International Macroeconomics 3rd Edition Feenstra Solutions Manual 1

International Macroeconomics 3rd Edition Feenstra
Solutions Manual
Download full solution manual at:
https://testbankpack.com/p/solution-manual-for-international-
macroeconomics-3rd-edition-feenstra-taylor-1429278439-
9781429278430/
15
Exchange Rates II: The Asset Approach

in the Short Run
1. Use the money market and FX diagrams to answer the following questions about the
relationship between the British pound (£) and the U.S. dollar ($).The exchange rate
is in U.S. dollars per British pound, E$/£. We want to consider how a change in the
U.S. money supply affects interest rates and exchange rates. On all graphs, label the
initial equilibrium point A.
a. Illustrate how a temporary decrease in the U.S. money supply affects the money
and FX markets. Label your short-run equilibrium point B and your long-run
equilibrium point C.
Answer: See the diagram below.
MS 2 MS1
i$ ER
B
DR2
i 2$ i $2
A C
i $1 i 1$ DR1
MD 1
FR1
M2US M1US E2 E1 E $/£

P 1US P 1US
S-23
S-24 Solutions ■ Chapter
Solutions 4(15)4(15)
■ Chapter Exchange RatesRates
Exchange II: TheII: Asset Approach
The Asset in thein Short
Approach Run Run S-24
the Short
b. Using your diagram from (a), state how each of the following variables changes
in the short run (increase/decrease/no change): U.S. interest rate, British interest
rate, E$/£, Ee$/£, and the U.S. price level.
Answer: The U.S. interest rate increases, the British interest rate does not
change, E$/£ decreases, E$/£
e
does not change, and the U.S. price level does not
change.
c. Using your diagram from (a), state how each of the following variables changes
in the long run (increase/decrease/no change relative to their initial values at
point A): U.S. interest rate, British interest rate, E$/£, Ee$/£, and U.S. price level.
Answer: All of the variables return to their initial values in the long run.This is
because the shock is temporary, implying the central bank will increase the
money supply from M2 to M1 in the long run.
2. Use the money market and FX diagrams from (a) to answer the following questions.
This question considers the relationship between the Indian rupees (Rs) and the U.S.
dollar ($).The exchange rate is in rupees per dollar, ERs/$. On all graphs, label the
initial equilibrium point A.
a. Illustrate how a permanent increase in India’s money supply affects the money and
FX markets. Label your short-run equilibrium point B and your long-run equi-
librium point C.
Answer: See the following diagram.Thick arrows indicate temporary movement
while thinner ones indicate the movements in the long run. In the short run,
prices are fixed.Therefore the real money supply changes from MS1 to MS2, thus
temporarily lowering the domestic interest rate. In the long run, as prices rise,
the real money supply and interest rate return to their original level. In the for-
eign exchange market, FR shifts to the right and stays there permanently because
of an expected depreciation of rupees.
MS1 MS2
iRs ER
A C A C
i 1Rs 1
i Rs DR1
2
B B
i Rs 2
i Rs DR2
FR2
MD1 FR1
M2 M1 M2 E1 E3 E2
IN IN IN E Rs/$
P 2IN P 1IN P 1IN

the Short
b. By plotting them on a chart with time on the horizontal axis, illustrate how each
of the following variables changes over time (for India): nominal money supply
MIN, price level PIN, real money supply MIN/PIN, India’s interest rate iRs, and the
exchange rate ERs/$.
Answer: See the following diagrams.
M IN i Rs
PIN ERs/$
T T n
MIN
1 /P1
IN
MIN
2 /P2
IN
c. Using your previous analysis, state how each of the following variables changes
in the short run (increase/decrease/no change): India’s interest rate iRs, ERs/$ ERs/$
e ,
and India’s price level PIN.
Answer: India’s interest rate decreases, the U.S. interest rate remains unchanged,
ERs/$ increases, ERs/$
e
increases, and India’s price level remains unchanged.
d. Using your previous analysis, state how each of the following variables changes
in the long run (increase/decrease/no change relative to their initial values at
point A): India’s interest rate iRs, ERs/$ ERs/$
e
, India’s price level PIN.
Answer: India’s interest rate remains unchanged, the U.S. interest rate remains
unchanged, ERs/$ increases, ERs/$
e
increases (remains unchanged in transition from
short to long run), India’s price level increases.

