Working Group 1 Questions
Question 1 (11th ed. (same as 10th ed.), Ch. 13, Problem 2):
Equation (13-2) tells us that to reduce a current account deficit a country must increase its private saving,
reduce domestic investment, or cut its government budget deficit. Nowadays, some people recommend
restrictions on imports from China (and other countries) to reduce the American current account deficit.
How would higher U.S. barriers to imports affect its private saving, domestic investment, and
government deficit? Do you agree that import restrictions would necessarily reduce a U.S. current
account deficit?
What do we know?
Equation 13 -2;
- SP = I + CA – Sg
- CA = SP – I – Sg
- CA = (SP – I) – (G – T)
- CA = (SP – I) + (T – G)
What is asked?
1. Claim; equation 13-2 says;
- SP ----> CA
- I ¯ ----> CA
- (T – G) ----> CA
2. What is the effect of import barriers on S or I or (T – G)? Would they necessarily reduce CA deficit?
Remember the “beyond the textbook” slide 33
Ex-post national income identity;
- National income = Y = C + I + G + CA = expenditure on domestic production
- Final product not purchased by households or the government are counted as inventory investment
by firms
Equation 13-2;
- Is based on this ex post identity and the definition of savings
- It is only true at the end of a period
- It says NOTHING about causality !!
Thus
1. Claim; equation 13-2 says;
- SP ----> CA
- I ¯ ----> CA
- (T – G) ----> CA
This claim is wrong! It is an identity, not a causal link!
2. What is the effect of import barriers on S or I or (T – G)? Would they necessarily reduce CA deficit?
- Here are more answers possible
- Not the answer itself, but the reasoning behind it makes an answer good or bad
1
,Domestic investment (I) could increase;
- Local industries protected by the tariff increase investment, since demand for locally produced
goods increases.
- This might even worsen the CA (according to the identity) (we don’t know what the rest would do
(SP and (T – G))
Domestic investment (I) could decrease;
- If intermediate goods, necessary for investment, are part of the tariff, this will lead to an increase in
the costs of investment
- An example can be steel. Steel is very needed good for investment and the US does not produce
such type of steel. This will lead to an increase in production costs (costs of investment) and
they will produce less (decrease in domestic investment)
- This might indeed improve the CA (according to the identity)
Private savings (SP) could increase;
- If the tariff is a temporary one, consumers expect a lower tariff, hence a lower price, in the future;
they save now and purchase the good in the future
Private savings (SP) could decrease;
- The tariff increases domestic prices. If consumers like to retain their present level of consumption,
they dissave. A higher share of their income is being consumed, so private saving falls
- Because of the import barriers, no foreign goods will come the market, domestic goods are
more expensive (we know that because that is the reason why we import foreign goods). If
people like to retain their present level of consumption, people have to dissave
- The CA might even worsen (according to the identity)
Government deficit (G – T) could increase;
- The tariff increases domestic prices. The government may not be able to avoid expenditure on
certain import goods (or expensive domestic substitution)
- The CA might even worsen (according to the identity)
Government deficit (G – T) could decrease;
- The tariff raises government revenues (import tariffs bring money to the government)
- The CA might indeed improve (according to the identity)
There is too little known to provide a definite answer, to predict how the CA is affected we require a
macroeconomic general equilibrium analysis
Question 2 (10th ed. (similar to 11th ed.), Ch. 13, Problem 3):
Explain how each of the following transactions generates two entries – a credit and a debit – in the
American balance of payments accounts, and describe how each entry would be classified.
What is asked?
- Debit or credit? Which account (CA or FA)?
What do we know?
