Part 1

Case Study: AUTO VER: PROTECTION WITH INTEGRITY?

In late 1981, your father went to a Honda dealer in his home state and paid about $1,000
more for a Civic than he would have paid the year before. Why?

Voluntary export restriction (VER) is a restriction imposed by a country on the quantity of

certain goods being exported upon the request of importing country for a specified time period.
VER arises when the import-competing industries seek for the protection from the high imports
from a particular exporting country. In 1970’s, sales of Japanese made automobiles accelerated
in US as Japanese manufacturers offered quality smaller cars at low prices, capturing a large
share of US automobile market. This caused the sales of US manufacturers to decelerate and
the US automobile industry was declining, resulting lose of jobs and lower profit for
manufacturers. So, in order to protect the US automobile industry, US government convinced
Japanese government to impose VER on the export of automobiles to US. The maximum
Japanese export of automobiles to US from 1981 to 1983 were set to 1.8 million vehicles per
year which was about 8% less than their total export in year 1980. As there was a limit set on
the maximum number of cars imported by US form Japan, it made US automobile consumers
to think that Japanese cars were sacred and hard to get. Also, as the limit was only set on the
quantity of vehicles to be exported by Japan but not on the value of trade, Japanese automakers
started to increase the sticker price of Japanese cars i.e. a rise of 28% in the price from 1980 to
1981.Therefore, with the implementation of auto VER, the value for Japanese cars increased
along with the increase in price by the Japanese manufacturers. The rise in value caused
demand for Japanese vehicles to increase and with rise in demand, the price for Japanese cars
raised. That is why, Japanese manufactured car Honda Civic was about $1,000 costlier in 1981
than a year ago.

Part 2
Multiple Choice

Select the best answer among the alternatives and also state the reason.
1. The statement “the yen rose today from 121 to 117” makes sense because
a. The U.S. gains when Japan loses.
b. These numbers measure yen per dollar, not dollars per yen.
c. These numbers are indexes, defined relative to a base of 100.
d. These numbers refer to time of day that the change took place.
e. The yen is a reserve currency.
Reason: It shows the rise in Yen 's currency per one US dollar.

2. The price at which one can enter into a contract today to buy or sell a currency 30 days from
now is called a:
a. Reciprocal exchange rate.
 b. Effective exchange rate.
c. Exchange rate option.
d. Forward exchange rate.
e. Multilateral exchange rate.
Reason: Because forward exchange rate is an exchange rate at which bank agrees to exchange
currency at a future date when it enters into a deal.

3. Based on the supply and demand model of the exchange rate, which of the following should
cause the Philippine peso to appreciate?
a. Concern abroad over the safety of Philippine toy exports.
b. An increase in remittances from Philippine workers abroad to their families at home.
c. Repayment by the Philippine government of its debt to the IMF.
d. Increased imports by Philippine consumers of electronics made in Taiwan.
e. An increase in Philippine savings that is used to purchase financial assets in Europe
Reason: Foreign currency inflows admire currency appreciation.

Question 4-6 refers to the situation as described below

The table below shows hypothetical values for the consumer price indexes (CPI) of the U.S.,
the U.K., and Japan in 2014 and 2018. Their currencies are also indicated as the dollar ($),
pound (£), and yen (¥) respectively. Suppose that exchange rates in 2014 were
2014: $/£= 1.60, ¥/$ = 100, and ¥/£= 160

Calculate the exchange rate for 2014:

4. £/$ = 0.625

5. $/¥= 0.01

6. £/¥= 0.00625

7. When a country devalues its currency, we expect that

a. Income will rise because the devaluation stimulates aggregate demand.
b. Income will rise because the devaluation stimulates aggregate supply.
c. Income will fall because the devaluation reduces aggregate demand.
d. Income will fall because the devaluation reduces aggregate supply.
e. There will be no change in income because income is earned from production, not from
trade.
Reason: Currency devaluation is the lowering of a country’s currency against another
currency within a fixed exchange rate system. Devaluation makes it easier for a country to
sell, which helps to maintain high economic development and it also allows country to raise
its export and lower the imports.

8. Suppose the central bank of Mexico is pegging its currency, the peso, to the U.S. dollar at
a rate of $0.10/peso. If on a particular day the demand for pesos exceeds the supply by 1.3
billion pesos, the central bank will
a. Use its reserves of U.S. dollars to buy 1.3 billion pesos.
b. Prohibit individuals from selling pesos for more than the official rate.
c. Add to its dollar reserves by $130,000,000.
d. Devalue the peso.
e. Buy 1.3 billion pesos on the open market and sell them to those whose demands are not
being met by private supply.

