Download Answers to Problem Set 1

ECON 321, International Monetary Theory, Spring 2016
Arslan Razmi
Answers to Problem Set 1
1. Current Account (CA)
Merchandise:
Exports of autos
+200
(goods)
Exports of computer components
+300
Imports of Boeing jets
-100
Import of food
-150
Purchase of insurance
-50
Sale of Airline tickets
+50
(Services)
Trade Balance (on Goods and Services) = +250 million dollars
Investment Income
Interest inflow from US Treasury Bills
+100
Transfers
Repatriation of profits by Japanese corporations
-25
Current account balance = 250+100-25 = +325 million dollars
CAPITAL ACCOUNT (KA) NO TRANSACTIONS
NON-RESERVE FINANCIAL ACCOUNT (FA)
Direct investment by Japanese corporations
+50
Long-term portfolio investment Purchase of US Treasury Bills
-250
Non-reserve Financial account balance -200 million dollars
Balance of payments = 325-200 = +125 million dollars
OFFICIAL RESERVE TRANSACTIONS (ORT)
Purchase of dollars by Bank of Thailand
* CHECK:
-125
CA+FA+KA+ORT = 0
325 + (-200) + (-125) = 0 OK.
A)
(I)
$250
(IV)
$0
(II)
$325
(V)
$125
(III)
-$200
(VI)
-$125
B)
A look at the current account (CA) indicates that the Thai Baht is undervalued. The Bank of Thailand prevents an
appreciation of the currency by purchasing the excess supply of foreign exchange (dollars).
C)
(i)
Since CA > 0 (i.e. current account surplus), Thailand is a net lender of excess savings, which means that
it is increasing its international investment position by $325 million.
(ii)
Since the Bank of Thailand is purchasing US dollars, its foreign exchange reserves increase by $125
million.
CHAPTER 2
3. a. The purchase of the German stock is a debit in the U.S. financial account. There is a corresponding credit in
the U.S. financial account when the American pays with a check on her Swiss bank account because her claims
on Switzerland fall by the amount of the check (think of it as an American export of an asset). This is a case in
which an American trades one foreign asset for another.
b. Again, there is a U.S. financial account debit as a result of the purchase of a German stock by an American.
The corresponding credit in this case occurs when the German seller deposits the U.S. chec, thus increasing
foreign holdings of US assets (the US has exported a financial asset).
c. The foreign exchange intervention by the Korean government involves the sale of a U.S. asset, the dollars it
holds in the United States, and thus represents a debit item in the U.S. (non-reserve) financial account. The
Korean citizens who buy the dollars increase their holdings of dollar assets, which is a credit item in the US
(non-reserve) financial account.
d. The meal is an American import of French services. The payment appears as a debit on the US current
account. Since paying with a Traveler’s check reduces US holding of a foreign (euro) asset, this is a credit
on the US financial account.
e. There is no credit or debit in either the financial or the current account because there has been no market
transaction
f. There is no recording in the U.S. Balance of Payments of this offshore transaction.
5. a. Balance of payments = BP = CA + KA + non-reserve FA = -$1 billion +$0.5 billion = -$0.5 billion.
Because non-central bank financial inflows fell short of the current account deficit by $500 million, the
balance of payments of Pecunia (official settlements balance) was –$500 million. The country as a whole
somehow had to finance its $1 billion current account deficit, so Pecunia’s net foreign assets fell by $1
billion.
b. By dipping into its foreign reserves, the central bank of Pecunia financed the portion of the country’s
current account deficit not covered by private financial inflows. Only if foreign central banks had acquired
Pecunian assets could the Pecunian central bank have avoided using $500 million in reserves to complete the
financing of the current account. Thus, Pecunia’s central bank lost $500 million in reserves, which would
appear as an official financial outflow (of the same magnitude) in the country’s balance of payments
accounts.
c.If foreign official capital inflows to Pecunia were $600 million, the central bank now increased its foreign
assets by $100 million. Put another way, the country needed only $1 billion to cover its current account
deficit, but $1.1 billion flowed into the country (500 million private and 600 million from foreign central
banks). There is now a balance of payments surplus of $100 million. The Pecunian central bank must,
therefore, have used the extra $100 million in foreign borrowing to increase its reserves. Purchases of
Pecunian assets by foreign central banks enter their countries’ balance of payments accounts as outflows,
which are debit items. The rationale is that the transactions result in foreign payments to the Pecunians who
sell the assets.
d. Along with noncentral bank transactions, the accounts would show an increase in foreign assets held in
Pecunia of $1.1 billion (a financial account credit, or inflow) and an increase Pecunian official reserve assets
held abroad of $100 million (a financial account debit, or outflow).
