International Finance 1-2

Portfolio investment is capital invested in activities that are ________ rather than ________.

Profit motivated; control motivated

Based on our class discussion and summary of the article by Prof. Ferguson, what 3 flaws in the original design of the euro led to the European Sovereign Debt Crisis starting in 2009?

"...the worst defect in the design of the EMU...was that it was uniting Europe's currencies but leaving its fiscal policies completely uncoordinated." Indeed, the Converge Criteria became permanent in what is termed the Stability and Growth Pact, but there was no mechanism to enforce them. If a member state, such as Greece became, ran persistent budget deficits the whole union would be placed in peril "because the new European Central Bank (ECB) was prohibited from bailing out a country...by lending money directly to the government. Yet, at the same time, there was no mechanism for [the country] to exit the monetary union."

The United States has been a net debtor nation since the mid-1980s meaning the US has had persistent current account deficits for decades. Why is that the case?

1) A strong dollar and undervalued currencies of trading partners such as Japan. 2) US domestic spending exceeding output 3)Lack of cost competitiveness of US industries

Japan has been a net creditor nation for decades meaning that Japan has had persistent current account surpluses for decades. What are possible explanations?

1) A weak yen 2) Competitiveness of Japanese exports 3) Restriction on foreign exporter access to Japanese markets 4) Mercantilist policies (maximize exports>imports)

Economic Activity. What are the two main types of economic activity measured by a country's BOP?

1) Current transactions having cash flows completed within one year, such as for the import or export of goods and services. 2) Capital and financial transactions, in which investors acquire ownership of a foreign asset, such as a company or a portfolio investment, such as bonds or shares of common stock. These transactions typically involve assets that subsequently generate cash flows long term.

The Financial Account. What are the primary sub-components of the financial account? Give examples of what would cause net deficits or surpluses in these individual components?

1) Direct Investment Debit: Ford builds a factory in Australia Credit: Ford sells its factory in Britain to British investors 2) Portfolio Investment: Debit: American buys shares of European food chain on Frankfurt stock exchange Credit: Korean gov buys US treasury bills to hold 3) Net financial derivatives: Debit: US Firm purchases financial derivative (currency swap) in London Credit: US Firms sells a financial derivative, like a forward contract on the dollaw vs the pound to a London buyer 4) Other investments Debit: US firm deposits $1M in bank balance in London Credit: US Firm generates an account rexeivable for exports to Canada

Current Account. What are the main component accounts of the current account? Give one debit and one credit example for each component account for the United States.

1) Goods: Debit: US firm purchases German machine tools Credit: Singapore Airlines buys Boeing jet. 2) Services: Debit: An American takes a cruise on Dutch cruise line. Credit: The Brazilian tourist agency placed an ad in the New York Times. 3) Primary Income: Debit: US subsidiary of a Chinese computer manufacturer pays dividends to its parent. Credit: British company pays the salary of its executive stationed in NY. 4) Secondary Income: Debit: US based international resuce committee pays for the medical expenses of tsunami victims in Thailand Credit: Spsanish company pays monthly room and board expenses for an employee to get MBA in the US

List and describe the exchange rate regimes as delineated by the IMF.

1) Hard Peg: No separate legal tender (Dollarization, monetary union); currency board (foreign currency fixed ratio) 2) Soft Peg: Conventional peg ( +/-1% of foreign backed currency); Stabilized arrangement (+/-2% and de facto); Crawling Peg (small adjustments with major trading partners currency or inflation rates; Craw-like agreement (2% margin); Pegged Exchange Rate within Horizontal bands (+/-1%) 3) Floating Arrangements: Floating (market-determined and gov involvement to moderate rate of change and prevent undue fluctuations); Free Floating (gov involvement only when disorderly market conditions) 4) Residual: include currencies with frequent shifts in policy (de facto)

What are characteristics of a fixed exchange rate regime?

1) Promotes international trade/investment by alleviating exchange rate risk 2) May require governments/central banks to restrict international trade/investment to maintain the exchange rate regime 3) Requires central banks to have a large amount of reserves

Business managers and investors need BOP data to anticipate changes in host country economic policies that might be driven by BOP events. From the perspective of business managers and investors, list three specific signals that a country's BOP data can provide.

