Week 1 Work Problem Solutions

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Feb 20, 2024

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Week 1 Work Problem Solutions Question 1. Please provide your name (Type: Fill In The Blank Survey) ___________ Question 2. Suppose that the pound is pegged to gold at £20 per ounce and the dollar is pegged to gold at $35 per ounce. This implies an exchange rate of $1.75 per pound. If the current market exchange rate is $1.80 per pound, how would you take advantage of this situation? Hint: assume that you have $350 available for investment. a. Start with $350. Buy 10 ounces of gold with dollars at $35 per ounce. Convert the gold to £200 at £20 per ounce. Exchange the £200 for dollars at the current rate of $1.80 per pound to get $360. b. Start with $350. Exchange the dollars for pounds at the current rate of $1.80 per pound. Buy gold with pounds at £20 per ounce. Convert the gold to dollars at $35 per ounce. c. a and b both work d. None of the above Question 3. Suppose that the pound is pegged to gold at £20 per ounce and the dollar is pegged to gold at $35 per ounce. This implies an exchange rate of $1.75 per pound. If the current market exchange rate is $1.60 per pound, how would you take advantage of this situation? Hint: assume that you have $350 available for investment. a. Start with $350. Buy 10 ounces of gold with dollars at $35 per ounce. Convert the gold to £200 at £20 per ounce. Exchange the £200 for dollars at the current rate of $1.80 per pound to get $360. b. Start with $350. Exchange the dollars for pounds at the current rate of $1.60 per pound. Buy gold with pounds at £20 per ounce. Convert the gold to dollars at $35 per ounce. c. a and b both work d. None of the above

Question 4. Suppose that the British pound is pegged to gold at £6 per ounce, whereas one ounce of gold is worth €12. Under the gold standard, any misalignment of the exchange rate will be automatically corrected by cross border flows of gold. Calculate the possible gains from selling £500 (one time), if the British pound becomes undervalued and trades for €1.80. (Assume zero shipping costs). (Hint: Gold is first purchased using British pounds from the Bank of England, then the gold is shipped to France and sold to the Bank of France for euros, and finally, the euros are sold in the currency market for pounds). a. £55.56 b. £65.56 c. £75.56 d. £85.56 Explanation : The pound is undervalued (euro is overvalued) in the currency market at £1.80 per €. £500 could be sold to the Bank of England for £500 ÷ £6/oz = 83.33 oz of gold. 83.33 oz of gold could be sold to the Bank of France for 83.33 oz x €12/oz = €1000. €1000 could be sold in the currency markets for €1000 ÷ (€1.80 per £) = £555.56. Question 5. Assume that a country is on the gold standard. In order to support unrestricted convertibility into gold, banknotes need to be backed by a gold reserve of some minimum stated ratio. In addition, a. The domestic money stock should rise and fall as gold flows in and out of the country. b. The central bank can control the money supply by buying or selling the foreign currencies. c. Both a and b. Question 6. Identify the benefits of the gold standard. a. Because gold is in finite supply, the potential for inflation is limited b. The international flow of gold automatically corrects a BOP disequilibrium c. Exchange rates are stable d. Because gold is in finite supply, as the world economy grows, the gold standard imposes

deflationary pressure on prices e. A mechanism to enforce adherence to the rules of the gold standard is absent; consequently, countries may engage in policies inconsistent with the gold standard f. Responsible governments/central banks lose monetary policy independence g. All of the above h. a., b., and c. i. d., e., and f. Question 7. Identify the disadvantages of the gold standard. a. Because gold is in finite supply, the potential for inflation is limited b. The international flow of gold automatically corrects a BOP disequilibrium c. Exchange rates are stable d. Because gold is in finite supply, as the world economy grows, the gold standard imposes deflationary pressure on prices e. A mechanism to enforce adherence to the rules of the gold standard is absent; consequently, countries may engage in policies inconsistent with the gold standard f. Responsible governments/central banks lose monetary policy independence g. All of the above h. a., b., and c. i. d., e., and f. Question 8. What are the advantages of a flexible exchange rate regime? a. Monetary policy independence b. Exchange rate adjustment automatically achieves balance of payments equilibrium c. Unrestricted capital flow/Full financial integration d. Promotes international trade/investment by alleviating exchange rate risk e. May require governments/central banks to restrict international trade/investment to maintain the exchange rate regime f. Requires central banks to have a large amount of reserves g. All of the above h. a., b., and c.