- The residence of the individual or the firm is what counts. In our US-centered problems, the question
is whether or not a US-resident is involved. Usually, nationality and residence coincide
- It is about the flows of money
2
, Types of transactions;
1. CA; export/import of goods/services
2. FA; purchase/sale of financial assets (bonds, money, stock, factories, government debt)
3. KA; selling financial claims (selling assets for buying assets)
- Example; a trade for gold for silver ---> asset for asset
Type 1;
Goods/services export CA
Money inflow; credit
US RoW
Money outflow; debit Asset
Asset import FA purchase
Type 2;
Goods/services import CA
Money outflow; debit
US RoW Asset
Money inflow; credit Asset export FA sale
Type 3;
Asset
Goods/services export FA sale
Money inflow; credit
US RoW
Money outflow; debit Asset
Asset import FA
purchase
b: An American buys a share of a German stock, paying the seller with a check [drawn] on an
American bank
US Balance of Payments Accounts
Credit Debit
- X (stock purchase, ‘import’ of an asset from
Germany; financial account; money outflow;
debit)
- X (deposit sale, ‘export’ of an asset to
Germany; financial account; money inflow;
credit)
3
,a: An American buys a share of a German stock, paying by writing a check on an account with a Swiss
bank
US Balance of Payments Accounts
Credit Debit
- X (stock purchase, ‘import’ of an asset from
Germany (to US); financial account; money
outflow; debit)
- X (deposit sale, ‘export’ of an asset to
Switzerland (from US); financial account;
money inflow; credit)
d: A tourist from Detroit buys a meal at an expensive restaurant in Lyon, France, paying with a
traveler’s check
US Balance of Payments Accounts
Credit Debit
- X (meal purchase, ‘import’ of a good from
France; current account; money outflow; debit)
- X (traveler check sale, ‘export’ of an asset;
financial account; money inflow; credit)
e: A California winemaker contributes a case of wine for a London wine tasting.
No transaction, it is a gift (no money involved).
f: A US-owned factory in Britain uses local earnings to buy additional machinery
Offshore transaction; no international flow of money
Question 3 (11th ed., Ch. 13, Problem 6):
Can you think of reasons why a government might be concerned about a large current account deficit or
surplus? Why might a government be concerned about its official settlements balance (that is, its balance
of payments)?
Note; the terms ‘official settlements balance’ and ‘balance of payments’ are both used by the book and
mean the same. However, do not mix up the balance of payments (in a narrow sense) and the Balance
of Payments Accounts (which refers to the actual balance sheet and contains all subaccounts)
Note on lecture slide 53;
‘Consider a deficit in BoP (official settlement balance) which corresponds to a surplus in the reserve
portion of the FA’
- It is not a good thing to have, it is seen as negative
- That is because a surplus in the reserve portion of the FA means losing international reserves
4
,The government might be concerned about a CA deficit (IM > EX)
This needs to be financed by;
1. A surplus in the non-reserve part of the financial account. This means lending from abroad. Higher
private debt could result in higher interest rates
And/or
2. A surplus in the reserve part of the FA. This leads to a depletion of the official foreign reserves
(and/or to a too high dependence on foreign central banks)
This means that we are purchasing foreign assets. This can cause the following problems;
1. Which foreign assets should we buy? Investment opportunities are not infinite and not without risk
2. If this situation takes too long (no adjustment of the exchange rate), a country can be accused of
engaging in unfair practices concerning international trade
An official settlement balance imbalance;
- If CA + FA (non-reserve portion) ¹ 0
- Then we speak of an ‘international payments gap’
- This is financed by the central banks by official foreign reserve transactions
- In this way the central bank ‘cover’ for the imbalances in other accounts
Concerns about an official settlement balance deficit;
- This corresponds to a surplus in the reserve portion of the FA and could mean a depletion of foreign
reserves
- For countries with fixed exchange rates; problematic because they could run out of foreign reserves
which are used to maintain the fixed exchange rate
- Developing countries; hold foreign reserves as a buffer, are considered more creditworthy if they
possess more foreign reserves
Additional question without answer key for your own practice:
Question 4 (10th ed. (similar to 11th ed.), Ch. 13, Problem 8):
Is it possible for a country to have a current account deficit and at the same time a surplus (deficit?) in
its balance of payments? (meant is official settlement balance)
Deficit CA and surplus BoP (deficit in reserve part of FA);
CA + FA (non-reserve) + stat. discr. + FA (reserve) = 0
-
¬ BoP ®
+
It is possible, if the surplus of the non-official part of the financial accounts exceeds the deficit on the
current account
Deficit CA and deficit BoP (deficit in reserve part of FA);
CA + FA (non-reserve) + stat. discr. + FA (reserve) = 0
-
¬ BoP ®
-
It is possible, if the surplus of the non-reserved portion of the financial account is not sufficient to finance
the deficit on the current account (or if the non-reserve part of the FA is also in deficit)
Question 5 (10th ed., Ch. 13, Problem 10):
How is it possible that the US, as a net debtor, receives more foreign asset income than it paid out?
