Economics 343
International Finance

This assignment must be handed in.

LECTURE NOTES
Lecture One
Lecture Two
Lecture Three
Lecture Four
Lecture Five
Lecture Six
Lectute Seven
Lecture Eight

Absolute advantage a producer (or a country) that uses smaller amount of resources to produce one unit of a certain product has absolute advantage over one that uses more resources to produce one unit of the same product. An Example: US uses 15 units of resources to produce one bushel of tomatoes; Mexico uses 10 units of resources to produce one bushel of tomatoes
An example

Consider Mexico and the US. Suppose that each country has 240 units of resources (say labor) being used in the production of corn and tomatoes. In the absence of trade between the two countries each country uses one half of its resources to produce corn and the other half to produce tomatoes.

Mexico    U.S.                  Mexico       U.S.           Wld
Resouces needed
to produce one unit                     Quantity produced
Tom. :10 hrs       15 hrs                    12               8                 20

Corn:   8 hrs        4 hrs                     15              30                45

After trade each country specializes in one of the two goods.

Mexico    U.S.       Total

OUTPUT
Tomatoes    24           0             24
Corn            0          60             60

Gains from trade: 4 units of  tomatoes ;         15 units of corn.

A country has a comparative advantage in the production of a product over another country if it can produce that product at a lower opportunity cost relative to the other country. Even if a country is less efficient in the production of all goods relative to another country, still it could have a comparative advantage in the production of one good if it is comparatively more efficient in the production of that good compared to the other good.

Again let us use Mexico and the U.S. in an example. We continue to assume that each country has 240 units of resources.

Mexico      U.S.         Mexico       U.S.       Wld
Resources Needed                 Output
Rugs      10 hrs      8 hrs            12              15           27

Comtrs  40 hrs      10 hrs           3               12            15

The concept of Relative price:  Pr/Pc
In Mexico the relative price of one computer is 4 rugs; that is 40/10
In the U.S. the relative price of one computer is 1.25 rugs; that ia 10/8

Mexico   U.S.     Total
Rugs                    24             0           24
Computers           0              24          24

Gains: -3  R   ;       + 9 C
Note that to both countries 9 computers are valued a lot more than 3 (lost) rugs.
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Study Questions- Test III
Study Questions- Test III

1. Explain the determinants of the demand for (real) money.
2. Why is it said that in the long run a one-time increase in the nominal money supply would not lead to a change in the interest rate?
3. Explain the equation of exchange.
4. Explain the concept of “purchasing power parity.”
5. Equilibrium in the money market at home and abroad is represented by:
M/P = L ,  M*/P* = L*
respectively. Where:
M, M* = Nominal money stock
P, P*    =  The price level
L, L*   =  Demand for real money

a. Explain what the following equation implies.

^    ^            ^      ^           ^    ^
(P – P*) =  ( M – M* ) – ( L – L*)        ( The symbol ^  represents % change.)

b. Assuming that purchasing power parity holds explain the long-run impact of an expansionary monetary policy by the monetary authorities of foreign
countries on the exchange rate.

6. Outline some of the important reasons why PPP does not hold.
7. Why does there seem to be more empirical support for relative PPP than for absolute PPP?
8. Suppose the rate of growth in the US money stock is around 10 percent per annum whereas the European Central Bank has kept the growth rate of the
euro (money) stock at 6% per year. Assuming that the growth rates of demand for money in the United States and Europe are the same,
a. what does the monetary theory of foreign exchange predict to happen to the exchange rate between the US dollar and the euro in the long run?
b. Suppose the actual changes in the exchange rate indicate a 10% annual rate of depreciation in the US dollar (e^ = .10). What has been the percentage
change in the real exchange rate?

9. We know that an expansionary monetary policy could lead to the depreciation of the home currency in the short run. Would the impact of an accelerated
expansion in the money stock on the expected rate of change in the exchange rate in the long run be the same? Explain.
10. Suppose based on historical trends, the expected inflation rate in the United States is 5% while  in the U.K. it is around 8%. Explain how this inflation
differential could be linked to the interest differential between the two countries in the long run? Be specific about your assumptions.
11. Explain why it is said that if relative purchasing power parity between two countries holds, in the long run the real exchange rate will be expected to remain
unchanged.
12. Demonstrate that in the long run the difference between the expected real interest rates in two countries reflects the rate of change in the real exchange rate
between the countries’ currencies.
13. Explain why the aggregate demand curve is downward-sloping.
14. Identify the short-run, the long-run and the medium run aggregate supply curves and explain the assumptions under which each is constructed.
15. Under what conditions could and economy move beyond its full-employment level of output. Explain briefly.
16. What causes shifts in the medium-run aggregate supply curve? Explain.
17.  Is it possible for the long-run aggregate supply curve to shift? Explain.
18. What are the automatic forces that are expected to push the economy toward full employment in the long run? Explain.
19. Why is monetary policy expected to be ineffective as a macroeconomic policy tool under a fixed exchange rate regime?
20. Assume an economy is operating below its full-employment level of output. Using an aggregate demand and aggregate supply diagram, demonstrate how
under a fixed exchange rate regime with flexible prices fiscal policy can bring the economy to full employment. Compare the results of fiscal policy with the
results of the (possible) long-run automatic adjustments that could bring the economy to full employment.
21. Blueland is a small economy operating at its full-employment level of output. Suppose Blueland’s only trading partner, Redland, devaluates its currency
against the currency of Blueland. Using an aggregate demand and aggregate supply diagram, analyze the medium-run and long-run effects of this devaluation
(which is a revaluation of Bluland’s currency) on Blueland’s economy.  Assume perfectly mobile capital. Assuming that prior to the devaluation of its
currency Redland was also operating at full employment discuss the medium and long-run effects of this policy on Redland’s economy.
22. It is said that under a flexible exchange rate regime fiscal policy is not effective in changing the output level. Explain why.
23. Consider a small country with a flexible exchange rare regime. The country is at full employment. Still its monetary authorities pursue an expansionary
monetary policy. Using an aggregate supply and aggregate demand diagram demonstrate and explain how this policy might affect this economy in the medium
and long run.
24. What is meant by exchange rate overshooting?
25. Explain the relationship between the mint exchange rate and the market exchange rate under a gold standard regime.
26. Outline the important terms of the Bretton Woods agreement.
27. What was the original (envisioned) function of the IMF in the Bretton Woods system?
28. Why is it argued that the maintenance of a fixed exchange rate regime could conflict with the internal economic objectives of a country?
29. What is a crawling-peg exchange rate regime? What makes it necessary for a country to adopt this kind of regime?
30. Outline the pros and cons of a flexible exchange rate regime.
31. Outline the important events that lead to the collapse of the Bretton Woods regime.
32. Briefly explain how a managed float system is supposed to work and the problems associated with such a system.

Study Questions- Test II

The following are some sample questions that might help you prepare for our second test. You should not study off these questions. Use the questions after you have completed studying the book and your notes. Also be sure to review the questions at the end of each chapter.

