Econ Practice Questions

A nation's BOP can be grouped into two major accounts. What are these accounts?

(1) Current account, (2) Capital and financial.

In 2002 the U.S. international investment position was -$2,200 billion. The current account balance was -$440 billion in 2003 and -$665 billion in 2004. The U.S. international investment position in 2004 was:

-$3,305 billion (To get this year's IIP, we have to add this year's current account balance to the last year's IIP. Therefore: 2003 IIP = 2003 CA + 2002 IIP = (-$440bi) + (-$2,200 bi) = -$2,640 billion 2004 IIP = 2004 CA + 2003 IIP = (-$665bi) + (-$2,640bi) = -$3,305 billion)

Given the following data, what is the country's current account balance? Merchandise trade balance = -120; Services trade balance = +45; Unilateral transfers received in excess of those made = +15; Investment income = -10; U.S. assets abroad = +20

-70 (This is found by adding -120 + 45 + 15 -10 = -70. )

The effective exchange rate is

. a measure of the weighted-average value of a currency (such as the U.S. dollar) relative to a selected group of countries [The EER is the value of a currency such as the U.S. dollar) against the weight average of a basket of foreign currencies). ]

Given that the quantity of U.S dollar is measured on the horizontal axis and the vertical axis measures the price of dollar in terms of pound, a surplus of dollars in the foreign exchange market under a flexible exchange rate system would result in

A depreciation of the dollar against the pound [A surplus of dollar means the price of dollar must fall (i.e., the dollar must depreciate in value). ]

How does BOP disequilibrium arise according to the monetary approach?

A disequilibrium in the BOP (a deficit or surplus) arises because of an imbalance between the demand and supply of money.

If the U.K. rate of inflation is above the U.S. rate of inflation, what is expected to happen to the real exchange rate? What is expected to happen to the U.S. and the U.K current account?

A higher rate of inflation in the U.K. will cause the British pound to appreciate in real terms, assuming the nominal exchange rate to remain constant or does not fully adjust to inflation. This would increase the U.K. imports from the U.S. and decrease the U.S. imports from the U.K. As a result, the U.K. will run a current account deficit and the U.S. will run a current account surplus.

In a flexible exchange rate system, why would the government intervene in the market? What is the major problem associated with the purely flexible exchange rate?

A purely flexible (floating) exchange rate system may result in large fluctuations in exchange rates which can discourage production, trade, and increase unemployment. So the government may let market forces determine the long-term trend in the exchange rate but intervene occasionally to moderate large exchange rate fluctuations. This system is called managed flexible (floating) exchange rates.

Which of the following is NOT recorded as capital inflows?

A reduction in the nation's liabilities [Capital and financial account inflows: (1) An increase in liabilities abroad, (2) A decrease in assets abroad, (3) An increase in the foreign assets in the home nation.]

Indicate how each of the following international transactions is entered into the U.S. BOP with double entry bookkeeping. A) A U.S. citizen sends $100 worth of gifts to his friend who is in Frankfurt. B) A U.S. investor receives $200 dividend from a German corporation and deposits it in a local bank. c. An American company imports $500 worth of goods from Japan and pays in yen

A) A U.S. citizen sends $100 worth of gifts to his friend who is in Frankfurt. Exports $100 (Credit) Unilateral Transfers $100 (Debit) B)A U.S. investor receives $200 dividend from a German corporation and deposits it in a local bank. Investment income $200 (Credit) Capital outflow $200 (Debit) (for a ↓ reduction in US liabilities abroad) C)An American company imports $500 worth of goods from Japan and pays in yen Imports $500 (Debit) Capital inflow $500 (Credit) (for a ↓ in US claims in Japan)

Differentiate between the futures markets and the option markets?

A. The futures market is more appealing to speculators, while the option market is more appealing to hedgers. b. Futures contracts must be honored if held until maturity, while the holders of option contracts may choose not to exercise their contract. c. Futures are traded on organized exchanges, while only a small fraction of options are traded on organized exchanges. The bulk of options are traded in a less formal market known as over-the-counter. d. Both the buyer and the seller must post a security deposit in the futures market, while only the option writer must post a security deposit.

In the monetary approach what factors determine the exchange rate under a flexible exchange rate system?

According to the monetary approach, in a flexible exchange rate system, the exchange rate is determined by a comparison between the demand for money and the supply of money in different countries. All factors affecting the demand for money and the supply of money (i.e., P, P* Y, Y*, i , i*,Ms, M*s ) as well the expected rate of change in inflation and the exchange rate influence the exchange rate.

