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Chapter
11.Thebalanceonmerchandisetradeisthedifferencebetweenexportsofgoods719andtheimportsofgoods1145foradeficitof
426.Thebalanceongoodsservicesandincomeis719+279+284–1145-210–269foradeficitof
342.Addingunilateraltransferstothisgivesacurrentaccountdeficitof391[-342+-49=-391].Notethatincomereceiptsarecreditsandincomepaymentsaredebits.
2.Becausethecurrentaccountbalanceisadeficitof391thenwithoutastatisticaldiscrepancythecapitalaccountisasurplusof
391.Inthisproblemhoweverthestatisticaldiscrepancyisrecordedasapositiveamountcreditof
11.Hencethesumofthedebitsinthebalanceofpaymentsmustexceedthecreditsby
11.Sothedeficitofthecurrentaccountmustbegreaterthanthesurplusonthecapitalaccountby
11.Thecapitalaccountthereforeisasurplusof391–11=
380.
3.Abalance-of-paymentsequilibriumiswhenthedebitsandcreditsinthecurrentaccountandtheprivatecapitalaccountsumtozero.Intheproblemabovewedonotknowtheprivatecapitalaccountbalance.Wecannotsaythereforewhetherthiscountryisexperiencingabalance-of-paymentssurplusordeficitorifitisinequilibrium.4Thecurrentaccountisadeficitof$541830andtheprivatecapitalaccountbalanceisasurplusof$
369068.TheU.S.thereforehasabalanceofpaymentsdeficit.5Positiveaspectsofbeinganetdebtorincludethepossibilityoffinancingdomesticinvestmentthatisnotpossiblethroughdomesticsavings;therebyallowingfordomesticcapitalstockgrowthwhichmayallowjobproductivityandincomegrowth.Negativeaspectsincludethefactthatforeignsavingsmaybeusedtofinancedomesticconsumptionratherthandomesticsavings;whichwillcompromisethegrowthsuggestedabove.Positiveaspectsofbeinganetcreditorincludetheownershipofforeignassetswhichcanrepresentanincomeflowstothecreditingcountry.Furtherthenetcreditorpositionalsoimpliesanetexportingposition.Anegativeaspectofbeinganetcreditorincludesthefactthatforeigninvestmentmaysubstitutefordomesticinvestment.6Anationmaydesiretoreceivebothportfolioanddirectinvestmentduetothetypeofinvestmenteachrepresents.Portfolioinvestmentisafinancialinvestmentwhiledirectinvestmentisdominatedbythepurchaseofactualrealproductiveassets.Totheextentthatacountrycanbenefitbyeachtypeofinvestmentitwilldesirebothtypesofinvestment.Furtherportfolioinvestmenttendstobeshort-runinnaturewhileFDItendstobelong-runinnature.ThisisalsoaddressedinmuchgreaterdetailinChapter
7.
7.DomesticSavings-DomesticInvestment=CurrentAccountBalanceDomesticSavings-DomesticInvestment=NetCapitalFlowsThereforeCurrentAccountBalance=NetCapitalFlows8Usingtheequationsaboveprivatesavingsof5percentofincomegovernmentsavingsof-1percentandinvestmentexpendituresof10percentwouldresultsinacurrentaccountdeficitof6percentofincomeandacapitalaccountsurplusnetcapitalinflowsof6percentofincome.Thiscouldbecorrectedwithareductioninthegovernmentdeficittoasurplusand/oranincreaseinprivatesavings.Chapter
21.Becauseitcostsfewerdollarstopurchaseaeuroaftertheexchangeratechangetheeurodepreciatedrelativetothedollar.Therateofdepreciationinabsolutevaluewas[
1.2168–
1.2201/
1.2201]100=
0.27percent.
2.NotethattheratesprovidedaretheforeigncurrencypricesoftheU.S.dollar.Everyvaluehasbeenroundedtotwodecimalplaceswhichmaycausesomedifferencesinanswers.A$£C$Sfr$Australia-
2.
351.
061.
121.53Britain
0.42-
0.
450.
470.65Canada
0.
952.23-
1.
061.45Switzerland
0.
902.
110.94-
1.37UnitedStates
0.
651.
540.
690.73-3Thecrossrateis
1.702/
1.234=
1.379€/£whichissmallerinvaluethanthatobservedintheLondonmarket.Thearbitrageurwouldpurchase£587544$1000000/
1.702withthe$1millionintheNewYorkmarket.Nexttheywouldusethe£587544inLondontopurchase€837250£587544*
1.
425.Finallytheywouldsellthe€837250intheNewYorkmarketfor$1033167€837250*
1.
234.Theprofitis#
33167.
4.Totaltradeis163681+160829+261180+210590=
796280.TradewiththeEuroareais163681+261180=
424861.TradewithCanadais160829+210590=
371419.Theweightassignedtotheeurois424861/796280=
0.53andtheweightassignedtotheCanadiandollaris
0.
47.Recalltheweightsmustsumtounity.Becausethebaseyearis2003the2003EERis
100.Thevalueofthe2004EERis:[
0.82/
0.88•
0.53+
1.56/
1.59•
0.47]•100=
0.4939+
0.4611•100=
95.4964or
95.
5.Thisrepresentsa
4.5percentdepreciationoftheU.S.dollar.5TherealeffectiveexchangerateREERfor2003isstill
100.Therealratesofexchangearefor
20030.88•
116.2/
111.3=.
91871.59•
116.2/
111.7=
1.6541andfor
20040.82•
119.0/
114.4=
0.
85301.56•
119.0/
115.6=
1.
6059.Thevalueofthe2004REERis:[
0.8530/
0.9187•
0.53+
1.6059/
1.6541•
0.47]•100=
0.4921+
0.4563•100=
94.84or
94.
8.Thisrepresentsa
5.2percentdepreciationoftheU.S.dollarinrealterms
6.ThisisanominalappreciationoftheeurorelativetotheU.S.dollar.Thepercentchangeis[
1.19–
1.05/
1.05]•100=
13.3percent.
7.TheJanuary200realexchangerateis
1.05•
107.5/
112.7=
1.
0016.TheMay2004realrateis
1.19•
116.4/
122.2=
1.
1335.8InrealtermstheeuroappreciatedrelativetotheU.S.dollar.Therateofappreciationis[
1.1335–
1.0016/
1.0016]*100=
13.17percent.9AbsolutePPPsuggeststheMay2004exchangerateshouldbe
122.2/
116.4=
1.
0498.Theactualexchangerateis
1.
19.HencetheeuroisovervaluedrelativetotheU.S.dollarby
1.19–
1.0498/
1.0498]•100=
13.35percent.10RelativePPPcanbeusedtocalculateapredictedvalueoftheexchangerateas:SPPP=
1.05•[
122.2/
112.7/
116.4/
107.5]=
1.
0014.
11.Theactualexchangerateis
1.
19.HencetheeuroisovervaluedrelativetotheU.S.dollarby
1.19–
1.0014/
1.0014]•100=
18.83percent.Chapter
31.Rankingthevariousexchangeratearrangementsbyflexibilityisnotsoclearcut.Nonethelessthearrangementsdescribedinthischapterarefromfixedtoflexible:dollarizationcurrencyboardcommoditystandardpegdollarstandardpegcurrencybasketpegcrawlingpegmanagedfloatflexible.
2.ThetwoprimaryfunctionsoftheInternationalMonetaryFundare:surveillanceofmembernationsmacroeconomicpoliciesandtoprovideliquiditytomembernationsexperiencingpaymentsimbalances.
3.ThevalueoftheCanadiandollarrelativetogoldisCAN$
691.38•$50andthevalueoftheBritishpoundrelativetogoldis£
33.33$50/
1.
50.
4.TheexchangeratebetweentheCanadiandollarandtheBritishpoundisC$/£
2.
071.38•
1.
50.
5.Thecurrencyvalueofthepesocanbeexpressedas$
0.50+€.50=P
1.Theexchangeratebetweenthedollarandtheeurocanbeusedtoconverttheeuroamounttoitsdollarequivalentof$
0.
55.Hence$
1.05=P1orandexchangevalueof
0.952P/$.Usingtheexchangeratebetweenthedollarandtheeuroagaintheexchangeratebetweenthepesoandtheeurois
0.
1.048P/€
0.952P/$•
1.10$/€.
6.Because$
1.05isthecurrencycontentofthebasketasshownaboveand$
0.50ofthatcontentisattributabletothedollartheweightassignedtothedollaris
0.50/
1.05=
0.476or
47.6percent.Becausetheweightsmustsumtounitytheweightassignedtotheeurois
52.4percent.
