Chapter 29-Open economy macroeconomics

Question 1

nominal exchange rate

Answer 1

price of one country’s currency in units of another country’s currency

-number of units of foreign currency that a can be purchased with one unit of domestic currency

e= (units of foreign currency)/ (1 unit of domestic currency)

• the higher the value e, the more units of foreign currency a dollar buys
• when it goes up: domestic currency appreciates against the foreign currency
• when goes down: domestic currency is depreciating against the foreign currency

Question 2

flexible exchange rate

Answer 2

• government does not intervene in the foreign exchange market (also referred to as floating exchange rate)
• with a flexible exchange rate, if a country’s current account increases, the country’s financial account must decrease

Question 3

dollar cost

Answer 3

dollar cost= yuan cost x dollar/yuan

Question 4

fixed exchange rate

Answer 4

government fixes the value for the exchange t=rate and intervenes to maintain that value

Question 5

managed exchange rate

Answer 5

gov intervenes actively to influence the exchange rate

Question 6

foreign exchange market

Answer 6

global financial market in which currencies are traded and nominal exchange rates are determined

Question 7

Why is the demand for dollars in exchange for yuan downward-sloping?

Answer 7

because the dollar appreciation increase the price of US goods faced by Chinese firms and consumers, reducing the quantity of goods they demand and thereby reducing the quantity of dollars they demand

Question 8

Why is the supply for dollars in exchange for yuan upward-sloping?

Answer 8

because the dollar appreciation increases the quantity of goods purchased by US buyers from Chinese producers, thus increasing the dollar earnings of Chinese producers and the quantity of dollars that they supply to the foreign exchange market.

Question 9

Why is the dollar overvalued?

Answer 9

because the dollar is worth more yuan than it would have been under a flexible exchange rate regime. The flexible eqm is still represented by e*. The pegged exchange rate is above the market clearing price at the intersection of the supply and demand curves.

Question 10

Describe the yuan/dollar market when yuan has a pegged exchange rate

Answer 10

At the exchange rate corresponding to the peg, the quantity supplied exceeds the quantity demanded. If the Chinese authorities simply announced the peg and do nothing else, the forces of S and D will lower the yuan-per dollar exchange rate below the peg. Recall that the supply curve represents the quantity of dollars supplied to the yuan-dollar foreign exchange market at a particular yuan/dollar exchange rate. If the quantity supplied exceeds the quantity demanded at a particular yuan/dollar exchange rate , there will be an excess S and D of dollars, which will drive down the price of dollars. In other words, the price of dollars (e) will fall, so the dollar will depreciate against the yuan. This process will lower the yuan/dollar exchange rate from the peg toward the market-clearing price at the intersection of the S and D curves. This will cause the increase of next exports from China and the quantity of foreign holdings.

Chinese authorities can print or electronically create as many yuan as they want, so they could perpetually supply yuan to buy dollars if they wished.

Question 11

peso/dollar

Answer 11

an undervalued dollar, hence an overvalued peso lowers the cost that Mexicans consumers pay in pesos to import GS from the US. To maintain an undervalued dollar and an overvalued peso the Mexican government needs to supply dollars to purchase pesos. The quantity of dollars that must be supplied is given by the difference between the quantity of dollars demanded and the quantity of dollars supplied at the pegged exchange rate.

-sell dollars and purchase pesos (M gov): pre-existing dollar reserves, which are limited.

Question 12

real exchange rate

Answer 12

Is defined as the ratio of dollar price of a basket of GS in US, divided by the dollar price of the same basket of GS in foreign country.

-when E appreciates a country imports more from other countries and exports less to other countries, reducing its net exports

Question 13

real exchange rate and nominal exchange rate movements

Answer 13

in most circumstances the nominal exchange rates and real exchange rates appreciate and depreciate together

Question 14

REAL EXCHANGE RATE AND TRADE FLOWS

Answer 14

REAL EXCHANGE RATE AND TRADE FLOWS
-when yuan/dollar goes up ($appreciates and Y depreciates): China import less from US, export more of US. Us export less to China, and imports more from China.

