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Chapter 20: International Financ Chapter 20: International Financial Policy Questions and Exercises 1. If a country is running a balance of trade deficit, the amount of goods it is exporting is less than the amount of goods it is importing. This is only one part of the current account, which is the part of the balance of payments that lists all short-term flows of payments. A deficit in merchandise could be offset by a surplus in other areas of the account, such as services. 2. When someone sends 100 British pounds to a friend in the United States, the transaction will show up as a positive value in the component of the current account called net transfers, which include foreign aid, gifts, and other payments to individuals not exchanged for goods or services. It will also appear as a negative value on the financial and capital account as a receipt of foreign currency, just like the purchase of a British stock or bond. Note that as expected, the current account entry balances against the capital account entry because the balance of payments follows double-entry accounting rules. 3. The capital and financial account measures the flow of payments between countries for assets such as stocks, bonds, and real estate, and a surplus means that capital inflows were more than capital outflows. To buy United States assets, foreigners need dollars, so the net capital inflows represent a demand for dollars that can balance the excess supply of dollars due to a current account deficit. In the short run, a current account deficit, necessarily balanced by a financial and capital account surplus, is nice because current expenditures, which include the trade balance, give society immediate pleasure. 4. A capital and financial account deficit means that financial outflows are more than financial inflows. The excess supply of dollars is balanced by a current account surplus, which means Americans are producing more than they are consuming. In the long run, financial and capital account deficits are nice because you are building up holdings of foreign assets, which will provide a future stream of income. 5. a. Supplier b. Supplier c. Supplier d. Demander e. Demander f. Demander. 6. a. Current account b. Current account c. Current account d. Current account e. Capital and financial account 7. a. This suggests that it was running a financial and capital account deficit since the two largely offset each other. b. If the private balance of payments was in surplus, China must have a fixed or partially flexible Colander’s Economics, 8e. McGraw Hill © 2010 1 Chapter 20: International Financ exchange rate regime, because the central bank was selling its currency. c. It had to be selling its currency to equalize the balance of payments. In the accompanying graph, the Chinese central bank had to be supplying (QD– QS) yuan. d. The value of the yuan would likely rise. That is, it would take more dollars to buy a yuan, or alternatively each yuan would get more dollars. e. The inflation would increase the price of Chinese goods, increasing the real exchange rate of the yuan, and thereby reducing the pressure on the yuan to rise. 8. a. A rise in the UK price level causes foreign goods to become cheaper. British demand for foreign currencies will tend to increase, and foreign demand for pounds will tend to decrease. Thus supply of pounds shifts outward from S0 to S1 and the demand for the pound shifts inward from D1 to D0. The exchange rate value of the pound falls from P1 to P2, as shown in graph (a) below. b. A reduction in U.S. tariffs would tend to shift the demand for pounds to the right from D0 to D1 as Americans buy more imports from the UK. The exchange rate value of the pound rises from P0 to P1., as shown in graph (b) below. (a) (b) c. A boom in the UK economy means an increase in its income, causing an increased demand for imports and an increase in the demand for the foreign currency to buy those imports, thus resulting in an increase in the supply of pounds. (This may also set off an expectations effect.) Thus, the supply of pounds shifts outward from S0 to S1. If demand is at D0, the exchange rate value of the pound falls from P0 to P1, as shown in graph (c) below. d. If interest rates in the UK rise, there will be an increased demand for its assets, so the demand for pounds will increase from D0 to D1 and the supply of pounds will decrease from S1 to S0 as fewer British investors sell their pounds to buy foreign assets. The exchange rate value of the pound rises from P0 to P1, as shown in graph d below. Colander’s Economics, 8e. McGraw Hill © 2010 2 Chapter 20: International Financ (c) (d) 9. a. This is an enormous change. In order to bring it about, the Never-Never government would have to run an enormously expansionary monetary policy, reducing the real interest rate possibly to negative amounts and probably generating significant inflation. As far as trade policies are concerned, the government could eliminate all tariffs or even subsidize imports, causing imports to rise and other countries’ currencies to appreciate relative to the neverback. Of course, since there’s already a large trade deficit, this may not be a viable option. b. Holders of neverbacks will demand foreign currencies (increase in supply of neverbacks) since the return on neverback assets has declined. This is shown as a rightward shift in the supply of neverbacks. Likewise, potential foreign investors will demand fewer neverbacks for the same reason. This is shown as a leftward shift in the demand for neverbacks. The effect is to reduce the exchange rate value of the neverback to $10 per neverback. 