Econ-244: Exercise Answers

International Finance Professor Canzoneri 

Exercise 1 Due: 

Preliminary figures (in billions of dollars) for 2004 taken from the 2005 Economic Report of the 

President showed that: Y = 11,728.0, C = 8,231.1, EX = 1,170.2, IM = 1,779.6, G = 2,183.8 and 

T = 1771.7. We can use the national income identities to describe the financing of U.S. business 

investment and the U.S. government deficit 

Part A: Use the income identities to find what U.S. private business investment, I, was in 2004. 

Show your work. 

Part B: Use the income identities to find what U.S. private savings, S, was in 2004. Show your 

work. 

Part C: Both U.S. private business investment and the U.S. government deficit need to be 

financed each year. What were the total financing needs of business and government in 2004? 

Part D: Was private savings sufficient to finance both private business investment and the 

government deficit? What was the shortfall? Where did U.S. firms and the U.S. government 

find the extra financing? Can you see the shortfall in the numbers provided at the outset (Hint: 

think about the current account)?


Exercise 1 ANSWERS 

Preliminary figures (in billions of dollars) for 2004 taken from the 2005 Economic Report of the 

President showed that: Y = 11,728.0, C = 8,231.1, EX = 1,170.2, IM = 1,779.6, G = 2,183.8 and 

T = 1771.7. We can use the national income identities to describe the financing of U.S. business 

investment and the U.S. government deficit 

Part A: Use the income identities to find what U.S. private business investment, I, was in 2004. 

Show your work. 

ANSWER – 

Y = C + I + G + EX - IM Y 

I = Y - (C + G + EX - IM) = 11,728.0 - (8,231.1 + 2,183.8 + 1,170.2 - 1,779.6) = 1,922.4 

Part B: Use the income identities to find what U.S. private savings, S, was in 2004. Show your 

work. 

ANSWER – 

Y = C + S + T Y S = Y - (C + T) = 11,728.0 - (8,231.1 + 1771.7) = 1725.2 

Part C: Both private U.S. business investment and the U.S. government deficit need to be 

financed each year. What were the total financing needs of business and government in 2004? 

ANSWER – 

I + (G - T) = 1,922.4 + ( 2,183.8 - 1771.7) = 2334.5 

Part D: Was private savings sufficient to finance both private business investment and the 

government deficit? What was the shortfall? Where did U.S. firms and the U.S. government 

find the extra financing? Can you see the shortfall in the numbers provided at the outset (Hint: 

think about the current account)? 

ANSWER – 

Shortfall = [I + (G - T)] - S = 2334.5 - 1725.2 = 609.3 

They had to borrow from foreigners. 

As shown in class, the income identities imply that I + (G - T) = S - CA. So, the shortfall, 

[I + (G - T)] - S = - CA = IM - EX = 1,779.6 - 1,170.2 = 609.3. The current account deficit is 

U.S. borrowing from abroad.



In the exercise, you will study two “arbitrage” conditions that show how financial markets 

determine exchange rates. 

I. CROSS RATE ARBITRAGE: E $/€ = E $/¥ * E ¥/€ 

A. Find recent quotes (Financial Times or use the internet 1 ) for the dollar rates for Euro and 

Yen, and also find the cross rate between Euro and Yen. Suppose you sell $1 and buy 

Euros, then you sell the proceeds to buy Yen, and finally you sell the proceeds of that 

sale to buy back dollars. Do you end up with more or less than the $1 you started out 

with? 

B. Economists would expect the rate of return in Part A to be quite small. Explain why? 

(Hint: think what would happen if there were a big return?) 

1997 1998 1999 2000 

US Dollar 1 1 1 1 

JPN Yen 116.05 130.615 113.3 102.31 

INA Rupiah 2363 5535 8005 7050 

Figures for January 1 st of each year 

C. Use the above figures for Part C. 

1. Suppose you are manager of an Indonesian company that borrowed the equivalent 

of US$1,000,000 in Yen from a Japanese bank at the beginning of 1997. That 

amount is immediately converted into Rupiah for operations in your Indonesian 

factory. How much Rupiah do you now have for operations? 

