Download Practice Question Set 1

Practice Questions for
International Trade Theory for the Determination of FOREX Rate in the Short- and Long-Run(1) .
(We will discuss some of these questions, but it would be critical that you try beforehand)
1. Suppose that the Purchasing Power Parity holds for a new ‘I Phong 7’ by Appule in the world.
Suppose that it costs $1000 in U.S.
Country
Local Price
U.S.
Canada
U.K.
Japan
China
1000 Dollars
1300
500
100,000
7000
PPP Equilibrium
FOREX Rate for a
US citizen ( so
many units of USD
for 1 local
currencies)
1
Actual FOREX
rate for a U.S.
citizen
1
1/1.4
2
1/110
1/6
Is the local
currency
Overvaluaed(+)
or
Undervalued)-)?
0
Formula?
(Hint: It would be easier if you insert one more column of the U.S. price of the I Phong. It is
because all FOREX rates are here expressed against ‘I USD’ or E = # Local Currencies per 1 USD:
Fill in the table:
Country
PPP eq.
PPP eq.
Price in
USD
Actual
Local
Price
P
Pf
US
FOREX
Rate
E
Actual
Local
FOREX
rate
E’
Is the local
currency
Overvaluaed(+)
or
Undervalued)-)?
If E’<E, then
“USD gets more
local currencies
than it should”:
USD is
overvalued, and
Local Currency
Undervalued
U.S.
USD 1000
1000
1
Canada
U.K.
Japan
China
USD 1000
USD 1000
USD 1000
USD 1000
1300
500
100,000
7000
1/1.4
2
1/110
1/6
“According to
PPP, 1 USD
should get 7; In
reality 1USD
gets 6”.
Formula?
P/Pf = E;
E Pf = P
2. The Purchasing Power Parity itself concerns the Long-run and the Flexible Price Level.
All goes through its impact on the Price Level in the long-run:
Absolute version of PPP: E = P/Ff; or
Relative Version of PPP:
%d E =% dP - % dPf ---------(1)
%d E = %dM - % dy + %dv - { %dMf - %d yf + %d vf} by Monetarists Theory
%d E = %dM - % dy - %dMf + %d yf by assuming %d v and %d vf are zero-------(2)
It is convenient to use the Relative Version of the PPP as we are mainly interested in the change
in E.
Use the following table for the start of your analysis:
%d E =
Or
%d P (+)
%d Pf (-)
d% E =
d% M
(+)
d% y
(-)
d% M d% y
(-) (+)
1) Inflation in this economy gets accelerated;
%d E =
%d P (+)
%d Pf (-)
2) The monetary authority adopts expansionary monetary policy one time only, and its impact on
the price level is insignificant due to the on-going weakness of the economy. Here, please, focus
on trade, and ignore the impact on international financial market and investment.
One Time:
(Hint: as there is no change in P or Pf, the purchasing power parity theory would not tell
anything about a possible change in E. This is only a temporary change, which in time will wear
out).
Expansionary monetary policy will lead, in the short-run, a large national income. What will be
the impact of an increase in national income on trade and trade balance? Imports will rise as
income rises. X-M will go down. And net supply of FOREX will go down. Thus, E will go up. There
will be depreciation of domestic currency.
As we shall see, this question can be best dealt with in the context of the Balance of Payment
3) The fiscal authority adopts fiscal monetary policy one time only, and its impact on the price level
is insignificant due to the on-going weakness of the economy.
One Time
(Hint: as there is no change in P or Pf, the purchasing power parity theory would not tell
anything about a possible change in E. This is only a temporary change, which in time will wear
out).
Expansionary fiscal policy will lead, in the short-run, a large national income. What will be the
impact of a rising income level on trade and trade balance? Imports will rise as income rises. XM will go down. And net supply of FOREX will go down. Thus, E will go up. There will be
depreciation of domestic currency
4) The strong economic growth starts due to healthy change/turn-around of the fundamentals of
the economy such as on-going technical innovation
In the long-run:
%d E =
d% E =
%d P (+)
d% M
(+)
d% y
(-)
%d Pf (-)
d% M d% y
(-) (+)
5) The monetary authority starts expansionary monetary policy, which increases real national
income (y) but not the price level due to the ongoing recession in the economy.
%d E =
%d P (+)
%d Pf (-)
6) *The monetary authority starts expansionary monetary policy, which raises the price level but
not real national income as the economy is close to the full employment level.
%d E =
%d P (+)
%d Pf (-)
3. In the International Trade Approach to FOREX rate, we can think of the Short-term direct
impact on Supply and Demand of FOREX, and its impact on FOREX rates. In an exact sense, this
is only a Trade Approach to FOREX rate, not exactly the Purchasing Power Parity Theorem
because the Price Level is assumed to be constant, which may be the case in the short-run. For
each one, use the following table of the Current Account portion of the Above-the-line Balance
of Payment Table:
Supply of FOREX(+)
Exports(X)
Up or Down
Demand for FOREX(-)
Imports(M)
Up or Down
Impact on Price of
FREX
Net: Excess Supply
X-M
Up or Down
Down or Up
1) International Demand for domestic goods (Exports) falls (the price level remains
unchanged).
