# Economic theory suggests that nancial intermediaries, and particularly banks, are essential for chanelling resources towards investment, which in turn fuels economic growth

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Question 1: Economic theory suggests that nancial intermediaries, and particularly banks, are essential for chanelling resources towards investment, which in turn fuels economic growth. In this question, you will use statistical techniques to investigate whether this relationship holds for developing countries.

Explain the basis for your choice of the other 18 countries. Note that trying to create a sample that spans the globe geographically may sound like a good idea to many students but it might equally re ect super cial thinking.

Question 2: From the WDI website: http://databank.worldbank.org/data/reports.aspx?source=wdi-database-archives-(beta)search for and download the following variables for three countries (one that corre- sponds to the rst letter of your rst name, another that corresponds to the rst letter in your surname, plus one more you can choose yourselves) for all the dates available. For each of the countries you choose, make sure that there are at least ten years of data for all the variables listed below.

Money and quasi money (M2) (current LCU).

Money and quasi money (M2) to total reserves ratio

Consumer price index (2010 = 100)

GDP (current LCU)

Lending interest rate (%)

O cial exchange rate (LCU per US\$, period average)

(a)Produce a scatter plot (choose the option that connects the dots) Money and quasi money (M2) on the horizontal axis and the Consumer Price index on the vertical axis. How does the relationship evolve over time?

(b)Produce a scatter plot (choose the option that connects the dots) Money and quasi money (M2) on the horizontal axis and GDP (current LCU) on the vertical axis. How does the relationship evolve over time? What happens to the slope of the graph and how do you interpret it? Explain in a few sentences. Hint: Think of David Hume`s Quantity Theory of Money.

(c)Plot the Money and quasi money (M2) to total reserves ratio as it evolves over time (M2 on the vertical axis, dates on the horizontal axis). Write a paragraph about how this is evolving over time. Are the changes a function of changes to regulation or economic conditions at di erent times?

(d)Suppose you have lending interest rate data and exchange rate data for pe- riods t through period t + h (take the largest period that has data for both series). In period t, a lender starts with one unit of the currency. He or she lends it out during that period and receives the principal plus interest at the beginning of the next period. Graph how the value of the investment evolves over time as both the principal and interest accrues from time t to time h-1. Hint: at the beginning of t+1 the value of the investment is: 1+it, at the beginning of period t+2: (1 + it) (1 + it+1), and at the beginning of period h: (1 + it) (1 + it+1)...(1 + it+h 1).

(e) Now redo the calculation but assume the initial amount is equal in the lo- cal currency to one dollar. Consider how the value of the investment evolves taking into account the exchange rate. Use the rstformula on page 404 in Mishkin et al., but remember the o cialexchange rate you downloaded from the WDI website is the inverse of the exchange rate Ein the book. Graph the result over time. Hint: after you invert the exchange rate, at the begin-

ningof t+1 the value of the investment is: 1+iEt+1 E, at the beginning of

Et

 period t+2: 1 + it + Et+1 Et 1 + it+1 + Et+2 Et+1 , and at the beginning of Et Et+1 Et+h Et+h 1 Et+1 Et Et+2 Et+1 period h: 1 + it + Et 1 + it+1 + ... 1 + it+h 1 + . Et+1 Et+h 1

(f)Now do the same calculation and graph for the United States (just the interest rate, the exchange rate for the US is always equal to 1) for periods t through h-1. Compare the rate of return as it evolves over time using a graph to the rate of return for each country you calculated in the previous question. Do your results support (approximately) the interest parity condition?

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