International Finance Final

Final Exam

The time for the exam is 180 minutes, do all questions. The exam is closed book, closed notes, you may not use a calculator.

Name: ____________________

1) Lane (2006) has presented the experience of countries in the Eurozone during its first years. In 2008 the Eurozone was hit by the global financial crisis. How did the developments in the years before 2008 make some countries particularly vulnerable? [10 points]

See Lane (2006). Cheap borrowing costs lead to a housing boom in many parts of the EMU, particularly in peripheral countries such as Spain and Ireland. Much of this was bank-financed increasing the vulnerability of the financial sector. In addition these countries also experienced higher inflation rates compared to Germany leading to a loss of competitiveness and increasing current account deficits in the years before 2008. At the same time due to low risk premiums in these peripheral countries, government borrowing expanded in Greece and Portugal in particular before the crisis leaving little room for fiscal maneuver when the crisis hit and growth and tax revenue plummeted.

2) Describe the research approach of Rose and van Wincoop (2001).

- Which question(s) did they test,

- how did they test it,

- and what are the results? [10 points]

They test how sharing a common currency affects bilateral trade. They use panel data going back to the 1970s and estimate bilateral trade as a function of a variety of control variables (including GDP, size, distance, common language, common border, landlocked etc.) and include a dummy variable for currency unions. The coefficient estimate on this currency union variable is significantly positive meaning that being a member of a currency union increases trade substantially. This result is robust to various specifications including different control variables.

3) When should two countries form a currency union? Lay out the basic recommendations according to the Theory of Optimum Currency Unions. [10 points]

As economic integration (trade, flows of capital etc) between countries increases, the monetary efficiency gain of joining a currency union increases as well. These include the elimination of transactions costs and the removal of uncertainty for business transactions. On the other hand as integration increases the economic stability loss from joining a currency union will fall. Giving up independent monetary policy and the possibility to react to external shocks will be easier if integration is high. So there will be a critical level of integration