INTERNATIONAL ECONOMICS—FINAL EXAM

(1-2 pm, September 12, 2000)

Instructor: Professor Kenichi Ohno

l PLEASE WRITE CLEARLY. Bad handwriting will be ignored and you will get no points.

l Answer ALL questions. Answer in any order. Use only TWO official answer sheets. Use only FRONT side of each answer sheet.

l ALLOCATE SPACE CAREFULLY. Answer clearly and concisely. Long answers do not guarantee high marks.

l Prohibited: books, lecture notes, handouts, assigned papers, etc. should not be used.

l After the exam, model answers will be distributed.

Q1. Explain the “Dutch disease.” (15 POINTS)

Q2. Explain the “Balassa-Samuelson effect.” (15 POINTS)

Q3. What is a “currency board”? What are its merits and demerits? (15 POINTS)

Q4. Explain the difference between the first generation and the second generation models of currency crisis. (15 POINTS)

Q5. McKinnon and Pill (American Economic Review, May 1997) argue that the combination of moral hazard and financial opening creates overborrowing. Explain “moral hazard,” and describe how it leads to overborrowing. (20 POINTS)

Q6. Describe the exchange rate management of YOUR country. How do you characterize it—free float, dollar peg, basket peg, currency union, managed float, etc.—and what are the problems, if any? (20 POINTS)

Model answers

(Other answers are often possible)

Q1. A rapid expansion of the natural resource sector and the resulting shrinkage of other tradable industries (typically manufacturing). This occurs through overvaluation caused either by domestic inflation (under a fixed exchange rate) or an exchange rate appreciation (under floating).

Q2. Diverging trends in tradable prices (say, WPI) and nontradable prices (say, CPI) due to different productivity growth in the two sectors. In a rapidly industrializing economy, the tradable sector enjoys higher productivity growth than the nontradable sector. As a result, CPI tends to rise faster than WPI.

Q3. An arrangement where the monetary authority issues domestic currency (base money) only against the equal holding of international reserves (no domestic credit to the government or commercial banks). This removes the discretionary power of the monetary authority. Its merits include greater credibility for convertibility and inflation-fighting. Its demerits are the loss of monetary policy independence and the lack of “lender-of-last-resort” function in the event of a financial crisis.

Q4. In the first generation models, a policy inconsistent with a fixed exchange rate (e.g., large fiscal or monetary expansion) causes a currency crisis. The exact timing of the speculative attack depends on the “shadow” exchange rate, the rate which would prevail if an attack occurs. By contrast, the second generation models argue that speculative attacks may occur even if the policy is basically sound. If there is a trade-off between currency stability and other policy goals (or if other policy nonlinearities exist), solutions with and without attack are both possible. This leads to investor herding, self-fulfilling attack, information cascade, etc.

Q5. Moral hazard refers to the incentive to take excessive risk by insured agents. If commercial banks are protected by the government (explicitly or implicitly) so that they expect to be bailed out in trouble, they will be less careful in making loans and tend to overlend. If the financial market is closed externally, overlending will occur but its extent is limited. But if the economy is financially open, domestic banks can borrow much larger amounts and the problem of overlending is amplified greatly. McKinnon and Pill argue that overborrowing is a natural consequence of an unregulated and externally open financial sector.

Q6. It’s up to you—just be clear, concise and consistent!