1) The BOP is an important indicator of pressure on a country's foreign exchange rate and thus on the potential for a firm trading with or investing in that country and experience foreign exchange gains or losses. 2) Changes in the BOP may predict the imposition or removal of foreign exchange controls. 3) Changes in a country's BOP may signal the imposition or removal of controls over payment of dividends and interest, license fees, royalty fees, or other cash disbursements to foreign firms or investors. 4) The BOP helps to forecast a country's market potential, especially in the short run. A country experiencing a serious trade deficit is not likely to expand imports as it would if running a surplus. It may, however, welcome investments that increase its exports.

It is 2027 and suppose the US trade deficit has reached $1.2 trillion. Which of the following fictitious initiatives are consistent with these events?

1) The President has signed legislation enacted by Congress that eliminates taxes on the profits of subsidiaries of foreign multinationals 2) Japan has imposed higher tariffs on US agricultural imports 3) US personal tax rates have been cut leading to greater US government debt

The US is a net debtor nation. Its Net International Investment Position is negative and continues to worsen on average. What does this possibly imply?

1) The US generally runs a financial account surplus 2) US domestic spending generally exceeds output (GDP/GNP)

Why would a country choose to devalue its currency?

1) To boost exports by effectively lowering the price of its exports in foreign currency terms. 2) To shrink trade decits. 3) To reduce sovereign debt burdens with repayment in home currency. Caution: First, as the demand for a country's exported goods increases worldwide, the price will begin to rise, offsetting the initial effect of the devaluation. Second, other countries may see this effect and be incentivized to devalue their own currencies in kind in a so-called "race to the bottom." This can lead to tit for tat currency wars and lead to unchecked inflation.

Classify the following as a transaction reported in a sub-component of the current account, the capital account, or financial account of the U.S.: French tourist from the provinces pays for a hotel in Paris with his French-issued American Express card.

A French resident most likely has a French-issued credit card, issued by the French subsidiary of Americans Express. In this instance, no entry would appear in either country's balance of payments. If, later, the French subsidiary of American Express paid a dividend back to the United States, that would be recorded in the income part of the current accounts.

De facto and de jure. What do the terms de facto and de jure mean in reference to the International Monetary Fund's use of the terms?

A country's actual exchange rate practices is the de facto system. This may or may not be what the "official" or publicly and officially system commitment, the de jure system.

BOP Accounting. If the BOP were viewed as an accounting statement, would it be a balance sheet of the country's wealth, an income statement of the country's earnings, or a funds flow statement of money into and out of the country?

A country's balance of payments is similar to a corporation's cash flow statement in that the balance of payments records events that cause the receipt and disbursement of funds into and out of the country.

What is the difference between a direct foreign investment and a portfolio foreign investment? Give an example of each. Which type of investment is a multinational industrial company more likely to make?

A direct investment is made with the intent that the investor will have a degree of control over the asset acquired. Typical examples are the building of a factory in a foreign country by the subsidiary of a multinational enterprise or the acquisition of more than 10% of the voting shares of a foreign corporation. A portfolio investment is the purchase of less than 10% of the voting shares of a foreign corporation or the purchase of debt instruments. Multinational enterprises are more likely to engage in direct foreign investment than in portfolio investment.

Go online and research the Argentine Currency Board. How did the Argentine currency board function from 1991 to January 2002, and why did it collapse?

Argentina's currency board exchange regime of fixing the value of its peso on a one-to-one basis with the U.S. dollar ended for several reasons: As the U.S. dollar strengthened against other major world currencies, including the euro, during the 1990s, Argentine export prices rose vis-à-vis the currencies of its major trading partners. This problem was aggravated by the devaluation of the Brazilian real in the late 1990s. These two problems, in turn, led to continued trade deficits and a loss of foreign exchange reserves by the Argentine central bank. This problem, in turn, led Argentine residents to flee from the peso and into the dollar, further worsening Argentina's ability to maintain its one-to-one peg.

The Impossible Trinity. Explain what is meant by the term impossible trinity and why it is in fact "impossible."

