Finance 410 Spring 2021 Midterm
Multiple Choice/Short Answer (11 points)
1. A country with a fixed exchange rate faces:
a. No monetary policy constraints in the long-run.
b. No monetary policy constraints in the short-run.
c. No monetary policy constraints in the long-run and short run.
d. Monetary policy constraints in the long-run and the short run.
2. The real exchange rate between two currencies tells us:
a. changes in the exchange rate over time.
b. how many units of one currency can be purchased with one unit of the home currency.
c. how much in terms of goods and services the home currency will buy in the foreign nation
compared to the home nation.
d. how much depreciation or appreciation has occurred in the home exchange rate.
3. Purchasing power parity may not hold because of:
a. transactions costs.
b. non-traded goods
c. taxes.
d. all of the above.
4. Estimate a nominal effective exchange rate for the UK for the years 2020 and 2021 (use
January 31st for both years as your exchange rate). Interpret your results. Assume the
following trade shares and exchange rates for the UK: (5 points)
Country Share of Trade $ per FX 2019 £ per FX 2020
France 30% 0.9271 0.7892
Canada 15% 0.0783 0.0368
US 35% 0.2608 0.2522
Japan 29% 0.0090 0.0097
Country Share of
Trade
$ per FX in
2020
£ per FX in
2021
France 30% 0.9271 0.7892


Canada 15% 0.0783 0.0368
US 35% 0.2608 0.2522
Japan 29% 0.009 0.0097
Average 0.383765 0.333363
Essay Questions (89 points)
1. Explain the policy trilemma and give examples. (10 points)
Policy trilemma is also known as the unholy trinity of international finance. The policy trilemma explains
that the country has three policy options. Nevertheless, the country can select two out of the three.
These options are:
1) Fixed exchange rate
2) Open capital markets
3) Independent monetary policy
A country like Hong Kong, has a fixed exchange rate to the US Dollar and also has an open capital
markets. With the two, the country cannot have an independent monetary policy. The Independent
monetary policy means that Hong Kong would print money to help stimulate the economy when they
are facing recession. In addition, they cannot print money with a fixed exchange rate.
United States on the other hand open capital markets and independent monetary policy. This would
mean that the United States would not have a fixed exchange rate. They can increase the money supply
when the market requires them to do so.
2. Using the money market and FX diagrams, please graph and explain the following. The US is the
home country. (15 points)
a) Temporary decrease in the US money supply. Discuss the impact on the US interest rate, Euro
interest rate, and the future expected exchange rate. (5 points)
A rise in foreign interest rates.
There is a rise in domestic interest rates.


ER
DR2
DR1
FR1
E2 E1 Exchange Rate
A decrease in money supply will increase the demand and increase in interest rate. This will also increase
the exchange rate as a result in decreased supply and increase in demand
b) Expected increase in the US dollar/euro exchange rate. (5 points)
ER
DR1
FR2 FR1
E2 E1 Exchange Rate
Because there is an expected appreciation of the US dollar, the FR curve shifts to the left. The dollar
appreciates against the euro as shown by the movement of the exchange rate from E1 to E2. The
domestic return line stays the same.
c) A decrease in foreign interest rates. (5 points)


ER
DR1
FR2 FR1
E2 E1 Exchange Rate
A fall in the foreign interest rate shifts the foreign return line to the left. Since the foreign return is lower,
investors are going to chase the higher yield. The demand for the foreign currency lowers as shown by a
move of the equilibrium exchange rate from E1 to E2.
3. Use the monetary approach to answer the following questions. Suppose that Mexico is the home
country and Spain is the foreign country. (12 points)
a. What is the expected depreciation rate of the Mexican peso if money growth is 11% in Mexico
and 8% in Spain? Assume that both countries have zero economic growth. (3 points)
Dep Rate of Arg. Peso = (11%)-(8%)
Dep Rate of Arg. Peso = 3%
b. Money growth is 6% in Mexico and 9% percent in Spain. What is the depreciation rate of the
Mexican peso assuming that both countries have no economic growth? (3 points)
Dep Rate of Arg. Peso = (6%)-(9%)
Dep Rate of Arg. Peso = -3%
c. Money growth is 2% in Mexico and output growth is 5% in Mexico. Spain has money growth of
6% and output growth of 8%. What is the depreciation rate of the Mexican peso? (3 points)
Dep Rate of Arg. Peso = (2%-5%) - (6%-8%)
Dep Rate of Arg. Peso = (-7%) - (-2%) =-5%
d. Money growth is 0% in Mexico and Spain. Output growth is 7% in Mexico and 3% in Spain.
What is the depreciation rate for the Mexican peso? (3 points)
Dep Rate of Arg. Peso = (0%-7%) - (0%-3%)


