Download Partial Keys to Question Set 2

Practice Questions #2 for
International Investment Theory for the Determination of FOREX Rate in the Short- and
Long-Run(Questions 1-5); the Combination of Investment and Trade Theories(Question 6),
and Real Factor Analysis (Questions 7-9)
(We will discuss some of these questions, but it would be critical that you try beforehand)
1. Summarize the Uncovered Interest Rate Parity (UCIP) Theory.
1) Show the equation of the UCIP theory by using i, if , Ee t+1, and Et.
2) Explain the equilibrium condition.
3) Explain how Et changes when there is a change in i, if , or/and Ee t+1.
4) 4) How long would an economy move from any disequilibrium to an equilibrium, as
shown above? Why would you feel reluctant to use the Long-Run Equilibrium for
the UCIP?
2. Summarize the Covered Interest Parity Theorem.
1) Show the equation of the UCIP theory by using i, if ,Ft, and Et. Explain the
equilibrium condition.
2) In the equilibrium condition, derive the Forward Premium, which is defined as ( FS/S). Assume all variables have one year duration.
3. 1) Use the CIP, and calculate the Forward Rate, and Forward Premium as would be
quoted in the FOREX market for the following case:
“There is no more of FOREX arbitrage going on;
I=3%, and if = 5%.”; Et = 1.4, where variables, including F, are already on the
annual basis.
3) Suddenly, i is raised to 5%. Now the economy will move to a disequilibrium, and try
to go to another equilibrium. Explain the movement of FOREX rate or Et: what will
happen to Et? What will be the new Et’ ?- Calculate it.
4. Some people use the Forward Rate Ft as a proxy for the expected future Spot Rate Eet+1.
What assumptions about the FOREX market do you need to develop such an idea?
Some people find the difference between the current Forward Rate or Ft and the actually
realized Spot Rate at t+1, Et+1 are random errors. What is the underlying assumption
other than the CIP and UCIP theories that you need to develop this line of idea?
Is this idea supported by empirical works or research results with data?
5. Analyze the impact of the following change on the FOREX rate in the context of
International Capital Flows and International Investment. This means that you are only
looking at the International Investment Market, ignoring the trade aspect. Later, in the
real world question, we will consider both trade and investment.
1) Please, be reminded of the premises/assumptions of the UCIP or CIP theorems about
the price level or inflation.
2) The (domestic) government adopts expansionary fiscal policy.
3) The (domestic) government adopts contractionary fiscal policy.
4) The foreign government adopts expansionary fiscal policy.
5) The foreign government adopts contractionary fiscal policy.
6) The domestic monetary authority adopts expansionary monetary policy.
7) The domestic monetary authority adopts contractionary monetary policy.
8) The foreign monetary authority adopts expansionary monetary policy.
9) The foreign monetary authority adopts contractionary monetary policy.
10) What is ambiguity for the analysis of the following change? For possible different
sets of auxiliary assumptions, explain its impact on capital flows, and FOREX rates:
“The domestic economy booms more than the foreign economy”. And we would
like to analyze its impact on the FOREX rate. In doing so, we would like to focus on
international investment market and international investors. That is because the
international investors are interested only in the impact of the domestic economic
boom on the domestic interest rate, and its immediate reaction in the international
financial market.
11) Suddenly, the international financial market participants revise the expected future
FOREX rate for a country.
6. Combining the Purchasing Power Parity Theory, and UC Interest Parity Theorem:
Similarities and Differences.
So far we have looked at either impact on Trade or International Investment. Now we
look at the impact on both Trade (account) and International Investment (account). In
a word, we now look at the impact on the total (above-the-line) BP account.
1) Analyze the impact of a ‘continuous’/repeated increase in Money Supply. Consider
the impact on Trade as well as International Investment:
In the short run
i)
What happens to International Investment? What is the impact on i? What is the
impact on Capital Flows? What is its impact on E?
In the short-run, the Liquidity Effect dominates for the relationship between MS and
i. Thus upon MS up, i falls. Capital Flows from domestic to foreign countries.
Capital Outflows. Demand for FOREX rises, and Supply of FOREX falls. ED for
FOREX. E goes up in the Capital/Financial Account.
ii)
What will happen to Trade an X-M? What is the impact on Y? What is its impact on
Trade? What is the impact on E?
The expansionary monetary policy many increase Y. It will in turn increase Imports.
And thus X-M down, and ED for FOREX. E will go Up.
iii)
What would be the net impact on BP? What is its impact on FOREX rates? –Would
the domestic currency appreciate or depreciate? Explain why.
ED for FOREX at Trade Account
ED for FOREX in Capital/Financial Account
Thus, the above-the-line Balance of Payment goes DOWN.
A big Excess Demand for FOREX. E will go up for sure.
iv)
Describe the dynamic process of “Overshooting” in this case. And illustrate it.
v)
Draw the relationship between nominal interest rates (X axis) and the FOREX rates
(Y axis).
In the short-run, i falls and E goes Up due to a falling BP (falling Trade Account and
falling Capital/Financial Account).. Here i and E move in the same direction.
The graph will have a downward slope.
In the long-run and suppose that an increase in Money Supply is repeated/continuous.
i)
What will happen to Inflation Rates?
Up.
ii)
What will happen to interest rates, nominal and real interest rate?
In the long-run, i will rise due to the development of inflation expectations in Irving
Fisher equation: i= r+ e . This is called ‘Inflation expectation effect’. In the longrun, this dominates over liquidity effect.
Note that upon an increase in MS, i fell due to liquidity effect (on r), and eventually i
rises due to inflation effect(.e ).
iii)
What will happen to FOREX rates?-Would the domestic currency appreciate or
depreciate?