According to the monetary approach, under a fixed exchange rate system a BOP surplus is the result of

An excess demand for money [The excess demand for money can then be offset by an increase in capital inflows until Ms=Md] {A more detailed answer: If the quantity demanded for money is larger than the quantity supplied of money, there is an excess demand for money. When Md > Ms, people reduce their expenditures on goods, services, and investments in order to increase their money balances. Thus, more goods and services are available for export. The rise in the demand for money will also cause the domestic interest rate to rise, creating opportunities for foreigners to invest in the domestic economy. This process will result in capital inflows (MsUp) and a surplus in the nation's BOP. .

Part B An increase in domestic money supply relative to foreign money supply. You need to determine if the foreign or domestic currency appreciates or depreciates.

An increase in Ms would cause R↑, implying that the foreign currency appreciates. Alternatively, the increase in Ms ->interest rate↓ -> domestic bond prices ↑-> people sell their domestic bonds and buy foreign bonds -> the foreign currency appreciates against the domestic currency.

Which of the following tends to cause the U.S. dollar to depreciate in value?

An increase in U.S. real income above foreign real income AND An increase in U.S. prices above foreign prices AND An increase in foreign interest rate above the U.S. interest rate AND A bill introduced to Congress by the President is viewed inflationary by the forex market [An increase in the U.S. real income, the inflation rate, foreign interest rate would shift the demand curve for foreign currency to the right, causing the dollar to depreciate (or the foreign currency to appreciate). When inflationary expectations are revised upward (choice D), the dollar will depreciate today. ]

When short-term interest rates increase in Frankfort, holding the U.S. interest rates constant, interest arbitrage operations will most likely result in

An increase in the dollar price of euro in the spot market [An increase in the German interest rate means American interest arbitragers will shift their short terms funds to Germany to take advantage of a higher return. To do so, their demand for Euro increases causing an increase in the dollar price of Euro. ]

A depreciation of the dollar refers to:

An increase in the dollar price of foreign currency [An increase in the dollar price of a foreign currency means it takes more dollars to buy a unit of the foreign currency. As a result, the foreign currency appreciates and the dollar depreciates in value]

Why do nations lose control over their money supply under a fixed exchange rate system according to the monetary approach?

Any change in money supply would lead to a capital outflow or inflow, pushing the money supply back to its original level. Starting from an equilibrium in the money market (i.e., Md= Ms), suppose the Fed increases the money supply, i.e., Ms ↑= m (D↑ + F) > Md. This causes a capital outflow (i.e. F↓). So the increase in D is offset by a corresponding decrease in F, leaving the money supply unchanged.

What is the main theme of the monetary approach to the balance of payments?

BOP deficits/surpluses are because of an imbalance between the demand and supply of money. BOP equilibrium is achieved only when the demand for money and the supply of money are equal.

How is the exchange rate determined in the PPP theory?

By the comparison between the domestic and foreign prices

If the U.S. current account is in deficit, another account must be in surplus in order to have a balance in the balance of payments. What is the name of this account?

Capital and financial

If the U.S. faces a current account surplus, it must run a deficit in:

Capital and financial account (The current account balance and the capital and financial account balance are the mirror image of one another. When one is in a deficit (surplus), the other one is in a surplus (deficit))

According to the covered interest arbitrage, if the interest differential in favor of the home country exceeds the forward premium on the foreign currency, there will be a:

Capital inflow from the foreign country to the home country [Assuming the maturity time for short terms funds is one year (i.e., t = 360), if (ia-ib) - FR -SR/SR >0 short-terms funds will move from foreign to domestic financial markets. If both terms in the above formula are positive but the first term is larger than the second term (i.e., the nominal interest rate differential is larger than the forward premium), then funds will move from foreign to domestic markets.

The capital and the financial account of the US includes:

Changes in US assets abroad and foreign assets in the US AND The flow of financial assets between private residents, foreign residents, and domestic and foreign governments (The Capital and financial account has two parts. The US private capital and financial account measures the flow of assets between domestic and foreign investors. The US public capital and financial account (The Official Reserve Account) measures changes within domestic and foreign governments. In short, capital and financial account measures changes in US assets abroad and foreign assets in the US. )

How does a deficit or surplus in the BOP arise according to the asset-markets approach?

Changes in the domestic and foreign interest rates, inflation rates, returns on equities, changes in the expected rate of inflation, the expected changes in exchange rates as well as changes in the flow of goods and services would lead to the flow of capital from one country to another, causing a deficit/surplus in the BOP.

Provide three examples for unilateral transfer payments.

Charities Gifts Foreign aid

(a) Write the equation for the exact covered interest arbitrage parity (CIAP). What does this equation tell you?

Consider the equation for CIAP: EQUATION IN CH14 The above means the rate of return from investing in the home country is equal to the rate of return from investing in the foreign country given that the foreign exchange risk is covered through the forward market.

A US company dealing in foreign exchange may desire to obtain an exchange quote between the Swiss franc and British pounds, whose values are both expressed relative to the dollar. ____________ are used to determine such a relationship.

