Assignment 2-Firm Location and FDI

A
Current account: (1120-930)+(1510-1870)+450=$280.
Financial account: (960-820)+(-580)=-$440

B
The country’s level of foreign debt over the course of the year decreased. A country’s
international lending position can be determined from the current account balance. Because the
country’s current account was positive ($280) foreigners paid for exports not matched by imports
by taking a loan from this country. This means that the foreign debt of the country decreased
during the year.

C
We want to compute the return for a 4-month investment. To do this, we’ll first calculate the
effective interest rate for 4 months. The effective interest rate for 4 months:
(1+annual interest rate)^(⅓)-1. For Japanese bonds: (1+0,126)^(⅓)-1=0,0403 is around 4,03%.
For Swedish bonds: (1+0,045)^⅓-1=0,0147 is around 1,475%.

The return on a Japanese bond for a 4-month investment is around 4,03%. The return on a
Swedish bond for a 4-month investment is: 1,0147*(13,75/13,25)=1,052, around 5,2%. This
would mean that we would choose to invest in the Swedish bonds.

To find the value of the annual interest rate on Japanese bonds where we would be indifferent
between the two investment options we can use the covered interest parity condition:
(1+ih)=(1+if)*f/e or (f-e)/e=ih-if.

(13.75 - 13.25) / 13.25 = x - 1.052

(0.5) / 13.25 = x - 1.052

x = (0.5 / 13.25) + 1.052

x ≈ (0.0377358) + 1.052

x ≈ 1.0897358
So, the 4-month effective rate would be around 9%. The annual rate would be

(1+0,0897)^3-1=0,2939 =, around 29,4%. That would be the annual rate for Japanese bonds if

we were indifferent between the two investment options.

According to the quantity theory of money there is a direct relationship between the money

supply and the price level in an economy. If the money supply increases more rapidly than the

real output of goods and services, it can lead to inflation. The purchasing power parity theory

(PPP) suggests that, in the long run, exchange rates should adjust to equalize the purchasing

power of the different countries. If there is a difference in the inflation rates of the two countries,

the exchange rate will adjust to compensate for this difference. This will maintain parity in the

purchasing power of the two countries. These two theories give us the following formula: ∆%𝑒

= ∆%𝑀𝑆,𝐻 − ∆%𝑀𝑆,𝐹 − (∆%𝑌𝐻 − ∆%𝑌F). We are assuming that the real output growth is the

same so (∆%𝑌𝐻 − ∆%𝑌F) = 0.

If the money growth in the US is higher than in Canada, the US will experience a higher inflation

of the US prices of goods and services than the inflation rate in Canada will be. This is due to the

excess money supply relative to the US economic output. With higher inflation in the US and

lower inflation in Canada, the relative purchasing power of the US dollar decreases compared to

the Canadian currency. This means that goods and services in the US will become more

expensive in comparison to those in Canada. According to the PPP theory, exchange rates will

adjust to bring parity in the purchasing power of the two currencies. This means that the US

dollar will depreciate relative to the Canadian dollar to compensate for the difference in inflation

rates.
So, assuming everything else remains constant, a higher money supply in the US than in Canada

will lead to inflation in the US, which will result in the depreciation of the US dollar.

In a situation with no international capital flows, global output willl not be maximized. In this

situation, Mexico’s output will only be the area M (picture 1) which is 11000

(2000*5+2000*1*0,5). This will also be the national welfare in Mexico. However when

international capital flows are allowed, capital will flow to where it generates the highest returns

(MPK): from Canada to Mexico. This will affect both the output and welfare of Mexico. Because

of the capital inflow Mexico’s output will increase to area M (picture 2) which is 20000

(4000*4+4000*2*0,5). The welfare of Mexico will also increase with area m (picture 3) which is

1000 (2000*1*0,5).
Picture 1: Showing output and welfare in the situation without international flows of capital.
Area C=Welfare and output Canada, area M=Welfare and output Mexico.

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Picture 2: Showing output in the situation with international flows of capital. Area C=Welfare
and output Canada, area M=Welfare and output Mexico.
Picture 3: Showing net welfare and capital income in the situation with international flows of
capital. Area C=Welfare and output Canada, area M=Welfare and output Mexico, area CI=
Capital income paid by Mexico to Canada, Area c= Increased welfare of Canada, area m=
increased welfare Mexico, area m+c=Increase global welfare.