10. a. We would suggest buying U.S. dollars and selling currencies of countries in the EU. (Increased growth in the EU will increase European demand for U.S. goods, thereby causing the dollar to appreciate.) b. We would suggest buying U.S. dollars. Since U.S. interest rates are expected to be higher, the quantity of U.S. assets demanded will rise, and thus the demand for dollars and the price of dollars will increase. c. Since the market will likely already have responded to the higher expected interest rates, the rise will likely have the same effect as a fall in interest rates. Thus, we would suggest selling U.S. dollars. d. We suggest selling U.S. dollars by reasoning opposite to that in b. e. We would suggest selling U.S. dollars in the expectation of a decrease in demand for U.S. dollars as U.S. goods become more expensive. Also, U.S.-denominated Colander’s Economics, 8e. McGraw Hill © 2010 3 Chapter 20: International Financ assets such as bonds will be worth less with greater inflation, making foreign assets more attractive to investors. f. We would suggest buying U.S. dollars because, if the U.S. government imposed new tariffs, the demand for imports would decline, shifting the supply of dollars to the left. This would lead to a higher value of the dollar. 11. Holding the exchange rate above the equilibrium market exchange rate will make a country's exports more expensive and its imports cheaper than they otherwise would have been. It will also require the country to finance the deficit using official reserves or borrowing to do so. It can allow the government to temporarily not make the contractionary macro adjustments that otherwise would be necessary to bring the economy into equilibrium. However, when the government runs out of reserves (or if investors think the government is running out of reserves), the “fixed” exchange rate will become unfixed and drop precipitously. 12. Income was likely increasing in the U.S. because imports are positively correlated with national income. 13. The schematics are shown in the text. 14. If Japan ran an expansionary monetary policy, it would increase Japanese imports of U.S. goods and make American goods comparatively more competitive, thereby decreasing the U.S. trade deficit. The U.S. dollar would rise relative to the Japanese yen. 15. Japan’s contractionary fiscal policy would have an ambiguous effect on the value of the U.S. dollar because the effect via the interest rate and income paths oppose one another, and the effect through the price level is a long-run effect. 16. A rising price level would replace the income effect usually associated with expansionary monetary policy. However, since rising prices and rising income both push the exchange rate down, the overall effect as presented in the chapter will not change. 17. The effect of expansionary fiscal policy on the exchange rate is ambiguous, while contractionary monetary policy has the effect of increasing exchange rates. The net effect will depend on which influence is stronger. 18. When a foreign country’s purchasing power parity exchange rate is less than the market exchange rate, the prices of goods in that country tend to be relatively cheaper than at home. This tends to make traveling there less expensive. 19. The real exchange rate remains constant since the change in the price level offsets the change in the exchange rate. Colander’s Economics, 8e. McGraw Hill © 2010 4 Chapter 20: International Financ 20. a. If foreigners start believing that there is an increased risk of default, they will require a higher premium to buy U.S. bonds. That is, they will offer a lower price to buy them (demand for U.S. bonds will shift to the left). As this happens, bond prices will fall and interest rates, which move in the opposite direction from their prices, will rise. The value of the dollar will fall as a result of the lower demand for bonds (foreigners will not be purchasing as many dollars). That is, the demand for dollars will also decline, lowering the value of the dollar. b. Higher interest rates increase the cost of borrowing. This hurts in the short run by reducing aggregate spending and crowding out private investment, a source of long-term growth for the U.S. economy. A lower value of the dollar may increase the competitiveness of U.S. goods in the global economy, but it also makes imports to the United States more expensive, which, in addition to hurting individuals, may hurt businesses that use imports as intermediate goods in their production processes. 