1.

Which of the following transactions could contribute to a British current account

surplus? Explain why.

a. A French firm sells defense equipment to the British government for 250
million pounds in bank deposits

b. Great Britain makes a gift of $500 million to the Iraqi government in the
form of equipment to aid in reconstruction.

Answer: The first transaction will lead to a debit entry in the current account, and this
will not contribute to a British current account surplus (rather to a deficit). The
second transaction will enter the financial account of Great Britain as a debit item.
The export of the British equipment to Iraq thus will be recorded as a credit item on
the current account of Great Britain. This will contribute to a British current account
surplus.

2. You are provided with the following information about a country's international
transactions during a given year:

Calculate the official settlements balance and the current account balance.

Is the country increasing or decreasing its net holdings of official reserve

assets? Why?

Answer:Current account balance: $346 - 354 + 480 - 348 + 153 - 142 = $135

Official settlements balance: $346 - 354 + 480 - 348 +153 -142 + 252 352 + 154 =
$189

Change in official reserve assets (net) = - official settlements balance = - $189.

The country is increasing its net holdings of official reserve assets.

3. We often hear that trade deficits are bad for a country. Do you agree or disagree with
this viewpoint? Explain carefully.

Answer: Having a deficit on the goods and services balance (also called trade
balance) means that a country imported more goods and services than it exported. A
trade deficit might be considered bad for a country because it indicates that the
country consumes more foreign goods than the country exports. This might be an
indicator that the economy is not able to produce the goods and services that its
citizens consume. It has to be mentioned however that the goods and services
balance is only part of the current account balance. It might the case that a country
is running a trade deficit but has a balanced current account. The current account
also contains international income flows (income received from foreigners and
income paid to foreigners). If the citizens of a country hold financial assets abroad,
then the returns on these financial assets could be used to buy foreign goods. That
way the country is not indebted even if the country has a deficit on the trade
balance. This suggests that a deficit on the current account should be a bigger
concern than a deficit on the trade balance.

4. A retailer in Mexico wants to buy $100,000 worth of Apple computers from theUnited
States. The Mexican retailer has pesos while the seller in the United States wants to
be paid in U.S. dollars. Explain how this transaction is completed with particular
emphasis on the foreign exchange market and banks in the United
States and Mexico.

Answer: The Mexican buyer has to sell pesos to get dollars to pay the U.S. exporter.
The Mexican firm contacts its bank and requests a quotation of the exchange rate
for selling pesos and acquiring 100,000 dollars. If the rate is acceptable, the Mexican
firm instructs its bank to take pesos from its checking account, convert into 100,000
dollars and transfer the dollars to the U.S.producer. The Mexican bank holds the
dollar denominated deposits in the United States, at its correspondent bank in New
York. The Mexican bank instructs its correspondent bank in New York to take dollars
from its checking account and transfer the dollars to the U.S. producer. This
completes the international payment for computers.

5. What predictions does the purchasing-power parity theory make concerning the
impact of domestic inflation on the home countrys exchange rate? What are some
limitations of the purchasing-power parity theory?
 Answer: There are two versions of purchasing power parity. Absolute purchasing
power parity states that a bundle of tradable products will have the same cost in
different countries if this cost is stated in the same currency. Relative purchasing
power parity states that the difference between changes over time in product price
levels in two countries will be offset by the change in the exchange rate over this
time. The exchange rate changes over time at a rate equal to the difference in the
inflation rate of the two countries. Thus, the higher the inflation at home, the greater
is the depreciation of the home currency against other currencies. The deviations
from the parity occur more for the absolute version and in the short-run. There is
more evidence to suggest relative version holds in the long-run. When measuring
the average price level, countries may not use the same bundle of goods thus
making the parity relationship more difficult to measure.

6. According to the Monetary Approach to Exchange Rate Determination, how should an

increase in foreign real income affect the value of domestic currency? Explain the logic
of your answer.

Answer: Using the quantity theory equations to determine the ratio of prices between
countries we have the equation e = P/P f = (Ms/Msf)*(kf/k)*(Yf/Y). An increase in
foreign real income will cause the foreign currency to appreciate, which would
automatically imply that the domestic currency would depreciate. In this equation,
holding other influences constant, when Yf increases the right hand side of this
equation is now greater than the left hand side. For the equality to be re-attained, e
must now rise, corresponding to a depreciation of the home currency.

