CHAPTER 2
1. a. The production possibility curve is a straight line that intercepts the apple axis at
400 (1200/3) and the banana axis at 600 (1200/2).
b. The opportunity cost of apples in terms of bananas is 3/2. It takes three units of labor to harvest an apple but only two units of labor to harvest a banana. If one foregoes harvesting an apple, this frees up three units of labor. These 3 units of labor could then be used to harvest 1.5 bananas.
c. Labor mobility ensures a common wage in each sector and competition ensures the price of goods equals their cost of production. Thus, the relative price equals the relative costs, which equals the wage times the unit labor requirement for apples divided by the wage times the unit labor requirement for bananas. Since wages are equal across sectors, the price ratio equals the ratio of the unit labor requirement, which is 3 apples per 2 bananas.
2. a. The production possibility curve is linear, with the intercept on the apple axis equal to 160 (800/5) and the intercept on the banana axis equal to 800 (800/1).
b. The world relative supply curve is constructed by determining the supply of apples relative to the supply of bananas at each relative price. The lowest relative price at which apples are harvested is 3 apples per 2 bananas. The relative supply curve is flat at this price. The maximum number of apples supplied at the price of 3/2 is 400 supplied by Home while, at this price, Foreign harvests 800 bananas and no apples, giving a maximum relative supply at this price of 1/2. This relative supply holds for any price between 3/2 and 5. At the price of 5, both countries would harvest apples. The relative supply curve is again flat at 5. Thus, the relative supply curve
is step shaped, flat at the price 3/2 from the relative supply of 0 to 1/2, vertical at the relative quantity 1/2 rising from 3/2 to 5, and then flat again from 1/2 to infinity.
3. a. The relative demand curve includes the points (1/5, 5), (1/2, 2), (1,1), (2,1/2).
b. The equilibrium relative price of apples is found at the intersection of the relative demand and relative supply curves. This is the point (1/2, 2), where the relative demand curve intersects the vertical section of the relative supply curve. Thus the equilibrium relative price is 2.
c. Home produces only apples, Foreign produces only bananas, and each country trades some of its product for the product of the other country.
d. In the absence of trade, Home could gain three bananas by foregoing two apples, and Foreign could gain by one apple foregoing five bananas. Trade allows each country to trade two bananas for one apple. Home could then gain four bananas by foregoing two apples while Foreign could gain one apple by foregoing only two bananas. Each country is better off with trade.
4. The increase in the number of workers at Home shifts out the relative supply schedule
such that the corner points are at (1, 3/2) and (1, 5) instead of (1/2, 3/2) and (1/2, 5). The intersection of the relative demand and relative supply curves is now in the lower horizontal section, at the point (2/3, 3/2). In this case, Foreign still gains from trade but the opportunity cost of bananas in terms of apples for Home is the same whether or not there is trade, so Home neither gains nor loses from trade.
5. This answer is identical to that in 3. The amount of \"effective labor\" has not changed
since the doubling of the labor force is accompanied by a halving of the productivity of labor.
6. This statement is just an example of the pauper labor argument discussed in the
chapter. The point is that relative wage rates do not come out of thin air; they are determined by comparative productivity and the relative demand for goods. The box in the chapter provides data which shows the strong connection between wages and productivity. Korea's low wage presumably reflects the fact that Korea is less productive than the United States in most industries. As the test example illustrated, a highly productive country that trades with a less productive, low-wage country will raise, not lower, its standard of living.
7. The problem with this argument is that it does not use all the information needed for
determining comparative advantage in production: this calculation involves the four unit labor requirements (for both the industry and service sectors, not just the two for the service sector). It is not enough to compare only service's unit labor requirements. If als < als*, Home labor is more efficient than foreign labor in services. While this demonstrates that the United States has an absolute advantage in services, this is neither a necessary nor a sufficient condition for determining comparative advantage. For this determination, the industry ratios are also required. The competitive advantage of any industry depends on both the relative productivities of the industries and the relative wages across industries.
8. While Japanese workers may earn the equivalent wages of U.S. workers, the
purchasing power of their income is one-third less. This implies that although w=w* (more or less), p decline as the share of nontraded goods increases. In other words, the higher the portion of goods which do not enter international marketplace, the lower the potential gains from trade. If transport costs were high enough so that no goods were traded then, obviously, there would be no gains from trade. 10. The world relative supply curve in this case consists of a step function, with as many \"steps\" (horizontal portions) as there are countries with different unit labor requirement ratios. Any countries to the left of the intersection of the relative demand and relative supply curves export the good in which they have a comparative advantage relative to any country to the right of the intersection. If the intersection occurs in a horizontal portion then the country with that price ratio produces both goods. CHAPTER 3 Answers to Textbook Problems 1. Texas and Louisiana are states with large oil-producing sectors. The real wage of oil-producing factors of production in terms of other goods falls when the price of oil falls relative to the price of other goods. This was the source of economic decline in these states in 1986. 2. To analyze the economy's production possibility frontier, consider how the output mix changes as labor is shifted between the two sectors. a. The production functions for goods 1 and 2 are standard plots with quantities on the vertical axis, labor on the horizontal axis, and Q1= Q1(K1,L1) with slope equal to the MPL1, and on another graph, Q2= Q2(K2,L2) with slope equal to the MPL2. PF2 Q1 slope= -1/2 100 L2 slope= -1 PPF 100 Q1 100 L1 PF1 Figure 3-1 b. To graph the production possibilities frontier, combine the production function diagrams with the economy's allocation of labor in a four quadrant diagram. The economy's PPF is in the upper right hand corner, as is illustrated in the four quadrant diagram above. The PPF is curved due to declining marginal product of labor in each good. 3. a. To solve this problem, one can graph the demand curve for labor in sector 1, represented by (w=MPL1=demand for L1) and the demand curve for labor in sector 2, represented by (w=MPL2=demand for L2) . Since the total supply of labor is given by the horizontal axis, the labor allocation between the sectors is approximately L1=27 and L2=73. The wage rate is approximately $0.98. wp2xMPL2$1.00p1xMPL10L127L2100L Figure 3-2 b. Use the same type of graph as in problem 2b to show that sectoral output is Q1=44 and Q2=90. (This involves combining the production function diagrams with the economy's allocation of labor in a four quadrant diagram. The economy's PPF is in the upper right hand corner, as illustrated in the text.) c. Use a graph of labor demands, as in part a, to show that the intersection of the demand curves for labor occurs at a wage rate approximately equal to $0.74. The relative decline in the price of good 2 caused labor to be reallocated: labor is drawn out of production of good 2 and enters production of good 1 (L1=62, L2=38). This also leads to an output adjustment, whereby production of good 2 falls to 68 units and production of good 1 rises to 76 units. d. With the relative price change from p2/p1=2 to p2/p1=1, the price of good 2 has fallen by 50 percent, while the price of good 1 has stayed the same. Wages have fallen, but by less than the fall in p2 (wages fell approximately 25 percent). Thus, the real wage relative to p2 actually rises while to real wage relative to p1 falls. Hence, to determine the welfare consequences for workers, information is needed about their consumption shares of good 1 and good 2. 4. The box diagram presented below is a useful tool for showing the effects of increasing the supply of the mobile factor of production, labor. a. For an economy producing two goods, X and Y, with labor demands reflected by their marginal revenue product curves, there is an initial wage of w1 and an initial labor allocation of Lx=OxA and Ly=OyA. When the supply of labor increases, the right boundary of this diagram is pushed out to Oy'. The demand for labor in sector Y is pulled rightward with the boundary. The new intersection of the labor demand curves shows that labor expands in both sectors, and therefore output of both X and Y also expand. The relative expansion of output is ambiguous. Wages paid to workers fall. PxMPLx 1 w1 w2 Ox 2 PyMPLy A B Oy Oy’ Figure 3-3 b. From the shape of the MPL curves, it is clear that labor will continue to exhibit diminishing returns. Using a four quadrant diagram, you can demonstrate that the new production possibility frontier is more concave and steeper (flatter) at the ends. Using the numerical example, L1 increases to 90 from 62 and L2 increases to 50 from 38. Wages decline from $0.74 to $0.60. This new allocation of labor yields a new output mix of approximately Q1=85 and Q2=77. CHAPTER 4 Answers to Textbook Problems 1. The definition of cattle growing as land intensive depends on the ratio of land to labor used in production, not on the ratio of land or labor to output. The ratio of land to labor in cattle exceeds the ratio in wheat in the United States, implying cattle is land intensive in the United States. Cattle is land intensive in other countries too if the ratio of land to labor in cattle production exceeds the ratio in wheat production in that country. Comparisons between another country and the United States is less relevant for this purpose. 2. a. The box diagram has 600 as the length of two sides (representing labor) and 60 as the length of the other two sides (representing land). There will be a ray from each of the two corners representing the origins. To find the slopes of these rays we use the information from the question concerning the ratios of the production coefficients. The question states that aLC / aTC = 20 and aLF / aTF = 5. Since aLC / aTC = (LC /QC) / (TC /QC) =LC /TC we have LC =20TC. Using the same reasoning, aLF / aTF = (LF /QF) / (TF /QF) =LF /TF and since this ratio equals 5, we have LF =5TF. We can solve this algebraically since L=LC+LF=600 and T=TC+TF=60. The solution is LC=400, TC=20, LF=200 and TF=40. b. The dimensions of the box change with each increase in available labor but the slopes of the rays from the origins remain the same. The solutions in the different cases are as follows. L=800: TC=33.33, LC=666.67, TF=26.67, LF=133.33 L=1000: TC=46.67, LC=933.33, TF=13.33, LF=66.67 L=1200: TC=60, LC=1200, TF=0, LF=0. (complete specialization). c. At constant factor prices, some labor would be unused, so factor prices would have to change, or there would be unemployment. 3. This question is similar to an issue discussed in Chapter 2. What matters is not the absolute abundance of factors, but their relative abundance. Poor countries have an abundance of labor relative to capital when compared to more developed countries. 4. In the Ricardian model, labor gains from trade through an increase in its purchasing power. This result does not support labor union demands for limits on imports from less affluent countries. Labor may gain or lose from trade in the context of the Immobile Factors model. Purchasing power in terms of one good will rise, but in terms of the other good it will decline. The Heckscher-Ohlin model directly addresses distribution by considering the effects of trade on the owners of factors of production. In the context of this model, unskilled U.S. labor loses from trade since this group represents the relatively scarce factors in this country. The results from the Heckscher-Ohlin model support labor union demands for import limits. 5. Conditions necessary for factor price equalization include both countries (or regions) produce both goods, both countries have the same technology of production, and the absence of barriers to trade. The difference between wages different regions of the United States may reflect all of these reasons; however, the barriers to trade are purely \"natural\" barriers due to transportation costs. U.S. trade with Mexico, by contrast, is also subject to legal limits; together with cultural differences that inhibit the flow of technology, this may explain why the difference in wage rates is so much larger. 6. The factor proportions theory states that countries export those goods whose production is intensive in factors with which they are abundantly endowed. One would expect the United States, which has a high capital/labor ratio relative to the rest of the world, to export capital-intensive goods if the Heckscher-Ohlin theory holds. Leontief found that the United States exported labor-intensive goods. Bowen, Leamer and Sveikauskas found for the world as a whole the correlation between factor endowment and trade patterns to be tenuous. The data do not support the predictions of the theory that countries' exports and imports reflect the relative endowments of factors. 7. If the efficiency of the factors of production differ internationally, the lessons of the Heckscher-Ohlin theory would be applied to “effective factors” which adjust for the differences in technology or worker skills or land quality (for example). The adjusted model has been found to be more successful than the unadjusted model at explaining the pattern of trade between countries. Factor-price equalization concepts would apply to the effective factors. A worker with more skills or in a country with better technology could be considered to be equal to two workers in another country. Thus, the single person would be two effective units of labor. Thus, the one high-skilled worker could earn twice what lower skilled workers do and the price of one effective unit of labor would still be equalized. CHAPTER 5 Answers to Textbook Problems 1. An increase in the terms of trade increases welfare when the PPF is right-angled. The production point is the corner of the PPF. The consumption point is the tangency of the relative price line and the highest indifference curve. An improvement in the terms of trade rotates the relative price line about its intercept with the PPF rectangle (since there is no substitution of immobile factors, the production point stays fixed). The economy can then reach a higher indifference curve. Intuitively, although there is no supply response, the economy receives more for the exports it supplies and pays less for the imports it purchases. 2. The difference from the standard diagram is that the indifference curves are right angles rather than smooth curves. Here, a terms of trade increase enables an economy to move to a higher indifference curve. The income expansion path for this economy is a ray from the origin. A terms of trade improvement moves the consumption point further out along the ray. 3. The terms of trade of Japan, a manufactures (M) exporter and a raw materials (R) importer, is the world relative price of manufactures in terms of raw materials (pM/pR). The terms of trade change can be determined by the shifts in the world relative supply and demand (manufactures relative to raw materials) curves. Note that in the following answers, world relative supply (RS) and relative demand (RD) are always M relative to R. We consider all countries to be large, such that changes affect the world relative price. a. Oil supply disruption from the Middle East decreases the supply of raw materials, which increases the world relative supply. The world relative supply curve shifts out, decreasing the world relative price of manufactured goods and deteriorating Japan's terms of trade. b. Korea’s increased automobile production increases the supply of manufactures, which increases the world RS. The world relative supply curve shifts out, decreasing the world relative price of manufactured goods and deteriorating Japan's terms of trade. c. U.S. development of a substitute for fossil fuel decreases the demand for raw materials. This increases world RD and the world relative demand curve shifts out, increasing the world relative price of manufactured goods and improving Japan's terms of trade. This occurs even if no fusion reactors are installed in Japan since world demand for raw materials falls. d. A harvest failure in Russia decreases the supply of raw materials, which increases the world RS. The world relative supply curve shifts out. Also, Russia’s demand for manufactures decreases, which reduces world demand so that the world relative demand curve shifts in. These forces decrease the world relative price of manufactured goods and deteriorate Japan's terms of trade. e. A reduction in Japan’s tariff on raw materials will raise its internal relative price of manufactures. This price change will increase Japan’s RS and decrease Japan’s RD, which increases the world RS and decreases the world RD (i.e., world RS shifts out and world RD shifts in). The world relative price of manufactures declines and Japan’s terms of trade deteriorate. 4. These results acknowledge the biased growth which occurs when there is an increase in one factor of production. An increase in the capital stock of either country favors production of good X while an increase in the labor supply favors production of good Y. Also, recognize the Heckscher-Ohlin result that an economy will export that good which uses intensively the factor which hat economy has in relative abundance. Country A exports good X to country B and imports good Y from country B. The possibility of immiserizing growth makes the welfare effects of a terms of trade improvement due to export-biased growth ambiguous. Import-biased growth unambiguously improves welfare for the growing country. a. A's terms of trade worsen, A's welfare may increase or, less likely, decrease, and B's welfare increases. b. A's terms of trade improve, A's welfare increases and B's welfare decreases. c. B's terms of trade improve, B's welfare increases and A's welfare decreases. d. B's terms of trade worsen, B's welfare may increase or, less likely, decrease, and A's welfare increases. 