International economics assignment

Chapter 10 (chap 13)

Problem 2

Consider the United States and the countries it trades with the most (measured in trade volume):
Canada, Mexico, China, and Japan. For simplicity, assume these are the only four countries with
which the United States trades. Trade shares and exchange rates for these four countries are as
follows:

Answer:

a.

%∆E$/C$ = (0.9643 – 0.9225) / 0.9225 = 4.53%

%∆E$/pesos = (0.0788 – 0.0756) / 0.0756 = 4.23%

%∆E$/yuan = (0.1473 – 0.1464) / 0.1464 = 0.61%

%∆E$/¥ = (0.0112 – 0.0105) / 0.0105 = 6.67%

b. The trade-weighted percentage change in the exchange rate is:

%∆Effective = 0.36(%∆E$/C$) + 0.28(%∆E$/pesos) + 0.20(%∆E$/yuan) +0.16(%∆E$/¥)

%∆Effective = 0.36*(4.53)% + 0.28*(4.23%) + 0.20*(0.61)% + 0.16*(6.67)% = 4.01%

c. The value of the US dollar depreciated by 4.01% against this basket of currencies.
Incomparison with peso, the dollar depreciated by 4.23%. The average depreciation is smaller
because the dollar depreciated by only 0.61% against China with a 20% trade share.

Problem 6

Consider a Dutch investor with 1,000 euros to place in a bank deposit in either the Netherlands
or Great Britain. The (one-year) interest rate on bank deposits is 2% in Britain and 4.04% in the
Netherlands. The (one-year) forward euro pound exchange rate is 1.575 euros per pound and the
spot rate is 1.5 euros per pound. Answer the following questions, using the exact equations for
UIP and CIP as necessary.

a. What is the euro-denominated return on Dutch deposits for this investor?

b. What is the (riskless) euro-denominated return on British deposits for this investor
usingforward cover?

c. Is there an arbitrage opportunity here? Explain why or why not. Is this an equilibrium in
theforward exchange rate market?

d. If the spot rate is 1.5 euros per pound, and interest rates are as stated previously, what is
theequilibrium forward rate, according to covered interest parity (CIP)?

e. Suppose the forward rate takes the value given by your answer to (d). Compute the
forwardpremium on the British pound for the Dutch investor (where exchange rates are in
euros per pound). Is it positive or negative? Why do investors require this premium/discount
in equilibrium?

f. If uncovered interest parity (UIP) holds, what is the expected depreciation of the euro
(againstthe pound) over one year?

g. Based on your answer to (f), what is the expected euro–pound exchange rate one year ahead?

Answer:

a.The investor’s return on euro-denominated Dutch deposits is equal to

€1,00.04 (= €1,000 * (1 +0.0404))

b. The euro denominated return on British deposits using forward cover is equal to
€1,071(=€1,000 * (1.575/1.5) * (1 + 0.02)).
c. Yes, there is an arbitrage opportunity.The euro-denominated return on British deposits
ishigher than that on Dutch deposits.The net return on each euro deposit in a Dutch bank is
equal to 4.04% versus 7.1% (=(1.575 / 1.5) * (1 + 0.02)) on a British deposit (using forward
cover).This is not an equilibrium in the forward exchange market.The actions of traders
seeking to exploit the ar- bitrage opportunity will cause the spot and forward rates to change.

d. CIP implies: F€/£ = E€/£ (1 + i€)/(1 + i£) = 1.5 * 1.0404/1.02 = €1.53 per £.

e. Forward premium = (F€/£ / E€/£ - 1) = (1.53/1.50) - 1 = 0.02 = 2%. The existence of a positive
forward premium would imply that investors expect the euro to depreciate relative to the
British pound.Therefore, when establishing forward contracts, the forward rate is higher than
the current spot rate.

f.If the UIP holds, the expected euro/pound exchange rate is the same as the forward rate, i.e., €
1.53 per £ (see part (d) above.The expected depreciation of Euro against pound is therefore 2%.

g. Following the answer to part (d) and (f), the expected euro/pound exchange rate is €1.53 per £
or 1/1.53 = 0.654 £/€.