(1) CA
-$1 billion
(2) KA
0 (assumed)
(3) Non-reserve FA
+$1.1 billion
(4 ) BP = (1) + (2) + (3) = +$0.1 billion (i.e., a BP surplus worth half a billion dollars)
(5) Official Settlements Balance -0.1 billion ($1 billion - $1.1 billion)
(6) Total FA = (3) + (5) = $1 billion
CHECK: CA + KA + FA = -1+1 = 0 (as it should be!)
6.
A current account deficit or surplus is a situation that may be unsustainable in the long run. There are
instances in which a deficit may be warranted, for example to borrow today to improve productive capacity
in order to have a higher national income tomorrow. But for any period of current account deficit, there
must be a corresponding period in which spending falls short of income (i.e., a current account surplus) in
order to pay the debts incurred to foreigners. Put differently, a current account deficit means we are
becoming more indebted to the rest of the world and this may become a major problem beyond a certain
point. Running a current account surplus, on the other hand, means that we are spending less than we are
earning (recall that CA = Y – C – I – G), which implies that we are lowering our standard of living.
The reserves of foreign currency held by a country’s central bank change with nonzero values of its official
settlements balance. Central banks use their foreign currency reserves to influence exchange rates. A
depletion of foreign reserves may limit the central bank’s ability to influence or peg the exchange rate. For
some countries (particularly developing countries), central-bank reserves may be important as a way of
allowing the economy to maintain consumption or investment when foreign borrowing is difficult. A high
level of reserves may also perform a signaling role by convincing potential foreign lenders that the country is
creditworthy. The balance of payments of a reserve- currency center (such as the United States under the
Bretton Woods system) raises special issues that are best postponed until Chapter 8.
8. A country could have a current account deficit and a balance of payments surplus at the same time if the
non-reserve financial and capital account surpluses exceeded the current account deficit. Recall that the
balance of payments surplus equals the current account surplus plus the non-reserve financial account
surplus plus the capital account surplus. If, for example, there is a current account deficit of $100 million,
but there are large capital inflows and the non-reserve financial account surplus is $102 million, then there
will be a $2 million balance of payments surplus.
We will revisit this issue when we talk about fixed and flexible exchange rates in chapter 7.
CHAPTER 3
5. The dollar rates of return are as follows:
a. ($250,000 − $200,000)/$200,000 = 0.25 or 25%.
b. ($275 − $255)/$255 = 0.08 or 8%.
c. There are two parts to this return. One is the loss involved due to the appreciation of the dollar; the
dollar appreciation is ($1.38 − $1.50)/$1.50 = −0.08. The other part of the return is the interest paid by the
London bank on the deposit, 10 percent. (The size of the deposit is immaterial to the calculation of the rate of
return.) In terms of dollars, the realized return on the London deposit is thus 2 percent per year.
7. The current equilibrium exchange rate must equal its expected future level since, with equality of nominal
interest rates, there can be no expected increase or decrease in the dollar/pound exchange rate in
equilibrium. Recall that, from the interest parity condition:
R$=R€ + (Ee$/€- E$/€)/ E$/€
If R$=R€, then the expected depreciation (Ee$/€- E$/€)/ E$/€ must be zero.
If the expected exchange rate remains at $1.52 per pound and the pound interest rate rises to 10 percent (5
percent higher than U.S. interest rates), then interest parity is satisfied only if the current exchange rate
changes such that there is an expected appreciation of the dollar equal to 5 percent. This will occur when the
exchange rate rises to $1.60 per pound (a depreciation of the dollar against the pound). Mathematically:
0.05 = 0.1 + (1.52- E$/€)/ E$/€, which yields E$/€=$1.6/€.
8. Consider Figure
3.6 of the text book. If market traders learn that the dollar interest rate will soon fall, they
R
also revise upward their expectation of the dollar’s future depreciation in the foreign exchange market. Given
the current exchange rate and interest rates, there is thus a rise in the expected dollar return on euro deposits
EU ,1
from R1€ to R2€. The curve representing expected ruro returns shifts rightwards as in Figure 3.6. At the
current exchange rate of E1$/€, the dollar return on a European asset exceeds the dollar return on a U.S. asset.
As investors shift their money into European assets, the dollar will depreciate against the euro. This will
drive down the dollar return on European assets until interest rate parity is restored at the new exchange rate
E2$/€.
10. a. If the Federal Reserve pushed interest rates down, with an unchanged expected future exchange rate, the
dollar would depreciate (note that the article uses the term “downward pressure” to mean pressure for
the dollar to depreciate). If there is a “soft landing,” and the Federal Reserve does not lower interest
rates, then this dollar depreciation will not occur.
b. The “disruptive” effects of a recession make dollar holdings more risky. Risky assets must offer some
extra compensation such that people willingly hold them as opposed to other, less risky assets. This
extra compensation may be in the form of a bigger expected appreciation of the currency in which the
asset is held. Given the expected future value of the exchange rate, a bigger expected appreciation is
obtained by a more depreciated exchange rate today. Thus, a recession that is disruptive and makes
dollar assets more risky will cause a depreciation of the dollar.