2. If you were to pay back the Japanese bank at the beginning of 1998, how much 

Rupiah does you company have to pay for the full principal borrowed in 1997? 

What about in 1999? And in 2000? 

3. If you were manager of an Indonesian company that exported goods to America, 

how would these exchange rate movements have affected the dollar sales price of 

your goods? 

2. INTEREST RATE ARBITRAGE: R $ = R € + (E e 

$/€ - E $/€)/E $/€ 

A. Suppose the rate of return on a Eurobond is 4.3%, and suppose the dollar is expected to 

depreciate by 0.5%; what is the expected dollar rate of return on the Eurobond? 

B. Suppose the rate of return on a Eurobond is 4.3%, and suppose the Euro is expected to 

appreciate by 0.5%; what is the expected dollar rate of return on the Eurobond? 

C. Use the interest rate parity equation to calculate the spot exchange rate (E $/€) when 

R $ = 0.045, R € = 0.043, and E e 

$/€ = 1.094. Is the resulting E $/€ greater or less than 1.094? 

D. Suppose R $, R €, and E e 

$/€ are at the values specified in Part C, but suppose that the spot 

exchange rate (E $/€) is initially equal to 1.094. Describe the market forces that would 

drive the spot rate to the answer you found in Part C. 

1 For example, you can use http://finance.yahoo.com or http://www.oanda.com/convert/classic



In the exercise, you will study two “arbitrage” conditions that show how financial markets 

determine exchange rates. 

I. CROSS RATE ARBITRAGE: E $/€ = E $/¥ * E ¥/€ 

A. Find recent quotes (Financial Times or use the internet 2 ) for the dollar rates for Euro and 

Yen, and also find the cross rate between Euro and Yen. Suppose you sell $1 and buy 

Euros, then you sell the proceeds to buy Yen, and finally you sell the proceeds of that 

sale to buy back dollars. Do you end up with more or less than the $1 you started out 

with? 

ANSWER- 

On September 9, 2003: E $/€= 1.12, E ¥/$= 116.37, E ¥/€= 130.15 

$1@ E €/$ @ E ¥/€ @ E $/¥ = 1@ (1/1.12) @ 130.15 @ (1/116.37) = $0.9986 < $1 

B. Economists would expect the rate of return in Part A to be quite small. Explain why? 

(Hint: think what would happen if there were a big return?) 

ANSWER- 

If the loss were large, arbitragers would go the other way, making large profits. People 

would be buying (not selling) dollars. The dollar would appreciate, raising E €/$ and E ¥/$. 

This would make the return converge on 0. 

1997 1998 1999 2000 

US Dollar 1 1 1 1 

JPN Yen 116.05 130.615 113.3 102.31 

INA Rupiah 2363 5535 8005 7050 

Figures for January 1 st of each year 

C. Use the above figures for Part C. 

1. Suppose you are manager of an Indonesian company that borrowed the equivalent 

of US$1,000,000 in Yen from a Japanese bank at the beginning of 1997. That 

amount is immediately converted into Rupiah for operations in your Indonesian 

factory. How much Rupiah do you now have for operations? 

ANSWER- 

$1,000,000 @ E ¥/$ @ E R/¥ = $1,000,000 @ 116.05 @ (2363/116.05) = 2,363,000,000R in 1997 

2. If you were to pay back the Japanese bank at the beginning of 1998, how much 

Rupiah does you company have to pay for the full principal borrowed in 1997? 

What about in 1999? And in 2000? 

2 For example, you can use http://finance.yahoo.com or http://www.oanda.com/convert/classic

ANSWER- 

$1,000,000 @ E ¥/$ = $1,000,000 @ 116.05 = 116,050,000 Yen initially borrowed 

1998: 

116,050,000 Yen @ E R/¥ = 116,050,000 @ (5535/130.615) = 4,917,787,008 R 

1999: 

116,050,000 Yen @ (8005/113.3) = 8,199,296,117 R 

2000: 

116,050,000 Yen @ (7050/102.31) = 7,996,798,944 R 

3. If you were manager of an Indonesian company that exported goods to America, 

how would these exchange rate movements have affected the dollar sales price of 

your goods? 

