Answers to End of Chapter QuestionsChapter 1Keeping Up With a Changing World-Trade Flows, Capital Flows, and the Balance Of Payments1. The balance on merchandise trade is the difference between exports of goods, 719 and the imports of goods,1,145, for a deficit of 426. The balance on goods, services and income is 719 + 279 +284 – 1145 - 210 –269, for a deficit of 342. Adding unilateral transfers to this gives a current account deficit of 391, [-342 + (-49) = -391]. (Note that income receipts are credits and income payments are debits.)2. Because the current account balance is a deficit of 391, then without a statistical discrepancy, the capitalaccount is a surplus of 391. In this problem, however, the statistical discrepancy is recorded as a positive amount (credit) of 11. Hence, the sum of the debits in the balance of payments must exceed the credits by11. So, the deficit of the current account must be greater than the surplus on the capital account by 11.The capital account, therefore, is a surplus of 391 – 11 = 380.3. A balance-of-payments equilibrium is when the debits and credits in the current account and the privatecapital account sum to zero. In the problem above we do not know the private capital account balance.We cannot say, therefore, whether this country is experiencing a balance-of-payments surplus or deficit or if it is in equilibrium.4 The current account is a deficit of $541,830 and the private capital account balance is a surplus of $369,068.The U.S., therefore, has a balance of payments deficit.5 Positive aspects of being a net debtor include the possibility of financing domestic investment that is notpossible through domestic savings; thereby allowing for domestic capital stock growth which may allow job, productivity, and income growth. Negative aspects include the fact that foreign savings may be used to finance domestic consumption rather than domestic savings; which will compromise the growth suggested above.Positive aspects of being a net creditor include the ownership of foreign assets which can represent anincome flows to the crediting country. Further, the net creditor position also implies a net exportingposition. A negative aspect of being a net creditor includes the fact that foreign investment may substitute for domestic investment.6 A nation may desire to receive both portfolio and direct investment due to the type of investment eachrepresents. Portfolio investment is a financial investment while direct investment is dominated by thepurchase of actual, real, productive assets. To the extent that a country can benefit by each type ofinvestment, it will desire both types of investment. Further, portfolio investment tends to be short-run in nature, while FDI tends to be long-run in nature. This is also addressed in much greater detail in Chapter 7.7. Domestic Savings - Domestic Investment = Current Account BalanceDomestic Savings - Domestic Investment = Net Capital FlowsTherefore, Current Account Balance = Net Capital Flows8 Using the equations above, private savings of 5 percent of income, government savings of -1 percent, andinvestment expenditures of 10 percent would results in a current account deficit of 6 percent of income and a capital account surplus (net capital inflows) of 6 percent of income. This could be corrected with areduction in the government deficit (to a surplus) and/or an increase in private savings.Chapter 2The Market for Foreign Exchange1. Because it costs fewer dollars to purchase a euro after the exchange rate change, the euro depreciated relativeto the dollar. The rate of depreciation (in absolute value) was [(1.2168 – 1.2201)/1.2201]100 = 0.27 percent.2. Note that the rates provided are the foreign currency prices of the U.S. dollar. Every value has been roundedto two decimal places which may cause some differences in answers.3 The cross rate is 1.702/1.234 = 1.379 (€/￡), which is smaller in value than that observed in the Londonmarket. The arbitrageur would purchase ￡587,544 ($1,000,000/1.702) with the $1 million in the New York market. Next they would use the ￡587,544 in London to purchase €837,250 (￡587,544*1.425).Finally, they would sell the €837,250 in the New York market for $1,033,167 (€837,250*1.234). The profit is #33,167.4. Total trade is (163,681 + 160,829 + 261,180 + 210, 590) = 796,280. Trade with the Euro area is (163,681 +261,180) = 424,861. Trade with Canada is (160,829 + 210,590) = 371,419. The weight assigned to the euro is 424,861/796,280 = 0.53 and the weight assigned to the Canadian dollar is 0.47. (Recall the weights must sum to unity.)Because the base year is 2003, the 2003 EER is 100. The value of the 2004 EER is:[(0.82/0.88)?0.53 + (1.56/1.59)?0.47]?100 = (0.4939 + 0.4611)?100 = 95.4964, or 95.5. This represents a4.5 percent depreciation of the U.S. dollar.5 The real effective exchange rate (REER) for 2003 is still 100. The real rates of exchange are, for 2003,0.88?