Download chapter 33 (18)

CHAPTER 33 (18)
Questions for Thought and Review
2.
When someone sends 100 British pounds to a friend in the United States, the transaction will show up 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 on the capital account as a receipt of
foreign currency just like the purchase of a British stock or bond.
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, capital account deficits are nice because you are building up
holdings of foreign assets, which will provide a future stream of income.
6.
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.
8.
It was likely increasing because imports are positively correlated with national income.
10. If Japan ran an expansionary monetary policy, it would increase Japanese imports of U.S. goods and make
American goods comparatively more competitive, and thereby decrease the U.S. trade deficit. The U.S.
dollar would rise relative to the Japanese yen.
12. Since the effect of monetary policy is to push the exchange rate down in all effects, this will not change the
effect presented in the chapter, other than to eliminate the effect through income and replace it with the
effect through prices.
14. 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.
16. 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 policymakers have opted
for a policy in between-partially flexible exchange rates.
18. 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 speculator’s
predictions self-fulfilling.
20. 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.
22. The U.S. 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.
24. Two disadvantages is 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.
Problems and Exercises
2.
The graph below shows the fundamental analysis of the supply and demand for British pounds sterling in
terms of dollars, and the effect of the following changes:
Price of pounds in
dollars per pound
S0
S1
P1
P0
D1
P2
D0
Q0 Q1 Q2
Quantity of pounds
a.
b.
c.
d.
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.
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. If supply is at S1, the exchange rate value of the pound rises
from P2 to P0.
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 P2.
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 P2 to P1.
4.
a.
Supplier; b. Supplier; c. Supplier;
d. Demander; e. Demander; f. Demander.
6.
a.
b.
c.
d.
e.
Current account
Current account
Current and capital and financial accounts
Current account
Capital and financial account
8.
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.
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 who use imports as intermediate goods in their production processes.
b.
Web Questions
2.
The answer to this question depends on the country chosen. We chose Brazil.
a. The Brazilian currency is the real.
b. The currency remained virtually unchanged from 2004 to 2005.
c. Brazil has gotten inflation under control. Unemployment is expected to decline as the economy
continues to grow. Fiscal spending is under control. The economy appears to be in good health, which
may be contributing to a stable currency.