inter eco short answers/ essays questions

Who are the major participants in the foreign exchange market?

(1) Commercial banks (2) Corporations (3) Nonbank financial institutions (4) Central banks

Suppose Russia's inflation rate is 200% over one year but the inflation rate in Switzerland is only 2%. According to relative PPP, what should happen over the year to the Swiss franc's exchange rate against the Russian ruble?

(Eruble/franc, t - Eruble/franc, t-1)/Eruble/franc, t-1 = 2 - 0.02 = 1.98 So there will be a 198% depreciation of the ruble against the franc or, conversely, a 198% appreciation of the franc against the ruble.

Assume that the euro interest rate is constant at 5 percent, and that the expected exchange rate is 1.05 dollars per one euro. Find the expected dollar return on euro deposits for the following cases. Expected Dollar Depreciation Today's Interest Rate Expected Dollar Dollar/Euro Rate on Against Return on Euro Exchange Euro Euro Deposits Case Rate Deposits (1.05 - E)/E Re + (1.05 - E)/E 1 1.07 2 1.06 3 1.05 4 1.04 5 1.03 6 1.02 7 1.01 8 1 9 0.99 10 0.98

1 1.07 0.05 -0.0186916 0.031308411 2 1.06 0.05 -0.009434 0.040566038 3 1.05 0.05 0 0.05 4 1.04 0.05 0.0096154 0.059615385 5 1.03 0.05 0.0194175 0.069417476 6 1.02 0.05 0.0294118 0.079411765 7 1.01 0.05 0.039604 0.08960396 8 1 0.05 0.05 0.1 9 0.99 0.05 0.0606061 0.110606061 10 0.98 0.05 0.0714286 0.121428571

Show graphically a drop in the interest rate paid by euro deposits. What is the effect on the dollar?

A drop in the interest rate from R1$ to R2$ causes the dollar to depreciate from E 1 $/€ (point 2) to E 2 $/€ (point 1)

Explain why (holding interest rates constant), a rise in the expected depreciation in a country's currency leads to depreciation of that currency today.

A rise in the expected depreciation rate of the dollar raises the expected dollar return on euro deposits. Now, there are excess supply of dollar deposits (euro deposits offer higher expected rate of return than do dollar deposits). The dollar must depreciate to remove this excess supply.

Explain what is a "vehicle currency." Why is the U.S. dollar considered a vehicle currency?

A vehicle currency is one that is widely used to denominate international contracts made by parties who do not reside in the country that issues the vehicle currency. Since in 2004, nearly 90 percent of foreign exchange transactions involve exchanges of foreign currencies for U.S. dollars; therefore, it is considered a vehicle currency.

How can long run values in the real exchange rate change?

An increase in world relative demand for U.S. output causes a long-run real appreciation of the dollar against the euro (a fall in real dollar/euro exchange rate). A relative expansion of U.S. output causes a long-run real depreciation of the dollar against the euro (a rise in real dollar/euro exchange rate).

Present and explain the Fundamental Equation of the Monetary Approach.

Assume E$/€ = PUS/PE and that domestic price levels depend on domestic money demands and supplies: PUS = MUSS/L(R$, YUS) PE = ME S/L(R€, YE) Therefore, the exchange rate is fully determined in the long run by the relative supplies of those monies and the relative real demands for them. Shifts in interest rates and output levels affect the exchange rate only through their influence on money demand

Fill in the following table. CA Sp I G T 15 50 25 12 8 50 15 3 9 25 10 4 35 50 10 5 10 30 20 10 22 200 50 12 -25 140 100 15 400 200 20 -280 100 200 200

CA Sp I G T 15 50 25 12 2 8 50 30 15 3 9 40 25 10 4 35 50 10 10 5 -30 10 30 20 10 22 200 140 50 12 -25 200 140 100 15 70 400 200 150 20 -280 100 200 200 20

Describe the chain of events leading to exchange rate determination for the following cases: (a) An increase in U.S. money supply (b) Increase in growth rate of U.S. money supply (c) Increase in world relative demand for U.S. products (d) Increase in relative U.S. output supply

Chain of events leading to exchange rate determination: E$/ = q $/ × (Pus/PE) Increase in U.S. money supply: Pus rises in proportion to the money supply; q remains the same. All dollar prices will rise (including dollar price of euro). Increase in growth rate of U.S. money supply: Inflation rate, dollar interest rate, Pus, E, rises in proportion to Pus. Increase in world relative demand for U.S. products: E falls, and q does as well. Increase in relative U.S. output supply: Dollar depreciates, lowers relative price of U.S. output, rise in q, effect on E is not clear since q and Pus work in opposite directions.