Usually, the rate of return on US-assets (especially government bonds) is fairly now
Moreover, US-investors themselves take more risk when investing money, which means a higher return
5
, Working Group 2 Questions
Question 1 (9th ed. (similar to 11th ed.), Ch. 14, Problem 2):
A US dollar costs 7.5 Norwegian kroner, but the same dollar can be purchased for 1.25 Swiss francs.
What is the Norwegian kroner/Swiss franc exchange rate?
What is given?
- 𝐸!"# /$ = 𝑁𝑂𝐾 7.5/$ (7.5 Norwegian Kroner = $1)
- 𝐸$%& /$ = 𝐶𝐻𝐹 1.25/$ (1.25 Swiss Francs = $1)
How to obtain NOK ? / CHF ?
- Triangular exchange;
1. Change 7.5 kroner into a $
2. Change a $ into Swiss francs (use 1/(𝐸$%& /$))
'.)*
𝑁𝑂𝐾 ?/ 𝐶𝐻𝐹 = 𝑁𝑂𝐾 7.5/$ ∗ {1/(𝐶𝐻𝐹 $
)} = 𝑁𝑂𝐾 6 / 𝐶𝐻𝐹
- Make sure the dimensions are correct; 𝑁𝑂𝐾 / 𝐶𝐻𝐹 = (𝑁𝑂𝐾 / $) ∗ ($/𝐶𝐻𝐹)
- Underlying assumption; there is no triangular arbitrage (i.e. no risk free profitable triangular
exchange)
How I did it myself;
We know that;
!"# $ !"#
8 9×8 9=8 9
$ $%& $%&
$ $%&
But we don’t have 8 9 but 8 9
$%& $
$%& $
1/ 8 9 =8 9
$ $%&
$%& '.)* $
1/ 8 $
9 = 8$%& '.)*9
!"# -.* $ !"# -.*
8 $
9 × 8$%& '.)*9 = 8$%& '.)*9
!"# .
Divide by 1.25; 8 $%& ' 9
But what if the rates did not match, how could you make money from triangular arbitrage?
- 𝐸!"# /$ = 𝑁𝑂𝐾 7.5/$ (7.5 Norwegian Kroner = $1)
- 𝐸!"# /𝐶𝐻𝐹 = 𝑁𝑂𝐾 6/𝐶𝐻𝐹 (6 Norwegian Kroner = 1 Swiss Franc)
- 𝐸$%& /$ = 𝐶𝐻𝐹 2/$ (2 Swiss Francs = $1)
Triangular arbitrage;
1. Change $1 for 2 𝐶𝐻𝐹 (𝐸$%& /$ = 𝐶𝐻𝐹 2/$)
2. Change 2 𝐶𝐻𝐹 for 12 𝑁𝑂𝐾 (𝐸!"# /𝐶𝐻𝐹 = 𝑁𝑂𝐾 6/𝐶𝐻𝐹)
- 2 𝐶𝐻𝐹 x (𝑁𝑂𝐾 6/ 𝐶𝐻𝐹) = 𝑁𝑂𝐾 12
3. Get $1.60 for 12 NOK (𝐸!"# /$ = 𝑁𝑂𝐾 7.5/$)
- 𝑁𝑂𝐾 12 / (𝑁𝑂𝐾 7.5/$) = $1.60
Thus from $1 you make $1.60 (free money due to arbitrage)
6
,Question 2 (11th ed. (same 10th ed.), Ch. 14, Problem 17):
Multinationals generally have production plants in a number of countries. Consequently, they can move
production form expensive locations to cheaper ones in response to various economic developments –
a phenomenon called outsourcing when a domestically based firm moves part of its production abroad.