ANSWER- 

From 1997 to 1999, the dollar is appreciating relative to the Rupiah, meaning the dollar 

sales price is decreasing (Indonesian goods are getting cheaper for Americans). In 2000, 

the Rupiah appreciated against the dollar from its 1999 level, making Indonesian goods 

more “expensive” in dollars than the year before- the dollar sales price went up. 

2. INTEREST RATE ARBITRAGE: R $ = R € + (E e 

$/€ - E $/€)/E $/€ 

A. Suppose the rate of return on a Eurobond is 4.3%, and suppose the dollar is expected to 

depreciate by 0.5%; what is the expected dollar rate of return on the Eurobond? 

ANSWER- 

R € = 4.3% 

$ depreciation = (E e 

$/€ - E $/€)/E $/€ = .5% 

R $ = 4.3 + .5 = 4.8% dollar rate of return on the Eurobond 

B. Suppose the rate of return on a Eurobond is 4.3%, and suppose the Euro is expected to 

appreciate by 0.5%; what is the expected dollar rate of return on the Eurobond? 

ANSWER- 

R € = 4.3% 

Euro appreciation = $ depreciation = .5% 

R $ = 4.3 + .5 = 4.8% dollar rate of return on the Eurobond 

C. Use the interest rate parity equation to calculate the spot exchange rate (E $/€) when R $ 

= 0.045, R € = 0.043, and Ee $/€ = 1.094. Is the resulting E $/€ greater or less than 1.094? 

ANSWER- 

Interest rate parity equation: R $ = R € + (Ee $/€ - E $/€)/E $/€ 

.045 = .043 + (1.094 - E $/€)/E $/€ 

.002 E $/€ = 1.094 - E $/€ 

E $/€ = 1.092 ...the resulting E $/€ is less than 1.094 

D. Suppose R $, R €, and E e 

$/€ are at the values specified in Part C, but suppose that the spot 

exchange rate (E $/€) is initially equal to 1.094. Describe the market forces that would 

drive the spot rate to the answer you found in Part C. 

ANSWER- 

If the spot rate starts at 1.094, the left side of the interest rate parity eqn is greater than

the right, meaning there is a greater return on dollar bonds than Eurobonds. People would 

dump Euros and buy dollars, leading to an appreciation of the dollar relative to the Euro, 

and driving the spot rate back to that found in part C.



The financial markets diagram shows how the money market and the bonds market 

simultaneously determine equilibrium E and R. In this exercise, you will get practice using it. 

I. Suppose the European Central Bank (ECB) raises its interest rate (R*) in an attempt to 

establish an anti-inflation reputation similar to the Bundesbank's. 

A. Use the financial markets diagram to show what this would do to the US interest rate (R) and 

exchange rate (E) assuming the FED did not change the US money supply. Explain intuitively 

why the exchange rate moves the direction it does? (Hint: what happens to the supplies and 

demands for home and foreign bonds?) What would all of this do to the price of US imports 

from Europe? 

B. Suppose the FED wanted to avoid these price level consequences in the US. Use the 

financial markets diagram to show what the FED would have to do to its money supply (M) to 

maintain the original exchange rate. 

C. Is there any way that the FED could simultaneously maintain its original exchange rate and 

its original interest rate? Justify your answer. 

II. As Europe comes out of its present recession, it will import more from the US, and this 

will expand US output (Y). 

A. Use the diagram to show what this will do to the US interest rate (R) and exchange rate (E). 

Explain intuitively why the interest rate and the exchange rate move in the directions they do. 

(Hint: again, what happens to supplies and demands?) 

B. Is there any way that the FED could change its money supply so as to simultaneously 

maintain its original exchange rate and its original interest rate? Use the diagram to justify 

your answer.



The financial markets diagram shows how the money market and the bonds market 

simultaneously determine equilibrium E and R. In this exercise, you will get practice using it. 

