Week 1 Flashcards
The Bank of England decides to stabilize the British pound against the euro due to an unexpected depreciation. Explain how the central bank would conduct a non-sterilized intervention and how this might affect the domestic money supply and interest rates.
- Non-sterilized Intervention: Central bank buys GBP (selling euros), increasing GBP demand.
- Money supply impact: Increases domestic money supply.
- Interest rates: Likely decrease due to higher money supply.
Imagine a country with a fixed exchange rate suddenly experiences a speculative attack on its currency. Describe two measures the central bank could take to defend the peg and explain potential consequences for the economy.
Measures:
- Sell foreign reserves to buy domestic currency.
- Raise interest rates to attract foreign investment.
Consequences:
- Depleted reserves might lead to abandoning the peg.
- Higher interest rates may slow economic growth.
If the European Central Bank (ECB) intervenes in the forex market to strengthen the euro but wishes to avoid altering the eurozone’s money supply, what actions constitute a sterilized intervention? Why might the ECB prefer sterilized interventions?
Sterilized Intervention Steps:
- Buy euros in forex markets (direct intervention).
- Sell government securities domestically to offset increased money supply.
Preference: Maintains stability of domestic money supply and interest rates.
A developing country decides to adopt a fixed exchange rate to the US dollar to stabilize inflation. Discuss the benefits and risks of this decision, using Argentina’s experience in the 1990s as an example.
Benefits:
- Currency stability reduces inflation.
- Encourages foreign investment.
Risks:
- Loss of monetary policy independence.
- Vulnerable to external shocks (e.g., US policy shifts).
Example: Argentina’s currency board (1991) succeeded initially but collapsed due to rigid policies amid economic crises.
A central bank initially uses non-sterilized intervention to prevent the appreciation of its currency but faces a risk of inflation due to the increased money supply. It then conducts sterilized intervention by selling government bonds in the open market.
a) Explain the sequence of effects on the domestic money supply, interest rates, and exchange rate resulting from this sterilized intervention.
b) Critically evaluate why this approach might fail to achieve the desired weaker exchange rate.
a)Selling bonds reduces money supply, increasing interest rates.Higher interest rates attract capital inflows, leading to currency appreciation.
b)Sterilized interventions lack lasting economic impacts.Traders might view the intervention as non-credible and expect the currency to revert.
The Bank of England engages in sterilized intervention by selling pounds in the forex market but also uses public statements to signal its preference for a weaker pound.
a) Discuss the psychological mechanisms by which the central bank’s actions might influence trader behavior in the short term.
b) Analyze why this psychological effect might be temporary without accompanying changes in interest rates or money supply.
a)Traders interpret the central bank’s signals as a call to sell pounds, amplifying market movements.This can lead to short-term depreciation as traders align expectations with policy.
b)Lack of structural economic changes undermines the intervention’s credibility.Traders may anticipate a reversal of depreciation, reducing the intervention’s effectiveness.
Using the scenario where the pound initially appreciates from 1.35 to 1.50 USD/GBP despite sterilized interventions, critically evaluate:
a) Why sterilized interventions are generally less effective than non-sterilized interventions for achieving exchange rate objectives.
b) Under what circumstances might a central bank still prefer sterilized interventions over non-sterilized ones?
a)Sterilized interventions do not alter money supply or interest rates, limiting their impact.Traders often discount these interventions due to a lack of commitment to economic shifts.
b)Sterilized interventions minimize inflationary pressures and maintain domestic monetary stability.Useful for signaling policy intentions without creating distortions in the domestic economy.
Central banks and commercial banks both participate in forex markets, but their objectives differ significantly.
a) Contrast the goals of central banks with those of commercial banks when participating in the forex market.
b) Provide an example where central bank intervention in the forex market might conflict with the goals of commercial banks.
a)Central Banks: Stabilize currency, control inflation, support exports.Commercial Banks: Profit from trading and facilitate client transactions.
b)Example: Central bank intervention to weaken currency might reduce commercial banks’ forex trading profitability by creating volatility.