7.ThemaindifferencebetweenthetwosystemswasthatintheSmithsoniansystemthedollarwasnotpeggedtothevalueofgold.OnereasonthatthesystemwasshortwasbecausetherewaslittleconfidencethatU.S.economicpolicywouldbeconductedinamannerconducivetoasystemofpeggedexchangerates.
8.Theprincipleresponsibilitiesofacurrencyboardaretoissuedomesticcurrencynotesandpegthevalueofthedomesticcurrency.Acurrencyboardisnotallowedtopurchasedomesticdebtactasalenderoflastresortorsetreserverequirements.
9.TheLourveaccordestablishedunofficiallimitsoncurrencyvaluemovements.Inasenseitwaspegwithbandsforeachofthemaincurrenciesdollaryenandmark.
10.Differencesinthefundamentaldeterminantsofcurrencyvaluesbetweenthepeggingcountryandtheothercountryshouldbeconsidered.Tothispointofthetexttherateofinflationisagoodexample.RelativePPPcanbeusedtodeterminetherateofcrawl.
11.Underacurrencyboardsystemanationstillmaintainsitsdomesticcurrency.Hencepolicymakerscanchangeexchangeratepoliciesandmonetarypoliciesiftheysodesire.Whenanationdollarizesanddisposesofitsdomesticcurrencyitnolongerhasthisoption.Chapter
41.Giventhattheexchangerateisexpressedasdollarstoeuroswetreatthedollarasthedomesticcurrency.Notealsothatinterestratesarequotedonanannualbasiseventhoughthematurityperiodisonlyonemonth.Inthisproblemwedividetheinterestratesby12toputthemonaone-monthbasis.a.Theinterestratedifferentialthereforeis
1.75%/12-
3.25%/12=-
0.125%.Theforwardpremium/discountexpressedasapercentageiscalculatedas:F-S/S•100=
1.089–
1.072/
1.072•100=
1.5858%b.Transactioncostsareshowninthefigureabovebythedashedlinesthatinterestthehorizontalaxisatvaluesof-
1.00and
1.
00.c.Thepositivevalueindicatesthattheeuroissellingatapremium.Inadditiontheinterestratedifferentialfavorstheeuro-denominatedinstrument.Henceasavershiftfundstoeuro-denominatedinstruments.
2.Usingtheprovidedinformation:
1.75/12–
3.25/12[
1.089-
1.072/
1.072]•100-
0.125%
1.5858%.
3.Thefourmarketsaregraphedbelow.Anexplanationfollows.Graph1thespotmarketfortheeuro.Graph2theforwardmarketfortheeuro.Graph4U.S.loanablefundsGraph5EuroloanablefundsIngraph1thedemandfortheeurorisesasinternationalsaversshiftfundsintoeuro-denominatedinstruments.Ingraph2thesupplyofeurosincreasesintheforwardmarket.ConsideraU.S.saverthatmovesfundsintoaeuro-denominatedinstrument.Theywoulddesiretoselltheeuroforwardsotheymayconverteuro-denominatedproceedsatthetimeofmaturityintotheirdollarequivalent.Graph3illustratesadecreaseinloanablefundsintheUnitedStatesassaversshiftfundstoeuro-denominatedinstruments.Graph4illustratestheincreaseinthesupplyofloanablefundsthatoccurswhensaversshiftfundstotheeuro-denominatedinstrument.
4.Because
1.
031251.
042501.4575/
1.5245=
0.9967anarbitrageopportunityexistsinthisexampleifoneweretoborrowthepoundandlendtheeuro.Supposeyouweretoborrowonepoundthestepsarethen:a.Borrow£1convertto€
1.5245onthespotmarket.b.Lendeurosyielding€
1.5245•
1.03125=€
1.
5721.c.Seeeurosforwardyielding€
1.5721/
1.4575=£
1.
0787.d.Repaythepoundloanat£1•
1.04250=£
1.
04250.e.Theprofitis£
0.0362or
3.62percent.
5.Becauseinterestratesarequotedasannualizedratesweneedtodivideeachinterestrateby412/
3.Theuncoveredinterestparityequationis:R-R*=Se+1-S/Sa.Rewritingtheequationfortheexpectedfutureexpectedexchangerateyields:Se+1=[R-R*+1]Sb.UsingthevaluesgivenyieldstheexpectedfuturespotrateSe+1=[
0.0124/4-
0.0366/4+1]•
1.5245=
1.
5153.
6.Giventhisinformationwecancalculatetheforwardpremium/discountwiththeUIPcondition:F-S/S=R-R*Theinterestdifferentialis
1.75%-
3.25%=
1.5%.Thisistheexpectedforwardpremiumontheeuro.HenceF–
1.08/
1.08=
0.015impliesthatF=
1.
0962.
7.Wecanadjustfortheshortermaturitybydividingtheinterestratesby212/
6.Nowtheinterestdifferentialis
0.75%stillaforwardpremiumontheeuro.TheforwardratenowisF–
1.08/
1.08=
0.0075impliesthatF=
1.
0881.
8.TheU.S.realrateis
1.24%–
2.1%=-
0.86%andtheCanadianrealrateis
2.15%–
2.6%=-
0.45%.Ignoringtransactioncostsbecausetherealinterestratesarenotequalrealinterestparitydoesnothold.
9.UncoveredinterestparityisR-R*=Se+1-S/S+ρ.a.Usingthesameprocessasinquestion5abovetheexpectedfuturespotrateis:Se+1=[R-R*+1]SSe+1=[
0.075-
0.035+1]•
30.35=
31.
564.b.Usingthesameprocessasinquestion5abovetheexpectedfuturespotrateis:Se+1=[R-R*+1-ρ]SSe+1=[
0.075-
0.035+1–
0.02]•
30.35=
30.
957.
10.Becausetheforwardrate
30.01islessthantheexpectedfuturespotrate
30.957youshouldsellthekorunaforward.Forexample$1wouldpurcasek
30.957whichyoucouldsellforwardyieldingk
30.957/
30.01=$
1.
0316.
11.Internationalfinancialinstruments:a.GlobalBond:longterminstrumentsissuedinthedomesticcurrency.b.Eurobond:termislongerthanoneyearandisissuedinaforeigncurrency.c.Eurocurrency:keywordisthatitisadeposit.d.Globalequity:keywordisthatitisashare.Chapter
51.Giventhat:PB=C/1+R+C/1+R2+C/1+R3+C/1+R4+...;multiplyeachsideby1+R:PB1+R=C+C/1+R+C/1+R2+...;andsubtractPBfromeachside:PB1+R-PB=[C+C/1+R+C/1+R2+...]-[C/1+R+C/1+R2+...];Simplifying:PB*R=C.ThereforePB=C/R.
2.Inthissituationannualyieldsdeclineasthetermtomaturityincreaseswhichmeansthattheyieldcurveslopesdownward.Accordingtotheexpectationstheoryofthetermstructureofinterestratesthissituationarisesbecausebond-markettradersanticipatesthatshort-terminterestrateswillfallsharply.Thusanaverageofcurrentandfutureshort-termrateswhichwhenaddedtoanytermpremiumapplicabletoalongermaturityislowerthanthecurrentshort-termrate.
3.YestheexcessreturnontheGermangovernmentbondequals
3.5percent–5percent–3percent=
1.5percent.
4.ParityConditions:a.UsinguncoveredinterestparityR-R*=S+1e-S/S.Becausetheleft-hand-sideisnegativewewouldexpecttheright-handsidetobenegativeindicatingadomesticcurrencyappreciation.b.UsingrelativePPP-*=%S.Becausetheleft-hand-sideisnegativewewouldexpecttheright-handsidetobenegativeindicatingadomesticcurrencyappreciation.
5.Thedomesticrealinterestrateis5percentless2percentor3percent.Theforeignrealinterestrateis6percentless4percentor2percent.Realinterestratesarenotequalsotherealinterestparityconditiondoesnothold.Wewouldexpectfundstoflowintothedomesticcountryandoutoftheforeigncountrywhichwoulddrivethedomesticrealinterestratedownandtheforeignrealinterestrateup.
6.Incontrasttoforwardcurrencycontractscurrencyfuturesrequiredeliveryofstandardquantitiesofcurrencies.Inadditionholdersofcurrencyfuturesexperienceprofitsoflossesonthecontractsduringtheentireperiodbeforethecontractsexpirewhereasprofitsorlossesoccuronlyattheexpirationdateofaforwardcurrencycontract.
