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Summary ECS3703 _ International Finance Notes
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- University Of South Africa (Unisa)
ECS3703 _ International Finance Notes
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ECS3703 MAY/JUNE 2014 MEMORANDUMSection A
You must answer ALL questions in this section
1. Explain (with the aid of two diagrams using the IS/LM/BP analysis) the
effectiveness of expansionary fiscal policies as well as ease monetary policies
in an open economy with flexible exchange rates and perfect capital mobility.
(25)
Monetary Policy is effective and Fiscal Policy ineffective.
Fiscal Policy Monetary Policy
i i
LM LM
6.25
E’
LM’
5.0 E F
BP
E 5.0
IS’
BP
IS
0 Y
Yn Yf
Expansionary fiscal policy shifts the IS to Easy monetary policy shifts the LM
IS’. The IS’ and LM intersect at point E curve to LM' and lowers the interest to
due to tendency of the nation’s interest i = 3.5 at point E". The nation reaches
rate to rise to i = 6.25. This leads to full employment Yf. LM' curve
massive capital inflows and appreciation intersects IS curve. This leads to
of the nation’s currency which capital outflow and a tendency of the
discourages exports and encourages nation's currency to depreciate which
imports and shifts the IS’ curve back to shifts the IS curve to the right to IS'
its original position. Thus fiscal policy is (exports are stimulated and imports
ineffective. discouraged).L M' shifts a little to LM"
(due to fall in money supply because
of rising prices in the nation). Final
equilibrium is at F where IS' and LM"
cross on the BP curve at Yf. Thus
monetary policy is effective.
2
, 2. Discuss covered interest arbitrage on the foreign exchange markets. Include
an example in your answer. (25)
Interest arbitrage refers to the international flow of short term liquid funds to earn
higher interest abroad. Can be covered or uncovered.
Covered interest arbitrage
Covered interest arbitrage is the spot purchase of the foreign currency to make
investment and the offsetting simultaneous forward sale (swap) of the foreign
currency to cover foreign exchange risk.
Example:
Assumptions:
Interest rate in the RSA = 10% per year
Interest rate in the USA = 3% per year
Spot exchange rate is $1 = R10,00
One year forward rate is $1 = R10,50
A USA citizen with $100,00 wants to investigate the possibility of arbitrage
profits by investing it in the RSA
To invest in the RSA he will have convert his $100,00 to R1000,00 on the spot
market and invest it in the RSA @10% interest rate (resulting in R1100,00 after a
year) and simultaneously cover it (hedge) using the forward rate. That means the
bank guarantees him that by the end of the year he can convert his money back to $
at the rate of $1,00 = R10, 50 resulting in $104,76 (R1100,00 ÷ R10, 50)
Comparison:
Should he have invested his $100 in the USA it would have grown to only $103,00
by the end of the year. He thus makes an arbitrage profit of $1,76 ($104,76 -
$103,00) by rather investing it in the RSA. At a forward rate of $1,00 = R10,68 no
arbitrage profits will be possible (R1100,00 ÷ R10,68 = $103,00)
The net return from covered interest arbitrage is usually equal to the interest
differential return in favour of the foreign monetary minus the forward discount on the
foreign currency. As covered interest arbitrage continues, the net gain is reduced
and finally eliminated. When the net gain is zero, it is said to be at covered interest
arbitrage parity (CIAP).
3
,SECTION B
You must answer TWO of the following FOUR questions
3. (a) Explain the ‘J-curve effect’. Include a graph in your answer (8)
A nation's trade balance may worsen soon after devaluation or depreciation before
improving. This is due to the tendency of the nation's domestic currency price of
imports to rise faster than export prices soon after devaluation or depreciation while
quantities remain the same. Over time the quantity of exports rises and the quantity of
imports falls, export prices increase and catch up with import prices so that the initial
deterioration in the trade balance is reversed. This tendency of a nation's trade
balance to first deteriorate before improving as a result of depreciation or devaluation
in the nation's currency is called the J-Curve effect.
J-Curve
Trade Balance
A Time
Starting from the origin and a given trade balance, a devaluation or depreciation of the
nation's currency will first result in a deterioration of the nation's trade balance before
improving (after time A)
(b) Suppose a nation with an open economy and fixed exchange rate is in the short
run and long run equilibrium (at its natural level of output). Explain with the aid of a
diagram (use aggregate demand and aggregate supply curves) the effect of
expansionary fiscal policy (17)
4
, Fiscal Policy Fixed Exchange rates
LRAS SRAS’
Pc SRAS
C
Pa A
Pe E AD’
AD
0
Expansionary fiscal policy shifts the AD. Curve up to AD' with a new short run
equilibrium at point A at the intersection of the AD' and SRAS curves at PA and
YA exceeding Yn. The temporary expansion of output YA occurs because of
market imperfections (because firms originally believe that only the price of the
products they sell has increased and actual prices temporarily exceed expected
prices. Over time all prices increase causing the SRAS curve to shift up to
SRAS'. Intersection of the AD', SRAS and LRAS curves define a new
equilibrium at point C, Pc and Yn. Prices level is higher butt the level of output
has returned to its lower long-run natural level
4 (a) Name and explain the items of the financial account of the South African Balance
of Payments (15)
-The financial account (previously referred to as the capital account) records
exchanges of international asset claims. For example, if a US bank buys a bond issued
by the South African government, a South African company purchases shares in a
British company or a foreign company establishes a controlling interest in a local
manufacturing concern, the value of these transactions will be reflected in the financial
account of the countries concerned. Note that the financial account does not record
the stocks of the assets and liabilities. It is the changes in foreign assets and liabilities
that are shown in the balance of payments.
5
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