Calculate the interest rate in the United States, if interest parity condition holds, for the following 15 cases. Expected Rate of Dollar Depreciation Against Euro Case RE E R$ 1 0.06 0 2 0.06 0.04 3 0.06 0.08 4 0.12 -0.04 5 0.18 0 6 0.06 0 7 0.06 0.04 8 0.06 0.08 9 0.12 -0.04 10 0.18 0 11 0.06 0 12 0.06 0.04 13 0.06 0.08 14 0.12 -0.04 15 0.18 0

Expected Rate of Dollar Depreciation Against Euro Case RE E R$ 1 0.06 0 0.06 2 0.06 0.04 0.1 3 0.06 0.08 0.14 4 0.12 -0.04 0.08 5 0.18 0 0.18 6 0.06 0 0.06 7 0.06 0.04 0.1 8 0.06 0.08 0.14 9 0.12 -0.04 0.08 10 0.18 0 0.18 11 0.06 0 0.06 12 0.06 0.04 0.1 13 0.06 0.08 0.14 14 0.12 -0.04 0.08 15 0.18 0 0.18

Describe and explain the relationship between expected inflation rates in two countries and their interest rate differential according to the PPP theory.

Expected inflation is given by the following equation: ̓e = (Pe - P)/P where Pe is the expected price level in a country a year from today. If relative PPP is expected to hold then: (E e $/€ - E$/€)/E$/€ ̓ e US - ̓ e E Combine the expected version of relative PPP with the interest parity condition: R$ = R€ + (E e $/€ - E$/€)/E$/€ Rearrange: R$ - R€ = ̓ e US - ̓ e E If, as PPP predicts, currency depreciation is expected to offset international inflation difference, the interest rate difference must equal the expected inflation difference

What can explain the failure of relative PPP to hold in reality?

Government measures of the price level differ from country to country. One reason for these differences is that people living in different countries spend their income in different ways. Because of this inherent difference among countries, certain baskets will be affected more by price changes given their consumptions basket. For example, consumers in country, X, eats more fish relative to another country. More than likely, the government, upon determining a commodity basket to reflect preference, will have an overwhelming representation of fish in their basket. Any price level change in the fish market will be felt particularly by country X, and their overall price level will reflect this. Thus, changes in the relative prices of basket components can cause relative PPP to become distorted.

Consider how the United States balance of payments accounts are affected when U.S. banks forgive two billion in debt owed to them by the government of Argentina.

In this case, the United States makes a two billion dollars capital transfer to Argentina, which should appear as a negative two billions entry in the capital account. The associated credit is in the financial account, in the form of a two billion dollars reduction in U.S. assets held abroad, i.e., a net asset "export," and therefore a positive balance of payments entry.

To answer the following question, please refer to the figure below. Concentrating only at the lower right quadrant, discuss the effects of a change in U.S. expected inflation

Lower right quadrant shows the equilibrium in the U.S. Money Market, where R 1 $ = M 1 US /P 1 US A given interest rate R1$ corresponds with a given U.S. real money supply, M 1 US /P 1 US . Consider a rise of ̇̓ in the future rate of U.S. money supply growth (i.e. an increase in the expected rate of inflation). The Key Point: The rise in expected future inflation generates expectations of more rapid currency depreciation in the future. Under PPP the dollar now depreciates at a rate of ̓ + ̇̓. Interest parity therefore requires the dollar interest rate to rise where R 2 $ = R 1 $ + ̇̓. (Point 2 in the figure.) Note: R$ - R€ = ̓ e US - ̓ e E This relation shows a change in the U.S. interest rate due to an increase in expected U.S. inflation has no effect on the euro interest rate. The rise in the interest rate from R 1 $ to R 2 $ creates a momentary excess supply of real U.S. money balances at the prevailing price level P 1. However, since under this. Monetary Approach, prices are assumed to be flexible, prices will immediately adjust from P 1 to P 2, thus causing the following two effects: One, Reducing real money supply and two, bringing U.S. money market back into equilibrium.

What are the predictions for the long run equilibrium of the Monetary Approach?