Retail clients, such as multinational corporations and international investors, rely on intermediaries to access the forex market.
a) Explain why retail clients do not directly participate in the forex market and the advantages of using commercial banks as intermediaries.
b) Consider a scenario where a multinational corporation hedges currency risk using a commercial bank. What are the potential risks if the bank fails to manage the transaction efficiently?
a)Retail clients lack scale and expertise for direct trading.Banks offer liquidity, better pricing, and hedging instruments.
b)Risks: Hedging failure, exposure to unexpected currency movements, and potential financial loss.
The nominal exchange rate between USD and JPY is 140 JPY/USD. The US consumer price index is 120, and Japan’s consumer price index is 100.
a) Calculate the real exchange rate.
b) Discuss what the real exchange rate indicates about US price competitiveness compared to Japan.
a) Real Exchange Rate: Sr=S×P/P∗=140×120/100=168
b) Indicates US goods are relatively more expensive than Japanese goods, reducing competitiveness.
Explain how the effective exchange rate (EER) might overstate or understate the impact of exchange rate movements on a country’s trade balance. Use the example of a country heavily trading with a single partner whose currency experiences significant volatility.
- EER uses weighted averages but may not capture full impact if trade is concentrated in one partner.
- Example: A 20% appreciation against one partner (e.g., US) could severely impact competitiveness if the country conducts 90% of trade with the US, even if the EER shows a smaller overall change.
Discuss how changes in the domestic and foreign inflation rates impact the real exchange rate, even if the nominal exchange rate remains constant. Provide an example of a country experiencing higher inflation than its trading partner.
- Real exchange rate rises (currency becomes less competitive) if domestic inflation exceeds foreign inflation.
- Example: If US inflation is 5% while Japan’s is 1%, US goods become relatively more expensive, reducing export competitiveness.
Critically evaluate the limitations of using nominal and real exchange rate indices to measure a country’s international competitiveness. Provide examples of scenarios where each might fail to provide accurate insights.
-Nominal: Does not account for price level differences (e.g., a nominal depreciation might not reflect improved competitiveness if domestic inflation is high).
-Real: Lag in data availability can obscure real-time insights (e.g., monthly CPI updates delay competitiveness assessment).
Suppose US income rises significantly due to economic growth.
a) Illustrate and explain the impact on the demand curve for pounds in the forex market.
b) Discuss how this would affect the spot exchange rate between the pound and the dollar, and the competitiveness of UK exports.
a) Higher US income increases demand for UK exports, shifting the demand curve for pounds rightward.
b) Pound appreciates, making UK exports more expensive and less competitive in the US market.
If the UK experiences a rise in income, explain using a supply-demand framework how this affects the supply of pounds in the forex market and the spot exchange rate. Include implications for the UK trade balance.
Rise in UK income increases demand for US goods, shifting the supply curve of pounds rightward.
Pound depreciates, improving UK export competitiveness but worsening the trade balance due to higher imports.
Explain how a shift in US consumer preferences toward UK goods impacts the spot exchange rate. Provide a real-world example of a scenario that could lead to such a preference shift.
Increased US demand for UK goods shifts the demand curve for pounds rightward, leading to pound appreciation.
Example: US consumers demand more UK luxury items (e.g., Burberry) after a major international campaign.
A UK trader must pay $100,000 in one year. The spot rate is $1.25/£1, and the forward rate is $1.30/£1.
a) Calculate the cost of using a forward contract versus relying on the spot market if the spot rate in one year is $1.20/£1.
b) Explain why the trader might choose the forward contract despite the potential for a better spot rate in the future.
a)Forward: $100,000 ÷ $1.30 = £76,923.Spot: $100,000 ÷ $1.20 = £83,333.Forward saves £6,410.
b) The trader avoids exchange rate risk and gains certainty for budgeting.
The spot exchange rate is $1.40/£1, and the forward rate is $1.35/£1. Discuss how interest rate differentials between the US and UK explain the forward discount on the pound.