Dep Rate of Arg. Peso = (-7%) - (-3%) =-4%
4. Answer the following questions about the Big Mac. (12 points)
a. What is the law of one price? (3 points)
he law of one price is an economic concept that states that the price of an identical asset or
commodity will have the same price globally
b. Below gives the cost of a Big Mac in local currency. Use the information below to compute the
implied exchange rate using the US dollar as the foreign currency. (4 points)
Canada 4 Canadian dollars
Mexico 8 pesos
Switzerland 12 francs
US 4$
Canadian Dollar/US= 4 Canadian Dollar/US Dollar
Peso/US= 8 Peso/1 US Dollars
Francs/US = 12 Franc/1 US Dollars
c. Use the actual exchange rates (see below) to compute the percent by which the currencies above
are over or undervalued against the US dollar. Which currency would you invest in and why? (5
points)
Canada$/US$=2
Mexican Peso/US$=4
Swiss franc/US$=9
The Canadian Dollar is undervalued
5. Answer the following questions about nominal anchors. Suppose that you have been hired as a
consultant for Guam, an island in the Pacific Ocean, which recently became independent from the
US. You have been asked to write a report on the three different nominal anchors:1) exchange rate
targeting, 2) money supply targeting, and 3) inflation targeting through interest rate targeting.
Please explain and give numerical examples for each of the three different policy rules. Also
explain which policy you think would be best for Guam. (15 points)
Monetary policy is the policy that is maintained by a government so as to control the exchange rates of its
currency. The nominal anchors that can be used are the exchange rate targeting, money supply targeting
and the inflation targeting through interest rate targeting. The exchange rate targeting is more or less a
fixed exchange rate where the government tries to maintain a fixed exchange rate. On the other hand, the
money supply targeting is level at which a particular government would want to have the target on the


money supply in the market. This would involve the ability of the government to print more money to
supply the market. The inflation rate target are where the government would want to maintain a fixed
interest rate for the borrowing. All the three nominal anchors limit the ability of the market to be
influenced by the market forces to determine the equilibrium. The exchange rate targeting keeps the
inflation under control.
Exchange rate targeting: Domestic inflation = Exchange rate dep + foreign inflation (inflation of the
country you peg to). Here the depreciation is set to 0. This would translate to inflation rate being equal
to the anchor country inflation rate.
If exchange rate depreciation equals 0, then domestic inflation equals foreign inflation 3%= 3%
Money supply targeting. This is calculated as MV=PY where m=p+y and p=m-y
With y=6% and 3% inflation thus the m=9%. So the money growth is set to equal to 9%
Interest rate targeting – inflation rate targeting through the interest rate. In the Real world interest
r=2%. If one would want a 4% inflation rate then i = r + inflation and thus 6%=2%+4%. The target interest
rate would be 6%


Of the three the Inflation targeting increases accountability, which helps the time-inconsistency trap (in
which the central bank tries to expand output and employment. Inflation targeting is more likely to
improve economic performance in countries that choose to have an independent domestic monetary
policy. A key advantage of inflation targeting is that it helps to increase the transparency and
accountability, inflation targeting helps promote central bank independence.
6. Use the following information to answer the question on covered interest arbitrage. Suppose that
you are a US investor and you have 1,000 dollars to invest. You can invest in US short term
bonds with a 3 percent interest rate. Alternatively, you can invest in short-term German bonds that
yield 5 percent. The US and German bonds are both risk-free debt instruments. The spot
exchange rate is 1.20 dollars per euro. The one-year forward exchange rate is 1 dollar per euro.
(10 points)
a. What is the gross and net return for the US investors if they invest $1,000 in short-term US
bonds? (2.5 points)
Net return = 3% x 1000 = 300
b. What is the gross and net return for the US investors if they invest $1,000 in short-term German
bonds? (2.5 points)
Net return = 5% x 1000 = 500
c. Is there an arbitrage opportunity? Explain. (2.5)
d. Suppose that the forward rate adjusts so that CIP holds. What should the value of the forward rate
be in long-run equilibrium? Assume that the interest rate for the US and German bonds remains 3
percent for the US and 5 percent for Germany. The spot exchange rate is 1.20 dollars per euro.
(2.5 points)
7. Use the excel file stimulus.xls to examine the impact of the recent trillion dollar stimulus package
passed by the US government. Please estimate the impact of the package on US, Canadian, and Mexican
stocks. The US Senate passed the bill on Saturday, March 6th. Please be sure to include dummy variables
into your regression to capture the impact of the stimulus bill. Then write up a paragraph summarizing
your results in the space below. (15 points)