Questions - Johan Lindén, Mälardalens högskola



Chapter 15Open Economy MacroeconomicsQuestions1.How is the nominal exchange rate between two currencies defined? Answer: The nominal exchange rate is the price of one country’s currency in units of another country’s currency. Specifically, the nominal exchange rate is the number of units of foreign currency that can be purchased with one unit of domestic currency. The nominal exchange rate (e) is calculated as 2.When is a currency said to appreciate or depreciate?Answer: When the nominal exchange rate goes up, the domestic currency appreciates against the foreign currency, and the domestic currency is said to be strong. When the nominal exchange rate goes down, the domestic currency depreciates against the foreign currency, and the domestic currency is said to be weak. For example, suppose the nominal exchange rate between the U.S. dollar and the Chinese yuan changes from10 yuan to 1 U.S. dollar to 8 yuan to the dollar. The dollar has become “cheaper” in terms of yuan; it takes fewer yuan to “buy” one dollar. So, the dollar has depreciated. Conversely, the Chinese yuan is said to have appreciated against the U.S. dollar. 3. Distinguish among flexible, fixed, and managed exchange rates. Answer: If the government does not intervene in the foreign exchange market, then the country has a flexible exchange rate, which is also referred to as a floating exchange rate. If the government sets a long-run value for the exchange rate and intervenes to defend that value, then the country has a fixed exchange rate. If the government intervenes actively in the foreign exchange market without setting a particular value for the exchange rate, then the country has a managed exchange rate. The values of managed exchange rates do change, but the fluctuations are relatively smooth when they occur. 4.What does the demand curve for dollars show? Why does the demand curve for dollars slope downward? Answer: The demand curve for dollars represents the relationship between the quantity of dollars demanded and the nominal exchange rate between the dollar and another currency—say, the euro. The demand for dollars in exchange for euros is downward sloping because a higher exchange rate increases the price of U.S. goods faced by European firms and consumers, reducing their quantity of goods demanded and thus the quantity of dollars demanded.5.What does the supply curve for dollars show? Why does the supply curve for dollars slope upward? Answer: The dollar supply curve represents the relationship between the quantity of dollars supplied and the nominal exchange rate between the dollar and another currency—say, the euro. The supply of dollars in exchange for euros is upward sloping because a higher exchange rate increases the quantity of goods supplied by European firms to the U.S. market, thus raising their dollar earnings and the quantity of dollars supplied to the foreign exchange market.6.What does it mean to say that, at an exchange rate of 1 USD = 60 INR, the U.S. dollar is overvalued and the Indian rupee (INR) is undervalued? Answer: When we say that the dollar is overvalued with respect to the rupee, we mean that the dollar is worth more rupees than it would have been under a flexible exchange rate regime. Currencies may be overvalued or undervalued in a fixed or managed exchange rate regime. Suppose the Indian central bank pegs the rupee to the dollar. An undervalued rupee means that the exchange rate (rupee per dollar) at this peg is higher than the exchange rate that would have prevailed under a flexible exchange rate regime. When the price in the foreign exchange market is higher than the equilibrium price, the quantity of dollars supplied to the market is greater than the quantity demanded in exchange for rupees. In order to maintain the peg, the Indian authorities need to buy up these surplus dollars in exchange for rupees. 7.Why might a country peg its exchange rate at a level that overvalues its own currency?Answer: In many cases, countries maintain overvalued exchange rates. There are several reasons for this:Most countries regularly borrow from foreign lenders. In developing countries like Mexico, these loans are typically denominated in dollars. Thus, Mexican borrowers receive dollars when they take out their loan and pay back dollars, not pesos, at the end of the loan period. If the peso is overvalued and allowed to depreciate, the number of pesos that are needed to pay back dollar-denominated debts will increase. An undervalued dollar—and by implication, an overvalued peso—lowers the cost that Mexican consumers pay in pesos to import goods from the United States. Consequently, the Mexican government can keep prices and inflation low by keeping the dollar undervalued and the peso overvalued.Another reason why countries maintain an overvalued fixed exchange rate is because a fall in the value of a currency is often perceived as a failure of government policies. This perception can be a problem for incumbent politicians in democratic countries.8.How did George Soros