.In
iv)
the long-run, E rises in PPP or % E = % P.
Draw the relationship between nominal interest rates (X axis) and the FOREX rates
(Y axis)
Here i and E move in the opposite direction. The graph will have a upward slope.
Note that in the long-run, both Purchasing Power Parity and Interest Parity holds:
According to the PPP, this country will have a higher inflation rate, and thus there
will be Appreciation of FOREX or Depreciation of domestic currency.
According to the Irving Fisher theory, while this country will eventually have a
higher inflation rate, and have a higher nominal interest rate than the foreign country.
Yet, capital will not flow into this country. That is because that there has been
depreciation of the domestic currency, and it is expected to continue. Just as the
Interest Parity Theorem says that international investors expect its higher interest rate
to be offset by the future (on-going) depreciation of its (domestic) currency. So the
IPT of i – if = expected rate of depreciation of domestic currency.
Note that this is the case for Japanese recent move to negative interest rate: It is
perhaps inevitable for Japan to increase the Money Supply in ordet to boost
investment through the falling interest rate. The consequence on FOREX rate is that
the falling interest rate will cause Capital Outflows; Demand for FOREX in Japan;
and thus Immediate Appreciation of FOREX (or immediate depreciation of Japanese
Yen). This is from the viewpoint of International Investment. From the viewpoint of
Trade, an increase in Y or its expectations will lead to an increase in Imports, and a
decrease in X-M; an increase in Demand for FOREX; X-M or trade account DOWN,
and thus E Up. This is from the view point of Trade.
In the long-run, if the Japanese monetary authority keeps this line of policy, and
repeatedly increases money supply, inflation rate will go up. And, in the long-run,
both PPP and UCIP predict that there will be continued appreciation of FOREX in
Japan(or Japanese Yen’s continue depreciation). One thing to note is that with
inflation rate going up, the Japanese interest rate cannot be kept low any more:
through Irving Fisher’s equation, the (nominal) interest rate will go up. However, a
higher will NOT attract any International Capital to Japan, the long-run equilibrium
Interest Parity Theory says that the higher interest rate in Japan or the positive interest
rate differential in Japan is matched with an expected depreciation of Japanese Yen.
There will be no Capital Flows into Japan even if Japan gets a higher interest due to a
higher inflation rate.
2) Analyze the impact of a continuous/repeated increase in Government Expenditures
which is funded by issues of Bonds. Consider the impact on both trade and
international investment:
In the short
i)
ii)
iii)
What happens to International Investment and Financial Account of BP? What is the
impact on i? What is the impact on Capital Flows? What is its impact on E?
What will happen to Trade an X-M and Trade Account of BP? What is the impact on
Y? What is its impact on Trade? What is the impact on E?
What would be the net impact on the total BP? What would be its impact on
theFOREX rates? –Would the domestic currency appreciate or depreciate? Explain
why.
Answers
In the short-run
The key is that Trade Account falls due to Y up and M up, but Capital/Financial
Account improves due to i Up, which attracts international investment or Capital
Inflows.
Trade Account: Down
+) Capital Account: Up
The Above-the-line BP: ?
Note that this above-the-line BP shows the overall net Supply or Demand of FOREX
and thus indicates what will happen to E. Now, it depends on the relative magnitude
of Trade Account Down versus Capital Account Up. For example, if Capital Flows
very freely between the two countries, or International Capital is highly mobile, then
overall above-the-line BP will improve. E will fall (domestic currency appreciates).
If international capital is not so mobile, then E will rise.
iv)
v)
Describe the dynamic process of “Overshooting” in this case. And illustrate it.
Draw the relationship between nominal interest rates (X axis) and the FOREX rates
(Y axis)
In the long run
Its impact on P or inflation is only through its change in Money Supply. Is an increase in G made
possible by sakes of bonds to the central bank, which will lead to an increase in Money Supply
or printing of money? P or inflation rate Up, and E Up as well.
Alternatively, if the increase in G is made possible by sales of bonds to the general public, the
money supply would not change. P or E does not change.
Real Factor Analysis
7. Why does the Purchasing Power Parity theorem work better with Tradable Goods than
with Non-tradable goods? (Hint: Is Arbitrage of Non-tradable goods possible?)
8. Take the case of Japan in the 1960s to 1980s.
1) Set up a Two-Sector/Industry model of Tradable goods and Non-tradable goods with
equal economic weights. Suppose that there occur technical innovations in an on-going
fashion. What will happen to the Prices of Tradable goods PT, Prices of Non-tradable
goods PNT, and the overall Price Level of the domestic economy P.
2) Suppose that the overall price level of the foreign economy Pf is rising over time at a
moderate speed. Draw the time trend of P/Pf. If the purchasing power parity is correct,
what will be the time trend of the FOREX rate of E, and q = E / (P/Pf )?
3) What happened to q over time? Did q go up or down? How would you describe the
change of q?
4) How would you relate the actual change in q to some underlying real factor of the
Japanese Tradable good sector?
5) Fill out the following table:
In the usual case where changes in E alone affect international trade-here E causes X, the
appreciation of the domestic currency leads to an (increase/decrease: circle one for the
answer) in exports. E and X(or X-M) are moving in the (same/opposite) direction.
In the case where a ‘third’ real factor affects international trade- here the third factor
causes E and X, the appreciation of the domestic currency comes with an
(increase/decrease: circle one for the answer) in exports. E and X(or X-M) are moving in
the (same/opposite) direction.
9. During the period of the 1970s to 2000s, the nominal and real FOREX rate in Canada
rose. The main factor was differences in productivity between U.S. and Canada. What
could have happened to the Canadian economy if the Canadian government tried to fix
the FOREX rates?