Countries with floating rate regimes can maintain monetary independence and financial integration but must sacrifice exchange rate stability. Countries with tight control over capital inflows and outflows can retain their monetary independence and stable exchange rate but surrender being integrated with the world's capital markets. Countries that maintain exchange rate stability by having fixed rates give up the ability to have an independent monetary policy.

Explain how each of the following transactions will be classified and recorded in the debit and credit of the U.S. balance of payments. A Japanese insurance company purchases U.S. Treasury bonds and pays out of its bank account with Chase in New York City.

Credit: Japanese company purchases US Bonds: Debit: Japanese copmany pays from its NYC account

Explain how each of the following transactions will be classified and recorded in the debit and credit of the U.S. balance of payments. A U.S. computer programming firm is hired by a British company and is paid from the British company's U.S. bank account.

Credit: US firm sells programming services to a British firm Debit: British pays from US bank account

Under the assumptions of our class notes (namely, approximately equal rates of real growth in the two economies), according to the Quantity Theory of Money, what is the cause of one currency appreciating relative to another? Provide a numerical example. To conventionally peg an exchange rate according to the Quantity Theory of Money, what must a central bank do?

Currency F appreciates relative to the dollar if dollar money supply growth exceeds currency F money supply growth and vice versa. Suppose the money supply growth in the $ is %ΔM$=4% and in currency F it is %ΔMF=2%, = 4% -2% = +2% Because the money supply growth in the dollar exceeds that of currency F, currency F appreciates, in this case by 2%. To peg currency F versus the $, for example, the Quantity Theory of Money implies that the central bank of currency F must match its money supply growth rate to that of the $. In the above equation, for %ΔS$/F=0, the central bank that prints currency F must grow its money supply such that %ΔMF=%ΔM$

A US firm has a long-standing capital investment in a profitable subsidiary in Indonesia, and that subsidiary sends to the US parent $1 million in dividends by transferring the funds to the parent's (US firm's) bank account in Jakarta, Indonesia. What are the credit and debit entries on the US Balance of Payments? To answer the question, consider the following table, use the IMF major account names (Current, Capital, or Financial), and express values in millions of US dollars:

Current Account Credit 1 Financial Account Debit 1 US balance of payments (in US dollars M): The US parent receives a dividend from a foreign subsidiary, which is a credit to Current Account-Primary Income. The funds are placed on deposit in a foreign bank, which is a debit to Financial Account-Other.

Codelco, a Chilean mining company, exports 1,000 tons of processed, refined copper ingots to Philatron, a US manufacturer of wire and cable. Philatron pays for the copper by transferring funds from its bank account at Santander Bank in Santiago, Chile to Codelco's bank account at ABN AMRO, also in Santiago. Assume the current price of copper is $1,000 per ton. Assuming an exchange rate of 500 Chilean pesos per $, what are the credit and debit entries on the Chilean Balance of Payments? To answer the question, consider the following table, use the IMF major account names (Current, Capital, or Financial), and express values in millions of Chilean pesos:

Current Account Credit 500 Financial Account Debit 500 Chilean balance of payments (in Chilean pesos M): A Chilean firm exports product worth 500 million pesos, which is a credit to Current Account-Goods. To make payment, the foreign importer removes funds on deposit with a Chilean bank, which is a debit to Financial Account-Other.

A US firm has a long-standing capital investment in a profitable subsidiary in Indonesia, and that subsidiary sends to the US parent $1 million in dividends by transferring the funds to the parent's (US firm's) bank account in Jakarta, Indonesia. Assuming an exchange rate of 10,000 Indonesian rupiah per $, what are the credit and debit entries on the Indonesian Balance of Payments? To answer the question, consider the following table, use the IMF major account names (Current, Capital, or Financial) and express values in millions of Indonesian rupiah:

Current Account Credit: 10,000 Financial Account Debit: 10,000 Indonesian balance of payments (in rupiah M): The Indonesian subsidiary pays a dividend to a foreign parent, which is a debit to Current Account-Primary Income. The funds are deposited in an Indonesian bank, which is a credit to Financial Account-Other.