Cross exchange rates

If an American investor receives dividends from the shares of stock she or he owns in Toyota, Inc., a Japanese firm, this transaction would be recorded on the U.S. balance of payments as a

Current account credit (Returns to financial assets are investment incomes that are part of current account. Current account is credited and the capital and financial account is debited. Investment income,Current account is credited, Capital outflows, Capital and financial account is debited )

If the United States government sells military hardware to Saudi Arabia and receives dollars, the transaction would be recorded on the U.S. balance of payments as a

Current account credit and the capital and financial account debit (In this case, the export of merchandize is credited in the current account and its receipts from Saudi Arabia are debited as capital outflows in the capital and financial account. )

An overvalued currency in a fixed exchange rate system tends to:

Deteriorate the current account balance AND Deplete the foreign reserves of the nation [An overvalued currency means the domestic currency is expensive: Each unit of the domestic currency can buy more units of the foreign currency. As a result imports tend to rise and exports tend to fall causing a deficit in the current account. If the currency overvaluation is not corrected, it will deplete the foreign exchange reserves of the nation. ]

If the effective exchange rate for the U.S. dollar decreases, it implies that

Dollar has depreciated against the basket of currencies used to calculate the EER [The EER is the value of a currency such as the U.S. dollar) against the weight average of a basket of foreign currencies). An increase in the EER means the dollar has appreciated and a decrease means the dollar has depreciated against the weighted average of a basket of currencies.]

Suppose at the beginning of the year, the dollar price of euro is $1.38/€ and during the year, the inflation rates in the U.S. and the EU are 6% and 8%, respectively. Has dollar appreciated or depreciated in real terms (assuming that the nominal exchange rate is constant)? If yes, by how much?

Dollar has depreciated by 2% [%ChangeRr ≈ %ChangeRn + (%ChangeP* - %ChangeP) Assuming the nominal exchange rate is constant, the inflation differential is 2% in favor of the U.S. (= 8%-6%), i.e., the U.S. inflation is below the E.U inflation by 2%. This means the dollar has 2% less purchasing power in Europe than in the U.S. So the dollar has depreciated in real terms by 2%].

In the monetary approach

Domestic and foreign bonds are perfect substitutes [This is one of the assumptions of the model. ]

(b) In the less complicated version of the covered interest arbitrage parity, if the domestic interest rate exceeds that of the foreign interest rate, is the domestic currency at a forward premium or discount, given that the parity holds? Explain.

EQUATION IN CH14 If the domestic interest rate is above the foreign interest rate, the foreign currency must be at a forward premium which means the domestic currency must be at a forward discount.

What is the main difference between Eurocurrencies and Eurobonds?

Eurocurrencies are short-term bank deposits outside the country that has issued the currency, while Eurobonds and Eurobonds are long-term debt instruments sold outside the borrower's country in a currency other than the currency of the nation where these instruments are issued.

What is a Eurocurrency? Why would the term "offshore deposits" be more appropriate than the term "Eurocurrency deposits"?

Eurocurrency refers to short-term bank deposits outside the national boarder of the country that issues the currency. Eurocurrencies are not necessarily bank deposits in Europe, although this was how they were initially created. As long as a bank-deposit is outside the country that has issued the currency, it is called Eurocurrency, even though they might be in Hong Kong, for example. As a result, the term "off-shore deposits" is a more appropriate term.

A deficit in the current account implies an

Excess of imports over exports of goods, services, unilateral transfers, and investment income

What is the main cause of the world inflation in the monetary approach?

Excessive growth in money supply

The exchange rate is kept the same in all parts of the market by

Exchange arbitrage [The main force that brings all markets into the same equilibrium level is the exchange arbitrage. If the exchange rate differs in a market against other markets, exchange arbitragers will take advantage of the exchange rate differential and cause the differential to be eliminated]

Distinguish between the terms "foreign exchange arbitrage" and "interest arbitrage"?

Exchange arbitrage involves the simultaneous purchase and sale of a currency or currencies in different foreign exchange markets to make money, while interest arbitrage involves moving short-term funds in different countries to earn higher returns.

What determines the exchange rate under a flexible exchange rate system according to the portfolio approach?

Exchange rate is determined through the interaction between the demand and supply of all financial assets (of which money is only one).

What is the advantage of the portfolio approach over the monetary approach to exchange rate determination?

Exchange rate is determined through the interaction between the demand and supply of all financial assets (of which money is only one). Further, in this approach (unlike the monetary approach) domestic and foreign bonds are imperfect substitutes. Also in this approach the flow of trade plays a role. It is a more realistic version of the monetary approach.

It is said that the foreign exchange market acts as a "clearing house". What does this statement mean?

Foreign exchange transactions are mainly done at commercial banks. Those who have an excess supply of a foreign currency would exchange them for the domestic currency and those who need a foreign currency would exchange their domestic currency for the foreign currency at a commercial bank. So commercial banks act as a "clearing house" between the demanders and suppliers of foreign exchange.