exploit the overvaluation of the British pound? Answer: George Soros bet against the overvalued British pound just before the government devalued the pound. In 1979, to limit fluctuations in the values of their exchange rates, most Western European countries formed an exchange rate regime called the European Exchange Rate Mechanism. In 1990, Britain also joined this system. The ERM countries agreed to keep their exchange rates trading in tight bands around target values. In 1992, changing market forces put pressure on the German mark to appreciate and the other European currencies to depreciate. The British authorities spent about $24 billion of foreign currency reserves trying to defend the pound. Eventually, as it began running low on reserves, the British government gave up trying to prop up its currency and accepted a sharp depreciation. Soros had borrowed in pounds and then sold the pounds in the market to buy German marks, accelerating the pace of the British government’s reserve losses. He is believed to have made more than $1 billion on his bet against the pound, following which the press called Soros “the man who broke the Bank of England.” 9.How is the real exchange rate for the United States calculated?Answer: The real exchange rate for the United States is defined as the ratio of the dollar price of a basket of goods and services in the United States divided by the dollar price of the same basket of goods and services in a foreign country. The real exchange rate between the U.S. dollar and the Indonesian rupiah is calculated as follows: or 10.How does a change in a country’s real exchange rate affect its net exports?Answer: When the real exchange rate increases, a country imports more from and exports less to foreign economies, reducing its net exports. Conversely, when the real exchange rate depreciates, a country imports less from and exports more to foreign economies, increasing its net exports. For example, when the U.S. dollar appreciates against the Chinese yuan, the United States imports more from China and exports less to China.11.All else being equal, explain how an increase in the real interest rate is likely to affect a country’s net exports, labor demand, and level of employment. Answer: An increase in interest rates in the United States, relative to rates in other countries, implies that foreign investors will receive higher returns on their investments than they could elsewhere. Hence, with the increase in interest rates, foreigners will increase their demand for U.S. assets. Because assets in the United States are denominated in U.S. dollars, the demand for dollars will increase. This will shift the demand curve for dollars to the right. Given flexible exchange rates, this leads to an appreciation of the dollar relative to other currencies. An appreciation of the U.S. dollar means that American goods are more expensive for foreigners to buy, so exports will decline. Conversely, foreign goods are cheaper for Americans to buy, so imports increase. An increase in imports coupled with a decrease in exports means that net exports decline. The decrease in demand for U.S. products due to lower exports results in a decrease in demand for the labor to produce those products. This is reflected in a leftward shift of the labor demand curve, and the new equilibrium level of employment will thus be lower.12.The economy of Freedonia is currently faced with negative net exports and high unemployment. Explain two measures that the Freedonian central bank could take to increase net exports and lower unemployment.Answer: Two measures the bank could pursue are as follows:Enact expansionary monetary policy to lower interest rates. The overall stimulatory effects of this policy were discussed in previous chapters but also relate to the open economy issues that are the subject of the present chapter. Lower rates mean a decreased demand for domestic assets and therefore a decreased demand for domestic currency. This, in turn, leads to a decline in the nominal exchange rate and thus a decline in the real exchange rate. The decline in the real exchange rate means that domestic goods are cheaper for foreigners to buy and that foreign goods are more expensive for domestic purchasers to buy. Exports will increase, imports decline, so net exports go up. As net exports increase, demand for domestic goods increases, and so the demand for labor to produce those goods increases. This results in an increase in employment as the labor demand curve shifts to the right. Intervene in the foreign exchange market so as to depreciate the Freedonian currency. The chapter discussed such interventions on the part of the Chinese central bank in recent years. Domestic currency is supplied to the market by the central bank, which increases its holdings of foreign reserves by buying foreign currency and selling domestic currency. The result of such policies is to depress the nominal exchange rate and thereby decrease the real exchange rate. As the real exchange rate declines, the same consequences for GDP and unemployment described in the previous paragraph come into play.Problems1.Suppose that the European Union follows a flexible exchange rate regime. The exchange rate between the euro (EUR) and the U.S. dollar (USD) is currently 1 EUR = 1.17 USD. a.Use a graph to show the equilibrium in the foreign exchange market with the U.S.