Forward discount arises because UK interest rates are higher than US interest rates. Investors require compensation to hold lower-yield US dollars.
The UK raises interest rates, making pound-denominated assets more attractive to US investors. Simultaneously, the US economy slows, reducing demand for UK exports.
a) Analyze the net impact on the pound’s spot exchange rate using supply-demand analysis.
b) Explain how these conflicting forces could stabilize the exchange rate in the short run.
a) Higher UK interest rates increase demand for pounds, appreciating the pound. Reduced UK export demand decreases pound demand, potentially offsetting appreciation.
b) The opposing effects can balance the exchange rate if magnitudes are similar.
A UK-based car manufacturer anticipates receiving $10 million in one year from a US distributor. The spot rate is $1.30/£1, and the forward rate is $1.28/£1. Analyze the advantages and disadvantages of locking in the forward rate versus waiting for the spot rate.
Advantages: Certainty of receiving £7.81 million; avoids potential dollar depreciation risk.
Disadvantages: Loses potential upside if the pound depreciates further.
Explain why the condition of perfect capital mobility is crucial for CIP to hold. Use a real-world scenario where capital controls might prevent CIP from functioning.
Capital mobility allows arbitrage to equalize returns.
Explain how a change in the forward rate affects the spot rate in the context of CIP, using the example of a forward premium increasing from 2% to 4%.
Higher forward premium implies increased demand for foreign currency in spot markets.
Arbitrage ensures that rising forward demand pushes up the spot rate until CIP equilibrium is restored.
Discuss how real-world factors, such as transaction costs or political risk, might prevent CIP from holding, despite the theoretical assumption of efficient markets.
Transaction costs erode arbitrage profits.
Political risk creates uncertainty, discouraging cross-border investment.
Examples: Brexit’s impact on U.K. investments and currency volatility.
Suppose the U.S. interest rate is 3% and the U.K. interest rate increases from 4% to 5%. The spot exchange rate is $1.30/£1, and the forward rate is $1.28/£1.
a) Explain how arbitrageurs would react to the increase in r∗r^*r∗, ensuring that CIP is reestablished.
b) Illustrate the sequence of market adjustments in both the spot and forward markets.
a) Arbitrageurs would exchange USD for GBP to invest in higher-yielding U.K. assets.
b) Sequence:Increased demand for GBP in the spot market → spot rate increases.Arbitrageurs enter forward contracts to hedge exchange rate risk → forward supply of GBP increases.Forward rate adjusts until (1+r)=(1+r∗)⋅(F/S), reestablishing CIP.
Arbitrageurs investing in foreign assets are exposed to exchange rate risk.
a) Discuss how forward contracts mitigate this risk in the context of CIP.
b) Analyze the impact of arbitrage activity on the forward exchange rate and explain why this ensures that CIP holds in efficient markets.
a) Forward contracts lock the future exchange rate, eliminating uncertainty in converting foreign returns back to domestic currency.
b) Impact of arbitrage:Increased supply of foreign currency in the forward market reduces the forward premium or increases the forward discount.Adjustments in forward and spot rates ensure (1+r)=(1+r∗)⋅(F/S), closing arbitrage opportunities.
A German automobile company has a factory in the United States, while a U.S.-owned technology firm operates a factory in Mexico.
a) Which of these would be included in U.S. GDP and U.S. GNP?
b) Explain the distinction between GDP and GNP with examples.
a) U.S. GDP: Includes production from both factories because GDP considers location.
b) GNP focuses on ownership:Production from a U.S.-owned firm in Mexico contributes to U.S. GNP but not U.S. GDP.Production from a German firm in the U.S. contributes to U.S. GDP but not U.S. GNP.
Why is Gross National Disposable Income (GNDI) considered a better indicator of a nation’s actual income available for consumption and investment compared to GDP? Use examples of net unilateral transfers in your response.
GNDI includes net unilateral transfers (e.g., remittances, foreign aid) and net factor income from abroad.
Example: A country receives $2 billion in remittances from citizens working abroad. This directly boosts disposable income for consumption and savings.
