ECON 3 - International Economics - Midterm Study

Would each of the following groups be happy or unhappy if the Mexican peso appreciates against the U.S. dollar? Answer the question for each of the following: (a) The U.S. pension funds holding Mexican government bonds (peso-denominated) (b) U.S. tourists planning a trip to Mexico (c) Mexican manufacturers exporting to the U.S. (d) A Mexican firm trying to buy properties in the U.S.

(a) Happy. The peso appreciation / USD depreciation means that Mexican assets have higher return in dollar terms. (b) Unhappy. It now costs more to travel to Mexico and buy goods and services while in Mexico. (c) Unhappy. The manufacturing goods of Mexican exporters become relatively more expensive, in USD, than their counterparts in the United States. (d) Happy. The Mexican peso can buy more American dollar and thus more property than would be the case otherwise.

Explain the benefits and costs of allowing capital to move freely across countries.

1) Foreign capital inflows are beneficial because they enable countries who don't have enough domestic funds to access foreign funds and increase their investments in factories, ports raising living standards and incomes. 2) Allowing free capital movements exposes countries to possible outward flight of foreign financial capital which generates a debt crisis and throw a country into a recession. Extreme volatility in financial markets and the severe damage can be a factor to these countries which rives interest in regulations to limit the damage caused by unexpectedly large financial outflows.

The Congressional Research Service noted: "The US has a long-running overall trade deficit (imports exceed exports); the goods trade deficit outweighs the services trade surplus. Most economists hold that macroeconomic variables affect the deficit more than trade policy." Explain the last statement in this quote.

Low savings relative to investment are more important determinants of the deficit than trade policies. Ultimately, only if savings increase will the deficit decrease.

If the government has a $100 million budget deficit, private saving is equal to$500 million, private investment is equal to $300 million, what is the value of the current account? A) $100 million surplus B) $700 million surplus C) $100 million deficit D) $700 million deficit

A) $100 million surplus

Which of the following correctly explains how expansionary fiscal policy works? A. G↑⇒ C↑⇒ Y↑ B. T↑⇒ C↑⇒ Y↑ C. M↑⇒ i↓⇒ I↑⇒ Y↑ D. M↑⇒ i↓⇒ I↓⇒ Y↑

A) G↑⇒ C↑⇒ Y↑

If there is a trade deficit, which of the following is true? A) The current account balance could be positive, negative, or zero. B) There will be a current account deficit. C) There will be a current account surplus. D) There will be a financial account surplus.

A) The current account balance could be positive, negative, or zero.

Which of the following transactions would be recorded in the financial account? A) U.S. investors purchase bonds from Germany. B) A person living in the United States sends money home to her family in Cuba. C) The Fed increases its holdings of yen. D) The U.S. transfers a military base to another country.

A) U.S. investors purchase bonds from Germany.

If the residents of a country receive income from their foreign investments, it is counted as a A) credit in the current account. B) debit in the current account. C) credit in the capital account. D) debit in the capital account.

A) credit in the current account.

Holding nominal exchange rates constant, if inflation in Europe exceeds inflationin the United States, A) the real exchange rate ($/€) will rise, and the euro will buy more in the U.S. B) the real exchange rate ($/€) will rise, and the euro will buy less in the U.S. C) the real exchange rate ($/€) will fall, and the euro will buy more in the U.S. D) the real exchange rate ($/€) will fall, and the euro will buy less in the U.S.

A) the real exchange rate ($/€) will rise, and the euro will buy more in the U.S. If prices rise higher in Europe (foreign country) the real exchange rate will rise because R_nominal • P* rises. This means that foreign/European goods are more expensive in $ compared to U.S. goods, so the euro will buy more in the U.S.

Under a fixed exchange standard, if the domestic demand for foreign exchange increases, A) the central monetary authority must meet the demand out of its reserves to maintain the peg. B) the central monetary authority must increase the supply of domestic money to maintain the peg. C) the country will be forced to abandon the peg. D) inflation will increase.

A. In order to keep the exchange rate fixed, the central bank has to offset the increased demand for FX. It does that by selling FX, that is selling its FX reserves, and buying domestic currency. This would be a monetary policy contraction for the domestic economy (buying domestic currency means a reduction in the domestic money supply).