I. Suppose the European Central Bank (ECB) raises its interest rate (R*) in an attempt to 

establish an anti-inflation reputation similar to the Bundesbank's. 

A. Use the financial markets diagram to show what this would do to the US interest rate (R) and 

exchange rate (E) assuming the FED did not change the US money supply. Explain intuitively 

why the exchange rate moves the direction it does? (Hint: what happens to the supplies and 

demands for home and foreign bonds?) What would all of this do to the price of US imports 

from Europe? 

ANSWER – 

If the FED does not change M, then neither the 

supply nor the demand for M is affected, 

and R is unchanged. 

R*8 6 ED for Euro-bonds 6 people move 

out of $ and into Euro 6 $ depreciates. 

This depreciation raises the price of 

imports, since it now takes more $ to meet 

a given price quoted in Euro. 

B. Suppose the FED wanted to avoid these price level consequences in the US. Use the financial 

markets diagram to show what the FED would have to do to its money supply (M) to maintain the 

original exchange rate. 

ANSWER – 

The FED has to lower M enough to make R 

rise as much as R* did. 

Then, E remains at E1.

C. Is there any way that the FED could simultaneously maintain its original exchange rate and 

its original interest rate? Justify your answer. 

ANSWER – 

No. If the Fed changes M, then R must move to re-establish equilibrium in the money market. If 

the FED does not change M, then E must move, for reasons given in part A. 

II. As Europe comes out of its present recession, it will import more from the US, and this 

will expand US output (Y). 

A. Use the diagram to show what this will do to the US interest rate (R) and exchange rate (E). 

Explain intuitively why the interest rate and the exchange rate move in the directions they do. 

(Hint: again, what happens to supplies and demands?) 

ANSWER – 

Y8 6 L()8 6 money demand curve shifts down. 

ED for money 6 R8 to clear the money market. 

R8 6 ED for $-bonds 6 people try to get 

out of Euro and into $ assets 6 $ depreciates. 

B. Is there any way that the FED could change its money supply so as to simultaneously maintain 

its original exchange rate and its original interest rate? Use the diagram to justify your answer. 

ANSWER – 

Yes. FED has to increase money supply 

enough to accommodate the new money 

demand at the original R1. 

If R1 is maintained, then the E1 will also be 

maintained. 

This is possible here because the interest 

parity curve has not shifted.



The AA-DD diagram illustrates the short run equilibrium in financial markets and in the goods 

market. In this exercise, you will get practice using it. 

I. Suppose the economy is initially at full employment, Y fe. Then, a stock market crash (such as 

the one we had in 1987 or 1998) makes firms curtail some of their investment projects (since they 

become harder to finance). Use the AA-DD diagram to show how this could cause a recession. 

Part A: Do the AA-DD curve analysis; be sure to explain why you shift any curve. 

Part B: Tell the “story” of what is happening in the goods market, and how it spills over to the 

financial markets. 

Part C: Show the path of adjustment to the new short run equilibrium. Is there any exchange rate 

“overshooting”? 

II. Now suppose the FED takes steps to offset the recession. 

Part A: Begin with an AA-DD diagram that shows where you ended up in question I; then show 

what the FED would have to do to restore the original level of output, Y fe. Once again, be sure 

to explain why you shift any curve. 

Part B: Tell the “story” of what is happening in the financial markets, and how it spills over to the 

goods market; show the path of adjustment to the new short run equilibrium. Is there any 

exchange rate “overshooting” in this case? 

Part C: Y has been restored to Y fe, but E has not been restored to its initial level, E 1. Why didn't it 

go back to its initial level; that is, why was a depreciation necessary? 

III. Suppose now that the FED wanted to simultaneously offset the recession and appreciate the 

exchange rate (for lower prices) to some E 3 < E 1; suppose further that it could persuade Congress 

to help in the effort. 

Part A: Begin with an AA-DD diagram that shows where you ended up in question I, and then 

show how a combined monetary and fiscal policy could restore both the initial level of output, 

Y fe, and the exchange rate E 3. 