1. What constitutes money stock (or supply)?
2. Is it possible for a banking system without a central bank to create money?
3. What links the commercial banking system to the central bank?
4. What do we mean by “required reserve?”
5. What are the constituents of a central bank’s asserts?
6. What are the main components of a commercial bank’s assets?
7. What is the money multiplier?
8. What are the central bank’s main tools of money management (or monetary policy)?
9. Explain how a purchase of foreign exchange by the central bank could affect the foreigh exchange market, as well as the money market and the goods market.
10. Explain the demand function for money.
11. Explain why is the LM curve normally upward-sloping?
12. What does the slope of the LM curve reflects?
13. What causes shifts in the LM curve?
14. Explain equilibrium in the foreign exchange market.
15. What does the PBP curve represent?
16. Why is the BOP curve generally upward-sloping?
17. What does it mean when the BOP curve is horizontal?
18. What does it mean when the BOP curve is vertical?
19. What makes the BOP curve shift to the right?
20. What makes the BOP curve shift to the left?
21. What does the textbook mean by “general equilibrium?”
22. Under a fixed exchange-rate regime, how do monetary authorities keep the exchange rate constant when facing a balance of payments deficit?
23. Consider an open economy with a flexible exchange rate regime. Suppose due to an external disturbance the country is having a balance of payment deficit. Explain the mechanism through which the country’s external balance might be restored.
24. Consider an open economy with a fixed exchange rate regime. Suppose as a result of an external disturbance the country is experiencing a balance of payments deficit. Explain the process by which this country’s external balance would be restored.
25. What do we mean by external and internal balance?
26. Briefly explain the macroeconomic policy tools available to a country’s policy makers.
27. What is sterilization?
28. Explain why under a fixed exchange rate regime monetary policy is generally ineffective.
29. It is argued that when investors consider (domestic) bonds risky, under a fixed exchange rate regime, expansionary monetary policy could be at least partially effective. Explain why.
30. Consider an open economy with a fixed exchange rate regime and high level of capital mobility. The economy is presently at a general equilibrium, but it is suffering from unemployment. To deal with this problem the government resort to fiscal policy (deficit spending). Explain how fiscal policy might or might not remedy the unemployment problem in this country; what will be the effect of this policy on the country’s income level and interest rate? Be sure to use graphs in your analysis.
31. Explain how monetary policy in a reserve-currency country might affect non-reserve currency countries.
32. Consider an open economy with flexible exchange rates and perfectly mobile capital. To reduce the budget deficit the policy makers have reduced government spending by \$500 million. The country’s spending multiplier has been estimated to be 2.4. Explain how this expenditure cut would affect the economy’s output, the domestic interest rate, and the exchange rate. First assume the expenditure cut is perceived to be temporary. Next, assume it is perceived to be permanent.
33. Consider an open economy with flexible exchange rates and perfectly mobile capital. The economy is operating below its full-employment level of output. What kind of monetary policy would you recommend for this economy? Explain how your recommended policy could solve the country’s unemployment problem. Under what conditions would your recommended monetary policy most effective? What would be the effects of your recommended policy on country’s interest rate, spending, and exchange rate?
34. Consider an economy with a flexible exchange rate regime. The country is open to international trade but no capital flow is allowed. Suppose the country is experiencing unemployment. The country’s policy makers are considering their policy options for dealing with the unemployment problem. What would be your recommendation and why? Be as specific as you can in describing how your recommended policy might work and why you consider that preferable to other policy options available to the policy makers.
35. Consider an economy with a flexible foreign exchange market and highly (but not perfectly) mobile capital. The country is operating very close to the full-employment level of output. Fearing possible inflationary pressure, the country’s policy makers decide to undertake concretionary fiscal. They propose a \$100 million tax increase in the country’s budget. Carefully explain how this tax increase could affect the country’s income, interest rate and foreign exchange rate. Evaluate the effectiveness of the policy first under the assumption that the tax increase is perceived as temporary. Next discuss the policy assuming that the tax increase is permanent.
36. Consider an economy with a flexible foreign exchange market and highly (but not perfectly) mobile capital. The economy is operating under the full-employment level of output. The country’s policy makers are evaluating the macroeconomic policy tools that could be used to eliminate or at least reduce the unemployment. While they want to make the economy grow to higher levels of output they want to keep the interest rate about the same (to minimize possible structural changes in the economy.) What kind of policy would you recommend and why? Carefully explain how your recommended policy would help this economy achieve both objectives.

Review questions for test 1:

After you have completed studying the relevant chapters in the book and your class notes, give yourself a quick test by going over the following questions. Do NOT limit yourself to only studying these questions.

1. Explain the important elements that distinguish economic relations between the residents of two different countries from the economic relations among the residents of the same country.
2. Your book points to a number of statistical trends as evidence of increasing international (economic) interdependence. Briefly explain them.
3. What are the major factors believed to have contributed to the expansion of the international economic relations since WW II
4.  The relative size of the US international trade in the past 40 years has nearly tripled, and since early 1980s the US has consistently been running a balance of trade deficit. In 2003 the US trade deficit exceeded \$450 billion, a new record. One could conclude that these developments indicate the US economy is increasing becoming more dependent on other economies and that could be detrimental to the country’s long-term economic health. Do you agree? Give a brief explanation.
5. Identify and describe different types of foreign exchange markets and their functions.
6. Explain FX arbitrage? What are impacts of arbitrage transactions on FX markets?
7. Based the following (hypothetical) spot rates, construct a currency cross-rate table:
Dollar/ Pound = 1.80; Yen/Dollar = 120; Dollar/Euro = 1.25; Peso/Dollar =11; Dollar/ C. dollar = .65
8. Suppose the spot rate between the euro and the pound is 1.40 euros per pound. Using the spot rates given in Question 7, Is there an arbitrage opportunity? If there is, how can one take advantage of it?
9. What is meant by “foreign exchange risk?” Give an example.
10. What is “hedging?”
11. What are some of the commonly used hedging instruments?
12. When the forward rate on a currency is greater that its spot rate we say that currency is at a forward   ……………..
13. When the market expects a currency to depreciate the forward rate of that currency is expected to be …………… than its spot rate.
14. When a speculator expects a currency to depreciate more than what market indicates, should the speculator go long or short on that currency. Explain.
15. Consider an American investor who is not risk averse. This investor observes that the interest rate on a dollar-denominated time deposit is 5 percent whereas the interest rate on a similar euro-denominated deposit is 7 percent. Explain the conditions under which the speculator would still choose to keep her money in a dollar-denominated form of deposit.
16. Suppose a risk-avers investor is faced with the same investment options explained in Question 15. Explain the conditions that would make the two investment options equal to this risk-averse investor.
17. Why do economists generally assume that the supply of a foreign exchange could be represented by a vertical line?
18. What do we generally mean by “eurocurrencies?”
19. What might be some of the important reasons for interest parity not to hold?
20.  By referring to their impacts on the supply of and/or the demand for the Japanese yen, determine or discuss the expected effect of each of the following on the exchange rate (the \$value of ) the yen, ceteris paribus:
a. An increase in the US interest rate along with a reduction in the forward value of  the yen
b. Increases in both Japanese and US interest rates.
c. Widespread speculation that the dollar would depreciate along with the tightening of the money supply by the US monetary authorities.
d. The Central Bank of Japan sells a significant amount of its US dollar reserves in the market while the Federal Reserve of the US tightens the money supply.
e. Due to speculation against the yen the forward rate for the yen decreases.
f. Due to the Federal budget deficit the US interest rates increase.
g. Concerned about inflation the Fed raises the discount rate.
21. Suppose the US (annual) interest rate is 8% while the UK interest rate is 12%. The forward rate of the 90-day pound is \$1.81 whereas the spot rate for the pound is 1.80.
a. Do you observe parity between the two markets? Explain.
b. If not, what kinds of changes would you speculate would make the market move toward parity?
22. Since the 1970s during what period did the effective value of the US dollar reach its peak? What was the relative status of the US trade balance during that period? (An analytical question)
23. How are the effects of surpluses and shortages on the foreign exchange market controlled under a fixed (pegged) exchange rate regime? Explain.
24. Identify and explain the major categories of the US balance of payments.
25. Explain why the overall balance of payments is always zero.
26. Identify the types of transactions that are entered under the current accounts.
27. What is the official settlement balance?
28.  Be sure to review all of the questions at the end of BOP chapter.
29. What would be the impact of a current account surplus on the foreign exchange market (or the value of the home currency) under a flexible exchange rate regime?
30. How is a current surplus dealt with under a fixed (pegged) exchange rate regime? Discuss the impact of such a surplus on the country’s balance of payments.
31. What is the difference between GNP and GDP?
32. Identify and explain each of the components of aggregate spending?
33. Why do we say that among the expenditure components only consumption and imports are endogenous?
34. The depreciation of the dollar will cause the (US) relative price to …………………………
35. How (and why) a reduction in the exchange rate, e, affect the US’s exports?
36. How (and why) a reduction in the exchange rate, e, affect the US’s imports?
37. How does an increase in the US’s marginal propensity to consume, MPC, affect the expenditure line in the national income diagram?
38. What does the multiplier measure (or reflect)?
39. What is the effect of an increase in the marginal propensity to import, mpm, on the expenditure line in the national income diagram?
40. Explain the J-curve effect.
41. Consider an economy with a GNP (Y) of \$800 billion dollars. Presently this economy is having a current account deficit of \$50 billion. The estimated mpc for this economy is .80 and its marginal propensity to import has been estimated to be .20 Demonstrate (in diagrams) and examine the effects of each of the following on the economy’s national income and its currant account position:
a. A tax increase of \$40 billion
b. A reduction of \$10 billion in exports along with and increase of \$5 billion in the government spending
c. An increase in investment due to a decline in the interest rate.
d. The devaluation of the country’s currency resulted in a \$4 billion increase in exports and a reduction of \$3 in autonomous imports.
e. While cutting taxes by \$10 billion the government increases expenditure by \$8 billion.
42. Consider an economy with a GNP (Y) of \$900 billion dollars. Presently this economy is having a current account deficit of \$ 60 billion. The estimated mpc for this economy is .75 and its marginal propensity to import has been estimated to be .10.
a. Use a set of diagrams to demonstrate the (internal and external) status of this economy.
b. Suppose each one-percent devaluation of the country’s currency would make its exports increase by \$15 billion and its autonomous imports decrease by \$10 billion. How much devaluation would bring the country’s current accounts to a zero balance?
c. How would your recommended devaluation affect the country’s national income?

