Download Chapter 28 Exchange Rates and Macroeconomic Policy

Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
87
Chapter 28 Exchange Rates and Macroeconomic Policy
Review Questions
2.
Foreigners supply foreign currency (say, in the market where their currency is exchanged for U.S.
dollars) because they want to buy U.S. goods and services or U.S. assets. In general economists
believe that the supply curve for foreign currency is upward sloping. As the price of foreign
currency increases, U.S. goods and services become cheaper. Foreigners buy more U.S. goods
and services, and supply more foreign currency to get the dollars with which to buy the goods.
The following shift the supply of foreign currency schedule to the right: an increase in foreign
GDP, an increase in the relative interest rate in the United States, a change in tastes that makes
U.S. goods more desirable to foreigners, a relative decrease in prices in the United States, and an
expectation that the foreign currency will depreciate. The following shift the supply of foreign
currency curve to the left: a decrease in foreign GDP, a decrease in the relative interest rate in the
United States, a change in tastes that makes U.S. goods less desirable to foreigners, a relative
increase in prices in the United States, and an expectation that the foreign currency will
appreciate.
4.
In the very short run, exchange rates move mainly due to changes in interest rates and
expectations of future exchanges rates since these forces drive hot money. In the short run,
business cycles account for most of the change in exchange rates. Countries with higher relative
GDPs demand more foreign currency, causing their own currencies to depreciate.
6.
Purchasing power parity says that the exchange rate between two countries should adjust until
the average price of goods is approximately the same in the two countries. Exchange rates might
deviate from purchasing power parity because of high transportation costs, barriers to trade, and
the inherent difficulty in trading some goods.
8.
A managed float is when the central bank intervenes in the foreign currency market to prevent an
appreciation or depreciation of its currency. Governments use a managed float to help their
export-oriented industries, to keep costs down for firms that import inputs, or to decrease the risks
of international trade that arise from exchange rate changes.
10.
During the 1980s interest rates rose due to the rising budget deficit, a burst of investment
spending, and a drop in the private saving rate. All of these contributed to a higher U.S. interest
rate, and a capital inflow, as foreigners purchased more U.S. assets than Americans purchased of
foreign assets. The dollar appreciated making American goods more expensive to foreigners, and
foreign goods cheaper to Americans, and a trade deficit resulted. The trade deficit persisted in the
1990s because of the continuing budget deficit, strong investment spending, and relatively low
private savings.
12.
Managed floats are controversial because countries often intervene when the forces behind an
appreciation or depreciation are strong, which only serves to delay inevitable changes in the
exchange rate—sometimes at great cost to a country’s currency reserves.
Problems and Exercises
2.
a. Setting the quantity of pounds demanded equal to the quantity supplied, we have
10 – 2e = 4 + 3e  6 = 5e  e = 6/5, or 1.2 dollars per pound.
b. After the U.S. government intervenes, the demand for pounds equation becomes
12 – 2e. Resolving for equilibrium, the exchange rate climbs to 1.6 dollars per pound, a
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depreciation of the dollar. The U.S. government might intervene in this way if it wanted to
help its export-oriented industries.
4.
Dollars
per
Peso
S1
pesos
pesos
S2
e1
D1
e2
D2
pesos
pesos
Quantity
of pesos
a. As the money supply decreases, the interest rate rises, causing a and I to fall, and, therefore,
decreasing GDP. As the interest rate rises, U.S. assets are more attractive to Americans and
Mexicans. This, combined with the fall in U.S. GDP, causes the demand curve for Mexican
pesos to shift leftward and the supply curve to shift rightward. The U.S. dollar appreciates.
b. The U.S. dollar appreciation causes net exports to fall, further shrinking equilibrium GDP in
the U.S.
c. If the Mexican central bank raised its interest rates just as much as the United States, then the
dollar would not appreciate as much. (It might still appreciate somewhat, depending on the
relative decline in U.S. and Mexican GDP, and the impact of these declines on U.S. net
exports). While U.S. output would still fall, it would not fall as much as in the initial analysis.
6.
a.
Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
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b. A fixed rate of 1.41 dinars per dollar is the equivalent of $0.71 per dinar. Since this is higher
than the market equilibrium price of $0.50 per dinar, Jordan’s central bank must buy dinars to
keep the dinar from depreciating.
c. Jordan would eventually run out of foreign reserves, and so could not buy dinars forever.
d.
An expected fall in the dinar causes the supply curve for dinars to shift rightward from S 1 to
S2and the demand curve to shift leftward D1 to D2.
e. The end result is that Jordan’s central bank must buy even more dinars to maintain the fixed
rate
8.
