econ 2202 chapter 4
What three factors regarding differences in interest rates on similar bonds can prevent the interest parity condition from holding?
1. Investors typically see even similar bonds as having important differences in default risk and liquidity. 2. Typically, the cost of purchasing foreign financial assets (the transactions costs) are higher than for domestic assets. 3. The interest parity condition does not take into account the exchange-rate risk from investing in a foreign asset.
What real world complications keep purchasing power parity from being a complete explanation of exchange rate fluctuations in the long run. Explain
1. Not all products are traded internationally. As a result, there is no way to take advantage of profit opportunities to buy in one country and sell in another country, so exchange rates will not reflect exactly the relative purchasing power of currencies. 2. Countries impose trade barriers. If there are barriers to trade, it may not be possible to take advantage of profit opportunities to buy in one country and sell in another country, so exchange rates will not reflect exactly the relative purchasing power of currencies. 3. Products differ across countries as firms adapt products to to local tastes. As a result, consumers in one country might be willing to pay different prices for products than consumers in another country, and exchange rates might not adjust for that difference in the long run.
What is the difference between nominal exchange rates and real exchange rates?
A nominal exchange rate measures the value of one country's currency in terms of another country's currency. A real exchange rate measures the price of domestic goods in terms of foreign goods. Mathematically, the real exchange rate is equal to the nominal exchange rate times the ratio of the domestic price level to the foreign price level.
Why is the balance of payments always zero
If a country spends more on goods and services and other items in the current account than it receives, it must have received the income needed to buy those items from investments from foreigners. In other words, a current account deficit must be offset by a surplus in the financial account. Apart from measurement errors, the sum of the current account and the financial account must equal zero (assuming the relatively minor and unimportant capital account is zero). Therefore, the balance of payments must equal zero.
Explain what happens to the world real interest rate if the government of Panama runs a large government budget deficit.
Since Panama is a small open economy, the world real interest rate would not be affected by the government of Panama running a large government budget deficit.
What determines the supply of loanable funds and the demand for loanable funds
The supply of loanable funds is determined by the willingness of households to save, by the extent of government saving, and by the extent of foreign saving that is invested in U.S. financial markets. The demand for loanable funds is determined by the willingness of firms to borrow money to engage in new investment projects.
What are the three major types of foreign-exchange systems, and how do they operate?
The three major types of foreign-exchange systems are the fixed exchange-rate system, the floating exchange-rate system, and the managed float exchange-rate system. A fixed exchange rate exists when the government maintains one fixed rate at which currency can be exchanged. The currency can be fixed relative to all other currencies, it can be fixed relative to a specific amount of gold (the gold standard), it can be fixed to a basket of several currencies or fixed to just one other currency (an exchange-rate peg). A floating exchange-rate is determined solely by equilibrium of demand and supply in the foreign exchange market. Under a managed float, the exchange rate is primarily determined by demand and supply in the market for foreign exchange, with occasional central bank intervention. This is also called a dirty float regime.
When determining interest rates, the loanable funds model is more useful when we are concerned with the determinants of the ________, and the money market model is more useful when we are concerned with the determinants of the ________. A) long-term real interest rate; short-term nominal interest rate B) short-term real interest rate; long-term nominal interest rate C) short-term real interest rate; short-term nominal interest rate D) long-term real interest rate; long-term nominal interest rate
a
Exports of goods and services $775 Imports of goods and services -920 Increase in foreign holdings of assets in the United States 650 Increase in U.S. holdings of assets in foreign countries -485 Income received on investments and labor compensation 240 Income payments on investments and labor compensation -205 Net income on investments and labor compensation 15 Net transfers -60 Net financial derivatives 5 Balance on capital account 0 16) Refer to Table 4.1. Using the data in the table calculate the following: a. The balance on the current account b. The balance on the financial account c. The statistical discrepancy d. The balance of payments
a. The balance on the current account = 775 + (-920) + 240 + (-205) + 15 + (-60) = -$155. b. The balance on the financial account = 650 + (-485) + 5 = $170. c. The statistical discrepancy = -155 + 170 = $15. d. The balance of payments = -155 + 170 - 15 = $0.
1. Not all products are traded internationally. As a result, there is no way to take advantage of profit opportunities to buy in one country and sell in another country, so exchange rates will not reflect exactly the relative purchasing power of currencies. 2. Countries impose trade barriers. If there are barriers to trade, it may not be possible to take advantage of profit opportunities to buy in one country and sell in another country, so exchange rates will not reflect exactly the relative purchasing power of currencies. 3. Products differ across countries as firms adapt products to to local tastes. As a result, consumers in one country might be willing to pay different prices for products than consumers in another country, and exchange rates might not adjust for that difference in the long run.
a. The return on Japanese bonds = 7% - 10% = -3%. b. The return on Japanese bonds is -3% and the return on U.S. bonds is +3 percent, so investing in U.S. bonds would be the better choice. c. The interest rate on Japanese bonds would need to increase by 6% (from 7% to 13%) to make the return on Japanese bonds equal to the 3% return on U.S. bonds.