Homework Assignment 4
1. Consider an open economy with perfectly mobile capital and a fixed exchange rate regime. The economy is at a general equilibrium. Suppose the country’s central bank sells some of its government bonds.
a) Carefully explain how this sale would affect the country’s internal and external balance.
b) Would the domestic interest rate and the level of output change as a result of this sale? Explain.
c) Now suppose capital is perfectly immobile. How would this open market sale affect the country’s internal and external balance in this case? Would this sale affect the domestic interest rate?
d) Next consider the same scenario with imperfectly mobile capital. Carefully explain how the effects of the open market sale under imperfectly mobile capital might be different from those of the two previous cases.

2. Do Problem 1, page 498 from the textbook.

Note: Also review the other problems on this page. (You do not have to turn those in.) We’ll review some of them in class.

Homework Assignment 3
March 24
1. The banking system in Southland, a small country, is made up of a Central Bank and a number of commercial banks whose operations are supervised by the Central Bank. The Central Bank’s assets (holdings) consist of only two types of assets: government bonds and foreign exchange. Commercial banks, whose only functions are accepting deposits and making loans, hold all their (cash) reserves with the Central Banks. Commercial banks are required to hold at least 20 percent of the value of their (checkable) deposits with the country’s Central Bank as “reserves.” Presently, there is \$50 billion worth of the Central Bank’s notes in circulation and the commercial banks’ consolidated reserve deposits with the Central Bank also amount to \$50 billion. Moreover, the Central Bank has \$60 billion worth of government bonds. The commercial banks have collectively made \$180 billion worth of loans and hold \$200 billion checkable deposits for their customers.
Answer the following questions based on the information given above.
a. What is the consolidated net worth of the commercial banks?
b. Determine the country’s money stock.
c. Are the commercial banks (collectively) meeting their reserve requirements? Explain.
d. Can the commercial banks make any more loans without exceeding the limits of their     reserves? Explain.
e. Can you determine the amount of foreign exchange the Central Bank is holding from the information given above?
f. Now suppose the Central Bank has purchased \$20 billion worth of foreign exchange. Assuming no change in the amounts of the notes in circulation, explain how this purchase would affect the Central Banks’ assets and liabilities. Also determine the potential effect of this FX purchase on the money stock of the country.

2. Determine the effect each of the following on the shape (slope) and the position of the IS and/or LM curve, ceteris paribus.
a. An increase in the marginal propensity to consume
b. An increase in the domestic price level
c. Appreciation of the domestic currency
d. A reduction in government spending
e. An increase in the income level of the country’s trading partners
f. Inflation in foreign countries
g. Recession in foreign countries
h. A reduction in the marginal propensity to import
i. A reduction in the sensitivity of investment to changes in the interest rate
j. An increase in the sensitivity of demand for money to changes in the interest rate

HOMEWORK ASSIGNMENT- Oct 9
1. Consider the following equation representing the equilibrium in the goods market:

Q =Y = E = C + I + G
where:
Y = income
E = expenditure
C = 500 + mpc (Y – T); mpc = 0.80 ; Ca = autonomous consumption; T = lump-sum tax = 300
I =  1500 - 20000 i
G = government expenditures = 400
i = interest rate = 0.05

a. Draw a diagram to demonstrate this equilibrium.
d. Determine the equilibrium income (Y).
c. Now suppose the interest rate is lowered to 0.04. How will this change affect the level of the economy’s output (Y)?
d. Show this change on your diagram.
e. See if you can derive this economy’s IS curve from your analysis.
f. Suppose the lowering of the interest rate is done by the Fed through an expansionary monetary policy (purchase of bonds). Explain how this policy affects economy’s money stock.

2. Explain the primary instruments that the Fed (or a central bank) could use to control the money supply.

3. Suppose the Fed sells \$100 million worth of euro. Show the effect of this transaction on the Fed’s balance sheet and the consolidated balance sheet of commercial banks. Assuming that the required reserve ratio is 10 percent, how does this transaction affect the economy’s money stock?

Homework Assignment (Balance of Payments)

For each of the following show the entries in the US balance pf payments.

a. Boeing sells five passenger airplanes to China for a total price of \$200 million. One half of this amount is paid out of the Chinese deposits in a US commercial bank in New York. Export-Import Bank of the United States finances the other half.
b. Microsoft Corporation pays its Indian subsidiary \$100 million for software products produced in India. The payment is made by a check on one of Microsoft’s accounts with Bank of America.
c. Bill and Melinda Gates Foundation gives \$500 million to a number of African countries for fight against AIDS. This money goes directly to a number of American pharmaceutical companies and American aid agencies that provide health care in developing countries.
d. With government approval, Boeing sells four advanced fighter jets to Saudi Arabia for a total price of \$200 million. The Saudis pay \$100 million in cash out of their bank account in a British bank. (This transaction reduces the British bank’s deposits in the US.) The balance of the invoice is financed by Export-Import Bank of the United States.
e. A major New York’s spirit merchant buys \$15 million worth of vodka from Russia. \$5 million of this amount is paid cash by a direct transfer into the Russian exporter’s bank account in an American bank. The American importer has agreed to pay the balance in two equal installments within 9 months.
f. Determine the net effect of the above transactions on each of the following balances:
i·   The current account balance
ii·  The non-official capital balance
iii· The official settlement balance

2. Consider a country with a GNP, Y, of \$100 billion. Suppose presently the country is having a currant account balance of \$8 billion.
a. Assuming the economy is at equilibrium, demonstrate the country’s national income, Y, and current account balance in a set of diagrams.
b. Now suppose the economy’s marginal propensity to consume is .85 while its marginal propensity to import is .10. Assuming no change in the country’s interest rare, exchange rate, price level, taxes, and its trading partners’ incomes and prices, determine the impact of a \$10 billion increase in government spending (deficit spending) on the country’s current account.
c. Now suppose while increasing the government expenditure (as explained above), to correct its current account balance, the government devaluates the country’s currency by 20 percent. The initial effect of this devaluation is an (exogenous) increase in the country’s exports in the amount of \$12 billion. The devaluation has also a direct immediate (exogenous) effect on imports; it reduces impotrs by \$4 billion. Taking into account the secondary (endogenous) effects of the increased exports and imports determine the total effect of deficit spending and devaluation on the country's current account balance.

1. The BOP problem:

Debit                   Credit
Current Accts
a. Exports                                                    200
b. Imports                       100
c. Exports                                                    500
e. Imports                        15
d. Exports                                                     200
c. Unilateral transfers     500
------------------------------------
615                         900
Capital Accts
a. Reduction in f. dep.     100
a. Loan to foreigners       100
b. Increase in f. dep                                       100
d. Reduction in f.dep       100
d. Loan to foreigners       100
e. Increase in f. dep                                           5
e. Commercial loan
to a US Importer                                          10
-----------------------------------
400                         115
=====================
1,015                        1,015

Official Settlement Balance  00                         00

a. Graph
b. Change in government spending:  +10

Change in CAB = - ((mpm)/1-mpc+mpm)) . Change in G

=  -(.10/.25) (+10) = -4

c. Change in CAB = (Chng in X – Chng in Ma ) ( 1- ((mpm/(1-mpc+mpm)))
= (12 +4) ( 1 -.4) = +9.6
Total change in CAB = 9.6 -4 = 5.6

Homework Assignment I
Due date: Monday, Feb 16

1. The relative sizes of the US and Japanese trade are not very different. In your view, which country is more (internationally) trade-dependent? Briefly explain.

2. Which of the following has been larger in recent years?

i. The value of the total US annual international trade transactions (exports + imports)
ii. The value of the total US annual private international investment transactions (US private investments abroad + foreign private investments in the US)

3. Suppose, on a certain day, in NY the Japanese yen is traded at 128.5 yen per dollar, while the British pound exchange rate is \$1.455 per pound. On the same day, in London the Japanese yen is traded at 184 yen per pound.
a. Do you see an arbitrage opportunity? Explain
c. Suppose, one could engage \$10,000,000 in this arbitrage transaction. How much profit could this person make?

