Answers to review quizzes marcroeconomics 12e parkin chapter 9

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W H AT I S E C O N O M I C S ? 153 THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS** Answers to the Review Quizzes Page 256 (page 664 in Economics) What are the influences on the demand for U.S dollars in the foreign exchange market? The demand for U.S dollars depends on four main factors: the exchange rate, the world demand for U.S exports, the interest rate in the United State and other countries, and the expected future exchange rate What are the influences on the supply of U.S dollars in the foreign exchange market? The supply of U.S dollars depends on four main factors: the exchange rate, the U.S demand for imports, the interest rate in the United States and other countries, and the expected future exchange rate How is the equilibrium exchange rate determined? The equilibrium exchange rate is the exchange rate that sets the quantity of U.S dollars demanded equal to the quantity of U.S dollars supplied At the equilibrium exchange rate there is neither a shortage nor a surplus of U.S dollars What happens if there is a shortage or a surplus of U.S dollars in the foreign exchange market? If there is a shortage of U.S dollars, the quantity of U.S dollars demanded exceeds the quantity supplied As long as there is a shortage, this upward pressure on the price automatically forces the price higher to its equilibrium If there is a surplus of U.S dollars, the quantity of U.S dollars demanded is less than the quantity supplied As long as there is a surplus, this downward pressure on the price automatically forces the price lower to its equilibrium What makes the demand for U.S dollars change? Three factors change the demand for U.S dollars: the world demand for U.S exports, the interest rate in the United States and other countries, and the expected future exchange rate If world demand for U.S exports increases, the demand for U.S dollars increases If the interest rate in the United States rises relative to interest rates in other countries, the demand for U.S dollars increases 153 154 And if the expected future exchange rate rises, the demand for U.S dollars increases What makes the supply of U.S dollars change? Three factors change the supply of U.S dollars: U.S demand for imports, the interest rate in the United States and other countries, and the expected future exchange rate If U.S demand for imports increases, the supply of U.S dollars increases If the interest rate in the United States falls relative to interest rates in other countries, the supply of U.S dollars increases And if the expected future exchange rate falls, the supply of U.S dollars increases What makes the U.S dollar exchange rate fluctuate? Changes in the demand for U.S dollars and the supply of U.S dollars lead to fluctuations in the U.S dollar exchange rate Because the demand for dollars and the supply of dollars generally change at the same time and in opposite directions, exchange rate fluctuations are frequently large Page 260 (page 668 in Economics) What is arbitrage and what are its effects in the foreign exchange market? Arbitrage is seeking to profit by buying in one market and selling for a higher price in another market Arbitrage has several effects:  Law of one price: At any one time, an exchange rate is the same in all markets  No round-trip profit: It is impossible to make a profit by using currency A to buy currency B and then selling currency B to buy currency A It is impossible to make a profit if even longer chains of currency are used  Interest rate parity: For risk-free transactions, the rate of return earned by a unit of currency is the same in different nations  Purchasing power parity: Purchasing power parity occurs when a unit of money buys the same amount of goods and services in different nations What is interest rate parity and what happens when this condition doesn’t hold? Interest rate parity occurs when, for risk-free transactions, the rate of return earned by a unit of currency is the same in different nations If the rate of return for the U.S dollar is higher than that for, say, the Japanese yen, interest rate parity does not hold In this case people will expect the value of the dollar to fall against the yen (that is, the U.S dollar is expected to depreciate over time) so that interest rate parity is restored because the rate of return earned by a unit of currency is the same in both nations What makes an exchange rate hard to predict? The exchange rate depends on the expected future exchange rate The expected future is volatile For example, the U.S expected future exchange rate changes when news occurs that changes the future demand and/or supply of U.S dollars Consequently the current demand and supply of U.S dollars changes, thereby changing the U.S exchange rate What is purchasing power parity and what happens when this condition doesn’t hold? Purchasing power parity means equal value of money If prices of goods and services are higher in the United States than the (exchange rate adjusted) prices of goods and services in, say, Japan, purchasing power parity does not occur because a unit of currency buys less in the United States than in Japan The demand for 154 W H AT I S E C O N O M I C S ? 