7.Acurrencyfuturealreadyisaderivativebecauseitsvaluevarieswiththeexchangerate.Thevalueofacurrencyfuturesoptioninturndependsontheunderlyingvalueofacurrencyfuturescontractsoitsvalueisderivedfromthefuturesderivative.Inthiswayacurrencyfuturesoptionisaderivativeofaderivative.
8.a.Thecompanyowes500000SfrandisconcernedaboutthefuturespotexchangevalueoftheU.S.dollar-Swissfranc.Itcanthereforepurchasefuturecontractstosetalimittoitspotentialexchangeratelosses.b.TheSfrispurchasedin125000francincrements.Thereforethefirmwouldwanttopurchase500000/125000=4futurescontracts.Giventheinitialmarginonafranccontractthetotalinitialmarginthefirmestablishesis:4$1688=$
6752.Thedailymarginchangesareasfollows:First:
0.6252-
0.62511250004=+$
50.Thereforeitsmarginequals$
6802.Second:
0.6127-
0.62521250004=-$
6250.Thereforethemarginwouldfallto$
552.Howeverthemaintenancemarginisequalto$
1250.Thusthemarginwillequal$
1250.Third:
0.6115-
0.61271250004=-$
600.Againthemarginmustremainat$
1250.Fourth:
0.6806-
0.61151250004=-$
1450.Againthisdailychangewouldfallbeneaththemaintenancemargin.Thusitremainsat$
1250.c.AsthedollarcontinuestoappreciaterelativetotheSwissfrancthevalueofthefuturescontractfalls.Howeverthecostof500000francpaymentisbecomingcheaperontermsoftheU.S.dollar.
9.a.Thecalloptioniscurrentlyoutofthemoney.b.
0.018862500=$1175$11758contracts=$9400c.AtS=$
0.96/€theoptionisnotexercisedandthefirmisout$9400AtS=$
1.02/€theoptionisexercised.Thefirmearns$10600AtS=$
0.9657/€thefirmdoesnotexercisetheoptionandisout$9400d.Breakeven:$
0.9988/€e.SeeDiagramgiveninpartb.
10.Theprosandconsofforwardcontractsandswapsliewithinhoweachworks.Aforwardcontractcanbearrangedbetweenapurchaserandasellerandisdependentuponeachparticipantsbeliefsofwhatwillhappeninthefuture.Sometimesitcanbedifficulttomatchcounterpartiestosuchcontracts.Swapsontheotherhanddirectlymatchtraderswhorequireflowsofcurrenciesheldbyoneanother.Swapsmayalsoallowborrowerstoreceivebetterloanratesbyissuingdebtintheirhomecurrencyratherthaninaforeigncurrency;therebypotentiallyavoidingariskpremium.Considerationsofthereasonforthelongpositiononacurrencyandwhichcurrencyisatissuewillinfluencethedecisionofwhichderivativetouse.Chapter61Thebankscapital-assetratioisequaltoitequityof100millionyendividedbyitstotalassetsof1000millionyenwhichequals
0.10or10percent.Hencethebankdefinitelymeetsthe4percentcapital-assetratiorequirement.Becausecashassetsandgovernmentsecuritiesreceiveazeroriskweightthisbankhas800millionyeninloansthatitmustcountamongrisk-adjustedassets.Togetherwiththeassignedexposureof400millionyenfromderivativestradingthisyieldsatotalamountofrisk-adjustedassetsequalto1200millionyen.Thusthebanksrisk-adjustedcorecapitalrationisequalto100millionyendividedby1200millionyenwhichisequaltojustover
0.083or
8.3percent.Thusthebanksrisk-adjustedcorecapitalratioalsomeetsthe8percentregulatoryrequirement.2Themainoverlapintheinstitutions’functionsisthatbothmakelong-termloansintendedtopromotegrowthofdevelopingandemergingnations.TheWorldBankhoweverconcentratessolelyonthistaskwhereastheInternationalMonetaryFundfocusesmuchofitsattentionlendingtopromoteshort-andintermediate-termstabilization.Chapter
71.Thedifferencebetweendirectandindirectfinancinghastodowithwhethertheborrowerandlenderseekeachotheroutorwhetheranintermediarymatchesborrowersandlenders.Directfinancingrequiresnointermediarytomatchsaversandborrowers.Aneconomywillbenefitfromhavingbothdirectandindirectfinancingbecausebothareappropriatewaystosaveandinvestunderdifferentcircumstances.Asdiscussedinthetextfinancialintermediariesabsorbafractionofeachsaversdollarthatisborrowed.Thustheintermediarytakessomeofthefundsthatotherwisewouldhavegonetoaborrower.Howeverthefinancialintermediaryprovidesanimportantservicebyreducinginformationasymmetriesallowingsaverstopoolriskandmatchingriskandreturn.Thereforewhenanindividualcannotresearchtheseissuesonhis/herowntheintermediaryisnecessarytohelpthefinancialmarketsoperate.Howeverastrongbondmarketinwhichborrowersandsaverscandirectlyinteractallowsforinformedpartiestosavethefundsthatotherwisewouldgotoanintermediary.Thisinturnusesthesavingsmoreefficiently.
2.Portfolioflowsarerelativelyshortterminnaturehaveashortertermtomaturityinvolvelowerborrowingcostsandcangeneratenear-termincome.Theyalsodonotrequireafirmtogiveupcontroltoaforeigninvestor.Consequentlytheymayhelptoimprovecapitalallocationwithinaneconomyandhelptheeconomysfinancialsectordevelop.Theseareallpotentialbenefitsofportfolioinvestments.Bythesametokenhowevertheyarealsorelativelyeasytoreverseindirectionwhichisapotentialdisadvantageofportfolioinvestment.OntheotherhandforeigndirectinvestmentFDIinvolvesomedegreeofownershipandcontrolofaforeignfirmaretypicallylongterminnatureandhelpprovideastabilizinginfluenceonanationseconomy.AssuchFDIistypicallymoredifficulttoarrange.Itisnotadvantageoustorelyoneithertypeofinvestmentexclusivelyinsofaraseachtypeaccomplishesdifferentgoalsforaneconomy.Bothnear-andlong-termcapitalareimportantforaneconomysgrowth.
3.AseitherportfolioinvestmentofFDIincreasethedemandforthelocalcurrencyrisese.g.thereisashiftfromD0toD1whichputsupwardpressureonthevalueofthecurrencyfromS0toS
1.IfthecentralbankexpectstoholdthevalueofthecurrencyconstantatS0itwillhavetoincreasethequantityofthedomesticcurrencysuppliede.g.accommodatetheexcessquantitydemandedattheinitialspotrateS0tomaintainthepeg.Theoppositewouldholdforcapitaloutflows.
4.SupposethatamultinationalbankMNBheadquarteredinadevelopedeconomyentersadevelopingeconomy.TheMNBhasgainedconsiderableexpertiseinworkingasafinancialintermediaryandlikelyhasachievedeconomiesofscaleindoingso.Byenteringaforeignmarketithelpstoallocatethesavingsmoreefficientlythroughitsintermediationservices;whichinturnwillleadtoadditionaleconomicdevelopment.Specificallyitshouldhelptomakesurethatthebestinvestmentprojectsarefunded.Moreoverthecompetitionitintroducesintothecapitalmarkethelpstoimprovethequalityoftheindigenousfinancialintermediaries.Thisinturnshouldalsoaddtofinancialstability.
5.Saversandborrowerscanalsobenefitfromtheregulationoffinancialintermediarieswhenportfoliocapitalflowsdominateacountryscapitalinflows.Itcanbearguedthatregulationtolimitshort-terminflowscanstabilizetheeconomyandthattheseregulationscanbegraduallyliftedastheeconomybecomesmorestablefinancialmarketsdevelopandresilienttoexternalshocks.Theseregulationsdoimposecostsinthattheyrequireresourcestoenforceandmayinhibitotherwisehelpfulcapitalinflowswhichmayaideconomicdevelopment.Howeverthesecostsmustbeconsideredagainstthepotentiallossesthatmaybeincurrediftheabsenceofcapitalcontrolswouldleadtomorevolatileandcapitalmarketswhichmaydetertheinflowofforeigncapital.