5. Immiserizing growth occurs when the welfare deteriorating effects of a worsening in an economy's terms of trade swamp the welfare improving effects of growth. For this to occur, an economy must undergo very biased growth and the economy must be a large enough actor in the world economy such that its actions spill over to adversely alter the terms of trade to a large degree. This combination of events is unlikely to occur in practice. 6. Aid which must be spent on exports increases the demand for those export goods and raises their price relative to other goods. There will be a terms of trade deterioration for the recipient country. This can be viewed as a polar case of the effect of a transfer on the terms of trade. Here, the marginal propensity to consume the export good by the recipient country is 1. The donor benefits from a terms of trade improvement. As with immiserizing growth, it is theoretically possible that a transfer actually worsens the welfare of the recipient. 7. Given the difference in technological development between most Eastern European countries and the United States and Japan, the effects on Western European prices will depend, in the short run, on transfer problem issues and, in the long run, on the likely biases in Eastern Europe's growth. The transfer problem point is concerned with the consumption demands of countries which receive available international credit supplies. If loans to developing countries shift from availability to Latin American countries, which have a relatively high propensity to consume U.S. goods, to availability to Eastern European countries, which have a lower propensity to consume U.S. goods and a higher propensity to consume German goods, the price of German exports will rise relative to the price of U.S. exports. This would lead to an improvement in the terms of trade of Germany and a worsening of the terms of trade of the United States. Note, however, that in the long term, the analysis of terms of trade effects should also consider whether the biases in economic growth in Eastern Europe will be in sectors of the economy more closely aligned with the export industries of Germany or of the United States. The greater the similarity of the export-oriented industrial push in Eastern European with the existing industries in Germany, the greater the supply side reversal of the favorable German terms of trade movement which had arisen from the demand side forces of the transfer problem. 8. When a country subsidizes its exports, the world relative supply and relative demand schedules shift such that the terms of trade for the country worsen. A countervailing import tariff in a second country exacerbates this effect, moving the terms of trade even further against the first country. The first country is worse off both because of the deterioration of the terms of trade and the distortions introduced by the new internal relative prices. The second country definitely gains from the first country's export subsidy, and may gain further from its own tariff. If the second country retaliated with an export subsidy then this would offset the initial improvement in the terms of trade; the \"retaliatory\" export subsidy definitely helps the first country and hurts the second. CHAPTER 6 Answers to Textbook Problems 1. Cases a and d reflect external economies of scale since concentration of the production of an industry in a few locations reduces the industry's costs even when the scale of operation of individual firms remains small. External economies need not lead to imperfect competition. The benefits of geographical concentration may include a greater variety of specialized services to support industry operations and larger labor markets or thicker input markets. Cases b and c reflect internal economies of scale and occur at the level of the individual firm. The larger the output of a product by a particular firm, the lower its average costs. This leads to imperfect competition as in petrochemicals, aircraft, and autos. 2. The profit maximizing output level of a monopolist occurs where marginal revenue equals marginal cost. Unlike the case of perfectly competitive markets, under monopoly marginal revenue is not equal to price. Marginal revenue is always less than price under imperfectly competitive markets because to sell an extra unit of output the firm must lower the price of all units, not just the marginal one. 3. By concentrating the production of each good with economies of scale in one country rather than spreading the production over several countries, the world economy will use the same amount of labor to produce more output. In the monopolistic competition model, such a concentration of labor benefits the host country, which can also capture some monopoly rents, while it may hurt the rest of the world which could then face higher prices on its consumption goods. In the external economies case, such monopolistic pricing behavior is less likely since imperfectly competitive markets are less likely. 4. Although this problem is a bit tricky and the numbers don't work out nicely, a solution does exist. The first step in finding the solution is to determine the equilibrium number of firms in the industry. The equilibrium number of firms is that number, n, at which price equals average cost. We know that AC=F/X + c , where F represents fixed costs of production, X represents the level of sales by each firm, and c represents marginal costs. We also know that P=c+ (1/bn), where P and b represent price and the demand parameter. Also, if all firms follow the same pricing rule, then X=S/n where S equals total industry sales. So, set price equal to average cost, cancel out the c's and replace X by S/n. Rearranging what is left yields the formula n2=S/Fb. Substitute in S=900,000+ 1,600,000+ 3,750,000 =6,250,000, F=750,000,000 and b=1/30,000. The numerical answer is that n=15.8 firms. However, since you will never see .8 firms, there will be 15 firms that enter the market, not 16 firms since the last firm knows that it can not make positive profits. The rest of the solution is straight-forward. Using X=S/n, output per firm is 41,666 units. Using the price equation, and the fact that c=5,000, yields an equilibrium price of $7,000. 5. a. The relatively few locations for production suggest external economies of scale in production. If these operations are large, there may also be large internal economies of scale in production. b. Since economies of scale are significant in airplane production, it tends to be done by a small number of (imperfectly competitive) firms at a limited number of locations. One such location is Seattle, where Boeing produces. c. Since external economies of scale are significant in semiconductor production, semiconductor industries tend to be concentrated in certain geographic locations. If, for some historical reason, a semiconductor is established in a specific location, the export of semiconductors by that country is due to economies of scale and not comparative advantage. d. \"True\" scotch whiskey can only come from Scotland. The production of scotch whiskey requires a technique known to skilled distillers who are concentrated in the region. Also, soil and climactic conditions are favorable for grains used in local scotch production. This reflects comparative advantage. e. France has a particular blend of climactic conditions and land that is difficult to reproduce elsewhere. This generates a comparative advantage in wine production. 6. The Japanese producers are price discriminating across United States and Japanese markets, so that the goods sold in the United States are much cheaper than those sold in Japan. It may be profitable for other Japanese to purchase these goods in the United States, incur any tariffs and transportation costs, and resell the goods in Japan. Clearly, the price differential across markets must be non-trivial for this to be profitable. 7. a. Suppose two countries that can produce a good are subject to forward-falling supply curves and are identical countries with identical curves. If one country starts out as a producer of a good, i.e. it has a head start even as a matter of historical accident, then all production will occur in that particular country and it will export to the rest of the world. b. Consumers in both countries will pay a lower price for this good when external economies are maximized through trade and all production is located in a single market. In the present example, no single country has a natural cost advantage or is worse off than it would be under autarky. 8. External economies are important for firms as technology changes rapidly and as the “cutting edge” moves quickly with frequent innovations. As this process slows, manufacturing becomes more routine and there is less advantage conferred by external economies. Instead, firms look for low cost production locations. Since external economies are no longer important, firms find little advantage in being clustered and it is likely that locations other than the high-wage original locations are chosen. CHAPTER 7 Answers to Textbook Problems 1. The marginal product of labor in Home is 10 and in Foreign is 18. Wages are higher in Foreign, so workers migrate there to the point where the marginal product in both Home and Foreign is equated. This occurs when there are 7 workers in each country, and the marginal product of labor in each country is 14. 2. There is no incentive to migrate when there is factor price equalization. This occurs when both countries produce both goods and when there are no barriers to trade (the problem assumes technology is the same in the two countries). A tariff by country A increases the relative price of the protected good in that country and lowers its relative price in the country B. If the protected good uses labor relatively intensively, the demand for labor in country A rises, as does the return to labor, and the return to labor in the country B falls. These results follow from the Stolper-Samuelson theory, which states that an increase in the price of a good raises the return to the factor used intensively in the production of that good by more than the price increase. These international wage differentials induce migration from country B to country A. 3. The analysis of intertemporal trade follows directly the analysis of trade of two goods. Substitute \"future consumption\" and \"present consumption\" for \"cloth\" and \"food.\" The relevant relative price is the cost of future consumption compared to present consumption, which is the inverse of the real interest rate. Countries in which present consumption is relatively cheap (which have low real interest rates) will \"export\" present consumption (i.e. lend) to countries in which present consumption is relatively dear (which have high real interest rates). The equilibrium real interest rate after borrowing and lending occur lies between that found in each country before borrowing and lending take place. Gains from borrowing and lending are analogous to gains from trade--there is greater efficiency in the production of goods intertemporally. 4. Foregoing current consumption allows one to obtain future consumption. There will be a bias towards future consumption if the amount of future consumption which can be obtained by foregoing current consumption is high. In terms of the analysis presented in this chapter, there is a bias towards future consumption if the real interest rate in the economy is higher in the absence of international borrowing or lending than the world real interest rate. a. The large inflows of immigrants means that the marginal product of capital will rise as more workers enter the country. The real interest rate will be high, and there will be a bias towards future consumption. b. The marginal product of capital is low and thus there is a bias towards current consumption. c. The direction of the bias depends upon the comparison of the increase in the price of oil and the world real interest rate. Leaving the oil in the ground provides a return of the increase in the price of oil whereas the world real interest rate may be higher or lower than this increase. d. Foregoing current consumption allows exploitation of resources, and higher future consumption. Thus, there is a bias towards future consumption. e. The return to capital is higher than in the rest of the world (since the country's rate of growth exceeds that of the rest of the world), and there is a bias toward future consumption. 5. a. $10 million is not a controlling interest in IBM, so this does not qualify as direct foreign investment. It is international portfolio diversification. b. This is direct foreign investment if one considers the apartment building a business which pays returns in terms of rents. c. Unless particular U.S. shareholders will not have control over the new French company, this will not be direct foreign investment. d. This is not direct foreign investment since the Italian company is an \"employee,\" but not the ones which ultimately control, the company. 6. In terms of location, the Karma company has avoided Brazilian import restrictions. In terms of internalization, the firm has retained its control over the technology by not divulging its patents. CHAPTER 8 Answers to Textbook Problems 1. The import demand equation, MD, is found by subtracting the home supply equation from the home demand equation. This results in MD = 80 - 40 x P. Without trade, domestic prices and quantities adjust such that import demand is zero. Thus, the price in the absence of trade is 2. 2. a. Foreign's export supply curve, XS, is XS = -40 + 40 x P. In the absence of trade, the price is 1. b. When trade occurs export supply is equal to import demand, XS = MD. Thus, using the equations from problems 1 and 2a, P = 1.50, and the volume of trade is 20. 3. a. The new MD curve is 80 - 40 x (P+t) where t is the specific tariff rate, equal to 0.5. (Note: in solving these problems you should be careful about whether a specific tariff or ad valorem tariff is imposed. With an ad valorem tariff, the MD equation would be expressed as MD=80-40 x(1+t)P). The equation for the export supply curve by the foreign country is unchanged. Solving, we find that the world price is $1.25, and thus the internal price at home is $1.75. The volume of trade has been reduced to 10, and the total demand for wheat at home has fallen to 65 (from the free trade level of 70). The total demand for wheat in Foreign has gone up from 50 to 55. b. and c. The welfare of the home country is best studied using the combined numerical and graphical solutions presented below in Figure 8-1. PriceHome SupplyPT=1.75abcdPW=1.50PeHome DemandT*=1.2550556070Quantity Figure 8-1 where the areas in the figure are: a: 55(1.75-1.50) -.5(55-50)(1.75-1.50)=13.125 b: .5(55-50)(1.75-1.50)=0.625 c: (65-55)(1.75-1.50)=2.50 d: .5(70-65)(1.75-1.50)=0.625 e: (65-55)(1.50-1.25)=2.50 Consumer surplus change: -(a+b+c+d)=-16.875. Producer surplus change: a=13.125. Government revenue change: c+e=5. Efficiency losses b+d are exceeded by terms of trade gain e. [Note: in the calculations for the a, b, and d areas a figure of .5 shows up. This is because we are measuring the area of a triangle, which is one-half of the area of the rectangle defined by the product of the horizontal and vertical sides.] 4. Using the same solution methodology as in problem 3, when the home country is very small relative to the foreign country, its effects on the terms of trade are expected to be much less. The small country is much more likely to be hurt by its imposition of a tariff. Indeed, this intuition is shown in this problem. The free trade equilibrium is now at the price $1.09 and the trade volume is now $36.40. With the imposition of a tariff of 0.5 by Home, the new world price is $1.045, the internal home price is $1.545, home demand is 69.10 units, home supply is 50.90 and the volume of trade is 18.20. When Home is relatively small, the effect of a tariff on world price is smaller than when Home is relatively large. When Foreign and Home were closer in size, a tariff of .5 by home lowered world price by 25 percent, whereas in this case the same tariff lowers world price by about 5 percent. The internal Home price is now closer to the free trade price plus t than when Home was relatively large. In this case, the government revenues from the tariff equal 9.10, the consumer surplus loss is 33.51, and the producer surplus gain is 21.0. The distortionary losses associated with the tariff (areas b+d) sum to 4.14 and the terms of trade gain (e) is 0.819. Clearly, in this small country example the distortionary losses from the tariff swamp the terms of trade gains. The general lesson is the smaller the economy, the larger the losses from a tariff since the terms of trade gains are smaller. 5. The effective rate of protection takes into consideration the costs of imported intermediate goods. In this example, half of the cost of an aircraft represents components purchased from other countries. Without the subsidy the aircraft would cost $60 million. The European value added to the aircraft is $30 million. The subsidy cuts the cost of the value added to purchasers of the airplane to $20 million. Thus, the effective rate of protection is (30 - 20)/20 = 50%. 6. We first use the foreign export supply and domestic import demand curves to determine the new world price. The foreign supply of exports curve, with a foreign subsidy of 50 percent per unit, becomes XS = -40 + 40(1+0.5) x P. The equilibrium world price is 1.2 and the internal foreign price is 1.8. The volume of trade is 32. The foreign demand and supply curves are used to determine the costs and benefits of the subsidy. Construct a diagram similar to that in the text and calculate the area of the various polygons. The government must provide (1.8 - 1.2) x 32 = 19.2 units of output to support the subsidy. Foreign producers surplus rises due to the subsidy by the amount of 15.3 units of output. Foreign consumers surplus falls due to the higher price by 7.5 units of the good. Thus, the net loss to Foreign due to the subsidy is 7.5 + 19.2 - 15.3 = 11.4 units of output. Home consumers and producers face an internal price of 1.2 as a result of the subsidy. Home consumers surplus rises by 70 x .3 + .5 (6 x.3) = 21.9 while Home producers surplus falls by 44 x .3 + .5(6 x .3) = 14.1, for a net gain of 7.8 units of output. 7. At a price of $10 per bag of peanuts, Acirema imports 200 bags of peanuts. A quota limiting the import of peanuts to 50 bags has the following effects: a. The price of peanuts rises to $20 per bag. b. The quota rents are ($20 - $10) x 50 = $500. c. The consumption distortion loss is .5 x 100 bags x $10 per bag = $500. d. The production distortion loss is .5 x 50 bags x $10 per bag = $250. CHAPTER 9 Answers to Textbook Problems 1. The arguments for free trade in this quote include: • Free trade allows consumers and producers to make decisions based upon the marginal cost and benefits associated with a good when costs and prices are undistorted by government policy. • The Philippines is \"small,\" so it will have little scope for influencing world prices and capturing welfare gains through an improvement of its terms of trade. • \"Escaping the confines of a narrow domestic market\" allows possible gains through economies of scale in production. • Free trade \"opens new horizons for entrepreneurship.