-dollar-per-euro exchange rate on the vertical axis and the quantity of euros on the horizontal axis. b.Suppose that due to challenges in the Eurozone economic environment, the costs of producing goods in the Eurozone increase sharply. What effect will this have on the exchange rate? Use a graph to explain. Answer:a.The following graph shows the foreign exchange market in the Eurozone. The supply curve for EURs in exchange for USDs is shown as an upward-sloping curve. The demand curve for EURs in exchange for USDs is shown as a downward-sloping curve. The y-axis shows how many USDs can be exchanged per EURs, while the x-axis shows the quantity of EURs traded in the foreign exchange market. Because the Eurozone follows a flexible exchange rate regime, the market is in equilibrium at the point where the supply and demand curves intersect at an exchange rate of 1 EUR = 1.17 USD.b.Because the Eurozone production has become less competitive, the prices have increased. Because of the price increase there will be less demand for products coming out from the Eurozone, therefore the demand curve will shift to the left. As opposed to 1 EUR=1.17 USD, the EUR will depreciate to for instance 1 EUR= 1 USD. 2.Recall from Chapter 6 that the Big Mac index is used as a rough measure of purchasing power parity across countries. The Economist magazine recently included the Vietnamese dong (VND) in its calculation of the Big Mac index. A Big Mac costs $5.06 in the United States but only 60,368 dong or $2.66 in Vietnam (at the current exchange rate). What does this data suggest about the value of the real exchange rate of the U.S. dollar relative to the Vietnamese dong (treating the U.S. as the domestic economy, so the nominal exchange rate is expressed dong per dollar)? Is the real exchange rate likely to be greater than or less than one? Answer: A Big Mac costs $2.84 or 60,000 dong at the current exchange rate. This means that the current exchange rate is, or 1 USD = 22,694.74 VND. Because the Big Mac costs $5.06 in the United States, for purchasing power parity to hold, the equilibrium exchange rate should be, or 1 USD = 11,930.43 VND. Because the current VND/USD exchange rate is above the rate implied by purchasing power parity, the U.S. dollar is said to be overvalued against the dong, and the dong is said to be undervalued against the U.S. dollar. This means that the dollar is worth more dong than it would be under a flexible exchange rate regime. To calculate the real exchange rate given the current nominal exchange rate of 22,694.74 VND/1 USD, we can use the formula for the real exchange rate: Adapted from: 3.In 2011, the government of Argentina developed a new policy (sometimes called the “dollar clamp”) to prevent Argentines from exchanging pesos, the local currency, for U.S. dollars. New restrictions hampered currency exchange: for example, buying dollars required advance approval from the national tax authority. a. How would you expect these restrictions to affect the foreign exchange market for pesos? Explain using a supply and demand chart, as in 29.3, but this time put pesos per dollar on the y-axis.b. Consider that Argentina has had a tumultuous economic history, with periods of high inflation and economic volatility. In particular, right before the restrictions were put in place, foreign investors (who were holding Argentinian assets) were starting to get skittish. Given this environment, why might the government put these exchange restrictions in place? c. Even with the restrictions in place, dollars were still available in the flourishing black market (if you’re interested, the twitter feed @dolarblue posts the daily black market exchange rate in Argentina). In these circumstances, would you expect the black market exchange rate (pesos per dollar) to be higher or lower than the official exchange rate? Explain. d. At the end of 2015, the new President of Argentina, Mauricio Macri, eliminated the restrictions. Examine a five year chart of the Peso-dollar exchange rate here: . What happened to the official exchange rate when Macri enacted his policy of unrestricted foreign exchange transactions? Explain. Answer: a. We would expect this to limit the demand for dollars by putting up expensive (time or money) restrictions on exchange. In the supply and demand chart (see below) this policy would drive a left shift in the demand curve for dollars, leading to a lower peso-dollar exchange rate. In other words, the peso would appreciate. b. As we saw in this chapter, currency appreciation increases the value of a country’s assets, leading to increased foreign investment. If the government was worried about investors selling off their assets, it might want to appreciate the currency. In addition, nervous Argentinian