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Problem 12.2 A country’s current account deficit is necessarily matched by it’s national
borrowing, i.e., its private borrowing plus its public borrowing:
- CA = (I – Sp) + (G – T)
This equation suggests that in order to reduce a current account deficit a country must
reduce domestic investment, increase private saving, or cut its government budget deficit.
In the 1980’s, at the time of the Volcker disinflation, many people recommended
restrictions on imports from Japan and other countries to reduce the US current account
deficit.
1) How might higher barriers to imports affect domestic investment, private saving,
and the government deficit in the US? Would import restrictions necessarily
reduce a US current account deficit?
2) What measures were actually taken by the US and its trading partners to reduce
the US current account deficit in the 1980s? Did these measures succeed? Why
and/or why not?
3) Plaza, Louvre, bubble economy: connect the dots.
Problem 13.11 In October 1979, the Fed announced it would play a less active role in
limiting fluctuations in US interest rates. Once the new policy was put into effect, the
dollar’s exchange rates against foreign currencies became more volatile.
1) What is the connection between these two events?
2) What other repercussions did US monetary policies of the 1980s have on the
economies of other countries? E.g., the 1980s were a “lost decade” for much of
Latin America. What is the connection, if any, to the Volcker disinflation?
Problems 13.13, 13.12 Suppose the one-year forward $/Є exchange rate is $1.26 per
euro and the spot exchange rate is $1.20 per euro.
1) What is the forward premium on the euro?
2) What is the difference between the interest rate on one-year dollar deposits and
one-year euro deposits (assuming no political risk)?
3) Suppose that the US - eurozone interest difference is less than your answer to (2)
above. What do you expect to happen?
4) Imagine that everyone in the world pays a tax of τ percent on interest earnings and
on any capital gains due to exchange rate changes. How would such a tax affect
your answers to (2) and (3) above?
5) How do these answers change if the tax applies to interest earnings, whether at
home or abroad, but not to capital gains on exchange rate changes, which are
untaxed.
6) Nobel Laureate James Tobin proposed a tax on short-term capital gains on
exchange rate changes? Describe the “Tobin tax” proposal in detail; discuss its
intended consequences.
Problem 13.8 The following report appeared in the New York Times on August 7,1989
(“Dollar’s Strength a Surprise”).
But now the sentiment is that the economy is heading for a “soft landing,” with
the economy slowing significantly and inflation subsiding, but without a recession.
This outlook is good for the dollar for two reasons. A soft landing is not as
disruptive as a recession, so foreign investments that support the dollar are more likely to
continue.
Also, a soft landing would not force the Fed to push interest rates sharply lower
to stimulate growth. Falling interest rates can put downward pressure on the dollar
because they make investments in dollar-denominated securities less attractive to
foreigners, prompting the selling of dollars. In addition, the optimism sparked by the
expectation of a soft landing can even offset some of the pressure on the dollar from
lower interest rates.
1) Interpret the third paragraph of this report using the model of exchange rate
determination developed in Chapter 13 of your text and summarized in Figure
13.4.
2) What addition factors not captured by the Chapter 13 model might help you
explain the second paragraph?
3) Is there a threat of a “hard landing” for the US economy in the fall of 2003? Why
and/or why not?
4) What consequences might follow from a “hard landing” in the fall of 2003?
Problem 14.6 If a currency reform has no effects on an economy’s real variables, why do
governments typically institute currency reforms in connection with broader programs
aimed at halting runaway inflation? In particular, discuss the motivation, mechanics, and
consequences (success and/or failure) of Israel’s currency reform in the 1980s.
Problem 14.6 If a currency reform has no effects on an economy’s real variables, why do
governments typically institute currency reforms in connection with broader programs
aimed at halting runaway inflation? In particular, discuss the motivation, mechanics, and
consequences (success and/or failure) of Brazil’s currency reforms in the 1980s and
1990s.
Problem 14.6 If a currency reform has no effects on an economy’s real variables, why do
governments typically institute currency reforms in connection with broader programs
aimed at halting runaway inflation? In particular, discuss the motivation, mechanics, and
consequences (success and/or failure) of Argentina’s currency reforms in the 1980s and
1990s.
Problem 15.5 Explain the rise and fall of the British pound’s real effective exchange rate
between 1978 and 1984 (see data on page 427 of your textbook). Pay particular attention
to the role of nontradables and events in the world economy, not just the British
economy.
Problems 16.6, 16.13 Suppose that interest rate parity does not hold exactly, but the true
relationship is
R = R* + (Ee – E) / E + ρ
where ρ measures the differential riskiness of domestic versus foreign deposits. Also,
suppose a permanent cut in taxes and a permanent rise in government spending, by
creating the prospect of future government budget deficits, raises ρ.
1) Evaluate the expansionary fiscal policy’s output effects.
2) Evaluate the policy’s impact on the country’s exchange rate. How does this
impact depend on expectations of debt monetization?
3) The tax cuts and defense expenditure increases enacted since 2001 create a
situation much like that described in these textbook problems. Does US
economic experience bear out your answers to parts (1) and (2) of this question?
Describe the path of the US economy and of the dollar’s exchange rate since
2001. How, if at all, do these relate to US fiscal policies?
Problem 16. 9 Some economists put part of the blame for the persistent US current
account deficit of the late 1980s on the apparently small size of the relative price change
between US exports and imports. In Chapter 12, however, the blame was placed on
private and government saving behavior. Give a unified account of the current account
data of the late 1980s and of the early 2000s, reconciling both price and
saving/expenditure effects.
Problem 17.5 The following paragraphs appeared in the New York Times on September
22, 1986 (“Europeans May Prop the Dollar”).