\" • Special interests may dictate trade policy for their own ends rather than for the general welfare. Free trade policies may aid in halting corruption where these special interests exert undue or disproportionate influence on public policy. 2. a. This is potentially a valid argument for a tariff, since it is based on an assumed ability of the United States to affect world prices -- that is, it is a version of the optimal tariff argument. If the United States is concerned about higher world prices in the future, it could use policies which encourage the accumulation of oil inventories and minimize the potential for future adverse shocks. b. Sharply falling prices benefit U.S. consumers, and since these are off-season grapes and do not compete with the supplies from U.S. producers, the domestic producers are not hurt. There is no reason to keep a luxury good expensive. c. The higher income of farmers due to export subsidies and the potentially higher income to those who sell goods and services to the farmers comes at the expense of consumers and taxpayers. Unless there is some domestic market failure, an export subsidy always produces more costs than benefits. Indeed, if the goal of policy is to stimulate the demand for the associated goods and services, policies should be targeted directly at these goals. d. There may be external economies associated with the domestic production of semiconductors. This is a potentially a valid argument. But the gains to producers of protecting the semiconductor industry must as always be weighed against the higher costs to consumers and other industries which pervasively use the chips. A well-targeted policy instrument would be a production subsidy. This has the advantage of directly dealing with the externalities associated with domestic chip production. e. Thousands of homebuyers as consumers (as well as workers who build the homes for which the timber was bought) have benefited from the cheaper imported timber. If the goal of policy is to soften the blow to timber workers, a more efficient policy would be direct payments to timber workers in order to aid their relocation. 3. Without tariffs, the country produces 100 units and consumes 300 units, thus importing 200 units. a. A tariff of 5 per unit leads to production of 125 units and consumption of 250 units. The increase in welfare is the increase due to higher production of 25 x 10 minus the losses to consumer and producer surplus of (25 x 5)/2 and (50 x 5)/2, respectively, leading to a net gain of 62.5. b. A production subsidy of 5 leads to a new supply curve of S = 50 + 5 x(P+5). Consumption stays at 300, production rises to 125, and the increase in welfare equals the benefits from greater production minus the production distortion costs, 25 x 10 - (25 x 5)/2 = 187.5. c. The production subsidy is a better targeted policy than the import tariff since it directly affects the decisions which reflect a divergence between social and private costs while leaving other decisions unaffected. The tariff has a double-edged function as both a production subsidy and a consumption tax. d. The best policy is to have producers fully internalize the externality by providing a subsidy of 10 per unit. The new supply curve will then be S = 50 + 5 x(P+10), production will be 150 units, and the welfare gain from this policy will be 50 x 10 - (10 x 50)/2 =250. 4. The government's objective is to maximize consumers surplus plus its own revenue plus twice the amount of producers surplus. A tariff of 5 per unit improves producers surplus by 562.5, worsens consumers surplus by 1375, and leads to government revenue of 625. The tariff results in an increase in the government's objective function of 375. 5. The United States has a legitimate interest in the trade policies of other countries, just as other countries have a legitimate interest in U.S. activities. The reason is that uncoordinated trade policies are likely to be inferior to those based on negotiations. By negotiating with each other, governments are better able both to resist pressure from domestic interest groups and to avoid trade wars of the kind illustrated by the Prisoners' Dilemma example in the text. 6. a. While tariffs are legal, the United States is obliged to offer compensation for any unilateral tariff increase by reducing other tariffs to compensate the affected exporting country. b. Export subsidies on agricultural products are legal under GATT. c. This is not legal under GATT because the United States is not offering compensating reductions in other tariffs on Canadian goods. Interestingly, in the late 1980s, U.S. efforts to protect the shakes and shingles industry were met with an outcry and Canadian threats of a trade war. These protectionist efforts by the United States were rescinded. d. This is legal under GATT since the action is taken by Canada on its own exports. e. This is legal under GATT since it does not involve any direct export subsidies. f. This is legal under GATT and, in fact, may help increase the benefits from trade. 7. The potential economic costs associated with the entrance of Poland and Hungary into an expanded EU depend largely on whether their membership results in trade creation or trade diversion. In particular, Poland and Hungary will gain if they engage in new trade with Western Europe although they might lose if trade within the European Union simply replaces trade which had been occurring with Eastern bloc countries. Furthermore, both of these nations will face at least higher structural unemployment during the transition period. Some of the negative effects on workers might be lessened if labor mobility is permitted across borders. The Western nations should also be concerned on the trade creation versus trade diversion aspects of the entry of Poland and Hungary. For distributional and political reasons, they may be concerned about whether the prices of their own products will be driven down by competition or whether the entrants will simply bring to the Western markets an expanded variety of products and scope for additional scale economies of production. Workers in Western markets may be concerned that inflows of foreign labor drive down wages, although, as we have observed in previous chapters, the nominal wage shifts should be considered in light of changes in the prices of consumption goods. Countries outside of the EU, such as the United States and Japan, would express concern if the supplies of products to the EU by Poland and Hungary substitute for goods previously supplied by the United States and Japan. The large outsiders, however, could reap substantial positive gains from having expanded access to the consumers of Poland and Hungary. CHAPTER 10 Answers to Textbook Problems 1. The Japanese example gives pause to those who believe that protectionism is always disastrous. However, the fact of Japanese success does not demonstrate that protectionist trade policy was responsible for that success. Japan was an exceptional society that had emerged into the ranks of advanced nations before World War II, and was recovering from wartime devastation. It is arguable that economic success would have come anyway, so that the apparent success of protection represents a \"pseudo-infant-industry\" case of the kind discussed in the text. 2. a. The initial high costs of production would justify infant industry protection if the costs to the society during the period of protection were less than the future stream of benefits from a mature, low cost industry. b. An individual firm does not have an incentive to bear development costs itself for an entire industry when these benefits will accrue to other firms. There is a stronger case for infant industry protection in this instance because of the existence of market failure in the form of the appropriability of technology. 3. There are larger markets in larger countries like Brazil and industries which benefit from import substituting policies could realize economy of scale advantages there which would not be available to industries producing solely for the market of Ghana. 4. The value of the marginal product of labor in the production of food is 9 x $10 = $90. a. The wage will be equated in each sector when there are no distortions. This occurs when there are 8 workers in manufacturing and 12 in food production. The wage of all workers will be $90. The output of each sector can be found by calculating the area under the marginal product of labor curves. This curve is a horizontal line for food, so output in this sector is 12 x 9 = 108. Summing the area under the MPL curve for manufacturing up to 8 workers results in output of 110. b. Manufacturing output shrinks to 3 workers, and there are 17 workers in the food sector. Food output now equals 153 while manufacturing output equals 54. The cost of the distortion equals the value of output lost, which is $110. c. The probability of being employed is 1 - (n+3/n) = 3/n where n is the number of city workers. Workers will migrate to the city until the wage times the probability of being employed equals the wage offered in the rural area with certainty. There will be 5 workers in manufacturing, 15 workers in agriculture, and 2 unemployed workers. The output of the manufacturing sector is 54 and for food is 135. 5. Under these circumstances, workers are both \"pulled\" into the urban, \"modern\" sector by the lure of high wages and \"pushed\" from the rural areas due to stagnant conditions in the agricultural sector. To correct this problem of the bias toward the urban-manufacturing sector, explicit attention should be paid to making the agricultural sector more rewarding, In order to retain labor, the agricultural sector might be provided with wage subsidies so that the rural-urban wage gap is reduced. Policies can also be targeted at promoting light rural enterprise and agricultural investment which would increase wages through increasing worker productivity. In addition, development of the rural infrastructure and social services might increase the relative attractiveness of the countryside. 6. Import quotas on capital-intensive goods and subsidies for the import of capital equipment foster the development of a capital intensive sector, and thus of a dual economy. If the capital-intensive sector pays high wages relative to the traditional sector, the result may be rural-urban migration and the emergence of persistent urban unemployment. CHAPTER 11 Answers to Textbook Problems 1. If everyone knows that an industry will grow rapidly, private markets will funnel resources into the industry even without government support. There is need for special government action only if there is some market failure; the prospect of growth by itself isn't enough. 2. A valid reason for supporting high-technology industries would be that they generate technologies which benefit the whole economy. The value to the whole economy of this aspect of the high-technology firms' existence exceeds the benefits to the firms themselves, and there will be too little expansion of these firms from a social point of view. Other stated benefits are not valid reasons for industrial policy since the market provides incentives for the realization of these benefits. The protection from foreign competition is also a spurious argument since, as has been shown in previous chapters, the economy as a whole benefits from cheap foreign high-technology goods. The exception being if the industry provides monopoly rents and the foreign government is trying to capture these rents for its home economy. 3. The results of basic research may be appropriated by a wider range of firms and industries than the results of research applied to specific industrial applications. The benefits to the United States of Japanese basic research would exceed the benefits from Japanese research targeted to specific problems in Japanese industries. A specific application may benefit just one firm in Japan, perhaps simply subsidizing an activity that the market is capable of funding. General research will provide benefits that spill across borders to many firms and may be countering a market failure, externalities present in the advancement of general knowledge. 4. A subsidy is effective when the firm in the other country does not produce when the domestic firm enters the market. As the text tables show, a subsidy may present a credible threat of entry and deters production by the other firm: a subsidy encourages Airbus to produce and Boeing not to produce. However, Boeing may still produce even if Airbus receives a subsidy. Airbus' return is less than the subsidy if Boeing enters the market. 5. Because the economy has limited resources, a trade policy that conveys a strategic advantage on one industry necessarily puts other industries at some strategic disadvantage. It is not possible to achieve a strategic advantage in all industries. This point should be clear from the emphasis on movements along production possibility frontiers as illustrated in previous chapters. Korea's across-the-board subsidy probably has little net effect on the strategic position of the industries because while it provides each industry with a direct subsidy, it indirectly raises all industries' costs. 6. The potential gains for the high technology industries depend on the extent to which a great deal of government sponsored research and development is filtered through the military budget. This is especially relevant when military expenditures on research and development have spillover effects and produce a marginal social gains of knowledge which benefit other firms in U.S. industry. However, there are several caveats to this argument. To the extent that military industry is particularly concentrated and oligopolistic, there may be a serious market failure. More importantly, there remains the issue of how relevant and applicable will be any knowledge spillovers from military research and development to the high technology sectors. Moreover, the military fields may be siphoning off many highly talented researchers from civilian high-technology industries. Much of it may not be well-suited. In this case, the goal of developing a broad application to high technology through military research would not be a well-targeted program. 7. A primary argument must be that there is some sort of market failure that voids the standard logic of free trade. One might argue that Microsoft’s’ monopoly position allows it to capture excessive profits, and that its market power dissuades entry. A state-sponsored firm might be able to over-come these entry costs. Furthermore, the software industry may have numerous knowledge spillovers with other industries and high-tech applications that make it desirable to have some local presence even if the local industry loses money. On the other hand, Microsoft may be a natural monopoly. It is much easier for the world to have one computer standard. Furthermore, state direction of an industry where innovation is so important is unlikely to be successful. Finally, in software, physical location may be of minor importance as ancillary industries could develop anywhere and use modern telecommunications technology to interact with U.S. based software firms. 8. The French may be following an active nationalist cultural policy as an economic or strategic trade policy to the extent that cultural activities, such as art, music, fashion, and cuisine, are linked to other French major industries. Indeed, the fashion industry is tied to the huge textile industry, as well as to the retail sector and advertising services. One could argue that the promotion of fashion, art, and music will benefit both tourism, and these large strategic trade sectors of the French economy. However, the existence of market failures is not clearly documented in the cultural sector except to the extent that there are other less tangible externalities. Furthermore, the cultural promotions are not, in economic terms, the first best approach to supporting larger industries. CHAPTER 12 Answers to Textbook Problems 1. The reason for including only the value of final goods and services in GNP, as stated in the question, is to avoid the problem of double counting. Double counting will not occur if intermediate imports are subtracted and intermediate exported goods are added to GNP accounts. Consider the sale of U.S. steel to Toyota and to General Motors. The steel sold to General Motors should not be included in GNP since the value of that steel is subsumed in the cars produced in the United States. The value of the steel sold to Toyota will not enter the national income accounts in a more finished state since the value of the Toyota goes towards Japanese GNP. The value of the steel should be subtracted from GNP in Japan since U.S. factors of production receive payment for it. 2. Equation 2 can be written as CA = (Sp - I) + (T - G). Higher U.S. barriers to imports may have little or no impact upon private savings, investment, and the budget deficit. If there were no effect on these variables then the current account would not improve with the imposition of tariffs or quotas. It is possible to tell stories in which the effect on the current account goes either way. For example, investment could rise in industries protected by the tariff, worsening the current account. (Indeed, tariffs are sometimes justified by the alleged need to give ailing industries a chance to modernize their plant and equipment.) On the other hand, investment might fall in industries that face a higher cost of imported intermediate goods as a result of the tariff. In general, permanent and temporary tariffs have different effects. The point of the question is that a prediction of the manner in which policies affect the current account requires a general-equilibrium, macroeconomic analysis. 