Codelco, a Chilean mining company, exports 1,000 tons of processed, refined copper ingots to Philatron, a US manufacturer of wire and cable. Philatron pays for the copper by transferring funds from its bank account at Santander Bank in Santiago, Chile to Codelco's bank account at ABN AMRO, also in Santiago. Assume the current price of copper is $1,000 per ton. What are the credit and debit entries on the US Balance of Payments? To answer the question, consider the following table, use the IMF major account names (Current, Capital, or Financial), and express values in millions of US dollars:

Current Account Debit 1 Financial Account Credit 1 US balance of payments (in US dollars M): A US firm pays $1 million (1,000 tons X $1,000 per ton) for imports, which is a debit to Current Account-Goods. To make the payment, the firm removes funds on deposit with a foreign bank, which is a credit to Financial Account- Other.

A US firm has a long-standing capital investment in a profitable subsidiary in Indonesia, and that subsidiary sends to the US parent $1 million in dividends by transferring the funds to the parent's (US firm's) bank account in Jakarta, Indonesia. Assuming an exchange rate of 10,000 Indonesian rupiah per $, what are the credit and debit entries on the Indonesian Balance of Payments? To answer the question, consider the following table, use the IMF major account names (Current, Capital, or Financial) and express values in millions of Indonesian rupiah:

Current Account Debit 10,000 Financial Account Credit 10,000 Indonesian balance of payments (in rupiah M): The Indonesian subsidiary pays a dividend to a foreign parent, which is a debit to Current Account-Primary Income. The funds are deposited in an Indonesian bank, which is a credit to Financial Account-Other.

A US firm has a long-standing capital investment in a profitable subsidiary in Indonesia, and that subsidiary sends to the US parent $1 million in dividends by transferring the funds to the parent's (US firm's) bank account in Jakarta, Indonesia. What are the credit and debit entries on the US Balance of Payments? To answer the question, consider the following table, use the IMF major account names (Current, Capital, or Financial), and express values in millions of US dollars:

Current Credit: $1M Financial Account Debit: $1M US balance of payments (in US dollars M): The US parent receives a dividend from a foreign subsidiary, which is a credit to Current Account-Primary Income. The funds are placed on deposit in a foreign bank, which is a debit to Financial Account-Other.

Explain how each of the following transactions will be classified and recorded in the debit and credit of the U.S. balance of payments. A U.S. citizen purchases a ticket on Air France with her debit card from Bank of America and the bank wires payment to Air France's US bank account with Citibank.

Debit: US citizen buys transportation on Air France Credit: Payment wired to Air France's US bank account

Explain how each of the following transactions will be classified and recorded in the debit and credit of the U.S. balance of payments. Tata Motors, an Indian car manufacturer, sells cars to a U.S. car dealership and the dealership pays Tata by wiring funds into Tata's bank account with Wells Fargo in Los Angeles.

Debit: US dealership imports cars from teh Indian firm Credit: Payment is wired from its US bank account

Which of the following is NOT a common argument against dollarization? a. Dollarization causes a loss of sovereignty over domestic monetary policy. b. Dollarization removes currency volatility against the dollar. c. Dollarization causes the country to lose the power of seignorage. d. The central bank of the dollarized country loses the role of lender of last resort

Dollarization removes currency volatility against the dollar.

Recall the concept of the "Impossible Trinity." By joining the European Monetary Union, Italy has chosen to achieve __________________________; but has relinquished _______________?

Exchange rate stability (in the union) and full financial integration; monetary policy independence

Balance. Why does the BOP always "balance"?

From an economic perspective, transactions involve the receipt of goods, services, financial assets, etc. by a resident of one country who in turns pays for them in some way to a resident of another country. Consequently, the BOP has directional flows that net to zero, that is, balance. From an accounting perspective, the algebraic sum of all flows (credits, debits) accounted for in the BOP should, in theory, sum to zero. Because data for the balance of payments are collected on a single-entry basis and some data are missed, the equalization usually does not occur. The imbalance is "plugged" by an entry in the "errors and omissions" account that makes all accounts balance.

The Ideal Currency. What are the attributes of the ideal currency?

