Download Exchange$ Exercise #1 Answers

Course
Course Number
University or College
Professor’s Name
Student Name: ________________________
Section: ______________________________
Exchange$ Exercise #1 Answers (
points)
Please limit your answers to the spaces provided. If necessary, write on the back of the page.
Do not attach printout or additional pages. All questions pertain to the Exchange$ module in the
SimEcon® software package.
Make sure that you have read the “Exchange$ Manual” and “SimEcon® Operation
Instructions.” These materials may be found at the Class Web site prior to beginning the
exercise. For many of the exercise’s questions, it will be necessary to refer to those instructions.
For many of the exercise’s questions, it will be necessary to refer to your text.
Open the Exchange$ Module. You will see the “Initial Conditions.” Print out or copy this table
for future use. Domestic and foreign price indices are shown in this table. If the domestic real
prices of goods and services increase, what will happen to imports and exports of the domestic
nation at a given exchange rate? People will be more inclined to purchase goods and services
from the other nation, so imports will rise. Foreign consumers will buy more goods and
services from their own country, so export will fall. Domestic and foreign interest rates are
also included. If domestic interest rates rise relative to foreign rates, will people be more or less
inclined to invest in the U.S. (domestic)? They will be more inclined.
Click “Continue.” You will see a graph of the supply and demand curves for Euros. Is this
market currently in equilibrium? Yes (Yes, No). Click “Disturb the Market.” Select “Domestic
Price Index” and click “Continue.” Change the domestic price level to 1.25 and click
“Continue.” As a result of this change, at a given exchange rate what will happen to demand for
imports into the U.S.? It will increase. What will happen to foreign demand for exports from
the U.S.? It will decrease. At a given exchange rate will the balance of trade for the U.S.
“improve” or “get worse.” The balance of trade will get worse. Overall, what will happen to
the demand for dollars? Demand will decrease. What will happen to the supply of dollars?
The supply of dollars will increase. As a result of this, what will happen to the Euro price of
dollars? The price will decrease. Draw the resulting graph of this situation.
Price of $
(in €)
S1
S2
$/€1
$/€2
D1
D2
Quantity of $
0
Q1 = Q2
Course
Exchange$ Exercise #1 Answers
Page 2
Click “New Disturbance.” Select “Foreign Interest Rate” and click “Continue.” Increase the
foreign interest rate to 9% and click “Continue.” As a result of this change, what will happen to
the level of foreign financial investments in the U.S. versus Europe? Such investments will go
down. What impact will this have on the demand for dollars, other things being equal? The
demand for dollars will go down. As a result of the higher foreign interest rate, what will
happen to the level of U.S. investments in Europe? Such investments will increase. What
impact will this have on the supply of dollars? The supply of dollars will increase. As a result
of these changes in supply and demand, what will happen to the price of dollars? The price of
dollars will go down.
Click “New Disturbance.” Select “Domestic Interest Rate” and click “Continue.” Increase the
domestic interest rate to 12% and click “Continue.” As a result of this change, what will happen
to the level of foreign financial investments in the U.S. versus Europe? Such investments will
increase. What impact will this have on the demand for dollars, other things being equal? The
demand for dollars will go up. As a result of the higher domestic interest rate, what will
happen to the level of U.S. investments in Europe? Such investments will decrease. What
impact will this have on the supply of dollars? The supply of dollars will decrease. As a
result of these changes in supply and demand, what will happen to the price of dollars? The
price of dollars will go up. Draw a graph of this situation below:
Price of $
(in €)
S2
S1
$/€2
$/€1
D2
D1
Quantity of $
0
Q1 =Q2
Click “New Disturbance,” select “Domestic Real GDP” and click “Continue.” Increase the
domestic real GDP to 12 trillion and click “Continue.” As a result of this change, what will
happen to U.S. demand for imports from Europe? U.S. imports will increase. As a result, what
will happen to the supply of U.S. dollars? The supply of U.S. dollars will increase. Other
things being equal, what will happen to the price of U.S. dollars in Euros? The price of U.S.
dollars will decrease.
Click “New Disturbance.” Select “Foreign Political Stability Index” and click “Continue.”
Decrease the index to 0.50 and click “Continue.”
