Economics Chapter 6 Assignment

6 Assignment

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?
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
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
What is the real exchange rate equation for S = dollars per yen?
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
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?
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?
Forward premiums and discounts imply that there is risk in foreign exchange
6a. Explain
the three types of FX risk?
How can foreign exchange rate risk be fully covered or hedged?
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



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