(116.2/111.3) = .9187, 1.59?(116.2/111.7) = 1.6541, and for 2004, 0.82?(119.0/114.4) = 0.8530,1.56?(119.0/115.6) = 1.6059. The value of the 2004 REER is:[(0.8530/0.9187)?0.53 + (1.6059/1.6541)?0.47]?100 = (0.4921 + 0.4563)?100 = 94.84, or 94.8. Thisrepresents a 5.2 percent depreciation of the U.S. dollar in real terms6. This is a nominal appreciation of the euro relative to the U.S. dollar. The percent change is [(1.19 –1.05)/1.05]?100 = 13.3 percent.7. The January 200 real exchange rate is 1.05?(107.5/112.7) = 1.0016. The May 2004 real rate is1.19?(116.4/122.2) = 1.1335.8 In real terms the euro appreciated relative to the U.S. dollar. The rate of appreciation is [(1.1335 –1.0016)/1.0016]*100 = 13.17 percent.9 Absolute PPP suggests the May 2004 exchange rate should be 122.2/116.4 = 1.0498. The actual exchangerate is 1.19. Hence, the euro is overvalued relative to the U.S. dollar by (1.19 – 1.0498)/1.0498]?100 =13.35 percent.10Relative PPP can be used to calculate a predicted value of the exchange rate as:S PPP = 1.05?[(122.2/112.7)/(116.4/107.5)] = 1.0014.11. The actual exchange rate is 1.19. Hence, the euro is overvalued relative to the U.S. dollar by (1.19 –1.0014)/1.0014]?100 = 18.83 percent.Chapter 3Exchange Rate Systems, Past to Present1. Ranking the various exchange rate arrangements by flexibility is not so clear cut. Nonetheless thearrangements described in this chapter are (from fixed to flexible): dollarization, currency board,commodity (standard) peg, dollar (standard) peg, currency basket peg, crawling peg, managed float,flexible.2.The two primary functions of the International Monetary Fund are: surveillance of member nations' macroeconomic policies, and to provide liquidity to member nations experiencing payments imbalances. 3.The value of the Canadian dollar relative to gold is CAN$69 (1.38 ? $50) and the value of the British pound relative to gold is ￡33.33 ($50/1.50). 4.The exchange rate between the Canadian dollar and the British pound is C$/￡2.07 (1.38 ? 1.50). 5.6. Because $1.05 is the currency content of the basket, as shown above, and $0.50 of that content isattributable to the dollar, the weight assigned to the dollar is 0.50/1.05 = 0.476, or 47.6 percent.Because the weights must sum to unity, the weight assigned to the euro is 52.4 percent.7. The main difference between the two systems was that, in the Smithsonian system, the dollar was notpegged to the value of gold. One reason that the system was short was because there was littleconfidence that U.S. economic policy would be conducted in a manner conducive to a system of pegged exchange rates.8. The principle responsibilities of a currency board are to issue domestic currency notes and peg the valueof the domestic currency. A currency board is not allowed to purchase domestic debt, act as a lender of last resort, or set reserve requirements.9.The Lourve accord established unofficial limits on currency value movements. In a sense, it was peg with bands for each of the main currencies (dollar, yen and mark). 10. Differences in the fundamental determinants of currency values between the pegging country and theother country should be considered. To this point of the text, the rate of inflation is a good example. Relative PPP can be used to determine the rate of crawl.11. Under a currency board system, a nation still maintains its domestic currency. Hence, policymakerscan change exchange rate policies and monetary policies if they so desire. When a nation dollarizesand disposes of its domestic currency it no longer has this option.Chapter 4The Forward Currency Market and International Financial Arbitrage1. Given that the exchange rate is expressed as dollars to euros, we treat the dollar as the domestic currency. Note also that interest rates are quoted on an annual basis even though the maturity period is only one month. In this problem we divide the interest rates by 12 to put them on a one-month basis.a. The interest rate differential, therefore, is (1.75%/12 - 3.25%/12) = -0.125%. The forwardpremium/discount, expressed as a percentage, is calculated as:((F-S)/S)?100 = ((1.089 – 1.072)/1.072)?100=1.5858%R –R*450(F-S)/S -0.125 1.5858 1.00 -1.00b.Transaction costs are shown in the figure above by the dashed lines that interest the horizontal axis at values of -1.00 and 1.00. c. The positive value indicates that the euro is selling at a premium. In addition, the interest rate differentialfavors the euro-denominated instrument. Hence, a saver shift funds to euro-denominated instruments.2. Using the provided information:(1.75/12) – (3.25/12) < [(1.089 - 1.072/1.072)]?100-0.125% < 1.5858%. 