If Juana contracts to buy U.S. office equipment in U.S. dollars and her domestic currency depreciates against the U.S. dollar between the time the contract is signed and the bill is paid, A) she will wind up paying less for the equipment because she stayed in the spot market. B) the amount she pays for the equipment will be unchanged because she stayed in the spot market. C) she will wind up paying more for the equipment because she stayed in the spot market. D) the price in the contract will be amended higher

C. Juana will have to pay more of her domestic currency to match the U.S.dollar price of the office equipment.

Use a J-curve to illustrate the effect on the current account of an exchange rate depreciation. Show this in a graph. Explain why the curve has the shape that it does.

After a depreciation, there is usually a short period of no noticeable impact on the volume (i.e., quantity) of goods and services imported and exported. A depreciation makes foreign goods immediately more expensive, but it takes time for households and businesses to find domestic substitutes for the goods and services they used to import. Therefore, after the exchange rate depreciates, with no change in the quantity of imports and exports, the immediate effect is an increase in the value of imports, pushing the current account balance deeper into deficit. Over time, domestic buyers substitute away from imports, and the current account balance improves. Likewise, on the exports front, the depreciation makes exports cheaper to foreign buyers and it increases the demand for exports, but this effect will also take time (e.g., it would take time for domestic exporters to find foreign buyers).

Which of the following transactions would be recorded in the current account? A) U.S. investors purchase bonds from Germany. B) A person living in the United States sends money home to her family in Cuba. C) The Fed increases its holdings of yen. D) The U.S. transfers a military base to another country.

B) A person living in the United States sends money home to her family in Cuba.

If the dollar/pound exchange rate is $2/£, a Big Mac costs $5 in New York City and costs £4 in London, the pound is ________, and U.S. tourists will be ________.

B. At the current exchange rate, a Big Mac in London costs £4 • $2/£ = $8. So the Big Mac is more expensive in London than in NYC, which means the pound is overvalued, and U.S. tourists are better off in NYC where the Big Mac is cheaper.

Consider the following two statements: A. Although financial crises can be unpredictable, they are usually preceded byidentifiable vulnerabilities. B. Financial crises due to weak financial sectors can often be avoided if international lenders respond appropriately. Which of these statements are true?

Both statements are true.

The biggest disadvantage of a fixed exchange rate system is the, A) increased probability of high inflation. B) giving up the ability to adjust the trade balance. C) giving up the ability to use monetary policy to respond to recessions D) the inability to maintain a balanced budget.

C) Monetary policy needs to be committed to keep the exchange rate fixed.

If a country has a collapsing currency due to large budget deficits financed by monetary expansion, the policy response would be to A) default on sovereign debt and restructure the economy. B) peg the currency to a different reserve currency. C) cut the budget deficit and raise interest rates. D) increase the rate of inflation to reduce the real value of government debt

C) cut the budget deficit and raise interest rates.

If a country wants to reduce its CA deficit, what macroeconomic policy options does it have? Which policy option is best? Explain how would that policy work to reduce the CA deficit, and what other effects it would have on the economy.

Contractionary fiscal policy improves the CA balance, i.e. reduces the CA deficit. Expansionary fiscal policy has the opposite effect and monetary policy has an uncertain effect on the CA balance.Contractionary fiscal policy works in two channels: (1) it reduces income and spending, which means reduced imports and improved CA balance. (2) it lowers interest rates(because the lower income means lower demand for money) and leads to an exchange rate depreciation, which leads to decreased imports and increased exports, improving the CA balance. The first channel is an expenditure reducing channel and the second channel is expenditure switching (from imports to domestic goods). The overall effect on the economy would be contractionary, i.e. recession.

People sometimes worry that American trade with other countries will lead to large U.S. trade deficits and the movement of massive amounts of American capital out of the country. Explain why this worry is unfounded.

Countries cannot have both current account and financial account deficits at the same time. A current account deficit means that the country, U.S in this case, is borrowing from abroad, so foreigners are investing in U.S. financial assets. This is the opposite of capital moving out of the U.S.

According to purchasing power parity, which of the following is FALSE about an overvalued dollar compared to the Japanese yen? A) U.S. merchants would be motivated to import more Japanese goods. B) Japanese merchants would tend to export more to the United States. C) Prices in the United States would tend to fall. D) the USD to Yen exchange rate falls means a dollar appreciation.

D) the USD to Yen exchange rate falls means a dollar appreciation. If the dollar is overvalued, PPP predicts the USD exchange rate will depreciate.

Carefully explain why monetary policy is likely to be more effective in stimulating the domestic economy in an open economy compared to fiscal policy.

