulate huge international reserves, there will surely be an upward pressure on the East Asian currencies in the future. In that case, they should collectively float upward against the dollar. … For this to work, China’s exchange rate policy must also become more flexible by adopting a similar G3 currency basket. This arrangement will promote mutual stability among the East Asian currencies while they collectively float against the dollar.

Model answers

(Other answers are often possible)

Q1. UIP says that the expected exchange rate change is equal to the interest differential between the two countries in question. For example, if the US interest rate is 5% and the Japanese interest rate is 1%, it is inferred that the market expects the yen to appreciate against the dollar by 4% per year. While capital mobility is high among major industrial countries, UIP does not necessarily hold among them empirically. This is partly due to difficulty in measuring expectations and partly due to large and variable risk premium.

Q2. Sterilization is an operation by the central bank to offset the change in international reserves by selling or buying an equal amount of domestic assets (typically government bonds), thereby keeping the size of the central bank’s liabilities (“monetary base”) constant. This is conducted for the purpose of insulating domestic monetary policy from interventions in the foreign exchange market.

Q3. The yen appreciates against the dollar in the long run due to the special policy configuration between Japan and the US. There is a large bilateral trade “imbalance” (=capital flow) because of Japan’s over-saving and America’s saving shortage. The US tries to reduce this “imbalance” through (i) yen appreciation and (ii) bilateral trade negotiation. This policy is executed every several years which drives the yen higher. Since the saving-investment balances of the two countries basically remain the same, this only destabilizes the Japanese economy without solving the trade gap problem.

Q4. First, there was a currency mismatch in which banks had too much dollar debt compared with dollar assets. This created exchange risk. Second, there was a maturity mismatch in which banks borrowed short from abroad and lent long to domestic borrowers. This led to the liquidity problem when foreign banks refused to rollover the debt. Third, the deep recession and credit crunch associated with the currency crisis turned domestic loans into bad debt. [Other possible answers: high dependency on bank loans (“indirect finance”), moral hazard and overborrowing, and capital liberalization that was too fast.]

Q5. [Different answers are also acceptable] While the currency basket partly offsets shocks associated with the movement of major currencies (such as the dollar’s sharp fall), it is relatively a small part of total instability. There are other large shocks such as domestic inflation, overborrowing, regional currency crisis, political instability, etc. for which the currency basket is useless. Moreover, Kawai’s proposal assumes that floating is highly desirable among major currencies while stability is needed among smaller regional currencies. The reason for this dualism remains unexplained. It may even be argued that currency flexibility is more suitable for small developing countries which are subjected to greater shocks as noted above. An alternative proposal in which currency stability is pursued realistically for both advanced and developing economies should be seriously considered.

[Please also note: Kawai’s article confirms the expectation of long-term appreciation of the yen against the dollar, which is the core assumption of the syndrome of the ever-higher yen.]