4. Suppose the euro 180-day forward rate today is \$1.235 per euro. The annual interest rate on a risk-free German security is 8 percent, whereas in the US the annual rate on a similar investment instrument is 6 percent.
a. What would be the euro spot rate, if there were parity between the two capital markets?
b. Now suppose the actual spot rate for euro is \$1.26 per euro. What changes, would you say, would bring the two capital markets to a state of parity?

Review Questions for Exam III
1. What are the macroeconomic goals in an open economy? Briefly describe each.
2. What are the policy instruments commonly used to achieve macroeconomic objectives? Briefly describe each.
3. Are all policy instruments available to policy makers under all circumstances? Explain.
4. What do we mean by “automatic balance-of-payments adjustment?
5. What is the basic rule in formulating (or using) policy instruments when targeting macroeconomic objectives?
6. Explain carefully what each of the following represents.
a. IS curve
b. LM curve
c. BOP curve
7. How do the monetary authorities maintain the exchange rates of the home currency relative to foreign currencies fixed?

8. Using the IS, LM and BOP curves, use a diagram to demonstrate a situation characterized by external (BOP) surplus under a fixed exchange rate regime, perfectly immobile capital, and unemployment.

9. Using the IS, LM and BOP curves, use a diagram to demonstrate a situation characterized by external (BOP) surplus under a fixed exchange rate regime, perfectly mobile capital, and unemployment.

10. Using the IS, LM and BOP curves, use a diagram to demonstrate a situation characterized by external (BOP) surplus under a fixed exchange rate regime, imperfectly immobile capital, and unemployment.

11. Explain the mechanism by which the external balance could be restored under a fixed exchange rate regime.

12. Consider a country with a fixed exchange rate regime. The country does not allow any movements of capital. Presently, the country is experiencing unemployment. To deal with this unemployment problem the country’s policy makers are considering a mix of tax cuts and increased government expenditures. Demonstrate how such fiscal policies would affect this economy. (Assume no changes in the overall price level.)

13. Consider a country with a fixed exchange rate regime. The country does not allow any movements of capital. Presently, the country’s policy makers are concerned about the economy over-expanding and its possible inflationary tendencies.  To keep the economy from overheating and getting onto an inflationary spiral, the policy makers are considering a mix of tax increases and cutbacks in government expenditures. Demonstrate how such policies would affect this economy.

14. Consider a country with a fixed exchange rate regime. The country does not allow any movements of capital. Presently, the country is experiencing unemployment. To deal with this unemployment problem the country’s policy makers are considering expansionary monetary policies.  Demonstrate how such monetary policies would affect this economy in terms of the level of output and employment as well as the interest rate. (Assume no changes in the overall price level.)

15. Because of automatic balance of payment adjustment mechanism under a fixed exchange rate regime with immobile capital, monetary policies are not very effective. What do policy makers do to counter the effects of automatic (monetary) balance of payment adjustments? What are the limits of such countervailing policies?

16. Consider a country with a fixed exchange rate regime. The country does not allow any movements of capital. Presently, the country is experiencing unemployment. To deal with this unemployment problem the country’s policy makers are considering devaluation the country’s currency. Demonstrate how a devaluation would affect this economy in terms of the level of output and employment as well as the interest rate. (Assume no changes in the overall price level.)

17. Consider a country with a fixed exchange rate regime with perfectly mobile capital. Presently, the country is experiencing unemployment. To deal with this unemployment problem the country’s policy makers are considering a mix of tax cuts and increased government expenditures. Demonstrate how such fiscal policies would affect this economy in terms of the level of output and employment as well as the interest rate. (Assume no changes in the overall price level.)

18. Consider a country with a fixed exchange rate regime with perfectly mobile capital. Presently, the country’s policy makers are concerned about the economy over-expanding and its possible inflationary tendencies. To keep the economy from overheating and getting onto an inflationary spiral, the policy makers are considering a mix of tax increases and cutbacks in government expenditures. Demonstrate how such policies would affect this economy in terms of the level of output and employment as well as the interest rate.

19. Consider a country with a fixed exchange rate regime and perfectly mobile capital. Presently, the country is experiencing unemployment. To deal with this unemployment problem the country’s policy makers are considering expansionary monetary policies.  Demonstrate how such monetary policies would affect this economy in terms of the level of output and employment as well as the interest rate. (Assume no changes in the overall price level.) What would be the implications for the capital market, if sterilization were to be used along with expansionary monetary policies?

20. Consider a country with a fixed exchange rate regime and perfectly mobile capital. Presently, the country is experiencing unemployment. To deal with this unemployment problem the country’s policy makers are a devaluation of the country’s curency.  Demonstrate how a devaluation would affect this economy in terms of the level of output and employment as well as the interest rate, assuming no further devaluation will be expected. (Assume no changes in the overall price level.)

21. Consider a country with a fixed exchange rate regime and perfectly mobile capital. Presently, the country is experiencing unemployment. To deal with this unemployment problem the country’s policy makers are a devaluation of the country’s curency.  Demonstrate how a devaluation would affect this economy in terms of the level of output and employment as well as the interest rate, assuming the devaluation would result in expectations of further devaluations in the capital market. (Assume no changes in the overall price level.)

22. Consider a country with a fixed exchange rate regime with imperfect capital mobility. Presently, the country is experiencing unemployment. To deal with this unemployment problem the country’s policy makers are considering a mix of tax cuts and increased government expenditures. Demonstrate how such fiscal policies would affect this economy in terms of the output and employment level as well as the interest rate. (Assume no changes in the overall price level.)

23. Consider a country with a fixed exchange rate regime with imperfect capital mobility. Presently, the country is experiencing unemployment. To deal with this unemployment problem the country’s policy makers are considering a mix of tax cuts and increased government expenditures. Demonstrate how such fiscal policies would affect this economy in terms of the output and employment level as well as the interest rate. (Assume no changes in the overall price level.)

24. Consider a country with a fixed exchange rate regime with imperfect capital mobility. Presently, the country is experiencing unemployment. To deal with this unemployment problem the country’s policy makers are considering devaluation the country’s currency. Demonstrate how a devaluation would affect this economy in terms of the level of output and employment as well as the interest rate. (Assume no changes in the overall price level.)

25. Consider a country with a flexible exchange rate regime and perfectlyimmobile capital. Presently, the country is experiencing unemployment. To deal with its unemployment problem the country’s policy makers are considering a mix of tax cuts and increased government expenditures. Demonstrate how such fiscal policies would affect this economy in terms of the output and employment level as well as the interest rate and exchange rate. (Assume no changes in the overall price level.)

26. Consider a country with a flexible exchange rate regime and perfectly immobile capital. Presently, the country is experiencing unemployment. To deal with its unemployment problem the country’s policy makers are considering expansionary monetary policies. Demonstrate how such policies would affect this economy in terms of the output and employment level as well as the interest rate and exchange rate. (Assume no changes in the overall price level.)

27. Consider a country with a flexible exchange rate regime and perfectly mobile capital. Presently, the country is experiencing unemployment. To deal with its unemployment problem the country’s policy makers are considering a mix of temporary tax cuts and increased government expenditures. Demonstrate how such fiscal policies would affect this economy in terms of the output and employment level as well as the interest rate and exchange rate. (Assume no changes in the overall price level.)

28. Consider a country with a flexible exchange rate regime and perfectly mobile capital. Presently, the country is experiencing unemployment. To deal with its unemployment problem the country’s policy makers are considering a mix of permanent tax cuts and increased government expenditures. Demonstrate how such fiscal policies would affect this economy in terms of the output and employment level as well as the interest rate and exchange rate. (Assume no changes in the overall price level.)

29. Consider a country with a flexible exchange rate regime and perfectly mobile capital. Presently, the country is experiencing unemployment. To deal with its unemployment problem the country’s policy makers are considering expansionary monetary policies. Assuming that these policies are expected to be temporary, demonstrate how such policies would affect this economy in terms of the output and employment level as well as the interest rate and exchange rate. (Assume no changes in the overall price level.)

30. Consider a country with a flexible exchange rate regime and perfectly mobile capital. Presently, the country is experiencing unemployment. To deal with its unemployment problem the country’s policy makers are considering expansionary monetary policies. Assuming that these policies are expected to be permanent, demonstrate how such policies would affect this economy in terms of the output and employment level as well as the interest rate and exchange rate. (Assume no changes in the overall price level.)

31. Consider a country with a flexible exchange rate regime and imperfectly mobile capital. Presently, the country is experiencing unemployment. To deal with its unemployment problem the country’s policy makers are considering a mix of tax cuts and increased government expenditures. Demonstrate how such fiscal policies would affect this economy in terms of the output and employment level as well as the interest rate and exchange rate. (Assume no changes in the overall price level.)