Since Country B has the higher inflation rate, its relative price level is rising. As its basket of
goods becomes relatively more expensive, only a depreciation of its currency can restore
purchasing power parity. Traders would buy Country A’s currency in order to buy its goods for
resale in Country B. Country A’s currency will appreciate relative to Country B’s (alternately
stated: Country B’s currency will depreciate relative to Country A’s).
10.
(a)
(b)
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(c)
The initial increase in the money supply causes the interest rate to fall (panel (a)), which increases
investment and consumption spending, which shifts the AD curve rightward from AD1 to AD2 in
panel (b). The lower interest rate also shifts the supply of pounds curve leftward, and the demand
for pounds curve rightward in panel (c). The price per pound measured in U.S. dollars rises, and
this dollar depreciation causes net exports to rise. This shifts the AD curve rightward from AD2 to
AD3 in panel (b). Monetary policy is more effective when the effects on exchange rates are
included.
Challenge Questions
2.
More spending by the U.S. government causes U.S. interest rates to rise. This makes U.S. assets
more attractive, increasing the supply and decreasing the demand for foreign currency. The dollar
appreciates, causing net exports to fall, thus reducing real GDP. This makes fiscal policy less
effective in changing equilibrium GDP than it would be if the effects on exchange rates were
excluded.
Economic Applications Exercises
2.
a. Virtually all economists argue that free international trade increases the total consumption
possibilities for all trading partners. Adam Smith noted in The Wealth of Nations, total output
increases in an economy as a result of specialization and division of labor. It is argued that
countries gain in a similar manner as a result of international specialization and division of
labor. David Ricardo elaborated on this argument by noting that gains from international trade
will always occur when each country specializes in the production of those goods and services
in which it possesses a comparative advantage. A comparative advantage exists when the
opportunity cost of producing a good is lower in the domestic economy than in foreign
economies. The gains from trade occur because each country is able to import goods at a lower
opportunity cost than it would face if it produced these goods domestically. If each good is
produced in the country in which the opportunity cost is lowest, the total output of the world
economy is greater.
b. Following Smith and Ricardo, most economists support free international trade and recognize
only a few possible rationales for trade barriers:
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
to protect “infant industries” that cannot compete effectively during their formative
period but will acquire a comparative advantage in the future once a trained labor force
and the necessary infrastructure has been developed,
 to protect industries that are important for national security reasons (to prevent political
pressure from countries or cartels - such as OPEC - that might be able to exert control
over a critical commodity or resource),
 as a mechanism for correcting for differences in environmental and labor laws that result
in lower production costs in countries with fewer environmental and safety regulations,
and
 as a temporary measure to reduce the adjustment costs associated with job losses due to
the loss of comparative advantage in a particular industry.
The political reasons for trade barriers include:
 While consumers always gain from the reduction of trade barriers, firms and workers in
specific industries are better off when substantial trade barriers exist. The owners of firms
and workers in these industries receive very large losses if trade barriers are eliminated;
each individual consumer tends to receive relatively small gains from the elimination of
these barriers. If trade barriers are eliminated, the dollar value of the gains to consumers
will always outweigh the dollar value of the losses to producers and workers. Each
individual consumer, though, has little incentive to lobby for a reduction in specific trade
barriers (nor is even aware of most such trade barriers). Each individual worker and
owner, however, has a substantial incentive to lobby for such trade restrictions. This
“special-interest” effect often results in the passage of laws resulting in trade barriers.
 There is also a concern that free trade with low-wage economies will reduce the wage of
high-wage U.S. workers. In specific industries, such an effect is likely. This argument
was at the heart of much of the opposition to NAFTA (since wage rates are generally
lower in Mexico).
4.
a. When the value of the dollar falls relative to the yen (the number of yen per dollar decreases),
Japanese goods become relatively more expensive for the U.S. to import, while U.S. goods
become relatively less expensive for Japanese to import. Thus when exchange rates drive the
current account, the U.S. current account balance should rise when the value of the dollar
decreases relative to the yen. As one can see in the diagram and the data table below,
throughout the 1980’s and into the early 1990’s there tended to be an inverse relationship
between changes in the U.S. current account balance and changes in the value of the dollar.
Interestingly, since the mid-1990’s there has been a direct rather than an inverse relationship
between current account and the value of the dollar in terms of yen.
b. One can see in the diagram on the Web site that rising real disposable personal income in the
U.S. has helped fuel our consumption of imports. Specifically, the current account tended to
be in deficit (imports exceeding exports) during times of growing real personal income as
Americans used their rising affluence to finance the purchase of imports. Note that in each of
the four recessions since 1980 (1981, 1982, 1990-91, and 2001, as well as the near-recession
in 1995), the current account balance tended to increase, or at least decline more slowly,
indicating that imports tend to decline during recessions. It is interesting to note that real
personal disposable income has continued to grow even through our most recent recession,
spurring greater consumption of imported goods.