Appendix A

Sample examination paper

Important note: This Sample examination paper reflects the examination and assessment
arrangements for this course in the academic year 2015–2016. The format and structure of the
examination may have changed since the publication of this subject guide. You can find the
most recent examination papers on the VLE where all changes to the format of the
examination are posted.
Time allowed: three hours.
Candidates should answer FOUR of the following TEN questions: QUESTION 1 of Section A
(40 marks), and THREE questions from Section B (20 marks each). Candidates are strongly
advised to divide their time accordingly.
SECTION A Answer all parts of Question 1 (40 marks in total).

1. Consider the following market for the homogenous good, rice, in Home country: The
country’s demand curve for rice is: DH = 27 − 0.75PH , where DH is domestic quantity of
rice demanded and PH is the domestic price of rice. The country’s supply for rice is:
QH = −6 + 0.75PH , where QH is the domestic quantity of rice supplied and PH is the
domestic price of rice.
(a) Determine home import demand for rice. (2 marks)
(b) Let Foreign export supply be defined as the difference between supply (QF ) and
demand (DF ) in the foreign country: (QF − DF ) = −3 + 1.5PF , where PF is the
domestic price of the homogenous good. Find the world’s free trade equilibrium
price and the equilibrium level of Foreign exports. Find also Home consumer’s
surplus and Home producer’s surplus. (3 marks)
(c) Suppose the government in the home country decides to introduce an import quota
q. Let q = 9. What is the import tariff that is equivalent to the quota in terms of its
effects on home imports? (4 marks)
(d) Let the Home country be a big country. What is the new world market clearing price
after Home introduces a tariff t = 4? Draw a diagram for the home country, the
foreign country and the market clearing for import and export market. Does the
introduction of the tariff improve the welfare of Home country? (6 marks)
(e) Suppose now that the big Home country also produces manufactures. Use a general
equilibrium diagram to describe the welfare implications of the introduction of the
tariff on the imported goods. (5 marks)
Consider a small open economy that is pegging its exchange rate by intervening in the
foreign exchange market if necessary; however, the domestic central bank keeps
expanding the domestic credit component of money supply at a constant rate, µ. In the
case of a speculative attack on the currency, the central bank will deplete all its foreign
reserves (and will not replenish them) and will let the currency float from then onwards.

229
A. Sample examination paper

There is perfect capital mobility and output is fixed in both countries, the foreign interest
rate, i∗ is assumed to be zero. Also assume that purchasing power parity holds and that
the log of real money demand depends linearly on the nominal interest rate.
(f) Impose the equilibrium condition in the money market to determine the relationship
between the nominal exchange rate, foreign reserves and the domestic credit
component of money supply. (5 marks)
(g) Define the shadow exchange rate. What is its evolution? (3 marks)
(h) When will investors attack the fixed exchange rate regime? Draw a graph with the
evolution of the shadow exchange rate, the currency peg, s, and the level of the
foreign reserves in a diagram on which you put time on the horizontal axis. Discuss
the path the exchange rate will follow. (5 marks)
(i) Is the above model a good description of the ERM crisis in 1992? If yes, explain
why; if not, give an explanation of the ERM crisis. (5 marks)
(j) Suppose now that the central bank can credibly commit to stop increasing the
domestic component of the money supply when foreign reserves hit the lower bound
(F t = 0). Is the peg sustainable under this new policy? Explain.
(2 marks)
SECTION B Answer any THREE questions (20 marks per question).
2. Consider the neoclassical model of trade with two countries, two goods and two factors
of production. Markets are perfectly competitive. Use a general equilibrium diagram to
examine whether an import subsidy can improve welfare for a large country. Explain the
economic intuition of your answer.

3. Consider the specific factor model for a small open economy. There is a mobile factor,
labour, and two short-run sector-specific types of capital K1 and K2 . Discuss the short run
implications of an increase in labour endowment L on the allocation of the three
production factors across sectors. Suppose that in the long run K1 and K2 are freely
mobile across sectors. What is the long-run effect of the increase in L on the allocation of
the three production factors?

4. Find a combination of domestic policies reproducing the effects of an export subsidy in a

5. Are there any arguments in favour of trade protection? Do these arguments change for
small and big countries? Do differences in competitive situations lead to different
strategic policy prescriptions? If protection from trade is bad, why are trade restrictive
policies so widespread?

6. Despite having observed the depreciation of some currency (both in real and nominal
terms), the trade balance and the current account of that country have failed to improve in
the short-run. What could be possible explanations for such patterns?

7. People sometimes talk about ‘twin deficits’, where the twins are the current account and
the government budget deficit. Explain how these two deficits are related economically so
that changes in one are reflected in changes in the other.

230
 8. Show how, in the flexible-price monetary model, the exchange rate can be expressed as a
function of expectations about future fundamentals. What will happen to the exchange
rate if people’s expectations of future income decreases? What will happen to the
exchange rate if people’s expectations of future money supply decrease? (Try to show
mathematically and explain the intuition.)

9. East Asian countries have accumulated very large stocks of foreign exchange reserves in
the past decade. Explain why, in the context of a first generation model of currency
crises, countries would like to have a large stock of foreign exchange reserves.

10. Explain why fiscal policy is more effective under fixed exchange rates than floating, and
explain why monetary policy is more effective under floating exchange rates than fixed.
(Note: You are expected to provide a graphical analysis as well as an explanation.)

END OF PAPER

231