e. Explain how overshooting applies to this situation.
Answer: The short-run exchange rate overshoots its long-run value, EE as in the
text Figure 4-13 (15-13).We can see this in the impulse response diagrams shown
previously. The overshooting is caused by the investors’ adjustment of exchange
rate expectations coupled with lower domestic interest rates. Since the rupees in-
terest rate falls, investors must be compensated by a rupee appreciation for UIP
with U.S. interest rate to hold. For a rupee appreciation to be possible, it must
depreciate more in the short run than its longer-run value.
the Short
3. Is overshooting (in theory and in practice) consistent with purchasing power parity?
Consider the reasons for the usefulness of PPP in the short run versus the long run
and the assumption we’ve used in the asset approach (in the short run versus the long
run). How does overshooting help to resolve the empirical behavior of exchange rates
in the short run versus the long run?
Answer: Yes, overshooting is consistent with PPP. Investors forecast the expected ex-
change rate based on the theory of PPP. When there is some change in the market, the
investors know the exchange rate will change to equate relative prices in the long run.
This is why we observe overshooting in the short run—the investors incorporate this
information into their short-run forecasts. Exchange rates are volatile in the short run.
The theory’s implication that there is exchange rate overshooting (in response to per-
manent shocks) is one explanation for short-run volatility in exchange rates.
4. Use the money market and foreign exchange (FX) diagrams to answer the following
questions.This question considers the relationship between the euro (€) and the U.S.
dollar ($). The exchange rate is in U.S. dollars per euro, E$/€. Suppose that with fi-
nancial innovation in the United States, real money demand in the United States de-
creases. On all graphs, label the initial equilibrium point A.
a. Assume this change in U.S. real money demand is temporary. Using the FX and
money market diagrams, illustrate how this change affects the money and FX
markets. Label your short-run equilibrium point B and your long-run equilib-
rium point C.
Answer: See the following diagram.The long-run values are the same as the ini-
tial values because the shock is temporary. Also because the shock is temporary,
we assume that the reversal of real money demand occurs before the price level
adjusts—that is, MD returns from MD2 to MD1 before the price level changes.
MS1
i$ ER
A C A C
i $1 i 1$ DR1
B B
i $2 i $2 DR
MD1 FR1
1 /P1 MD 2
M US US E1 E2 E $/€
b. Assume this change in U.S. real money demand is permanent. Using a new dia-
gram, illustrate how this change affects the money and FX markets. Label your
short-run equilibrium point B and your long-run equilibrium point C.
Answer: See the following diagram. In the long run, the price level will have to
increase to adjust for the drop in real money demand (assuming the central bank
does not change the money supply, M).That is, the nominal interest rate returns
to its initial value in the long run. This requires that the price level increase to
reduce real money supply.The drop in real money demand will have to be met
one-for-one with a drop in real money supply (generated by an increase in the
price level). In this case, the expected exchange rate changes because the shock
is permanent.Therefore, FR schedule in the forex market also shifts upward.
the Short
MS 3 MS1
i$ ER
A
i $1 i $1 A C
DR1
C
B
i $2 i $2 B DR2
MD1
MD 2
1 2 M1 1 E1 E3 E2 E
MUS / PUS US / PUS $/€
c. Illustrate how each of the following variables changes over time in response to a
permanent reduction in real money demand: nominal money supply MUS, price
level PUS, real money supply MUS/PUS, U.S. interest rate i$, and the exchange rate
E$/€.
Answer: See the following diagrams.
M US i$
P US E $/
T T n
M 1 /P 1 M 2 /P 2
US US US US
the Short
5. This question considers how the FX market will respond to changes in monetary
policy. For these questions, define the exchange rate as Korean won per Japanese yen,
EWON/¥. Use the FX and money market diagrams to answer the following questions.
On all graphs, label the initial equilibrium point A.
a. Suppose the Bank of Korea permanently decreases its money supply. Illustrate the
short-run (label the equilibrium point B) and long-run effects (label the equilib-
rium point C) of this policy.
Answer: See the following diagram. In the short run, prices are fixed. Therefore
the real money supply changes from MS1 to MS2, thus temporarily raising the Ko-
rean interest rate. In the long run, as prices fall, the real money supply and interest
rate return to their original levels. In the foreign exchange market, FR shifts to the
left and stays there permanently because of an expected appreciation of won.
MS2 MS1
iwon ER
B B
i 2won i 2won DR 2
A C
C A
i 1won i 1won DR1
MD1
FR2 FR1
2 1 M1 1 2 2 2 3 1
M K / PK K / PK MK / P K E E E E won/¥
b. Now, suppose the Bank of Korea announces it plans to permanently decrease its
money supply but doesn’t actually implement this policy. How will this affect the
FX market in the short run if investors believe the Bank of Korea’s announcement?
Answer: See the following diagram. In this case, interest rates on won-
denominated deposits don’t change because the Bank of Korea doesn’t cut the
money supply. However, because investors expected the Bank of Korea to cut the
money supply, they expect the won will appreciate relative to the yen, causing a
decrease in the return on yen-denominated deposits in the short run. Notice the
resulting change in the exchange rate is relatively small (compared with the dra-
matic decrease we see in [a]).
MS1
iwon ER
A B B A
i 1won 1
i w on DR1
MD1
FR2 FR1
M K1 / P1K E2 E1 Ewon/¥
the Short
c. Finally, suppose the Bank of Korea permanently decreases its money supply but
this change is not anticipated. When the Bank of Korea implements this policy,
how will this affect the FX market in the short run?
Answer: In this case, the expected exchange rate is unchanged because the in-
vestors didn’t expect the decrease in the money supply.
MS 2 MS1
iwon ER
B
B
2
i won i 2won DR2
A
A
i 1won i 1won DR1
MD1
FR1
2 1
M /P K / PK E2 E1
E won/¥
K K M1 1
d. Using your previous answers, evaluate the following statements:

