Deck 20: International Financial Policy

Question 1

What is an exchange rate and how is it related to its balance of payments? What are the four fundamental determinants of a country's exchange rate and what is likely to happen to the exchange rate in the following cases?
(1)A fall in the U.S.interest rate relative to interest rates abroad (dollar).
(2)A higher inflation rate in Japan compared to other countries (yen).
(3)A severe recession in Europe (euro).
(4)The U.S.imposes a 15% tariff on Japanese imported cars (dollar).

Answer 1

An exchange rate is the rate at which one country's currency can be traded for another country's currency.It is determined by the demand and supply of a currency.When private quantity demanded of the currency equals the private quantity supplied,the balance of payments is in equilibrium.If the exchange rate is too high (demand greater than supply),there will be a deficit in the balance of payments.If the exchange rate is too low (supply greater than demand),there will be a surplus in the balance of payments.The four fundamental determinants of a country's exchange rate are: changes in a country's income,changes in a country's prices,changes in interest rates,and changes in trade policy.They are illustrated in the examples below.(1)The US interest rate falls relative to interest rates abroad.The demand for U.S.assets declines,and the demand for dollars declines.The dollar will lose value.(2)The demand for Japanese goods declines.The demand for Japanese yen declines and the yen will lose value.(3)Income decreases in Europe.The demand for imports declines.As a result the supply of euros declines.Hence,the euro will gain value.(4)The US imposes a 15% tariff on Japanese cars.The price of Japanese cars in the U.S.rises.The demand for Japanese yen declines,which implies that the supply of dollars will decline.The dollar will gain value.

Question 2

How can a country influence its exchange rate through expansionary fiscal policy?

Answer 2

Fiscal policy affects exchange rates by the same three paths,namely changes in income,prices and interest rates.As in the case of monetary policy,expansionary fiscal policy increases income and thereby increases imports and the trade deficit.As in the case of monetary policy,expansionary fiscal policy increases prices including the price of exports,which lowers exports; at the same time it makes imports relatively less expensive,thus increasing imports and lowering the exchange rate.Unlike monetary policy,expansionary fiscal policy increases the interest rate,which increases the demand for US bonds.This increases the demand for dollars and thus increases the US exchange rate.This occurs because the US government sells bonds to finance the governmental deficit.The net effect of expansionary fiscal policy on the exchange rate is ambiguous because the interest rate effect may or may not be sufficient to offset the income and price effects.(LO3)

Question 3

How can a country influence its exchange rate through expansionary monetary policy?

Answer 3

Monetary policy affects exchange rates in three primary ways: (1)through its effect on the interest rate, (2)through its effect on income and, (3)through its effect on price levels.Expansionary monetary policy pushes down the US interest rate,which decreases the demand for US bonds; this decreases the demand for dollars and thus lowers the US exchange rate.This interest rate effect is the dominant short-run effect.In addition,expansionary monetary policy causes US income to rise.This causes imports to rise.The supply of dollars increases and the US exchange rate falls.Expansionary monetary policy also pushes up the US price level relative to that of other countries.This makes US exports more expensive in foreign markets while making imports less expensive in domestic markets.This reduces the demand for US dollars while increasing the supply of dollars.The result is a fall in the US exchange rate.All three of these effects work in the same direction so it can be said that expansionary monetary policy lowers exchange rates.(LO3)

Question 4

How does the balance of payments differ from the balance on goods and services? How do these balances relate to the international supply and demand for a nation's currency?

Question 5

How is a country's exchange rate related to its balance of payments?

Question 6

What is an exchange rate,and what are the factors that influence it?

Question 7

What is the difference between a fixed,flexible,and partially flexible exchange rate regime? What are the advantages and disadvantages of each of these exchange rate regimes?

Question 8

What kind of pressure will a surplus in the U.S.balance of payments account place on the value of the dollar?

Question 9

If a country wants to fix its exchange rate at a rate that is lower than the market rate,what monetary or fiscal policy must it use? Explain.

Question 10

Explain the effect of an expansionary monetary policy on the exchange rate value of the U.S.dollar via the income and price routes.

Question 11

What is a fixed exchange rate policy? What must the government do to fix its exchange rate?

Question 12

What is purchasing power parity and how is it related to changes in the real exchange rate?

Question 13

A country that wants to fix its exchange rate cannot achieve an interest rate target and an exchange rate target simultaneously.Explain why.

Question 14

What is purchasing power parity?

Question 15

If a country wants to use stabilization policy to fix its exchange rate,why is it important for the country to know what the long-run equilibrium exchange rate of its currency is?

Question 16

How is currency support different from currency stabilization? Why is it difficult for countries to achieve either currency support or currency stabilization?

Question 17

What are the four fundamental determinants of exchange rates?

Question 18

What is the difference between currency support and currency stabilization?

Question 19

What are four economic advantages and two disadvantages of adopting a common currency,such as the euro?

Question 20

Define the balance of payments,and briefly describe its three components.

Question 21

What is the net effect of contractionary fiscal policy on the exchange rate?

Question 22

What are the three pathways through which monetary policy can influence exchange rates?