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i. d., e., and f. Question 9. What are characteristics of a fixed exchange rate regime? a. Allows for monetary policy independence b. Automatically achieves balance of payments equilibrium c. Promotes international trade/investment by alleviating exchange rate risk d. May require governments/central banks to restrict international trade/investment to maintain the exchange rate regime e. Requires central banks to have a large amount of reserves f. All of the above g. a. and b. h. c., d., and e. Question 10. All of the following are true about a conventional fixed exchange rate regime EXCEPT: a. Fixed rates provide relative stability in international prices and thereby promote international trade/investment b. Fixed exchange rate regimes necessitate that central banks maintain large quantities of international reserves for use in the defense of the fixed rate c. Fixed rates are inherently inflationary in that they encourage countries to follow loose monetary and fiscal policies d. Stable prices aid in the growth of international trade and lessen exchange rate risks for businesses Question 11. In a fixed exchange rate regime, domestic monetary policy cannot be conducted freely and independently of management of the exchange rate because:

a. Monetary policy involves market operations that change money supply b. Money supply changes affect the supply-demand equilibrium in the currency market c. Monetary policy affects interest rates and therefore the demand for currency for investment d. All of the above Question 12. A country suffering from a persistent current account deficit may indicate that the country’s products and services are not competitive on the international markets. a. True b. False Question 13. The United States has been a net debtor nation since the early 1980s meaning the US has had persistent current account deficits for decades. Why is that the case? a. A strong dollar and undervalued currencies of trading partners such as Japan b. US domestic spending exceeding output c. Lack of cost competitiveness of US industries d. All of the above Question 14. Japan has been a net creditor nation for decades meaning that Japan has had persistent current account surpluses for decades. What are possible explanations? a. A weak yen b. Competitiveness of Japanese exports c. Restriction on foreign exporter access to Japanese markets d. Mercantilist policies e. All of the above

Question 15. Portfolio investment is capital invested in activities that are ________ rather than ________. a. Short term; long term b. Long term; profit motivated c. Profit motivated; control motivated d. Control motivated; profit motivated Question 16. It is 20 27 and suppose the US trade deficit has reached $1.2 trillion. Which of the following fictitious initiatives are consistent with these events? a. The President has signed legislation enacted by Congress that eliminates taxes on the profits of subsidiaries of foreign multinationals b. Japan has imposed higher tariffs on US agricultural imports c. US personal tax rates have been cut leading to greater US government debt d. All of the above Question 17. The US is a net debtor nation. Its Net International Investment Position is negative and continues to worsen on average. What does this possibly imply? a. The US generally runs a current account surplus b. The US generally runs a financial account surplus c. US domestic spending generally exceeds output (GDP/GNP) d. All of the above e. b. and c. Question 18. In a currency board exchange rate system, a country: a. Circulates the US dollar/major currency instead of its own printed currency b. Prints its own currency, but backs it with the US dollar/major currency in a fixed ratio c. Uses a currency printed by a monetary union of countries d. Manages its currency’s value relative to a narrow board of several major currencies

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Question 19. Recall the concept of the “Impossible Trinity.” By joining the European Monetary Union, Italy has chosen to achieve __________________________; but has relinquished _______________? a. Exchange rate stability (in the union) and monetary policy independence; full financial integration b. Exchange rate stability (in the union) and full financial integration; monetary policy independence c. Monetary policy independence and full financial integration; exchange rate stability (in the union) d. None of the above Question 20. Which of the following is NOT a common argument against dollarization? a. Dollarization causes a loss of sovereignty over domestic monetary policy. b. Dollarization removes currency volatility against the dollar. c. Dollarization causes the country to lose the power of seignorage. d. The central bank of the dollarized country loses the role of lender of last resort Question 21. The following statement: “Under a floating exchange rate system, the exchange rate adjusts to imbalances. If there is a net capital outflow (inflow) and the BOP goes into deficit (surplus), the currency depreciates (appreciates) and the BOP is restored to equilibrium,” is: a. True b. False Question 22. Consider the following: A foreign automobile company builds a manufacturing plant in Tennessee and European investors buy US Treasury Bonds. a. Both activities would be considered direct investment b. Both activities would be considered portfolio investment c. The auto manufacturer is engaged in portfolio investment, and the European investors are engaged in direct investment d. The auto manufacturer is engaged in direct investment, and the European investors are engaged in portfolio investment

