## Economics Chapter 6 Assignment

Economics

Chapter

6 Assignment

1.

Note that the current and capital accounts in the U.S. Balance of payments

(BOP) are mostly private transactions while the official settlements balance

involves transactions between governments. If trade with China causes more

imports than exports in the balance of merchandise trade account and the

current account. Then there must be more debits than credits in these two

subsets of BOB accounts. Because we didn’t pay for our imports with

sufficient exports, foreigners must loan us money to finance our over

consumption. If the purchases of U.S. stocks and bonds by private sector

foreigners results in a net capital inflow in the capital account that is less

than our current account deficit, then what can the Chinese government do to

make up for the difference in the official settlements balance?

2.

Assume that the U.S. dollar and the Japanese yen are the only two

currencies in the world.

2a A

bilateral nominal exchange rate S is the spot (now) exchange value of one

currency in terms of the other and S can be written as dollars per 1 yen

or yen per 1 dollar. If S = yen/1 dollar = 76.92 then the inverse 1/S

gives dollars per 1 yen where 1/S = 1/(yen/1 dollar) = 1/76.92

= .013. If the 1/S increases to .014, has the dollar

appreciated (1 dollar is worth more yen) or depreciated (1 dollar is worth

less yen)? Explain.

2b. Changes

in demand and supply in the foreign exchange (FX) market determine the value of

floating exchange rates S. If S is expresses as S = yen/1

dollar, then we have the FX market in terms of the demand and supply of

dollars. (If S = dollars/1 yen, then we get the FX market

in terms of the demand and supply of yen. Note also that no matter

which currency the FX market is expressed, it is still a FX market where

dollars are exchanged for yen. This means that an upward sloping

supply of dollars curve is exactly the same as a demand for yen

curve and a downward sloping demand for dollars curve is exactly the

same as a supply of yen curve). Using S = yen/1 dollar and the

FX market in terms of the demand and supply of dollars, an increase in S

(dollar appreciation) leads to an increase in the quantity of dollars

supplied (increase in the quantity of yen demanded). For dollar

demand (or the supply of yen), and increase in S (dollar appreciation) leads to

a decrease in the quantity of dollars demanded (or an increase in the quantity

of yen supplied). The dollar demand curve shifts to the right if more yen

are offered for dollars at any exchange rate S. An increase in dollar

demand is caused mostly by private sector transactions in the current

and capital accounts. Either an increase in demand for U.S. goods

(merchandise trade in the current account) or an increase in demand

for U.S. stocks and bonds (capital account inflows) will shift the

dollar demand curve to the right. If private transactions in the current

and capital accounts also cause shifts in the dollar

supply curve, what are the corresponding factors that would lead to

an increase in dollars supplied (yen demanded) at any exchange rate

S?

3.

Because it acts like a price, U.S. export demand is inversely related to the

U.S. real exchange rate. U.S. import demand is inversely related to the

real exchange rate of foreign trading partners, which would just be the

inverse of the U. S. real exchange rate for those two

countries. A nominal variable like nominal GDP is converted to real

GDP by dividing by the CPI (average price level (P) in the U.S.). Nominal

bilateral exchange rates are converted to real exchange rates in the same

way. Because one currency can be expressed in terms of another, dividing

by the price level that corresponds to that currency involves

cross-multiplication by the inverse of the price levels between the two trading

countries. For example, if S = yen/1 dollar, then S x (the U.S.

price level / price level in Japan) = the real exchange rate of yen per

dollar.

3a.

What is the real exchange rate equation for S = dollars per yen?

3b.

If the percentage change is computed as the (change in a value/original value)

x 100 = [(value now – value previous)/(value previous) x100] and the real

exchange rate between the yen and the dollar is 105 today, but was only

100 last month, what is the percentage change in the real exchange

rate?

4.

A forward premium for a given currency (say the nominal

bilateral exchange rate value of the dollar where S = 80 yen/1 dollar = 80)

occurs when the value of the currency as given by the forward spot rate

appreciates such as S = 85 yen/1 dollar = 85. If a currency such as

the dollar has a lower forward spot rate where S = 75, it depreciates and

is at a forward discount. If Fn = 85 is the forward spot rate for yen/1

dollar n months from now and S = 80 is the current spot rate of yen/1

dollar, then the dollar is at a forward premium while the yen is at a forward

discount. The percentage change is the same formula but it can

be converted to an annualized percentage change by using the formula (Fn

– S)/S x (12/n) x 100. If Fn = 81 yen/dollar = 81, S = 79, and

n = 3 months, what is the annualized percentage forward premium for the

dollar? The annualized percentage forward discount for the yen?

5.

Cross-rates allow you to calculate a third exchange rate from two that are

known and that have a common currency. The method requires that you set

up the cross-rate multiplication so that the common currency is canceled

out. For example, if a U.S. dollar is worth 80 yen or 1.4 Canadian

dollars, then how many yen is 1 Canadian dollar worth? This can be

determined by setting up a cross-multiplication that cancels out the

common currency, in this case the U.S. dollar. You can’t just go (80

yen/1 dollar) x (1.4 Canadian dollars/1 dollar) because the dollar doesn’t

cancel. Thus you must invert one side or the other such as obtaining

.013 dollars/1 yen. Now you can just do (.013

dollars/yen) x (1.4 Canadian dollars/1 dollar) = .013 x 1.4 and you will

have the number of Canadian dollars per yen. If you want it as yen

per Canadian dollars, just invert it. If the Danish Crone is 7.5

Kr/dollar and the British pound is worth $1.58, then what is the exchange rate

in Kr per British pound?

6.

Forward premiums and discounts imply that there is risk in foreign exchange

transactions.

6a. Explain

the three types of FX risk?

6b.

How can foreign exchange rate risk be fully covered or hedged?

6c.

Foreign exchange risk also allows for speculation through financial

instruments known as foreign exchange derivatives. What are three

common types of foreign exchange derivatives and how do they

work?