155 U.S dollars decreases and the supply of U.S dollars increases so that the value of the dollar falls against the yen to restore purchasing power parity What determines the real exchange rate and the nominal exchange rate in the short run? The real exchange between the United States and Japan, RER, equals E  P/P* where P is the U.S price level, P* is the Japanese price level, and E is the nominal exchange rate in yen per dollar In the short run, changes in the nominal exchange rate bring an equal change in the real exchange rate because the price levels in Japan and the United States not adjust instantly to a change in the nominal exchange rate In the short run, the nominal U.S exchange rate is determined in the foreign exchange market as the exchange rate that sets the quantity of U.S dollars demanded equal to the quantity of U.S dollars supplied What determines the real exchange rate and the nominal exchange rate in the long run? In the long run, the real exchange rate is determined by demand and supply in the goods market Identical goods in the United States and Japan sell for the same price once adjusted for the (nominal) exchange rate The relative prices of goods that are not identical are determined by the supply and demand for them and so the relative price levels in different countries are determined by supply and demand These relative price levels determine the real exchange rate In the long run, changes in the real exchange rate and changes in the price levels change the nominal exchange rate In the long run, the price level is determined by the quantity of money So changes in the U.S or the Japanese quantity of money change the price level and also bring an offsetting change in the nominal exchange rate Page 263 (page 671 in Economics) What is a flexible exchange rate and how does it work? A flexible exchange rate policy is an exchange rate that is determined by demand and supply with no direct intervention in the foreign exchange market by the central bank In this arrangement, the forces of supply and demand with no direct central bank intervention are the only factors that influence the exchange rate What is a fixed exchange rate and how is its value fixed? A fixed exchange rate policy is an exchange rate that is pegged at a value decided by the government or central bank The central bank directly intervenes in the foreign exchange market to block the unregulated forces of supply and demand from changing the exchange rate away from its pegged value For instance, if a central bank wanted to hold the exchange rate steady in the presence of diminished demand for its currency, the central bank props up demand by buying its currency in the foreign exchange market to keep the exchange rate from falling If the demand for its currency increases, the central bank increases the supply by selling its currency and keeps the exchange rate from rising What is a crawling peg and how does it work? A crawling peg exchange rate policy selects a target path for the exchange rate and then uses direct central bank intervention in the foreign exchange market to achieve that path A crawling peg works like a fixed exchange rate except that the central bank changes the target value of the exchange rate in accord with its target path How has China operated in the foreign exchange market, why, and with what effect? 155 156 From 1997 until 2005, the People’s Bank of China fixed the Chinese yuan exchange rate Over this time, the demand for the yuan increased, so the People’s Bank of China supplied additional yuan to keep the exchange rate constant By supplying yuan, the People’s Bank acquired large amounts of foreign currency In addition, by fixing its exchange rate China essentially pegged its inflation rate to equal the U.S inflation rate Since 2005 the yuan has been allowed to appreciate slightly as the People’s Bank moved to a crawling peg exchange rate policy The exchange rate has not been allowed to change much, so over the long run the Chinese inflation rate remains closely tied to U.S inflation Page 269 (page 677 in Economics) What are the transactions that the balance of payments accounts record? The current account records payments for