21. Both fixed and flexible exchange rate systems have advantages and disadvantages. While fixed exchange rates provide international monetary stability and force governments to make adjustments to meet their international problems, they have some disadvantages as well: they can become unfixed, creating enormous instability; and their effect of forcing governments to make adjustments to meet their international problems can be a disadvantage as well as an advantage. Flexible rates provide for orderly incremental adjustment of exchange rates and allow governments to be flexible in conducting domestic monetary and fiscal policies, but also allow speculation to cause large jumps in exchange rates (and, as before, the government flexibility may be a disadvantage too). Given the pluses and minuses of both systems, most policy makers have opted for a policy in between, called partially flexible exchange rates. 22. They will sell that currency, which will force the government to use reserves to protect the currency. Once the government runs out of reserves, it may be forced to devalue the currency, making the speculators’ predictions self-fulfilling. 23. If a country eliminates tariffs, the demand for imports will likely increase. To buy more imports, residents of the country will have to supply more of their own currency, depressing their currency’s value. 24. The United States would want to hold up the value of the dollar to help prevent the surge in import prices that would result from the fall in exchange rates, and to keep foreigners from buying our assets cheaply. Other countries would want a higher value of the dollar in order to keep their goods competitive with U.S. goods. 25. Three advantages of the euro for Europe are the elimination of the cost of exchanging currencies, easier price comparisons, and the creation of a larger market. Colander’s Economics, 8e. McGraw Hill © 2010 5 Chapter 20: International Financ 26. Two disadvantages are loss of independent monetary policy for those countries that adopt the euro and loss of national identity because the country must give up its own currency. Issues to Ponder 1. In the early 1980s the U.S. government was pursuing tight monetary policy and expansionary fiscal policy. The high interest rate resulted in a strong dollar. Expansionary fiscal policy failed to stimulate domestic demand as export demand fell sharply due to the high dollar. This, accompanied by the high interest rate that had cut investment, drove the economy into a recession with twin deficits, but a strong dollar. 2. He was advocating significant trade restrictions. These trade restrictions would have likely provoked retaliation by our trading partners, hurting international cooperation, and hurting the world economy. 3. No. It is extremely difficult to affect exchange rates. Since we don’t know what the correct exchange rates are, it is probably best not to try to significantly change the exchange rates determined by the market by foreign exchange intervention. If one is going to change exchange rates, one must change one’s domestic monetary and fiscal policies. 4. We would use a combination of purchasing power parity, current exchange rates, and estimates of foreign exchange traders to determine the long-run exchange rate of the neverback. This combination approach can be justified only by the “that’s all we have to go on” defense. Since no one really knows what the long-run equilibrium exchange rate is, and since that exchange rate can be significantly influenced by other countries’ policies, the result we arrive at could well be wrong. 5. He will more likely prefer fixed exchange rates. They provide an anchor, which restricts government temptation to use expansionary monetary policy. 6. a. Three assumptions of the law of one price are that (1) there are zero transportation costs, (2) the goods are tradable, and (3) there are no barriers to trade. (There are many others.) b. For the law of one price to apply directly, labor would have to be completely mobile and of identical efficiency and ability in all countries. Thus, it does not apply directly. However, assuming capital is flexible, there will be significant indirect pressure toward an equalization of wage rates. c. Since capital is more mobile than labor, we would expect that the law of one price would hold more for capital than for labor. Colander’s Economics, 8e. McGraw Hill © 2010 6 Chapter 20: International Financ 7. A common currency would tie these countries together much more closely, create a larger common market, and make price comparisons among Canada, the United States, and Mexico easier. It would be politically difficult since each country would have to give up its own currency, which is a source of national identity. Since the U.S. dollar would likely predominate, this would be especially problematic for Canada and Mexico. These countries would also have to give up their independent monetary policy. Since the economic conditions in the three countries can differ substantially, doing so would likely be unacceptable for Canada and Mexico. Colander’s Economics, 8e. McGraw Hill © 2010 7