Question 23. According to class discussion and the research of Ben Bernanke on the Great Depression and the gold standard, the following statement, “No country exhibited significant economic recovery until it abandoned the gold standard and regained autonomy over its domestic monetary policy” is: a. True b. False Question 24. In 2012, a highly significant change in the “Other Investment” account of the Financial Account of China was observed. Before 2007, China’s foreign exchange regime required firms and households to convert all income from current account transactions into Chinese yuan (renminbi) immediately. This “surrender requirement” has been gradually loosened since then, giving firms and households more flexibility to hold FX deposits abroad. In addition, Chinese residents, firms, and banks had the incentive to immediately convert their FX income into yuan to benefit from the expected appreciation of the yuan. In 2012, the expectations reversed and motivated holding foreign currency deposits by residents and firms and lending cross-border by banks. Other Investment went from a small net surplus (inflow) balance in 2011 to a large net deficit (outflow) balance in 2012 representing a shift of foreign exchange activity away from China’s central bank. P.R. of China’s Balance of Payments for 2011 is provided in the table below. $ Billion. Credits (+) and Debits (–) 2011 2012 Current Account 137 Goods 244 Services -62 Primary Income -70 Secondary Income 25 Capital Account 5 Financial Accout (Excluding Official Reserves) 260 Direct Investment 231 Portfolio Investment 20 Other Investment 9 Official Reserves -388 Net Errors and Omissions -14

Now, help complete China’s Balance of Payments for 2012 by answering the following questions. Assume in 2012 China’s deposit and loan outflows increased by $270B and its trade (goods) surplus increased by $80B. In addition, assume the Official Reserves Account changed, but no other balances (except the totals) changed as compared to 2011. a. What is China’s 2012 Balance of Trade (Current Account-Goods)? Express your answer in billions of US dollars and indicate a debit using “-“. b. What is China’s 2012 Financial Account-Other Investment balance? Express your answer in billions of US dollars and indicate a debit using “-“. c. What is China’s 2012 Official Reserves Balance? Express your answer in billions of US dollars and indicate a debit using “-“. i. a: 324 b: -261 c: -198 ii. a: 324 b: 261 c: 198 iii. a: 80 b: -270 c: 0 iv. a: 164 b: -279 c: 115 Explanation : a. Current Account-Goods for 2012 is calculated by adjusting the 2011 value: 244 + 80 = 324 b. Similarly, Financial Account Other Investment is: 9 - 270 = -261 c. Official Reserves must change such that the Balance of Payments balances. The changes in all other accounts total 80 - 270 = -190. Therefore, Official Reserves must offset the negative balance exactly by increasing by 190: -388 + 190 = -198

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Question 25. A US firm has a long-standing capital investment in a profitable subsidiary in Indonesia, and that subsidiary sends to the US parent $1 million in dividends by transferring the funds to the parent’s (US firm’s) bank account in Jakarta, Indonesia. a. What are the credit and debit entries on the US Balance of Payments ? To answer the question, consider the following table, use the IMF major account names (Current, Capital, or Financial), and express values in millions of US dollars: Account Debit Credit Current b. Assuming an exchange rate of 10,000 Indonesian rupiah per $, what are the credit and debit entries on the Indonesian Balance of Payments ? To answer the question, consider the following table, use the IMF major account names (Current, Capital, or Financial) and express values in millions of Indonesian rupiah: Account Debit Credit Current i. a: Current Account Debit 1; Financial Account Credit 1 b: Current Account Credit 10,000; Financial Account Debit 10,000 ii. a: Current Account Credit 1; Financial Account Debit 1 b: Current Account Debit 10,000; Financial Account Credit 10,000 iii. a: Current Account Credit 10,000; Financial Account Debit 10,000 b: Current Account Debit 1; Financial Account Credit 1 iv. a: Current Account Credit 1; Capital Account Debit 1 b: Current Account Debit 10,000; Capital Account Credit 10,000 Explanation :

a. US balance of payments (in US dollars M): The US parent receives a dividend from a foreign subsidiary, which is a credit to Current Account-Primary Income. The funds are placed on deposit in a foreign bank, which is a debit to Financial Account-Other. Account Debit Credit Current 1 Financial 1 b. Indonesian balance of payments (in rupiah M): The Indonesian subsidiary pays a dividend to a foreign parent, which is a debit to Current Account-Primary Income. The funds are deposited in an Indonesian bank, which is a credit to Financial Account-Other. Account Debit Credit Current 10,000 Financial 10,000 Question 26. Codelco, a Chilean mining company, exports 1,000 tons of processed, refined copper ingots to Philatron, a US manufacturer of wire and cable. Philatron pays for the copper by transferring funds from its bank account at Santander Bank in Santiago, Chile to Codelco’s bank account at ABN AMRO, also in Santiago. Assume the current price of copper is $1,000 per ton. a. What are the credit and debit entries on the US Balance of Payments ? To answer the question, consider the following table, use the IMF major account names (Current, Capital, or Financial), and express values in millions of US dollars: Account Debit Credit Current b. Assuming an exchange rate of 500 Chilean pesos per $, what are the credit and debit entries on the Chilean Balance of Payments ? To answer the question, consider the following table, use the