A difference between a forward and futures contract is that

Forward contracts have negotiable delivery dates, while future contracts have set delivery times [Forward contracts can be tailored in amount and delivery dates to the needs of importers or exporters, while future contracts are standardized in every respect. ]

How does the forward exchange differ from the spot exchange?

Forward exchange contracts are for delivery at a future date, while the spot exchange contacts are for delivery within two business days.

Use a demand and supply diagram to show the effect of the following change on the dollar price of pound in the foreign exchange markets: Last year the U.S. rate of GDP growth was below the U.K GDP growth rate.

GRAPH IN CH 14 ESSAY QS

In a flexible exchange rate system, explain the effect of the following changes on the exchange rate according to the monetary approach: a. An increase in domestic Y relative to foreign Y. b. .

Given R =Ms k*Y*/M*skY = domestic price of foreign currency, an increase in Y would cause R↓, implying that the foreign currency depreciates. Alternatively, this would result in an increase in Md which can be satisfied either by an increase in the nation's domestic monetary base (D) or by an inflow of int'l reserves (F). If the nation's monetary authorities do not increase D (i.e., Change in D = 0), the nation will experience capital inflows because domestic bond prices fall due to an increase in domestic interest rate. This in turn causes the domestic currency to appreciate.

What is meant by hedging in the foreign exchange market? How is it done?

Hedging is the act of covering foreign exchange risk. This can be done by buying a forward, option, or a futures contract to lock in a given exchange rate.

Which basket of goods would be most likely to exhibit absolute purchasing power parity?

Highly tradable commodities, such as wheat [The PPP is based on the calculation of a price ratio between the domestic and foreign economies. The price in each country is the price of a basket of tradable goods.]

Redo the above question assuming the exchange rate is fixed

If Ms > Md -> BOP deficit capital outflow causing the foreign component of monetary base (F) to fall until Md = Ms which means equilibrium in the BOP. So the adjustment takes place through a change in money supply.

Explain the process by which a BOP deficit is corrected under a flexible exchange rate system according to the monetary approach

If Ms> Md -> BOP deficit -> automatic depreciation of the domestic currency -> domestic prices increase until Md= Ms which means equilibrium in the BOP. So the adjustment takes place through a change in money demand.

What happens to the exchange rate, according to the portfolio approach, when foreign inflation rates are expected to fall? Explain both the short-run and the long-run effects on the exchange rate.

If foreign inflation rates are expected to fall, expected yield on foreign bonds will rise. Domestic residents will sell some of their domestic bonds and buy foreign bonds. As they do so, the domestic currency depreciates and overshoots itself at first. Over time imports fall and exports rise causing some appreciation of the domestic currency. This will continue until the overshooting problem is corrected.

Concerning the covering of exchange market risks, assuming that a depreciation of the domestic currency is anticipated, one can say that there is an incentive for:

Importers to rush to cover their future needs [Depreciation of dollar means importers must give up more dollars to purchase their required foreign exchange in order to pay for their imports. So if they have to make payments in the future and they expect the dollar will depreciate in the future, they will rush to buy their required foreign exchange now before dollar loses its value. ]

How is the exchange rate determined in the short-run and the long-run in the portfolio approach?

In the short-run, the stock adjustments in financial assets take place causing the overshooting problem. In the long-run, adjustments in trade flows correct the overshooting problem.

Choose a point in zone IV of the covered interest arbitrage parity (CIAP) grid. Determine the direction of the flow of funds. What will happen to the interest rate differential and the forward premium/discount? Part 2; Answer the above question assuming we are in zone I.

In zone IV, (ia - ib) < 0 and the foreign currency is at a forward discount. But the forward discount is larger than the interest rate differential. So the CIAM is positive and hence short-term funds will move from B to A. As this happens, the interest rate will rise in will get larger Further, the spot rate will fall and the forward rate will rise causing the FD to decrease in absolute value. PART 2 In zone I, (ia - ib) > 0 and the foreign currency is at a forward premium. But the forward premium is greater than the interest rate differential. So the CIAM is negative and hence short-term funds will move from A to B. As this happens, the interest rate will rise in A and fall in B. So the interest rate differential in favor of the home country will get larger. Further, the spot rate will rise and the forward rate will fall causing the FP to decrease.

Suppose that real incomes increase more rapidly in the United States than in Mexico. In the United States, this situation would likely result in a(n):

Increase in the demand for pesos AND Increase in the quantity supplied of pesos , which result in an appreciation of pesos [When the demand curve shifts to the right along the supply curve, quantity supplied increases as well]

Indicate how the following transition is entered into the U.S. balance of payment: A foreign investor redeems his U.S. Treasury Bills. He receives $740 ($700 for the principal and $40 for interest).