Expansionary fiscal policy • increases interest rates, causing an exchange rate appreciation. • The exchange rate appreciation switches expenditures toward foreign goods because it makes them relatively cheaper, thereby increasing imports and reducing the current account balance. Therefore, the expansionary fiscal policy leads to more imports, both from the rise in income and from exchange rate appreciation. • The shift in expenditures toward foreign goods offsets some of the increase in the demand for domestic goods and diminishes the impact of expansionary fiscal policy. In contrast, expansionary monetary policy • causes the interest rate to fall and the currency to depreciate. • Exchange rate depreciation switches some consumer spending from foreign goods (imports) to domestic goods, because foreign goods become relatively expensive. • The effect of this expenditure switching is to partially or completely offset the increase in imports caused by rising incomes. • In addition, the switch from foreign goods to domestic goods increases demand for domestic goods, rises exports and therefore further increasing income (GDP).And there is less leakage of the economic expansion outside of the economy via more imports. • As a result, there is a more robust expansion of the domestic economy.Practice Problem Set #81. The biggest disadvantage of a fixed exchange rate system is the

True or False: An increase in government budget deficits will necessarily be associated with a worsening of the current account balance. Explain.

FALSE. The key word here is "necessarily." An increase in government budget deficits will not necessarily mean a worsening of the current account balance. It may mean a worsening of the current account balance, holding everything else constant.However, if at the same time as government deficits increase private savings also increase or private domestic investment decreases, then the current account balance may not worsen

True or false: Expansionary fiscal policy is likely to cause a nation's currency to depreciate. Explain.

FALSE. And expansionary fiscal policy would lead to increased incomes and spending, increased demand for money, leading to increased interest rates which (per the interest parity condition) lead to an exchange rate appreciation, not a depreciation.

If the forward rate is greater than the spot rate, what are markets signaling about their expectations for the future spot rates for the home currency?

Higher forward rate means exchange rate depreciation, so this means that the home currency is expected to depreciate over the maturity period of the forward contact.

The policy trilemma states that government must choose between free capital mobility, exchange rate management and monetary policy autonomy. Only two of the three are possible. Explain why.

If there is free capital mobility, the interest parity condition must hold. The interest parity condition links interest rates and exchange rates. So if a country wants to enact monetary policy via movements in interest rates, that would automatically affect exchange rates so the country would not be able to manage its exchange rate. If a country wants to manage its exchange rate, then it would not be able to implement monetary policy for any other policy goals other than the exchange rate.• If there is no free capital mobility, then the interest parity condition would not hold and a country could both manage its exchange rate and be able to implement monetary policy aimed at the domestic macroeconomic situation.• Think back to the triangle drawing from The Economist article. See last slide inExchange Rate Regimes lecture slides, week 8 module.

All other things equal, an increase in government spending that is NOT funded by taxes will Savings by households 3% Savings by businesses 15% Private investment 14% Net taxes paid 20% Government spending 22%

Increase the current account deficit. An increase in G not matched by increase in T leads to increase in government deficit, all else equal, which lowers domestic savings and leads to an increase in the current account deficit.

Explain why current account deficits may or may not be harmful to a country.

On the positive side, a current account deficit enables more investment, and since higher investment is correlated with higher living standards, the current account deficit might be interpreted as beneficial. The capital inflows associated with current account deficits are an implicit vote of confidence by foreigners. On the negative side, capital inflows occur with a current account deficit increase from stock of foreign-owned assets in home country, raising the possibility that a change in investor expectations about the economy's future can lead to a capital outflows. In the worst-case scenario, capital flight is causes a depletion of international reserves and a financial crisis

True or false: A depreciation of the currency can switch spending away from foreign goods and reduce the effect of rising incomes on the current account. Explain

TRUE. A depreciation makes imports more expensive to domestic buyers and exports less expensive to foreign buyers, leading (after some adjustment period -remember the J-curve), to expenditure switching away from imports (i.e., foreign goods). This would improve the CA balance, while rising incomes would worsen the CA balance (via higher consumption and higher imports).

True or False: Expansionary monetary policy is likely to cause a depreciation of the nation's currency. Explain

TRUE. Expansionary monetary policy means lowering of interest rates, which, holding everything else constant, would lead to a (spot) exchange rate depreciation per the interest parity condition.

True or false: A common response to stop a depreciation of a currency is to use contractionary monetary policy, which could lead to a recession. Explain. (Your explanation should include why is contractionary monetary policy the more common response as well as why it would lead to a recession.)

