Suggested an swers to questio ns and p roblems(in the textbook)Disagree, at least as a general statement. One meaning of a current account surplus is that thecountry is exporting more goods and services than itis importing. One might easily judge that this is not good — the country isp roduci ng goods and services that are exp orted, but the country is not at the same time getting the imports of goods and services that would allowdo more consump tio n and domestic inv estme nt. I n this way a curre nt acco unt deficit mightbe con sidered good — the extra imp orts allow the country to con sume and in vest domesticallymore tha n the value of its curre nt production. Another meaning of a current account surplus isthat the country is en gag ing in foreig n finan cial inv estme nt — it is buildi ng up its claimson foreig ners, and this adds to n ati onal wealth. This sounds good, but as no ted above it comesat the cost of forego ing curre nt domestic pu rchases of goods and services. A curre nt acco untdeficit is the country running dow n its claims on foreigners or increasing its indebtedness toforeigners. Thissounds bad, but it comeswith the ben efit of higher levels of curre nt domestic expen diture.Differe nt coun tries at differe nt times may weigh the bala nee of these costs and ben efitsdiffere ntly, so that we cannot simply say that a curre nt acco unt surplus is better tha n a current acco unt deficit.Disagree. If the country has a surplus (a p ositive value) for its official settleme nts bala nee, then the value for its official reserves bala nee must be a negative value of the sameamount (so that the two add to zero). A negative value for this asset item means that funds are flow ing out in order for the country to acquire more of these kinds of assets. Thus, the country is in creas ing its hold ings of official reserve assets.Item e is a tran sacti on in which foreig n official hold ings of U.S. assets in crease. This is a po sitive (credit) item for official reserve assets and a negative (debit) item for private capital flowsas the U.S. bank acquires pound bank depo sits. The debit item con tributes to a U.S. deficit in theofficial settleme nts bala nee (while the credit item is recorded "below the lin e," p ermitti ng the official settleme nts bala nee to be in deficit). All other transactions invoIve debit and credit items both of which are includedin the official settleme nts bala nee, so that they do not directly con tribute to a deficit (orsurpi us) in the official settleme nts bala nee.Chap ter 22. it 4. 6.8. a. Mercha ndise trade bala nee: $330 - 198 = $132Goods and services bala nee: $330 - 198 + 196 - 204 = $124Curre nt account bala nee: $330 - 198 + 196 - 204 + 3 - 8 = $119Official settleme nts bala nee: $330 - 198 + 196 - 204 + 3 - 8 + 102 - 202 + 4 = $23b. Change in official reserve assets (net) = - officialsettlements balanee=-$23. The country is in creas ing its net hold ings of official reserve assets.10. a. In ternatio nal in vestme nt p ositio n (billio ns): $30 + 20 + 15 - 40 - 25 =$0.The country is n either an intern ati onal creditor nor a debtor. Its hold ing of intern ati onalassets equals its liabilities to foreig ners.b. A curre nt acco unt surplus p ermits the country to add to its net claims on foreig ners. For thisreas on the coun try's intern atio nal inv estme nt po siti on will becomea p ositive value. Theflow in crease in net foreig n assets results in the stock of net foreig n assets beco ming positive.Exports of merchandise and services result in supply of foreign currency in the foreig n exchange market. Domestic sellers ofte n want to be p aid using domestic curre ncy, while the foreign buyers want to pay in their curre ncy.In the p rocess of paying for these exp orts, foreig n curre ncy is excha nged for domestic currency, creat ing supply of foreig n curre ncy. Intern ati onalcap ital in flows result in a supply of foreig n curre ncy in the foreig n excha nge market. I nmaki ng inv estme nts in domestic finan cial assets, foreig ninvestors often start with foreign currency and must exchange it for domestic curre ncy before theycan buy the domestic assets. The excha nge creates a supply of foreig n curre ncy. Sales of foreign finan cial assets that the country's residents had previously acquired, and borrowing fromforeignersby this coun try's reside nts are other forms of cap ital in flow that can create supply of foreign curre ncy.The U.S. firm obta ins a quotatio n from its bank on the spot excha nge rate for buying yen withdollars. If the rate is acce ptable, the firm in structs its bank that it wants to use dollars fromits dollar check ing acco unt to buy 1 millio n yen at this spot excha nge rate. It also in structsits bank to send the yen to the bank acco unt of the Japan ese firm. To carry out thisChap ter 32. 