9. Which one of the following was not a contributory factor in the financial crisis of 2008?
a. Financial instruments backed by intangible assets, so that if the instrument itself failed,
there were no assets to cover the deficit
b. Over-optimistic ratings by the credit rating agencies
c. Mortgage lending to house buyers who were extremely unlikely to be able
to pay their mortgage obligations
d. A scarcity in the global supply of gold mined in Alaska
Reason: The scarcity of the global supply of gold mined in Alaska is not a contributing factor
to the 2008 financial crisis because it was more related with supply and demand factors in oil
price of stock.

10. Which one of the following best describes subprime mortgage lending?
a. Lending to people to buy houses who are at greater risk of being unable to meet the repayments
b. A bank lending to someone who is not one of their customers
c. Lending on overvalued properties
d. Lending to people who do not have a bank account
Reason: Subprime mortgage loan is usually given to people who have difficulty in maintaining
the repayment schedule.
 Part 3
Short Answers

1) Identify the following transactions by whether they belong in the U.S. current
account, capital account, or financial account, positively (contributing to a surplus
in that account) or negatively. Put a plus (+) or a minus (-) sign in the appropriate
column.

International Economic Transactions Current Account Capital Account Financial Account

a. A US farmer sells a truckload of artichokes +

to a Canadian restaurant

b. A German professor is paid royalties on a _

textbook published by a Boston publishing
firm

c. A Student in Thailand deposits dollars in a +

Los Angeles bank account, planning later to
pay tuition at UCLA

d. The owner of a pizza chain in Kansas sends _

$1000 to relatives in Sicily

e. An American company buys a warehouse in _

Ireland

f. AT&T pays dividends to holders of its stock _

in Brazil

g. A Brazilian widow buys stock in AT&T +

h. A Michigan student, preparing for a _

semester abroad in France, buys $1000 worth
of French currency
a. Explain how financial crisis in another developing country in the region can
cause or contribute to a financial crisis in a developing country.
A financial crisis is a situation where the liquidity evaporates because of the money withdrawn
from financial institutions or because of the assets sold by the shareholders because of fear of
the value of their assets dropping which results in the financial institution to sell their other
investments or to collapse. A financial crisis is associated with the failure of banks,
overvaluation of assets, substantial reduction of asset values, over-indebtedness, and
international capital fight. The financial crisis in developing countries can be a result of
macroeconomic instability and structural weakness of the financial system or policy
inconsistencies. Lack of microeconomic structure of the financial system creates excessive risk
for banks increasing the possibility of a financial crisis. Bank failures can be resulted from a
decline in the performance of loan portfolios, run on deposits caused by loss of confidence in
banks, reduction of real asset values, etc. As banks among developing countries are linked, a
financial crisis in a developing country can affect another developing country. Banks are linked
through derivatives and international contracts which depend upon the performance of each
bank in the chain. Banks in the chain own each other money and if one fails to pay the money
owned, it causes other banks inability to pay the money they own resulting in the entire chain
to fall. Similarly, a country that depends on another country for imports can also be affected
by the financial crises. For example, Nepal highly depends on India for the import of most of
its products, so if a financial crisis starts in India, it will directly impact the Nepalese economy.
It will cause inflation, as the imports will decrease and due to lack of resources, price will rise
for imported goods and as Nepal highly depends upon imported goods, it will create a crisis in
Nepalese market. Also some country’s currency is pegged with other country’s currency. For
example, Nepalese currency is pegged with Indian currency which is why a financial crisis in
India can have high impact on Nepal’s economy.

b. Explain official reserve account of BOP and its major components.

Official reserve is a subdivision of capital account that accounts for the foreign currency and
securities held by the official monetary authorities of a nation. The reserve is usually held by
the central bank of a country and used to balance the payments year to year. The reserve
increases in case of a trade surplus and decreases in case of trade deficit. The reserve is also
used to intervene in foreign exchange market to influence their exchange rate to more favorable
rate for the government. But the impact of intervention is for short time as market force always
keeps on influencing the exchange rate, so the market equilibrium will soon return after the
intervention. This account covers the purchase and sales of reserve assets by the monetary
authority of a nation. It keeps track of transaction involving gold, foreign exchange reserves,
Bank deposit and special drawing rights (SDR). These reserves are usually comprised of major
currencies used in international trade. It includes gold, foreign exchange, bank deposit and
special drawing rights. Gold comprises gold bullion and unallocated gold accounts. Foreign
exchange and bank deposit comprises banknotes, deposit, bonds, treasury bill, etc. SDR is the
international monetary reserve currency created by IMF to respond the concern about limitation
of gold and dollars as the only means of settling international accounts.