GDP doesn’t capture these transfers, making GNDI a fuller measure.
Under what circumstances would GDP equal GNDI, and what happens when net factor income or net unilateral transfers are non-zero?
When GDP = GNDI: Net factor income abroad and net unilateral transfers = 0.
When these are non-zero: GNDI adds these flows to GDP to represent the total income available to a nation’s residents.
Explain how exchange rate fluctuations can affect GNDI
GNDI includes net factor income and unilateral transfers from abroad. Changes in exchange rates affect their real value.
What are unilateral transfers and how do they differ from net factor income in the context of GNDI?
Unilateral Transfers: Examples include remittances and foreign aid sent without expecting goods/services in return.
Factor Income: Income from foreign investments and labor.
Key Difference: Unilateral transfers are one-way payments, while factor income involves ownership-related income flows.
A U.S. company builds a new factory in Canada. The factory earns $1 billion annually. How would this affect U.S. GDP and GNP?
GDP: The $1 billion in production does not count towards U.S. GDP because it is produced outside U.S. borders.
GNP: The $1 billion does count toward U.S. GNP because it reflects U.S. ownership of production abroad.
If a country experiences a significant increase in net unilateral transfers, what would you expect to happen to its GNDI and economic well-being?
Increase in Net Unilateral Transfers: Improves GNDI as it directly increases residents’ income without requiring trade-offs in goods/services.
Economic Well-being: Higher income allows for better consumption, savings, and investment.
Compare the role of national savings in a closed economy versus an open economy. Use real-life examples to illustrate the differences.
Closed Economy: All national savings are used for domestic investment. Example: In a country with no international trade, all savings would only finance local projects.
Open Economy: National savings can be used for domestic or foreign investment. Example: U.S. savings can finance domestic infrastructure projects or invest in foreign markets like European bonds.
How can a home country’s surplus savings finance the foreign country’s imports?
Home country saves more than it invests domestically → this excess can be lent to a foreign country.
Suppose a foreign country has a persistent trade deficit. How can the home country’s surplus savings be used to address this issue?
Foreign countries with trade deficits require financing to pay for excess imports.
Explain the relationship between national savings and the current account using the identity S - I + T - G = CA. How does this equation highlight trade-offs?
National Savings Identity: S−I+T−G=CA.
This shows no causal relationship; changes in savings, investment, or government spending can affect CA.
When a country has a current account deficit, how is this linked to borrowing from abroad and capital outflows?
Trade Deficit (CA < 0): Spending exceeds earnings; financed by borrowing or selling assets abroad.
Example: The U.S. has run consistent trade deficits, financing these deficits by selling bonds to foreign investors like China. These are asset outflows.
Explain the mechanisms through which a country with a current account deficit borrows from abroad. How does this impact capital flows?
A country with a CA deficit borrows by selling financial assets, such as bonds and stocks, to foreign investors.
This leads to capital inflow from foreign investment to support the deficit. Example: The U.S. sells Treasury bonds to China to finance its deficit, leading to increased capital flows into the U.S.
If S−I+T−G<0, what does this indicate about a nation’s national savings in comparison to its spending? What are the broader economic implications?
It indicates that a country’s savings are insufficient to finance its investment and government spending without borrowing.
Implications: Increased debt from borrowing, reliance on foreign financing, and vulnerability to currency fluctuations.
Example: The United States has historically borrowed from foreign countries to maintain its imports.
How do capital flows (borrowing and lending) affect the balance of payments?
Capital flows represent the movement of financial assets (e.g., bonds, stocks, loans) across borders.
They are linked to trade deficits and surpluses.
Example: China’s capital flows into U.S. Treasury bonds (borrowing by the U.S.) finance America’s trade deficits by providing capital.
Describe the economic consequences when national savings fall short of domestic investment and government spending needs.
National savings shortfall → borrowing from abroad → leads to trade deficits and debt accumulation.
Example: A nation with low savings like Greece in the Eurozone had to borrow heavily during the 2008 financial crisis, leading to debt dependency and economic austerity measures.
