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Chapter 20: International Financ
Chapter 20: International Financial Policy
Questions and Exercises
1.
If a country is running a balance of trade deficit, the amount of goods it is
exporting is less than the amount of goods it is importing. This is only one part of
the current account, which is the part of the balance of payments that lists all
short-term flows of payments. A deficit in merchandise could be offset by a
surplus in other areas of the account, such as services.
2.
When someone sends 100 British pounds to a friend in the United States, the
transaction will show up as a positive value in the component of the current
account called net transfers, which include foreign aid, gifts, and other payments
to individuals not exchanged for goods or services. It will also appear as a
negative value on the financial and capital account as a receipt of foreign
currency, just like the purchase of a British stock or bond. Note that as expected,
the current account entry balances against the capital account entry because the
balance of payments follows double-entry accounting rules.
3.
The capital and financial account measures the flow of payments between
countries for assets such as stocks, bonds, and real estate, and a surplus means
that capital inflows were more than capital outflows. To buy United States assets,
foreigners need dollars, so the net capital inflows represent a demand for dollars
that can balance the excess supply of dollars due to a current account deficit. In
the short run, a current account deficit, necessarily balanced by a financial and
capital account surplus, is nice because current expenditures, which include the
trade balance, give society immediate pleasure.
4.
A capital and financial account deficit means that financial outflows are more
than financial inflows. The excess supply of dollars is balanced by a current
account surplus, which means Americans are producing more than they are
consuming. In the long run, financial and capital account deficits are nice because
you are building up holdings of foreign assets, which will provide a future stream
of income.
5. a. Supplier b. Supplier c. Supplier
d. Demander e. Demander f. Demander.
6. a. Current account b. Current account
c. Current account
d. Current account e. Capital and financial account
7. a. This suggests that it was running a financial and
capital account deficit since the two largely offset
each other.
b. If the private balance of payments was in surplus,
China must have a fixed or partially flexible
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Chapter 20: International Financ
exchange rate regime, because the central bank was selling its currency.
c. It had to be selling its currency to equalize the balance of payments. In the
accompanying graph, the Chinese central bank had to be supplying (QD– QS)
yuan.
d. The value of the yuan would likely rise. That is, it would take more dollars to buy
a yuan, or alternatively each yuan would get more dollars.
e. The inflation would increase the price of Chinese goods, increasing the real
exchange rate of the yuan, and thereby reducing the pressure on the yuan to rise.
8. a. A rise in the UK price level causes foreign goods to become cheaper. British
demand for foreign currencies will tend to increase, and foreign demand for
pounds will tend to decrease. Thus supply of pounds shifts outward from S0 to S1
and the demand for the pound shifts inward from D1 to D0. The exchange rate
value of the pound falls from P1 to P2, as shown in graph (a) below.
b. A reduction in U.S. tariffs would tend to shift the demand for pounds to the right
from D0 to D1 as Americans buy more imports from the UK. The exchange rate
value of the pound rises from P0 to P1., as shown in graph (b) below.
(a)
(b)
c. A boom in the UK economy means an increase in its income, causing an
increased demand for imports and an increase in the demand for the foreign
currency to buy those imports, thus resulting in an increase in the supply of
pounds. (This may also set off an expectations effect.) Thus, the supply of pounds
shifts outward from S0 to S1. If demand is at D0, the exchange rate value of the
pound falls from P0 to P1, as shown in graph (c) below.
d. If interest rates in the UK rise, there will be an increased demand for its assets, so
the demand for pounds will increase from D0 to D1 and the supply of pounds will
decrease from S1 to S0 as fewer British investors sell their pounds to buy foreign
assets. The exchange rate value of the pound rises from P0 to P1, as shown in
graph d below.
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Chapter 20: International Financ
(c)
(d)
9. a. This is an enormous change. In order to bring it about, the Never-Never
government would have to run an enormously expansionary monetary policy,
reducing the real interest rate possibly to negative amounts and probably
generating significant inflation. As far as trade policies are concerned, the
government could eliminate all tariffs or even subsidize imports, causing imports
to rise and other countries’ currencies to appreciate relative to the neverback. Of
course, since there’s already a large trade
deficit, this may not be a viable option.
b. Holders of neverbacks will demand foreign
currencies (increase in supply of
neverbacks) since the return on neverback
assets has declined. This is shown as a
rightward shift in the supply of neverbacks.