Money supplies: Given the equations, E$/€ = PUS/PE PUS = MUSS/L(R$, YUS) PE = ME S/L(R€, YE) one can show that an increase in the U.S. money supply MUSS causes a proportional increase in the U.S. price level PUS, which in turn causes a proportional increase in E$/€. Thus, an increase in U.S. money supply causes a proportional long-run depreciation of the dollar against the euro and vice versa. Interest rates: A rise in the interest rate R$ lowers U.S. money demand L(R$, YUS) thereby causing a rise in the U.S. price level and a proportional depreciation of the dollar against the euro. Output levels: A rise in U.S. output YUS raises real U.S. money demand leading to a fall in the long-run U.S. price level and an appreciation of the dollar against the euro.

How does an economy's central bank manage the supply of money through official reserve transactions?

Official foreign exchange interventions are a way for the central bank to inject money into the economy or withdraw it from circulation. They can buy or sell international reserves in private asset markets in order to alter macroeconomic conditions without noticeably impacting the money supply. When a central bank purchases or sells a foreign asset, the transaction appears in its country's financial account as if a private citizen had carried out the same transaction.

Discuss the effects of ongoing inflation based on the PPP theory

Other things equal, money supply growth at a constant rate eventually results in ongoing price level inflation at the same rate as the money supply growth, but changes in this long-run inflation rate do not affect the full-employment output level or the long-run relative prices of goods and services. The interest rate, however, is affected by continuing growth in the money supply (inflation). This can be shown by combining PPP with the interest parity condition. To show it analytically, recall that the condition of parity between dollar and euro assets is: R$ = R€ + (E e $/€ - E$/€)/E$/€ And according to relative PPP: (E$/€, t - E$/€, t-1)/E$/€, t-1 =ȱ̓US,t -ȱ̓E,t If people expect relative PPP to hold, the difference between interest rates offered by dollar and euro deposits will equal the difference between the expected inflation rates, over the relative horizon, in the U.S. and Europe.

Explain Purchasing Power Parity

PPP states that the exchange rate between two countries' currencies equals the ratio of the countries' price levels. A fall in a currency's domestic purchasing power (i.e. an increase in the domestic price level) will be associated with a proportional currency depreciation in the foreign exchange market and vice versa. E$/€ = PUS/PE where P is the price of a reference commodity basket. Rearrange: PUS = E$/€ × (PE) Thus, PPP asserts that all countries' price levels are equal when measured in terms of the same currency

Explain why exchange rate model based on PPP is a long run theory

PPP theory is a monetary approach to the exchange rate. It is a long-run theory because it does not allow for price rigidities. It assumes that prices can adjust right away to maintain full employment as well as PPP.

Explain risk and liquidity of assets

Risk is the variability an asset contributes to a savers' wealth. An asset's real return can be unpredictable and savers dislike this uncertainty if the return fluctuates widely. Liquidity refers to the ease with which an asset can be sold or exchanged for goods. Cash is the most liquid of assets because it is always acceptable at face value as payment for goods or other assets. Thus, savers consider an asset's liquidity and its expected return and risk in deciding how much of it to hold.

Based on the case study, "Exchange Rates, Auto Prices, and Currency Wars," explain why exchange rates are of critical importance to firms in the automobile industry, and how Japan has benefited from changes in the value of the Yen.

See the discussion at the beginning of the chapter and in the case. Japan experienced a 15% drop in the value of the yen relative to the U.S. dollar in 2013. This increased Japanese exports of autos while reducing imports from the U.S.

Explain the purpose of the following figure 14-2 from the text in the context of the interest rates on the dollar and the Japanese Yen between 1980 and 2010.

Since the dollar and the Yen interest rates are not measured in comparable terms, they can move quite differently over time. Except for a period from 1990 to 1993 when the Yen interest rate was higher than the dollar, dollar interest rates have been higher than the Yen, indicating depreciation of the dollar against the Yen.

What is the interest parity condition?

The condition that the expected returns on deposits of any two currencies are equal when measured in the same currency is called the interest parity condition. It implies that potential holders of foreign currency deposits view them as equally desirable assets, i.e. risk is assumed away. In notational forms: R$ = RE + (E e $/E - E$/E)/E$/E

What effect do non-tradable goods have on PPP?

The effect is quite substantial. In 2006, the output of non-tradable goods accounted for about 46% of U.S. GNP. Along with haircuts, non-tradable goods include routine medical treatment, housing etc. For the most part, non-tradable goods are comprised of services, and the output of the construction industry. Non-tradable help explain much of the wide departure from PPP that is present in empirical data.

Discuss why the empirical support for PPP and the law of one price is weak in recent data.

The failure of these propositions in the real world is related to trade barriers and departures from free competition, factors that can result in pricing to market by exporters. In addition, different definitions of price levels in different countries bedevil attempts to test PPP using the price indexes governments publish. For some products, including many services, international transport costs are so steep that these products become non-tradable.

