CEA International Trade and Finance 4 — Questions and Answers
Question 1: Which exchange rate regime gives a central bank the least discretion to conduct independent monetary policy?
- Managed float
- Currency union (dollarization) (Correct answer)
- Crawling peg
- Target zone with wide bands
Correct answer: Currency union (dollarization)
Under full dollarization or a currency union, the country adopts another currency and entirely surrenders monetary policy independence.
Question 2: The Balassa-Samuelson effect predicts that countries with higher productivity growth in tradables will have:
- Lower overall price levels than less productive countries
- Higher price levels and appreciation of the real exchange rate (Correct answer)
- Current account surpluses due to export competitiveness
- Lower wages in the non-tradable sector over time
Correct answer: Higher price levels and appreciation of the real exchange rate
The Balassa-Samuelson effect explains why fast-growing economies tend to have higher price levels, as rising tradable-sector wages pull up non-tradable sector prices.
Question 3: An optimal currency area (OCA) theory, developed by Robert Mundell, suggests that a common currency is beneficial when member regions have:
- Diverse economic structures to balance shocks
- Low labor mobility and asymmetric business cycles
- High factor mobility and synchronized business cycles (Correct answer)
- Independent central banks and different inflation targets
Correct answer: High factor mobility and synchronized business cycles
OCA theory holds that a currency union works best when regions face symmetric shocks and factors can move freely to facilitate adjustment without exchange rate tools.
Question 4: A 'sudden stop' in international finance refers to:
- A central bank halting foreign exchange intervention
- An abrupt reversal of capital inflows to an emerging market (Correct answer)
- The IMF freezing a standby credit facility
- A government imposing emergency trade restrictions
Correct answer: An abrupt reversal of capital inflows to an emerging market
A sudden stop occurs when foreign capital inflows to a country abruptly cease or reverse, often triggering a balance of payments and currency crisis.
Question 5: Under the Mundell-Fleming model with a fixed exchange rate and perfect capital mobility, fiscal policy is:
- Completely ineffective due to full crowding out
- Highly effective because monetary policy accommodates it (Correct answer)
- Mildly effective with partial crowding out
- Effective only in the short run before capital flows adjust
Correct answer: Highly effective because monetary policy accommodates it
With a fixed exchange rate and perfect capital mobility, fiscal expansion raises income and the central bank must expand money supply to defend the peg, making fiscal policy highly effective.
Question 6: The 'original sin' hypothesis in international debt markets refers to the inability of:
- Developed countries to issue bonds in foreign currencies
- Emerging market countries to borrow internationally in their own currency (Correct answer)
- IMF members to access emergency lending without conditionality
- Central banks to maintain fixed exchange rates without reserves
Correct answer: Emerging market countries to borrow internationally in their own currency
Original sin describes the structural constraint that prevents emerging market economies from issuing external debt denominated in their own currency, creating currency mismatch risk.
Question 7: A country's international investment position (IIP) measures:
- The annual flow of foreign direct investment into the country
- The stock of foreign assets owned minus foreign liabilities owed (Correct answer)
- The cumulative value of imports minus exports over time
- The central bank's foreign exchange reserves only
Correct answer: The stock of foreign assets owned minus foreign liabilities owed
The IIP is a balance sheet measure of a country's net financial claim on (or liability to) the rest of the world at a given point in time.
CEA International Trade and Finance 4
Which exchange rate regime gives a central bank the least discretion to conduct independent monetary policy?