6.PolicymakersshouldundertakeactionsthatattractbothportfoliocapitalflowsandFDIflows.Actionsthatimprovetransparencyinboththeprivateapublicsectorreducesinformationasymmetriesandtheirassociateproblemstherebymakingportfolioflowsmorestableinotherwordsreducingtheriskofmassivecapitaloutflows.Policymakersmayalsoundertakeactionsthatpromoteeducationimprovethetaxstructureandtaxcollectionandimprovethecountriesinfrastructure.TheseactionsmayinturnattractFDI.
7.Inthefollowingtwoexamplesitisassumedthatthepolicymakermaintainsapegged-exchangerateregimeanddoesnotoptforafloating-rateregime.Hencethepolicymakermayeitherinterveneandmaintainthepegorchangethevalueofthepeg.Inbothcasesthereispressureforthedomesticcurrencytoappreciatevisavistheforeigncurrency.a.Iftheexchangeratepressureisonlytemporaryinnaturethenthepolicymakermayintervenebyaccommodatingtheexcessquantitydemandedasexplainedinquestion3above.b.Becausetheexchangeratepressureislonger-terminnaturethepolicymakerwouldbewelladvisedtorevaluethedomesticcurrency.
8.TheWorldBankwasinitiallyestablishedtohelpcountriesrebuildafterWWIIandinthe1960sexpandedtoalsomakelongtermloanstodevelopingnationsinordertohelpreducepovertyandimprovelivingstandards.RecentlysomeoftheWorldBanksactivitieshavebeguntooverlaptheIMFsactivitiestofinancelong-termstructuraladjustmentsandproviderefinancingforsomeheavilyindebtedcountries.CriticsmayarguethatthetasksthatareduplicatedbytheIMFandtheWorldBankcreateconflictinggoalsfortheWorldBank.Thusthetwoorganizationsmayeachbenefitbyfocusingondifferentaims.ForinstancetheIMFmayreturntofinancingshorter-termobjectivesandleavetheWorldBanktoworryaboutlonger-termprojects.AnotherconflictinglineofreasoninginvolvesdonorsexpectationthattheWorldBankmaintainarevenuestreamformitsprojects.Thiscanbearguesasunrealistichoweverinthatthepoorestcountriesarelesslikelytoyieldapayofffortheneededprojects;andthesearepreciselythecountriesthattheWorldBankisdesignedandintendedtohelp.Ontheotherhandthelessriskyprojectswhichcouldprovideapositiverevenuestreamarelikelytoattractprivatecapital.
9.Thefirstcauseofacrisiscouldbeanimbalanceintheeconomy.Inotherwordsanincongruityineconomicfundamentalscouldcauseacrisis.Possibleindicatorsincludetheoreticaldivergencesbetweenvariouseconomicvariablessuchastheexchangerateandinterestratesincomeandmoneysupply.Intermsofevaluationiffundamentaleconomicvariablesseemtobeoutoflinetheremaybeanimpendingcrisis.Asecondcauseisthatofself-fulfillingexpectationsandcontagioneffects.Inthiscasemereexpectationsofapotentialinabilitytomaintainaspecifiedexchangerateoraslightincongruitybetweeneconomicconditionsandthemarketexchangeratemaycauseacascadeofspeculationthatleadstoacrisis.Sincethisisbasedonperceptionitisdifficulttofindanindicator.Onepossibleindicatorwouldbetradingvolumesofcurrencyforcountriesthatmaybeatriskfromtheviewpointofeconomicfundamentals.Iftradingvolumesgrewquicklyacrisismaybeonthehorizon.Finallythestructuralmoralhazardproblemmayindicateacrisis.InthiscaseacreditratingbureausuchasMoodysmayprovidethedataneededtoindicateapotentialcrisis.Thequalityofthecreditratingwouldberelativelyeasilyinterpretedtoindicateapotentialcrisis.
10.Itcanbearguedthatsuchbelowmarketinterestrateloansarecriticalforadevelopingnationseconomyinorderfortheeconomytogrowunburdenedbyhighinterestpaymentswhenitistryingtofunnelprofitsbackintotheeconomyandsustaingrowth.Converselyprovidingthesenon-marketrateloanscanalsobearguedtodistortthemarketforloanablefundsandattractinefficientinvestment.Studentsperspectiveswillvaryastowhichargumentisthebest.Chapter
81.Usingtheformulaprovidedinthequestiontheelasticityofforeignexchangedemandisinabsolutevalueandtheelasticityofforeignexchangesupplyis
2.A1percentdepreciationoftheCanadiandollarresultsina
0.52percentdeclineinimportsdemandedandariseof
0.58percentinexportssupplied.
3.InabsolutevaluethesmallestelasticitymeasuremostinelasticisGermany’selasticityofimportdemandfromtheU.K.InabsolutevaluethelargestelasticitymeasuremostelasticistheUnitedStates’elasticityofdemandforimportsfromGermany.
4.Table8-1providesmeasuresofthepriceelasticityofimportdemand.IftheU.S.dollardepreciatesrelativetotheJapaneseyenU.S.exportsbecomerelativelylessexpensivetoJapaneseconsumersandJapaneseexportsbecomerelativelymoreexpensivetoU.S.consumers.a.TheU.S.quantityofimportsdemandedfromJapanfallsby
1.13percent.b.Japan’squantityofimportsdemandedfromtheU.S.risesby
0.72percent.c.BecauseU.S.exportsriseandimportsdeclinethetradebalanceshouldimprove.
5.Thetradebalancemaynotimproveintheshort-runbecauseofpass-throughandJ-curveeffects.Overalongertimehorizonimportdemandisrelativemoreelasticandthetradebalanceshouldimprove.
6.IftheCanadiandollardepreciatesrelativetotheU.S.dollarthenthequantityofhockeypucksdemandeddeclines.HenceSlovakianmanufacturerswouldhavetoabsorballoftheexchangeratechangeintheirprofitmarginsandthepriceofhockeypuckswouldhavetodeclineby5percentforthequantitydemandedtoremainunchanged.
7.Usingthevaluesgivenintheproblem:a.realincomeyequalsc+i+g+x=$23500absorptionaequalsc+i+g+im=$
24000.b.Netexportsx-imequals-$
500.Thereforethereisatradedeficitof$
500.
8.Netexportsnowequal$550-$950=$
400.Thedevaluationdidimprovetheexternalbalance.
9.Theadvertisingcampaignwouldinduceconsumerstoincreaseexpendituresondomesticoutputanddecreaseexpendituresonforeignoutput.Domesticabsorptionwillriseandifexpendituresonimportsdecreasethetradebalanceimproves.
10.AstheU.S.economyexpandswewouldexpectrealincomeandrealabsorptiontoincrease.Ontheonehandifrealincomeincreasesmorethanrealabsorptionnetexportswillrise.ThiswouldleadtoanappreciationoftheU.S.dollar.Ifontheotherhandrealabsorptionrisesfasterthanrealincomenetexportsfall.ThiswouldleadtoadepreciationoftheU.S.dollar.Chapter
91.Usingtheformulaprovidedonpage222mDC+FER=kSP*y.a.Themoneystockis2$1000+$80=$2160million.b.Thelevelofrealincomeis:[2$1000+$80]/[
0.
201.22]=$4500million.2Anopenmarketpurchaseofsecuritiesintheamountof$10million:a.Afixedexchangerateregimerequiresadecreaseinforeignreservesinanequalamount.Hencethisactionresultsinabalanceofpaymentsdeficitintheamountof$10million.b.Aflexibleexchangerateregimeresultsinanewspotexchangerateof
2.019whichisadepreciationofthedomesticcurrency.Thisproblemissolvedbyusingthevalueforrealincomederivedin5babove:[2$1010+80]/[
0.
201.2$4500]=
2.
019.
3.Thewealthidentityisgivenonpage229asW≡M+B+SB*.Anopenmarketsaleofsecuritieswouldreducebankreservesincreasingthedomesticinterestrate.Individualswouldshiftfromforeignbondstodomesticbondsleadingtoanappreciationofthedomesticcurrency.Underafixedexchangeratetheopenmarketsalewouldresultinanimprovementofthedomesticnation’sbalanceofpayments.TheelasticitydiagramsinChapter8areusefulinansweringthisquestion.
4.Thisanswerisanillustrationofproblem3underflexibleexchangerates.Theopenmarketsalewouldcauseanincreaseinthedemandforthedomesticcurrencyandthedomesticcurrencywouldappreciateasaresult.