Investment Incomes- $40 (Debit) Capital outflow- $700 (Debit) (for a decrease in foreign assets in the U.S.) Capital inflow- $740 (Credit) (for an increase in U.S. liability abroad)

The burden of a current account deficit would be the least if the surplus in the capital and financial account is used to finance

Investment expenditures on capital goods (A current account deficit means a nation has borrowed from the rest of the world. Economists have argued that as long as this borrowed money is used to expand the productive capacity of the nation through investment expenditures on capital goods, the deficit in the current account (or a surplus in the capital and financial account)is not bad)

Unlike the balance of payments, the balance of international indebtedness (international investment position) indicates the international

Investment position of a country at a given moment in time (Over a one-year period means the concept is a flow concept (like the BOP) At given moment in time, makes the concept is a stock concept (like the investment position of a country). It is the snap shot of a nations' accumulated stock of assets and liabilities against all other nations)

Debit (-) entries in the balance of payments correspond to anything that:

Involves paying money to foreign residents (By definition, a debit transaction involves money leaving the country; therefore, imports involving paying money to foreign residents would be an example of a debit transaction).

A current account deficit in the U.S. is:

Is neither good nor bad since it depends on the reason behind the deficit (Depends on the cause of the current account deficit. If it is caused by the excess imports of consumption goods, it is bad. If the nation has a current account deficit because it has imported capital goods from abroad, it is good. )

When a country realizes a surplus in its current account:

It becomes a net supplier of funds to other countries AND Its international investment position improves

If the U.S. interest rate is higher than the U.K. interest rate, will investors place their funds in New York or London? Explain.

It depends on whether the investors would want to cover their interest arbitrage. If they do not cover their investment, then short-terms funds will move from the U.K. to the U.S. If, on the other hand, the investors cover their interest arbitrage, the flow of short-terms funds from one country to another will depend on whether the CIAM is positive or negative. If CIAM < 0, short-term funds will move from the US to the UK. If CIAM > 0, short-terms funds will move from the UK to the US. And finally, if CIAM is zero, there would be no flow of funds from one country to another.

A capital outflow from New York to London under covered interest arbitrage can take place if the interest rate differential in favor of London (that is, the U.K interest rate is above the U.S interest rate) is: use the less complicated interest arbitrage formula

Larger than the forward discount on the pound AND Is accompanied by a forward premium on the pound [See Problem 17 in chapter 14)

Are devaluations, tariffs, and other commercial policies necessary in this system to correct a BOP deficit in the monetary approach and under a flexible exchange rate?

Market will take care of itself. If there is a deficit/surplus in the BOP, market forces will eliminate the deficit/surplus automatically. There is no need for the government to impose corrective policies.

Suppose that a nation's nominal GDP is $2,000 billion, k = 0.2, money supply = $400 billion, RRR = 0.25: Part A - Does this nation have a deficit or surplus in its balance of payments? What is the size of deficit or surplus?

Md= 0.2 (2,000) = $400 billion Since Md= Ms, there is no deficit or surplus

Suppose that a nation's nominal GDP is $2,000 billion, k = 0.2, money supply = $400 billion, RRR = 0.25: Part B - How would your answer to the previous part change if the monetary authorities increase the size of money supply to $500 billion? By how much will the monetary base change?

Md= 400, Ms= 500. Ms> Md -> deficit in the BOP Money multiplier = 1/.25 = 4 The size if deficit is $100/4 = $25 billion. The F component of the monetary base will fall by $25 billion.

If the inflation is 15% in Nation A and 20% in Nation B, what is expected to happen to the exchange rate according to the relative PPP, given that the currency of Nation B is directly quoted?

Nation B's currency depreciates by 5%

Write out a positive and negative aspect of a nation being net debtor

Positive aspects of being a net debtor include the possibility of financing domestic investment that is not possible through domestic savings; thereby allowing for domestic capital stock growth which may allow job, productivity, and income growth. Negative aspects include the fact that foreign savings may be used to finance domestic consumption rather than domestic savings; which will compromise the growth suggested above.

What condition must be satisfied in order to have an efficient foreign exchange market?

Prices should quickly reflect all available information.

If Canadian speculators believed the Swiss franc was going to appreciate against the U.S. dollar, they would:

Purchase Swiss francs [If they purchase Swiss francs now, they sell them at a higher price later when its value appreciates against the dollar and make a profit.]

Given the exchange rate is the dollar price of foreign currency, stabilizing speculation refers to the:

Purchase of foreign currency when the exchange rate falls or is low AND Sale of foreign currency when the exchange rate rises or is high [Given that the speculation is stabilizing and the foreign currency is the British pound, speculators will sell pounds when they believe its value has peaked and will fall in the future in anticipation that they can buy them back at a lower price. They will also buy more pounds when its value is believed has reached its lowest level against the dollar in anticipation that its value will increase in the future and they can sell them at a profit]

An increase in U.S. demand for foreign assets (such as foreign bonds) will result in a:

Rightward shift in the supply of U.S. dollars (To buy foreign assets, U.S. investors must supply dollars and exchange them for foreign currencies. As a result, the supply of dollars in the forex market increases]

Suppose a nation spends 8 percent of its income on investment and the private sector saves 6 percent. Further, suppose the national government runs a surplus of 1 percent. Explain what the above conditions mean for the nation's capital & financial account and current account. How might the imbalance be corrected?