3.The four markets are graphed below.Graph 1, the spot market for the euro.euro-denominated instrument. They would desire to sell the euro forward so they may convert euro-denominated proceeds at the time of maturity into their dollar equivalent.) Graph 3 illustrates a decrease in loanable funds in the United States as savers shift funds to euro-denominated instruments. Graph 4 illustrates the increase in the supply of loanable funds that occurs when savers shift funds to the euro-denominated instrument.4.Because (1.03125) > (1.04250)(1.4575/1.5245) = 0.9967, an arbitrage opportunity exists in this example if one were to borrow the pound and lend the euro. Suppose you were to borrow one pound, the steps are then:a. Borrow ￡1, convert to €1.5245 on t he spot market.b. Lend euros, yielding €1.5245?(1.03125) = €1.5721.c. See euros forward, yielding €1.5721/1.4575 = ￡1.0787.d. Repay the pound loan at ￡1?(1.04250) = ￡1.04250.e. The profit is ￡0.0362, or 3.62 percent. 5.Because interest rates are quoted as annualized rates, we need to divide each interest rate by 4 (12/3). The uncovered interest parity equation is:R -R* = (S e +1 - S) /S a. Rewriting the equation for the expected future expected exchange rate yields:S e +1 = [(R- R*) + 1]S b.Using the values given yields the expected future spot rate $/€ $/€S e+1 = [(0.0124/4 - 0.0366/4) + 1]?1.5245 = 1.5153.6. Given this information, we can calculate the forward premium/discount with the UIP condition:(F - S)/S = R - R*The interest differential is 1.75% - 3.25% = 1.5%. This is the expected forward premium on the euro.Hence, (F – 1.08)/1.08 = 0.015 implies that F = 1.0962.7. We can adjust for the shorter maturity by dividing the interest rates by 2 (12/6). Now the interest differentialis 0.75%, still a forward premium on the euro. The forward rate now is (F – 1.08)/1.08 = 0.0075 implies thatF = 1.0881.8. The U.S. real rate is 1.24% – 2.1% = -0.86% and the Canadian real rate is 2.15% – 2.6% = -0.45%.Ignoring transaction costs, because the real interest rates are not equal, real interest parity does not hold.9. Uncovered interest parity is R -R* = (S e+1 - S) /S + ρ.a. Using the same process as in question 5 above, the expected future spot rate is:S e+1 = [(R- R*) + 1]S,S e+1 = [(0.075 - 0.035) + 1]?30.35 = 31.564.b. Using the same process as in question 5 above, the expected future spot rate is:S e+1 = [(R- R*) + 1 - ρ]S,S e+1 = [(0.075 - 0.035) + 1 – 0.02]?30.35 = 30.957.10. Because the forward rate, 30.01, is less than the expected future spot rate, 30.957, you should sell the korunaforward. For example, $1 would purcase k30.957, which you could sell forward yielding k30.957/30.01 = $1.0316.11. International financial instruments:a. Global Bond: long term instruments issued in the domestic currency.b. Eurobond: term is longer than one year and is issued in a foreign currency.c. Eurocurrency: keyword is that it is a deposit.d. Global equity: keyword is that it is a share.Chapter 7The International Financial Architecture and Emerging Economies1. The difference between direct and indirect financing has to do with whether the borrower and lender seekeach other out or whether an intermediary matches borrowers and lenders. Direct financing requires no intermediary to match savers and borrowers. An economy will benefit from having both direct and indirect financing because both are appropriate ways to save and invest under different circumstances. As discussed in the text, financial intermediaries absorb a fraction of each saver's dollar that is borrowed. Thus, theintermediary takes some of the funds that otherwise would have gone to a borrower. However, the financial intermediary provides an important service by reducing information asymmetries, allowing savers to pool risk, and matching risk and return. Therefore, when an individual cannot research these issues on his/her own, the intermediary is necessary to help the financial markets operate. However, a strong bond market, inwhich borrowers and savers can directly interact, allows for informed parties to save the funds that otherwise would go to an intermediary. This, in turn, uses the savings more efficiently.2. Portfolio flows are relatively short term in nature (have a shorter term to maturity), involve lower borrowingcosts, and can generate near-term income. They also do not require a firm to give up control to a foreign investor. Consequently, they may help to improve capital allocation within an economy and help theeconomy's financial sector develop. These are all potential benefits of portfolio investments. By the same token, however, they are also relatively easy to reverse in direction, which is a potential disadvantage ofportfolio investment.On the other hand, foreign direct investment (FDI) involve some degree of ownership and control of a foreign firm, are typically long term in nature, and help provide a stabilizing influence on a nation's economy. As such, FDI is typically more difficult to arrange.It is not advantageous to rely on either type of investment exclusively, in so far as each type accomplishes different goals for an economy. Both near-and long-term capital are important for an economy's growth. 