TRUE. When the currency is depreciating fast, as may be the case in a currency crisis, the macro policy response is to raise interest rates and increase the demand for the currency, so that the value of the currency stabilizes. Raising interest rates is contractionary monetary policy. This means it would be more expensive to finance investments in the economy, leading to lower output. In addition, not allowing the currency to depreciate may also perpetuate weak exports and high imports, which would also constrain economic growth.

The nominal interest rate in the U.S. is 6% and the nominal interest rate inCanada is 3%. The spot value of the U.S. dollar is 1 ($/Canadian dollar) and the forward rate is 1.2 ($/Canadian dollar). Calculate the expected change in the dollar exchange rate (i.e., forward discount or premium for the dollar). Does the interest parity condition hold? If not, explain what is likely to occur in foreign exchange markets. Assume that interest rates cannot change.

The forward rate is higher, meaning the forward rate is depreciated relative to the current/spot rate by [(F-R)/R] = [(1.2-1)/1] = 0.2 Remember: increase in the exchange rate means depreciation. So this is a forward discount because the forward rate is depreciated relative to the current/spot rate. The interest rate differential is positive .06-.03 = .03, or 3%. Interest parity doesn't hold. The depreciation is much larger than the interest differential. The higher U.S. interest rate isn't sufficiently attractive to investors given that the dollar is expected to depreciate sharply. Funds will flow into Canada. Assuming no changes in Ir, the current/spot exchange rates will adjust until interest parity holds - e.g., the Canadian dollar will appreciate and the U.S. dollar will depreciate until interest parity holds.

Suppose that U.S. interest rates are 4 percent more than rates in the EU. a. Would you expect the dollar to appreciate or depreciate against the euro, and by how much?

The interest differential U.S./domestic vs. foreign/EU is positive. This means that the dollar exchange rate is expected to depreciate (or, the expected change in the exchange rate is positive). The expected depreciation would match the interest differential (approximately), so it would be by about 4%. Due to higher interest rates, investment in U.S. assets is more attractive than in Europe. The expected depreciation could come about through an appreciation of the spot exchange rate and a depreciation of the future/forward exchange rate.

If the nominal exchange rate does not change, but U.S. prices rise and foreign prices do not change, the real exchange rate has (increased/decreased),meaning the USD experiences a real exchange rate (appreciation/depreciation),and U.S. imports are likely to (rise/fall).

The real exchange rate decreased (that is a real exchange rate appreciation) because the denominator P (domestic US prices) has increased. This makes U.S.goods more expensive, so U.S. imports are likely to rise (foreign goods are relatively cheaper)

Suppose that U.S. interest rates are 4 percent more than rates in the EU. b. If, contrary to your expectations, the forward and spot rates are the same, which direction would you expect financial capital to flow? Why?

This suggests that one side of the interest parity equation (the expected change in the exchange rate) is equal to zero, while the other side of the same equation (the interest differential) is positive 4%. In this case, the return on U.S. assets is higher, since the dollar is not expected to depreciate. Capital would flow to the United States, which would lead to a spot appreciation of the U.S. dollar. With no changes in the future/forward rate, the spot exchange rate will appreciate until the expected change in the exchange rate matches the interest differential of positive 4%, so until the U.S.dollar is expected to depreciate by about 4% in the future.

Use the following table to answer the next two questions. All values are measured as a percent of GNP. Savings by households 3% Savings by businesses 15% Private investment 14% Net taxes paid 20% Government spending 22% Find the total Savings:

Total savings, private plus public, is equal to 16% Savings by households (+) Savings by businesses (+) Net Taxes Paid (+) Government Spending (-) 3% + 15% + 20% - 22% = 16%

For each transaction below, indicate what BoP category they would be recorded under, and whether they are recorded as a credit or a debit. a. Apple sells $5 mill of iPhones to Indian buyers, who pay through a tradecredit contract. b. A US family pays for a holiday in Paris by using money from their U.S.bank account. c. U.S. investor buys $500K in Romanian government bonds. They pay with dollars from their U.S. bank account. d. U.S. firm buys a Mexican clothing factory for $5M and pays by offering theMexican counterpart shares in the U.S. firm.

