Candidates are advised that the examiners attach considerable importance

to the clarity with which answers are expressed

Answer 2 out of 3 questions in Section A

and ALL questions in Section B

Typed responses must be submitted to all questions

Graphs drawn by hand and scanned can be submitted, but graphs

drawn electronically are preferable

CONTINUED OVER

1 of 5

Section A

Questions (10 points each; total: 20 points)

Answer succinctly (in no more than 150 words each) two of the following three

questions. All answers must be written in complete sentences. Do a word count and indicate

the number of words after each answer.

Question A1. What are the benefits, in terms of the efficiency of financial intermediation,

associated with banking globalisation?

Question A2. Explain the financial trilemma. How can countries avoid a regulatory war?

Provide an example.

Question A3. Explain how budget deficits, financed by public borrowing, may create a negative

cross-border externality which in turn may hamper international fiscal coordination.

Section B

Problem (60 points)

Answer all questions clearly and succinctly.

Consider a small open economy producing a (composite) good which is an imperfect

substitute for a foreign good. There are five categories of agents: firms, households, commercial

banks, the central bank, and the government. The world price of the foreign good is taken as

exogenous and normalized to unity. The nominal exchange rate, E, is flexible.

The supply of the domestic good is given by

(1) Ys

= Ys

(PD

),

where PD

is the price of the domestic good and Ys

′ = dYs

/dPD

> 0.

Investment, I, is financed by bank loans and is defined as

(2) I = I(iL

),

where iL

is the loan rate and I′ < 0.

CONTINUED OVER

2 of 5

Households hold three categories of assets: domestic currency (which bears no interest),

deposits with banks, and foreign-currency deposits abroad. All assets are imperfect substitutes.

Household financial wealth, FH

, is defined as:

(3) FH

= M + D + ED*,

where M is currency holdings, and D (respectively, D*) domestic (respectively, foreign) bank

deposits. Equivalently

The demand for deposits is

(4) D/M = v(iD

),

where iD

is the interest rate on domestic deposits, and v′ > 0.

The deposit ratio depends on the interest rate differential:

(5) ED*/D = (iD

– iW),

where iW is the interest rate on foreign deposits, and ′ < 0.

Question B1 [8 points]

B1-1: Using equations (3), (4), and (5), and assuming that D*0 = 0, solve for the foreigncurrency value of the demand for foreign deposits as a function D*() of the price of the domestic

good, PD

, the real exchange rate, z = E/PD

, the domestic deposit rate, iD

, and the world interest

rate, iW. [4pts]

B1-2: Calculate and explain the sign of the partial derivatives of that function with respect to

all its determinants. What is the condition needed to ensure that D*i

D

= D*/i

D

< 0? [4pts]

NOTE: in deriving D*(), do NOT start by deriving the demand for domestic deposits.

Write the equation for the foreign-currency value of foreign deposits, D*, as

equation (6).

Consumption spending by households, C, depends on factor income, interest rates, and

wealth:

(7) C = 1Y

s

– 2(iD

+ iW) + 3(FH

0/PD

),

where 0 < 1 < 1, 2, 3 > 0.

The balance sheet of commercial banks is

CONTINUED OVER

3 of 5

(8) L = D + LB

,

where L = PD

I denotes loans to firms, and LB

borrowing from the central bank.

The interest rate on domestic deposits is

(9) iD

= iR

,

where iR

is the cost of borrowing from the central bank, or the refinance rate.

The interest rate on loans is

(10) iL

= iR

+ ,

where is a risk premium, defined as

(11) = (PDK0 – L0),

where L0 is beginning-of-period loans and ′ 0.

The equilibrium condition of the market for domestic goods is

(12) Ys

– X(z, YW) = (1 – )C + I + G,

where G is government spending, X exports, z the real exchange rate (defined such that an

increase is a depreciation), Xz, XY

w

> 0, and 0 < < 1 is the fixed fraction of total consumption

which is spent on imported goods.

Question B2 [9 points]

B2-1. Using equations (1) to (12), as needed, derive the financial equilibrium and the goods

market equilibrium conditions of the model, and combine them to establish the internal balance

condition as a function FG() relating z to PD

, G, iR

, and YW. [5pts]

B2-2. Explain intuitively the signs of each partial derivative of FG(). [4pts]

The equilibrium condition of the market for foreign exchange is given by

(13) z-1 [X(z; YW) – C] + (1+iW)D*0 – (D* – D*0) = 0.

Question B3 [9 points]

B3-1. Using equations (1) to (13), as needed, and setting again D*0 = 0, derive the external

balance condition as a function XX() relating z to PD

, G, iR

, and YW. [5pts]

CONTINUED OVER

4 of 5

B3-2. Explain intuitively the signs of each partial derivative of XX(). [4pts]

Suppose that an economic expansion abroad raises foreign output, YW.

Question B4 [5 points]. Examine, analytically and graphically, the macroeconomic effects of

the increase in foreign output, and show that in the new equilibrium domestic prices can be either

higher or lower than at the initial equilibrium.

Let E′ denote the new equilibrium point (after the increase in foreign output)

characterized by higher domestic prices. Suppose that the government would like to bring the

economy back to its original equilibrium position (before the shock), point E.

The central bank imposes reserve requirements at the rate 0 < < 1 on bank deposits; as

a result, the deposit rate is now determined by, instead of (9),

(9′) iD

= (1 – )iR

.

Question B5 [12 points]

B5-1. Using equation (9′), and in the general case where 2 > 0 in equation (7), explain how

the structure of the model is affected and write the partial derivatives of FG() and XX() with

respect to using results from your answers to B1, B2, and B3. [6pts]

B5-2. Analyse, graphically only, the impact of an increase in the required reserve ratio, , on

macroeconomic equilibrium. Explain movements in curves FG and XX, if any, and describe the

transition from the initial equilibrium to the new equilibrium. [6pts]

Question B6 [17 points]

B6-1. Study, graphically only, if an increase or a decrease in the refinance rate, iR

, can bring

the economy from point E′ back to point E. Either way, explain why. [5pts]

B6-2. Study, graphically only, if an increase or a decrease in government spending, G, can

bring the economy from point E′ back to point E. Either way, explain why. [5pts]

B6-3. Study, graphically only, if the combination of an increase or a decrease in the refinance

rate, iR

, and an increase or a decrease in government spending, G, can bring the economy from

point E′ back to point E. Either way, explain why. [5pts]

B6-4. What is the fundamental reason why monetary policy by itself, or fiscal policy by

itself, may or may not be able to bring the economy from point E′ back to point E? [2pts]

NOTE: in answering B6-1 to B6-3, use different colors to illustrate the shifts, if any, in FG

and XX associated with the policy change(s) under consideration.

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