32. Consider a country with a flexible exchange rate regime and imperfectly mobile capital. Presently, the country is experiencing unemployment. To deal with its unemployment problem the country’s policy makers are considering expansionary monetary policies. Demonstrate how such policies would affect this economy in terms of the output and employment level as well as the interest rate and exchange rate. (Assume no changes in the overall price level.)

An exercise:

1. Suppose both the market for goods and services and the money market are at equilibrium, and, at the same time, the economy is experiencing high unemployment and a balance payments deficit.
a. Draw a diagram to demonstrate this economic situation.
b. Assuming a flexible exchange rate regime, explain the process by which a balance of payment could be automatically restored.
c. How would these automatic adjustments affect the level of employment?
d. Could the same result be achieved through monetary policy?

Review Questions on the IS curve and Chapter 15

1. Explain the factors affecting the demand for money.
2. What constitutes the supply of money?
3. What are the main asset categories in the Fed’s balance sheet?
4. What is the “reserve requirement” ratio?
5. What do we mean by “excess reserve”?
6. How do commercial banks create money?
7. Explain the effect of an increase in the economy’s real output (income) on the interest rate.
8. Explain the instruments that the Fed uses to control the money supply?
9. Explain how the sale of government bonds by the Fed could affect the commercial banks’ balance sheet and, therefore, the money supply.
10. Explain how the purchase of foreign exchange by the Fed could affect the commercial banks’ balance sheet and, therefore, the money supply.
11. Suppose the Fed purchases \$100 million worth of bonds. Show the effect of this purchase on the balance sheet of the Fed and also on the consolidated balance sheet of commercial banks.
12. Suppose the Fed sells \$100 million worth f foreign exchange. Show the effect of this transaction on the Fed’s balance sheet and the consolidated balance sheet of commercial banks.
13. A commercial bank has \$50 million in excess reserve.
i. How much of this excess reserve can the bank lend out?
ii. Show the effect of this new loan (issued by this commercial bank) on its balance sheet and on the Fed’s balance sheet.
iii. What is the effect of this loan on the money supply?
iv. Would this loan affect the balance sheets of other commercial banks? Explain.
14. What is an IS curve?
15. What are the factors that cause the IS curve to shift to the right?
16. Determine the effect of each of the following on the IS curve:
i. The Federal Reserve buys bonds through Open Market Operations.
ii. An increase in exports resulting from the appreciation of Japanese yen.
iii. A reduction in the government expenditure.
17. Draw an IS cure. Pick a point to the right of it. In the context of the IS curve model explain the (possible) economic mechanism that would push the economy from that point toward the IS curve.
18. What is an LM curve?
19. What is the effect of each of the following on the LM curve?
i. An increase in exports due to economic growth in the EU countries
ii. The purchase of foreign exchange by the Fed
iii. An increase in the real income (output)
iv. The Fed sells bonds through Open Market Operations
v. An increase in the level of government expenditures
vi. A reduction in the domestic price level
vii. The depreciation of the domestic currency
20. What are some of the conditions that may lead to runs on a commercial bank?
21. How could a run on a bank spread to other banks?
22. What do we mean by equilibrium in the foreign exchange market?
23. What are the factors that affect the Current Account Balance (CAB)?
24. What are the factors that affect the Capital Account Balance (KAB)?
25. In a two-dimensional space with CAB measured vertically and KAB horizontally, draw a 45-degree line to show the BOP equilibrium. Then, pick an arbitrary point in the northeast quadrant of your diagram. Suppose that point indicates the position of the economy relative to the BOP equilibrium line. Explain the BOP position of the economy at that point.
26.  In a two-dimensional space with CAB measured vertically and KAB horizontally, draw a 45-degree line to show the BOP equilibrium. Then, pick an arbitrary point in the southwest quadrant of your diagram. Suppose that point indicates the position of the economy relative to the BOP equilibrium line. Explain the BOP position of the economy at that point.
27. In a two-dimensional space with CAB measured vertically and KAB horizontally, draw a 45-degree line to show the BOP equilibrium. Then, pick an arbitrary point in the northwest quadrant of your diagram. Suppose that point indicates the position of the economy relative to the BOP equilibrium line. Explain the BOP position of the economy at that point.
28. In a two-dimensional space with CAB measured vertically and KAB horizontally, draw a 45-degree line to show the BOP equilibrium. Then, pick an arbitrary point in the southeast quadrant of your diagram. Suppose that point indicates the position of the economy relative to the BOP equilibrium line. Explain the BOP position of the economy at that point.
29. What does the BOP curve reflect?
30. Explain the adjustment mechanism that links the real output level to the interest rate along the BOP curve.
31. Explain the factors that make the BOP curve shift to the right (down).
32. Explain the factors that make the BOP curve shift to the left (up).
33. Draw the IS and LM curve in the same interest rate and income space. What does the intersection point between the two curves indicate?
34. Draw the IS and LM curve in the same interest rate and income space. Then draw a BOP curve to the right of the LM curve. Explain the BOP position of the economy as indicated by your diagram.
35. Draw the IS and LM curve in the same interest rate and income space. Then draw a BOP curve to the left of the LM curve. Explain the BOP position of the economy as indicated by your diagram.
36. Explain for each of the cases described in questions 34 and 35 what kind of adjustments would bring the economy to a general equilibrium.

Consider a country that is experiencing unemployment and a balance of trade deficit.
It has been estimated that an increase of \$1,000.000 in the county's income will significantly improve its employment situation. The country’s MPC is .75 and its MPI is .15.

Suppose it has been decided to stimulate the economy through an increase in the government expenditure (G).

1. How much increase in the government expenditure do we need to increase the economy’s output by  \$1,000,000.
2. How does this increase in the government expenditure affect the country’s balance of trade? Try to be as specific as you can.

1. According to U.S. Census Bureau the U.S. trade deficit with China in 2001 was \$83 billion. China, however, claims that the U.S. trade statistics significantly overstate the its trade deficit with China. The case article on page 545 in your book addresses this issue. What are some of the possible explanations for this discrepancy?

2. United States has the largest external debt in the world. Often the US external debt to compared to those of developing countries. While large international debts can be a cause economic instability for developing countries the US's growing debt has not been much of a concern. Briefly explain why. See the case article on page 547.

Currency Options Exercises

1. You have purchased one block (62,500 units) of December put option on German marks at 1.40 cents per unit. The strike price on your option is 60.
a. On December 1, the spot rate on the German mark is \$.59/DM. Will you exercise your option? Explain.

b. Now suppose you have not exercised your option until the settlement day. On the settlement day the spot rate for the German mark is \$.61/DM. Will you exercise your option or will you let it expire? Explain. Determine your total profit (or loss) on the option.

c. Determine the spot rate at which you would have broken even.

2. You have purchased one block (62,500 units) of June call option on German marks at 1.40 cents per unit. The strike price on your option is 60.
a. On June 1, the spot rate on the German mark is \$.625/DM. Will you exercise your option? Explain.

b. Now suppose you have not exercised your option until the settlement day. On the settlement day the spot rate for the German mark is \$.61/DM. Will you exercise your option or will you let it expire? Explain. Determine your total profit (or loss) on the option.

c. Determine the spot rate at which you would have broken even.
========
1)a. Spot<Strike ; .59<.60 => Yes, you would; loss = (.60 -.59-.0140)62500= (\$250)
1)b. Spot>Strike; 61>50 => No, you would not; loss = .014(62500) = (\$875)
1)c. Break-even spot = strike - premium = .60 -.014 = \$.586/DM
2)a. Spot>Strike; .626>.60 => Yes, you would.
2)b. Spot>Strike; .61>.60 => Yes; loss = (spot- strike- premium)62500= (.61-.60-.014)62500= (250)
2)c. Break-even spot = strike + premium = .60 +.014 = \$.614/DM

A Balance of Payments Exercise

Show how each the following transactions is entered into the U.S. balance of payments and determine the effect of each on the following balances:

The Current Account Balance
The Capital Account Balance
The Official Accounts Balance

1. Exports of computer software : \$2000,000

Payment method: Cash \$1000,000
One-year credit : \$1000,000

2. Imports of beer: \$1000,000

Payment method: Cash \$200,000
18-month payables \$800,000

3. An American investor purchases an office building in Germany for \$500,000.
She pays \$100,000 cash and finances the balance buy acquiring a mortgage from a German bank.

4. The U.S. government pays Egypt \$4000,000 as part of its assistance package to that country. The payment is maid by a check on an American bank. The government of Egypt deposits the check in another American bank in New York in the name of the Central Bank of Egypt.