imports of goods and services from abroad, receipts from exports of goods and services sold abroad, net interest income paid abroad, and net transfers abroad (such as foreign aid payments) The capital and financial account records foreign investment in the U.S minus U.S investment abroad Any statistical discrepancy is also recorded in the capital account The official settlements account records the change in U.S official reserves Is the United States a net borrower or a net lender? Is it a debtor or a creditor nation? The United States is a net borrower and is a debtor nation How are net exports and the government sector balance linked? Net exports is the value of exports of goods and services minus the value of imports of goods and services Net exports is equal to the sum of government sector surplus or deficit plus the private sector surplus or deficit The government sector balance is equal to net taxes minus government expenditure on goods and services If the government sector balance is negative, then the government sector has a deficit, that is, a budget deficit Because net exports equals the sum of the government sector balance plus private sector balance, if the government budget deficit increases and the private sector balance does not change, the value of net exports becomes more negative 156 Answers to the Study Plan Problems and Applications Use the following data to work Problems to The U.S dollar exchange rate increased from $0.96 Canadian in June 2011 to $1.03 Canadian in June 2012, and it decreased from 81 Japanese yen in June 2011 to 78 yen in June 2012 Did the U.S dollar appreciate or depreciate against the Canadian dollar? Did the U.S dollar appreciate or depreciate against the yen? The U.S dollar appreciated against the Canadian dollar and it depreciated against the yen What was the value of the Canadian dollar in terms of U.S dollars in June 2011 and June 2012? Did the Canadian dollar appreciate or depreciate against the U.S dollar over the year June 2011 to June 2012? One Canadian dollar was worth 104 U.S cents in June 2011 and 97 U.S cents in June 2012 The Canadian dollar depreciated against the U.S dollar What was the value of 100 yen in terms of U.S dollars in June 2011 and June 2012? Did the yen appreciate or depreciate against the U.S dollar over the year June 2011 to June 2012? One hundred yen was worth 123 U.S cents in June 2011 and 128 U.S cents in June 2012 The yen appreciated against the U.S dollar On March 30, 2012, the U.S dollar was trading at 82 yen per U.S dollar on the foreign exchange market On August 30, 2012, the U.S dollar was trading at 79 yen per U.S dollar a What events in the foreign exchange market could have brought this fall in the value of the U.S dollar? The fall in the U.S exchange rate is the result of a decrease in the demand for U.S dollars and/or an increase in the supply of U.S dollars Factors that decrease the demand for U.S dollars include a decrease in the Japanese demand for U.S exports; a fall in the U.S interest rate relative to the Japanese interest rate; and, a fall in the expected future exchange rate Factors that increase the supply of U.S dollars include an increase in the U.S demand for Japanese imports; a fall in the U.S interest rate relative to the Japanese interest rate; and, a fall in the expected future exchange rate b Did the events you’ve described change the demand for U.S dollars, the supply of U.S dollars, or both demand and supply in the foreign exchange market? A decrease in the Japanese demand for U.S exports leads to only a decrease in the demand for U.S dollars An increase in the U.S demand for Japanese imports leads only to an increase in the supply of U.S dollars The other factors, a fall in the U.S interest rate relative to the Japanese interest rate and a fall in the expected future exchange rate, change both the demand for U.S dollars and the supply of U.S dollars T H E E X C H A N G E R AT E A N D T H E B A L A N C E O F PAY M E N T S Colombia is the world’s biggest producer of roses The global demand for roses increases and at the same time Colombia’s central bank increases the interest rate In the foreign exchange market for Colombian pesos, what happens to a The demand for pesos? The demand for the peso increases because the Colombian interest rate differential increases and because the demand for Colombia’s export, roses, increases b The supply of pesos? The supply of the pesos decreases because the Colombian interest rate differential increases c The quantity of pesos demanded? The Colombian exchange rate rises The rise in the exchange rate creates a movement upward along the new demand curve, so along the new demand curve for pesos, the quantity of pesos demanded decreases d The quantity