5.Thewealthidentityisgivenonpage315asW≡M+BSB*.FromtheforeignnationitisW≡M*+B*+1/SB.Anopenmarketsaleofsecuritiesbytheforeigncentralbankwouldreduceforeignbankreservesincreasingtheforeigninterestraterelativetothedomesticinterestrate.Individualswouldshiftfromdomesticbondstoforeignbondsleadingtoandepreciationofthedomesticcurrency.Chapter
101.Leakages=s+t+imInjections=i+g+xInequilibriuminjectionswillequalleakages;i.e.s+t+im=i+g+x
1.Onecaninterprettheinterceptsofthesefunctionsastheamountofeachactivitythattakesplacewhendisposableincomeisequaltozero.Onecouldalsoconsidertheinterceptsmorebroadlyastheamountofeachactivitythattakesplaceindependentofdisposableincome.Thelatterisabetterinterpretationforanupperdivisionclass.Themarginalpropensitiestosaveconsumeandimportmustsumtoequalonebecausethesearetheonlyactivitiesinwhichoneengagesafterpayingtaxes.
2.TheequationfortheLMscheduleunitsin$trillionis
1.8=
0.9*Ror100*R=
0.9*y-
1.
8.Dividingby100wehaveR=
0.009*y-
0.
018.Ify=8thenR=
0.009*8-
0.018=
0.072-
0.018=
0.
054.Hencetheequilibriuminterestrateatanincomelevelof$8trillionis
5.4percent.Chapter11Chosetherightanswersfromthefollowing10answersbyyourself.SuGuangjin)
1.Achievingabalance-of-paymentssurplusrequiresthatthesumofthecapitalaccountbalanceandcurrentaccountbalanceispositivewhichrequiresahigherinterestratetoattractgreatercapitalinflowsandlowerrealincometodampenimportspending.ConsequentlytheBPschedulewouldlieaboveandtotheleftofthepositionitotherwisewouldhaveoccupiediftheexternal-balanceobjectiveweretoensureonlyabalance-of-paymentsequilibrium.Undoubtedlyifthecentralbankfeltpressuretosterilizeunderthelatterobjectivethepressuretodosowouldbegreaterifitseekstoattainabalance-of-paymentssurpluswhichwouldrequirethecentralbanktosteadilyacquireforeign-exchangereserves.Intheabsenceofsterilizationthenationsmoneystockwouldsteadilydecline.
1.Inthissituationvariationsinthedomesticinterestraterelativetointerestratesinothernationswouldhavenoteffectonthenationscapitalaccountbalanceanditsbalanceofpayments.ItsBPschedulethereforewouldbevertical.AnexpansionaryfiscalpolicygivenafixedexchangerateasassumedinthischapterwouldcausetheISscheduletoshiftrightwardinitiallyinducingariseinequilibriumrealincome.Thishoweverwouldcauseimportspendingtoincreaseandthenationwouldexperienceabalance-of-paymentsdeficitwhichwouldplacedownwardpressureonthevalueofitscurrency.Topreventachangeintheexchangeratethecentralbankwouldhavetosellforeignexchangereserves.IfthisinterventionisunsterilizedthenthenationsmoneystockwoulddeclineultimatelycausingtheLMscheduletoshiftbacktooafinalIS-LMequilibriumatapointverticallyabovetheinitialequilibriumpointalongtheverticalBPschedule.
3.AreductioninthequantityofmoneyshiftstheLMscheduleleftward.AtthenewIS-LMequilibriumthenominalinterestraterisesandrealincomedeclines.IrrespectiveoftheshapeoftheBPschedulethiswouldresultinabalanceofpaymentsurpluswhichwouldtendtoplaceupwardpressureonthevalueofthenationscurrency.Tomaintainafixedexchangeratethecentralbankwouldhavetopurchaseforeignexchangereserves.Ifthisforeign-exchange-marketinterventionisunsterilizedthenthenationsmoneystockincreasescausingtheLMscheduletoshiftbacktotheright.UltimatelytheoriginalIS-LMequilibriumisre-attained.
4.Ifcapitalishighlymobileadropingovernmentspendingwilllikelycauseaprivatepaymentsdeficit.Thefallinincomewillcauseadecreaseinimportsandatradesurplus.Asthedomesticinterestrateincreaseshoweverthecapitaloutflowwillleadtoaprivatepaymentsdeficit.Ifcapitalisnotmobilethecapitaloutflowsarelikelynotlargeenoughtocounteracttheeffectofadropinimports.Thereforeaprivatepaymentssurpluswouldresult.
5.AcontractionaryfiscalpolicyactionsuchasareductioningovernmentspendingcausestheISscheduletoshiftleftwardinducinganinitialdeclineinthenominalinterestrateandreductioninrealincome.Asaresultthereisacapitaloutflowandfallinimportspending.Becausecapitalishighlymobilethecapital-outfloweffectdominatesandthenationexperiencesabalance-of-paymentsdeficit.Thisplacesdownwardpressureonthevalueofthenationscurrencywhichinducesthecentralbanktosellforeignexchangereserves.IfthisactionisunsterilizedthenthenationsmoneystockdeclinescausingtheLMscheduletoshiftbacktotheleftwaswellwhichyieldsanewIS-LMequilibriumalongtheBPscheduletotheleftoftheoriginalequilibriumpoint.
6.Ifontheotherhandthereislowcapitalmobilitythenationexperiencesabalance-of-paymentssurplus.Thisplacesupwardpressureonthevalueofthenationscurrencywhichinducesthecentralbanktopurchaseforeignexchangereserves.IfthisactionisunsterilizedthenthenationsmoneystockrisescausingtheLMscheduletoshifttotheright.
7.AforeignfiscalcontractionleadstotheforeignISscheduletoshifttotheleftresultinginalowery*andr*.Financialresourceswillflowfromtheforeigncountrytothedomesticcountryplacingpressureonthedomesticcurrencytogainvalue.Inresponsethereforethedomesticcentralbankpurchasesforeignexchangetomaintainthefixedexchangerate.ConsequentlythedomesticmoneysupplyrisesleadingthedomesticcountrysLMscheduletoshiftrightward.Thelowerforeignincomelevelalsoleadstolowerdomesticexportsfewforeignimports.ThereforethedomesticcountrysISscheduleshiftsleftandtheforeigncountrysISscheduleshiftstotheright.InbothcountriesgraphstheBPscheduleshiftsdowntoreflectlowerinterestrates.
8.AdomesticfiscalcontractionleadstoaleftwardshiftinthedomesticISscheduleresultinginalowerdomesticincomelevelandinterestrate.Consequentlydomesticimportsfallforeignexportsfall.FurtherasforeignexportsfalltheforeignISscheduleshiftsleftanddecreasesforeignincome.InturndomesticexportsfallanddomesticISscheduleshiftsfurtherleft.Thelowerdomesticinterestrateleadstoacapitaloutflowofthedomesticcountryandputspressureonthevalueofthedomesticcurrencytofall.Thedomesticcentralbankrespondsbysellingforeignexchangeinordertomaintainthefixedexchangerate.AsthedomesticmoneysupplyfallsthedomesticLMscheduleshiftstotheleft.FinallybothcountriesBPlinesshiftdowntothenewlowerequilibriuminterestrate.
9.AdomesticmonetaryexpansionshiftsthedomesticLMschedulerightwardwhichreducesthedomesticinterestrate.Thistendstoinduceadomesticbalance-of-paymentsdeficitandplacesdownwardpressureonthevalueofthedomesticcurrencyrelativetotheforeigncurrency.NowbothcentralbanksworktogethertokeeptheexchangerateunchangedsotheforeigncentralbankmustincreaseitsownmoneystockshiftingitsLMscheduletotherightandreducingtheequilibriumforeigninterestrateaswell.IntheendthereforebothBPschedulesshiftdownwardandthenationsinterestratesareequalizedsopaymentsimbalancesareeliminated.Equilibriumrealincomerisesinbothnationssothereisalocomotiveeffectontheforeigncountryasaresultofthedomesticmonetaryexpansionassumingunchangingpricelevels.