3. As either portfolio investment of FDI increase, the demand for the local currency rises (e.g., there is a shiftfrom D0 to D1), which puts upward pressure on the value of the currency, from S0 to S1. If the central bank expects to hold the value of the currency constant at S0, it will have to increase the quantity of the domestic currency supplied (e.g., accommodate the excess quantity demanded at the initial spot rate S0) to maintain the peg. The opposite would hold for capital outflows.4. Suppose that a multinational bank (MNB) headquartered in a developed economy enters a developingeconomy. The MNB has gained considerable expertise in working as a financial intermediary, and likely has achieved economies of scale in doing so. By entering a foreign market, it helps to allocate the savingsQ s Q dmore efficiently through its intermediation services; which in turn will lead to additional economicdevelopment. Specifically, it should help to make sure that the best investment projects are funded.Moreover, the competition it introduces into the capital market helps to improve the quality of the indigenous financial intermediaries. This, in turn, should also add to financial stability.5. Savers and borrowers can also benefit from the regulation of financial intermediaries when portfolio capitalflows dominate a country's capital inflows. It can be argued that regulation to limit short-term inflows can stabilize the economy and that these regulations can be gradually lifted as the economy becomes more stable (financial markets develop) and resilient to external shocks. These regulations do impose costs in that they require resources to enforce, and may inhibit otherwise helpful capital inflows which may aid economic development. However, these costs must be considered against the potential losses that may be incurred if the absence of capital controls would lead to more volatile and capital markets (which may deter the inflow of foreign capital).6. Policymakers should undertake actions that attract both portfolio capital flows and FDI flows. Actions thatimprove transparency in both the private a public sector reduces information asymmetries and their associate problems thereby making portfolio flows more stable, in other words, reducing the risk of massive capital outflows. Policymakers may also undertake actions that promote education, improve the tax structure and tax collection, and improve the countries infrastructure. These actions may, in turn, attract FDI.7. In the following two examples it is assumed that the policymaker maintains a pegged-exchange rate regimeand does not opt for a floating-rate regime. Hence, the policymaker may either intervene and maintain the peg or change the value of the peg. In both cases there is pressure for the domestic currency to appreciate visa vis the foreign currency.a. If the exchange rate pressure is only temporary in nature, then the policymaker may intervene byaccommodating the excess quantity demanded, as explained in question 3 above.b. Because the exchange rate pressure is longer-term in nature, the policymaker would be well advised torevalue the domestic currency.8. The World Bank was initially established to help countries rebuild after WWII and in the 1960s expanded toalso make long term loans to developing nations in order to help reduce poverty and improve living standards.Recently, some of the World Bank's activities have begun to overlap the IMF's activities to finance long-term structural adjustments and provide refinancing for some heavily indebted countries. Critics may argue that the tasks that are duplicated by the IMF and the World Bank create conflicting goals for the World Bank.Thus, the two organizations may each benefit by focusing on different aims. For instance, the IMF may return to financing shorter-term objectives and leave the World Bank to worry about longer-term projects.Another conflicting line of reasoning involves donors' expectation that the World Bank maintain a revenue stream form its projects. This can be argues as unrealistic, however, in that the poorest countries are less likely to yield a payoff for the needed projects; and these are precisely the countries that the World Bank is designed and intended to help. On the other hand, the less risky projects, which could provide a positive revenue stream are likely to attract private capital.9. The first cause of a crisis could be an imbalance in the economy. In other words, an incongruity ineconomic fundamentals could cause a crisis. Possible indicators