S = Private Sector Saving + Public Sector Saving S - I = Net Capital Flows CA = Net Capital Flows CA = - KA Using the equations above, S% = 6% + 1% = 7% 7% - 8% = -1% Deficit in CA as a % of GDP KA% = -(-1%) = 1% Surplus in KA as a % of GDP The current account deficit could be corrected with a reduction in the government deficit (to a surplus) and/or an increase in private savings.

Can the overall BOP be in deficit or surplus?

Since the BOP follows the basic rule of double-entry bookkeeping, the overall BOP must be equal to zero. It can not be in surplus or deficit

Suppose you believe that the Swiss franc will appreciate to 85¢ /SF in three months. Suppose further that the strike price on the call and put options is 79¢/SF. The premium on the call option is 0.85¢ /SF and on the put option is 0.90¢/SF. You decide to buy an option to speculate in this market. Will you buy a call option or a put option? Suppose on the due date the spot rate is 79.8¢/SF. Will you exercise your option, given that the spot transaction cost is 0.15¢/SF? Explain why

Since the expected spot rate is larger than the strike price, you should buy a call option. If your expectations come through, Swiss francs that you receive from the option writer can be sold at a profit in the spot market. Since the premium is a sunk cost, you should not consider it in your decision on whether or not you should exercise your option. As long as the sum of the exercise price and the spot transaction cost is less than the spot rate at the maturity, you should exercise your option. Here 79¢+ 0.15¢ = 79.15¢ < 79.8¢. So you should exercise your option.

Suppose that ¥1= $0.0085 in London, €1= $1.1418 in New York, and €1 = ¥ 136.45 in Paris. If an investor begins by holding ¥1,000,000, how could he make money from these exchange rates? Ignore the transaction costs and determine the amount of profit.

Since the investor is holding yen, the cross rate should be the dollar price of yen: $/¥ = ($/€)x(€/¥) = (1.1418)(1/136.35)= $0.008367/¥ So yen is expensive in London. We want to sell yen in London. ¥1,000,000 -> $8,500 London $8,500 -> €7,444.39 NY €7,444.39 -> ¥1,015,786.48 Paris Profit= ¥1,015,786.48 - ¥1,000,000 = ¥15,786.477

How can a speculator make money in the forward market? In the spot market?

Speculation in the forward market: Suppose a speculator believes that the spot rate of a foreign currency will be higher in three months than its current three-month forward rate. He will purchase the foreign exchange forward now. If his expectations come through, he will sell the foreign exchange that he receives from his forward contract at a higher rate in the spot market. Speculation in the spot market: Suppose a speculator believes that the spot rate of a foreign currency will be higher in three months than its current spot rate. He will purchase the foreign exchange spot now. If his expectations come through, he will sell the foreign exchange that he has purchased in the spot market at a higher rate in the spot market.

Why international investors especially concerned with the real interest rate as opposed to the nominal rate?

Suppose the U.S. interest rate rises by as much as its inflation rate such that the real interest rate remains unchanged, ceteris paribus. The increase in the nominal interest rate under these conditions would not attract foreign investors to invest in dollar denominated securities in the U.S. because the U.S. inflation would cause the dollar to depreciate. Therefore, higher nominal interest rates on U.S. securities will be offset by the depreciation of dollar leaving no extra gain for investing in the U.S.

How does the net gain from covered interest arbitrage diminish as short-term funds move from one market to another? Use the less complicated formula for the covered interest arbitrage. Suppose the interest rate differential in favor of the home country is larger than the forward premium.

Suppose the U.S. is nation A, the U.K. is nation B, and the following holds: iUS - iUK - FR-SR/SRx 360/t >0 UK -> US The U.K. investors will buy financial assets in the U.S. and cover the foreign exchange risk through forward markets. As they do this, rUS down - rUKup - FRup - SR down/ SR down The net result is a reduction in CIAM which means the net gain is diminishing. This process will continue until the covered interest arbitrage parity holds.

List four differences between the futures and forward markets. List four differences.

TABLE IN CH14 ESSAY QS

What is the difference between the balance of payments (BOP) and the international investment position (or the balance of international indebtedness)?

