ECON3372 | Accounting in Economics - Boston university

20) The evidence of positive returns on the currency trading strategy called the “carry trade” suggests that A) the returns are too small, hence we can conclude interest parity holds with no modifications B) returns are big, but are well explained by the risk foreign currency investors face, hence the interest parity condition augmented with a risk-premium holds in the data C) returns are big and are not well explained by risk-considerations D) returns are on average negative, suggesting there are no profits to be made hence interest parity holds at least in one direction E) returns are big, but in line with the direction implied by interest parity SHORT-ANSWER QUESTIONS (120 points) Let ! be the domestic nominal interest rate, and !∗ is similarly the foreign interest rate. The nominal exchange rate, E, is defined, as usual, to be the number of home currency units per foreign currency. M, P, Y are the domestic money supply, aggregate price level and output respectively and starred variables are the foreign counterparts. Unless told otherwise, assume that output is fixed in both the short and long-runs, the economy is initially at its long-run equilibrium, i.e .#$%& = #( and !$%& = !( , and that the two countries are symmetric #( = #( ∗ , !( = ! ∗ . For all graphical analysis, explain why curves shift (if necessary use graphs for multiple markets).

• (6 pts) We have derived the expression for the demand of foreign currency deposits from first principles. Write down the optimal demand for foreign currency deposits, and describe how it combines the two key characteristics of foreign investments that investors trade-off.

b) (6 pts) Using the above expression, derive the equilibrium condition that guarantees market clearing in the market for foreign currency deposits. What assumption do you need to make so that this equation simplifies to the interest parity condition? c) (6 pts) What does the AA curve characterize and how is it derived? d) (6 pts) Define the real exchange rate and explain how the nominal exchange rate relates to the real exchange rate in the long-run. e) (6 pts) Do the nominal and real exchange rates move one-to-one with one another in the short-run? What about in the long-run? Explain why or why not f) (10 pts) Using figures for both the short and the long-run, explain the effects of a temporary increase in domestic money supply on the exchange rate and output. Show the initial impact, the long-run impact and the transition between the two. g) (10 pts) Using figures for both the short and the long-run, explain the effects of a temporary increase in domestic taxes on the exchange rate and output. Show the initial impact, the long-run impact and the transition between the two. h) (10 pts) Now assume that while there is a temporary increase in taxes, the CB is also committed to keeping the exchange rate fixed. Using appropriate graphs, show what happens to the exchange rate and the output in the short and long-run in this case. i) (15 pts) Using figures for both the short and the long-run, explain the effects of a permanent decrease in domestic money supply on the exchange rate and output. Show the initial impact, the long-run impact and the transition between the two. j) (15 pts) For this question assume that physical investment I is a decreasing function of R – i.e. that I’(R)