include theoretical divergences between various economic variables such as the exchange rate and interest rates, income, and money supply. In terms of evaluation, if fundamental economic variables seem to be out of line, there may be an impending crisis.A second cause is that of self-fulfilling expectations and contagion effects. In this case, mere expectationsof a potential inability to maintain a specified exchange rate or a slight incongruity between economicconditions and the market exchange rate may cause a cascade of speculation that leads to a crisis. Since this is based on perception, it is difficult to find an indicator. One possible indicator would be trading volumes of currency for countries that may be at risk from the viewpoint of economic fundamentals. If tradingvolumes grew quickly, a crisis may be on the horizon.Finally, the structural moral hazard problem may indicate a crisis. In this case, a credit rating bureau, such as Moody's may provide the data needed to indicate a potential crisis. The quality of the credit rating would be relatively easily interpreted to indicate a potential crisis.10. It can be argued that such below market interest rate loans are critical for a developing nation's economy inorder for the economy to grow unburdened by high interest payments when it is trying to funnel profits back into the economy and sustain growth. Conversely, providing these non-market rate loans can also be argued to distort the market for loanable funds and attract inefficient investment. Students' perspectives will vary as to which argument is the best.Chapter 8Traditional Approaches to Exchange-Rate and Balance-Of-Payments Determination1. Using the formula provided in the question, the elasticity of foreign exchange demand is, in absolute valueand the elasticity of foreign exchange supply is2. A 1 percent depreciation of the Canadian dollar results in a 0.52 percent decline in imports demanded and arise of 0.58 percent in exports supplied.3. In absolute value, the smallest elasticity measure (most inelastic) is Germany’s elasticity of import demandfrom the U.K. In absolute value, the largest elasticity measure (most elastic) is the United States’ elasticity of demand for imports from Germany.4. Table 8-1 provides measures of the price elasticity of import demand. If the U.S. dollar depreciates relativeto the Japanese yen, U.S. exports become relatively less expensive to Japanese consumers and Japaneseexports become relatively more expensive to U.S. consumers.a. The U.S. quantity of imports demanded from Japan falls by 1.13 percent.b. Japan’s quantity of imports demanded from the U.S. rises by 0.72 percent.c. Because U.S. exports rise and imports decline, the trade balance should improve.5. The trade balance may not improve in the short-run because of pass-through and J-curve effects. Over alonger time horizon, import demand is relative more elastic and the trade balance should improve.6. If the Canadian dollar depreciates relative to the U.S. dollar, then the quantity of hockey pucks demandeddeclines. Hence, Slovakian manufacturers would have to absorb all of the exchange rate change in their profit margins and the price of hockey pucks would have to decline by 5 percent for the quantity demanded to remain unchanged.7. Using the values given in the problem:a. real income, y, equals c + i + g + x = $23,500, absorption, a, equals c + i + g + im = $24,000.b. Net exports, x - im, equals -$500. Therefore, there is a trade deficit of $500.8. Net exports now equal $550 - $950 = $400. The devaluation did improve the external balance.9. The advertising campaign would induce consumers to increase expenditures on domestic output anddecrease expenditures on foreign output. Domestic absorption will rise and, if expenditures on imports decrease, the trade balance improves.10. As the U.S. economy expands, we would expect real income and real absorption to increase. On the onehand, if real income increases more than real absorption, net exports will rise. This would lead to anappreciation of the U.S. dollar. If, on the other hand, real absorption rises faster than real income, netexports fall. This would lead to a depreciation of the U.S. dollar.Chapter 9Monetary and Portfolio Approaches to Exchange-Rate and Balance-of-Payments Determination1. Using the formula provided on page 222, m(DC + FER) = kSP*y.a. The money stock is 2($1,000 + $80) = $2,160 million.b. The level of real income is: [2($1,000 + $80)]/[(0.20)(1.2)(2)] = $4,500 million.2 An open market purchase of securities in the amount of $10 million:a. A fixed exchange rate regime requires a decrease in foreign reserves in an equal amount. Hence, thisaction results in a balance of payments deficit in the amount of $10 million.b. A flexible exchange rate regime results in a new spot exchange rate