Tutorial 3 for 5QQMN937 - Macroeconomics

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Questions and Solutions
Michele Piffer∗

Question 1
The uncovered interest parity states that the equality
Et
(1 + it ) = (1 + iw
t ) e
(1)
Et+1

must hold, with it the domestic nominal interest rate, iw

t the foreign nominal interest
rate, Et the nominal exchange rate (defined as the ratio of units of foreign currency
e
per one unit of domestic currency), and Et+1 the nominal exchange expected at time
t for period t + 1.

a) Suppose iw = 0.02 and Et = 3. Suppose the domestic currency is expected to

(nominally) depreciate by 5%. Compute the effective nominal return that a
domestic resident expects to earn if he invests abroad;

b) suppose instead that the domestic currency does not depreciate by 5% as ex-
pected, but it appreciates by 2%. Compute the effective nominal return that
a domestic resident earns if he invests abroad.

∗
King’s Business School, King’s College London, UK. Email: michele.piffer@kcl.ac.uk, personal
web page: https://sites.google.com/site/michelepiffereconomics/.

1
Question 2
Select the correct words in italics:

A domestic monetary policy expansion takes the form of an increase/a decrease

in the domestic interest rate. This can lead to an increase/a decrease in the cap-
ital account, which is defined as the difference between capital inflows and capital
outflows/capital outflows and capital inflows. In a flexible exchange rate regime,
the change in the capital account can lead to an appreciation/a depreciation of the
domestic currency, which in turn increases/decreases exports, lowering/stimulating
domestic aggregate demand.

Question 3
Select the correct words in italics:

A sudden improvement in the economic prospects of the domestic country can

lead to a capital inflow/capital outflow, which increases/decreases the capital ac-
count. The flow of capital puts pressure on the exchange rate, generating a tendency
for the domestic currency to appreciate/depreciate. In a fixed exchange rate regime,
the domestic central bank must buy/sell foreign assets and increase/decrease the
domestic money supply. This leads to an increase/a decrease in the domestic in-
terest rate, which reduces/increases the capital account by increasing/lowering the
incentives to invest in the domestic economy.

Question 4
Use the IS-LM model in closed and open economy to compare how the effects of
a monetary policy contraction differ depending on whether the economy is closed,
open with a flexible exchange rate, or open with a fixed exchange rate. For each case
considered, give your answer mathematically, graphically, and with the underlying
economic intuition.