5. The Federal Reserve Bank (of New York) sells \$1000,000 worth of British pounds to sure up the dollar against this currency. The pounds are purchased by British individuals and commercial entities.

6.  A Japanese investor (stock holder) receives \$50,000 in dividend from IBM Corporation (of America). The payment is in the form of a check on Chase Manhattan Bank. The Japanese Investor deposits the check in her account at a branch of Citibank in New York.

7. An American executive flies to Paris on an Air France flight. His company pays for his first-class tickets by a check on Citibank. The price of the tickets is \$7,000.
==========

1. Imports:............debit 7,000
Capital-liquid liab................................credit 7,000
Balances affected:  balance of merchandise trade, balance of trade, the current account balance, Capital account balance

2. Exports:.................................................credit 2000,000
Capital:.....................debit 1000,000
Capital
Cash(liquid)claim......debit 1000,000
Balances affected:  balance of merchandise trade, balance of trade, the current account balance, capital account balance
3. .Imports:..................debit 1000,000
Capital:................................................credit 800,000
Capital cash liab...................................credit 200,000

Balances affected:  balance of merchandise trade, balance of trade, the current account balance, Capital account balance

3.Capital-direct investment: debit 500,000
Capital-cash liab:................................credit 100,000
Capital-loan........................................credit 400,000
Balances affected: balance of capital accounts

4.Unilateral transfers: debit 4,000,000
Official liabilities:..................................credit 4,000,000

Balances affected: Current account balance, Official Reserve Transaction Balance

5.Capital-cash liabilities....debit 1,000,000
Official reserves:..................................credit 1,000,000

Balances affected: Cash capital account, Official Reserve Transaction Balance

6. Import (Inv. ser.)...debit 50,000
Capital-liquid liab................................credit 50,000

Balances affected:  balance of trade, balance of trade, the current account balance, liquid capital account balance

Homework - September 27

The annual interest rate on government securities in the US is 4.5 percent. Similar investment instruments in Japan pay 2.5 percent. The spot exchage rate between Japanese yen and the US dollar is 120 yen per dollar, whereas the one-year forward rate between these two currencies is 112 yen per dollar.

a. Is the yen at a discount or a premium against the US dollar? Demonstrate.

b. Do you see an arbitrage opportunity between Japan and US? Explain.

c. If your answer to (b) is yes, how does one take advantage of this arbitrage oppotunity and in which direction will the funds flow?

d. Assuming that one could engage \$1000,000 in an arbitrage transaction, how much profit would he or she be able to make?

e. What are the impacts of arbitrage transactions on the US and Japanese currencies and interest rates?

Homework - Sep 20, 2006
Do the following three problems and hand them in on September 20.

1. Calculate all of the possible cross rates among the following exchange rates.

\$/Pound      \$1.80

\$/Euro         \$1.22

Yen/\$         125 yen

SF/\$           1.25 SF

\$/Krona      \$0.137

Euro/Pound    1.475 Euro

Yen/Euro       149.10 yen

2. The following are quotes on foreign exchange spot rates in New York and London. Determine if there are any arbitrage opportunities between these markets. If there are, demonstrate how one could take advantage of them. (Suppose the investor’s home currency is the dollar.)

New York
Dollar/Pound:  \$1.85
Yen/Dollar: Y122

London
Yen/Pound: Y 222
Euro/Pound: ( 1.50
Euro/Pound: (  0.82

3. Suppose the interest rate on one year treasury bills in the United States is 8 percent while the interest rate on similar risk-free securities in London is 7 percent. Today’s spot rate on the British pound in New York is \$1.85. Suppose an investor expects that in one year the pound will appreciate to \$2.00 per pound. With this expectation, in which securities will this investor invest her money? Demonstrate. Assume no transaction costs.

2. The following spot rates are quoted in New York and Tokyo:

New York

Yen/\$  exchange rate :   132 Yen
\$/Pound exchange rate:  \$1.80
\$/Euro:      \$1.28

Tokyo
Yen/Pound exchange rate:  241.5 Yen
Yen/Euro exchange rate:    172.6 Yen

Do you see any arbitrage opportunities between these markets? If you do, how can one take advantage of them?
Explain.

1. During the past 20 years the United States has steadily been running balance of trade deficits; it has been importing more than it has been exporting. How has the US been able to sustain such deficits for such a long time?

2. For both US and Canada it takes 8 units of labor to produce one metric ton of lumber. To produce corn, however, US uses 2 units of labor per ton Canada uses 4.

a. What is the relative price of lumber in Canada?
b. What is the relative price of lumber in US?
c. Which country has absolute advantage in corn and which in lumber?
d. Which country has comparative advantage in lumber?
e. Would US and Canada gain from trade in these two commodities?

A Supplementary Final Assignment
Due: Thursday, May 10, 2001
*********************
1.  Rockland is a small island nation that imports most of its needs, whereas its major source of external revenue is its export of oil. The country’s currency is “ rial”.  Rockland’s demand schedule for imported goods is a follows:
Price (Rials)         Quantity
100                        7500
120                        7000
140                         6500
160                         6000
180                         5500
200                         5000

a. Assuming that the dollar unit price of Rockland’s imports is \$10 --i.e., changes in the rial price of imports are the result of changes in the exchange rate— draw up the demand schedule of Rockland for dollars.

b. Presently the price of oil in the international market is \$20 per barrel and as a small supplier of oil, Rockland sells its entire output of crude on the open market. Its production capacity is about 3000 barrel a day, and Rockland generally produces to the capacity. Draw the country’s supply of dollar.

c. Presently Rockland’s central bank has fixed the exchange rate at 14 rials per dollar. What is the status of the current account balance of Rockland at this exchange rate?

d. If Rockland's central bank lets its currency float, will it depreciate or appreciate?

e. Now suppose Rockland enters into a bilateral agreement with a neighboring country, Agriland, to sell all of its oil to that country. In return, Rockland agrees to buy most of its imports from that country as long as their prices are in line with international prices. Rockland however does not have the option of selling its oil to other countries. It has agreed to sell all of its oil to Agriland, provided that it can charge whatever price it wants according to that country's market. Agriand's currency is dollar and its demand for oil is as follows:

\$P            Quantity (barrels)
24                2460
23                2480
22                2500
21                2520
20                2540
19               2560

At the exchange rate of 14 rials per dollar, to take advantage of its monoply power Rockland charges Agriland's residents 308 rials per barrel for its oil.  Determine the status of Rockland's current account (in rials)?

f. Assuming a fixed rial price for oil (308 rials), plot Rockland's supply of dollars.

g. In order to improve its current account should Rockland's central bank devaluate or revaluate (raise the value of) the country's currency (the rial)?

2. You are given the following national expenditure and income functions:

Y = C + I + G + X - M
Y = C + S + T

where  C = 200 + .75  Yd
Yd = Y - T
I = 40
G = 80
T = 60
X = 60
M = 20 + .15Y   (Note here that import is directly linked to income (Y) not disposable income, Yd)

a. Determine the equilibrium level of output for this economy.
b. What is the country's balance of trade?
c. Using an injection-leakage graph, show the country's balance of trade.
d. If you were to improve the country's balance of trade through fiscal policy, would you increase taxes, reduce taxes, increase government expenditures, or reduce government expenditures? Explain.
*****************************

Test Two
Part B
Take-home questions:

1. The interest rate on one-year US treasury bills is 7 percent. The interest rate on similar securities in UK is 5 percent, in Germany 7 percent and in Japan 2 percent. The spot rates on the currency of these countries are as follows:
Pound:    \$1.45/£                German Mark:  \$.45/GM             Yen:   \$.0085/Y

a.   Assuming no risk associated with investment in theses countries, determine the
expected spot rate of each currency  for a year from now.
b.   Now suppose US investors associate 1 percent risk (premium) with investments in the
UK, 2 percent with investments in Germany, and 5 percent with investment in Japan.
Assuming no transaction cost, determine the expected appreciation rate of each of
these currencies.
c.   If the financial markets are efficient what would be the forward premium for each
currency? (Assume covered interest arbitrage.)

2.   Suppose to tighten the money supply, through open market operations, the US Federal
Reserve sells some bonds in the market. Determine the effect of this policy on each of
the following:

a. Lending interest rate in NY
b. Deposit interest rate in NY
c. Lending interest rate on Eurodollar (London)
d. Interest rate on Euroollar deposits (London)
e. Lending rate (Pound) in London
f. Interest rate on pound deposit (London)
g. Lending interest rate on Eurosterling ( NY)
h. Interest rate on Eurosterling deposits (NY)
i. Spot rate on the pound (\$/£)
j. Forward rate on the pound (\$/£)

3. In the context of the portfolio approach to external balance, assuming a flexible exchange rate, outline the effects of an expansionary monetary policy (say, a purchase of securities by the monetary authorities) on the domestic money market, the domestic bond market, and the market for foreign bonds. Explain how adjustments in these three markets could lead to the reestablishment of equilibrium.