The BOP is a flow concept in that we record the flow of international transactions of a nation with all other nations during a given time period, while the IIP is a stock concept in that we measure the stock of accumulated financial and real assets and liabilities of a nation against all other nations at a given point of time

Suppose that the demand for money Md = 50 and the supply of money Ms = 60. According to the monetary approach in a fixed exchange rate system:

The BOP is in deficit by less than 10 [Since Md = 50 and Ms = 60, the excess supply of money is 10. So there will be a deficit in BOP. The size of the deficit is 10 divided by the money multiplier. Since the multiplier is a value greater than 1, the deficit in the BOP would be less than 10.]

Suppose that the velocity of money is V = 4 and the nominal GDP of the nation is 500. Suppose further that the monetary base is 20 and the legal reserve requirement (AKA reserve-required ratio) is 20%. According to the monetary approach

The BOP is in surplus by 5 [Md = (1/4)×500 = 125. Ms = (1/0.2)×20 = 100. Since the money demand exceeds the money supply by 25 and the money multiplier is 5 (=1/0.2), the BOP surplus is 25/5 = 5.

Starting from an equilibrium condition in the BOP, suppose the demand for money increases. The monetary approach predicts that under a purely flexible exchange rate system:

The BOP to run a surplus and the domestic currency to appreciate [Given %∆R = (%∆Ms + %∆k* + %∆Y*) - (%∆M*s + %∆k + %∆Y) The domestic demand can increase by either an increase in Y or k. Note: Both Y and k are the components of the money demand. In either case, %∆R <0. Since R is defined as the price of foreign currency in terms of domestic currency (say the dollar), the domestic currency will appreciate.

Starting from the condition of BOP equilibrium in the monetary approach and under a fixed exchange rate system, suppose there is a once-and-for-all increase in the nation's GDP. Assuming the monetary authorities do not change the domestic component of the monetary base

The BOP will be in surplus in the short-run and in equilibrium in the long-run [An increase in real GDP leads to an increase in money demand. Assuming the money supply remains constant, the increase in demand for money results in an excess demand for money. As it is explained in the previous question, the excess demand for money will produce a surplus in the BOP. ]

To what exchange rate determination model is the law-of -one-price related?

The PPP model

Given R0 = $2/£, P0 = $100, P1= $125, P0*= £100, P1*= £115, then

The PPP predicts that the British pound to appreciate by 8.69% [The new exchange rate is R1 =2 x (125/100)/(115/00) = 2.174 Thus, the British pound appreciated by: 2.174- 2/2 x 100= 8.69%.

What is the advantage of the relative PPP over the absolute PPP?

The absolute PPP imposes restrictive assumptions: (1) There are no trade barriers, (2) Only traded goods are included in the calculation of average price. The relative PPP is a better measure of the PPP given that there are no significant changes in trade barriers and no significant changes in the number of goods tradable goods.

How does the asset-markets approach attempt to improve on the monetary approach to exchange rate determination?

The asset-markets approach contends that stock adjustments among financial assets are the key determinants of exchange-rate movements. This approach is thus a more comprehensive and realistic approach than the monetary approach that focuses only on the demand and supply of money. In fact, the portfolio approach is an extension of the monetary approach, in that it includes stock adjustment in other financial assets in addition to money

When a US firm exports goods, its receipts from the importing nation are recorded in

The capital and financial account (The merchandize part of this transaction (i.e., the exports) is recorded in current account and the payment part (i.e., receipts from the importing nation) is recorded in the capital and financial account. )

What items does the capital and financial include?

The capital and financial measures the flow of financial assets between private residents, foreign residents, and domestic and foreign governments. Specifically, it records exports and imports of corporate stocks and bonds, government securities (bonds, notes, and TBs), commercial bank deposits, real estate, and production plants.

Suppose the nominal interest rate is i = 8% in NY and i* = 5% in London, the spot rate is SR = $2/£ today and is expected to be $2.2/£ in one year.

The condition for UIP is satisfied if £ appreciates by 7% today [Substituting the values given in the question in i - i* = EA, we get 8%-5% = 3%. So, for UIP to hold, the expected appreciation of pound must be 3%. Now if, for some reason, the expected annual appreciation of the British pound increases from 3% to 10%, this would make the return on investing in the U.K. 15% per year (5% in interest and 10% from the annual appreciation of the British pound) as opposed to 8% rate of return on investing in the U.S. This leads to an immediate capital outflow from the U.S. to the U.K. which will continue until the British pound appreciates by 7% today on annual basis and the UIP is again satisfied]

A Korean trader wishes to make a purchase of Czech crystal worth 3 million Czech korunas. Unfortunately, there is no published value of the Korean won to Czech koruna exchange rate. But their exchange rates are available in terms of the U.S. dollar. In order to calculate the current price of the crystal in won, the trader will need to calculate

The cross rate [If we know the won price of dollar and korunas price of dollar and divide the first exchange rate by second exchange rate, I will get won price of korunas ]

If the PPP determined exchange rate is above the market determined exchange rate, then

The currency that is directly quoted is undervalued in the marketplace AND The currency that is indirectly quoted is overvalued in the marketplace [The PPP states that if an exchange rate is above market value, then the currency that is directly quoted is undervalued in the marketplace. Also the currency that is indirectly quoted is overvalued in the marketplace]

Distinguish between the current account and the trade balance

The current account measures the exports and imports of goods, services, investment income, and unilateral transfers, while the trade balance measures the exports and imports of goods.