of pesos supplied? The Colombian exchange rate rises The rise in the exchange rate creates a movement upward along the new supply curve, so along the new supply curve of pesos, the quantity of pesos supplied increases e The peso-U.S dollar exchange rate? The U.S exchange rate depreciates (and the Columbian exchange rate appreciates) because the demand for Colombian pesos increases and the supply decreases If a euro deposit in a bank in France earns interest of percent a year and a yen deposit in Japan earns 0.5 percent a year, other things remaining the same and adjusted for risk, what is the exchange rate expectation of the Japanese yen? For interest rate parity to hold, the Japanese yen must be expected to appreciate by the difference in the interest rates So the Japanese yen must be expected to appreciate by 4.0 percent minus 0.5 percent, or 3.5 percent The U.K pound is trading at 1.50 U.S dollars per U.K pound and purchasing power parity holds The U.S interest rate is percent a year and the U.K interest rate is percent a year a Calculate the U.S interest rate differential The U.S interest rate differential equals percent minus percent, or 2 percent per year b What is the U.K pound expected to be worth in terms of U.S dollars one year from now? For interest rate parity to hold, the U.K pound must be expected to depreciate percent per year Therefore next year the U.K pound is expected to be equal to 0.98  1.50 U.S dollars per U.K pound, which is 1.47 U.S dollars per U.K pound c Which country more likely has the lower inflation rate? How can you tell? Because the U.K pound is expected to depreciate, the United Kingdom likely has the higher inflation rate, which means that the United States is expected to have the lower inflation rate 115 116 CHAPTER The U.S price level is 115, the Japanese price level is 92, and the real exchange rate is 98.75 Japanese real GDP per unit of U.S real GDP What is the nominal exchange rate? The real exchange rate equals (E × P)/P* in which E is the nominal exchange rate, P is the U.S price level, and P* is the Japanese price level Rearranging this formula gives E = (real exchange rate × P*)/P Using the rearranged formula, the nominal exchange rate equals (98.75 × 92)/115 = 79.0 yen per dollar With the strengthening of the yen against the U.S dollar in 2012, Japan’s central bank did not take any action A Japanese politician called on the central bank to take actions to weaken the yen, saying it will help exporters in the short run and have no long-run effects a What is Japan’s current exchange rate policy? Japan’s current exchange rate policy is a flexible exchange b What does the politician want the exchange rate policy to be in the short run? Why would such a policy have no effect on the exchange rate in the long run? The politician wants the exchange rate to be a crawling peg by lowering it over a period of time This policy has no effect on the exchange rate in the long run because in the long run the real exchange rate is determined by supply and demand for the nation’s goods In addition, the nominal exchange rate adjusts to make the ratio of the nations’ price levels equal to the real exchange rate T H E E X C H A N G E R AT E A N D T H E B A L A N C E O F PAY M E N T S 10 The table gives some information about the U.S international transactions a Calculate the balance on the three balance of payments accounts Item Imports of goods and services Foreign investment in the United States Exports of goods and services U.S investment abroad Net interest income Net transfers Statistical discrepancy Billions of U.S dollars 2,215 The current account balance equals 1,408 exports of goods and services ($1,754 billion) minus imports of goods and services ($2,215 billion) 1,754 plus net interest income ($167 billion) plus net transfers ($142 1,200 billion) So the current account 167 balance is $436 billion −142 The capital and financial account 231 balance equals foreign investment in the United States ($1,408 billion) minus U.S investment abroad ($1,200 billion) plus the statistical discrepancy ($231 billion) So the capital and financial account balance is $439 billion The official settlements account balance equals  current account balance ($436 billion)  capital and financial account balance ($439 billion) So the official settlements account balance is −$3 billion Because the official settlements account is negative, U.S official reserves are increasing b Was the United States a net borrower or a net lender? Explain your answer The United States was a net borrower because foreign investment in the United States exceeded U.S investment abroad 117 118 CHAPTER Answers to Additional Problems and Applications 11 Suppose that yesterday, the U.S dollar was