To keep the dollar from falling against the West German mark, the European
central banks would have to sell marks and buy dollars, a procedure known as
intervention. But the pool of currencies in the marketplace is vastly larger than all the
governments’ holdings.
Billions of dollars worth of currencies are traded each day. Without the support
of the US and Japan, it is unlikely that market intervention from even the two most
influential members of the European community – Britain and West Germany – would
have much impact on the markets. However, just the stated intention of the Community’s
central banks to intervene could disrupt the market with its psychological effect.
Economists say that intervention works only when markets turn unusually erratic,
as they have done upon reports of the assassination of a President, or when intervention is
used to push the markets along in a direction where they are already headed anyway.
1) Do you agree with the statement that Germany had little ability to influence the
exchange rate of the DM? Explain.
2) Do you agree with the last paragraph’s evaluation of the efficacy of intervention?
Why and/or why not?
3) Describe how “just the stated intention to intervene” could have a “psychological
effect” on the foreign exchange market. Would this effect support or negate the
stated intention of the monetary authorities?
4) Rewrite the above paragraphs to reflect how you believe intervention and
intended intervention affect foreign exchange markets.
Problem 18.3 In spite of the flaws of the pre-1914 gold standard, exchange rate changes
were rare. In contrast, such changes became quite frequent in the interwar period (1919 –
1939). Contrast the pre – World War I and interwar periods. Explain the difference is
exchange rate behavior in the two periods. (It is not enough to say that currencies were
fixed to gold in the pre – war period. Rather, why did the gold standard “work” before
1914 and why could it not be restored after 1919?)
Problem 18.6 Was the growth of dollar reserve holdings in th eBretton Woods years
“demand-determined” (that is, determined by central banks’ desire to add to their
international reserves) or “supply-determined” (that is, determined by the speed of US
monetary growth)?
1) What do you think? Could both answers be right, depending on what span of
years are being considered? Explain.
2) Does “demand-determined” versus “supply-determined growth of international
reserves matter as far as an explanation of global inflation is concerned? Relate
your answer to the worldwide experience of inflation at different times of the
Bretton Woods era.
Problems 19.8, 19.7 After 1985 the US asked Germany and Japan to adopt fiscal and
monetary expansion as ways of increasing foreign demand for US output and reducing
the US current account deficit.
1) Would fiscal expansion by Germany and Japan have accomplished these goals?
Why or why not?
2) Would monetary expansion by Germany and Japan have accomplished these
goals? Why or why not?
3) After 1985, the US tried to reduce its current account deficit by accelerating
monetary growth and depreciating the dollar. Assume that the US was in internal
balance (inflation and unemployment under control) but external balance called
for an expenditure reducing policy (fiscal contraction) as well as expenditure
switching via currency depreciation. But fiscal contraction was not implemented.
How would you expect the use of monetary expansion alone to affect the US
economy in the short-run? In the long-run?
4) How would German and Japanese actions, as outlined in parts (1) and (2) above,
have helped the US attain external balance without an expenditure-reducing
policy, just monetary expansion and expenditure-switching?
Problem 20.7 During the speculative pressure on the EMS exchange rate mechanism
(ERM) shortly before Britain allowed the pound to float in September 1992, the
Economist opined as follows (“Crisis? What Crisis?” August 29, 1992):
The British government’s critics want lower interest rates, and think this would be
possible if Britain devalued sterling, leaving the ERM if necessary. They are wrong.
Quitting the ERM would soon lead to higher, not lower, interest rates, as British
economic management lost the degree of credibility already won through ERM
membership. Two years ago British government bonds yielded three percentage points
more than German ones. Today the gap is half a point, reflecting investors’ belief that
British inflation is on its way down – permanently.
1) Why might the British government’s critics have thought it possible to lower
interest rates after taking sterling out of the ERM? (Britain was in deep recession
at the time the article appeared.)
2) Why did the Economist think the opposite would occur soon after Britain exited
the ERM?
3) In what way might ERM membership have gained credibility for British
policymakers? (Britain entered the ERM in October 1990.)
4) Why would a high level of British nominal interest rates relative to German rates
have suggested an expectation of high future British inflation? Are there other
explanations for the high British interest rates?
5) Suggest other reasons why British interest rates might have been somewhat higher
than German rates at the time of writing in the Economist, despite the alleged
“belief that British inflation is on its way down – permanently.”
Problem 20.7 Argentina’s situation prior to abandoning her Currency Board 1:1 tie to the
dollar was eerily similar to Britain’s in September 1992, prior to her abandoning
membership in the Exchange Rate Mechanism (ERM). During the speculative pressure
on the Argentine peso shortly before Argentina allowed the peso to float in January 2001,
some economists opined as follows:
The Argentine government’s critics want lower interest rates, and think this would be
possible if Argentina devalued the peso, leaving her fixed exchange rate Currency Board
arrangement. They are wrong. Quitting the Currency Board would soon lead to higher,
not lower, interest rates, as Argentine economic management lost the degree of credibility
already won through Currency Board adherence. (Note: Argentine interest rates were
almost 40 percentage points above US interest rates at this time.)
1) Why might the Argentine government’s critics have thought it possible to lower
interest rates after abandoning the peso’s 1:1 tie to the dollar? (Argentina was in
deep recession at the time.)
2) Why others think the opposite would occur soon after Argentina abandoned her
Currency Board arrangement?
3) In what way might the Currency Board arrangement have gained credibility for
Argentine policymakers? (Argentina instituted her Currency Board in 1991.)
4) What were the consequences of Argentina’s abandoning the peso’s 1:1 tie to the
dollar?
5) Evaluate Argentina’s Currency Board arrangement, from its inception to its
abandonment.