citizens might also, in volatile times, want to exchange pesos for the more stable USDs. This increase in demand would cause a devaluation—and, if the devaluation sparked more concerns, a downward spiral of continued devaluation. By restricting exchange, the government can stymie this channel for devaluation. c. We would expect the black market exchange rate to be higher (pesos per dollar) than the official exchange rate—because the government is stifling demand, we expect demand to be at its normal, unimpeded level in the black market. Thus, it should take more pesos to buy one dollar in the black market. d.When Macri eliminated the restrictions, the peso-dollar exchange rate shot upwards. This makes sense, because we would expect the elimination of the restrictions to cause the demand for dollars to shift back to its initial level, leading to a depreciation of pesos. 4.The Evidence-Based Economics feature in the chapter discusses how George Soros’s hedge fund made money by betting on the devaluation of the British pound. Interestingly, Soros also made money betting against the Thai baht.In 1997, the baht had been continually falling against the U.S. dollar. The Bank of Thailand attempted to defend its overvalued exchange rate by pegging the baht to the U.S. dollar at a rate of 25 bahts per dollar. Explain how each of the following factors made it difficult for the Thai authorities to continue to defend their exchange rate, leading eventually to a sharp devaluation of the baht.a.The Thai government’s reserves of U.S. dollars fell to a 2-year low in 1997.b.A very large quantity of corporate debt in Thailand was denominated in U.S. dollars. Answer:a.When we say that the Thai baht is overvalued and the U.S. dollar is undervalued, we mean that the dollar is worth fewer baht than it would have been under a flexible exchange rate regime. When the exchange rate in the market is below the market-clearing rate, the quantity of dollars demanded will exceed the quantity of dollars supplied. Thai authorities will have to supply dollars to the market to purchase baht. This implies that overvalued exchange rates can be defended only as long as the Thai authorities have dollar reserves. Given that the government’s reserves of U.S. dollars fell to a two-year low in 1997, it would have been increasingly difficult for the authorities to continue to defend the exchange rate, prompting a devaluation. b.When debt is denominated in dollars, borrowers in Thailand will have to sell baht and buy dollars to pay back the debt and make interest payments. This will further increase the demand for dollars. As the demand for dollars increased in Thailand, the authorities would have found it difficult to supply dollars to the foreign exchange market and defend the pegged exchange rate. Data from: 5. Using the net exports curve and the labor demand and labor supply curve, explain how a fall in the real exchange rate can lead to an increase in employment in a country. Answer: The net exports curve shows the relationship between the real exchange rate and net exports. When the real exchange rate between, say, the U.S. dollar and the euro, declines to R", the United States will export more to European countries. Net exports is defined as the difference between a country’s exports and imports. As exports increase, the value of U.S. net exports will also increase. The economy moves to point A' in the following graph. Because the foreign demand for U.S. goods and services increases, producers in the United States will increase employment in the face of greater demand for their products. The demand for labor curve will shift to the right from D to D'. Assuming that wages are flexible, the real wage as well as the level of employment in the United States will increase to W' and L', respectively. 6.Econia trades with its neighbors, the countries of Governmentia and Sociologia. In Econia, the currency is called the econ; in Governmentia, the currency is called the gov; and in Sociologia, the currency is the soc.Nominal exchange rates follow:200 econ = 1 gov4 socs = 1 gov,100 econ = 1 socA good that is produced and consumed in all three countries is the Mack Burger. The price of Macks in the three countries is as follows: 1 Mack costs 2 govs in Governmentia, 16 socs in Sociologia, and 600 econs in Econia.a.From the perspective of Governmentia, calculate the real exchange rate in Mack Burgers between Governmentia and Sociologia, using the nominal exchange rate (4 socs per gov) and prices listed above. Explain in words what the number you calculated means.b.If these three currencies can be freely traded so that their exchange rates are flexible or floating, can the nominal exchange rates listed above persist over time? Why or why not? (Hint: Show that currency traders could make unlimited profits if they could trade at these exchange rates.) Answer:a.The equation for the real exchange rate (denoted by E) is as follows:WhereDomestic price = the domestic price of the Mack Burgere = Nominal Exchange Rate, expressed in units of foreign currency per unit