3. a. The purchase of the German stock is a debit in the U.S. financial account. There is a corresponding credit in the U.S. financial account when the American pays with a check on his Swiss bank account because his claims on Switzerland fall by the amount of the check. This is a case in which an American trades one foreign asset for another. b. Again, there is a U.S. financial account debit as a result of the purchase of a German stock by an American. The corresponding credit in this case occurs when the German seller deposits the U.S. check in its German bank and that bank lends the money to a German importer (in which case the credit will be in the U.S. current account) or to an individual or corporation that purchases a U.S. asset (in which case the credit will be in the U.S. financial account). Ultimately, there will be some action taken by the bank which results in a credit in the U.S. balance of payments. c. The foreign exchange intervention by the French government involves the sale of a U.S. asset, the dollars it holds in the United States, and thus represents a debit item in the U.S. financial account. The French citizens who buy the dollars may use them to buy American goods, which would be an American current account credit, or an American asset, which would be an American financial account credit. d. Suppose the company issuing the traveler’s check uses a checking account in France to make payments. When this company pays the French restaurateur for the meal, its payment represents a debit in the U.S. current account. The company issuing the traveler’s check must sell assets (deplete its checking account in France) to make this payment. This reduction in the French assets owned by that company represents a credit in the American financial account. e. There is no credit or debit in either the financial or the current account since there has been no market transaction. f. There is no recording in the U.S. Balance of Payments of this offshore transaction. 4. The purchase of the answering machine is a current account debit for New York, and a current account credit for New Jersey. When the New Jersey company deposits the money in its New York bank there is a financial account credit for New York and a corresponding debit for New Jersey. If the transaction is in cash then the corresponding debit for New Jersey and credit for New York also show up in their financial accounts. New Jersey acquires dollar bills (an import of assets from New York, and therefore a debit item in its financial account); New York loses the dollars (an export of dollar bills, and thus a financial account credit). Notice that this last adjustment is analogous to what would occur under a gold standard (see Chapter 19). 5. a. Since non-central bank capital inflows fell short of the current-account deficit by $500 million, the balance of payments of Pecunia (official settlements balance) was -$500 million. The country as a whole somehow had to finance its $1 billion current-account deficit, so Pecunia's net foreign assets fell by $1 billion. b. By dipping into its foreign reserves, the central bank of Pecunia financed the portion of the country's current-account deficit not covered by private financial inflows. Only if foreign central banks had acquired Pecunian assets could the Pecunian central bank have avoided using $500 million in reserves to complete the financing of the current account. Thus, Pecunia's central bank lost $500 million in reserves, which would appear as an official financial inflow (of the same magnitude) in the country's balance of payments accounts. c. If foreign official capital inflows to Pecunia were $600 million, the country had a balance of payments surplus of $100 million. Put another way, the country needed only $1 billion to cover its current-account deficit, but $1.1 billion flowed into the country. The Pecunian central bank must, therefore, have used the extra $100 million in foreign borrowing to increase its reserves. Purchases of Pecunian assets by foreign central banks enter their countries' balance of payments accounts as outflows, which are debit items. The rationale is that the transactions result in foreign payments to the Pecunians who sell the assets. d. Along with non-central bank transactions, the accounts would show an increase in foreign official reserve assets held in Pecunia of $600 million (a financial account credit, or inflow) and an increase Pecunian official reserve assets held abroad of $100 billion (a financial account debit, or outflow). Of course, total net financial inflows of $1 billion just cover the current-account deficit. 6. A current account deficit or surplus is a situation which may be unsustainable in the long run. There are instances in which a deficit may be warranted, for example to borrow today to improve productive capacity in order to have a higher national income tomorrow. But for any period of current account deficit there must be a corresponding period in which spending falls short of income (i.e. a current account surplus) in order to pay the debts incurred to foreigners. In the absence of unusual investment opportunities, the best path for an economy may be one in which consumption, relative to income, is smoothed out over time. The reserves of foreign currency held by a country's central bank change with nonzero values of its official settlements balance. Central banks use their foreign currency reserves to influence exchange rates. A depletion of foreign reserves may limit the central bank's ability to influence or peg the exchange rate. For some countries (particularly developing countries), central-bank reserves may be important as a way of allowing the economy to maintain consumption or investment when foreign borrowing is difficult. A high level of reserves may also perform a signaling role by convincing potential foreign lenders that the country is credit-worthy. The balance of payments of a reserve-currency center (such as the United States under the Bretton Woods system) raises special issues best postponed until Chapter 18. 7. The official settlements balance, also called the balance of payments, shows the net change in international reserves held by U.S. government agencies, such as the Federal Reserve and the Treasury, relative to the change in dollar reserves held by foreign government agencies. This account provides a partial picture of the extent of intervention in the foreign exchange market. For example, suppose the Bundesbank purchases dollars and deposits them in its Eurodollar account in a London bank. Although this transaction is a form of intervention, it would not appear in the official settlements balance of the United States. Instead, when the London bank credits this deposit in its account in the United States, this transaction will appear as a private financial flow. 8. A country could have a current account deficit and a balance of payments surplus at the same time if the financial and capital account surpluses exceeded the current account deficit. Recall that the balance of payments surplus equals the current account surplus plus the financial account surplus plus the capital account surplus. If, for example, there is a current account deficit of $100 million, but there are large capital inflows and the capital account surplus is $102 million, then there will be a $2 million balance of payments surplus. This problem can be used as an introduction to intervention (or lack thereof) in the foreign exchange market, a topic taken up in more detail in Chapter 17. The government of the United States did not intervene in any appreciable manner in the foreign exchange markets in the first half of the 1980s. The “textbook” consequence of this is a balance of payments of zero, while the actual figures showed a slight balance of payments surplus between 1982 and 1985. These years were also marked by large current account deficits. Thus, the financial inflows into the United States between 1982 and 1985 exceeded the current account deficits in those years. CHAPTER 13 Answers to Textbook Problems 1. At an exchange rate of $1.50 per euro, the price of a bratwurst in terms of hot dogs is 3 hot dogs per bratwurst. After a dollar appreciation to $1.25 per euro, the relative price of a bratwurst falls to 2.5 hot dogs per bratwurst. 2. franc. The Norwegian krone/Swiss franc cross rate must be 6 Norwegian krone per Swiss 3. The dollar rates of return are as follows: a. ($250,000 - $200,000)/$200,000 = 0.25. b. ($216 - $180)/$180 = 0.20. c. There are two parts of this return. One is the loss involved due to the appreciation of the dollar; the dollar appreciation is ($1.38 - $1.50)/$1.50 = -0.08. The other part of the return is the interest paid by the London bank on the deposit, 10 percent. (The size of the deposit is immaterial to the calculation of the rate of return.) In terms of dollars, the realized return on the London deposit is thus 2 percent per year. 4. Note here that the ordering of the returns of the three assets is the same whether we calculate real or nominal returns. a. The real return on the house would be 25% - 10% = 15%. This return could also be calculated by first finding the portion of the $50,000 nominal increase in the house's price due to inflation ($20,000), then finding the portion of the nominal increase due to real appreciation ($30,000), and finally finding the appropriate real rate of return ($30,000/$200,000 = 0.15). b. Again, subtracting the inflation rate from the nominal return we get 20%- 10% = 10%. c. 2% - 10% = -8%. 5. The current equilibrium exchange rate must equal its expected future level since, with equality of nominal interest rates, there can be no expected increase or decrease in the dollar/pound exchange rate in equilibrium. If the expected exchange rate remains at $1.52 per pound and the pound interest rate rises to 10 percent, then interest parity is satisfied only if the current exchange rate changes such that there is an expected appreciation of the dollar equal to 5 percent. This will occur when the exchange rate rises to $1.60 per pound (a depreciation of the dollar against the pound). 6. If market traders learn that the dollar interest rate will soon fall, they also revise upward their expectation of the dollar's future depreciation in the foreign-exchange market. Given the current exchange rate and interest rates, there is thus a rise in the expected dollar return on euro deposits. The downward-sloping curve in the diagram below shifts to the right and there is an immediate dollar depreciation, as shown in the figure below where a shift in the interest-parity curve from II to I'I' leads to a depreciation of the dollar from E0 to E1. E ($/euro) I I’ E1 E0 I’ I i Figure 13-2 7. The analysis will be parallel to that in the text. As shown in the accompanying diagrams, a movement down the vertical axis in the new graph, however, is interpreted as a euro appreciation and dollar depreciation rather than the reverse. Also, the horizontal axis now measures the euro interest rate. Figure 13-3 demonstrates that, given the expected future exchange rate, a rise in the euro interest rate from R0 to R1 will lead to a euro appreciation from E0 to E1. Figure 13-4 shows that, given the euro interest rate of i, the expectation of a stronger euro in the future leads to a leftward shift of the downward-sloping curve from II to I'I' and a euro appreciation (dollar depreciation) from E to E'. A rise in the dollar interest rate causes the same curve to shift rightward, so the euro depreciates against the dollar. This simply reverses the movement in figure 13-4, with a shift from I'I' to II, and a depreciation of the euro from E' to E. All of these results are the same as in the text when using the diagram for the dollar rather than the euro. E (euro/$) E0 E1 i0 i1 rates of return (in euros) Figure 13-3 EI’(euro/$)IEE’II’irates of return (in euros) Figure 13-4 8. a. If the Federal Reserve pushed interest rates down, with an unchanged expected future exchange rate, the dollar would depreciate (note that the article uses the term \"downward pressure\" to mean pressure for the dollar to depreciate). In terms of the analysis developed in this chapter, a move by the Federal Reserve to lower interest rates would be reflected in a movement from R to R' in figure 13.5, and a depreciation of the exchange rate from E to E'. If there is a \"soft landing\dollar depreciation will not occur. Even if the Federal Reserve does lower interest rates a little, say from R to Rhis case, the expected future value of the exchange rate will be more appreciated than before, causing the interest-parity curve to shift in from II to I'I' (as shown in figure 13.6). The shift in the curve reflects the \"optimism sparked by the expectation of a soft landing\" and this change in expectations means that, with a fall in interest rates from R to R\from E to E\rather than from E to E*, which would occur in the absence of a change in expectations. E ($/foreign currency) E* E R’ R rates of return (in dollars) Figure 13-5 E I’ I ($/foreign currency) E* E”” E I I’ R” R rates of return (in dollars) Figure 13-6 The \"disruptive\" effects of a recession make dollar holdings more risky. Risky assets must offer some extra compensation such that people willingly hold them as opposed to other, less risky assets. This extra compensation may be in the form of a bigger expected appreciation of the currency in which the asset is held. Given the expected future value of the exchange rate, a bigger expected appreciation is obtained by a more depreciated exchange rate today. Thus, a recession that is disruptive and makes dollar assets more risky will cause a depreciation of the dollar. 9. The euro is less risky for you. When the rest of your wealth falls, the euro tends to appreciate, cushioning your losses by giving you a relatively high payoff in terms of dollars. Losses on your euro assets, on the other hand, tend to occur when they are least painful, that is, when the rest of your wealth is unexpectedly high. Holding the euro therefore reduces the variability of your total wealth. 10. The chapter states that most foreign-exchange transactions between banks (which accounts for the vast majority of foreign-exchange transactions) involve exchanges of foreign currencies for U.S. dollars, even when the ultimate transaction involves the sale of one nondollar currency for another nondollar currency. This central role of the dollar makes it a vehicle currency in international transactions. The reason the dollar serves as a vehicle currency is that it is the most liquid of currencies since it is easy to find people willing to trade foreign currencies for dollars. The greater liquidity of the dollar as compared to, say, the Mexican peso, means that people are more willing to hold the dollar than the peso, and thus, dollar deposits can offer a lower interest rate, for any expected rate of depreciation against a third currency, than peso deposits for the same rate of depreciation against that third currency. As the world capital market becomes increasingly integrated, the liquidity advantages of holding dollar deposits as opposed to yen deposits will probably diminish. The euro represents an economy as large as the United States, so it is possible that it will assume some of that vehicle role of the dollar, reducing the liquidity advantages to as far as zero. Since the euro has no history as a currency, though, some investors may be leary of holding it until it has established a track record. Thus, the advantage may fade slowly. 11. Greater fluctuations in the dollar interest rate lead directly to greater fluctuations in the exchange rate using the model described here. The movements in the interest rate can be investigated by shifting the vertical interest rate curve. As shown in figure 13.7, these movements lead directly to movements in the exchange rate. For example, an increase in the interest rate from i to i' leads to a dollar appreciation from E to E'. A decrease in the interest rate from i to i\" leads to a dollar depreciation from E to E\". This diagram demonstrates the direct link between interest rate volatility and exchange rate volatility, given that the expected future exchange rate does not change. E($/foreign currency)IE”EE’Ii\"ii'rates of return (in dollars) Figure 13-7 12. A tax on interest earnings and capital gains leaves the interest parity condition the same, since all its components are multiplied by one less the tax rate to obtain after-tax returns. If capital gains are untaxed, the expected depreciation term in the interest parity condition must be divided by 1 less the tax rate. The component of the foreign return due to capital gains is now valued more highly than interest payments because it is untaxed. 13. The forward premium can be calculated as described in the appendix. In this case, we find the forward premium on euro to be (1.26 – 1.20)/1.20 = 0.05. The interest-rate difference between one-year dollar deposits and one-year euro deposits will be 5 percent because the interest difference must equal the forward premium on euro against dollars when covered interest parity holds. CHAPTER 14 Answers to Textbook Problems 1. A reduction in real money demand has the same effects as an increase in the nominal money supply. In figure 14.1, the reduction in money demand is depicted as a backward shift in the money demand schedule from L1 to L2. The immediate effect of this is a depreciation of the exchange rate from E1 to E2, if the reduction in money demand is temporary, or a depreciation to E3 if the reduction is permanent. The larger impact effect of a permanent reduction in money demand arises because this change also affects the future exchange rate expected in the foreign exchange market. In the long run, the price level rises to bring the real money supply into line with real money demand, leaving all relative prices, output, and the nominal interest rate the same and depreciating the domestic currency in proportion to the fall in real money demand. The long-run level of real balances is (M/P2), a level where the interest rate in the long-run equals its initial value. The dynamics of adjustment to a permanent reduction in money demand are from the initial point 1 in the diagram, where the exchange rate is E1, immediately to point 2, where the exchange rate is E3 and then, as the price level falls over time, to the new long-run position at point 3, with an exchange rate of E4. 2. A fall in a country's population would reduce money demand, all else equal, since a smaller population would undertake fewer transactions and thus demand less money. This effect would probably be more pronounced if the fall in the population were due to a fall in the number of households rather than a fall in the average size of a household since a fall in the average size of households implies a population decline due to fewer children who have a relatively small transactions demand for money compared to adults. The effect on the aggregate money demand function depends upon no change in income commensurate with the change in population -- else, the change in income would serve as a proxy for the change in population with no effect on the aggregate money demand function. E E3 E2 E4 E1 2 3 1 I2 I1 R (M/P2) (M/P1) L2 L1 Figure 14-1 3. Equation 14-4 is Ms/P = L(R,Y). The velocity of money, V = Y/(M/P). Thus, when there is equilibrium in the money market such that money demand equals money supply, V = Y/L(R,Y). When R increases, L(R,Y) falls and thus velocity rises. When Y increases, L(R,Y) rises by a smaller amount (since the elasticity of aggregate money demand with respect to real output is less than one) and the fraction Y/L(R,Y) rises. Thus, velocity rises with either an increase in the interest rate or an increase in income. Since an increase in interest rates as well as an increase in income cause the exchange rate to appreciate, an increase in velocity is associated with an appreciation of the exchange rate. 4. An increase in domestic real GNP increases the demand for money at any nominal interest rate. This is reflected in figure 14-2 as an outward shift in the money demand function from L1 to L2. The effect of this is to raise domestic interest rates from R1 to R2 and to cause an appreciation of the domestic currency from E1 to E2. 