7. You observe the following current rates:

Spot exchange rate: $1.25/SFr

Annual interest rate on 90-day U.S.-dollar-denominated bonds: 8%

Annual interest rate on 90-day SFr-denominated bonds: 2%

Assuming uncovered interest parity holds, what spot exchange rate do investors
expect in 90 days? What is likely to be the effect on the spot exchange rate if
the U.S. money supply unexpectedly jumps 10%? In your answer assume that the
asset market clears faster than the goods market (i.e. that prices adjust slowly and
interest rates adjust quickly). Also in your answer address short-run changes in the
exchange rate as well as long-run changes.

Answer: The difference in annual interest rates is 6 percentage points, so the

difference for 90 days in 1.5 percentage points. For uncovered interest parity,
investors must expect the Swiss franc to appreciate by 1.5 percent in the next 90
days. Investors will expect the spot rate to be $1.26875/SFr in 90 days [= 1.25*(1 +
0.015)]. When the U.S. money supply jumps 10% unexpectedly, the dollar will first
 overshoot its long run equilibrium value in the short-run and depreciate more than
10%, and the dollar will slowly appreciate toward its new equilibrium in the longer
run.

8. Why does exchange rate overshooting occur?

Answer: Overshooting occurs because in this sticky price version of the monetary
approach, prices are assumed to be fixed in the short run and completely flexible in the
long run. A considerable amount of time must pass for the increase in money supply to
lead to an increase in domestic prices. Thus, purchasing power parity is more
realistically assumed to hold in the long run but not in the short run. Because prices are
sticky at first, the increase in money supply drives down domestic interest rates. This
shift favors foreign currency assets which results in immediate depreciation of the
domestic currency. As prices adjust, the domestic currency reverts back to its new long
run equilibrium.

9. A fixed exchange rate country experiences upward pressure on the exchange rate
value of its currency. The central bank chooses to intervene in the market to
maintain its fixed exchange rate. How would the central bank go about intervening?
If the pressures for the currency to appreciate persist, would it be difficult to maintain
the fixed exchange rate? Why or why not? Would your answers differ if the country
carried out sterilized intervention? Why or why not. Give an example of a country
that attempted to maintain their exchange rate in the face of upward pressures on
their currency value. What was the result?

Answer: The upward pressure means pressure on home country currency to

appreciate. The central bank would have to buy foreign currency and sell domestic
currency in the foreign exchange market. It could eventually be difficult to maintain
the fixed exchange rate. The central bank increases the domestic money supply by
selling domestic currency in the foreign exchange market. Sooner or later there
would be more inflation. And, the country would come under foreign political
pressures because of its persistent payments surpluses. Sterilization means
offsetting the consequences of foreign exchange intervention on domestic money
supply. The central bank would have to carry out contractionary domestic monetary
actions to sterilize. Such sterilization could hold off the inflation, but would not stop
the foreign pressures. One such example was China. Chinas foreign exchange
reserves more than quadrupled from 2000 to 2005. In the end, the Chinese
government had to revalue its currency.

10. . Describe the Bretton Woods exchange rate system and explain why it fell apart.
 Answer: As in every fixed exchange rate system crisis, the main reason why the
Bretton Woods exchange rate system fell apart was because exchange rates then
were not adjusted frequently enough. Other related reasons were the U.S. ran large
official settlements balance deficits which became a concern in Europe
and Japan which had recovered from the war and whose firms competitiveness
increased globally. The concern led to increased demands of gold for dollar.
Eventually, the convertibility of dollars into gold was suspended.

11. What are the five major forces that can lead to financial crises? Explain each of
these forces in depth.

Answer:

1. Waves of overlending and overborrowing. In the late 1970s and mid 1990s
lenders were lending excessively to some countries. This often results from
excessive expansionary policies in the borrowing country. These policies lead
to governments borrowing to finance growing budget deficits. Further loans to
private borrowers may be guaranteed by the government to finance the
growing current account deficits. The governments have an incentive to
default when they realize they borrowed too much. When foreign lenders
realize that too much has been borrowed, they have an incentive to stop
lending and demand repayment quickly. When all cannot be paid quickly
financial crisis occurs.

2. Exogenous international shocks. A decline in export earnings due to a

decline in the worlds price of a countrys key export commodity may
constitute such a shock. In such a situation, the country may find it difficult to
service its foreign debt and therefore default. A change in the U.S. real
interest rates in the early 1980s and 1990s was a major exogenous shock.
When interest rates in theU.S. increase, new funding flows to developing
countries decrease because it is harder to find those projects that offer a rate
of return greater than the already high interest rates in the United States.