of domestic currency Foreign price = the foreign price of the Mack BurgerGovernmentia is the domestic country, and Sociologia is the foreign country, as stated in the question. We know that the PDom is equal to 2 govs and that the PFor is equal to 16 socs. The nominal exchange rate is 4 socs/gov. Substituting these values into the real exchange rate equation yields:R = (2 × 4) / 16 = ?We find the real exchange rate is equal to ?, which is the price of goods in Governmentia in terms of the price of goods in Sociologia. In other words, the real exchange rate is the relative price of goods in the two countries, or it is the rate at which we can trade goods in Governmentia for goods in Sociologia: A Governmentia Mack costs ? of a Sociologia Mack.b.No, in a freely traded market currency traders have an opportunity to conduct arbitrage trades. (Arbitrage means that a trader can lock in a price differential for the same asset and make a profit without taking any risk.) The exchange rates as given allow for arbitrageurs to make money. For instance, starting with 1 gov, you could first trade the 1 gov for socs in the currency markets and receive 4 socs. Next, you could trade the 4 socs in the currency markets for 400 econs. Lastly, you could trade the 400 econs in the currency markets for 2 govs. There is an arbitrage opportunity to make a 1 gov profit by trading govs into socs into econs and then back into govs. For floating currencies, arbitrageurs will capitalize on the market inefficiencies and drive all nominal exchange rates to a consistent level; thus, the exchange rates as listed cannot persist over time. If they did, traders could continue the arbitrage trading given previously, and make unlimited profits. They would have discovered a money machine!7.8.The graph below shows the Hungarian forint (HUF) per U.S. dollar (USD) exchange rate between 2008 and 2017. The table that follows shows the real interest rates in these two countries during the same period.Real Interest Rate in the United States and HungaryYear20092010201120122013201420152016United States2.521.11.41.61.42.12.2Hungary6.85.1625.9785.43.2691.0521.151.1What could explain why the Hungarian forint depreciated between 2008 and 2017 vis-á-vis the U.S. dollar? Explain your answer with the help of the information given in the table.Answer: In this case, despite the fact that interest rates were higher in Hungary between 2008 and 2014, investors were selling the forint and buying the dollar. This partially could have been due to fears of the Hungarian economy collapsing in this period, whereas the US economy was thought to be relatively more stable. In fact, Hungary had to turn to the IMF and the EU for a stand-by loan agreement in October 2008. This was when the HUF depreciated around 60% against the USD as seen on the graph. Once the Hungarian economy normalized around 2013/2014, the interest rate also decreased and the exchange rate stayed in the band between 250-300 HUF per USD.Graph source: is from 2008, the dollar has appreciated against the euro.a.Suppose that in the short run the Fed wanted both to weaken the dollar (that is, stop its appreciation and/or cause it to depreciate) and stimulate investment. Based on what you have learned in this chapter and in Chapter 13, discuss whether the Fed can achieve both of these goals simultaneously through monetary policy.b.Suppose instead that the European Central Bank (ECB) conducts contractionary monetary policy. What is the short-run effect, if any, of this policy on the euro/dollar nominal exchange rate and on the real exchange rate between the United States and the European Monetary Union? In your answer regarding the real exchange rate, state any assumptions you are making.Answer:a.We are told that the dollar has depreciated relative to the euro. Facing this situation, the Federal Reserve wants both to weaken the dollar and to stimulate investment. To weaken the dollar, the Fed must conduct expansionary monetary policy—e.g., buy bonds in an open-market operation, which would increase reserves in the banking system and thereby increase the money supply. The supply of reserves would shift to the right, resulting in a lower equilibrium fed funds rate, and lower interest rates in general, in the United States. Holding everything else constant, an decrease in the U.S. real interest rate makes investment in U.S. financial markets a less attractive opportunity than investment Europe, and thus leads to capital flowing out of the United States and into Europe. As investors abandon dollar-denominated assets for those denominated in the euro, they sell dollars and buy euros, thus causing the dollar to depreciate (and the euro to appreciate).In addition, the decrease in interest rates necessary to defend the dollar is consistent with the Fed’s second goal of stimulating investment. Investment is, among other things, negatively related to the real interest rate. Therefore, the Fed can achieve both goals simultaneously through expansionary monetary policy. b.Contractionary monetary policy carried out by the