5. Just as money simplifies economic calculations within a country, use of a vehicle currency for international transactions reduces calculation costs. More importantly, the more currencies used in trade, the closer the trade becomes to barter, since someone who receives payment in a currency she does not need must then sell it for a currency she needs. This process is much less costly when there is a ready market in which any nonvehicle currency can be traded against the vehicle currency, which then fulfills the role of a generally accepted medium of exchange. E E1 E2 R1 Interest Parity Schedule R2 R (M/P) L1 M/P L2 Figure 14-2 6. Currency reforms are often instituted in conjunction with other policies which attempt to bring down the rate of inflation. There may be a psychological effect of introducing a new currency at the moment of an economic policy regime change, an effect that allows governments to begin with a \"clean slate\" and makes people reconsider their expectations concerning inflation. Experience shows, however, that such psychological effects cannot make a stabilization plan succeed if it is not backed up by concrete policies to reduce monetary growth. 7. The interest rate at the beginning and at the end of this experiment are equal. The ratio of money to prices (the level of real balances) must be higher when full employment is restored than in the initial state where there is unemployment: the money-market equilibrium condition can be satisfied only with a higher level of real balances if GNP is higher. Thus, the price level rises, but by less than twice its original level. If the interest rate were initially below its long-run level, the final result will be one with higher GNP and higher interest rates. Here, the final level of real balances may be higher or lower than the initial level, and we cannot unambiguously state whether the price level has more than doubled, less than doubled, or exactly doubled. 8. The 1984 - 1985 money supply growth rate was 12.4 percent in the United States (100%*(1.0 - 570.3)/570.3) and 334.8 percent in Brazil (100%*(106.1 - 24.4)/24.4). The inflation rate in the United States during this period was 3.5 percent and in Brazil the inflation rate was 222.6 percent. The change in real money balances in the United States was approximately 12.4% - 3.5% = 8.9%, while the change in real money balances in Brazil was approximately 334.8% - 222.6% = 112.2%. The small change in the U.S. price level relative to the change in its money supply as compared to Brazil may be due to greater short-run price stickiness in the United States; the change in the price level in the United States represents 28 percent of the change in the money supply ((3.5/12.4)*100%) while in Brazil this figure is 66 percent ((222.6/334.8) *100%). There are, however, large differences between the money supply growth and the growth of the price level in both countries, which casts doubt on the hypothesis of money neutrality in the short run for both countries. 9. Velocity is defined as real income divided by real balances or, equivalently, nominal income divided by nominal money balances (V=P*Y/M). Velocity in Brazil in 1985 was 13.4 (1418/106.1) while velocity in the United States was 6.3 (4010/1). These differences in velocity reflected the different costs of holding cruzados compared to holding dollars. These different costs were due to the high inflation rate in Brazil which quickly eroded the value of idle cruzados, while the relatively low inflation rate in the United States had a much less deleterious effect on the value of dollars. E E3 E2 E4 E1 R3 R2 R1 R (M1/P) (M2/P) L1 L2 Figure 14-3 10. If an increase in the money supply raises real output in the short run, then the fall in the interest rate will be reduced by an outward shift of the money demand curve caused by the temporarily higher transactions demand for money. In figure 14-3, the increase in the money supply line from (M1/P) to (M2/P) is coupled with a shift out in the money demand schedule from L1 to L2. The interest rate falls from its initial value of R1 to R2, rather than to the lower level R3, because of the increase in output and the resulting outward shift in the money demand schedule. Because the interest rate does not fall as much when output rises, the exchange rate depreciates by less: from its initial value of E1 to E2, rather than to E3, in the diagram. In both cases we see the exchange rate appreciate back some to E4 in the long run. The difference is the overshoot is much smaller if there is a temporary increase in Y. Note, the fact that the increase in Y is temporary means that we still move to the same IP curve, as LR prices will still shift the same amount when Y returns to normal and we still have the same size M increase in both cases. A permanent increase in Y would involve a smaller expected price increase and a smaller shift in the IP curve. Undershooting occurs if the new short-run exchange rate is initially below its new long-run level. This happens only if the interest rate rises when the money supply rises – that is if GDP goes up so much that R does not fall, but increases. This is unlikely because the reason we tend to think that an increase in M may boost output is because of the effect of lowering interest rates, so we generally don’t think that the Y response can be so great as to increase R. CHAPTER 15 ANSWERS TO TEXTBOOK PROBLEMS 1. Relative PPP predicts that inflation differentials are matched by changes in the exchange rate. Under relative PPP, the franc/ruble exchange rate would fall by 95 percent with inflation rates of 100 percent in Russia and 5 percent in Switzerland. 2. A real currency appreciation may result from an increase in the demand for nontraded goods relative to tradables which would cause an appreciation of the exchange rate since the increase in the demand for nontradables raises their price, raising the domestic price level and causing the currency to appreciate. In this case exporters are indeed hurt, as one can see by adapting the analysis in Chapter 3. Real currency appreciation may occur for different reasons, however, with different implications for exporters' incomes. A shift in foreign demand in favor of domestic exports will both appreciate the domestic currency in real terms and benefit exporters. Similarly, productivity growth in exports is likely to benefit exporters while causing a real currency appreciation. If we consider a ceterus paribus increase in the real exchange rate, this is typically bad for exporters as their exports are now more expensive to foreigners which may reduce foreign export demand. In general, though, we need to know why the real exchange rate changed to interpret the impact of the change. 3. a. A tilt of spending towards nontraded products causes the real exchange rate to appreciate as the price of nontraded goods relative to traded goods rises (the real exchange rate can be expressed as the price of tradables to the price of nontradables). b. A shift in foreign demand towards domestic exports causes an excess demand for the domestic country's goods which causes the relative price of these goods to rise; that is, it causes the real exchange rate of the domestic country to appreciate. 4. Relative PPP implies that the pound/dollar exchange rate should be adjusted to offset the inflation difference between the United States and Britain during the war. Thus, a central banker might compare the consumer price indices in the United States and the U.K. before and after the war. If America's price level had risen by 10 percent while that in Britain had risen by 20 percent, relative PPP would call for a pound/dollar exchange rate 10 percent higher than before the war--a 10 percent depreciation of the pound against the dollar. A comparison based only on PPP would fall short of the task at hand, however, if it ignored possible changes in productivity, productive capacity or in relative demands for goods produced in different countries in wake of the war. In general, one would expect large structural upheavals as a consequence of the war. For example, Britain's productivity might have fallen dramatically as a result of converting factories to wartime uses (and as a result of bombing). This would call for a real depreciation of the pound, that is, a postwar pound/dollar exchange rate more than 10% higher than the prewar rate. 5. The real effective exchange rate series for Britain shows an appreciation of the pound from 1977 to 1981, followed by a period of depreciation. Note that the appreciation is sharpest after the increase in oil prices starts in early 1979; the subsequent depreciation is steepest after oil prices soften in 1982. An increase in oil prices increases the incomes received by British oil exporters, raising their demand for goods. The supply response of labor moving into the oil sector is comparable to an increase in productivity which also causes the real exchange rate to appreciate. Of course, a fall in the price of oil has opposite effects. (Oil is not the only factor behind the behavior of the pound's real exchange rate. Instructors may wish to mention the influence of Prime Minister Margaret Thatcher's stringent monetary policies.) 6. The announcement puzzle is that interest rates rise when the market learns money supply growth has been higher than expected (and fall in the opposite case), in contrast to what a simple money-market equilibrium analysis might seem to suggest. Were this phenomenon due to higher expected inflation, we would expect to see the dollar depreciate against foreign currencies, since the expectation of future currency depreciation is one result of higher expected inflation. As demonstrated in the previous chapter, a depreciation of the expected future exchange rate causes the spot rate today to depreciate. If, however, nominal rates are higher because the market expects the Fed to adjust for excessive money growth by tightening, then the higher nominal interest rates reflect a decrease in money supply as banks adjust for expected lower high-powered money in the future. In this case, we would expect to see an appreciation of the currency. Thus, the foreign exchange market can help us distinguish between the two competing explanations for the phenomenon. In fact, Engel and Frankel found that in the early 1980s, the dollar tended to appreciate after unexpectedly high monetary growth was announced and depreciate in the opposite case. This implies expectations regarding Fed action are the likely cause of the increase in nominal interest rates. 7. A permanent shift in the real money demand function will alter the long-run equilibrium nominal exchange rate, but not the long-run equilibrium real exchange rate. Since the real exchange rate does not change, we can use the monetary approach equation, E = (M/M*)·{L(R*,Y*)/L(R,Y)}. A permanent increase in money demand at any nominal interest rate leads to a proportional appreciation of the long-run nominal exchange rate. Intuitively, the level of prices for any level of nominal balances must be lower in the long run for money market equilibrium. The reverse holds for a permanent decrease in money demand. The real exchange rate, however, depends upon relative prices and productivity terms which are not affected by general price-level changes. 8. The mechanism would work through expenditure effects with a permanent transfer from Poland to The Czech Republic appreciating the zloty (Czech currency) in real terms against the koruna (Polish currency) if (as is reasonable to assume) the Czechs spent a higher proportion of their income on Czech goods relative to Polish goods than did the Poles. 9. As discussed in the answer to question 8, the zloty appreciates against the koruna in real terms with the transfer from Poland to The Czech Republic if the Czechs spend a higher proportion of their income on Czech goods relative to Polish goods than did the Poles. The real appreciation would lead to a nominal appreciation as well. 10. Since the tariff shifts demand away from foreign exports and toward domestic goods, there is a long-run real appreciation of the home currency. Absent changes in monetary conditions, there is a long-run nominal appreciation as well. 11. The balanced expansion in domestic spending will increase the amount of imports consumed in the country that has a tariff in place, but imports cannot rise in the country that has a quota in place. Thus, in the country with the quota, there would be an excess demand for imports if the real exchange rate appreciated by the same amount as in the country with tariffs. Therefore, the real exchange rate in the country with a quota must appreciate by less than in the country with the tariff. 12. A permanent increase in the expected rate of real depreciation of the dollar against the euro leads to a permanent increase in the expected rate of depreciation of the nominal dollar/euro exchange rate, given the differential in expected inflation rates across the US and Europe. This increase in the expected depreciation of the dollar causes the spot rate today to depreciate. 13. Suppose there is a temporary fall in the real exchange rate in an economy, that is the exchange rate appreciates today and then will depreciate back to its original level in the future. The expected depreciation of the real exchange rate, by real interest parity, causes the real interest rate to rise. If there is no change in the expected inflation rate then the nominal interest rate rises with the rise in the real exchange rate. This event may also cause the nominal exchange rate to appreciate if the effect of a current appreciation of the real exchange rate dominates the effect of the expected depreciation of the real exchange rate. 14. International differences in expected real interest rates reflect expected changes in real exchange rates. If the expected real interest rate in the United States is 9 percent and the expected real interest rate in Europe is 3 percent then there is an expectation that the real dollar/euro exchange rate will depreciate by 6 percent (assuming that interest parity holds). 15. The initial effect of a reduction in the money supply in a model with sticky prices is an increase in the nominal interest rate and an appreciation of the nominal exchange rate. The real interest rate, which equals the nominal interest rate minus expected inflation, rises by more than the nominal interest rate since the reduction in the money supply causes the nominal interest rate to rise and deflation occurs during the transition to the new equilibrium. The real exchange rate depreciates during the transition to the new equilibrium (where its value is the same as in the original state). This satisfies the real interest parity relationship which states that the difference between the domestic and the foreign real interest rate equals the expected depreciation of the domestic real exchange rate -- in this case, the initial effect is an increase in the real interest rate in the domestic economy coupled with an expected depreciation of the domestic real exchange rate. In any event, the real interest parity relationship must be satisfied since it is simply a restatement of the Fisher equation, which defines the real interest rate, combined with the interest parity relationship, which is a cornerstone of the sticky-price model of the determination of the exchange rate. 16. One answer to this question involves the comparison of a sticky-price with a flexible-price model. In a model with sticky prices, a reduction in the money supply causes the nominal interest rate to rise and, by the interest parity relationship, the nominal exchange rate to appreciate. The real interest rate, which equals the nominal interest rate minus expected inflation, increases both because of the increase in the nominal interest rate and because there is expected deflation. In a model with perfectly flexible prices, an increase in expected inflation causes the nominal interest rate to increase (while the real interest rate remains unchanged) and the currency to depreciate since excess money supply is resolved through an increase in the price level and thus, by PPP, a depreciation of the currency. An alternative approach is to consider a model with perfectly flexible prices. As discussed in the preceding paragraph, an increase in expected inflation causes the nominal interest rate to increase and the currency to depreciate, leaving the expected real interest rate unchanged. If there is an increase in the expected real interest rate, however, this implies an expected depreciation of the real exchange rate. If this expected depreciation is due to a current, temporary appreciation, then the nominal exchange rate may appreciate if the effect of the current appreciation (which rotates the exchange rate schedule downward) dominates the effect due to the expected depreciation (which rotates the exchange rate schedule in the upwards). 17. Combining the Fisher relationship with the interest parity condition we find that expected depreciation of the dollar/Swiss franc exchange rate equals the difference between U.S. and Swiss inflation rates less the difference between U.S. and Swiss real interest rates. The question states that the ex post difference between U.S. and Swiss real interest rates was positive between 1976 and 1980. Inspecting the data presented in figure 16-1 in the text demonstrates that U.S. inflation was consistently higher than Swiss inflation over this period. We, thus, expect that this period saw a consistent expected and actual depreciation of the dollar relative to the Swiss franc. Between 1981 and 1982 this pattern reverses with very high real U.S. interest rates, and comparable U.S. and Swiss inflation rates. This corresponds to the beginning of the dramatic appreciation of the dollar in 1981. The actual data are as follows; the average Swiss franc/dollar exchange rate in 1978 was 1.79, for 1979 1.66, for 1980 1.68, for 1981 1.96 and for 1982 2.03. Thus we see an appreciation of the Swiss franc between 1978 and 1980 followed by a dramatic depreciation of the Swiss franc from 1981 to 1982. CHAPTER 16 Answers to Textbook Problems 1. A decline in investment demand decreases the level of aggregate demand for any level of the exchange rate. Thus, a decline in investment demand causes the DD curve to shift to the left. 2. A tariff is a tax on the consumption of imports. The demand for domestic goods, and thus the level of aggregate demand, will be higher for any level of the exchange rate. This is depicted in figure 16-1 as a rightward shift in the output market schedule from DD to D'D'. If the tariff is temporary, this is the only effect and output will rise even though the exchange rate appreciates as the economy moves from point 0 to point 1. If the tariff is permanent, however, the long-run expected exchange rate appreciates, so the asset market schedule shifts to A'A'. The appreciation of the currency is sharper in this case. If output is initially at full employment then there is no change in output due to a permanent tariff. E A A’ 0 1 2 D D’ A D D’ Yf Y A’ Figure 16-1 3. A temporary fiscal policy shift affects employment and output, even if the government maintains a balanced budget. An intuitive explanation for this relies upon the different propensities to consume of the government and of taxpayers. If the government spends $1 more and finances this spending by taxing the public $1 more, aggregate demand will have risen because the government spends the entire $1 while the public reduces its spending by less than $1 (choosing to reduce its saving as well as its consumption). The ultimate effect on aggregate demand is even larger than this first round difference between government and public spending propensities, since the first round generates subsequent spending (Of course, currency appreciation still prevents permanent fiscal shifts from affecting output in our model.) 