After (briefly) examining each of the following online articles choose one and study it more carefully. Write up a one-page report summarizing the article and reflecting your views.

1. You have purchased one block (125,000 units) of June putoption on the German mark at 1.40 cents per unit. The strike price on your option is \$.60

a. On May 15, the spot rate on the German mark is \$.59/DM. Will you exercise your option? Explain.
b. Now suppose you have not exercised your option until the settlement day. On the settlement day the spot rate for the German mark is \$.57/DM. Will you exercise your option or will you let it expire? Explain. Determine your total profit (or loss) on the option.
c. Determine the spot rate at which you would have broken even.
d. What is the spot rate at which the seller of the option would break even?

2. You have purchased one block (62,500 units) of June call option on the British pound at 1.50 cents per unit. The strike price on your option is \$1.45.

a. On May 15, the spot rate on the German mark is \$.1.46/Pound. Will you exercise your option? Explain.
b. Now suppose you have not exercised your option until the settlement day. On the settlement day the spot rate for the British pound is \$1.475. Will you exercise your option or will you let it expire? Explain. Determine your total profit (or loss) on the option.
c. Determine the spot rate at which you would have broken even.
d. What is the spot rate at which the seller of the option would break even?

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Spot arbitrage practice:

Determine if there is a spot arbitrage oppotunity amoung each of the follwing two sets of spot rates. Next, show how an investor can take advatage of it, if there is one. Assume that the dollar is your home currency.

a.  \$/Pound   =    \$1.65
\$/DM      =    \$.554
DM/Pound  =  DM 3
1.To determine whether or not there an arbitrage opportunity cross two of the rates and compare the cross rate with the third rate. In this case let us cross \$/DM and DM/Pound. That will give us cross \$/Pound:  3 x .554  =  \$1.662/Pound

2. The cross rate \$1.662 is greater than the third rate. That tells us that there is an arbitrage oppotunity.

3. We will do our calculation for one dollar. Convert your dollar to pound: 1/1.65 = .6060 pound.

4. Convert the pound to DM:  .6060 x 3 =  1.8181 DM

5. Convert the DM to dollar:  1.8181 x .554 =  1.0072

This mean that you have made \$.0072 on each dollar that you engaged in this arbritrage transaction.
If you engaged \$1,000,000., you would make \$7,200 on the spot.
====================
b. Yen/DM = 65 DM
\$/DM    =  \$.554
Yen/\$    =   120 Yen
1.To determine whether or not there an arbitrage opportunity cross two of the rates and compare the cross rate with the third rate. In this case let us cross \$/DM and Yen/\$. That will give us cross Yen/DM: 120 x .554  =  66.48 Yen

2. The cross rate 66.48 Yen is greater than the third rate, 65 Yen/DM. That tells us that there is an arbitrage oppotunity.

3. We will do our calculation for one dollar. Convert your dollar to Yen: 1 X 120 = 120 Yen.

4. Convert the Yen to DM:  120/65  =  1.84615 DM

5. Convert the DM to dollar:  1.84615  x .554 =  1.022

This mean that you have made \$.022 on each dollar that you engaged in this arbritrage transaction.
If you engaged \$1,000,000., you would make \$22,000 on the spot.

The table on this page contains information about the sizes of US trade with its top trding partners. You can obtain the historical exchage rates of the currencies of these countries from this site. For current exchage rates you can use either the Wall Street Journal or the Internet resources. (Check  the Web sites listed on our link page.) Calculate the (nominal) effective exchage rate of the US dollar agaist the currencies of these counties. Use 1990 (January) as your base year.

1. How do you expect each of the following conditions to affect the exchange rate between the U.S. dollar and the Japanese yen?

· A recession in Japan
· The U.S. has lowered its import tariffs on all auto parts.
· The U.S. Federal Reserve raises the discount rate
· Inflation in Japan
· A recession in the U.S.
· A reduction in the amount of trade between Japan and European Union
· An increase in the price of crude oil
· The U.S. stock markets going into a “bear” mood

2. Find all of the possible cross rates among the following exchange rates.

\$/Pound      \$1.65

\$/DM         \$.554

Yen/\$         120 yen

FF/\$           5.75 FF

\$/Guilder      \$.45

DM/Pound     3 DM

Yen/DM        65 yen

Identify the possible arbitrage opportunities and demonstrate how one can take advantage of each.

3. Calculate the premium or discount rate for the following forward rates:

British pound spot: \$1.620

Forward
30-day       1.610
60-day       1.625
90-day       1.635

German mark spot: \$ .62
Forward
30-day        .610
60-day        .635
90-day        .645

Japanese yen spot: 120 yen/\$
Forward
30-day        119
60-day        122
90-day        123
180-day       125

Your given the following (spot) exchange rates in three different markets: New York, London and Paris. Do you see any arbitrage opportunities in these markets? If you do, how could you take advantage of them. Explain how you go about identifying arbitrage opportunities.

New York: Home currency   U.S. \$

Japanese yen                 105.26 Y/\$                  101.01 Y/\$

British pound               1.6390 \$/Pound           1.660 \$/Pound

German mark               .5053 \$/GM                .5250 \$/GM

French franc                 .1507 \$/FF                  .1690 \$/FF

London: Home Currency     British Pound

U.S. \$                             1.65 \$/Pound             1.640 \$/Pound

Japanese yen                 172.20 Y/Pound          170.0 Y/Pound

German mark                 3.211 GM/Pound         3.05 GM/Pound

French franc                  10.878 FF/Pound        10.25 GM/Pound

Paris: Home Currency       French Franc

U.S. \$                              6.640 FF/\$                        6.660 FF/\$

British pound                   10.24 FF/Pound                        10.37 FF/Pound

Japanese yen                   15.90 Y/FF                       15.3 Y/FF

German mark                   3.35 FF/GM 3.39 FF/GM

Homework Assignment

Use the information in the Table 1 of the Survey of Current Business to answer the following questions.
1. Show how the "current account balance" is calculated.
2. The total income US residents received from their investments abroad was \$276 billion, while foreign investors received
\$294.6 billion from their investments in the US. What does this statement indicate?
3. The total income US residents received from their direct investments abroad was \$118.8 billion, while foreign investors
received \$56 billion from their direct investments in the US. What does this statement indicate?
4. Try to calculate the US Official Reserve Transaction Balance (ORB) from the information in the table.

1. As it is shown in the Survey of Current Business table, the U.S. current account in 1999 was \$-311,479 billion. Explain what that indicates.

2. Compare and interpret the different trade balances (e.g., trade on goods) of the U.S. in 1999.

3. Explain the changes in the U.S. official accounts in 1999. What do these changes indicate?

4. Try to sort and categorize the 1999 U.S. capital/financial transactions into the following groups

Direct private investments
All non-official  private (non-government) securities/claims
All government (but not official) holdings
All official holdings (including SDRs)
All private cash holdings
5. Demonstrate how the currant account transactions (balance) were balanced in the U.S. balance of payments in 1999.

An Assignment

A balance-of-payments exercise:

Note: Review the entry examples in the textbook before attempting to do this exercise.

Show how the following transactions are entered into the U.S. balance of payments and determine their effects on the following balances:

•     The Current Account Balance
•     The Basic Balance
•     The Official Reserve Transaction Balance  (ORTB)

1.Exports of computer software : \$200,000

Payment method: Cash \$100,000
6-month draft : \$100,000

2.Imports of beer: \$100,000

Payment method: Cash \$20,000
3-month payables \$80,000

3. An American investor purchases an office building in Germany for \$500,000.
She pays \$100,000 cash and finances the balance by acquiring a mortgage from a German bank.

4. The U.S. government pays Egypt \$400,000 as part of its assistance package to that country. The payment is maid by a check on an American bank. The government of Egypt deposits the check in another American bank in New York in the name of the Central Bank of Egypt.

5. The Federal Reserve Bank (of New York) sells \$1000,000 worth of British pound to sure up the dollar against this currency.

6.  A Japanese investor (stock holder) receives \$50,000 in dividend from IBM Corporation (of America). The payment is in the form of a check on Chase Manhattan Bank. The Japanese Investor deposits the check in her account at a branch of Citibank in New York.

7. An American executive flies to Paris on an Air France flight. His company pays for his ticket (\$4,000) by a check on Citibank. The check is deposited in Air France's account at Bank of America.