If the ideal currency existed in today's world, it would possess three attributes, often referred to as the Impossible Trinity: Exchange rate stability. The value of the currency would be fixed in relationship to other major currencies so that traders and investors could be relatively certain of the foreign exchange value of each currency in the present and into the near future. Full financial integration. Complete freedom of monetary flows would be allowed; thus, traders and investors could willingly and easily move funds from one country and currency to another in response to perceived economic opportunities or risks. Monetary independence. Domestic monetary and interest rate policies would be set by each individual country to pursue desired national economic policies, especially as they might relate to limiting inflation, combating recessions, and fostering prosperity and full employment. The reason that it is termed the Impossible Trinity is that a country must give up one of the three goals described by the sides of the triangle, monetary independence, exchange rate stability, or full financial integration. The forces of economics do not allow the simultaneous achievement of all three.

Classify the following as a transaction reported in a sub-component of the current account, the capital account, or financial account of the U.S.: A U.S. university gives a tuition grant to a foreign student from Singapore.

If the student is already in the United States, no entry will appear in the balance of payments because payment is between U.S. residents. (A student already in the United States becomes a resident for balance of payments purposes.)

Crawling Peg. How does a crawling peg fundamentally differ from a pegged exchange rate?

In a crawling peg system, the government will make occasional small adjustments in its fixed rate of exchange in response to changes in a variety of quantitative indicators, such as inflation rates or economic growth. In a truly pegged exchange rate regime, no such changes or adjustments are made to the official fixed rate of exchange.

Currency Board or Dollarization. Fixed exchange rate regimes are sometimes implemented through a currency board (Hong Kong) or dollarization (Ecuador). What is the difference between the two approaches?

In a currency board arrangement, the country issues its own currency but that currency is backed 100% by foreign exchange holdings of a hard foreign currency—usually the U.S. dollar. In dollarization, the country abolishes its own currency and uses a foreign currency, such as the U.S. dollar, for all domestic transactions.

What is the cause of inflation according to the Quantity Theory of Money? Provide a numerical example. What is the prescription for inflation management according to the Quantity Theory of Money?

Inflation arises when money supply growth exceeds output growth. Suppose US output grows at %ΔY=4% and money supply grow is %ΔM=3% %∆𝑃𝑃 ≅ 3%− 4% =−1% In this less common situation, the US would experience a fall in prices of 1%, deflation. Based on the quantity theory of money, the central bank should keep the money supply fairly steady, expanding it slightly each year to allow for the natural growth of the economy.

In a currency board exchange rate system, a country:

Prints its own currency, but backs it with the US dollar/major currency in a fixed ratio

What are the advantages of fixed exchange rates?

Provide stability in international prices for the conduct of trade. Stable prices aid in the growth of international trade and lessen risks for all businesses. Anti-inflationary, follow restrictive monetary and fiscal policies.

What are the disadvantages of fixed exchange rates?

Restrictive monetary and fiscal policies. Burden to solve internal problems like unemployment and slow economy. Large international reserves (hard currencies and gold) for defense of the fixed rate. Foreign currencies have grown, and having reserves becomes expensive. "Fixed rates, once in place, may be maintained at rates that are inconsistent with economic fundamentals. As the structure of a nation's economy changes, and as its trade relationships and balances evolve, the exchange rate itself should change. Flexible exchange rates allow this to happen gradually and efficiently, but fixed rates must be changed administratively—usually too late, too highly publicized, and at too large a one-time cost to the nation's economic health."

The Hong Kong dollar has long been pegged (backed in a currency board) to the U.S. dollar at HK$7.80 per $. When the Chinese yuan was revalued in July 2005 against the U.S. dollar from Yuan 8.28 per $ to Yuan 8.11 per $, how did the value of the Hong Kong dollar change against the yuan?

