Download Economics 4333/5333

Economics 4333/5333
Fall 2000
Assignment #3 Sample Answers
1. a. If the country is running a BOP deficit, its imports of goods, services, and assets exceed
its exports. This means that the private supply of its currency on the FX market exceeds
the private demand as residents try to sell their currency to buy the foreign currency
needed for all those imports. If they get this foreign currency from the country’s central
bank, that means the central bank is selling the foreign currency and buying the domestic
currency. (This means the country’s central bank is losing reserves.)
b. If the country’s central bank is not intervening, the one or more other central banks must
be intervening to sell FX and buy the country’s currency.
2. With no central bank intervention, the current account and capital account must offset one
another. With a net capital inflow into the U.S., foreigners must get dollars from somewhere
to acquire U.S. assets. They get those dollars from U.S. importers, so the U.S. must import
more than it exports. In this case, the U.S. ran a current account deficit over this period.
In general, it is technically possible for a capital inflow to occur simultaneously with a
balanced current account or even a current account surplus. In this case, foreign investors do
not get the domestic currency they need from the country excess of goods and services
imports over exports. Instead, in the modern world, they would get it from one or more
central banks that are selling the country’s currency and buying up the currencies of other
countries.
In the late 1800s, however, the world economy was on a gold standard and there was no
central bank in the U.S. The inflow of investment funds into the U.S. could have been the
result of gold shipments here. That is, if foreign investors were unable to obtain dollars in
the foreign exchange market, they could have shipped gold here to obtain dollars. In fact,
however, the U.S. did run a substantial current account deficit, importing all kinds of
manufactured goods for use in the settlement of the western frontier.
3. a. The Fed should buy dollars and sell yen. The additional demand for dollars and supply
of yen will, if done in sufficient quantity, stop the fall in the dollar’s value.
b. The Fed will lose yen reserves, which means the U.S. is running a balance of payments
deficit.
4. The pound value of UK imports determines the supply of pounds (demand for $) in the FX
market. The pound value of UK exports determines the demand for pounds (supply of $) in
the FX market. This means that:
(1)
(2)
Supply of pounds = pound price of imports * Real quantity of imports, and
Demand for pounds = pound price of exports * Real quantity of exports
Consider (1). The pound price of imports is PI/S, where S is the spot exchange rate measured
in $/pound and PI is the $ price of UK imports. The real quantity of imports will be
Economics 4333/5333
Assignment #3 Sample Answers
Page 2
unchanged if the pound price of imports rises 8%, because UK inflation is 8%. We know P I
rises 15% because US inflation is 8%. For PI/S to rise 8%, S must rise by about 7%.
[Technically, S must rise 6.48%, because x = 1.0648 solves (1.15/x) = 1.08.]
Now consider (2). The pound price of UK exports is also given by PX/S, where PX is the $
price of UK exports. The real quantity of pound exports is unchanged if PX/S rises by 8%
because UK inflation is 8%. We know PX rises 15% because US inflation is 8%. For PX/S to
rise 8%, S must rise by about 7%. [Technically, S must rise 6.48%, because x = 1.0648
solves (1.15/x) = 1.08.]
Thus we have a new equilibrium of both the supply and demand curves in the foreign
exchange market shift up by about 7% (technically 6.48%) and rightward by 15%. Thus the
pound appreciates by about 7% (really 6.48%). That is, the pound appreciates by about the
extent to which UK inflation is lower than U.S. inflation (15% - 8% = 7%, or technically
1.15/1.08 = 1.0648).
5. I messed up on this question. I meant to have the quantity measured in yen rather than
dollars. As it is, you can follow the book exactly:
a. The demand curve for USD is downward sloping. As the exchange rate (in JPY/USD)
falls, the dollar price of exports (given a fixed JPY price) rises. This increases the real
quantity of US exports. Since both the quantity of exports and the USD price of exports
rise, the demand for USD rises unambiguously.
The supply curve for USD may slope upward or downward depending on the
elasticity of US import demand. When the exchange rate falls, this increases the dollar
price of imports and the quantity of imports falls. If import quantity falls a lot relative to
the USD price (elastic import demand), the supply of USD will fall and the supply curve
is upward-sloping. If import quantity falls only a little relative to the USD price (inelastic
import demand) , the supply of USD will rise and the supply curve is downward sloping.
b. The market is unstable if the supply curve is downward sloping and flatter than the
demand curve.
NOTE: If we use measure the quantity in JPY rather than USD but continue to measure
the exchange rate as JPY/USD, then the following things happen. The supply curve for
JPY (which is the demand for USD) is unambiguously downward-sloping. The demand
curve for JPY (which is the supply of USD) may be either downward or upward sloping.
If it slopes downward and is flatter than the supply curve, the market will be unstable.