Question: In Year 1, domestic saving is 100, and domestic investment is 200. What is the current account this year? Does the home country run a current account surplus or deficit? (4’)

Balance of Payments and Net Foreign Asset Position (32’)

The home country has zero net foreign asset position at the beginning of Year 1 (or equivalently, at the end of Year 0), i.e., it does not owe any debt to foreign countries, nor does it have any loans to foreigners.

a) In Year 1, domestic saving is 100, and domestic investment is 200. What is the current account this year? Does the home country run a current account surplus or deficit? (4’)

b) Suppose the interest rate on international borrowing is 5%. What is home country’s net foreign asset position at the end of Year 1? (4’)

c) In Year 2, domestic saving is 200, and domestic investment is 100. What is the current account in Year 2? What is home country’s net foreign asset position at the end of Year 2? (4’)

d) After a few years, Home’s net foreign asset position is -400. For simplicity, assume GDP is 1000 every year afterward, and the interest rate on international borrowing is kept at zero from now on. Suppose Home wants to maintain a current account surplus at 2% of GDP and gradually pay back the debt. How many years will it take for Home to pay back the debt fully? (Note that in 2014, U.S. net foreign asset position is about -40% of GDP as assumed here) (4’)

e) Suppose you are hired as an economist at the IMF and is sent to the country to advise its government on the external debt. They tell you that the net foreign asset position is currently sitting at about -40% of GDP. Do you think the debt is sustainable or not? What other information do you need to make the judgment? (16’)

Interest rates, exchange rates and macroeconomic policies (40’)

The home country has a floating exchange regime. Please answer the following questions. (You can either use intuitive words, or use expressions, graphs and curves when necessary. Both approaches are fine as long as your analysis is clear)

a) What is interest rate parity? Why does it hold? (8’)

b) How is the domestic interest rate determined in the money market? What factors influence the interest rate? (8’)

c) As the next election approaches, the central bank was pressured to conduct an expansionary monetary policy to boost the economy and to increase the likelihood that the current president will be reelected. How does the central bank achieve this policy in practice? How does it affect the interest rate and the exchange rate if we assume output does not change? (8’)

d) Now assume that output can indeed change. How will the output move after the expansionary monetary policy? Why? How does this change feed back into the interest rate and exchange rate? (16’)