4. A permanent fall in private aggregate demand causes the DD curve to shift inward and to the left and, because the expected future exchange rate depreciates, the AA curve shifts outward and to the right. These two shifts result in no effect on output, however, for the same reason that a permanent fiscal expansion has no effect on output. The net effect is a depreciation in the nominal exchange rate and, because prices will not change, a corresponding real exchange rate depreciation. A macroeconomic policy response to this event would not be warranted. EAA’X021DD’XADD’Y A’Figure 16-2 5. Figure 16-2 can be used to show that any permanent fiscal expansion worsens the current account. In this diagram, the schedule XX represents combinations of the exchange rate and income for which the current account is in balance. Points above and to the left of XX represent current account surplus and points below and to the right represent current account deficit. A permanent fiscal expansion shifts the DD curve to D'D' and, because of the effect on the long run exchange rate, the AA curve shifts to A'A'. The equilibrium point moves from 0, where the current account is in balance, to 1, where there is a current account deficit. If, instead, there was a temporary fiscal expansion of the same size, the AA curve would not shift and the new equilibrium would be at point 2 where there is a current account deficit, although it is smaller than the current account deficit at point 1. 6. A temporary tax cut shifts the DD curve to the right and, in the absence of monetization, has no effect on the AA curve. In figure 16-3, this is depicted as a shift in the DD curve to D'D', with the equilibrium moving from point 0 to point 1. If the deficit is financed by future monetization, the resulting expected long-run nominal depreciation of the currency causes the AA curve to shift to the right to A'A' which gives us the equilibrium point 2. The net effect on the exchange rate is ambiguous, but output certainly increases more than in the case of a pure fiscal shift. E A’ A 0 1 A’ D D’ A Y 2 D D’ Figure 16-3 7. A currency depreciation accompanied by a deterioration in the current account balance could be caused by factors other than a J-curve. For example, a fall in foreign demand for domestic products worsens the current account and also lowers aggregate demand, depreciating the currency. In terms of figure 16-4, DD and XX undergo equal vertical shifts, to D'D' and X'X', respectively, resulting in a current account deficit as the equilibrium moves from point 0 to point 1. To detect a J-curve, one might check whether the prices of imports in terms of domestic goods rise when the currency is depreciating, offsetting a decline in import volume and a rise in export volume. EAD’DX’XX’XD’DY10A Figure 16-4 8. The expansionary money supply announcement causes a depreciation in the expected long-run exchange rate and shifts the AA curve to the right. This leads to an immediate increase in output and a currency depreciation. The effects of the anticipated policy action thus precede the policy's actual implementation. EAA’DD’D”0XX2DD”1D’A’YA Figure 16-5 9. If exchange rate pass-through is incomplete in the short-run then the DD curve becomes steeper; a given appreciation of the exchange rate crowds out less imports because the foreign currency price of these imports falls concurrent with the appreciation of the currency. In this case, a permanent fiscal expansion both shifts out the DD curve and, because of pricing behavior by foreign exporters, makes it steeper. This results in an increase in output along with a current account deficit, as depicted in figure 16-5 by a shift from DD to D'D' which shifts the equilibrium point from 0 to 1. Over time, as the foreign currency price of imports rise, the slope of the DD returns to its original value, which reduces output and offsets, to some extent, the current account deficit. In the diagram, this is depicted as a movement from point 1 to point 2 with a flattening of the output market curve from D'D' to D\"D\". Thus, low government and private savings caused the current account deficit, but incomplete pass-through exacerbated the initial effect on the current account. 10. The DD curve might be negatively sloped in the very short run if there is a J-curve, though the absolute value of its slope would probably exceed that of AA. This is depicted in figure 16-6. The effects of a temporary fiscal expansion, depicted as a shift in the output market curve to D'D', would not be altered since it would still expand output and appreciate the currency in this case (the equilibrium point moves from 0 to 1). E D A’ A 2 D’ 0 1 A’ A Y D D’ Figure 16-6 Monetary expansion, however, while depreciating the currency, would reduce output in the very short run. This is shown by a shift in the AA curve to A'A' and a movement in the equilibrium point from 0 to 2. Only after some time would the expansionary effect of monetary policy take hold (assuming the domestic price level did not react too quickly). 11. The derivation of the Marshall-Lerner condition uses the assumption of a balanced current account to substitute EX for (q x EX*). We cannot make this substitution when the current account is not initially zero. Instead, we define the variable z = (q x EX*)/EX. This variable is the ratio of imports to exports, denominated in common units. When there is a current account surplus, z will be less than 1 and when there is a current account deficit z will exceed 1. It is possible to take total derivatives of each side of the equation CA = EX - q EX* and derive a general Marshall-Lerner condition as n + z n* > z, where n and n* are as defined in the appendix. The balanced current account (z=1) Marshall-Lerner condition is a special case of this general condition. A depreciation is less likely to improve the current account the larger its initial deficit when n* is less than 1. Conversely, a depreciation is more likely to cause an improvement in the current account the larger its initial surplus, again for values of n* less than 1. E A A’ A” 0 1 2 D D’ A A’ A” Y D D’ Figure 16-7 12. If imports constitute part of the CPI then a fall in import prices due to an appreciation of the currency will cause the overall price level to decline. The fall in the price level raises real balances. As shown in diagram 16-7, the shift in the output market curve from DD to D'D' is matched by an inward shift of the asset market equilibrium curve. If import prices are not in the CPI and the currency appreciation does not affect the price level, the asset market curve shifts to A\"A\" and there is no effect on output, even in the short run. If, however, the overall price level falls due to the appreciation, the shift in the asset market curve is smaller, to A'A', and the initial equilibrium point, point 1, has higher output than the original equilibrium at point 0. Over time, prices rise when output exceeds its long-run level, causing a shift in the asset market equilibrium curve from A'A' to A\"A\ 13. An increase in the risk premium shifts the asset market curve out and to the right, all else equal. A permanent increase in government spending shifts the asset market curve in and to the right since it causes the expected future exchange rate to appreciate. A permanent rise in government spending also causes the goods market curve to shift down and to the right since it raises aggregate demand. In the case where there is no risk premium, the new intersection of the DD and AA curve after a permanent increase in government spending is at the full-employment level of output since this is the only level consistent with no change in the long-run price level. In the case discussed in this question, however, the nominal interest rate rises with the increase in the risk premium. Therefore, output must also be higher than the original level of full-employment output; as compared to the case in the text, the AA curve does not shift by as much so output rises. 14. Suppose output is initially at full employment. A permanent change in fiscal policy will cause both the AA and DD curves to shift such that there is no effect on output. Now consider the case where the economy is not initially at full employment. A permanent change in fiscal policy shifts the AA curve because of its effect on the long-run exchange rate and shifts the DD curve because of its effect on expenditures. There is no reason, however, for output to remain constant in this case since its initial value is not equal to its long-run level, and thus an argument like the one in the text that shows the neutrality of permanent fiscal policy on output does not carry through. In fact, we might expect that an economy that begins in a recession (below Yf) would be stimulated back towards Yf by a positive permanent fiscal shock. If Y does rise permanently, we would expect a permanent drop in the price level (since M is constant). This fall in P in the long run would move AA and DD both out. We could also consider the fact that in the case where we begin at full employment and there is no impact on Y, AA was shifting back due to the real appreciation necessitated by the increase in demand for home products (as a result of the increase in G). If there is a permanent increase in Y, there has also been a relative supply increase which can offset the relative demand increase and weaken the need for a real appreciation. Because of this, AA would shift back by less. We do not know the exact effect without knowing how far the lines originally move (the size of the shock), but we do know that without the restriction that Y is unchanged in the long run, the argument in the text collapses and we can have both short run and long run effects on Y. 15. The text shows output cannot rise following a permanent fiscal expansion if output is initially at its long-run level. Using a similar argument, we can show that output cannot fall from its initial long-run level following a permanent fiscal expansion. A permanent fiscal expansion cannot have an effect on the long-run price level since there is no effect on the money supply or the long-run values of the domestic interest rate and output. When output is initially at its long-run level, R equals R*, Y equals Yf and real balances are unchanged in the short run. If output did fall, there would be excess money supply and the domestic interest rate would have to fall, but this would imply an expected appreciation of the currency since the interest differential (R - R*) would then be negative. This, however, could only occur if the currency appreciates in real terms as output rises and the economy returns to long-run equilibrium. This appreciation, however, would cause further unemployment and output would not rise and return back to Yf. As with the example in the text, this contradiction is only resolved if output remains at Yf. CHAPTER 17 Answers to Textbook Problems 1. An expansion of the central bank's domestic assets leads to an equal fall in its foreign assets, with no change in the bank's liabilities (or the money supply). The effect on the balance-of-payments accounts is most easily understood by recalling how the fall in foreign reserves comes about. After the central bank buys domestic assets with money there is initially an excess supply of money. The central bank must intervene in the foreign exchange market to hold the exchange rate fixed in the face of this excess supply: the bank sells foreign assets and buys money until the excess supply of money has been eliminated. Since private residents acquire the reserves the central bank loses, there is a non-central bank capital outflow (a capital-account debit) equal to the increase in foreign assets held by the private sector. The offsetting credit is the reduction in central bank holdings of foreign assets, an official capital inflow. 2. An increase in government spending raises income and also money demand. The central bank prevents the initial excess money demand from appreciating the domestic currency by purchasing foreign assets from the domestic public. Central bank foreign assets rise, as do the central bank's liabilities and with them, the money supply. The central bank's additional reserve holdings show up as an official capital outflow, a capital-account debit. Offsetting this debit is the capital inflow (a credit) associated with the public's equal reduction in its own foreign assets. 3. A one-time unexpected devaluation initially increases output; the output increase, in turn, raises money demand. The central bank must accommodate the higher money demand by buying foreign assets with domestic currency, a step that raises the central bank's liabilities (and the home money supply) at the same time as it increases the bank's foreign assets. The increase in official foreign reserves is an official capital outflow; it is matched in the balance of payments accounts by the equal capital outflow associated with the public's own reduction in net foreign asset holdings. (The public must exchange foreign assets for the money it buys from the central bank, either by selling foreign assets or by borrowing foreign currency abroad. Either course of action is a capital inflow.) A more subtle issue is the following: when the price of foreign currency is raised, the value of the initial stock of foreign reserves rises when measured in terms of domestic currency. This capital gain in itself raises central-bank foreign assets (which were measured in domestic currency units in our analysis)--so where is the corresponding increase in liabilities? Does the central bank inject more currency or bank-system reserves into the economy to balance its balance sheet? The answer is that central banks generally create fictional accounting liabilities to offset the effect of exchange-rate fluctuations on the home-currency value of international reserves. These capital gains and losses do not automatically lead to changes in the monetary base. 4. As shown in figure 17-1, a devaluation causes the AA curve to shift to A'A' which reflects an expansion in both output and the money supply in the economy. Diagram 17-1 also contains an XX curve along which the current account is in balance. The initial equilibrium, at point 0, was on the XX curve, reflecting the fact that the current account was in balance there. After the devaluation, the new equilibrium point is above and to the left of the XX curve, in the region where the current account is in surplus. With fixed prices, a devaluation improves an economy's competitiveness, increasing its exports, decreasing its imports and raising the level of output. E A’ A 1 D X X D 0 A’ A Y Figure 17-1 5. a. Germany clearly had the ability to change the dollar/DM exchange simply by altering its money supply. The fact that \"billions of dollars worth of currencies are traded each day\" is irrelevant because exchange rates equilibrate markets for stocks of assets, and the trade volumes mentioned are flows. b. One must distinguish between sterilized and nonsterilized intervention. The evidence regarding sterilized intervention suggests that its effects are limited to the signaling aspect. This aspect may well be most important when markets are \"unusually erratic,\" and the signals communicated may be most credible when the central bank is not attempting to resist clear-cut market trends (which depend on the complete range of government macroeconomic policies, among other factors). Nonsterilized intervention, however, is a powerful instrument in affecting exchange rates. c. The \"psychological effect\" of a \"stated intention\" to intervene may be more precisely stated as an effect on the expected future level of the exchange rate. d. A rewrite might go as follows: To keep the dollar from falling against the West German mark, the European central banks would have to sell marks and buy dollars, a procedure known as intervention. Because the available stocks of dollar and mark bonds are so large, it is unlikely that sterilized intervention in the dollar/mark market, even if carried out by the two most economically influential members of the European Community--Britain and West Germany--would have much effect. The reason is that sterilized intervention changes only relative bond supplies and leaves national money supplies unchanged. Intervention by the United States and Germany that was not sterilized, however, would affect those countries' money supplies and have a significant impact on the dollar/mark rate. Economists believe that the direct influence of sterilized intervention on exchange rates is small compared with that of nonsterilized intervention. Even sterilized intervention can affect exchange rates, however, through its indirect influence on market expectations about future policies. Such psychological effects, which can result from just the stated intention of the Community's central banks to intervene, can disrupt the market by confusing traders about official plans. The signaling effect of intervention is most likely to benefit the authorities when their other macroeconomic policies are already being adjusted to push the exchange rate in the desired direction. 6. The problems caused by exchange-rate variability are discussed at length in Chapter 19; some monetary policy autonomy might willingly be sacrificed to reduce these problems. Policy-makers might also sacrifice autonomy to enter into cooperative arrangements with foreign policy-makers that reduce the risk of \"beggar-thy-neighbor\" policy actions (see the appendix to Chapter 19). 