Ming Chuan University

International College
International Business & Management Program

International Economics

HW#4, Chapters: 13 and 14

Due: June 3, 2014
ID/Name: Suggested Solutions

Multiple Choice (69% total, 3% each)

1) Answer: A 9) Answer: B 17) Answer: E

2) Answer: D 10) Answer: E 18) Answer: A
3) Answer: C 11) Answer: B 19) Answer: C
4) Answer: B 12) Answer: B 20) Answer: A
5) Answer: E 13) Answer: E 21) Answer: A
6) Answer: C 14) Answer: B 22) Answer: B
7) Answer: A 15) Answer: D 23) Answer: B
8) Answer: A 16) Answer: B

Problems (31%)
1. (7%)

Equation can be rewritten as

CA = (Sp – I) + (T – G).

Higher U.S. barriers to imports may have little or no impact upon private savings,
investment, and the budget deficit. If there were no effect on these variables, then
the current account would not improve with the imposition of tariffs or quotas. It is
possible to tell stories in which the effect on the current account goes either way.
For example, investment could rise in industries protected by the tariff, reducing
the current account. On the other hand, investment might fall in industries that face
a higher cost of imported intermediate goods as a result of the tariff. In general,
permanent and temporary tariffs have different effects. The point of the question is
that a prediction of the manner in which policies affect the current account requires
a general macroeconomic analysis.

1
2. (24%) You are a foreign exchange trader specialized in the US dollar-British pound market
($/￡).(1) One morning, you find the following two $/￡ quotes:
From dealer A, quote A: 1.7750 (bid) − 1.7761(ask);
from dealer B, quote B: 1.7766(bid) − 1.7777(ask)
(“bid” is the buy price and “ask” is the sell price).
(a) (7%) Can you make money from these quotes, how and why? Explain your trade. (show
work for full credit)

Ans:

Whenever such two quotes don’t overlap, there exists an arbitrage opportunity. How to do the
arbitrage? Basically we could buy dollars for British pounds at 1.7761 and immediately sell
British pounds for dollars at 1.7766. By this transaction, we could pocket the difference of
0.0005 dollars for each pound we trade.

For dealer A, he would build up an inventory of dollars while his British pounds inventory would
shrink.
For dealer B, he would build up an inventory of British pounds while his dollar inventory would
shrink. Eventually, dealer A and B would adjust their bid-ask spread to manage their portfolios,
which leads to the overlap of these two quotes.

(b) (7%) What will happen if other forex traders decide to follow your strategy?

Ans:

If other forex traders follow our strategy, this arbitrage opportunity will disappear and there
will be only one quote for $/￡. In other words, because of arbitrage, quotes A and B cannot
coexist, they will eventually overlap.

(2) (10%) Another morning, you notice that the one-year dollar interest rate is 4%, while the
one year interest rate on British pound is 2.9%. Today’s $/￡ rate is $1.7 for ￡1. What is the
one-year forward rate do you expect for the $/￡rate? (show work for full credit)

Ans:

Uncovered Interest Parity (UIP) or Interest Rate Parity (IRP) condition implies:

Forward rate−1.7
4 %=2.9 %+ ⇒ Forward rate = 1.7187
1.7