Chapter 11 (chap 14)

Problems 2

Consider each of the following goods and services. For each, identify whether the law of one

price will hold, and state whether the relative price 𝑞 𝑔US/Foreign is greater than, less than, or equal

to 1. Explain your answer in terms of the assumptions we make when using the law of one price.

a. Rice traded freely in the United States and Canada

b. Sugar traded in the United States and Mexico; the U.S. government imposes a quota on
sugarimports into the United States

c. The McDonald’s Big Mac sold in the United States and Japan

d. Haircuts in the United States and the United Kingdom

Answer:

a. Rice trade freely in the US and Canada

 𝑞 𝑔US/Foreign = 1

LOOP should hold in this case because its assumption are met

b. Sugar traded in the US and Mexico, the US government imposes a quota on sugar
imports into the US

𝑞 𝑔US/Foreign > 1

If the US government imposes a quota on sugar, this will lead to an increase in the relative price
of sugar in the United States through restricting competition.

c. Haircuts in the United States and the United Kingdom

𝑞 𝑔US/Foreign ≄ 1

Because the haircuts cannot be traded across the US and the UK, consumers will not arbitrage
away differences in the price of haircuts in these regions.

Problems 7

Consider two countries: Japan and Korea. In 1996 Japan experienced relatively slow out-put
growth (1%), while Korea had relatively robust output growth (6%). Suppose the Bank of Japan
allowed the money supply to grow by 2% each year, while the Bank of Korea chose to maintain
relatively high money growth of 12% per year.

For the following questions, use the simple monetary model (where L is constant). You will find
it easiest to treat Korea as the home country and Japan as the foreign country.

a. What is the inflation rate in Korea? In Japan?

b. What is the expected rate of depreciation in the Korean won relative to the Japanese yen (¥)?
c. Suppose the Bank of Korea increases the money growth rate from 12% to 15%. If nothing
inJapan changes, what is the new inflation rate in Korea?

d. Using time series diagrams, illustrate how this increase in the money growth rate affects
themoney supply MK, Korea’s interest rate, prices PK, real money supply, and Ewon/¥ over
time.
(Plot each variable on the vertical axis and time on the horizontal axis.)

e. Suppose the Bank of Korea wants to maintain an exchange rate peg with the Japanese
yen.What money growth rate would the Bank of Korea have to choose to keep the value of
the won fixed relative to the yen?

f. Suppose the Bank of Korea sought to implement a policy that would cause the Korean won
toappreciate relative to the Japanese yen. What ranges of the money growth rate (assuming
positive values) would allow the Bank of Korea to achieve this objective?

Answer:

a. The inflation rate in Korea, and JapanπK = μK − gK = 12% − 6% = 6% πJ = μJ − gJ = 2% −

1% = 1%

b. The expected rate of depreciation in the Korean won relative to the Japanese yen (¥)

%ΔEewon/¥ = (πK − πJ) = 6% − 1% = 5%.

You can check this by using the following expression from the monetary model: %ΔEewon/¥ =
(μK − gK) = (μJ − gJ).

c. Suppose the Bank of Korea increases the money growth rate from 12% to 15%. If nothing
inJapan changes, the new inflation rate in Korea:

πnewK = μK − gK = 15% − 6% = 9%

d. Using time series diagrams, illustrate how this increase in the money growth rate affects
themoney supply MK, Korea’s interest rate, prices PK, real money supply, and Ewon/¥ over
time.
(Plot each variable on the vertical axis and time on the horizontal axis.)
e. To keep the exchange rate constant, the Bank of Korea must lower its money growth rate. We
can figure out exactly which money growth rate will keep the exchange rate fixed by using
the fundamental equation for the simple monetary model (used above in b):

%ΔEewon/¥ = (μK − gK) − (μJ − gJ)

The objective is to set %ΔEewon/¥ = 0:

(μ*K − gK) = (μJ − gJ)

Plug in the values given in the question and solve for μ*K:

(μ*K − 6%) = (2% − 1%) μ*K = 7%

Therefore, if the Bank of Korea sets its money growth rate to 7%, its exchange rate with Japan
will remain unchanged.

f. Using the same reasoning as previously, the objective is for the won to appreciate:
%ΔEewon/¥ < 0

This can be achieved if the Bank of Korea allows the money supply to grow by less than 7%
each year. The diagrams on the previous page show how this would affect the variables in the
model over time

Problems 9

Both advanced economics and developing countries have experienced a decrease in inflation
since the 1980s (see Table 14-3 in the text). This question considers how the choice of policy
regime has influenced such global disinflation. Use the monetary model to answer this question.