4.instruction, the U.S. bank instructs its correspondent bank in Japan to take1 milli on yen from its acco unt at the corres pondent bank and tran sfer the yen to the bank account of the Japan ese firm. (The U.S. bank could also use yen at its own branch if it has a branchin Japan.)The trader would seek out the best quoted spot rate for buying euros with dollars, either throughdirect con tact with traders at other banks or by using the services of a foreign exchange broker.The trader would use the best rate to buy euro spot. Sometime in the n ext hour or so (or, typically at least by the end of the day), the trader will en ter the in terba nk market aga in, toobtain the best quoted spot rate for selling euros for dollars. The trader will use the best spot rate to sell her p reviously acquired euros. If the spot value of the eurohas rise n duri ng this short time, the trader makes a p rofit.The cross rate betwee n the yen and the krone is too high (the yen value of the krone is toohigh) relative to the dollar-foreig n curre ncy excha nge rates. Thus, in a p rofitable tria ngulararbitrage, you want to sell kroner at the high cross rate. The arbitrage will be: Use dollars to buykroner at $0.20/kr one, use these kroner to buy yen at 25 yen/krone, and use the yen to buy dollarsat $0.01/ye n. For each dollar that you sell in itially, you can obta in 5 kroner, these 5 kronercan obta in 125 yen, and the 125 yen can obta in $1.25. The arbitrage p rofit for each dollar istherefore 25 cen ts.Selli ng kroner to buy yen p uts dow nward p ressure on the cross rate (the yen price ofkrone). The value of the cross rate must fall to 20 (=0.20/0.01) yen/krone to elimi nate theopportunity for tria ngular arbitrage, assu ming that the dollar excha nge rates are un cha nged.The in crease in supply of Swiss francs puts dow nward p ressure on the excha nge-rate value($/SFr) of the franc. The mon etary authorities must intervene to defend the fixed exchange rate bybuying SFr and sellingb. The in crease in supply of francs puts dow nward p ressure on the excha nge-rate value ($/SFr) ofthe franc. The mon etary authorities must intervene to defend the fixed exchange rate by buying SFrand sellingc. The in crease in supply of francs puts dow nward p ressure on the excha nge-rate value($/SFr) of the franc. The mon etary authorities must intervene to defend the fixedexchange rate by buying SFr and selling6.8. a. b.10. a.dollars. dollars. dollars.d. The decrease in dema nd for francs puts dow nward p ressure on the excha nge-rate value ($/SFr) ofthe franc. The mon etary authorities must intervene to defend the fixed exchange rate by buying SFrand selling You will need data on four market rates: The current interest rate on bonds issued by the U.S. government that mature in one year, the interest rate (or yield) on bonds issued by the British government that maturein one year, the curre nt spot excha nge rate betwee n the dollar and pound, and the current one-year forward exchange rate between the dollar and pound. Do these rates result in a coveredinterestdifferential that is very closeto zero?Relative to your exp ected spot value of the euro in 90 days ($1.22/euro), the current forward rate ofthe euro ($1.18/euro) is low — the forward value of the euro is relatively low. Using the principle of "buy low, sell high," you can sp eculate by en teri ng into a forward con tract now to buy euros at$1.18/euro. If you are be able to immediately of $0.04 for each euro this way, then massivedollars.Chap ter 42.(or yield) curre nt 4. a. The U.S. firm has an asset p ositi on in yen — it has a long p ositi on in yen. To hedge its exp osure to excha nge rate risk, the firm should en ter into a forward exchange con tract now in which the firm commits to sell yen and receive dollars at the curre ntforward rate. The con tract amounts are to 1 millio n yen and receive $9,000, both in 60days.sell b. The stude nt has an asset po siti on in yen — a long p ositi on in yen. Tohedge the exp osure to excha nge rate risk, the stude nt should en ter into a forward exchange con tract now in which the stude nt commits to sell yen and receive dollars at the current forward rate. The con tract amounts are to 10 millio n yen and receive $90,000, both in 60 days.sellc. The U.S. firm has an liability position in yen — a short position in To