a. US export, CA credit; FA debit, purchase of a foreign asset ("other investment -trade credit", a form of loan) b. US import (services), CA debit; FA credit - US residents take money from theirdomestic bank accounts ("other investment - currency and deposits"), sell US asset,being cash deposits c. the bond purchase represents US FA debit (portfolio); $ flowing out from US bank account represents FA credit (under other investment - currency and deposits). Net zero FA transactions. Purchase of asset is a simultaneous sale of an asset of equal value. If the payment happened from the investor's UK bank account, it would not register in the US balance of payments. d - FA FDI debit; the Mexican party owning shares in US firm recorded as FA credit

Using table below the current account balance is: Savings by households 3% Savings by businesses 15% Private investment 14% Net taxes paid 20% Government spending 22%

savings (+) investment (-) = 18% - 14% = 2% surplus;

b. Increased price of imported commodity (e.g., oil, natural gas) What would be different if exchange rates are fixed rather than flexible?

• Increased Price of Imports will lead to an increase in the CA deficit, assuming that the quantity of imports cannot change (much) if the commodity considered is an essential input that the country depends on. • The increased in the price of imports will lead to inflation. Plus, if the commodity is an intermediary product to the production of other goods and services, e.g. oil, that would further fuel inflation. • Inflation could make Exports less competitive, further worsening the CA deficit. • If the price of imports in FX ($) increases, then there will be increased demand for FX to pay for the IM. This means that the foreign currency will appreciate and the domestic currency will depreciate. • The domestic currency depreciation helps the CA balance adjust back up. • Monetary policy could increase interest rates to tame inflation but that would not allow the exchange rate to depreciate and would lead to recession. • If the exchange rate is fixed, monetary policy would have to be contractionary, i.e. increase interest rates, buy home currency, sell FX, to prevent the exchange rate fixed.

Consider the following potential shocks to an economy. Explain what would be the effect of the shock on the economy in terms of income, prices, imports, exports and the current account balance, the exchange rate. Assume that exchange rates are flexible. a. Recession in large foreign economy, main trading partner What would be different if exchange rates are fixed rather than flexible?

• Recession in a large foreign economy that is the country's main trading partner leads to decreased demand for Exports and lower income overall. • This will lead to a larger CA deficit. (There may also be a secondary effect of lower Imports due to the decreased in income Y, which may temper the increase in the CA deficit.) • The lower demand for exports means lower demand for the domestic currency so the domestic currency will depreciate (R increases). • If the domestic currency depreciates, IM more expensive, EX less expensive, so there will be an automatic adjustment of the CA balance - i.e. the CA deficit would improve (smaller deficit). This means that the CA deficit gets worse initially after the negative external shock from the large foreign economy, but over time the CA deficit would recover (somewhat). • If the exchange rate needs to be kept fixed, the central bank would have to off set the lower demand for domestic currency by buying domestic currency, which contracts the money supply, increases interest rates and is contractionary on the economy as a whole. This policy response would preclude the automatic adjustment from the exchange rate depreciation, though the economic contraction would slow down Imports and somewhat improve the CA deficit through that Income/Imports channel.

c. Decreased price of exported commodity (e.g., oil, cocoa, sugar, wheat, lumber, palm oil, etc.) What would be different if exchange rates are fixed rather than flexible?

• The decreased price of an export commodity (oil, or coffee) would lead to a decrease in the value of exports (assuming that the quantity of exports does not change much). • The CA deficit would increase. • Decreased exports would mean lower Y. • Decreased exports would also mean lower demand for the home currency, so the home currency would depreciate. • An exchange rate depreciation would help improve the CA deficit, so it would be the same automatic adjustment as in previous scenarios.

Match the following transactions to the correct recording in the balance of payments accounts. • U.S. investors purchase bonds from Germany • A person living in the U.S. sends money to their friends and family in Ukraine • The U.S. transfers a military base to another country • A citizen of India buys stock in Microsoft • Toyota buys an automobile plant in Ohio • A U.S. firm sells soybeans to China • An Italian couple buys a vacation package to visit Florida

• U.S. investors purchase bonds from Germany - FA Debit, portfolio investments. • A person living in the U.S. sends money to their friends and family in Ukraine [CA debit, secondary income (remittances).] • The Fed increases its holdings of Yen (FA, Debit, reserve assets.) • The U.S. transfers a military base to another country (Capital Account, Credit, Capital account.) • A citizen of India buys stock in Microsoft (FA credit, portfolio investments.) • Toyota buys an automobile plant in Ohio (FA credit, direct investments.) • A U.S. firm sells soybeans to China (CA credit, goods export.) • An Italian couple buys a vacation package to visit Florida (CA credit, service export.)