Answer:
In the 1970s, most of the world was struggling with high inflation. An economic slowdown
prompted central banks everywhere to loosen monetary policy. In advanced countries, a move to
floating exchange rates allowed great freedom for them to loosen their monetary policy.

Developing countries had already proven vulnerable to high inflation and now many of them
were exposed to even worse inflation.

In the 1980s, inflationary pressure continued in many developed countries, and in many
developing countries high levels of inflation, and even hyperinflations, were not uncommon.
Governments were forced to respond to public demands for a more sta- ble inflation
environment. In the 1990s, policies designed to create effective nominal anchors were put in
place in many countries, and these have endured to the present.

One study found that the use of explicit targets grew markedly in the 1990s, replacing regimes in
which there had previously been no explicit nominal anchor. The number of countries in the
study with exchange rate targets increased from 30 to 47. The number with money targets
increased from 18 to 39. The number with inflation targets increased most dramatically, almost
sevenfold, from 8 to 54. Many countries had more than one target in use: in 1998, 55% of the
sample announced an explicit target (or monitoring range) for more than one of the exchange
rate, money, and inflation. These shifts have persisted. As of 2010, more than a decade later,
there were still more than 50 inflation-targeting countries (many now part of the single Eurozone
block), and there were more than 80 countries pursuing some kind of exchange rate target via a
currency board, peg, band or crawl type arrangement.

Looking back from the present we can see that most, but not all, of those policies have turned
out to be credible, too, thanks to political developments in many countries that have fostered
central bank independence. Independent central banks stand apart from the interference of
politicians: they have operational freedom to try to achieve the inflation target, and they may
even play a role in setting that target.

Overall, these efforts are judged to have achieved some success, although in many countries
inflation had already been brought down substantially in the early to mid-1980s before inflation
targets and institutional changes were implemented. Table 14-3 shows a steady decline in
average levels of inflation since the early 1980s. The lowest levels of inflation are seen in the
advanced economies, although developing countries have also started to make some limited
progress. In industrial countries, central bank independence is now commonplace (it was not in
the 1970s), but in developing countries it is still relatively rare.

Chapter 13 (chap 16)

Problems 2

Note the following accounting identity for gross national income (GNI):

GNI = C + I + G + TB + NFIA

Using this expression, show that in a closed economy, gross domestic product (GDP), gross
national income (GNI), and gross national expenditures (GNE) are the same. Show that
domestic investment is equal to domestic savings.

Answer:

Given: GNI = C + I + G + TB + NFIA

GNDI = GNI + NUT

In the closed economy, external factor does not exist, thus export, import, foreign transfer are
zero

GDP = C + I + G => I = GDP - C - G (1)

GNE = C+I+G

Thus, in closed economy, GDP = GNI = GNDI = GNE

Domestic saving includes private saving and public saving

S = private saving + public saving = (GDP - T - C) + (T - G) = GDP - C - G (2)

So, based on (1) and (2) that domestic investment is equal to domestic savings in a closed
economy.

Problems 7

During the 1980s, the United States experienced “twin deficits” in the current account and
government budget. Since 1998 the U.S. current account deficit has grown steadily along with
rising government budget deficits. Do government budget deficits lead to current account
deficits? Identify other possible sources of the current account deficits. Do current account
deficits necessarily indicate problems in the economy?

Answer:
“Twin deficits” are possible, but there are other factors that influence the current account. Since
1998, the decline in the current account has been associated with movements in investment and
national savings. Note the following expression from the textbook:

It is not clear that budget deficits cause current account deficits.There are two possibilities
besides a budget deficit (SG < 0):

Private savings (SP) may change when the government changes taxes (e.g., tax rates). Suppose
tax rates decrease, causing a decrease in government savings. According to Ricardian
equivalence, households will respond to a tax cut today by increasing savings in anticipation of a
future tax increase needed to finance the current budget deficit. This implies private savings will
increase, possibly offsetting the effect on national savings.

The current account may move independently of saving, namely because of changes in
investment (I). An increase in domestic investment opportunities could lead to current account
deficits.