1. (25 points)

In 2008, the dollar depreciated sharply vis-à-vis the euro.

a. (15 points)

Suppose that during this period, the Fed had wanted both to defend the dollar (i.e. stop its decline and/or cause it to appreciate) and stimulate investment. Could it have achieved both of these goals simultaneously through monetary policy? Explain.

FED could raise interest rate which make dollars more attractive to foreigners.

b. (10 points)

Suppose instead that the European Central Bank (ECB) had conducted expansionary monetary policy. What would have been the short-run effect, if any, of this policy on the euro/dollar nominal exchange rate. Explain fully.

2. (15 points)

Fully explain the “Policy Trilemma.”

The assertion that market forces restrict the ability of a country to meet three policy objectives simultaneously. The Trilemma implies that a country can accomplish only two out of the following policy goals- financial integration with the global capital market, exchange rate stability, and monetary independence.

3. (20 points)

According to the BBC, inflation in the country of Zimbabwe reached an annualized rate of 231,000,000% in October of 2008. Prices got so high that in January of 2009, the country’s central bank—the Reserve Bank of Zimbabwe—introduced a $100 trillion bill.

(Sources: http://news.bbc.co.uk/2/hi/africa/7660569.stm; http://news.bbc.co.uk/2/hi/africa/7832601.stm)

Read the summary of Zimbabwe’s experience with hyperinflation in Wikipedia (http://en.wikipedia.org/wiki/Hyperinflation_in_Zimbabwe). How does the history of hyperinflation in the country illustrate the points made in the chapter regarding the root causes, costs and benefits of inflation? What were some of the adaptations that citizens of the country adopted to cope with the situation?