hedge its exp osure to excha nge rate risk, the firm should en ter into a forward exchange con tract now in which the firm commits to sell dollars receive yen at the curre ntforward rate. The con tract amounts are to sell $900,000 and receive 100 millio n yen, bothin 60 days.yen.and 6. correct in your expectation, then in 90 days you will resell those euros for $1.22/euro, pocketing a profit that you boughtforward. If many people sp eculate in pu rchases now of euros forward(in creas ing the dema ndfor euros forward) will tend to drive up the forward value of the euro, toward a curre nt forwardrate of $1.22/euro.The Swiss franc is at a forward prem ium. Its curre nt forward value($0.505/SFr) is greater than its current sp ot value ($0.500/SFr).The covered in terest differe ntial "i n favor of Switzerla nd" is ((1 + 0.005) (0.505) / 0.500) - (1 + 0.01) = 0.005. (Note that the interest rate used must match the time p eriod of the in vestment.) There is a covered interest differential of 0.5% for 30 days (6 percent at an annual rate). TheU.S. investor can make a higher return, covered against exchange rate risk, by inv esti ng in SFr-de nomin ated bon ds, so p resumably the inv estor should makethis covered investment. Although the interest rate on SFr-denominated bonds is lower tha n the in terest rate on dollar-de nomin ated bon ds, the forward p remium on the franc is larger tha n this differe nee, so that the covered inv estme nt is a good idea.The lack of demandfor dollar-denominated bonds (or the supply of thesebonds as in vestors sell them in order to shift into SFr-de nomin ated bon ds) puts dow nward p ressure on the p rices of U.S. bon ds —up ward p ressure on U.S. in terest rates. The extra dema nd for the franc in the spot excha nge market (as in vestors buy SFr in order to buy SFr-de nomin ated bon ds)puts up ward p ressure on the spot excha nge rate. The extra dema nd for SFr-de nomin ated bonds puts up ward p ressure on the p rices of Swiss bonds — dow nward p ressureon Swiss in terest rates. The extra supply of francs in the forward market (as U.S. i nv estors cover their SFr in vestme nts back into dollars) p uts downwardpressure on the forward exchange rate. If the only rate that changes is the forward exchange rate, this rate must fall to about $0.5025/SFr. Withthis forward rate and the other in itial rates, the covered in terest differe ntial is close to zero. In test ing covered in terest p arity, all of the in terest rates and excha nge rates that are n eeded to calculate the covered in terest differe ntial are rates that can observed in the bond and foreignexchange markets. Determining whether the covered in terest differe ntial is about zero (covered interest parity) is then straightforward (although somemore subtle issues regardingtim ing of tran sact ions may also n eed to be addressed). I n order to test uncovered interestparity, we need to know not only three rates — two interest rates and the current spot exchangerate — that can be observed in the market, but also one rate— the exp ected future spot exchange rate — that is notobserved in any market. The tester the n n eeds a way to find out aboutinv estors' exp ectati ons. One way is to ask them, using a survey, but they may not say exactlywhat they really think. Ano ther way is to exam ine the actual un covered in terest differe ntialafter we know what the future spot excha nge rate actually turns out to be, and see whether thestatistical characteristics of the actual uncovered differential are consistentwith an expected uncovered differential of about zero (uncovered interest parity). 8. a.b.c.10.Cha pter 52. a. The euro is expected to appreciate at an annual rate of approximately ((1.005 -1.000)/1.000) (360/180)100 = 1%. The exp ected un covered in terestdifferential is approximately 3%+ 1%- 4%= 0, so uncovered interest parityholds (app roximately).b. If the in terest rate on 180-day dollar-de nomin ated bonds decli nes to3%, the n the spot excha nge rate is likely to in crease —the euro willappreciate, the dollar depreciate. At the initial current spot exchange rate,the initial expected future spot exchange rate, and the initial euro interestrate, the exp ected un covered in terest differe ntial shifts in favor of investing in euro-denominated bonds (the expected uncovered differential is now p ositive, 3% + 1% - 3% = 1%, favori ng un covered inv estme nt in euro-de nomin ated bon ds.The in creased dema ndfor euros in the spot excha nge market tends to app reciate the euro. If the euro in terest rate and the exp ected future spot excha