These are original Marlbridge practice questions, not past exam questions. All questions use Valdoria, a fictional country whose currency is the valda (VD), and Kestria, a fictional country whose currency is the kesta (KS); all interest rates and figures are fictional. The rubrics are a suggested Marlbridge rubric to help you check your work; they are not an official scoring guideline. Assumptions: exchange rates are flexible; investors respond only to real interest rates; other things are equal; CA + CFA = 0 with no statistical discrepancy.
Question 1 (multiple choice · foundation)
Valdorian bonds pay a nominal interest rate of 6% and expected inflation in Valdoria is 4%. Kestrian bonds pay 4% and expected inflation in Kestria is 1%. Other things equal, which statement is correct?
- (A) Financial capital flows to Valdoria, because its nominal interest rate is higher.
- (B) Financial capital flows to Kestria, because its real interest rate is higher.
- (C) Financial capital flows to Valdoria, because its real interest rate is 10%.
- (D) Financial capital does not flow, because both real interest rates are positive.
Answer and explanation
Answer: (B). Valdoria’s real rate is 6% − 4% = 2%; Kestria’s is 4% − 1% = 3%. Funds flow to the relatively higher real rate, Kestria’s.
- (A) compares nominal rates. Savers care about what their returns will buy, so the real rate matters.
- (C) adds expected inflation instead of subtracting it.
- (D) misreads the rule. Funds respond to the difference between real rates, not to whether they are positive.
Question 2 (multiple choice · core)
Valdoria’s real interest rate rises relative to Kestria’s. Other things equal, what happens in the foreign exchange market for valdas?
- (A) The demand for valdas increases and the valda appreciates.
- (B) The supply of valdas increases and the valda depreciates.
- (C) The demand for valdas decreases and the valda depreciates.
- (D) The demand for valdas increases and the valda depreciates.
Answer and explanation
Answer: (A). Kestrian savers want more Valdorian assets, and they need valdas to buy them. The demand curve for valdas shifts right, raising the exchange rate.
- (B) describes Valdorians buying more foreign assets, which happens when Valdoria’s real rate falls relative to Kestria’s.
- (C) reverses the direction of the capital flow.
- (D) gets the demand shift right but its effect wrong: higher demand raises a currency’s price.
Question 3 (multiple choice · core)
Financial capital flows out of Valdoria and into Kestria. Other things equal, what happens in Kestria’s loanable funds market?
- (A) The supply of loanable funds increases and the real interest rate falls.
- (B) The demand for loanable funds increases and the real interest rate rises.
- (C) The supply of loanable funds decreases and the real interest rate rises.
- (D) The demand for loanable funds decreases and the real interest rate falls.
Answer and explanation
Answer: (A). The inflow is extra saving lent in Kestria, so the supply of loanable funds shifts right and Kestria’s real interest rate falls.
- (B) shifts demand instead of supply. Borrowers’ plans have not changed; more funds are being offered.
- (C) describes Valdoria’s loanable funds market, which loses funds.
- (D) shifts the wrong curve in the wrong direction.
Question 4 (multiple choice · core)
Valdoria’s real interest rate rises above Kestria’s, and net financial capital inflow into Valdoria increases. Assuming CA + CFA = 0, which of the following is consistent with this change in Valdoria’s balance of payments?
- (A) The capital and financial account moves towards a larger surplus, and the current account moves towards a larger deficit.
- (B) The capital and financial account and the current account both move towards a larger surplus.
- (C) The capital and financial account moves towards a larger deficit, and the current account moves towards a larger surplus.
- (D) The current account moves towards a larger surplus, because capital inflows are recorded in the current account.
Answer and explanation
Answer: (A). A net capital inflow is a credit in the capital and financial account (CFA), so the CFA balance rises. Because CA + CFA = 0, the current account (CA) balance must fall by the same amount. This matches the trade side: the inflow makes the valda appreciate, so Valdoria’s net exports fall.
- (B) breaks the identity: the two balances cannot both rise when they must sum to zero.
- (C) treats an inflow as a debit. Money flowing into a country is a credit.
- (D) puts capital flows in the wrong account. Purchases and sales of assets between countries are recorded in the CFA.
Question 5 (calculation · core)
| Nominal interest rate | Expected inflation | |
|---|---|---|
| Valdoria | 5% | 2% |
| Kestria | 8% | 6% |
(a) Calculate each country’s real interest rate. (b) State the direction of financial capital flows between the two countries and the effect on the valda. (c) Expected inflation in Kestria then falls to 3%, while both nominal rates stay the same. Calculate Kestria’s new real interest rate and state what happens to the direction of capital flows and the valda. (d) Before the change in (c), Valdoria’s capital and financial account balance was +VD 9 billion. After it, the balance is −VD 6 billion. Calculate Valdoria’s current account balance before and after, and explain how the change is consistent with your answer to (c).
Worked solution
(a) Valdoria: 5% − 2% = 3%. Kestria: 8% − 6% = 2%.
(b) Capital flows from Kestria to Valdoria (3% > 2%). The demand for valdas rises, so the valda appreciates.
(c) Kestria: 8% − 3% = 5%, now above Valdoria’s 3%. Capital now flows from Valdoria to Kestria, and the valda depreciates.
(d) CA = −CFA. Before: CA = −VD 9 billion (deficit). After: CA = +VD 6 billion (surplus), a rise of VD 15 billion. This fits (c): the valda depreciates, so Valdorian exports rise and imports fall, raising net exports and the current account.