10.AdomesticfiscalexpansioncausesthedomesticISscheduletoshifttotherightwhichraisesthedomesticinterestrate.Thistendstoinduceadomesticbalance-of-paymentssurplusandplacesupwardpressureonthevalueofthedomesticcurrencyrelativetotheforeigncurrency.BothcentralbanksworktogethertokeeptheexchangeratefixedsotheforeigncentralbankmustreduceitsownmoneystockshiftingitsLMscheduleleftwardandincreasingtheforeigninterestrateaswell.IntheendbothBPschedulesshiftupwardandthenationsinterestratesareequalizedsopaymentsimbalancesareeliminated.Equilibriumrealincomerisesinthedomesticcountrybutdeclinesintheforeigncountry.Thusthereisabeggar-thy-neighboreffectontheforeigncountryasaresultofthedomesticfiscalexpansionassumingunchangingpricelevels.Chapter
121.Acurrencydepreciationleadstoariseinexports.Tomaintainabalance-of-paymentequilibriumthenominalinterestratemustdeclinetoinduceaninflowoffinancialassetorrealincomemustrisetoinduceariseinimports.ConsequentlytheBPscheduleorsetofinterestrate-realincomecombinationsthatyieldbalance-of-paymentsequilibriummustliedownandtotherightofitspreviouspositionfollowingadepreciationofthehomecurrency.
2.AnexpansionaryfiscalpolicyactionsuchasanincreaseingovernmentexpendituresshiftstheISschedulerightwardalongtheLMscheduleinducingariseinequilibriumrealincomeandspurringimportspending.Becausecapitalisperfectlyimmobilethisunambiguouslycausesabalance-of-paymentsdeficitwhichresultisarightwardshiftoftheBPscheduletoacrossingpointatthefinalIS-LMequilibriumwithahigherlevelofrealincome.
3.TheISscheduleshiftstotheleftasgovernmentspendingfalls.Giventhelowcapitalmobilitytherewilllikelybeaprivatebalance-of-paymentssurplusresultinginacurrencyappreciation.NetexportsconsequentlywillfallwhichservestoshifttheISschedulefurthertotheleftatthesametimeastheBPscheduleshiftstotheleft.Asaresulttheequilibriuminterestrateandincomelevelbothfall.
4.ThecontractionarymonetarypolicyshiftstheLMscheduleup.Givenhighcapitalmobilitythiswilllikelyleadtoaprivatebalance-of-paymentssurplus.ThusthecurrencywillappreciatewhichwillshifttheBPlineupandtheISscheduleleft.Thusincomefallsandtheinterestraterises.
5.AsforeigngovernmentspendingcontractstheforeignISscheduleshiftsleft.thisresultsinlowerforeignincomeandinterestrates.Capitalwillflowfromtheforeigneconomytothedomesticeconomywhichputspressureontheforeigncurrencytolosevalue.Asaresultdomesticexportsfallandimportsrisei.e.thedomesticISscheduleshiftsleftwhileatthesametimeforeignexportsriseandimportsfallforeignISshiftsright.Atthesametimetheprivatebalanceofpaymentslineshiftsdownsuchthateacheconomyisinequilibriumatlowerinterestratesandlowerincomelevels.
6.AsthedomesticgovernmentspendingfallsthedomesticISscheduleshiftsleft.Asaresultdomesticincomeandinterestratesfall.Thereisacapitaloutflowtotheforeigneconomyandconsequentlythedomesticcurrencylosesvalue.Netexportsriseinthedomesticeconomyandnetexportsfallintheforeigneconomy.ThusthedomesticISscheduleshiftspartiallybacktotherightandtheforeignISscheduleshiftstotheleft.
7.AriseinJapanesegovernmentspendingandaJapanesetaxcutwouldhavecausedtheJapaneseISscheduletoshifttotherightdrivingupJapansnominalinterestrate.ThiswouldhaveinducedacapitalinflowintoJapanwhichwithnear-perfectcapitalmobilitywouldhavecausedJapantoexperienceabalance-of-paymentssurplusresultinginariseinthevalueoftheyen.ThisalongwiththeriseinJapaneserealincomethatwouldhaveresultedwouldhaveinducedJapaneseresidentstopurchasemoreU.S.exportgoodscausingtheU.S.ISscheduletoshiftrightwardtherebypushingtheU.S.interestrateupwardandexpandingequilibriumU.S.realincome.HencethisrequestwasintheinterestoftheUnitedStatesifitsgoalwastoraiseitsownrealincomelevel.
8.AnexpansionarymonetarypolicyactioninJapanwouldhaveraisedequilibriumrealincomebutwouldhaveledtoadepreciationoftheyen.IftheeffectofhigherrealincomeonJapanesespendingonU.S.exportgoodswouldhavebeengreaterthanthenegativeeffectonsuchspendingofthelowervalueoftheyenthenthispolicyactionalsowouldhavebeenadvantageousfortheUnitedStates.
9.Asdiscussedinthischapterfixingexchangeratesdoesnoteliminatethepotentialforrisksresultingfromdevaluationsorrevaluations.ThefactthatsomanyrealignmentsoccurredindicatesthatindividualsandfirmswouldhavecontinuedtofacethistypeofriskinaWesternEuropeanregimeoffixedexchangerates.
10.VariabilityingovernmentspendingcausestheISscheduletoshifttotherightorleft.UnderafixedexchangerateunsterilizedmonetaryinterventionstostabilizetheexchangerateultimatelyinduceLMshiftsthatreinforcethereal-incomeeffectsofISvariations.UnderafloatingexchangeratehowevermovementsintheexchangeratecausenetexportexpenditurestomoveintheoppositedirectionsfromvariationsingovernmentspendingwhichautomaticallytendstostabilizetheISschedulesposition.Thusinthissituationinwhichmoneydemandisrelativelystableafloatingexchangerateismoreconsistentascomparedwithafixedexchangeratewithreal-incomestability.Chapter
131.False.Asdiscussedinthischapterunderafloatingexchangeratethepotencyofmonetarypolicyseffectonaggregatedemandandconsequentlythepricelevelandrealoutputisenhancedbygreatercapitalmobility.Thereasonisthatamonetaryexpansioninducesafallinthevalueofthedomesticcurrencythatinducesariseinexportswhichinturnreinforcestheexpansionaryeffectofthemonetaryexpansion.
2.Underafixedexchangerateandrelativelyhighcapitalmobilityanexpansionaryfiscalpolicyplacesupwardpressureonthevalueofanationscurrencywhichrequiresthenationscentralbanktopurchaseforeignexchangereserves.Ifthismonetaryactionisunsterilizedthenthedomesticmoneysupplyalsoexpandstherebyreinforcingtheeffectoftheexpansionaryfiscalpolicyonaggregatedemandandtheequilibriumpricelevel.Ifakeygoalistolimitinflationthenfiscalpolicyrestraintsmaybejustified.
3.Tobringaboutadevaluationthenationscentralbankmustincreasethemoneystockforatime.WhenthevalueofthedomesticcurrencyfallstheBPandISschedulesshifttotherightsothatequilibriumrealincomerisesatanygivenpricelevel.Thusthereisanincreaseinaggregatedemand.Ifworkersexpectationsarerationalandifwageadjustmentsarerapidthentherewillbeashort-runincreaseinequilibriumrealoutputfollowingthisincreaseinaggregatedemandonlyifthedevaluationisunanticipatedsothatthereisnoshort-runshiftinthepositionoftheaggregatesupplyschedule.Ifworkersareabletoanticipatethedevaluationhoweverthentheywillimmediatelybargainforhigherwagesinlightoftheirexpectationsofhigherprices.Theresultingwageincreasecausestheaggregatesupplyscheduletoshirtupwardandtotheleftatthesametimethataggregatedemandincreasessothatrealoutputisunchangedinequilibrium.
4.Ifallotherfactorsareunchangedthenaboostinnominalwagescausestheaggregatesupplyscheduletoshiftupwardandleftwardalongtheaggregatedemandschedule.Asaresulttheequilibriumpricelevelrisesandequilibriumrealoutputdeclines.
5.Thetheoryofdiscretionarypolicymakingimpliesthatthecentralbankwilldevalueunderthesecircumstances.Giventhecentralbankslowlevelofconcernaboutinflationitwilldevalueinanefforttoraiseaggregatedemandseequestion3abovetherebycausingandupwardmovementalongtheeconomysaggregatesupplyscheduleandashort-runincreaseinrealoutput.Sinceworkersrealizethattherequireddevaluationwillraiseinflationby10percenttheywillbargainforawageincrease.Thiswillcauseaggregatesupplytoshiftupwardandleftward.Theresultwillbeinflationbutnochangeinequilibriumrealoutput.
6.Nominalwagesfullyindexedtoinflationwillrenderanydiscretionarypolicytoimmediatelybeoffsetbylaborsupplyrestrictionsthatkeepequilibriumoutputfromchanging.Thusacentralbanksincentivetoproduceaninflationbiasiseliminated.