trading on the foreign exchange market at 0.75 euros per U.S dollar and today the U.S dollar is trading at 0.80 euros per U.S dollar Which of the two currencies (the U.S dollar or the euro) has appreciated and which has depreciated today? The U.S dollar appreciated because its exchange rate rose The euro depreciated because its exchange rate fell (from 1.33 U.S dollars per euro to 1.25 U.S dollars per euro) 12 Suppose that the exchange rate rose from 80 yen per U.S dollar to 90 yen per U.S dollar What is the effect of this change on the quantity of U.S dollars that people plan to sell in the foreign exchange market? The rise in the exchange rate increases the quantity of U.S dollars that people plan to sell in the foreign exchange market 13 Suppose that the exchange rate for the Mexican peso fell from 15 pesos per U.S dollar to 10 pesos per U.S dollar What is the effect of this change on the quantity of U.S dollars that people plan to buy in the foreign exchange market? The fall in the exchange rate increases the quantity of U.S dollars that people plan to buy in the foreign exchange market 14 Today’s exchange rate between the Lebanese pound and the U.S dollar is 1,500 LBP per dollar and the central bank of Lebanon is buying U.S dollars in the foreign exchange market If the central bank of Lebanon did not purchase U.S dollars would there be excess demand or excess supply of U.S dollars in the foreign exchange market? Would the exchange rate remain at 1,500 LBP per U.S dollar? If not, which currency would appreciate? In the absence of the purchases by the central bank of Lebanon, there would be an excess supply of U.S dollars in the foreign exchange market Without these purchases, the exchange rate would fall from 1,500 LBP per dollar to something lower The Lebanese pound would appreciate (and the U.S dollar would depreciate) 15 On October 25, 2000, the exchange rate was 0.8307 U.S dollar per euro It increased to 1.588 U.S dollars per euro on July 16, 2008, and then decreased to 1.0557 U.S dollar per euro on March 16, 2015 If the euro is expected to bounce back to its 2008 exchange rate, explain how this would affect the demand for and the supply of euros in the foreign exchange market? If the euro is expected to bounce back to its 2008 exchange rate, it raises the expected profit from holding euros and thereby affects both the demand for and the supply of euros The rise in the expected profit from holding euros increases the demand for euros because people would rather hold more profitable currencies But the supply of euros will decrease 16 The exchange rate changed from 1.0557 U.S dollar per euro on July 16, 2008 to 1.588 U.S dollars per euro on March 16, 2015 Which factors caused these changes in the exchange rate? Which factors would change both demand and supply? The factors that influenced the exchange rate for the euro include (i) the Eurozone debt crisis which caused the investors to invest less in Eurozone sovereign bonds The investors preferred to invest in bonds of other countries such as the U.S (ii) The European Central Bank kept interest rates low and started pumping euros into the money market to boost the economy (iii) The demand for U.S exports and T H E E X C H A N G E R AT E A N D T H E B A L A N C E O F PAY M E N T S European imports dropped because of the U.S subprime mortgage crisis that caused a recession in the U.S and the Eurozone Because of these reasons, there is a high supply of and a lower demand for euros, pushing the euro down Changes in the interest rate differential and expected future exchange rate between the U.S and the Eurozone can change both demand and supply 17 Australia produces natural resources (coal, iron ore, natural gas, and others), the demand for which has increased rapidly as China and other emerging economies expand a Explain how growth in the demand for Australia’s natural resources would affect the demand for Australian dollars in the foreign exchange market The growth in demand for Australia’s natural resources increases the demand for Australian dollars b Explain how the supply of Australian dollars would change Absent any change in the expected future exchange rate, the supply of Australian dollars does not change (there is a change in the quantity supplied) c Explain how the value of the Australian dollar would change The increase in demand for Australian dollars raises the value of the Australian dollar d Illustrate your answer with a graphical analysis Figure 9.1 illustrates the effect of the increase in demand for Australian dollars The demand curve for Australian dollars shifts rightward, from D0 to D1 The supply curve does not shift The exchange rate rises from 90 yen per Australian dollar to 95 yen per Australian