European Central Bank (ECB) will raise interest rates in those European countries over which the ECB has jurisdiction—that is, the countries that belong to the European Monetary Union (EMU). These are the countries that use the euro. An increase in EMU interest rates will lead to capital flowing into EMU countries from the United States. Because euro-denominated assets will become more attractive relative to dollar-denominated assets, investors will demand more euro-denominated assets, and hence demand more euros to buy those assets. This will cause an appreciation of the euro, and a depreciation of the dollar. The euro/dollar nominal exchange rate will decrease—it will take fewer euros to buy one dollar.From the standpoint of the United States, the real exchange rate is equal to , where e is equal to the nominal exchange rate (the number of euros per dollar). A decrease in e will lead to a decrease in the real exchange rate, assuming no increase in relative prices in the United States and European Monetary Union, i.e., assuming that does not increase, or if it does increase, it does not do so enough to offset the decrease in e.10.Thailand and Taiwan are both rapidly growing economies in East and Southeast Asia that trade actively with other countries. a.Suppose a computer circuit board is the only good produced in Thailand and Taiwan. This circuit board costs 100?baht in Thailand and 200 NT (New Taiwan dollars) in Taiwan. The nominal exchange rate is 2 NT per baht.. Calculate the real exchange rate from Thailand’s perspective (that is, using Thailand as the domestic economy, so the nominal exchange rate is 2 NT per baht). Show your work. Intuitively, what does this number represent?b.The Taiwanese current account with the rest of the world is initially balanced –in other words, it is running neither a deficit nor a surplus. Taiwan alone experiences an economic boom and its real interest rate rises at the same time. Thoroughly explain the mechanisms by which the Taiwanese current account is affected by its boom and the increase in its real interest rate.c.Assume that the change in the value of the NT-per-baht exchange rate was 50 percent, which, depending on your answer in part (b), was either appreciation or depreciation. What is the current nominal exchange rate expressed in NT per baht? Show your work.Answer:a. The real exchange rate is 1 Taiwanese computer circuit board per Thai computer circuit board. The real exchange rate formula is where e is the nominal exchange rate and E is the real exchange rate. The nominal exchange rate from the Thai perspective is 2 NT per bhat. Therefore, E = [(100 bhat) × (2 NT per bhat)] / 200 NT = 1. This represents the number of Taiwanese computer circuit boards it takes to buy one Thai computer circuit board.b. Both the economic boom and the rise in the real interest rate cause a current account deficit in Taiwan. The economic boom raises domestic income or output, which increases imports because domestic income is one of the determinants of import demand. Since NX = X – IM, an increase in imports decreases net exports, which leads to a current account deficit (or negative current account). The rising Taiwanese interest rates increase the attractiveness of Taiwanese or NT-denominated assets compared to foreign assets. The NT appreciates relative to other currencies, causing a rise in the nominal exchange rate. Therefore, the real exchange rate also rises according to the exchange rate formula. An increase in the real exchange rate makes Taiwanese exports relatively more expensive to foreigners and makes foreign imports relatively less expensive to the Taiwanese. This decreases exports and increases imports, which decreases net exports. Thus, the rise in interest rates also contributes to a Taiwanese current account deficit. c. From (b) we know that the NT appreciates. In part (a) you could exchange 2 NT for 1 baht. After the 50 percent appreciation of the NT, the value of the nominal exchange rate is 4/3 bhat per NT (e = 4/3 NT per baht). You can now exchange 4/3 NT for one baht. 11. You may have seen the term “Capital Flight” in news articles about developing countries. “Capital Flight” occurs when foreign investors, often spooked by political instability, lose confidence in a country’s assets and decide to sell them. This phenomenon is particularly concerning to the many developing countries that rely on Foreign Direct Investment, which we discussed in Chapter 28. a. Using Exhibit 23.13, show how capital flight—a reduction of demand for a country’s assets at every interest rate—would affect the real exchange rate. Assume that the domestic credit market (panel a) doesn’t change so that the real interest rate is held fixed (for example, the capital flight is caused by political instability). Explain why capital flight is represented by a rightward shift of the curve in panel b. Then explain how this rightward shift in panel b coincides with a movement along the curve in panel c and, therefore, a fall in the real exchange rate. b. Suppose the local government maintains a