-when yuan/dollar goes down: ($ depreciates and Y appreciates): China import more from Us and export less to US, US export more to China and import less from China

E= (domestic price x e)/ foreign prices

-falling real exchange rate: boosting net exports, raising labour demand, increasing GDP

Question 15

expansionary monetary policy

Answer 15

-expands the supply of credit and lowers real r = increasing the supply of credit will leaf to r* = lower domestic r= depreciate real r = increase of capital outflows and increase in net exports

Question 16

contractionary monetary policy

Answer 16

-increases domestic r= appreciate real interest rate = decrease of capital outflows = decrease in net exports

Question 17

A currency is said to appreciate against a foreign currency when the nominal exchange rate goes

Answer 17

. up, meaning the domestic currency now buys more of the foreign currency.

Question 18

The demand curve for dollars slopes downward because when the dollar

Answer 18

depreciates in value, U.S. goods become relatively less expensive abroad, causing more
people to buy dollars.

Question 19

What does it mean to say that, at an exchange rate of 1 USD = 40 INR, the U.S. dollar is
undervalued and the Indian rupee is overvalued?

Answer 19

The dollar is worth less rupee than it would be under a flexible exchange rate system; thus, the quantity of dollars supplied is less than the quantity of dollars demanded.

Question 20

How does a change in a country’s real exchange rate affect its net exports?

Answer 20

When a country’s real exchange rate appreciates, it imports more and exports less, causing its net exports to fall.

Question 21

The EvidenceBased 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—the Thai baht (THB) was pegged to the U.S.
dollar at a rate of 1 USD = 25 THB.
How did a very high level of corporate debt and debt repayment in Thailand denominated in U.S.
dollars impact the efforts of the Thai authorities to defend their exchange rates?

Answer 21

In order to make payments or pay off debts, borrowers had to sell baht and buy dollars. This
increased the demand for dollars, which made it more difficult for the Thai authorities to
defend the pegged currency

Question 22

How can an increase in the real interest rate affect a country’s current account and financial
account?

Answer 22

. It causes the current account to weaken and the financial account to strengthen.

Question 23

Over the last 10 years, the dollar has depreciated sharply vis-à-vis the euro. Suppose that in the
short run the Fed wanted both to defend the dollar (that is, stop its decline and/or cause it to
appreciate) and stimulate investment.
Can it achieve both of these goals simultaneously through monetary policy?

Answer 23

No, to stimulate investment the Fed will use expansionary policy that will lower interest rates. The lower interest rates, however, will reduce investment into the United States, which will increase the supply of dollars and cause a depreciation of the dollar.

Question 24

Suppose instead that the European Central Bank (ECB) conducts expansionary 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?

Answer 24

The nominal dollars per euro exchange rate will decrease and the real exchange rate will decrease as long as inflation in the European Monetary Union is not significantly lower than inflation in the United States.

Question 25

Explain how Country B can increase the trade deficit in country A by manipulating
the value of its currency?

Answer 25

country B can keep its currency relatively cheap compared to country A’s currency in order to make its exports cheaper thus increasing its export. This channel is possible if it implies a lower real exchange rate. In a graph, this is represented by a downward sloping net export curve with real exchange rate on the y‐axis.

For country A, due to the changes in real exchange rate with country B, its exports to country B will decrease while its imports from country B will increase, thus increasing its trade deficit. (2 marks) Exports to the rest of the world can also decrease if countries A and B are producing highly substitutable goods.

Question 26

Explain the effect of an increase in trade deficit on the labour market of country A
using the labour supply and labour demand curves in the competitive equilibrium with
perfect information. Discuss the effects on wage, employment, unemployment and
labour force participation.

Answer 26

As demand for country A’s good decreases (because of fall in export). This implies a fall in labour demand In a competitive labour market with perfect information, the effect on labour market variables can be represented in a graph with upward sloping labour supply curve and downward sloping labour supply curve. In a graph, the labour demand curve shifts to the left lowering wages, employment and labour force participation as represented by movement
along the labour supply curve.

There is no change in unemployment as it is zero in this economy.

Question 27

How does your answer to part (b) change if there is wage rigidity? Explain how the
absence of perfect information can cause wage rigidity.

Answer 27

With wage rigidity, wages will not fall. In the graph the labour demand curve shits to the left, but wages remain the same, so there is a larger all in employment with no all in labour force participation, thus unemployment increases.