Likewise, potential foreign investors will
demand fewer neverbacks for the same
reason. This is shown as a leftward shift in
the demand for neverbacks. The effect is to
reduce the exchange rate value of the
neverback to $10 per neverback.
10. a. We would suggest buying U.S. dollars and selling currencies of countries in the
EU. (Increased growth in the EU will increase European demand for U.S. goods,
thereby causing the dollar to appreciate.)
b. We would suggest buying U.S. dollars. Since U.S. interest rates are expected to be
higher, the quantity of U.S. assets demanded will rise, and thus the demand for
dollars and the price of dollars will increase.
c. Since the market will likely already have responded to the higher expected
interest rates, the rise will likely have the same effect as a fall in interest rates.
Thus, we would suggest selling U.S. dollars.
d. We suggest selling U.S. dollars by reasoning opposite to that in b.
e. We would suggest selling U.S. dollars in the expectation of a decrease in demand
for U.S. dollars as U.S. goods become more expensive. Also, U.S.-denominated
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Chapter 20: International Financ
assets such as bonds will be worth less with greater inflation, making foreign
assets more attractive to investors.
f. We would suggest buying U.S. dollars because, if the U.S. government imposed
new tariffs, the demand for imports would decline, shifting the supply of dollars
to the left. This would lead to a higher value of the dollar.
11.
Holding the exchange rate above the equilibrium market exchange rate will make
a country's exports more expensive and its imports cheaper than they otherwise
would have been. It will also require the country to finance the deficit using
official reserves or borrowing to do so. It can allow the government to temporarily
not make the contractionary macro adjustments that otherwise would be necessary
to bring the economy into equilibrium. However, when the government runs out
of reserves (or if investors think the government is running out of reserves), the
“fixed” exchange rate will become unfixed and drop precipitously.
12.
Income was likely increasing in the U.S. because imports are positively correlated
with national income.
13.
The schematics are shown in the text.
14.
If Japan ran an expansionary monetary policy, it would increase Japanese imports
of U.S. goods and make American goods comparatively more competitive,
thereby decreasing the U.S. trade deficit. The U.S. dollar would rise relative to the
Japanese yen.
15.
Japan’s contractionary fiscal policy would have an ambiguous effect on the value
of the U.S. dollar because the effect via the interest rate and income paths oppose
one another, and the effect through the price level is a long-run effect.
16.
A rising price level would replace the income effect usually associated with
expansionary monetary policy. However, since rising prices and rising income
both push the exchange rate down, the overall effect as presented in the chapter
will not change.
17.
The effect of expansionary fiscal policy on the exchange rate is ambiguous, while
contractionary monetary policy has the effect of increasing exchange rates. The
net effect will depend on which influence is stronger.
18.
When a foreign country’s purchasing power parity exchange rate is less than the
market exchange rate, the prices of goods in that country tend to be relatively
cheaper than at home. This tends to make traveling there less expensive.
19.
The real exchange rate remains constant since the change in the price level offsets
the change in the exchange rate.
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Chapter 20: International Financ
20. a. If foreigners start believing that there is an increased risk of default, they will
require a higher premium to buy U.S. bonds. That is, they will offer a lower price
to buy them (demand for U.S. bonds will shift to the left). As this happens, bond
prices will fall and interest rates, which move in the opposite direction from their
prices, will rise. The value of the dollar will fall as a result of the lower demand
for bonds (foreigners will not be purchasing as many dollars). That is, the demand
for dollars will also decline, lowering the value of the dollar.
b. Higher interest rates increase the cost of borrowing. This hurts in the short run by
reducing aggregate spending and crowding out private investment, a source of
long-term growth for the U.S. economy. A lower value of the dollar may increase
the competitiveness of U.S. goods in the global economy, but it also makes
imports to the United States more expensive, which, in addition to hurting
individuals, may hurt businesses that use imports as intermediate goods in their
production processes.