A depreciation of the Mexican peso relative to the U.S. dollar would ________ Mexican firms that are exporting goods to the United States and would ________ Mexican firms that have borrowed in U.S. dollars. A) help; help B) help; hurt C) hurt; help D) hurt; hurt
b
An American insurance company hires a call center in India to handle customer service calls in order to cut costs. Other things equal, this will ________ of the United States. A) decrease the financial account balance B) decrease net exports C) decrease the capital account balance D) increase the current account balance
b
The domestic real interest rate in a small open economy is A) determined by the intersection of the supply curve and demand curve for loanable funds in the country. B) equal to the world real interest rate. C) the same as its nominal interest rate. D) determined by the total value of net exports in the country.
b
Scenario Current interest rate — U.S. Current interest rate - Japan Current exchange rate Expected exchange rate in 1 year A 2% 4% ¥100 = $1 ¥103 = $1 B 3% 6% ¥100 = $1 ¥102 = $1 C 5% 2% ¥100 = $1 ¥97 = $1 D 4% 7% ¥100 = $1 ¥106 = $1 10) Refer to Table 4.2. With which scenario will you be best off by investing in Japanese bonds instead of U.S. bonds? A) A B) B C) C D) D 11) Refer to Table 4.2. With which scenario will you be worst off by investing in Japanese bonds instead of U.S. bonds? A) A B) B C) C D) D
bd
A shift from S1 to S2 will result from all of the following except A) a decrease in the government's budget deficit. B) a decrease in net exports. C) a decrease in corporate taxes. D) a decrease in the desire of households to consume today.
c
If the nominal exchange rate between the dollar and the euro is $1 = €0.70, and the price of an 8.4 oz. can of Red Bull is $1.75 in the United States and €1.40 in Germany, the real exchange rate between the dollar and the euro is A) 1.25 cans of Red Bull in Germany per can of Red Bull in the United States. B) 0.80 cans of Red Bull in the United States per can of Red Bull in Germany. C) 0.875 cans of Red Bull in Germany per can of Red Bull in the United States. D) 0.56 cans of Red Bull in Germany per can of Red Bull in the United States.
c
Purchasing power parity does a ________ job in explaining movements in nominal exchange rates in the short run and does a ________ job in explaining movements in nominal exchange rates in the long run. A) reasonable; reasonable B) reasonable; poor C) poor; reasonable D) poor; poor
c
A currency's spot exchange rate against every other individual currency is known as a ________ exchange rate, and the exchange rate which shows how a currency is changing relative to a group of other countries' currencies is known as a ________ exchange rate. A) nominal; real B) unilateral; bilateral C) nominal; parity D) bilateral; multilateral
d
If Greece chose to abandon the euro and the Greek government decided to exchange euro bank deposits for drachmas, the affected bank depositors would suffer losses if the A) euro then appreciated. B) euro then depreciated. C) drachma then appreciated. D) drachma then depreciated.
d
One disadvantage of a fixed exchange rate system compared to a floating or managed float exchange rate system is A) it more difficult for central banks to control inflation. B) it does not allow for government intervention. C) it can worsen inflation if domestic prices of imports rise quickly. D) it eliminates the possibility of depreciation during a recession.
d
The higher the real interest rate, the ________ investment projects firms can profitably undertake, and the ________ the quantity of loanable funds they will demand. A) more; smaller B) more; greater C) fewer; greater D) fewer; smaller
d
The return that a domestic investor receives on a foreign investment is equal to A) the interest rate on the foreign investment minus the interest rate on a comparable domestic investment. B) the appreciation rate of the foreign currency minus the appreciation rate of the domestic currency. C) the interest rate on the foreign investment times the appreciation rate of the foreign currency. D) the interest rate on the foreign investment minus the rate of appreciation of the domestic currency.
d
When the Fed pursues a monetary policy of low interest rates, the exchange rate between the dollar and other currencies will tend to ________, generally making it ________ for foreign firms to sell their goods in the United States. A) rise; easier B) rise; more difficult C) fall; easier D) fall; more difficult
d
Which of the following explains why purchasing power parity may not hold perfectly in the long run? A) Most countries have free markets with limited government regulation. B) Consumer preferences for goods and services across countries are very similar. C) Most countries do not impost trade barriers. D) Some goods and services produced in any country are not traded internationally.
d
Which of the following is an example of foreign direct investment in the United Kingdom? A) British Airways purchases a small, New York-based helicopter transport company. B) The Bank of England purchases U.S. Treasury securities. C) Verizon purchases stock in British Telecom. D) U.S.-based Amazon.com purchases a distribution warehouse in London.
d