If the dollar depreciates, what would you expect to happen to outsourcing by American companies?
Explain and provide an example.
What is asked?
1. How does a dollar depreciation affect outsourcing by American firms?
2. Example?
1. How does a dollar depreciation affect outsourcing by American firms?
- Outsourcing is done to reduce production costs, so that a firm becomes more competitive by
producing abroad
- However, if the home currency depreciates (loses value), local production becomes more
competitive, in particular;
- Foreign production facilities become more expensive in own currency
- Imports back into home country become more expensive
- Producing at home benefits from lower export prices
- Outsourcing will be reduced, and production will remain to be domestically situated
2. Examples?
- Ford Motor Company – outsourcing to India
- It development
- Customer service
- Apple production in Ireland, many services to India, and software to China
Question 3 (10th ed., Ch. 16, Problem 1):
Suppose in the year 2010 (where the price level is 100) the Japanese yen and the Indian rupee exchange
rate (¥/rupee) is 0.54. If the price level in 2013 stands at ¥105 and 110 rupees in Japan and India
respectively, what will be the exchange rate in 2013, based on PPP?
What is given?
- 2010; 𝐸¥/" = ¥0.54 / rupee
- 2010; 𝑃# and/or 𝑃$ =100 (unclear what is meant)
- 2013; 𝑃# = ¥105
- 2013; 𝑃$ = 110 rupees
What is asked?
- What is 𝐸¥/" in 2013 based on absolute PPP?
Absolute PPP;
𝐸¥/" = 𝑃# /𝑃$
%&'
𝐸¥/" = %%& = ¥0.95454/rupee
But does this make sense? Because in 2010 the exchange rate was ¥0.54/rupee, it is quite strange when
the exchange rate in 2013 is almost twice as much as that from 2010
But what if we look at relative PPP?
7
,Relative PPP;
What is given?
- 2010; 𝐸¥/" = ¥0.54 / rupee
- 2010; 𝑃# and/or 𝑃$ =100 (unclear what is meant)
- 2013; 𝑃# = ¥105
- 2013; 𝑃$ = 110 rupees
What is asked?
- What is inflation and how should 𝐸¥/" change according to relative PPP?
What do we know?
0 10
Relative PPP; ¥/𝑅0,# ¥/𝑅,#$% = 𝜋2,4 − 𝜋5,4 (𝜋( = (𝑃( − 𝑃()% )/𝑃()% )
¥/𝑅,#$%
What is 𝐸¥/" in 2013 based on relative PPP?
Relative PPP; the inflation rate difference is offset by the change rate in e
- More precisely; the expected rate of depreciation
0 10
- 𝜋2,4 − 𝜋5,4 = ¥/𝑅0,# ¥/𝑅,#$%
¥/𝑅,#$%
Calculate 𝜋2 and 𝜋5 ;
'6*1'66
𝜋2 = '66
= 5%
''61'66
𝜋5 = = 10%
'66
𝜋2 − 𝜋5 = 0.05 − 0.10 = −0.05
Yen should appreciate by 5%
0¥/𝑅,# 10¥/𝑅,#$%
0¥/𝑅,#$%
= −0.05
0¥/𝑅,# 16.*7
6.*7
= −0.05
𝐸¥/𝑅,4 = 0.513 = ¥0.513/rupee
This exchange rate makes much more sense!
8
,Question 4 (9th ed., Ch. 14, Problem 6 (similar 11th ed., Ch. 14, Problem 7)):
Suppose the dollar interest rate and the euro sterling interest rate are the same, 5 percent a year. What is
the relation between the current equilibrium $/€ exchange rate and its expected future level? Suppose
the expected future $/€ exchange rate, $1.52 per euro, remains constant as euro’s interest rate rises to 10
percent per year. If the US interest rate also remains constant what is the new equilibrium $/€ exchange
rate?