Suppose that a nation's nominal GDP is $2,000 billion, k = 0.2, money supply = $400 billion, RRR = 0.25: Part C - How is the deficit corrected? Explain.

The deficit is corrected automatically. Once the foreign exchange reserves (i.e., the F component of monetary base) decreases by $25 billion, the BOP returns to its equilibrium.

In the asset market approach, suppose the foreign interest rate falls relative to the domestic interest rate

The domestic currency appreciates in the short-run. It first overshoots itself and then through trade flows it depreciates somewhat to correct the overshooting problem [The reduction in foreign interest rate relative to domestic interest rate will decrease the demand for foreign bonds and increase the demand for domestic currency and domestic bonds. This in turn will cause the domestic currency to appreciate. At first, the appreciation of the domestic currency is excessive. Over time, exports decrease and imports increase generating a deficit in the trade balance, causing the domestic currency to depreciate a bit correcting the overshooting problem

In the asset market approach, suppose the foreign inflation is expected to fall relative to the domestic inflation

The domestic currency depreciates excessively in the short-run. In the long-run the domestic currency appreciates somewhat to correct the initial depreciation [Foreign inflation down -> Expected yield on foreign bonds up-> Domestic residents sell some of their domestic bonds and buy foreign bonds -> Domestic currency depreciates in the short-run. At first it overshoots itself. Over time, as exports up and imports down, some appreciation of the domestic currency, correcting the overshooting problem in the long-run.

In a purely flexible exchange rate, if inflationary expectations in the domestic economy are suddenly revised downward by 15%, the monetary approach expects

The domestic currency to appreciate by 15% today [If inflationary expectations in the U.S. are suddenly revised downward by, say 15%, ceteris paribus, the dollar will immediately appreciate by 15% vis-a-vis other currencies in order to maintain the law-of-one price.]

How is the exchange rate determined according the absolute PPP theory?

The exchange rate is determined ratio of domestic price over the foreign price. Example: $/£ = PUS/PUK.

If the U.S. government sends $2,500,000 worth of blankets, medicine, and other supplies to earthquake victims in a foreign country, then

The export is credited by $2,500,000 and the unilateral transfer is debited by $2,500,000

What is the similarity between the option, futures, and forward contracts?

The foreign exchange is bought or sold for delivery at a future date.

Is government intervention required to correct a BOP deficit according to the monetary approach under a fixed exchange rate system? Explain.

The monetary approach asserts that a BOP deficit or surplus is corrected automatically by market forces. So there is no need for the government to intervene to correct the problem.

In the futures market, contracts are "marked-to-market" at the end of each business day. How is it done?

The organized exchange first calculates the change in the value of the contract for the day, then its dollar-equivalent is transferred from the security deposit of the seller (buyer) to the security deposit of the (buyer (seller) depending on whether the contract value has increased or decreased.

What is the reason for the overshooting problem in the asset market approach?

The response of foreign exchange market to a change in financial markets or economic conditions is very quick and rapid in the immediate short-run because currency arbitragers and interest arbitragers can quickly transfer large sums of money from one market to another to take advantage of exchange rate and interest rate differentials. As a result, the exchange rate overshoots itself in the immediate short-run.

When all of the debit or credit items in the BOP are combined:

The sum of surpluses and deficit of various accounts equals zero

A decrease in the dollar price of yen tends to cause:

U.S. goods to be more expensive in Japan [A decrease in the dollar price of yen means yen has depreciated in value against the dollar. So it takes more yen to buy a dollar. This makes the American goods more expensive to Japanese consumers. ]

The United States is currently a net debtor nation. This necessarily implies that the

Value of U.S. held assets abroad is less than the value of foreign held assets in the U.S (Both the government and the private sector borrow (lend) money from (to) the rest of the world. Being a debtor nation does not necessarily imply that the government is the only reason for it. This is certainly true in the case of the U.S.)

An increase in the demand for the Canadian dollar will lead to

an appreciation of the Canadian dollar and a higher quantity of Canadian dollars traded (A rightward shift in demand means the demand curve has moved up along the supply curve causing the price of the currency measured on the horizontal axis (such as the Canadian dollar) to increase. )

In New York euro is selling for $1.1418/€ and the Japanese yen is selling for $0.0077/¥. What is the cross rate between euro and yen?

¥/€ = ($/€) (¥/$) = (1.1418)(1/0.0077) = ¥148.286/€