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1 D EPARTMENT OF E CONOMICS S PRING 2006 U NIVERSITY OF C ALIFORNIA , B ERKELEY E CONOMICS 182 Suggested solutions to final exam Part 1 1. A financial account inflow occurs when the country sells an asset (real or financial) to foreigners. This asset export is recorded as a credit (with a positive sign) in the financial account of the balance of payments. 2. The covered interest rate parity is R = R* + (F – E) / E, where R is the domestic interest rate, R* is the foreign interest rate, F is the forward exchange rate, and E is the spot exchange rate between domestic and foreign currency. The covered interest parity states that the interest rate difference between two countries’ currencies is equal to the percentage difference between the forward exchange rate and the spot exchange rate. The parity condition assumes perfect capital mobility and perfect asset substitutability. 3. Sterilized foreign-exchange intervention occurs when the central bank carries out equal foreign and domestic asset transactions in opposite directions to nullify the impact of its foreign exchange operations on the domestic money supply. For example: China has been receiving large capital inflows. Due to the fixed rate nature of their currency system, China’s central bank has to print RMB and accumulate foreign currency (USD) to avoid having an appreciation. However, China has been extensively sterilizing the capital inflow by issuing sterilization bonds. In this way the money supply that increased with the capital inflows is reduced with the sterilization leaving the money supply relatively unchanged after all. 4. The current account balance is the difference between a country’s savings and its investment. It is defined by the sum of the trade balance and the net factor payments, where the trade balance is the difference between the value of exports and imports of goods and services and net factor payments is the difference between factor income received and paid. 5.
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