nge rate rema in un cha nged, the n thecurre nt spot rate must cha nge immediately to be $1.005/euro, to reestablish un covered interest parity. Whenthe current spot rate jumps to this value, the euro'sexcha nge rate value is not exp ected to cha nge in value subseque ntly duri ng the next 180 days.The dollar has depreciated immediately, and the uncovered differe ntial then again is zero (3% + 0% - 3% = 0).4. a. For uncovered interest parity to hold, investors must expect that the rateof change in the spot exchange-rate value of the yen equals the interest rate differential, which is zero. Investors must expect that the future spot valueis the same as the curre nt spot value, $0.01/ye n.b. If inv estors exp ect that the excha nge rate will be $0.0095/ye n, the nthey expect the yen to depreciate from its initial spot value during the next 90 days. Give n theother rates, i nv estors tend to shift their inv estme nts toward dollar-de nomin ated inv estments. The extra supply of yen (and dema ndfor dollars) in the spot exchange market results in a decrease in the current spot value of the yen(the dollar appreciates). The shift to expecting that the yen will depreciate (the dollarappreciate) sometime during the next 90 days tends to cause the yen to dep reciate (the dollar toapp reciate) immediately in the curre nt spot market.The law of one p rice will hold better for gold. Gold can be traded easilyso that any price differences would lead to arbitrage that would tend to push gold p rices (stated in a com mon curre ncy by converting p rices using market excha nge rates) back close to equality. Big Macs cannot be arbitraged. If p rice differe nces exist, there is no arbitrage p ressure, so the p ricedifferences can persist. The prices of Big Macs(stated in a commoncurrency) vary widely around the world.According to PPP, the exchange rate value of the DM(relative to the dollar) has rise n since the early 1970s because Germa ny has exp erie need less inflation than has the United States ——the productprice level has risen lessin Germa ny since the early 1970s tha n it has rise n in the Un ited States.According to the monetary approach, the Germanprice level has not risen as muchbecause the Germa nmon eys upply has in creased less tha n the has in creased in the Un ited States,relative to the growth rates of real domestic production case —more in flati ongrowth in Brita in.rate ofthe domestic moneysupply (M s ) is two percentage points higher tha n it was previously, the mon etary app roach in dicates that the excha nge rate value (e) of the foreig n curre ncy will be higher tha n it otherwise would be — that is, the excha nge rate value of the coun try's curre ncy will be lower. Sp ecifically, the foreig n curre ncy will app reciate by two percentagepoints more per year, or depreciate by two percentage less. That is, the domestic currency will depreciate by two percentage more per year, or app reciate by two p erce ntage points less.b. The faster growth of the coun try's money supply eve ntually leads to afaster rate of inflation of the domestic price level (P). Specifically, inflation rate will be two percentage points higher than it otherwise be. Accord ing torelative PPP, a faster rate of in crease in the domestic level (P) leads to a higher rate of app reciatio n of the foreig n curre ncy.12. a. For the Un ited States in 1975, 20,000 = k 6.8. mon eys upply the opposite higher money in the two countries. The British pound is in Britain than in the United States, and 10. a. Because the growth pointspointsthewould price■100 800, or k = 0.25.For P ugelovia in 1975, 10,000 = k b. For the Un ited States, the qua ntity theory of money with a con sta nt kmeansthat the quantity equation with k = 0.25 should hold in 2002: 65,000=0.25 2601,000. It does. Because the quantity equation holds for both years with the samek, thechange in the price level from 1975 to 2002 is consistent with the quantity theory of moneywith aconstant k. Similarly, for Pugelovia, the quantity equation with k = 0.5 should hold for 2002, and it does (58,500 =0.5 390 300).14. a. The tighte ning typ ically leads to an immediate in crease in the coun try'sin terest rates. In additi on, the tighte ning p robably also results ininvestors' expecting that the exchange-rate value of the country's currencyis likely to be higher in the future. The higher expected exchange-rate value for the currency isbased on the expectation that the country's price level will be lower in the future, and PPP indicates that the curre ncy will the n be stro nger. For both of these reas