7. By raising output, fiscal expansion raises imports and thus worsens the current-account balance. The immediate fall in the current account is smaller than under floating, however, because the currency does not appreciate and crowd out net exports. 8. The reason that the effects of temporary and permanent fiscal expansions differ under floating exchange rates is that a temporary policy has no effect on the expected exchange rate while a permanent policy does. The AA curve shifts with a change in the expected exchange rate. In terms of the diagram, a permanent fiscal expansion causes the AA curve to shift down and to the left which, combined with the outward shift in the DD curve, results in no change in output. With fixed exchange rates, however, there is no change in the expected exchange rate with either policy since the exchange rate is, by definition, fixed. In response to both temporary and permanent fiscal expansions, the central bank must expand the money supply (shift AA out) to prevent the currency from appreciating (due to the shift out in the DD curve). Thus, Y goes up and E does not change after a permanent or temporary fiscal expansion when exchange rates are fixed. 9. By expanding output, a devaluation automatically raises private saving, since part of any increase in output is saved. Government tax receipts rise with output, so the budget deficit is likely to decline, implying an increase in public saving. We have assumed investment to be constant in the main text. If investment instead depends negatively on the real interest rate (as in the IS-LM model), investment rises because devaluation raises inflationary expectations and thus lowers the real interest rate. (The nominal interest rate remains unchanged at the world level.) The interest-sensitive components of consumption spending also rise, and if these interest-rate effects are strong enough, a current-account deficit could result. 10. An import tariff raises the price of imports to domestic consumers and shifts consumption from imports to domestically produced goods. This causes an outward shift in the DD curve, increasing output and appreciating the currency. Since the central bank cannot allow exchange rates to change, it must increase the money supply, an action depicted in the diagram as an outward shift in the AA schedule. Corresponding to this monetary expansion is a balance of payments surplus and an equal increase in official foreign reserves. The fall in imports for one country implies a fall in exports for another country, and a corresponding inward shift of that country's DD curve necessitating a monetary contraction by the central bank to preserve its fixed exchange rate. If all countries impose import tariffs, then no country succeeds in turning world demand in its favor or in gaining reserves through an improvement in its balance of payments. Trade volumes shrink, however, and all countries lose some of the gains from trade. 11. If the market expects the devaluation to \"stick,\" the home nominal interest rate falls to the world level afterward, money demand rises, and the central bank buys foreign assets with domestic money to prevent excess money demand from appreciating the currency. The central bank thus gains official reserves, according to our model. Even if another devaluation was to occur in the near future, reserves might be gained if the first devaluation lowered the depreciation expected for the future and, with it, the home nominal interest rate. An inadequate initial devaluation could, however, increase the devaluation expected for the future, with opposite effects on the balance of payments. 12. If the Bank of Japan holds U.S. dollars instead of Treasury bills, the adjustment process is symmetric. Any purchase of dollars by the Bank of Japan leads to a fall in the U.S. money supply as the dollar bills go out of circulation and into the Bank of Japan’s vaults. A Japanese balance of payments surplus increases the Bank of Japan’s money supply (if there is no sterilization) and reduces the U.S. money supply at the same time. 13. A central bank that is maintaining a fixed exchange rate will require an adequate buffer stock of foreign assets on hand during periods of persistent balance of payments deficits. If a central bank depletes its stock of foreign reserves, it is no longer able to keep its exchange rate from depreciating in response to pressures arising from a balance of payments deficit. Simply put, a central bank can either choose the exchange rate and allow its reserve holdings to change or choose the amount of foreign reserves it holds and allow the exchange rate to float. If it loses the ability to control the amount of reserves because the private demand for them exceeds its supply, it can no longer control the exchange rate. Thus, a central bank maintaining a fixed exchange rate is not indifferent about using domestic or foreign assets to implement monetary policy. 14. An ESF intervention to support the yen involves an exchange of dollar-denominated assets initially owned by the ESF for yen-denominated assets initially owned by the private sector. Since this is an exchange of one type of bond for another there is no change in the money supply and thus this transaction is automatically sterilized. This transaction increases the outstanding stock of dollar-denominated assets held by the private sector, which increases the risk premium on dollar-denominated assets. 15. The monetary authorities can combine a change in the money supply with a purchase or sale of its foreign assets to keep the exchange rate fixed while altering the domestic interest rate. For example, the monetary authorities lower domestic interest rates by increasing the money supply. To maintain a fixed value of the exchange rate, the monetary authority would also sell foreign assets and purchase domestic assets. In the figure below, the increase in the money supply lowers the interest rate from R0 to R'. The purchase of domestic assets and sale of foreign assets, while having no further effect on the money supply, lowers the risk premium, shifts the interest parity schedule from II to I'I' and maintains the exchange rate at E0. E I I’ I I’ R’ R0 R M1/P M2/P L1 M/P Figure 17-2 CHAPTER 18 Answers to Textbook Problems 1. a. Since it takes considerable investment to develop uranium mines, you would want a larger current account deficit to allow your country to finance some of the investment with foreign savings. b. A permanent increase in the world price of copper would cause a short term current account deficit if the price rise leads you to invest more in copper mining. If there are no investment effects, you would not change your external balance target because it would be optimal simply to spend your additional income. c. A temporary increase in the world price of copper would cause a current account surplus. You would want to smooth out your country's consumption by saving some of its temporarily higher income. d. A temporary rise in the world price of oil would cause a current account deficit if you were an importer of oil, but a surplus if you were an exporter of oil. 2. Because the marginal propensity to consume out of income is less than 1, a transfer of income from B to A increases savings in A and decreases savings in B. Therefore, A has a current account surplus and B has a corresponding deficit. This corresponds to a balance of payments disequilibrium in Hume's world, which must be financed by gold flows from B to A. These gold flows increase A's money supply and decrease B's money supply, pushing up prices in A and depressing prices in B. These price changes cease once balance of payments equilibrium has been restored. 3. Changes in parities reflected both initial misalignments and balance of payments crises. Attempts to return to the parities of the prewar period after the war ignored the changes in underlying economic fundamentals that the war caused. This made some exchange rates less than fully credible and encouraged balance of payments crises. Central bank commitments to the gold parities were also less than credible after the wartime suspension of the gold standard, and as a result of the increasing concern of governments with internal economic conditions. 4. A monetary contraction, under the gold standard, will lead to an increase in the gold holdings of the contracting country's central bank if other countries do not pursue a similar policy. All countries cannot succeed in doing this simultaneously since the total stock of gold reserves is fixed in the short run. Under a reserve currency system, however, a monetary contraction causes an incipient rise in the domestic interest rate, which attracts foreign capital. The central bank must accommodate the inflow of foreign capital to preserve the exchange rate parity. There is thus an increase in the central bank's holdings of foreign reserves equal to the fall in its holdings of domestic assets. There is no obstacle to a simultaneous increase in reserves by all central banks because central banks acquire more claims on the reserve currency country while their citizens end up with correspondingly greater liabilities. 5. The increase in domestic prices makes home exports less attractive and causes a current account deficit. This diminishes the money supply and causes contractionary pressures in the economy which serve to mitigate and ultimately reverse wage demands and price increases. 6. A \"demand determined\" increase in dollar reserve holdings would not affect the world supply of money as central banks merely attempt to trade their holdings of domestic assets for dollar reserves. A \"supply determined\" increase in reserve holdings, however, would result from expansionary monetary policy in the United States (the reserve center). At least at the end of the Bretton Woods era the increase in world dollar reserves arose in part because of an expansionary monetary policy in the United States rather than a desire by other central banks to increase their holdings of dollar assets. Only the \"supply determined\" increase in dollar reserves is relevant for analyzing the relationship between world holdings of dollar reserves by central banks and inflation. 7. An increase in the world interest rate leads to a fall in a central bank's holdings of foreign reserves as domestic residents trade in their cash for foreign bonds. This leads to a decline in the home country's money supply. The central bank of a \"small\" country cannot offset these effects since it cannot alter the world interest rate. An attempt to sterilize the reserve loss through open market purchases would fail unless bonds are imperfect substitutes. 8. Capital account restrictions insulate the domestic interest rate from the world interest rate. Monetary policy, as well as fiscal policy, can be used to achieve internal balance. Because there are no offsetting capital flows, monetary policy, as well as fiscal policy, can be used to achieve internal balance. The costs of capital controls include the inefficiency which is introduced when the domestic interest rate differs from the world rate and the high costs of enforcing the controls. CHAPTER 19 Answers to Textbook Problems A rise in the foreign price level leads to a real domestic currency depreciation for a given domestic price level and nominal exchange rate; thus, as shown in the following diagram, the output market curve shifts from DD to D'D' moving the equilibrium from point 0 to point 1. This shift causes an appreciation of the home currency and a rise in home output. If the expected future exchange rate falls in proportion to the rise in P*, then the asset market curve shifts down as well, from AA to A'A' with the equilibrium at point 2. Notice that the economy remains in equilibrium in this case, at the initial output level, if the current exchange rate also falls in proportion to the rise in P*. Why? The goods market is in equilibrium because the real exchange rate has not changed; the foreign-exchange market is in equilibrium if the domestic interest rate does not change (there has been no change in the expected rate of future currency depreciation); and with output and the interest rate the same, the money market is still in equilibrium. The economy thus remains in internal and external balance if these conditions held initially. EAA’012ADD’YA’DD’ Figure 19-1 2. A transitory increase in the foreign interest rate shifts the asset market curve up and to the right from AA to A'A', as shown in the figure 19-2 (there is no change in the expected exchange rate since this is a temporary rise). Under a floating exchange rate there is thus a depreciation of the home currency and an increase in output. (The effect could differ in the IS-LM model, where the real interest rate influences aggregate demand directly; the DD curve would shift up and to the right as well.) Under a fixed exchange rate, however, the monetary authority must intervene to prevent the depreciation, so it contracts the home money supply by selling foreign exchange and drives the home interest rate to the new higher world level. This causes AA to return to its original position, leaving output unaffected. (Once again, the result would differ in the IS-LM model since foreign interest-rate shocks are not pure money-market disturbances in that model.) 3. The effect of a permanent rise in the foreign nominal interest rate depends upon whether that rise is due to an increase in inflationary expectations abroad or a rise in the foreign real interest rate. If the foreign real interest rate rises because of monetary contraction abroad, there is a long-run depreciation of the domestic currency which reinforces the depreciation that occurs in problem 2. The expansionary effect on home output is thus greater than in the transitory case. If the foreign nominal interest rate rises only because foreign inflationary expectations rise, however, the expectations effect goes the other way and the long-run expected price of foreign currency falls, shifting AA to the left. Domestic output need not rise in this case. Under a fixed exchange rate there is still no short run effect on the economy in the DD-AA model, but as P* starts to rise the home country will have to import foreign inflation. Under a floating rate the home economy can be completely insulated from the subsequent foreign inflation. E A’ A D A’ D A Y Figure 19-2 4. A rise in foreign inflation could arise from a permanent increase in foreign monetary growth. This causes the home currency to appreciate against the foreign currency, implying also a real appreciation (since P and P* are fixed in the short run). Domestic output therefore falls as foreign output rises. In the long run, relative PPP implies that the rate of domestic currency appreciation rises to offset the higher foreign inflation. The foreign nominal interest rate rises by the increase in expected inflation (the Fisher effect); the domestic nominal interest rate is the same as its initial long-run value; and by relative PPP, interest parity continues to hold. Notice that in this case, the expected future exchange rate moves over time to reflect the trend inflation differential. 5. We can include the aspect of imperfect asset substitutability in the DD-AA model by recognizing that the AA schedule now must equate M/P=L(R*+ expected depreciation + risk premium, Y). An increase in the risk premium shifts out the AA curve, leading to a currency depreciation and an increase in output. Output will not change under a fixed-exchange-rate regime: since the exchange rate parity must be preserved, there will be no depreciation and no effect on output. 6. In Chapter 18 there is an analysis of internal and external balance for fixed exchange rates. It is possible to construct a corresponding diagram for floating exchange rates. In figure 19-4, the vertical axis measures expansion of the money supply and the horizontal axis measures fiscal ease. The internal balance curve II has a negative slope since monetary restraint must be met by greater fiscal expansion to preserve internal balance. The external balance curve XX has a positive slope since monetary expansion, which depreciates the exchange rate and improves the current account, must be matched by fiscal expansion to preserve external balance. The \"four zones of economic discomfort\" are : Zone 1 -- overemployment and excessive current account surplus; Zone 2 -- overemployment and current account deficit; Zone 3 -- underemployment and current account deficit; Zone 4 -- underemployment and current account surplus. I 1 Money Supply Growth X 4 0 2 3 X Fiscal Ease I Figure 19-4 7. The diagram described in the answer to question 6 can be used to answer this question. The United States begins at point 0 after 1985, where it is in internal balance but there is a large current account deficit. In the short run, monetary expansion (an upward shift in the point) moves the economy toward the goal of a greater current account surplus, but also moves the economy out of internal balance toward overemployment. The expenditure-reducing policy of reducing the budget deficit (represented by a leftward shift in the point), used in tandem with an expenditure-switching monetary expansion, can restore external balance while maintaining internal balance. Moving the economy into a zone of overemployment puts pressure on the price level which ultimately reverses the short-run effect of monetary expansion on the real exchange rate. 8. Fiscal expansion in Germany and Japan would have appreciated the currencies of those countries and diminished the bilateral U.S. trade deficits with them, as desired by American officials. On the other hand, monetary expansion in these countries would have worsened the U.S. current account since the dollar would have appreciated relative to the deutschemark and the yen. Our two-country models suggests that U.S. output would have fallen as a result. These effects would differ, of course, if the United States altered its policies in response to policy changes in Germany or Japan. For example, if the United States expanded its money supply with the expansion in either Germany or Japan there would be no bilateral effects. If the United States contracted fiscal policy as Germany or Japan expanded fiscal policy there would less of an effect on output in each country. 9. Sterilized intervention has no effect on the supply of high-powered money. A way to check whether the intervention in connection with the Louvre accord in February 1987 was sterilized is to see if there are unusual movements in German or Japanese stocks of high-powered money around that time. The International Financial Statistics, published by the IMF, includes measures of reserve money (line 14). These data, for Germany (in billions of DM at end of month) and Japan (in billions of yen at end of month), are as follows: Month/Yr. 10/86 11/86 12/86 1/87 2/87 3/87 4/87 5/87 Japan 26,318 27,772 32,119 27,844 29,016 30,146 29,998 29,379 Germany 169.6 179.3 182.9 169.8 178.3 193.3 180.5 192.8 These data for Japan reflect a more-or-less steady trend in high-powered money. The largest deviations from this trend do not occur around February 1987. The high-powered money series for Germany appears less stable. There is a substantial increase between the end of January 1987 and the end of March 1987, an increase that was somewhat reversed by the end of April, but rose again by the end of May 1987. 