30054 International and Monetary Economics (Spring 2022)

Individual Assignment 3

Instructions
When? The deadline to submit your solution is May 4, 2022 (23:59 Milan time).

Where? Upload your solution to the bboard webpage of our class.

What? You can submit your solution in either PDF or DOC format. When drawing
diagrams or writing formulas, you can either use build-in word processing tools
or you can draw diagrams and write formulas by hand, take pictures, and insert
them in your solution.

Who? This is an individual assignment. You must submit an individual solution.

How much? All problems have equal weight of 5 points each. This problem set has a 10%
weight of your final grade.

Be clear. If you make additional assumptions in your solution, state them clearly. Also
when drawing diagrams, clearly label all axes, lines, curves, and equilibrium
points.

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Problem 1

1. What is a currency crisis?

2. What is a self-fulfilling currency crisis?

The rest of the problem asks you to solve a simple model with the following assump-
tions (Hint: this is a 2nd generation model of currency crises that we studied in class).
There are two foreign exchange traders and a domestic central bank. Both traders are
endowed with S units of domestic currency, and the central bank has R units of for-
eign currency in reserves. The two traders can choose one of two actions: hold all
of their domestic currency or sell domestic currency in exchange for foreign currency
(this transaction costs C units of domestic currency). The trades choose their actions
simultaneously in non-coordinated way. The central bank, in turn, keeps its exchange
rate fixed at the level of E, that is, the bank defends the peg, when the demand for
foreign currency by two traders is below the reserves and drops the fixed exchange
rate (in which case the new depreciated exchange rate becomes E0 > E) when the to-
tal demand for foreign currency is equal or exceeds the level of reserves. Note also
that when the total demand for foreign reserves exceeds R and both traders attempt
to convert currencies, each trader only gets R/2 of foreign reserves by paying the cor-
responding amount of domestic currency.

3. Assume that E = 1, E0 = 1.5, S = 6, C = 1, and R = 6. Compute the profit of

(a) both traders choose to hold on to domestic currency;

4. Compute Nash equilibria in the currency crises model under the parameters in
specified above in question 3. Intuitively explain why you obtained such a result.

5. Imagine that the government imposes a tax on currency exchange transactions

Problem 2

1. Read Section “The Theory of Optimum Currency Areas” of Chapter 21 from the
KOM book.

2. Suppose that soon after Norway pegs to the euro, EMU benefits from a favorable
shift in the world demand for non-Norwegian EMU exports. What happens to
the exchange rate of the Norwegian krone against noneuro currencies? How is
Norway affected? How does the size of this effect depend on the volume of trade
between Norway and the euro zone economies?

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Problem 3
In a three-country world, a central bank fixes one exchange rate but lets the others
float.
1. Can it use monetary policy to affect output?
2. Can it fix both exchange rates?

Problem 4
Suppose that a country’s money supply is $1,200 million and its domestic credit (i.e.,
the supply of government bonds) is equal to $800 million in the year 2020. The country
maintains a fixed exchange rate, the central bank monetizes any government budget
deficit, and prices are sticky.
1. Compute total reserves for the year 2020. Illustrate this situation on a central
bank balance sheet diagram.
2. Now, suppose the government unexpectedly runs a $100 million deficit in the
year 2021 and the money supply is unchanged. Illustrate this change on your
diagram. What is the new level of reserves?
3. If the deficit is unexpected, will the central bank be able to defend the fixed ex-
change rate?
4. Suppose the government runs a deficit of $100 million each year from this point
forward. What will eventually happen to the central bank’s reserves?
5. In what year will the central bank be forced to abandon its exchange rate peg
and why? [Assume for this question that government deficit comes as a surprise every
year, that is, no one anticipates it.]
6. What if the future deficits are anticipated? How does your answer to part (5)
change? Explain briefly in words.

Problem 5
Suppose the central bank of a small country with a fixed exchange rate is faced by a
rise in the world interest rate, R∗ .
1. What is the effect on its foreign reserve holdings? On its money supply?
2. Can it offset either of these effects through domestic open-market operations?

Problem 6
Read Barry Eichengreen’s article “The Stable-Coin Myth” (the text of the article is
also posted on blackboard). Write a twitter-length (280 characters max including
spaces) summary of its main message. [If you are interested in learning more about
cryptocurrencies that aim at keeping their values stable, you can watch this video by Gary
Gorton of Yale University or read this paper by Richard K. Lyons and Ganesh
Viswanath-Natra]
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