Question 23

For each of the following,state whether it creates a demand for or a supply of U.S.dollars:
(a)A Japanese automobile firm builds an assembly plant in Ohio.
(b)A U.S.importer purchases a shipload of Saudi Arabia oil.
(c)A U.S.student spends a summer in England studying in Oxford.
(d)A French exporter ships products to Argentina using an American freighter.
(e)Currency traders feel that the value of the U.S.dollar will fall in the near future and act on that feeling.

Question 24

List the advantages and disadvantages of a fixed exchange rate system.

Question 25

What is the difference between a fixed,flexible,and partially flexible exchange rate regime?

Question 26

Where would each of the following appear in the balance of payments account?
(a)You order some tulip bulbs from a supplier in Holland.
(b)While on vacation in London,you pay to have your shoes repaired.
(c)A U.S.firm buys shares in a German company.
(d)You receive dividends from the ownership of a German company's stock.
(e)A Japanese citizen buys a U.S.bond.
(f)A U.S.company builds a manufacturing plant in Mexico.

Question 27

Using a supply and demand diagram for British Pounds,demonstrate graphically and explain in words how Great Britain can increase the exchange rate value of the Pound by influencing private demand for its currency.

Question 28

List the advantages and disadvantages of a flexible exchange rate system.

Question 29

Explain the effect of an expansionary fiscal policy on the exchange rate of the U.S.dollar through the price path.

Question 30

Explain the effect of an expansionary fiscal policy on the exchange rate of the U.S.dollar through the interest rate path.

Question 31

What are the dangers associated with maintaining a high fixed exchange rate.

Question 32

Explain the effect that a rise in a country's interest rate has on exchange rates.

Question 33

Demonstrate graphically and explain in words the effect of a decrease in demand for Japanese yen on the exchange rate for yens.

Question 34

Explain the effect of a contractionary fiscal policy on the exchange rate of the U.S.dollar through the income path.

Question 35

Suppose a government wants to fix its currency at its long run equilibrium value and decides to use the purchasing power parity method to estimate the long-run equilibrium value of its currency.Many economists would say that the purchasing power parity method is not a good method to use.Explain their reasoning.

Question 36

Answer the questions below based upon the following Balance of Payments table for Tundraland (figures are in millions of cugats):
(a)What is the balance on the current account? Did more cugats flow in or out of that account?
(b)What is the balance on the capital account? Did more cugats flow in or out of that account?
(c)Did Tundraland buy or sell its currency? How do you know? Is Tundraland trying to lower or raise the value of its currency? Show graphically.

Question 37

What are the three pathways through which fiscal policy can influence exchange rates?

Question 38

What will be likely to happen to exchange rates in the following cases?
(a)A fall in the U.S.interest rate relative to interest rates abroad (dollar).
(b)Higher inflation rate in Japan compared to other countries (yen).
(c)A severe recession in Europe (euro).
(d)The U.S.imposes a 15% tariff on Japanese imported cars (dollar).

Question 39

What overall effect does contractionary monetary policy have on a country's exchange rate?

Question 40

Demonstrate graphically and explain in words the effect of a decrease in the demand for dollars by Europeans on the exchange rate for euros.

Question 41

If the actual euro/dollar exchange rate is greater than the purchasing power parity (PPP)exchange rate,is the dollar or euro overvalued? What if the actual exchange rate is lower than the PPP exchange rate?

Question 42

You have recently been net surfing with your friends in Russia; the main topic of your recent e-mail exchange is the newest Dave Matthews Band CD.You inform your friends in Russia that you can purchase the CD at Tower Records for $11.99.You are told that in Russia the CD costs 70,000 rubles.Suppose that the current dollar/ruble exchange rate is 1 ruble = $.000175 (or equivalently $1 = 5,714 rubles).According to the purchasing power parity view of exchange rate calculations,does the current exchange rate represent a long-run equilibrium exchange rate? Is the dollar overvalued or undervalued? The ruble? Explain.

Question 43

Consider the following diagram showing supply and demand for euros in Germany:
If the price of euro is currently $P₀,what does this tell us about the balance of payments?

Question 44

Suppose the market for Japanese yen is as illustrated in the following supply and demand diagram:
If the private market price is P₁ but the government wants to facilitate exports by having a price of P₀,what can it do?

Question 45

Consider the following supply and demand for Mexican pesos:
Suppose income in Mexico increases.Demonstrate graphically and explain verbally the impact this will have on the market for pesos illustrated above.

Question 46

Consider the following supply and demand diagram for dollars in exchange for euros:
Describe and illustrate the impact each of the following will have on the supply and demand diagram shown above.
(a)Unemployment increases in Europe.
(b)Inflation in the U.S.drops to an all-time low relative to all other industrialized countries
(c)The European Central Bank raises interest rates.

Question 47

(a)Why is the supply of dollars upward sloping? Why is the demand for dollars downward sloping?
(b)Given the private supply and demand for the dollar shown below,if the government wants to keep the exchange rate value of the dollar at P₀ by intervening in the exchange market,what must it do?
(c)How does this action show up on the balance of payments account?
(d)At an exchange rate of P₀,does the country have a balance of payments surplus or deficit? Or is it in balance?