Supply of FOREX
Exports
Down
Demand for FOREX
Imports
0(no change)
Impact on Price of
FOREX or E
Excess Supply
X-M
Down
Up
2) Domestic Demand for domestic investment (such as construction) falls. And the national
income falls (the price level remains unchanged).
Supply of FOREX
Exports
No change
Demand for FOREX
Imports
Down
Excess Supply
X-M
Up
Impact on Price of
FOREX or E
Down
3) Economy booms and national income rises (the price level remains unchanged).
Supply of FOREX
Exports
Demand for FOREX
Imports
Up
Impact on Price of
FOREX or E
Excess Supply
X-M
Down
Up
4) Suppose that international demand for export goods rises for the reasons to be found in the
Japanese economy, such as ever improving quality or ever rising productivity.
In the short-run as
Supply of FOREX
Exports
Demand for FOREX
Imports
Excess Supply
X-M
Impact on Price of
FOREX or E
5) A one-time Fiscal Policy increases national income.
Supply of FOREX
Exports
Demand for FOREX
Imports
Excess Supply
X-M
Impact on Price of
FOREX or E
(Hint: it may not matter whether it is fiscal or monetary policies; what matters is Imports
which is a function of domestic national income (and relative price which is assumed to be
constant for now), Exports, which is a function of foreign national income (and relative price
which is assumed to be constant here).
6) A one-time expansionary monetary policy increases national income.
Supply of FOREX
Exports
Demand for FOREX
Imports
Excess Supply
X-M
Impact on Price of
FOREX or E
7) What will happen to the Canadian FOREX rate if the U.S. economy is expected to boom?
Supply of FOREX
Exports
Demand for FOREX
Imports
Excess Supply
X-M
Impact on Price of
FOREX or E
4.
We may combine the above 3. and 2. in the short-run (P is assumed to be fixe) and the longrun (P is now fully flexible) respectively. Still let us focus on Trade Account.
What will be impacts on FREX rate in the short-run (with rigid level) and in the long-run (with flexible
price level)? Obviously you will have to use the Trade Approach. Specify what theories you are using for
the analysis of the short- and the long-term impacts.
1) The government applies Monetary Policy, one time only, to increase national income.
In the short-run, an increased national income will lead to more consumption of all goods,
including Imports. As there is no reason why exports should change as there is no change in
foreign country’s national income. Thus X-M falls, and E may rise. (however, the rising E will be
worn out as the compensating changes happen over time: X-M rebounds and E falls to some
extent).
Supply of FOREX
Demand for FOREX
Excess Supply
Exports
No change
Imports
Up
Impact on Price of
FOREX or E
X-M
Down
Up
(later falling back to
an extent)
In the long-run, we use the PPP
%d E =% dP - % dPf
%d E = %dM - % dy + %dv - { %dMf - %d yf + %d vf} by Monetarists Theory
%d E = %dM - % dy - %dMf + %d yf by assuming %d v and %d vf are zero.
In this case, there is some ambiguity on what will happen to the price level. It depends whether
the current national income is at and above, or below, the full employment level.
However, we can deduct that no rational government would apply Expansionary Monetary
Policy if there is a real danger of imminent inflation or touching it off. Beside, even if the
economy is at the full employment level, a one-time-only increase in money supply would not
lead to on-going inflation as is specified in the PPP. Thus, it would be safe to assume that there
is no permanent change in inflation rates, or money creation rate, or long-term growth rate. E
would not move around.
%d E =
d% E =
%d P (+)
None
d% M
(+)
None
d% y
(-)
None
%d Pf (-)
None
d% M d% y
(-) (+)
None None
2) The government adopts Expansionary Fiscal Policy one time only to increase national income.
3) The monetary authority adopts Expansionary Monetary Policy over and again. And people think
that this is only a start of continuous Expansionary Monetary Policy for the future.
(Hint: In the long run, %d P will change as does %d M, but %d y would not change. Why? What do
the Monetarists say about the d%y and their contributing factors?)
You answer:
In the short-run
Supply of FOREX
Exports
Demand for FOREX
Imports
Excess Supply
X-M
Impact on Price of
FOREX or E
In the long-run,
%d E =
d% E =
%d P (+)
d% M
(+)
d% y
(-)
%d Pf (-)
d% Mf d% yf
(-) (+)
4) The national income starts growing strongly (continuously) due to the improvement of the
economy’s fundamentals, including productivity in general.
In the short-run
In the long-run