What can one learn from the following figure?

The figure shows the U.S. current account and net foreign wealth from 1977 until 2008. It shows that a string of current account deficits in the 1980s reduced America's net foreign wealth until, by the end 2008, the country had accumulated a substantial net foreign debt. In 1987 the country became a net debtor to foreigners for the first time since World War I.

Explain why the interest parity condition must hold if the foreign exchange market is in equilibrium.

The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return. Potential holders of foreign currency deposits view them all as equally desirable assets. If expected rate of return on any currency deposit is higher or lower than the other, there will exist an excess supply or demand for that currency because one will yield a higher return than the other.

Explain the Law of One Price. Give an example.

The law of one price states that in competitive markets free of transportation costs and trade barriers, identical goods sold in different countries must sell for the same price when expressed in terms of the same currency. P i US = (E$/£) × (P i £ ) for good i. E$/£ = P i US /P i UK If, for example, the price of the same sweater was cheaper in London than in New York, U.S. importers and British exporters would have an incentive to buy sweaters in London and ship them to New York, pushing the London price up and the New York price down, until both were equal.

To answer the following question, please refer to the figure below. Concentrating only at the lower left quadrant, discuss the relationship between the U.S. real money supply and the dollar/euro exchange rate, E$/E

The lower left quadrant in the figure described the Purchasing Power Parity (PPP) relationship. The relationship between the U.S. real money supply and the dollar/euro exchange rate, E$/E is negative. E$/€ is equal to the price level ratio, PUS/P€. In this derivation of the relationship, the following variables are assumed constants: M 1 US , R€, and P€. So, E$/€ = M 1 US /PUS PUS E$/ P 1 US P 2 US Thus, the purchasing power of dollar decreases due to the increase in the price level. E1$/€ E2$/€ i.e., dollar depreciates due to PPP

What are the three factors that affect the demand for foreign currency?

The three factors that affect the demand for foreign currency are expected return, risk and liquidity.

To answer the following question, please refer to the figure below. Concentrating only at the upper right quadrant, discuss the foreign exchange market equilibrium.

The upper right quadrant describes the equilibrium in the foreign exchange market. We begin with the Interest Parity Condition. R$ = R + (E e $/ - E$/ )/E$/ In general, two effects are present: R 1 $ R 2 $ and E 1 $/ E 2 $/ A rise in the interest rate normally creates an excess demand for dollar deposits and appreciation in the currency market. However, in this case the increase is due to higher expected inflation or higher expected monetary growth in the U.S. which implies a faster expected depreciation of the dollar against the euro, , thus, E e $/ goes up and thus reduced the attractiveness of U.S. deposits

Discuss the effects of a rise in the dollar interest rate on the exchange rate.

There are two effects to consider. A rise in the interest rate offered by dollar deposits combined with a constant expected exchange rate will cause the dollar to appreciate (see Figure 14-5 from the text). However, the expected exchange rate will likely change. As Figure 14-6 from the text shows, if the expected exchange rate increases, the dollar will depreciate.

Discuss the effects of a rise in the interest rate paid by euro deposits on the exchange rate.

There are two effects to consider. If we make the unrealistic assumption that the expected exchange rate will not change, then a rise in the interest rate paid by Euro deposits causes the dollar to depreciate. However, if the expected exchange rate were to rise, then the current exchange rate would also rise.

What types of international transactions are recorded in the balance of payment accounts?

Three types: transactions that involve exports and imports of good and services; transactions that involve the purchase or sell of financial assets; and exports and imports of good and services; other activities resulting in transfer of wealth between countries which are recorded in the capital account

Explain the purpose of the following figure.

To show that spot and forward exchange rates are in general close to each other.

"The Balance of payments is always balances." Discuss.

True. Every international transaction automatically enters the balance of payments twice, once as a credit and once as a debit. Current account + financial account + capital account = 0

In the year 2012, Shinzo Abe became prime minister of Japan, promising bold policies to improve Japan's economy. What was the focus of his policies and how did they affect Japan's trade position?

What has been called "Abenomics" involved monetary policies designed to reduce the value of the Japanese Yen relative to other currencies. This resulted in increased exports and reduced imports, strengthening the Japanese economy.

Does the existence of non-tradable goods allow for deviations from Purchasing power Parity?

Yes, the existence of nontradables allows deviations from PPP. This is because the price of a nontradable is determined entirely by its domestic supply and demand curves, and in turn fluctuations in demand and supply for these good will affect the price level. Examples include housing, haircut, services etc