Download YORK UNIVERSITY

YORK UNIVERSITY
DEPARTMENT OF ECONOMICS
ECONOMICS 3150C
INTERNATIONAL TRADE I
Test #2
October 28, 2010
ANSWER ANY THREE OF THE FOLLOWING QUESTIONS.
1. If country A is committed to maintaining a fixed exchange rate between its currency and
that of country B, would it be better off with this policy and its own currency, or would it be
better off giving up it currency and joining into a currency union with country B where the
union used country B’s currency?
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Only advantage in retaining own currency is ability to periodically change exchange rate
o Reduces credibility of commitment to fixed exchange rate
o Limits the sue of monetary policy for domestic purposes
o Opens the currency to speculative attacks, especially when the country lacks
adequate foreign reserves
Fixed exchange rate requires holding of foreign reserves – usually low yielding assets,
especially compared to alternative uses for the money
If country really is committed to fixed exchange rate with no intention of ever changing the
rate, then joining into currency union superior option
o Reduces currency risks and trading costs
o Eliminates speculation and need for foreign reserves
o Reduces interest rates if currency of larger country is adopted
Currency union makes sense if two countries are quite similar in many important
characteristics
o There needs to be alternative adjustment mechanisms to changes in exchange rate –
labor mobility, fiscal transfers, debt guarantees
2. Short-term interest rates in Canada are higher than the short-term interest rates in the US.
Despite this, the Canadian dollar declined in value against the US dollar this week when
investors anticipated that the Bank of Canada would not raise short-term interest rates. Why
did the Canadian dollar depreciate?
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Covered interest parity can result in stable exchange rates even when interest rates differ,
especially if there is a risk premium require for investments in Canadian dollar financial
assets
Financial markets may have anticipated an increase in short-term interest rates in Canada
and built this expectation into the spot and future exchange rates
o When B. of C. failed to increase rates, markets reacted by reducing value of
Canadian dollar both in spot and future markets
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Investors may have taken B. of C. action as signal that Canadian economy was weakening
and future returns on investment in Canadian dollar financial assets would be lower than
expected
Other variables may have changed to put downward pressure on Canadian dollar – e.g.,
lower commodity prices, increase in risk premium, improved expectations for investments
in US dollar financial assets
3. The Bank of Japan reduced interest rates to 0% and intervened directly in the currency
markets to force down the value of the Yen against the US dollar (depreciation of the Yen).
Since the Bank took these actions, the Yen has appreciated against the US dollar. Why?
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Financial markets might have expected as a result that government would take every
measure possible to stimulate Japanese economy and thus increase returns on investments in
select Yen denominated financial assets
Financial markets anticipated this move by B. of J. and so no impact on expectations
regarding continued appreciation of Yen
Expectations for US economy worse than for Japanese economy, especially following
reduction in rates in Japan, so capital flows out of US dollar assets into Yen denominated
assets
4. Can any country escape the negative spillover effects of a financial crisis in the US or the
European Union? Discuss.
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Not likely, but some countries might experience less of a negative economic spillover shock
o Currency depreciation
o Less dependent on trade – domestic demand more important and government
provided stimulus to domestic demand
o Less dependent on trade with US or EU – but other trading partners likely to be
adversely affected, so difficult to escape indirect effects
Less likely to escape financial shock because of flight to safety
o Positive effect of depreciation, but possibly sharply higher interest rates
o But, capital less available (credit crunch) – restricts domestic investment spending
o Erosion in investor confidence spills over to reduce business and consumer
confidence
5. China holds over $1 trillion in US Government securities. If the US seriously initiates trade
actions against Chinese companies, would China begin to sell its holdings of US
Government securities? Explain.
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Not likely
o Upward pressure on Yuan vs. US dollar eroding competitiveness of Chinese
companies in US and other markets
o Potential for sharp decline in US asset prices – collapse in confidence in US and
elsewhere – new recession in US further reducing demand for Chinese produced
products
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o Higher interest rates in US and elsewhere – compounds impact on aggregate demand
in US and most economies of decline in confidence
o Substantial losses on investments by China in US Government securities and other
US assets
6. The Bank of Canada will not intervene in the currency market to move the value of the
Canadian dollar either up or down against the US dollar. But the Bank has indicated that it
will intervene to limit the volatility of the exchange rate. That is, the Bank will try to
prevent the exchange rate from rising too rapidly or falling too rapidly or moving
dramatically from day-to-day. Do you agree with the Bank’s position? Discuss.
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Intervention to manage exchange rate limits use of monetary policy for domestic economic
objectives, also B. of C. may not be credible in financial markets
On the other hand, periodic intervention aimed at reducing volatility may not limit use of
monetary policy domestically and/or may be viewed as credible and worthwhile by
investors in the capital markets, including the currency markets
o B. of C. may be more likely to succeed with periodic intervention to smooth out
currency fluctuations
o Reduces uncertainty and currency risks – reduces hedging/trading costs
Problem: B. of C. may act too late an thus make volatility worse
o E.g., exchange rate may decline 10% one day – what does the Bank do? Wait to see
what happens next?
o If Bank waits, what if exchange rate rises 8% the next day – should it intervene
now? What if the rate were to stabilize on its own?
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