Course
Exchange$ Exercise #1 Answers
Page 3
As a result of this change, what will happen to the level of foreign financial investments in the
U.S. versus Europe? Such investments will increase. What impact will this have on the
demand for dollars, other things being equal? The demand for dollars will go up. As a result
of this change in demand, what will happen to the price of dollars? The price of dollars will go
up. Draw a graph of this situation below:
Price of $
(in €)
S
$/€2
$/€1
D2
D1
Quantity of $
0
Q1 Q2
Now click “Regulate Market.” Select the button entitled, “Impose a Rate Below Market
Equilibrium” and click “Continue.” Select an exchange rate of exactly 1.00 and click
“Continue.” In order to keep the price of U.S. dollars artificially low, what would the U.S.
central bank have to do to take care of the excess demand? They would have to sell U.S.
dollars. If the U.S. central bank sold U.S. dollars, what would they receive in return? They
would receive Euros. What would thus happen to the foreign exchange reserves of the U.S.
central bank? Such reserves would increase.
Now click “Change Regulation.” Select the button entitled, “Impose a Rate Above Market
Equilibrium” and click “Continue.” Enter a price of 1.25 and click “Continue.” In order to keep
the price of U.S. dollars artificially high, what would the U.S. central bank have to do to take
care of the excess supply? They would have to buy U.S. dollars. If the U.S. central bank
bought U.S. dollars, what would they have to give in return? They would have to give Euros.
What would thus happen to the foreign exchange reserves of the U.S. central bank? Such
reserves would decrease.
Now click “Reset Fixed Rate.” Suppose that the U.S. government wanted to keep the price of
U.S. dollars extremely high! Note that this example is much more typical of a developing
country, but this example uses the United States in order to keep the discussion simple. In order
to keep the price of U.S. dollars extremely high, would the U.S. central bank have to buy or sell a
huge number of U.S. dollars? They would have to buy a huge number of U.S. dollars. What
would the U.S. central bank have to do in return? The U.S. central bank would have to supply
a huge amount of foreign currency (in this case, Euros). In such a scenario, would the foreign
exchange reserves of the U.S. central bank increase tremendously or decrease tremendously?
Such reserves would decrease by a huge amount. Select 4.00 as the desired price of U.S.
dollars and click “Continue.”
Course
Exchange$ Exercise #1 Answers
Page 4
What has happened to the remaining reserves of the U.S. central bank? The reserves of the U.S.
central bank are almost zero. This scenario is exactly what happened during the Mexican Peso
Crisis of the early 1980’s, except that it happened to Mexico instead of the U.S. During the
Mexican Peso Crisis, how did the Mexican government attempt to deal with the situation? They
had to let the value of the peso drop by a lot and had to get help to pay off their debts!
******************************************************************************
Now click Menu to restart the Exchange$ module. When you get to the “Initial Conditions”
click “Continue.” Click “Disturb the Market” and select “Foreign Real GDP.” Click “Continue.”
If foreign real GDP increased, what would happen to U.S. exports to that nation? U.S. exports
would increase. As a result, what would happen to the demand for U.S. dollars? The demand
for U.S. dollars would increase. As a result of this change in demand, what would happen to
the price of U.S. dollars? The price of U.S. dollars would increase. Enter a foreign GDP of
$12 trillion and click “Continue.” Do the results confirm your expectations? They should.
Now click “New Disturbance.” Select the button entitled “Domestic Political Stability Index”
and click “Continue.” Enter an index of 0.70 and click “Continue.” Draw a picture of the
resulting graph below:
Price of $
(in €)
S1
S2
$/€1
$/€2
D
Quantity of $
0
Q1 Q2
This scenario is very unlikely, but suppose that the political stability of the U.S. fell precipitously
(possibly due to the implications of a massive terrorist attack). Would U.S. investors continue to
invest domestically or would they look for better opportunities elsewhere? They would look for
better opportunities elsewhere. What would thus happen to the amount of U.S. investment in
foreign nations? It would increase. What would thus happen to the supply of U.S. dollars? The
supply of U.S. dollars would increase. What would thus happen to the price of U.S. dollars?
The price of U.S. dollars would decrease. Would this be called appreciation or depreciation of
the U.S. dollar? This would be depreciation of the dollar. Considering only the value of the
dollar and no other effect, what would thus happen to the prices of U.S. imports? The prices of
U.S. imports would rise. Due to the Law of Demand, what would thus happen to the quantity
of U.S. imports? U.S. imports would fall.
Course
Exchange$ Exercise #1 Answers
Page 5
Considering only the value of the dollar and no other effect, if the dollar depreciated, would
foreign consumers of U.S. products pay more or less for these goods and services? Foreign
consumers would pay less for U.S. products. Due to the Law of Demand, what would thus
happen to the quantity of U.S. exports? The quantity of U.S. exports would rise. Not
considering more advanced topics and other things being equal, as a result of the devaluation,
would the U.S. balance of trade “improve” or “get worse.” As a result of the depreciation, the
U.S. balance of trade would “improve.”