of 2.019, which is a depreciation ofthe domestic currency. This problem is solved by using the value for real income derived in 5 b above: [(2($1,010 + 80)]/[(0.20)(1.2)($4,500)] = 2.019.3. The wealth identity is given on page 229 as W≡ M + B+ SB*. An open market sale of securities wouldreduce bank reserves, increasing the domestic interest rate. Individuals would shift from foreign bonds to domestic bonds, leading to an appreciation of the domestic currency. Under a fixed exchange rate, the open market sale would result in an improvement of the domestic nation’s balance of payments. (The elasticity diagrams in Chapter 8 are useful in answering this question.)4. This answer is an illustration of problem 3 under flexible exchange rates. The open market sale would causean increase in the demand for the domestic currency and the domestic currency would appreciate as a result.5. The wea lth identity is given on page 315 as W≡ M + B SB*. From the foreign nation it is W ≡ M* + B* +(1/S)B. An open market sale of securities by the foreign central bank would reduce foreign bank reserves, increasing the foreign interest rate relative to the domestic interest rate. Individuals would shift fromdomestic bonds to foreign bonds, leading to an depreciation of the domestic currency.Chapter11Economic Policy with Fixed Exchange Rates(Chose the right answers from the following 10 answers by yourself . SuGuangjin）1. Achieving a balance-of-payments surplus requires that the sum of the capital account balance and currentaccount balance is positive, which requires a higher interest rate to attract greater capital inflows and lower real income to dampen import spending. Consequently, the BP schedule would lie above and to the left of the position it otherwise would have occupied if the external-balance objective were to ensure only abalance-of- payments equilibrium. Undoubtedly, if the central bank felt pressure to sterilize under the latter objective, the pressure to do so would be greater if it seeks to attain a balance-of-payments surplus, which would require the central bank to steadily acquire foreign-exchange reserves. In the absence of sterilization, the nation's money stock would steadily decline.2. In this situation, variations in the domestic interest rate relative to interest rates in other nations would havenot effect on the nation's capital account balance and its balance of payments. Its BP schedule, therefore, would be vertical. An expansionary fiscal policy, given a fixed exchange rate (as assumed in this chapter), would cause the IS schedule to shift rightward, initially inducing a rise in equilibrium real income. This, however, would cause import spending to increase, and the nation would experience a balance-of-payments deficit, which would place downward pressure on the value of its currency. To prevent a change in the exchange rate, the central bank would have to sell foreign exchange reserves. If this intervention isunsterilized, then the nation's money stock would decline, ultimately causing the LM schedule to shift back too a final IS-LM equilibrium at a point vertically above the initial equilibrium point, along the vertical BP schedule.3. A reduction in the quantity of money shifts the LM schedule leftward. At the new IS-LM equilibrium, thenominal interest rate rises and real income declines. Irrespective of the shape of the BP schedule, this would result in a balance of payment surplus, which would tend to place upward pressure on the value of the nation's currency. To maintain a fixed exchange rate, the central bank would have to purchase foreign exchange reserves. If this foreign-exchange-market intervention is unsterilized, then the nation's money stockincreases, causing the LM schedule to shift back to the right. Ultimately, the original IS-LM equilibrium is re-attained.4. If capital is highly mobile, a drop in government spending will likely cause a private payments deficit. Thefall in income will cause a decrease in imports and a trade surplus. As the domestic interest rate increases, however, the capital outflow will lead to a private payments deficit. If capital is not mobile, the capital outflows are likely not large enough to counteract the effect of a drop in imports. Therefore, a privatepayments surplus would result.5. A contractionary fiscal policy action, such as a reduction in government spending, causes the IS schedule toshift leftward, inducing an initial decline in the nominal interest rate and reduction in real income. As a result, there is a capital outflow and fall in import spending. Because capital is highly mobile, thecapital-outflow effect dominates, and the nation experiences a balance-of-payments deficit. This places downward pressure on the value of the nation's currency, which induces the central bank to sell foreign。