7.Toindexawagebasedoninflationwhenaggregatesupplyshocksdominatetheeconomywouldbedestabilizing.Thisoccursbecauseoftheresultingshapeoftheaggregatesupplyscheduleundervaryingdegreesofindexation.Ifwagesarefullyindexedaverticalaggregatesupplyscheduleresults.Ifhoweverwagesareonlypartiallyindexedtheaggregatesupplyscheduleisupwardsloping.Consequentlyifweconsidertheeffectofanadversesupplyshockundereachalternativeequilibriumincomewillfallfurtherwithfullyindexedwages.Thussuchwageindexationwouldnotbedesirable.
8.Thestatementindicatesthatanargumentinfavorofcentralbankcontractsisthebalancebetweenthebenefitsofcentralbankindependencefrompoliticalinfluenceandresponsibilityforeconomyoutcomes.Howeverthephrasesubjectingthemtosocietalruleisindicativeofpoliticalinfluence.Thusthestatementseemstobesomewhatmisleading.Itmaybemoreappropriatetoreplacethatphrasewithholdingthecentralbankaccountableforexpectedeconomicoutcomes.
9.Whichleaderiscorrectwilldependonthesourceofeconomicgrowth.IfgrowthwereassumedtocomefromdemandmanagementtheGermanleaderswouldbecorrect.Howeverifgrowthweresupplysidedrivenlowerinflationandlowerunemploymentwouldcomplementeachother.
10.Factorsotherthancentralbankindependenceaffectinflationinaneconomy.Inparticularthestatementfocusesupondevelopingeconomies.Asstatedtheseeconomiessufferfromthelackofpropertyrightsbankruptcyrulesjudicialadjudicationetc.thatexistindevelopedeconomies.Withoutthesefundamentalsinplacemanyeconomicpoliciesthatresultinastableeconomicenvironmentwillnolongerhaveastabilizingeffect.Chapter
141.a.AnincreaseingovernmentspendingcausestheISscheduletoshiftrightwardwhichreducesequilibriumrealincome.TopushrealincomebacktoitsoriginallevelandtherebyreattaininternalbalancerequiresareductioninthemoneystockthatshiftstheLMscheduleleftward.Hencetheinternal-balancescheduleslopesdownwardasbefore.b.AnincreaseingovernmentspendingcausestheISscheduletoshiftrightwardtoanewequilibriumpointbelowtheLMschedulesothereisabalance-of-paymentsdeficit.Reattainingbalance-of-paymentsequilibriumandtherebyreestablishingexternalbalancerequiresanincreaseinthemoneystockthatshiftstheLMscheduleleftwardbutnotasmuchaswouldhavebeenrequiredtoachieveinternalbalance.Thustheexternal-balanceschedulealsoslopesdownwardbutitisshallowerthantheexternal-balanceschedule.c.Considerapointbelowandtotherightofthecrossingpointofthetwoschedulesandbetweenthetwoschedules.Giventhemoneystockattainingapointontheinternal-balanceschedulerequiresthefinanceministrytoreducegovernmentspending.Thenforthecentralbanktoachieveexternalbalancerequiresanincreaseinthemoneystockwhichthefinanceministryshouldfollowbyreducinggovernmentspendingfurther.Eventuallyback-and-fortheffortsbythetwoauthoritiesachievesthecrossingpointoftheschedulesandthemoneystockandgovernmentspendinglevelsconsistentwithbothinternalandexternalbalance.Thisimpliesthatthecentralbankshouldbeassignedexternalbalancewhilethefinanceministryshouldbeassignedinternalbalance.
2.a.IfthefinanceministryincreasesgovernmentspendingthentheISscheduleshiftsrightwardandequilibriumrealincomebeginstoincrease.Toreestablishinternalbalancethecentralbankmustreducetheexchange-ratepegthatisrevalueandreducethetargetvalueofStodiscourageexports.ThisrequiresthecentralbanktosellforeignexchangereservesandsinceinterventionsarenonsterilizedreducethequantityofmoneyincirculationwhichshiftstheLMscheduleleftward.ThedeclineinthepeggedexchangeratecausestheISandBPschedulestoshiftleftwardaswell.AtapointofinternalbalanceequilibriumrealincomereturnstoitsoriginallevelatanewcrossingpointofISLMandBPwherethereisnopressurefortheexchangeratetochange.Thismeansthattheinternal-balanceschedulerelatingtheexchangerateSandgslopesdownward.b.WithrelativelyhighcapitalmobilityanincreaseingovernmentspendingthatshiftstheISschedulerightwardandpushesupthedomesticinterestrategeneratesacapitalinflowandabalance-of-paymentssurplusatapointabovetheBPschedule.Reversingthecapitalinflowviaachangeintheexchange-ratepegrequiresadevaluationoranincreaseinSbroughtaboutbynonsterilizedpurchasesofforeignexchangereservesthatincreasethedomesticmoneystock.ThustheISscheduleshiftsfurthertotherightandtheLMandBPschedulesbothshiftrightwardaswelltoanewcommonpointofintersection.Consequentlytheexternal-balanceschedulerelatingSandgslopesupward.c.Considerapointaboveandtotheleftofthecrossingpointofthetwoschedules.Giventhemoneystockattainingapointontheexternal-balanceschedulerequiresthefinanceministrytoincreasegovernmentspending.Thenforthecentralbanktoachieveexternalbalancerequiresadecreaseinthemoneystockwhichthefinanceministryshouldfollowbyreducinggovernmentspending.Eventuallyappropriatechangesbythetwoauthoritiesachievethecrossingpointoftheschedulesandthemoneystockandgovernmentspendinglevelsconsistentwithbothinternalandexternalbalance.Thisimpliesthatthefinanceministryshouldbeassignedexternalbalancewhilethecentralbankshouldbeassignedinternalbalance.
3.a.IfthefinanceministryincreasesgovernmentspendingthentheISscheduleshiftsrightwardandequilibriumrealincomebeginstoincrease.Toreestablishinternalbalancethecentralbankmustreducetheexchange-ratepegthatisrevalueandreducethetargetvalueofStodiscourageexports.ThisrequiresthecentralbanktosellforeignexchangereservesandsinceinterventionsarenonsterilizedreducethequantityofmoneyincirculationwhichshiftstheLMscheduleleftward.ThedeclineinthepeggedexchangeratecausestheISandBPschedulestoshiftleftwardaswell.AtapointofinternalbalanceequilibriumrealincomereturnstoitsoriginallevelatanewcrossingpointofISLMandBPwherethereisnopressurefortheexchangeratetochange.Thismeansthattheinternal-balanceschedulerelatingtheexchangerateSandgslopesdownward.b.WithrelativelylowcapitalmobilityanincreaseingovernmentspendingthatshiftstheISschedulerightwardandpushesuprealincomegeneratesanimportincreaseandbalance-of-paymentsdeficitatapointbelowtheBPschedule.ReestablishingexternalbalancerequiresarevaluationorareductioninSthatraisesthevalueofthedomesticcurrencybroughtaboutbynonsterilizedsalesofforeignexchangereservesthatreducethedomesticmoneystock.TheresultingdeclineinexportshelpsoffsettheriseingovernmentspendingbycausingtheISscheduletoshiftbacktotheleft.TheLMandBPschedulesbothshiftleftwardaswellandtheresultisanewcommonpointofintersectionofallthreeschedulesataslightlyhigherrealincomelevelandhigherinterestrate.Consequentlytheexternal-balanceschedulerelatingSandgslopesupward.BecauserealincomeishighertherequiredreductioninSwaslessthaninpartasotheexternal-balanceschedulehasashallowerslopethantheinternal-balanceschedule.c.Considerapointbelowandtotherightofthecrossingpointofthetwoschedulesandbetweenthetwoschedules.Giventheexchange-ratepegattainingapointontheinternal-balanceschedulerequiresthefinanceministrytoreducegovernmentspending.Thenforthecentralbanktoachieveexternalbalancerequiresanincreaseintheexchange-ratepegwhichthefinanceministryshouldfollowbyreducinggovernmentspendingfurther.Eventuallyback-and-fortheffortsbythetwoauthoritiesachievesthecrossingpointoftheschedulesandtheexchange-ratepegandgovernmentspendinglevelsconsistentwithbothinternalandexternalbalance.Thisimpliesthatthecentralbankshouldbeassignedexternalbalancewhilethefinanceministryshouldbeassignedinternalbalance.