Simple Niki explanation: HK = $ (because it's pegged) Before, $1 could buy you 8.28 Yuan Now, $1 can ONLY buy you 8.11 Yuan This means that the $ has been devalued against the Yuan. And because HK = $, the HK has also devalued against the Yuan! Complicated Professor explanation: Assumptions Original Chinese yuan peg to the dollar, (yuan per $) 8.28 Revalued Chinese yuan to the dollar, (yuan per $) 8.11 Hong Kong dollar peg to the US dollar, (HK$ per $) 7.80 Before revaluation, let's convert 1 HK$ to US$ and then those US$ to Yuan: 1HK$ (1 US$/ 7.80HK$) = 0.12820513 US$ 0.12820513 US$ (8.28 Yuan/US$) = 1.0615385 Yuan After revaluation, let's convert 1 HK$ to US$ and then those US$ to Yuan: 1HK$ (1 US$/ 7.80HK$) = 0.12820513 US$ 0.12820513 US$(8.11 Yuan/US$) = 1.0397436 Yuan We see the rate of exchange has gone from: 1.0615385 Yuan per HK$ to: 1.0397436 Yuan per HK$. This means the HK$ lost value in Yuan terms. (Reasoning: The HK$ is fixed to the US$. The Yuan was revalued (increased in value) relative to the US$. Consequently, the Yuan was revalued (increased in value) relative to the HK$ too, or equivalently, the HK$ lost value relative to the Yuan.)

In December 1994 the government of Mexico officially changed the value of the Mexican peso from 3.2 pesos per dollar to 5.5 pesos per dollar. What was the percentage change in its value? Was this a depreciation, devaluation, appreciation, or revaluation? Explain.

Step 1: Percentage change of value [(new-old)/old] Old: 3.2 pesos/$1 Convert $1/pesos = 1/3.2 = $0.3125/peso New: 5.5 pesos/$1 Convert $1/pesos = 1/5.5 = $0.1818/peso [(new-old)/old] $0.1818 - $0.3125/ $0.3125 = -41.82% change Step 2: Depreciation, devaluation, appreciation, or revaluation? Devaluation, before, a peso could buy $0.3125, but now it can only buy $0.1818. It is devaluation NOT depreciation because the GOVERNMENT changed the currency rate. When the MARKTET changes the currency rate, it is depreciation (or appreciation). When it's the government it's devaluation or revaluation.

Flow Statement. What does it mean to describe the balance of payments as a flow statement?

The BOP is often misunderstood because many people infer from its name that it is a balance sheet, whereas in fact it is a cash flow statement. By recording all international transactions over a period such as a year, the BOP tracks the continuing flows of purchases and payments between a country and all other countries. It does not add up the value of all assets and liabilities of a country on a specific date like a balance sheet does for an individual firm.

Consider the following: A foreign automobile company builds a manufacturing plant in Tennessee and European investors buy US Treasury Bonds. What subcomponent of the Financial Account are manufacturer and investors part of?

The auto manufacturer is engaged in direct investment, and the European investors are engaged in portfolio investment

The Euro. Why is the formation and use of the euro considered to be of such a great accomplishment? Was it really needed? Has it been successful?

The creation of the euro required a near-Herculean effort to merge the monetary institutions of separate sovereign states. This required highly disparate cultures and countries to agree to combine, giving up a large part of what defines an independent state. Member states were so highly integrated in terms of trade and commerce that maintaining separate currencies and monetary policies was an increasing burden on both business and consumers, adding cost and complexity, which added sizable burdens to global competitiveness. The euro is widely considered to have been extremely successful since its launch

Balance of Payments Defined. What is the balance of payments?

The measurement of all international economic transactions between the residents of a country and foreign residents is called the balance of payments (BOP).

Net International Investment Position. What is a country's net international investment position, and how does it differ from the balance of payments?

The net international investment position (NIIP) of a country is an annual measure of the assets owned abroad by its citizens, its companies, and its government, less the assets owned by foreigners public and private in their country. Whereas a country's balance of payments is often described as a country's international cash flow statement, the NIIP may be interpreted as the country's international balance sheet. NIIP is a country's stock of foreign assets minus its stock of foreign liabilities.

Classify the following as a transaction reported in a sub-component of the current account, the capital account, or financial account of the U.S.: A Colombian drug cartel smuggles cocaine into the United States, receives a suitcase of cash, and flies back to Colombia with that cash.

This would not get captured in the goods part of the U.S. or Colombian current accounts. Assuming the cash was "laundered" appropriately, from the point of view of the smugglers, bank accounts in the United States might be credited. This imbalance would end up in the errors and omissions part of the U.S. balance of payments.

Under a conventionally pegged exchange rate regime, what are the implications for monetary policy flexibility/independence according to the Quantity Theory of Money?