IMF major account names (Current, Capital, or Financial), and express values in millions of Chilean pesos: Account Debit Credit Current i. a: Current Account Debit 1; Financial Account Credit 1 b: Current Account Credit 500; Financial Account Debit 500 ii. a: Current Account Credit 1; Financial Account Debit 1 b: Current Account Debit 500; Financial Account Credit 500 iii. a: Current Account Credit 500; Financial Account Debit 500 b: Current Account Debit 1; Financial Account Credit 1 iv. a: Current Account Debit 1; Capital Account Credit 1 b: Current Account Credit 500; Capital Account Debit 500 Explanation : a. US balance of payments (in US dollars M): A US firm pays $1 million (1,000 tons X $1,000 per ton) for imports, which is a debit to Current Account-Goods. To make the payment, the firm removes funds on deposit with a foreign bank, which is a credit to Financial Account-Other. Account Debit Credit Current 1 Financial 1 b. Chilean balance of payments (in Chilean pesos M): A Chilean firm exports product worth 500 million pesos, which is a credit to Current Account-Goods. To make payment, the foreign importer removes funds on deposit with a Chilean bank, which is a debit to Financial Account- Other.

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Account Debit Credit Current 500 Financial 500 Question 27. A country running a current account deficit is benefiting from more goods and services than it is producing. True False Question 28. A current account deficit implies the domestic spending exceeds GNP. True False

Question 29. Explain how each of the following transactions will be classified and recorded in the debit and credit of the U.S. balance of payments : a. A Japanese insurance company purchases U.S. Treasury bonds and pays out of its bank account with Chase in New York City. b. A U.S. citizen purchases a ticket on Air France with her debit card from Bank of America and the bank wires payment to Air France’s US bank account with Citibank. c. Tata Motors, an Indian car manufacturer, sells cars to a U.S. car dealership and the dealership pays Tata by wiring funds into Tata’s bank account with Wells Fargo in Los Angeles. d. A U.S. computer programming firm is hired by a British company and is paid from the British company’s U.S. bank account. To answer this question, in the following table, type “x” in the credit cell for credit transactions or in the debit cell for debit transactions: _____________________________________________________________________ Transactions Debit Credit _____________________________________________________________________ Japanese company purchases U.S. T-bonds x Japanese company pays from its NYC account x U.S. citizen buys transportation on Air France x Payment wired to Air France’s U.S. bank account x U.S dealership imports cars from the Indian firm x Payment is wired to Indian firm’s U.S. bank acct. x U.S. firm sells programming services to a British firm x British firm pays from its U.S. bank account x ____________________________________________________________________

Question 30. Examine the following summary of the IMF’s U.S. balance of payments for 2013 (in $ billion) and calculate the values for the blank entries. Provide answers in $ billion to two decimal places and indicate credit balances as positive numbers and debit balances as negative numbers. Use “-“ to indicate a negative number. $ Billion. Credits (+) and Debits (–) 2013 Current account -400.25 Goods Services 225.28 Primary income 199.65 Secondary income -123.52 Capital account -0.41 Financial account (Excl. Official Reserves) Direct investment -113.27 Portfolio investment 1.07 Financial derivatives -2.25 Other investment 482.01 Official Reserves 3.08 Net errors & omissions a. Goods: - 701.66; Financial account (Excl. Official Reserves): 370.64; Net errors & omissions: 30.02 b. Goods: - 701.66; Financial account (Excl. Official Reserves): 367.56; Net errors & omissions: - 30.02 c. Goods: - 701.66; Financial account (Excl. Official Reserves): 367.56; Net errors & omissions: 30.02 d. Goods: 701.66; Financial account (Excl. Official Reserves): - 367.56; Net errors & omissions: - 30.02

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Explanation : Goods: -400.25 - (225.28 + 199.65 - 123.52) = -701.66 Financial account (Excl. Official Reserves): -113.27 + 1.07 - 2.25 + 482.01 = 367.56 Net errors and omissions: Current + Capital + Financial (Excl. Official Reserves) + Official Reserves + Net errors and omissions = 0 -400.25 - 0.41 + 367.56 + 3.08 + Net errors and omissions = 0  Net errors and omissions = 30.02

Week 1 Work Problem Solutions

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