Download Chapter 33: International Finance

Chapter 32: International Financ
Chapter 32: International Financial Policy
Questions for Thought and Review
2.
When someone sends 100 British pounds to a friend in the United States, the transaction
will show up 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 on the financial and capital account as a receipt of foreign currency
just like the purchase of a British stock or bond.
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.
6.
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.
8.
It was likely increasing because imports are positively correlated with national income.
10.
If Japan ran an expansionary monetary policy, it would increase Japanese imports of U.S.
goods and make American goods comparatively more competitive, and thereby decrease
the U.S. trade deficit. The U.S. dollar would rise relative to the Japanese yen.
12.
Since the effect of monetary policy is to push the exchange rate down in all effects, this
will not change the effect presented in the chapter, other than to eliminate the effect
through income and replace it with the effect through prices.
14.
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.
16.
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-partially flexible exchange rates.
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Chapter 32: International Financ
18.
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.
20.
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.
22.
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.
24.
Two disadvantages is 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.
Chapter 32: Problems and Exercises
Price of yuan in dollars
26. a. This suggests that it was running a financial and
S0
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 exchange rate regime, because the
central bank was selling its currency.
c. It had to be selling its currency to equalize the
$/y
D0
balance of payments. In the accompanying
graph, the Chinese central bank had to be
QS
QD
supplying (QS – QD) yuan.
Quantity of 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.
28. 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 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.
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Chapter 32: International Financ
30. a. We would suggest buying U.S. dollars and selling currencies of 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 assets such
as bonds will be worth less with greater inflation making foreign assets more attractive to
investors.
f. We would suggest buying 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.
32. 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 it 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.
Chapter 32: Web Questions
2.
The answer to this question depends on the country chosen. We chose Brazil.
a. The Brazilian currency is the real.
b. The currency remained virtually unchanged from 2004 to 2005.
c. Brazil has gotten inflation under control. Unemployment is expected to decline as the
economy continues to grow. Fiscal spending is under control. The economy appears to be
in good health, which may be contributing to a stable currency.
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