Suggested mark points (5): 1 for both real rates in (a); 1 for the flow to Valdoria with appreciation; 1 for 5% with the reversed flow and depreciation; 1 for both CA values; 1 for linking the CA rise to the depreciation and higher net exports.
Question 6 (constructed response · core)
Valdorian households decide to save a larger share of their incomes. Kestria’s economy and policies do not change.
(a) Draw a correctly labelled graph of Valdoria’s loanable funds market. Show the effect of the extra saving on Valdoria’s real interest rate. (b) Based on your answer to (a), what happens to the flow of financial capital between Valdoria and Kestria? Explain. (c) Draw a correctly labelled graph of the foreign exchange market for valdas. Show the effect of the change in (b) on the exchange rate. (d) What happens to Valdoria’s net exports? Explain. (e) What happens to Kestria’s real interest rate? Explain using Kestria’s loanable funds market.
Worked solution and suggested Marlbridge rubric
(a) Axes: “Real interest rate” (vertical) and “Quantity of loanable funds” (horizontal), with a downward-sloping demand curve and an upward-sloping supply curve. More saving increases the supply of loanable funds, so supply shifts right and the real interest rate falls from r₁ to r₂.
(b) Valdoria’s real interest rate is now relatively lower than Kestria’s, so Kestrian assets become more attractive. Net capital inflow into Valdoria falls: Valdorian savers buy more Kestrian assets and Kestrian savers buy fewer Valdorian assets.
(c) Axes: exchange rate (KS per VD, or the price of a valda in kestas) and quantity of valdas. Valdorians supply more valdas to buy kestas, so the supply of valdas shifts right (and/or demand shifts left as Kestrians want fewer valdas). The exchange rate falls: the valda depreciates.
(d) Net exports rise. The weaker valda makes Valdorian goods cheaper for Kestrians (exports rise) and Kestrian goods dearer for Valdorians (imports fall).
(e) Kestria’s real interest rate falls. Funds flow into Kestria, so the supply of loanable funds in Kestria shifts right, lowering its real interest rate.
| Point | What earns it |
|---|---|
| 1 | Correctly labelled loanable funds graph with supply shifted right and a lower real interest rate |
| 1 | Net capital inflow into Valdoria falls (outflow rises), because its real interest rate is relatively lower |
| 1 | Correctly labelled foreign exchange graph with supply of valdas shifted right (or demand left) |
| 1 | Lower exchange rate shown (valda depreciates) |
| 1 | Net exports rise, with the price reason for exports or imports |
| 1 | Kestria’s real interest rate falls because its supply of loanable funds rises |
Carry forward consistent answers: if (a) shows a higher real interest rate, an inflow in (b), an appreciation in (c) and lower net exports in (d) each earn their points. In (e), “falls” with no market reasoning earns no point.
Question 7 (constructed response · stretch)
Kestria’s central bank uses contractionary monetary policy and raises Kestria’s interest rate. Expected inflation in both countries does not change, and Valdoria’s central bank takes no action.
(a) In which direction will net financial capital flow between the two countries? Explain. (b) What happens to the value of the valda? Explain. (c) What happens to Valdoria’s net exports and aggregate demand? (d) What happens to Valdoria’s real interest rate? Explain using Valdoria’s loanable funds market. (e) A Valdorian commentator says: “Kestria’s policy can only increase Valdoria’s aggregate demand.” Use your answer to (d) to explain why this is not certain.
Model answer and suggested Marlbridge rubric
(a) Kestria’s real interest rate rises relative to Valdoria’s, so financial capital flows from Valdoria to Kestria.
(b) Valdorian savers sell valdas to buy kestas for Kestrian assets, and Kestrians demand fewer valdas. The supply of valdas rises (and demand falls), so the valda depreciates.
(c) Valdorian goods become cheaper abroad and Kestrian goods dearer in Valdoria, so Valdoria’s net exports rise and its AD shifts right.
(d) Funds leaving Valdoria reduce the supply of loanable funds in Valdoria, so it shifts left and Valdoria’s real interest rate rises.
(e) A higher real interest rate in Valdoria makes borrowing dearer, so investment falls, which shifts AD left. AD is pushed right by higher net exports and left by lower investment. Without knowing the sizes of the two effects, the net change in AD cannot be predicted with certainty, so “can only increase” is too strong.
| Point | What earns it |
|---|---|
| 1 | Capital flows to Kestria because its real rate is relatively higher |
| 1 | Valda depreciates, with a supply or demand reason |
| 1 | NX rise and AD shifts right |
| 1 | Valdoria’s real interest rate rises because its supply of loanable funds falls |
| 1 | Investment falls, so the overall effect on AD is uncertain |
In (e), a reason is needed: stating “investment falls” without linking it to the higher real interest rate earns no point.
How did you do?
- Q1 or Q5(a), (c) wrong: re-read Worked example 1 in the study guide and subtract expected inflation first.
- Q2, Q6(c) or Q7(b) wrong: revisit step 2 of “The chain across three markets”.
- Q3, Q6(e) or Q7(d) wrong: revisit steps 4 and 5, and panels (a) and (b) of Figure 1.
- Q6(a)–(b) wrong: revisit “What changes real interest rates”.
- Q4 or Q5(d) wrong: revisit step 6 of the chain and the balance of payments check in Worked example 2.
Then tick off the topic checklist.