17. If the dollar depreciated, all else being equal, we would expect outsourcing to diminish. If, as the problem
states, much of the outsourcing is an attempt to move production to locations that are relatively cheaper, then
the United States becomes relatively cheap when the dollar depreciates. Although it may not be as cheap a
destination as some other locations, at the margin, labor costs in the United States will have become
relatively cheaper, making some firms choose to retain production at home. For example, we could say that
the labor costs of producing a computer in Malaysia is $220 and the extra transport cost is $50, but the U.S.
costs were $300; then we would expect the firm to outsource. On the other hand, if the dollar depreciated 20
percent against the Malaysian ringitt, the labor costs in Malaysia would now be $264 (that is, 20 percent
higher in dollar terms, but unchanged in local currency). This, plus the transport costs, makes production in
Malaysia more expensive than in the United States, making outsourcing a less attractive option.
CHAPTER 4
1.
A reduction in the home money demand creates excess supply of money and causes interest rates in the home
country to fall from Rh,1 to Rh,2. In terms of the graph below, the money demand curve shifts upwards.
Foreign assets are now more attractive. With no change in expectations or prices, there will be a depreciation
of the home currency from E1 to E2 as investors shift their savings into higher-interest-paying foreign assets.
In the long run, increased spending on home products (due to lower interest rates and a depreciated
currency) will cause prices to rise (recall that prices are fixed in the short-run but flexible over the longrun). This will shift the real money supply curve inward (not shown in the figure) to a point where home
interest rates return to their original level Rh,1 and the exchange rate falls back to E1.
Note: I haven’t talked about changing expectations here. As discussed in class, expectations change when
the money supply changes. Here it is money demand that changed.
4. An increase in domestic real GNP will cause domestic real money demand to rise. This will cause domestic
real interest rates to rise from Rh,1 to Rh,2 (see graph below). Domestic assets are now more attractive. With no
change in expectations, there will be an appreciation of the home currency from E1 to E2 as investors channel
their savings into domestic assets and away from foreign assets.
Notice that the question is about the short run. Extending it to the long-run would imply that we will have
to incorporate the effect of the price level changing.
7.
a. As we would expect, the price level rises consistently with the increase in the Bolivian money supply.
The long-run price level is defined as P = MS/L(R,Y), so an increase in the money supply should cause
prices to rise. An increase in the money supply and the price level should in turn cause the Bolivian peso
to depreciate against the dollar. With a few exceptions (March 1985 for example), this is also occurring.
b. Between April 1984 and July 1985, the price level rose by 22,908 percent, while the exchange rate
increased by 24,662 percent. Over this same period, the money supply increased by 17,434 percent. We
should expect the price level and the exchange rate to move by the same proportion, as the value of the
Bolivian peso is determined by its purchasing power (eroded by inflation). As the peso becomes less
valuable, then its price relative to another currency (the dollar) should change by the same proportion.
Interestingly, the price level and exchange rate change by a larger percentage than the money supply.
[This is also somewhat expected if we consider the equation for the long-run price level P = MS/L(R,Y).
Inflation will cause real money demand to fall, which causes prices to rise even further than that caused
by the increase in the money supply alone.]
c.
The stabilization plan was effective at reducing the increase in the price level and arresting the
depreciation of the Bolivian peso as supported by the price and exchange rate figures for September–
October 1985. Interestingly, the money supply continued to grow (albeit at a reduced rate) during these
two months. We can partially attribute the differential growth rates to expectations. If people believed the
Bolivian government’s commitment to the stabilization plan, they would have revised their inflation and
exchange rate expectations, causing the actual price and exchange rates to stop rising so quickly.
10. As the interest rate falls, people prefer to hold more cash and fewer financial assets. If interest rates were to
fall below zero, people would strictly prefer cash to financial assets as the zero return on cash would
dominate any negative return. Thus, interest rates cannot fall below zero because no one would hold a
financial asset with a negative rate of return when another asset at a zero rate of return (cash) exists.
Note: It’s funny how the world has changed since this edition was published (a couple of years ago!). We
now have negative inter-bank interest rates in Japan, Sweden, and and a couple of other countries. People
are now willing to pay for the privilege of parking money in short-term deposits and bonds! Why?
11.
One clear complication that a zero interest rate introduces is that the central bank is “out of ammunition.” It
literally cannot reduce interest rates any further and thus may struggle to respond to additional shocks that hit
the economy over time. The central bank is still not completely powerless; it can print more money and try
to increase inflation (increasing inflation with a constant zero interest rate would mean a declining real
interest rate) to stimulate the economy, but the standard toolkit is not operational. Think of the world that we
live in right now!