Part B: Could either monetary or fiscal policy have achieved this alone?



The AA-DD diagram illustrates the short run equilibrium in financial markets and in the goods 

market. In this exercise, you will get practice using it. 

I. Suppose the economy is initially at full employment, Yfe. Then, a stock market crash (such as 

the one we had in 1987 or 1998) makes firms curtail some of their investment projects (since they 

become harder to finance). Use the AA-DD diagram to show how this could cause a recession. 

Part A: Do the AA-DD curve analysis; be sure to explain why you shift any curve. 

Part B: Tell the “story” of what is happening in the goods market, and how it spills over to the 

financial markets. 

Part C: Show the path of adjustment to the new short run equilibrium. Is there any exchange rate 

“overshooting”? 

ANSWER – 

The story: I9 

D(EP*/P,Y-T,I,G)9 6 DD shifts left 

initial effect is in goods mkt 

y d 9 6 y s follows 

spills over to financial markets 

Y9 6 L9 6 R9 6 E8. 

move out along AA; no impact effect, 

or E “overshooting”.

II. Now suppose the FED takes steps to offset the recession. 

Part A: Begin with an AA-DD diagram that shows where you ended up in question I; then show 

what the FED would have to do to restore the original level of output, Yfe. Once again, be sure 

to explain why you shift any curve. 

ANSWER – 

Fed has to buy bonds to increase money 

supply 

Part B: Tell the “story” of what is happening in the financial markets, and how it spills over to the 

goods market; show the path of adjustment to the new short run equilibrium. Is there any 

exchange rate “overshooting” in this case? 

ANSWER -- 

FED has to M s8 The Story: 

initial effect in financial markets 

M s8 6 R9 6 E8 

E depreciates immediately to AA2 

spills over to goods market 

EP*/P8 6 yd 8 and y s follows 

as pictured, E initially “overshoots”.

Part C: Y has been restored to Yfe, but E has not been restored to its initial level, E1. Why didn't it 

go back to its initial level; that is, why was a depreciation necessary? 

ANSWER: 

E has to depreciate be cause (1) I9 6 E8 and (2) M s 8 6 E8; both work in the same direction on E, 

for reasons already given in the two “stories”. 

III. Suppose now that the FED wanted to simultaneously offset the recession and appreciate the 

exchange rate (for lower prices) to some E3 < E1; suppose further that it could persuade Congress 

to help in the effort. 

Part A: Begin with an AA-DD diagram that shows where you ended up in question I, and then 

show how a combined monetary and fiscal policy could restore both the initial level of output, 

Yfe, and the exchange rate E3. Part B: Could either monetary or fiscal policy have achieved this alone? 

ANSWER -- 

Fiscal policy should T9 and/or G8 to 

make DD cut the Y fe line at E 3. 

Monetary policy should M s 9 to make AA 

cut the Y fe line at E 3. 

Neither policy could do this alone; have 

to move both curves to get (E 3,Y fe). 

Have to combine an expansionary 

fiscal policy with a contractionary 

monetary policy.



In this exercise, you will study the relationship between the substitutability of (home and 

foreign) bonds and central bank independence. 

Suppose the FED wants to raise R (for domestic reasons) and depreciate E (for external 

reasons); that is, the FED wants to achieve the point (E 2,R 2) in the diagram below. 

I. Suppose B and B* are imperfect substitutes. Show that an OMO can bring R to R 2, and that a 

sterilized intervention can then bring E to E 2. In each case, explain what assets the FED swaps 

with the private sector. 

II. Suppose B and B* are perfect substitutes. Is there any way the FED can achieve the point 

(E 2,R 2)? What choices of (E,R) is the FED limited to? 

III. In the US, the Treasury Department (and not the FED) has the right to set exchange rate 

policy. If this right is interpreted to mean that Treasury can tell the FED what E to set, then does 

this right in effect abrogate the independence of the central bank? That is, can the FED still set 

whatever R it wants, independent of the wishes of the Treasury?