i. If a country wants to increase the value of its currency, it can do so (tem-
porarily) without raising domestic interest rates.
ii. The central bank can reduce both the domestic price level and the value of
its currency in the long run.
iii. The most effective way to increase the value of a currency is through sur-
prising investors.
Answer: Though it is theoretically possible, as shown in (b), it is not a good pol-
icy because it is bad for the policy makers reputation in the long run.
i. True; shown in (b).
ii. False; shown in (a) A reduction in price level implies an exchange rate ap-
preciation by PPP.
iii. False; shown in (b) and (c) compared with (a). The most dramatic appreci-
ation in the won occurs when the reduction in M is coupled with investors
anticipating the appreciation in the won. In general, a policy must be cred-
ible for it to have an effect in the long run.
6. In the late 1990s, several East Asian countries used limited flexibility or currency pegs
in managing their exchange rates relative to the U.S. dollar. This question considers
how different countries responded to the East Asian Currency Crisis (1997–1998).
For the following questions, treat the East Asian country as the home country and
the United States as the foreign country.Also, for the diagrams, you may assume these
countries maintained a currency peg (fixed rate) relative to the U.S. dollar. Also, for
the following questions, you need consider only the short-run effects.
a. In July 1997, investors expected that the Thai baht would depreciate.That is, they
expected that Thailand’s central bank would be unable to maintain the currency
peg with the U.S. dollar. Illustrate how this change in investors’ expectations af-
fects the Thai money market and the FX market, with the exchange rate defined
as baht (B) per U.S. dollar, denoted EB/$. Assume the Thai central bank wants to
maintain capital mobility and preserve the level of its interest rate and abandons
the currency peg in favor of a floating exchange rate regime.
the Short
Answer: If Thailand is willing to let its currency float against the dollar, then
Thailand’s central bank can maintain monetary policy autonomy and interna-
tional capital mobility. See the following diagram:
MS1
ibaht ER
A B
i 1baht i 1baht A B
DR1
MD1 FR2
FR1
M 1T / PT1 E1 E2 E baht/$
b. Indonesia faced the same constraints as Thailand—investors feared Indonesia