HERE IS A LINK TO THE IMF PAGE LISTING SOME OF THE RECENT SPEECHES ON INTERNATIONAL ECONOMIC/FINANCIAL ISSUES.  IMF SPEECHES

ONE ARTICLE I RECOMMEND YOU READ IS  STANLEY FISCHER'S  SPEECH.

Review Questions

A Look at the US Balance of Payments

Study Questions for the Final

1. Suppose the U.S. trade balance is showing a deficit of \$40; that is, Export - Import = -40.

Where \$Price of export = \$100

Pound price of import = 25 (Pounds)

Quantity of export = 200

Quantity of import = 300

a. Determine the exchange rate.

b. Now assuming that the (price) elasticity of demand for import is -.8 and the price elasticity of export is -.06, determine the effect of a 10 percent rise in the exchange rate ( devaluation of US\$ ) on the US balance of payment.

2. Discuss the effect of a devaluation (of the US dollar) on the US balance of payment under each of the following conditions.

a. Demand for imports is inelastic; demand for exports is elastic

b. Demand for imports is elastic; demand for exports is elastic

c. Demand for imports is elastic; demand for exports is inelastic

d. Demand for exports is inelastic; demand for imports is inelastic

e. Both demand for exports and demand for imports are initially inelastic ( in the short run), but gradually both demands become elastic

3. According to the "absorption" model Y - A = X - M . Discuss the effects of devaluation on the balance of payment,

a. assuming the economy is at full employment.

b. assuming the economy is having significant unemployment.

3. Discuss the effects of devaluation on GDP and the price level (inflation ) in the context of the "monetary approach to the balance of payments."

4. Assuming a float exchange rate system, discuss the effects of an expansionary monetary policy on the economy and the exchange rate.

5. What do we mean by overshooting exchange rate?

6. Carefully explain and derive the IS, LM and BP curves.

7. What do we mean by external and internal balance. Use the IS and LM and BP curves in your analysis.

8. A country with a fixed (pegged) exchange rate is experiencing an external deficit (balance of payments deficit). What are the policy options for this country and what are their implications. Use the IS, LM curves in your analysis.

9. What monetary policy should central banks follow under a fixed exchange rate system?

10. What monetary policy should central banks follow under a floating exchange rate system?

1. The following table contains probable returns on four investment instruments. The probabilities of all returns are the same.

 Investment  A Investment B Investment C Investment D .02 .04 .11 .08 .05 .03 .08 .07 .10 .07 .09 .06 .08 .08 .03 .06 .11 .09 .04 .09

Variance-Covariance Matrix

Invstmt A          Invstmnt B          Invstmnt C             Invstmnt D
Invstmt A          0.00137
Invstmnt B        0.00082             0.00067
Invstmnt C       -0.0008             -0.00065             0.00115
Invstmnt D       -3E-05                 2E-05              1.0842E-19             0.00017

a. Determine the the expected return of each investment.
b. Which investment is the riskiest? Explain.
c. If you were to make a portfolio equally divided between two assets which two assets would you choose? Explain.
d. Suppose you have been advised to put 60 percent of your money in the least risky investment and the other 40 percent in another. Which two assets will you choose? Will this reduce your risk? Explain. What is the expected return of your portfolio?

2. Suppose the spot rate for the German mark is \$.60 and its one-year forward rate is \$.62. Also suppose the interest rate in the U.S. is 10 percent.

a. If the interest parity were to hold, what would be the interest rate in Germany?

b. If the expected spot rate of the German mark (a year from now) is \$.64, what is the risk premium on this currency?

c. What would the expected return from investing in Germany (without hedging)?

3. The price of a basket of good and services in the U.S. is \$100. The same basket of goods and services in the U.K. is 60 pounds.

a. According to the purchasing power parity theory, what should be the exchange rate between the dollar and the pound?

b. If the inflation rate in the US is 5 percent and the inflation rate in the UK is 8 percent, what would be the future exchange rate if the purchasing power parity were to hold?

Problem Sets on Exchange Rate Determination

1.Assume the six-month forward exchange rate on the Canadian dollar is \$.65. The spot rate on this currency is \$.63.

a) Assuming that the (annual) interest rate in Canada is 10 percent and in the U.S. it is 9 percent, is there interest parity between these two countries? Explain. If interest parity does not exist, what will happen?

b) Assuming that the (annual) interest rate in the U.S. is 12 percent, what should be the Canadian interest rate for interest parity to prevail?

c) Now assume that the spot rate for the Canadian dollar is \$.63. If the (annual) interest rate in the U.S. is 10 percent and in Canada it is 13 percent, what should be the six-month forward rate for the Canadian dollar for interest parity to prevail?

2. The 90-day forward rate for the Canadian dollar is .\$67 (or C\$1.4925 per US\$) which puts it at a discount of 4 percent against the US dollar.

a. Determine the spot rate for the Canadian dollar.

b. Now assume that the interest rate on 90-day certificates of deposit in Canada is 11 per cent whereas in the US the interest rate on similar certificates is 5 percent. Suppose you could borrow up to \$5,000,000 for 90 days at 6 percent in the US. Also assume you could borrow the same amount in Canada for the same period at 12 percent. Do you see any interest arbitrage opportunity here? If yes, how would you take advantage of it without any risk? Clearly demonstrate.

3. The spot rate for the British pound ( in the U.S.) is \$1.65 . The U.S. interest rate on 180-day deposits is 6 percent. The British interest rate on similar deposits is 9 percent.

A. Assuming interest parity between the two countries, determine the 180 day forward exchange rate of the British pound.

B. Now suppose the spot rate has dropped to 1.62 while the interest rates and  forward rate have remained the same ( as you calculated in part A).   How do you expect the market to react to this change in the spot rate?

C. Assuming free flow of capital between the U.S. and the U.K., what kind of changes do you expect to see and how will interest parity between these two countries be restored?

1. Crossing Exchange Rates

Determine all possible cross rates between the following exchange rates

\$/GM               .554

Y/\$                  109.5

FF/\$                 6.55

GM/\$               1.950

\$/BP                 1.666

\$/SF                   .555

GM/BP              3.30

Y/BP                 183.5

Y/GM                57.60

2. An Arbitrage Exercise

You are given the following (spot) exchange rates in three different markets: New York, London and Paris. Do you see any arbitrage opportunities in these markets? If you do, how could you take advantage of them. Explain how you go about identifying arbitrage opportunities.

New York: Home currency   U.S. \$

Japanese yen          105.26 Y/\$                101.01 Y/\$

British pound          1.6390 \$/Pound         1.660 \$/Pound

German mark          .5053 \$/GM               .5250 \$/GM

French franc            .1507 \$/FF                .1690 \$/FF

London: Home Currency     British Pound

U.S. \$                   1.65 \$/Pound                  1.640 \$/Pound

Japanese yen         172.20 Y/Pound             170.0 Y/Pound

German mark          3.211 GM/Pound          3.05 GM/Pound

French franc           10.878 FF/Pound         10.25 GM/Pound

Paris: Home Currency       French Franc

U.S. \$                  6.640 FF/\$                     6.660 FF/\$

British pound      10.24 FF/\$                      10.37 FF/\$

Japanese yen      15.90 Y/FF                     15.3 Y/FF

German mark       3.35 FF/GM                   3.39 FF/GM

Answers:  a)   .072, .062,  .07,  .072
b)  A
c) B & C
d) B & D   ,   .068  (Note: The expected return on the previous portfolio was .071)

2: a. .0666; b. -.0333; c .1332

3: a. 1.666; b. 1.6203

Homework Assignment - Oct 28
Consider an open economy in which:

C = 200 + 0.8 Yd
Yd = Y –  T
T = 100
I =  1200 - 5000 i
i = .08
G = 250
X = 150
M = 50 +0. 2Yd

a. Determine the (equilibrium) income of this economy.
b. What is the current account balance of the economy?
c. Now suppose as a result of tighter monetary policy by the country’s monetary authority the interest rate increases to 10 percent (0.10). What is the impact of this policy on the countries income level?
d. Determine the effect of the increase in the interest rate (as mentioned above) on the country’s current account balance.
e. Keeping the interest rate at 10 percent, suppose government increases the tax to 150. Determine the effect of this tax increase on country’s income and current account balance.
f. Next,  keeping the interest rate at 0.10 and tax at 150, suppose as a result of depreciation of the country’s currency the country’s exports increase to 220 and its imports change to: M = 25 + 0.2Yd . Determine the effect of the devaluation on the country’s income and current account balance.