ons, intern ati onal investors will shift toward inv est ing in this coun try's bon ds. The in crease in dema nd for the coun try's curre ncy in the spot excha nge market causes the curre ntexcha nge-rate value of the curre ncy to in crease. The curre ncy maya pp reciate a lot because thecurrent exchange rate must "overshoot" its expected future spot value. Un covered in terest p arityis reestablished with a higher in terest rate and a subseque nt exp ected dep reciati on of the curre ncy.b. If everyth ing else is rather steady, the excha nge rate (the domesticcurrency price of foreign currency) is likely to decrease quickly by a large amount. After this jump, the excha nge rate maythe n in crease gradually toward its long-run value — the value con siste ntwith PPP in the long run.Weoften use the term pegged exchange rate to refer to a fixed exchange rate, because fixed ratesgen erally are not fixed forever. An adjustable peg isan exchange rate policy in which the "fixed" exchange rate value of a currency can be cha nged fromtime to time, but usually it is cha nged rather seldom(for in sta nee, not more tha n once every several years). A crawli ng peg isan exchange rate policy in which the "fixed" exchange rate value of a currency is cha nged ofte n(for in sta nee, weekly or mon thly), sometimes accordi ng to in dicators such as the differe nee inin flati on rates.Disagree. If a country is expected to impose exchange controls,which usually make it more difficult to move funds out of the country in the future,investors are likely to try to shift funds out of the country now before the100 200, or k = 0.5.Chap ter 62. 4.con trols are imp osed. The in crease in supply of domestic curre ncy into the foreig n excha ngemarket (or in crease in dema nd for foreig n curre ncy) p utsdownward pressure on the exchange rate value of the country's currency —the curre ncy tends to dep reciate.6. a. The market is atte mpting to dep reciate the pn ut (app reciate the dollar) toward a value of 3.5 pnutsper dollar, which is outside of the top of the allowable band (3.06 pnuts per dollar). In order todefend the pegged exchange rate, the Pu gelovia n mon etary authorities could use official in terve ntio nto buy pnuts (in exchange for dollars). Buying pnuts prevents the pnut ' s value from declining (selling dollars prevents the dollar ' s value fromrisin g). The in terve nti on satisfies the excess p rivate dema nd for dollarsat the curre nt p egged excha nge rate.b. In order to defend the pegged exchange rate, the Pugelovian governmentcould impose excha nge con trols in which some p rivate in dividuals who want to sell pnuts and buy dollars are told that they cannot legally do this (or cannot do this without gover nment p ermission, and not all requests are approved by the government). By artificially restricting the supply of pnuts (and the dema nd for dollars), the Pu gelovia n gover nment can force the remai ning p rivate supply and dema nd to "clear" within the allowable band.The exchange controls attempt to stifle the excess private demandfor dollars at the curre nt p egged excha nge rate.c. In order to defend the pegged exchange rate, the Pugelovian governmentcould in crease domestic in terest rates (p erha ps by a lot). The higher domestic interest ratesshift the incentives for international capital flows toward inv estme nts in Pu gelovia n bon ds. The in creased flow of intern ati onal finan cial cap ital into Pu gelovia in creases the dema nd forpnuts on the foreig n excha nge market. (Also, the decreased flow of intern ati onal financialcapital out of Pugelovia reduces the supply of pnuts on the foreignexcha nge market.) By in creas ing the dema nd for pnuts (and decreas ing the suppl y), the Pugelovia n gover nment can in duce the p rivate market to clear within the allowable band. The increased domestic in terest rates attem pt toshift the private supply and demandcurves so that there is no excess private dema nd for dollars at the curre nt p egged excha nge rate value.8. a. The gold sta ndard was a fixed rate system. The gover nment of each countryp artici pati ng in the system agreed to buy or sell gold in excha nge for itsown currency at a fixed price of gold (in terms of its own currency). Becauseeach currency was fixed to gold, the exchange rates between currencies also ten ded to be fixed, because in dividuals could arbitrage betwee n gold and curre ncies if the curre ncy excha nge rates deviated from those imp lied by the fixed gold p rices.Britai n was central to the system, because the British economy was the leader in