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The paper consists of FIVE questions.
Candidates must answer FOUR questions:
ALL THREE questions in Section A and ONE from SECTION B.
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and add to your document). You may also use Excel for equations and take screenshots
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BE630-6-SP/2
SECTION A
Answer ALL questions in this section.
QUESTION ONE
(a) What is the real exchange rate How does change in real exchange rate affect international
competitiveness of a country (5 Marks)
(b) Suppose prices (of goods and services) start rising in the United States relative to prices in
Britain. What would we expect to see happen to the dollar/pound exchange rate Explain.
(5 Marks)
Consider the exchange rates of Canada and Japan (with respect to the United States) over period t to
t+1.
S(CAD/USD) S(JPY/USD)
t 1.25 125.25
t+1 1.12 127.88
Note: CAD stands for Canadian dollar, JPY stands for Japanese yen, and USD stands for
United States dollar.
(c) What is the cross rate between Japan and Canada, S(JPY/CAD), at both times t and t+1
(5 Marks)
(d) Assume no transaction costs. If the market spot rate between Japan and Canada, S(JPY/CAD),
at time t is 110, is there an arbitrage opportunity If so, calculate the profits.
(5 Marks)
[TOTAL: 20 MARKS]
QUESTION TWO
(a) Define uncovered interest rate parity (UIP). Derive the equations of UIP in both levels and logs.
(5 Marks)
(b) Let the spot rate between the UK and Canada be 3.5 CAD/GBP, and the Canadian 6 month
(annualised) interest rate is 6% and the 6 month (annualised) UK interest rate is 8%.
(i) What should the market quoted forward rate be to ensure there is no arbitrage opportunity
(5 Marks)
(ii) If the actual forward rate was 4.5 CAD/GBP, demonstrate how you make an arbitrage profit
with 1 CAD. (5 Marks)
[TOTAL: 15 MARKS]
BE630-6-SP/3
QUESTION THREE
(a) What is the difference between Law of One Price (LOP) and Purchasing Power Parity (PPP)
(5 Marks)
(b) Consider a world that only comprises 3 goods (Good 1, Good 2, Good 3) and 2 countries
(France and Japan). Assume that consumption weights of these goods for both countries be
(0.50, 0.25, 0.25).
The price of the goods at time t are listed below:
France (EUR) Japan (JPY)
Good 1 40 20
Good 2 80 55
Good 3 60 150
Note: EUR stands for Euros and JPY stands for Japanese yen
(i) For each good, what exchange rate, S(EUR/JPY), is consistent with the law of one price
(5 Marks)
(ii) Let the spot exchange rate at time t be equal to 0.50 EUR/JPY. Does absolute purchasing power
parity (PPP) hold between the France and Japan (5 Marks)
[TOTAL: 15 MARKS]
END OF SECTION A
BE630-6-SP/4
SECTION B
Answer ONE question from SECTION B.
QUESTION FOUR
Consider the Balance of Payments of the United Kingdom in 2021 as depicted in the table below (in
millions of USD).
(a) Does the country exhibit a current account deficit or surplus Why
(15 Marks)
(b) What does this mean in terms of the integration of the country in the world economy Discuss
with respect to the flow of both goods/services and capital.
(15 Marks)
(c) Discuss the conditions that make a current account balance excessive.
(20 Marks)
[TOTAL: 50 MARKS]
1 Exports of goods 444,558
2 Imports of goods -655,991
3 Trade balance -211,433
4 Exports of services 429,928
5 Import of services -242,728
6 Interest, profits, and divideds received 256,143
7 Interest, profits, and divideds paid -269,988
8 Unilateral receipts 36,163
9 Unilateral payments -61,027
10 Current account -62,941
11 Capital account, credit 1,172
12 Capital account, debit -4,735
13 Capital account -3,563
14 Direct investment, assets -80,132
15 Direct investment, liabilities 18,493
16 Portfolio investment, assets 55,803
17 Portfolio investment, liabilities 267,029
18 Financial derivatives (other than reserves) and
employee stock options
37,411
19 Other investment, assets -404,994
20 Other investment, liabilities 201,360
21 Financial account 94,970
22 Net errors and omissions -5,102
23 Net credit and loans from the IMF 0
24 Reserves and related items 23,364
25 Reserve assets 23,364
BE630-6-SP/5
QUESTION FIVE
Brazil and Argentina are currently in talks to establish a common currency:
“We also decided to advance discussions on a common South
American currency that can be used for both financial and
commercial flows, reducing costs operations and our external
vulnerability,” […]
Reuters 23/01/2023
Referring to the theory of the optimum currency areas (OCA), how and under what conditions do
countries benefit from an OCA What are the costs of joining it
[TOTAL: 50 MARKS]