To peg currency F versus the $, for example, the Quantity Theory of Money implies that the central bank of currency F must match its money supply growth rate to that of the $. In the equation from class, we see that once the central bank of currency F commits to a pegged exchange rate vs. the $, that is, %ΔS$/F=0, the central bank of currency F loses its ability to independently set its own monetary policy as it must match its own currency's money supply growth rate to that of the $, that is, %ΔMF=%ΔM$

True of False. A country running a current account deficit is benefiting from more goods and services than it is producing.

True

True of False. A country suffering from a persistent current account deficit may indicate that the country's products and services are not competitive on the international markets.

True

True or False. A current account deficit implies the domestic spending exceeds GNP

True

True or False. According to Prof. Ferguson, a necessary requirement for an enduring monetary union may be fiscal policy coordination or even a fiscal union.

True

True or False. The following statement: "Under a floating exchange rate system, the exchange rate adjusts to imbalances. If there is a net capital outflow (inflow) and the BOP goes into deficit (surplus), the currency depreciates (appreciates) and the BOP is restored to equilibrium," is:

True

What is the relationship between the balance of payments and a fixed exchange rate regime?

Under a fixed exchange rate system, the government bears the responsibility to ensure that the BOP is near zero. If the sum of the current and capital accounts do not approximate zero, the government is expected to intervene in the foreign exchange market by buying or selling official foreign exchange reserves. If the sum of the first two accounts is greater than zero, a surplus demand for the domestic currency exists in the world. To preserve the fixed exchange rate, the government must then intervene in the foreign exchange market and sell domestic currency for foreign currencies or gold in order to bring the BOP back to near zero.

What are the advantages of a flexible exchange rate regime?

a. Monetary policy independence b. Exchange rate adjustment automatically achieves balance of payments equilibrium c. Unrestricted capital flow/Full financial integration

What is the relationship between the balance of payments and a floating exchange rate regime?

Under a floating exchange rate system, the government of a country has no responsibility to peg its foreign exchange rate. The fact that the current and capital account balances do not sum to zero will automatically—in theory—alter the exchange rate in the direction necessary to obtain a BOP near zero. For example, a country running a sizable current account deficit and a capital and financial accounts balance of zero will have a net BOP deficit. An excess supply of the domestic currency will appear on world markets. Like all goods in excess supply, the market will rid itself of the imbalance by lowering the price. Thus, the domestic currency will fall in value, and the BOP will move back toward zero.

Examine the following summary of the IMF's U.S. balance of payments in a recent year (in $ billion) and calculate the values for the blank entries. Provide answers in $ billion to two decimal places and indicate credit balances as positive numbers and debit balances as negative numbers. 1. Current Account: -400.25 Goods: a) ______________ Services: 225.28 Primary Income: 199.65 Secondary Income: -123.52 2. Capital Account: -0.41 3. Financial Account: b)___________ Direct Investment: -113.27 Portfolio Investment: 1.07 Financial Derivatives: -2.25 Other: 482.01 4. Official Reserves: 3.08 5. Net Errors and Omissions: c)________

a) -701.66 Current account = goods + services + primary income + secondary income b) 367.56 Financial account = direct investment + portfolio investment + finanicial derivatives + others c) 30.02 current account + capital account + financial account + official reserves + net errors and omissions = 0

In a fixed exchange rate regime, domestic monetary policy cannot be conducted freely and independently of management of the exchange rate because:

a. Monetary policy involves market operations that change money supply b. Money supply changes affect the supply-demand equilibrium in the currency market c. Monetary policy affects interest rates and therefore the demand for currency for investment

All of the following are true about a conventional fixed exchange rate regime EXCEPT: a. Fixed rates provide relative stability in international prices and thereby promote international trade/investment b. Fixed exchange rate regimes necessitate that central banks maintain large quantities of international reserves for use in the defense of the fixed rate c. Fixed rates are inherently inflationary in that they encourage countries to follow loose monetary and fiscal policies d. Stable prices aid in the growth of international trade and lessen exchange rate risks for businesses

c. Fixed rates are inherently inflationary in that they encourage countries to follow loose monetary and fiscal policies