3. Exchange rate risk. Private borrowers can take on excessive debt

denominated in foreign currency and back these with assets valued in local
currency. Liabilities are not matched by the same currency assets and
therefore exposure to exchange rate risk occurs. This mostly occurs because
private investors expect the government to successfully defend its fixed
exchange rate. Another name for this type of uncovered borrowing is carry
trade where investors borrow dollars or yen at low interest rates and lend in
the borrowing country at a higher rate. As long as the exchange value of local
currency is steady, this is a profitable investment. However, when the
 probability of devaluation increases, borrowers sell local currency, increasing
the pressure on the local currency to devalue. When the government has no
option but to devalue, borrowers suffer a loss.

12. Explain four reform measures that have been suggested to reduce the possibility
and frequency of international financial crises.

Answer:

1. Developing countries should pursue sound macroeconomic policies to

avoid creating conditions in which overborrowing or a loss of confidence in
the governments capability could lead to a crisis.

2. Countries should improve the data they report publicly to provide sufficient
details on total debt and its components, holdings of international reserves.
Such data should be reported promptly.

3. Developing countries should avoid short-term borrowing denominated in

foreign currency to avoid crises that begin with foreign lenders demanding
rapid repayment.

4. Better regulation and supervision of banks in developing countries. With

weak supervision and implicit guarantees that the government will rescue
banks in trouble, banks have an incentive to borrow too much internationally
and take unhedged foreign currency liabilities. Regulators should require
banks to use better accounting and disclose more information publicly and
use risk management to reduce risk exposures. Banks should have more
equity capital and recognize bad loans and make provisions for them.
Regulators should identify weak banks and insist on changes in practices and
management. Foreign banks should be able to compete locally to increase
efficiency of the system.

4. Fickle international short-term lending. Debt that is due to be paid off soon
can cause a major problem when foreign lenders refuse to refinance it.
Tesobonos were a major contributor to the December 1994 Mexican
economic crisis. In the Asian crisis large amounts of short-term borrowing by
banks were coming due creating a policy dilemma. The countrys government
could raise interest rates to attract foreign capital weakening the local
borrowers or the government could guarantee or take over the banks foreign
borrowings. However, the governments may not have sufficient foreign
 exchange reserves to pay off the debts risking a financial crisis when foreign
lenders demand repayment. A shift from one state of equilibrium to another
occurs more rapidly under short term borrowing than long term borrowing.

5. Global contagion. When a crisis hitting one country spreads to other

countries contagion occurs. Contagion may be the result of close trade ties
between affected countries. A downturn in one country like Argentina can
affect another country like Uruguay. Contagion may also result from
overreaction by foreign lenders and they struggle to exit. Herding may occur
when investors are not provided full information. The high cost of obtaining
accurate information may contribute to contagion. Recognition of real
problems in a neighboring country (wake-up call) similar to those in the crisis
country can cause contagion. Crisis in Thailand led to a wake-up call
in Indonesia andSouth Korea. Some common problems were a weak banking
sector, declining quality of domestic capital formation and a slowdown in
export growth.

13.

14. Use the standard IS-LM-FE framework and assume the country begins at a triple
intersection. What effect will the following have on domestic interest rates, output
levels, and the official settlements balance, assuming low capital mobility?

a. The central bank increases the money supply.

b. The government increases its spending.

Answer: a.The LM curve shifts to the right, and the country moves to a new
short-run equilibrium at the intersection of the IS curve and the new LM
curve. The domestic interest rate decreases, real GDP increases, and the official
settlements balance goes into deficit. With the increase in the money supply, it is
temporarily greater than money demand. To bring about an equilibrium in the
money market, interest rates must fall. The fall in interest rates increases
interest-sensitive spending, so the GDP output level increases. There is now a
payment deficit because the new intersection of the IS and LM curves takes
place to the right of the FE curve.

b. The IS curve shifts to the right, and the country moves to a new short-run
equilibrium at the intersection of the LM curve and the new IS curve. Real
GDP increases, the domestic interest rate increases, and the official
settlements balance goes into deficit. This new intersection occurs to the
right of the relatively steep FE curve, which corresponds to a payments
deficit.