in dustrializatio n and world trade, and because Brita in was con sidered finan cially secure and p rude nt. Brita in was able and willi ng to run p ayme nts deficits that p ermitted many other coun tries to run p ayme ntssurpi uses. The other coun tries used their surpi uses to build up their holdi ngs of gold reserves (and of intern ati onal reserves in the form of sterling-denominated assets). These other countries were satisfied with therate of growth of their holdings of liquid reserve assets, and most countries were able to avoid the crisis of running low on intern ati onal reserves.Duri ng the height of the gold stan dard, from about 1870 to 1914, theeconomic shocks to the system were mild. A major shock —World War I — caused many coun tries to sus pend the gold sta ndard.Sp eculati on was gen erally stabiliz ing, both for the excha nge rates between the currencies of countries that were adhering to the gold standard, and for the excha nge rates of coun tries that temp orarily allowed their curre ncies to float.10. a. The Brett on Woods system was an adjustable p egged excha nge rate system.Coun tries committed to set and defe nd fixed excha nge rates, financing temporary p ayme nts imbala nces out of their official reserve holdi ngs. If a "fun dame ntal disequilibrium "in a coun try's intern ati onal p ayme ntsdeveloped, the country could change the value of its fixed exchange rate to a new value.b. The Un ited States was cen tral to the system. As the Brett on Woodssystemevolved, it became esse ntially a gold-excha nge sta ndard. The mon etaryauthorities of other countries committed to peg the exchange rate values of their curre ncies to the U.S. dollar. The U.S. mon etary authority committedto buy and sell gold in exchange for dollars with other countries'monetaryauthorities at a fixed dollar p rice of gold. c. To a large extent speculation was stabilizing, both for the fixed ratesfollowed by most countries, and for the exchange rate value of the Canadian dollar, which floated duri ng 1950-62. However, the p egged excha nge rateb. c.d.values of curre ncies sometimes did come un der sp eculative p ressure.Intern ati onal inv estors and sp eculators sometimes believed that they had a on e-way sp eculativebet aga inst curre ncies that were con sidered to be "in trouble. ” If the country did managetodefend the pegged exchange rate value of its curre ncy, the inv estors bett ing aga inst the currency would lose little. They stood to gain a lot of p rofit if the curre ncy was devalued.Furthermore, the large speculative flows against the currency required large interventions to defendthe currency's pegged value, so that thewas more likely to run so low on official reserves that it was forced to devalue.12. a. The dollar bloc a nd the euro bloc. A nu mber of co un tries peg their to the U.S.dollar. A nu mber of European coun tries use the euro, and, in additi on, a nu mberof other coun tries peg their curre ncies to the euro.(as of the beg inning of 2002)the Japan ese yen, the Britishpound, the Can adia n dollar, and the Swiss franc. c. The exchange rates between the U.S. dollar and the other major currencieshave been floating since the early 1970s. The movementsin these rates exhibittrends in the long run — over the en tire p eriod since the early 1970s. The rates also showsubstantial variability or volatility in the short and medium runs — p eriods of less tha n oneyear to p eriods of several years. The long run trends app ear to be reas on ably con siste nt withthe econo mic fun dame ntals emp hasized by pu rchas ing po wer p arity ——differe nces in n ational in flati onrates. The variability or volatility in the short or medium run iscon troversial. It may simply rep rese nt rati onal res pon ses to the continuingflow of economic and political news that has implications for exchange rate values. The effects onrates can be large and rap id, because overshooti ng occurs as rates res pond to imp orta nt n ews.However, some part of the large volatility mayalso reflect speculative bandwagonsthat lead to bubbles that subseque ntly burst.Cha pter 72. Disagree. In a sense a n ati onal gover nment cannot go bankrupt, because it can print its own currency. But a n ati onal gover nment can refuse to honor its obligati ons, eve n if it might be able top ay. If the ben efit from not paying exceeds the cost of not paying, the gover nment may rati onally to p ay. And, a n ati onal gover nment can run short of foreig n curre ncy togover nment curre ncies The other major curre ncies that float independen tly in elude b.refusepay。