would be forced to abandon its currency peg. Illustrate how this change in in-
vestors’ expectations affects the Indonesian money market and the FX market,
with the exchange rate defined as rupiahs (Rp) per U.S. dollar, denoted ERp/$.As-
sume the Indonesian central bank wants to maintain capital mobility and the cur-
rency peg.
Answer: If Indonesia wants to maintain the currency peg against the dollar and
maintain international capital mobility, it will have to give up monetary policy
autonomy. In this case, Indonesia has to increase the domestic interest rate to keep
investors from dumping their rupiah-denominated deposits for U.S. dollars and
move their investments out of Indonesia (this would then cause a depreciation in
the rupiah).
MS 2 MS1
irup ER
B B
2
i rup i 2rup
DR2
A
1
A
i 1rup i rup DR1
MD1 FR2
FR1
2 1 M1 1 1
MI / P I I / PI E E ru p i ah / $
the Short
c. Malaysia had a similar experience, except that it used capital controls to maintain
its currency peg and preserve the level of its interest rate. Illustrate how this change
in investors’ expectations affects the Malaysian money market and the FX market,
with the exchange rate defined as ringgit (RM) per U.S. dollar, denoted ERM/$.You
need show only the short-run effects of this change in investors’ expectations.
Answer: See the following diagram. In the absence of capital controls Malaysian
interest rate would have to rise. However, by preventing investors from taking ad-
vantage of arbitrage, Malaysia creates a disequilibrium.The investors require i2RM
to keep their deposits in Malaysia, but they only receive i1RM. Because of the cap-
ital controls imposed by Malaysia, investors cannot withdraw their ringgit-
denominated deposits (selling ringgit in exchange for dollars in the FX market).
In effect, the foreign market equilibrium diagram shown below does not
work/exist. This allows Malaysia to maintain monetary policy autonomy and a
fixed exchange rate at the same time.
MS1
iRM ER
B
2 2
i RM i RM
1
A
i RM A i 1RM DR1
FR2
MD1 FR1
MM1 / PM1 E1 E RM/ $
d. Compare and contrast the three approaches just outlined. As a policy maker,
which would you favor? Explain.
Answer: There is no “correct” answer to this question.The cases above highlight
the trilemma because each country can choose a different option depending on
their domestic or international priorities.They need to compare the benefits of
having any two of (a) fixed exchange rates, (b) monetary autonomy, and (c) in-
ternational capital mobility against the cost of not having the third one.
7. Several countries have opted to join currency unions. Examples include the Euro
area, the CFA franc union in West Africa, and the Caribbean currency union.This in-
volves sacrificing the domestic currency in favor of using a single currency unit in
multiple countries. Assuming that once a country joins a currency union it will not
leave, do these countries face the policy trilemma discussed in the text? Explain.
Answer: These countries do face the trilemma because they are committed to main-
taining the first policy goal of a fixed exchange rate. Joining a currency union effec-
tively means a country has a fixed exchange rate without the need for government
intervention because the money supply is controlled by a regional central bank for
member countries.This effectively reduces the choice to a dilemma between mone-
tary policy autonomy versus international capital mobility.Typically, countries that are
parts of a currency union sacrifice monetary policy autonomy; policy decisions are
made jointly rather than independently.
the Short
8. During the Great Depression, the United States remained on the international gold
standard longer than other countries.This effectively meant that the United States was
committed to maintaining a fixed exchange rate at the onset of the Great Depression.
The U.S. dollar was pegged to the value of gold along with other major currencies,
including the British pound, the French franc, and so on. Many researchers have
blamed the severity of the Great Depression on the Federal Reserve and its failure to
react to economic conditions in 1929 and 1930. Discuss how the policy trilemma ap-
plies to this situation.
Answer: The United States was committed to the fixed exchange rate with gold;
consequently, policy makers had to sacrifice either monetary policy autonomy or cap-
ital mobility, just as the trilemma suggests. Based on the information given in the
question, we can assume that the policy did not respond to the U.S. business cycle
(policy makers did not exercise monetary policy autonomy). Thus, if we assume in-
ternational capital mobility, the United States could not react to the business cycle
with a monetary expansion until it abandoned the gold standard.
9. On June 20, 2007, John Authers, investment editor of the Financial Times, wrote the
following in his column “The Short View”:
The Bank of England published minutes showing that only the narrowest pos-
sible margin, 5–4, voted down [an interest] rate hike last month. Nobody fore-
saw this. . . . The news took sterling back above $1.99, and to a 15-year high
against the yen.
Can you explain the logic of this statement? Interest rates in the United Kingdom
had remained unchanged in the weeks since the vote and were still unchanged after
the minutes were released. What news was contained in the minutes that caused
traders to react? Use the asset approach.
Answer: The news item indicates that investors did not expect the decision to leave
interest rates unchanged would be divisive.They thought that any increases in inter-
est rates would happen further in the future. Higher interest rates would lead to an
appreciation in the pound sterling. When the minutes showed that interest rate in-
creases were more likely than previously thought, investors came to expect an appre-
ciation sooner rather than later. This caused an appreciation in the current spot ex-
change rate.
10. We can use the asset approach to both make predictions about how the market will
react to current events and understand how important these events are to investors.
Consider the behavior of the Union/Confederate exchange rate during the Civil
War. How would each of the following events affect the exchange rate, defined as
Confederate dollars per Union dollar, EC$/$?
a. The Confederacy increases the money supply by 2,900% between July and De-
cember of 1861.
Answer: The Confederate money supply increases, the exchange rate increases,
and the Confederate dollar depreciates.
b. The Union Army suffers a defeat in Battle of Chickamauga in September 1863.
Answer: Appreciation in the Confederate dollar is expected because a military
victory means a stable economy and monetary policy, implying decreased uncer-
tainty and risk, the exchange rate decreases, and the Confederate dollar appreci-
ates.
c. The Confederate Army suffers a major defeat with Sherman’s March in the au-
tumn of 1864.
Answer: Just the opposite of (b) above: depreciation in the Confederate dollar is
expected because of military defeat increases economic and monetary uncertainty
and risk; the exchange rate increases, and the Confederate dollar depreciates.

International Macroeconomics 3rd Edition Feenstra Solutions Manual 1

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

International Macroeconomics 3rd Edition Feenstra Solutions Manual 1

Uploaded by

Copyright:

Available Formats

International Macroeconomics 3rd Edition Feenstra

Exchange Rates II: The Asset Approach

M2US M1US E2 E1 E $/£

P 2IN P 1IN P 1IN

short to long run), India’s price level increases.

d. Using your previous answers, evaluate the following statements:

b. Indonesia faced the same constraints as Thailand—investors feared Indonesia

MM1 / PM1 E1 E RM/ $

You might also like