21.
Both fixed and flexible exchange rate systems have advantages and
disadvantages. While fixed exchange rates provide international monetary
stability and force governments to make adjustments to meet their international
problems, they have some disadvantages as well: they can become unfixed,
creating enormous instability; and their effect of forcing governments to make
adjustments to meet their international problems can be a disadvantage as well as
an advantage. Flexible rates provide for orderly incremental adjustment of
exchange rates and allow governments to be flexible in conducting domestic
monetary and fiscal policies, but also allow speculation to cause large jumps in
exchange rates (and, as before, the government flexibility may be a disadvantage
too). Given the pluses and minuses of both systems, most policy makers have
opted for a policy in between, called partially flexible exchange rates.
22.
They will sell that currency, which will force the government to use reserves to
protect the currency. Once the government runs out of reserves, it may be forced
to devalue the currency, making the speculators’ predictions self-fulfilling.
23.
If a country eliminates tariffs, the demand for imports will likely increase. To buy
more imports, residents of the country will have to supply more of their own
currency, depressing their currency’s value.
24.
The United States would want to hold up the value of the dollar to help prevent
the surge in import prices that would result from the fall in exchange rates, and to
keep foreigners from buying our assets cheaply. Other countries would want a
higher value of the dollar in order to keep their goods competitive with U.S.
goods.
25.
Three advantages of the euro for Europe are the elimination of the cost of
exchanging currencies, easier price comparisons, and the creation of a larger
market.
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Chapter 20: International Financ
26.
Two disadvantages are loss of independent monetary policy for those countries
that adopt the euro and loss of national identity because the country must give up
its own currency.
Issues to Ponder
1.
In the early 1980s the U.S. government was pursuing tight monetary policy and
expansionary fiscal policy. The high interest rate resulted in a strong dollar.
Expansionary fiscal policy failed to stimulate domestic demand as export demand
fell sharply due to the high dollar. This, accompanied by the high interest rate that
had cut investment, drove the economy into a recession with twin deficits, but a
strong dollar.
2.
He was advocating significant trade restrictions. These trade restrictions would
have likely provoked retaliation by our trading partners, hurting international
cooperation, and hurting the world economy.
3.
No. It is extremely difficult to affect exchange rates. Since we don’t know what
the correct exchange rates are, it is probably best not to try to significantly change
the exchange rates determined by the market by foreign exchange intervention. If
one is going to change exchange rates, one must change one’s domestic monetary
and fiscal policies.
4.
We would use a combination of purchasing power parity, current exchange rates,
and estimates of foreign exchange traders to determine the long-run exchange rate
of the neverback. This combination approach can be justified only by the “that’s
all we have to go on” defense. Since no one really knows what the long-run
equilibrium exchange rate is, and since that exchange rate can be significantly
influenced by other countries’ policies, the result we arrive at could well be
wrong.
5.
He will more likely prefer fixed exchange rates. They provide an anchor, which
restricts government temptation to use expansionary monetary policy.
6. a. Three assumptions of the law of one price are that (1) there are zero transportation
costs, (2) the goods are tradable, and (3) there are no barriers to trade. (There are
many others.)
b. For the law of one price to apply directly, labor would have to be completely
mobile and of identical efficiency and ability in all countries. Thus, it does not
apply directly. However, assuming capital is flexible, there will be significant
indirect pressure toward an equalization of wage rates.
c. Since capital is more mobile than labor, we would expect that the law of one price
would hold more for capital than for labor.
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Chapter 20: International Financ
7.
A common currency would tie these countries together much more closely, create
a larger common market, and make price comparisons among Canada, the United
States, and Mexico easier. It would be politically difficult since each country
would have to give up its own currency, which is a source of national identity.
Since the U.S. dollar would likely predominate, this would be especially
problematic for Canada and Mexico. These countries would also have to give up
their independent monetary policy. Since the economic conditions in the three
countries can differ substantially, doing so would likely be unacceptable for
Canada and Mexico.
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