fixed exchange rate by changing the domestic interest rate. Faced with capital flight, how would the government need to change the interest rate to maintain its exchange rate? Explain using the charts from the previous part of this question. Answer:a.Capital Flight first causes a rightward shift of the panel b curve. This shift occurs because now, at every interest rate, foreign investors will be less likely to invest in the home country. Thus, the country will have increased net capital outflows which, as we’ve seen in the previous chapter, is equal to net exports. As we can see in the chart below, net exports/NCOs will now increase at the equilibrium interest rate. As foreign investors transition their investments outside of the home country, they sell the home currency, leading to a depreciation of the home currency. We see this in panel c of the chart: the exchange rate decreases from E1 to E*. b.In order to counteract the depreciation caused by capital flight, the home country now needs to cause appreciation. They can achieve this appreciation by increasing domestic interest rates through, for example, contractionary monetary policy. We can see this in the charts below: the real interest rate increases from r* to r1, ultimately causing the real exchange rate to return to E1. 11.Imagine that there are two economies in the world: Bostonia and New Yorkland. Bostonia’s currency is the sock, and New Yorkland’s is the yank. Despite the long-standing rivalry between their citizens, Bostonia and New Yorkland are trading partners. The Central Bank of New Yorkland decides to conduct contractionary monetary policy. Explain the short-run effect, if any, on the following:a.The sock/yank nominal exchange rateb.New Yorkland’s net exportsc.Bostonia’s net exportsd.GDP in New Yorkland recently plummeted. At first, the citizens in Bostonia cheered, happy to see their rivals taken down a notch. But then an economist (always a killjoy) asserts that the fall in New Yorkland’s GDP is likely to hurt Bostonia’s GDP in the short run. Could the economist be correct? Why or why not? Answer:a.Contractionary monetary policy carried out by the New Yorkland Central Bank will increase nominal and real interest rates (holding expected inflation constant) in New Yorkland. An increase in New Yorkland interest rates will lead to capital flowing into New Yorkland and out of Bostonia. Because yank-denominated assets will become more attractive relative to sock-denominated assets, investors will demand more yank-denominated assets, and hence demand more yanks to buy those assets. This will cause an appreciation of the yank, and a depreciation of the sock.An appreciation of the yank means that the sock/yank nominal exchange rate will increase—it will take fewer yanks to buy one sock, i.e., one yank is worth more socks. b.An appreciation of the yank relative to the sock will lead to a fall in net export demand for New Yorkland. Bostonia goods become more attractive to New Yorkland consumers as the purchasing power of the yank abroad increases (increasing imports), while New Yorkland goods become less attractive to Bostonia consumers (the purchasing power of the sock decreases). Hence, New Yorkland’s net exports will decrease. c.A decrease in New Yorkland’s net exports implies an increase in the net exports of its trading partner, Bostonia.d.Yes, the economist could be correct. Income abroad is a determinant of net exports. When New Yorkland’s GDP decreases, citizens of New Yorkland will have less money to spend on goods, including imports from Bostonia, so there will be less demand for goods and services in Bostonia and less demand for the labor to produce them. GDP is likely to go down in the short run, and unemployment likely to go up, due to the falloff in exports to New Yorkland. 12.Recall the discussion in “Letting the Data Speak” regarding the Chinese yuan. Why did the Chinese authorities keep the yuan undervalued until the end of 2016? At the beginning of 2014, 1 USD was valued roughly at 6.05 yuan, while by the end of 2016, 1 USD was valued at 6.95 yuan, since then it has stabilized at 1 USD = 6.35 yuan by early March 2018. What factor may have caused the strengthening of the Chinese currency since early 2017? Answer: The undervalued Chinese yuan boosts Chinese exports towards the United States by keeping the price of Chinese goods low, to make them competitive. In return, China buys American debt to allow this transaction to be financed. The problem is that Chinese workers receive lower wages for their work, hence their purchasing power is lower; they cannot buy as many goods as they would be able to with a ‘normal’ exchange rate. The weak yuan is also hurting China’s competitors who would also be exporting to the United States. The weak yuan also distorts American business as it crowds out local manufacturing. Eventually, the exchange rate will have to stabilize between the United States and China, when exports from and production in China will probably decline. ................
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