10. One can construct a matrix analogous to figure 19A-1 in the text to show the change in inflation and the change in exports for each country in response to monetary policy choices by that country and by the other country. Export growth in a country will be greater, but inflation will be higher, if that country undertakes a more expansionary monetary policy, given the other country's policy choice. There is, however, a beggar-thy- neighbor effect because one country's greater export growth implies lower export growth for the other. Without policy coordination, the two countries will adopt over- expansionary monetary policies to improve their competitive positions, but these policies will offset each other and result simply in higher inflation everywhere. With coordination, the countries will realize that they can both enjoy lower inflation if they agree not to engage in competitive currency depreciation. CHAPTER 20 Answers to Textbook Problems 1. The stability of the EMS depended upon the ability of member countries' central banks to defend their currencies. The level of foreign currency reserves to which a central bank has access affects its ability to defend its currency; the larger the stock of reserves, the better positioned a central bank to defend its currency. Credits from the central bank of a strong-currency country can help a weak-currency central bank defend its currency by putting at its disposal more reserves when its currency is threatened. Participants in the foreign exchange market may be less apt to speculate against a weak currency if they know there are ample reserves in place to defend it. 2. The maximum change in the lira/DM exchange rate was 4.5 percent (if, for example, the lira starts out at the top of its band and then moves to the bottom of its band). If there was no risk of realignment, the maximum difference between a one-year DM and a one-year lira deposit would have reflected the possibility that the lira/DM exchange rate could have moved by 4.5 percent over the year; thus, by interest parity, the interest differential would have been 4.5 percent. The maximum possible difference between a six-month DM and a six-month lira deposit would have been about 9 percent. This reflects the possibility that the lira/DM exchange rate could have moved by 4.5 percent over six months, which is an annualized rate of change of about 9 percent (1.045*1.045 = 1.092). The difference on three month deposits could have been as high as 19.25 percent (1.0454). The intuitive explanation for these differences is that we are not holding constant the time over which the 4.5 percent change in the exchange rate occurs but we are expressing all interest rates on an annualized basis. 3. A three percent difference on the annual rate of a five-year bond implied a difference over five years of 1.035=1.159 (that is 15.9 percent). This means that the predicted change in the lira/DM exchange rate over 5 years was far above the amount that would be consistent with the maintenance of the EMS bands. Thus, there was little long-term credibility for the maintenance of the EMS band with these interest differentials on five-year bonds. 4. The answers to the previous two questions are based upon the relationship between interest rates and exchange rates implied by interest parity since this condition links the returns on assets denominated in different currencies. A risk premium would introduce another factor into this relationship such that the interest differentials would not equal the expected change in the exchange rate. 5. A favorable shift in demand for a country's goods appreciates that country's real exchange rate. A favorable shift in the world demand for non-Norwegian EMU exports appreciates the euro (and hence the Norwegian krone) against non-euro currencies. This adversely affects Norwegian output. The adverse output effect for Norway is smaller the greater the proportion of trade between Norway and other euro-zone countries (and therefore the smaller the proportion of trade between Norway and non-euro-zone countries). 6. Compare two countries which are identical except that one has larger and more frequent unexpected shifts in its money-demand function. In the DD-AA diagrams for each country, the one with the more unstable money demand has larger and more frequent shifts in its AA schedule resulting in bigger shifts in its output. The country with the more unstable money demand would benefit more from a policy rule under which authorities offset shifts in money demand; one such rule would be a fixed exchange rate. Therefore, the economic stability loss from pegging the exchange rate would be lower for a country with a more unstable money demand; its LL schedule would be below and to the left of the LL schedule of a country with a stable money demand. The GG-LL analysis suggests that a country with relatively unstable money demand would find it advantageous to join a currency union at a lower level of monetary integration than would a country with relatively stable money demand. 7. a. While in the ERM, British monetary authorities were obliged to maintain nominal interest rates at a level commensurate with keeping the pound in the currency band. If this obligation were removed, British monetary authorities could run an expansionary policy to stimulate the economy. This would cause the pound to depreciate vis-a-vis the DM and other currencies. b. Writers at the Economist believe that expected future inflation will rise in Britain if it leaves the EMS which will cause nominal interest rates to rise through the Fisher effect. c. British policymakers may have gained credibility as being strongly committed to fight inflation and to maintain the pound's value through Britain's membership in the ERM since they were willing to allow the British economy to go through a protracted slump without resorting to a monetary expansion which would have jeopardized their membership in the ERM. d. A high level of British interest rates relative to German interest rates would suggest high future inflation in Britain relative to that in Germany by the Fisher relationship. Higher British interest rates may also result from a relatively higher money demand in Britain (perhaps due to relatively higher British output) or relatively lower money supply growth in Britain than in Germany. e. British interest rates may have been higher than German interest rates if British output were relatively higher. The smaller gap at the time of the writing of the article cited may reflect relatively poor British output growth over the past two years. Also, German real interest rates may have risen because of the increased demand for capital for investing in eastern Germany after re-unification. Each central bank would have benefited from issuing currency because it would have gained seignorage revenues when it printed money; that is, it could have traded money for goods and services. Money creation leads to inflation, which central banks dislike. With a system of central banks, however, each country's central bank would have received the full benefit of the seigniorage revenues from money creation but would only partially bear the cost of higher inflation since this effect would have been somewhat dissipated across the entire EMS. This situation, where the central bank does not bear the full cost of its actions, is an example of an externality. It leads to more money creation than would otherwise occur if central bank actions were coordinated. A single labor market would facilitate the response of member countries to country-specific shocks. Suppose there is a fall in the demand for French goods which results in higher unemployment in France. If French workers could easily migrate to other countries where opportunities for employment were better, the effect of the reduction in demand is mitigated. If workers could not move, however, there is a greater incentive to devalue the franc to make workers more competitive with respect to workers in other countries. EMU’s success, in many respects, depends on the ability of labor markets to make the adjustments that can no longer be made by the exchange rate. The absence of a unified labor market would mean all adjustments would have to come through internal wage adjustments, a difficult prospect. CHAPTER 21 1. The better diversified portfolio is the one that contains stock in the dental company and the dairy company. Good years for the candy company may be correlated with good years for the dental company, and conversely. The return from a portfolio consisting of these stocks would be more volatile than the return from a portfolio consisting of the dental and dairy company stocks. 2. Our two-country model (Chapter 19) showed that under a floating exchange rate, monetary expansion at home causes home output to rise but foreign output to fall. Thus, national outputs (and earnings of companies in the two countries) will tend to be negatively correlated under a floating rate if all shocks are monetary in nature. Chapter 18 suggests, however, that the correlation will be positive under a fixed rate if all shocks are monetary. The gains from international asset exchange are therefore likely to be greater under floating under the conditions assumed. 3. The main reason is political risk--as discussed in the appendix to Chapter 13. 4. Reserve requirements are important for bank solvency. Maintaining adequate reserves enables a bank to remain solvent, even in periods in which it faces a relatively high amount of withdrawals relative to deposits. The higher the reserve requirements faced by a bank, however, the lower the bank's profitability. To create a \"level playing field\" for U.S. banks with foreign branches as compared to U.S. banks without foreign branches, it is important to ensure that banks with foreign branches cannot shift around their assets in a manner that reduces their reserve requirements, an option not open to U.S. banks without foreign branches. 5. This is again an open-ended question. The main criticism of Swoboda's thesis is that foreign central banks held dollars in interest-bearing form, so the United States extracted seigniorage from issuing reserves only to the extent that the interest it paid was less than the rate it would have paid were the dollar not a reserve currency. The high liquidity of the dollar make this plausible, but it is impossible to say whether the amount of seigniorage the U.S. extracted was economically significant. 6. Tighter regulation of U.S. banks increased their costs of operation and made them less competitive relative to banks which were not as tightly regulated. This made it harder for U.S. banks to compete with foreign banks, and led to a decline in U.S. banking in those markets where there was direct, unregulated foreign competition. 7. Banks are more highly regulated and have more stringent reporting requirements than other financial institutions. Securitization increases the role played by nonbank financial institutions over which regulators have less control. Regulators also do less monitoring of nonbank financial institutions. As the role of nonbank financial institutions increases with securitization, the proportion of the financial market that bank regulators oversee declines as does the ability of these regulators to keep track of risks to the financial system. CHAPTER 22 Answers to Textbook Problems 1. The amount of seigniorage governments collect does not grow monotonically with the rate of monetary expansion. The real revenue from seigniorage equals the money growth rate times the real balances held by the public. But higher monetary growth leads to higher expected future inflation and (through the Fisher effect) to higher nominal interest rates. To the extent that higher monetary growth raises the nominal interest rate and reduces the real balances people are willing to hold, it leads to a fall in real seigniorage. Across long-run equilibriums in which the nominal interest equals a constant real interest rate plus the monetary growth rate, a rise in the latter raises real seigniorage revenue only if the elasticity of real money demand with respect to the expected inflation rate is greater than -1. Economists believe that at very high inflation rates this elasticity becomes very negative (quite large in absolute value). 2. As discussed in the answer to problem 1, the real revenue from seigniorage equals the money growth rate times the real balances held by the public. Higher monetary growth leads to higher expected future inflation, higher nominal interest rates, and a reduction in the real balances people are willing to hold. In a year in which inflation is 100 percent and rising, the amount of real balances people are willing to hold is less than in a year in which inflation is 100 percent and falling; thus seigniorage revenues will be higher in 1980, when inflation is falling, than in 1990, when inflation is rising. 3. Although Brazil's inflation rate averaged 147 percent between 1980 and 1985, its seigniorage revenues, as a percentage of output, were less than half the seigniorage revenues of Sierra Leone, which had an average inflation rate of 43 percent. Since seigniorage is the product of inflation and real balances held by the public, the difference in seigniorage revenues reflects lower holdings of real balances in Brazil than in Sierra Leone. In the face of higher inflation, Brazilians find it more advantageous than residents of Sierra Leone to economize on their money holdings. This may be reflected in a financial structure in which money need not be held for very long to make transactions due to innovations such as automatic teller machines. Under interest parity, the nominal interest rate of the country with the crawling peg will exceed the foreign interest rate by 10 percent since expected currency depreciation (equal to 10 percent) must equal the interest differential. If the crawling peg is not fully credible, the interest differential will be higher as the possibility of a large devaluation makes the expected depreciation larger than the announced 10 percent. Capital flight exacerbates debt problems because the government is left holding a greater external debt itself but may be unable to identify and tax the people who bought the central-bank reserves that are the counterpart of the debt, and now hold the money in foreign bank accounts. To service its higher debt, therefore, the government must tax those who did not benefit from the opportunity to move funds out of the country. There is thus a change in the domestic income distribution in favor of people who are likely to be quite well-off already. Such a regressive change may trigger political problems. There may have been less lending available to private firms than to state-owned firms if lenders felt that state guarantees ensured repayment by state-owned firms. (In some cases, such as that of Chile, however, the government was pressured ex post into taking over the debts even of private borrowers.) Private firms may also have faced more discipline from the market -- their operating losses are unlikely to be covered with public revenues. Private firms would therefore have had to restrict borrowing to investment projects of high quality. By making the economy more open to trade and to trade disruption, liberalization is likely to enhance an developing country's ability to borrow abroad. In effect, the penalty for default is increased. In addition, of course, a higher export level reassures prospective lenders about the country's ability to service its debts in the future. Finally, by choosing policies which international lenders consider sound, such as open markets, countries improve lenders assessment of their credit-worthiness. Cutting investment today will lead to a loss of output tomorrow, so this may be a very short-sighted strategy. Political expediency, however, makes it easier to cut investment than consumption. Peter Kenen first proposed the IDDC plan in 1983, before there was a secondary market for debt. Even with a secondary market, there is scope for the IDDC to help debtor countries since it would alter the terms of their loans and provide some debt relief. There are some potential problems with the IDDC. First, the debt that banks would be willing to sell to the IDDC is that which is least likely to be repaid. Kenen argues that this problem could be avoided by forcing banks to sell baskets of debt, offering some or all of their claims on all participating debtor countries. There is also the so-called moral hazard problem; a debt relief scheme would invite debtors to pursue policies that would increase rather than reduce the size of their debt. Another obstacle is the free-rider problem; if one bank believes that other banks or the IDDC will grant debt relief, which improves the debtor's ability to repay, there is an incentive for that bank to demand a higher price from the IDDC, or to refuse to participate in the IDDC scheme. If Argentina dollarizes its economy, it will buy dollars from the United States with goods, services, and assets. This is, in essence, giving the US Federal Reserve assets for green paper to use as domestic currency. Since Argentina already operates a currency board holding U.S. bonds as its assets, dollarization would not be as radical as it would be for a country whose central banks hold domestic assets. Argentina can trade the U.S. bonds it holds for dollars to use as currency. When money demand increases, the currency board cannot simply print pesos and exchange them for goods and services, it must sell pesos and buy U.S. government bonds. So in switching to dollarization, the government has not surrendered its power to tax its own people through seignorage, it already does not have that power. Still, though, through dollarization, Argentina loses interest by holding non-interest bearing dollar bills instead of interest bearing U.S. treasury bonds. Thus, the size of the seignorage given to the United States each year would be the lost interest (the U.S. nominal interest rate times the money stock of Argentina). This comes on top of the fact that any expansion of the money supply requires sending real goods, services, or assets to the United States for dollars (just as they do with bonds under the currency board). This is not a long-run loss because Argentina could cash in those dollars (just as it could the bonds) for goods and services from the United States whenever it wants. So, what they lose is the interest they should be getting every year they hold the dollars.
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