Exercise 5 ANSWERS – 

Suppose the FED wants to raise R (for domestic reasons) and depreciate E (for external 

reasons); that is, the FED wants to achieve the point (E 2,R 2) in the diagram below. 

I. Suppose B and B* are imperfect substitutes. Show that an OMO can bring R to R 2, and that a 

sterilized intervention can then bring E to E 2. In each case, explain what assets the FED swaps 

with the private sector. 

ANSWER -- 

1. Contractionary OMO: FED sells B (in exchange for M) to bring M s to M 2 shown above. 

Note: The OMO will raise B/B*, increase ρ(B/B*) and shift interest parity condition up. 

far enough to achieve (E 2,R 2), then a sterilized intervention 

is needed to shift it further. 

If the curve has not shifted 

If the curve has already shifted too far up, then a sterilized intervention has to shift it 

back down some. 

In what follows, I will assume that the OMO has not shifted it far enough. 

2. Sterilized Intervention: 

FEI: FED buys B* (raising B/B*) in exchange for M. 

Offsetting OMO: FED sells B (raising B/B* even more) in exchange for M. 

Net effect: no change in M (that is, it stays at M 2), but B/B*, and ρ(B/B*), rise enough to 

achieve (E 2,R 2).

II. Suppose B and B* are perfect substitutes. Is there any way the FED can achieve the point 

(E 2,R 2)? What choices of (E,R) is the FED limited to? 

ANSWER -- 

No. If bonds are perfect substitutes, FED's operations can not shift interest parity curve. In 

effect, it is limited to shifting the equilibrium along this curve. 

III. In the US, the Treasury Department (and not the FED) has the right to set exchange rate 

policy. If this right is interpreted to mean that Treasury can tell the FED what E to set, then does 

this right in effect abrogate the independence of the central bank? That is, can the FED still set 

whatever R it wants, independent of the wishes of the Treasury? 

ANSWER -- 

The answer depends on whether or not bonds are imperfect substitutes. 

If bonds are imperfect substitutes, then the FED retains independence over interest rate policy. 

The FED can use OMO's to achieve its own R-target, and then use sterilized interventions to 

achieve the Treasury's E-target. 

If bonds are imperfect substitutes, then the FED does lose its independence; the Treasury's E 

target determines the R that the FED must set.



In this exercise, you will practice finding Nash solutions, and we will develop further Barro & 

Gordon's Inflation Credibility Model and Obstfeld's 2 nd Generation Speculative Attacks Model. 

I. Finding Nash Solutions – 

Part A: Define a “Nash Solution” to a non-cooperative game. (Hint: What must each player 

be doing in the Nash solution.) 

Part B: Consider the two games below. Start with Game 1, where the Nash solutions have 

already been circled. Go from box to box explaining why each is, or is not, a Nash 

solution. Then, do the same for Game 2, and circle the Nash solution(s?). 

II. Recall Able and Bernanke's box matrix example of Barro-Gordon's Inflation Credibility Model: 

Part A: Suppose the CB just announced that it would play M l, and that there was no need for the 

wage setters to expect P h. Would this announcement be believed? Why or why not? 

Part B: Suppose we change the point assignments as follows: 

W Setters CB 

N* 1 0 Now, the CB is not as concerned about achieving high levels of N: 

N h 0 1 N h gets 1 point instead of 2, N l gets -1 instead of -2. 

N l 0 -1 Otherwise, the point assignments are the same. 

P h 0 0 Recalculate the CB's payoffs in the four boxes, and find the 

P l 0 1 new Nash solution(s?). (Hint: there may be more than one.) 

Part C: If there are multiple solutions, how might the CB bring about the best one?

III. Recall Obstfeld's box matrix example of a “2 nd Generation” Speculative Attack Model: 

Part A: When foreign reserves were FR = 20, “fundamentals” were so strong that an attack 

was impossible. In this model, what is the minimum number of reserves that would be 

required to rule out the possibility of multiple equilibria, and thus, self-fulfilling attacks? 

Part B: When foreign reserves were FR = 6, “fundamentals” were so weak that an attack was 

inevitable. What is the minimum number of reserves that would at least keep the attack from 

being inevitable? 