What is asked?
- Relationship of the exchange rate and its expected future exchange rate before change
- Exchange rate after change
What is given?
:
- 𝐸$/€ = $1.52/€ (remains constant)
- 𝑅$ = 5% (remains constant)
- 𝑅€ = 5% -----> 10%
Wat do we know?
:
- UIP; 𝑅$ = 𝑅€ + [𝐸$/€ − 𝐸$/€ ]/𝐸$/€
First question;
What is the relation between the current equilibrium exchange rate and expected future exchange rate
before change?
- If interest rates are equal in both countries, the exchange rate must equal its expected exchange rate
:
- 𝐸$/€ = $1.52/€ and 𝐸$/€ = $1.52/€
- 5% = 5% + [1.52 − 1.52]/1.52
Second question;
What is the new equilibrium exchange rate after change?
- How can exchange rate adjust given expected exchange rate unchanged?
:
If we look at the UIP formula, 𝑅$ = 𝑅€ + [𝐸$/€ − 𝐸$/€ ]/𝐸$/€
We would expect that if 𝑅€ increases, that there must be a capital loss (expected rate of dollar
:
depreciation against the euro would decrease). But because 𝐸$/€ remains constant, 𝐸$/€ must increase
(depreciation of the dollar against the euro). But by how much?
:
𝑅$ = 𝑅€ + [𝐸$/€ − 𝐸$/€ ]/𝐸$/€
0.05 = 0.10 + [1.52 − 𝐸$/€ ]/𝐸$/€
−0.05 = [1.52 − 𝐸$/€ ]/𝐸$/€
−0.05𝐸$/€ = 1.52 − 𝐸$/€
0.95𝐸$/€ = 1.52
𝐸$/€ = 1.60
Note; The adjustment may also come through expected exchange rates, but that is usually caused by
expected changes in the future (see question 6)
- Here we had an unanticipated shock to the interest rate
- With future conditions being stable
9
, Question 5 (11th ed. (same 10th ed.), Ch. 14, Problem 12):
Does any of the discussion in this chapter lead you to believe that dollar deposits may have liquidity
characteristics different from those of other currency deposits? If so, how would the differences affect
the interest differential between, say, dollar and Mexican peso deposits? Do you have any guesses about
how the liquidity of euro deposits may be changing over time?
What is asked?
1. Dollar deposits more or less liquid than other currency deposits? Why?
2. How do liquidity differences affect interest rate differentials between, for instance, dollar and peso
deposits?
3. How might the liquidity of euro deposits change over time?
1. Answer;
- Huge markets
- Internationally accepted (vehicle currency); dollar already, euro more and more
2. Answer;
- How to take account of lower degree of liquidity of peso deposits?
- 𝑅 < 𝑅∗ + [𝐸 : − 𝐸]/𝐸
---> return* must be higher to make holding peso deposits equally attractive
- Adjust UIP; 𝑅 = 𝑅∗ + 𝛿 + [𝐸 : − 𝐸]/𝐸
with 𝛿 < 0 (liquidity premium taking account of liquidity risk and inconvenience)
Question 6 (11th ed. (same 10th ed.), Ch. 14, Problem 8):
Traders in asset market suddenly learn that the interest rate on dollars will decline in the near future.
Use the diagrammatic analysis of this chapter to determine the effect on the current dollar/euro exchange
rate, assuming current interest rate on dollar and euro deposits do not change.
What is given?
- Unchanged current home interest rate 𝑅$ and foreign interest rate 𝑅€
- Future decline of 𝑅$
What is asked?
- Use diagrammatic short-run foreign exchange market model
- Find the current exchange rate
What do we know?
:
- UIP determines equilibrium on the foreign exchange market; 𝑅$ = 𝑅€ + [𝐸$/€ − 𝐸$/€ ]/𝐸$/€
How to analyse?
Expected exchange rate;
- May be affected by future conditions on the foreign exchange market
- Which are influenced by the future R
Analyse backwards (backward induction);
- What will be the situation in the future?
- That is what determines expected exchange rate of today
10