4.Areductioninthemoneystockcausestheaggregatedemandscheduletoshiftleftwardalongthelong-runaggregatesupplycurveandthepriceleveldecreasesinthelongrun.Accordingtorelativepurchasingpowerwhichisassumedtoholdinthelongruntheultimateeffectisadecreaseintheexchangerateoradomesticcurrencyappreciation.
5.IntheshortrunthereductioninthemoneystockshiftstheLMscheduleleftwardresultinginabalance-of-paymentsurplusthatcausesthehomecurrencytoappreciatethevalueofSdeclines.Theresultingdeclineinaggregatedemandcausesthepriceleveltofallbutbylessthanitultimatelywillinthelongrun.HencethereisaninitialrealappreciationwhichreducesexportspendingandcausestheISscheduletoshiftleftward.AsthepricelevelbeginstodeclinetheLMscheduleshiftsbacktotherightsothereisnowabalance-of-paymentsdeficitthatcausesanominaldepreciationsothevalueofSmustrisesomewhataspartofthefinaladjustmenttolong-runequilibrium.OnnetSmustfallinthelongrunasdiscussedinQuestion4sothisreasoningimpliesthatinitiallySmustdeclinebeyonditslong-runvalueandthenrisesomewhattoattainthelong-runvalue.Thusexchange-rateovershootingoccurs.
6.Inanationwithperfectlycompetitiveproductmarketsthismightoccurbecauseworkersrespondtoincreasedopennessbyincorporatingmoreindexationofwagesintotheircontractualagreementswithemployersorbecausegreateropennessbycountriesthatimportarelativelylargeamountofinputsmakesproductpricesadjustmorerapidlytochangesininputprices.
7.Inacountrywithimperfectlycompetitiveproductmarketsthismightoccurbecausegreateropennessreducesthepricingpoweravailabletodomesticfirmssotheycannotraisetheirpricesasmuchasbeforewhenthequantityofoutputdemandedincreases.Thusagivenincreaseinaggregateoutputisassociatedwithasmalleroverallriseinthelevelofprices.Anotherpossibilityisthattheincreaseinopennessreducesinflationwhichgivesworkersmoreincentivetousefixed-wagecontractstherebymakingoutputmoreresponsivetoachangeinthepricelevel.
8.Ifincreasedopennessreducesthepricingpoweravailabletofirmsinacountrywithimperfectlycompetitiveproductmarketstheirinabilitytoraisetheirpricesasmuchasbeforewhenthequantityofoutputdemandedincreasesmightreduceinflation.Alternativelyifgreateropennessresultsinasteeperaggregatesupplyscheduleinanationwithperfectlycompetitiveproductmarketsthenthereislessincentiveforthecentralbankinthatnationtotrytogenerateshort-termincreasesinoutputviainflationarymonetarypolicieswhichreducesinflation.
9.Ifanation’scentralbankisalreadyhighlyindependenttheninflationisalreadylikelytobelowsoanypotentialinflation-reducingbenefitfromgreateropennessislikelytobemoremuted.
10.Thethreekeyfeaturesofthenewopeneconomymacroeconomicsarestickywagesandpricesimperfectlycompetitiveproductmarketsandtheuseofdynamictheories.Inthemoretraditionalapproachesdescribedinearlierchapterswageinflexibilitycausedthepricelevelnottoadjustfullyintheshortrunbuttherewerenomenucoststhatmightcontributetooutrightpricestickiness.Thetraditionalapproachesalsoassumeperfectlycompetitiveproductmarketsandconsiderpoint-in-timepolicysituationswithoutdevelopingtheoriesbasedondecisionsthatindividualsandbusinessesmakeovertime.Chapter
151.Thiswouldbeasituationofpolicycoordinationbecausethenationswouldactivelybeworkingtogethertoestablishacommonpaymentmechanismandregulatoryframeworkthatwouldapplysimultaneouslytobothcountriesbankingsystems.
2.Thisisanexampleofanegativepolicyexternalitybecausethedomestictaxcuttendstostimulatedomesticreal-incomegrowthattheexpenseoflowerreal-incomegrowthintheothercountry.Asaresultthedomestictaxcuthasabeggar-thy-neighboreffectontheothernation.
3.Accordingtotheoptimal-currency-areatheorythesethreeeconomiesaregoodcandidatesforasinglecurrency.Ifeventsweretoaffectthesub-regionsdifferentlycausingpaymentimbalancesamongthesub-regionsthentheresidentswhoshareacommoncultureandlanguageandarehighlymobilecouldadjustbymovingasdesiredamongtheregions.Henceexchange-rateadjustmentsarenotnecessarytocushionthesub-regionsinthefaceofsuchimbalances.Adoptingasinglecurrencywouldpermitthemtoavoidthesizablecurrency-conversioncoststhattheycurrentlyface.
4.Oneeconomicargumenttheymightgiverelatestothestandardcaseforafixedexchangerate:Itsaveshouseholdsandfirmsthecostsofhedgingagainstrisksofexchange-ratefluctuationwhichdefinitelycannotoccurunderacommoncurrency.Indeedwithacommoncurrencytherealsoisnoriskofcurrencyrealignmentsthatcantakeplaceunderfixedexchangeratesamongmultiplecurrencies.AnotherargumentisthatadoptingacommoncurrencyprovidesabasisforlowerEuropean-wideinflationiftheEuropeanCentralBankachievesgreatermonetarypolicycredibilityrelativetothecurrentcentralbankinginstitutionsofEurope.Finallymovingtoacommonmonetarypolicymighthelpengendergreatercoordinationoffiscalbankingandtradepoliciesamongtheparticipatingnations.
5.Thelanguagebarriercombineswiththeotherlegalandnaturalbarriersforfactormovementandservesasanimpedimenttolabormobility.Inthiscasethecountrycouldbenefitfromadoptingaflexibleexchangerate.Ifaflexibleexchangeratewereineffecttheincreasedtradedeficitwouldleadtoanaturaldepreciationofthenationscurrency.Thiswouldhelptostabilizeaggregatedemandi.e.reduceitsfallbymakingimportsmoreexpensiveandexportslessexpensive.Maintainingafixedexchangerateeliminatesthisstabilizingchannel.
6.ThesinglecurrencyinEuropewouldworkevenbetterinEuropeifthereexistedasinglecommonlanguagebecausethecommonlanguagewouldmakeiteasierforlabortobemobile;akeyassumptiontothetheorybehindanoptimalcurrencyarea.
7.Potentialbenefitsofnationalcoordinationofmonetarypoliciesincludetheinternalizationofpolicyexternalitiestheoptimizationoftheoutcomeofthelimitedsetofpolicyinstrumentsthebenefitofexternalcommitmentswhenfacedwithinternalpressurestofollowshort-termgoalsattheexpenseoflongtermstability.Answerswillvaryastowhichoneisconsideredthemostimportant.
8.Potentialdisadvantagesofmonetarypolicycoordinationincludethesovereigntyanindividualcountrysacrificesthepotentialofonecountrytocheatonanotherbydeviatingfromtheagreeduponcoordinationstrategythepotentialofpoorpolicymakingbyamembercountryandtheaddedpotentialofinflationbiaswhencredibilitylevelsarelowwithinindividualnations.Answerswillvaryregardingwhichisthegreatestsacrifice.
9.Inlightofthesetrade-offscountriesmayagreetoonlyintermittentlycoordinatepolicieswhenthecountriesinvolvedaresimilarlyaffectedbyanexogenousshocke.g.anenergypriceincrease.Insuchasituationthecountriesarerecoveringfromacommonshockandsharesimilarpolicygoals.Thustheycanmakethemostoftheadvantagesofpolicycoordinationwhileatthesametimeminimizingthedisadvantagesofpolicycoordination.
10.InthissituationthecentralbankwouldlackcredibilitytodefendthetargetzonesotheexchangeratecouldnolongerlieontheS-curve.Insteadthecurrency’svaluewouldfloatsoitwouldlieonthestraightlineassociatedwithafreefloat.R–R*450F-S/S-
0.
1251.
58581.00-
1.00$/€S0S1S0D1D0Q1Q0$/€S0S1S0S1D0Q1Q0S0S1R0S1R1S0R1R0D0D0Q1Q0Q1Q0NetProfitBreakEven
0.
9600.
9801.
020.9988InthemoneyAtthemoneyOutofthemoney0NetLoss940010600QdQsD0SSpotRate=foreign/domesticD1QuantitydomesticcurrencyS0S1。