Part C: Who do you think is to blame for exchange rate crises in Obstfeld's model ? The 

government? Speculators?


Exercise 6 Due: ANSWERS 

In this exercise, you will practice finding Nash solutions, and we will develop further Barro & 

Gordon's Inflation Credibility Model and Obstfeld's 2 nd Generation Speculative Attacks Model. 

I. Finding Nash Solutions – 

Part A: Define a “Nash Solution” to a non-cooperative game. (Hint: What must each player 

ANSWER -- 

be doing in the solution.) 

We have a Nash Solution when each player is doing the best he/she can do, given the actions 

of the other players in the game. 

Part B: Consider the two games below. Start with Game 1, where the Nash solutions have 

already been circled. Go from box to box explaining why each is, or is not, a Nash 

solution. Then, do the same for Game 2, and circle the Nash solution(s?). 

ANSWER --

ANSWER – 

Game 1: Game 2: 

NW box: both would deviate. NW box: neither would deviate. 

SW box: neither would deviate. SW box: Row would deviate. 

SE box: both would deviate. SE box: both would deviate. 

NE box: neither would deviate. NE box: Column would deviate. 

II. Recall Able and Bernanke's box matrix example of Barro-Gordon's Inflation Credibility Model: 

Part A: Suppose the CB just announced that it would play M l, and that there was no need for the 

wage setters to expect P h. Would this announcement be believed? Why or why not? 

ANSWER -- 

It would not be believed. Wage setters know that if they play W l (ie the SE box), the CB will 

be tempted to play M h, resulting in the NE box. The announcement is not credible. 

Part B: Suppose we change the point assignments as follows: 

W Setters CB 

N* 1 0 Now, the CB is not as concerned about achieving high levels of N: 

N h 0 1 N h gets 1 point instead of 2, N l gets -1 instead of -2. 

N l 0 -1 Otherwise, the point assignments are the same. 

P h 0 0 Recalculate the CB's payoffs in the four boxes, and find the 

P l 0 1 new Nash solution(s?). (Hint: there may be more than one.)

ANSWER – Here, there are two Nash solutions. 

Since the CB's incentive to create a surprise 

inflation is not as strong not, the good 

equilibrium (the SE box) is a possible 

outcome. 

Part C: If there are multiple solutions, how might the CB bring about the best one? 

ANSWER -- 

Here, the CB could simply announce that it would play M l. There is no reason for the wage 

setters not to believe the announcement. There is no credibility problem, since SE is a Nash 

solution. 

III. Recall Obstfeld's box matrix example of a “2 nd Generation” Speculative Attack Model: 

Part A: When foreign reserves were FR = 20, “fundamentals” were so strong that an attack was 

impossible. In this model, what is the minimum number of reserves that would be required to 

rule out the possibility of multiple equilibria, and thus, self-fulfilling attacks? 

ANSWER – 

The combined holdings of the two traders is 6 + 6 = 12. If the central bank holds 13, then even 

if both traders attack, they can not deplete the reserves and force a devaluation. So, 13 is the 

minimum level of reserves required to rule out any possibility of an attack.

Part B: When foreign reserves were FR = 6, “fundamentals” were so weak that an attack was 

inevitable. What is the minimum number of reserves that would at least keep the attack from 

being inevitable? 

ANSWER – 

Each trader holds 6. If the central bank holds 7, then no one trader alone can deplete the 

reserves. So, 7 is the minimum level of reserves required to keep the attack from being 

inevitable. 

Part C: Who do you think is to blame for exchange rate crises in Obstfeld's model ? The 

government? Speculators? 

ANSWER – 

There is no one answer to this. Governments can make themselves invulnerable to attack by 

keeping fundamentals very strong. On the other hand, this may (or may not) be a costly thing 

to do. Governments have to at least keep fundamentals in the intermediate range, so that an 

attack is not inevitable. And if fundamentals are in that intermediate range, there is no good 

reason for an attack, other than the greed of speculators.

Econ-244: Exercise Answers

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