INTERNATIONAL ECONOMICS—FINAL EXAM

(3-4 pm, July 19, 2002)

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

l After the exam, model answers will be distributed. The answer sheets will be later returned to the students and the overall results will be posted in the web.

All questions carry an equal weight of 20 points

Q1. Explain the Dutch disease.

Q2. Discuss the two types of dollarization.

Q3. Explain the exit policy problem which Argentina faced recently.

Q4. What is the difference between the liquidity problem and the solvency problem?

Q5. Describe the cause of the capital account crisis that hit East Asia in the late 1990s (see the graph below). What policies are needed to prevent or cope with this kind of crisis?

Model answers

(Other answers are often possible)

Q1. The Dutch disease is a phenomenon in which an expansion of the natural resource sector causes the shrinkage of other tradable industries, typically manufacturing. This happens because limited domestic factors of production (such as labor) are competed away to the resource extraction and nontradable sectors. Another way to look at this is through an overvaluation that reduces the competitiveness of the manufacturing sector. This overvaluation occurs either by domestic inflation (under a fixed exchange rate) or an exchange rate appreciation (under floating).

Q2. Private dollarization is a situation where domestic residents prefer to use US dollars in transactions and asset holding due to the distrust or inconvenience of the domestic currency. By contrast, official dollarization is a policy of the government to use the US dollar as the only legal money for that country. This permits the country to “import” the stability of the American monetary system and save the cost of money issuing. However, it also entails the loss of monetary policy and the lack of “lender-of-last-resort” function in case of a financial crisis.

Q3. The exit policy problem refers to the question of how to get out of exchange rate fixity without a crisis. A fixed exchange rate is often adopted as a means to regain monetary policy credibility after a high inflation or continued depreciation (usually both). But once successful, this policy becomes politically impossible to remove since that will be considered a policy failure. While overvaluation accumulates and the domestic economy loses competitiveness, the restoration of exchange rate flexibility is delayed until it is too late, leading to currency attacks, large deprecation and severe recession.

Q4. The liquidity problem (or illiquidity) is a situation where the borrower is unable to pay back due to cash constraint at present, but can repay later from expected future income. The solvency problem (or insolvency) is a situation where the borrower is unable to pay now or later because he has breached the inter-temporal budget constraint (i.e., borrowed and spent too much already). The proper response to illiquidity is delaying the repayment (debt rescheduling) or providing bridge loans. But for insolvency, canceling part of the past debt becomes necessary. In reality, however, illiquidity and insolvency are often hard to distinguish.

Q5. The capital account crisis is caused by an excessive private capital inflow and its subsequent outflow. Such capital reversal is often driven by herd instinct and/or moral hazard, and triggered by financial opening without proper preparation. To prevent it ex ante, external financial liberalization must be gradual and paced to the speed of domestic bank reform and the building of monitoring capability. Once the crisis occurs, ex post measures such as a rescue package, private sector involvement (foreign investors are asked to partly bear the cost), special credit to offset illiquidity, etc. must be introduced in proper order and amount. Severe macro tightening or bold reforms should not be attempted during this type of crisis.