dollar Use the following news clip to work Problems 18 and 19 Indian Entrepreneur Seeks Opportunities Rahul Reddy, an Indian real estate entrepreneur, believes that “The United States is good for speculative higher-risk investments.” He profited from earlier investment in Australia and a strong Australian dollar provided him with the funds to enter the U.S real estate market at prices that he believed “we will probably not see for a long time.” He said, “The United States is an economic powerhouse that I think will recover, and if the exchange rate goes back to what it was a few years ago, we will benefit.” Based on an article in Forbes, July 10, 2008 18 Explain why Mr Reddy is investing in the U.S real estate market At the time of the news article, the U.S dollar had depreciated The short-run effect of this depreciation was to make U.S goods and services and U.S properties less expensive for foreigners Mr Reddy, among others, was trying to take advantage of the lower price by purchasing investment properties and development opportunities in the United States 119 120 19 CHAPTER Explain what would happen if the speculation made by Mr Reddy became widespread Would expectations become self-fulfilling? Mr Reddy’s actions increase the demand for U.S dollars If others take similar actions, the demand for U.S dollars increases If U.S residents also begin to believe that buying U.S investment properties offers a profitable opportunity, the supply of U.S dollars decreases as U.S residents purchase U.S properties rather than foreign properties In addition, Mr Reddy is expecting that the dollar will appreciate back to its previous level If others have the same expectation, once again the demand for dollars increases and the supply of dollars decreases On both counts, the dollar appreciates This change in the exchange rate resembles a self-fulfilling prophecy because market participants expect the dollar to appreciate and, as a result, it does so Of course, the fundamental reason for the change is the shift in people’s beliefs Use the following information to work Problems 20 and 21 Brazil’s Overvalued Real The Brazilian real has appreciated 33 percent against the U.S dollar and has pushed up the price of a Big Mac in Sao Paulo to $4.60, higher than the New York price of $3.99 Despite Brazil’s interest rate being at 8.75 percent a year compared to the U.S interest rate at near zero, foreign funds flowing into Brazil surged in October Source: Bloomberg News, October 27, 2009 20 Does purchasing power parity hold? If not, does PPP predict that the Brazilian real will appreciate or depreciate against the U.S dollar? Explain Purchasing power parity (PPP) does not hold because a Big Mac is significantly more expensive in Brazil than in New York PPP predicts that the Brazilian real will depreciate against the U.S dollar Depreciation will reduce the number of U.S dollars it takes to buy a Brazilian real and thereby decrease the number of U.S, dollars it takes to purchase a Big Mac in Brazil back to equality with the number of dollars it takes to purchase a Big Mac in New York 21 Does interest rate parity hold? If not, why not? Will the Brazilian real appreciate further or depreciate against the U.S dollar if the Fed raises the interest rate while the Brazilian interest rate remains at 8.75 percent a year? Interest rate parity holds The difference in the interest rates is offset by the expected depreciation of the Brazilian real, so the real is expected to depreciate by 8.75 percent a year If the Fed raises the U.S interest rate, interest rate parity will continue to hold Because the U.S interest rate is now higher, the real depreciates The higher U.S interest rate means that the U.S interest rate differential increases The demand for dollars increases and the supply decreases, so the dollar immediately appreciates which means the real immediately depreciates The real is still expected to depreciate in the future, but the expected future depreciation is less than 8.75 percent a year because the interest rate differential is smaller T H E E X C H A N G E R AT E A N D T H E B A L A N C E O F PAY M E N T S 22 When the Chips Are Down The Economist magazine uses the price of a Big Mac to determine whether a currency is undervalued or overvalued In July 2012, the price of a Big Mac was $4.33 in New York, 15.65 yuan in Beijing, and 6.50 Swiss francs in Geneva The exchanges rates were 6.37 yuan per U.S dollar and 0.98 Swiss francs per U.S dollar Source: The Economist, July 25, 2012 a Was the yuan undervalued or overvalued relative to purchasing power parity? Changing the price of a Big Mac in China into U.S prices shows that the Chinese Big Mac has a dollar price of 15.65 yuan ÷ 6.37 yuan per dollar which is $2.46 The yuan was undervalued relative to purchasing power parity b Was the Swiss franc undervalued or overvalued relative to purchasing power parity? Changing the price of a Big Mac in Switzerland into U.S prices shows that the Swiss Big Mac has a dollar price of 6.50 francs ÷ 0.98 francs per dollar which is $6.63 The Swiss franc was overvalued relative to purchasing power parity c Do you think the price of a Big Mac in different countries provides a valid test of purchasing power parity? The price of a Big Mac is the price of only one good Purchasing power parity applies to national price levels not to the price of an individual good Using an individual good means that local supply and demand conditions might lead the price to diverge from purchasing power parity 121 122 CHAPTER Use the following news clip to work Problems 23 to 25 U.S Declines to Cite China as Currency Manipulator In 2007, the U.S trade deficit with China hit an all-time high of $256.3 billion, the largest deficit ever recorded with a single country Chinese currency, the yuan, has risen in value by 18.4 percent against the U.S dollar since the Chinese government loosened its currency system in July 2005 However, U.S manufacturers contend the yuan is still undervalued by as much as 40 percent, making Chinese products more competitive in this country and U.S goods more expensive in China China buys U.S dollar-denominated securities to maintain the value of the yuan in terms of the U.S dollar Source: MSN, May 15, 2008 23 What was the exchange rate policy adopted by China until July 2005? Explain how it worked Draw a graph to illustrate your answer The actions in the foreign exchange market of the People’s Bank allowed China to maintain a fixed exchange rate with the United States If, at the fixed exchange, there was surplus of dollars (which implies there is a shortage of yuan), the People’s Bank bought the dollars using yuan Without this action by the People’s Bank, the surplus of dollars would have depreciated the dollar and appreciated the yuan; with this action by the People’s Bank, the exchange rate stayed fixed Figure 9.2 shows the foreign exchange market At the fixed exchange of 7.00 yuan per dollar, there is a surplus of $0.2 trillion U.S dollars If the market is allowed to reach its equilibrium exchange rate, the dollar would depreciate to 5.00 yuan per dollar, which means that the yuan would appreciate But the People’s Bank purchased the $0.2 trillion U.S dollar surplus and thereby kept the exchange rate pegged at 7.00 yuan per dollar By fixing its exchange rate in order to keep the yuan from appreciating, the People’s Bank accumulated U.S dollars 24 What was the exchange rate policy adopted by China after July 2005? Explain how it works After July 2005 China has not allowed a truly flexible exchange rate Instead China uses a crawling peg policy, in which the exchange rate is allowed to make small changes 25 Explain how fixed and crawling peg exchange rates can be used to manipulate trade balances in the short run, but not the long run Changes in fixed and crawling peg exchange rates can affect the trade balance in the short run because these changes affect the relative price of the domesticallyproduced good and the foreign good But changes in fixed and crawling peg exchange rates cannot affect the trade balance in the long run because the trade balance is (ultimately) determined by the real exchange rate In the long run, the price levels will adjust to create a real exchange rate that balances trade T H E E X C H A N G E R AT E A N D T H E B A L A N C E O F PAY M E N T S 26 Aussie Dollar Hit by Interest Rate Talk The Australian dollar fell against the U.S dollar to its lowest value in the past two weeks The CPI inflation rate was reported to be generally as expected, but not high enough to justify expectations for an aggressive interest rate rise by Australia’s central bank next week Source: Reuters, October 28, 2009 a What is Australia’s exchange rate policy? Explain why expectations about the Australian interest rate lowered the value of the Australian dollar against the U.S dollar Because the Australian dollar was allowed to fall, the central bank must be following a flexible exchange rate policy When Australia’s central bank raises the interest rate, the demand for Australian dollars increases and the supply decreases, so the Australian exchange rate rises Before the report, traders expected the Australian central bank would raise the interest rate at some point in the future, which meant that the (expected) future exchange rate would rise But the report indicated that the interest rate would not rise, which thereby decreased the expected future exchange rate The fall in the expected future exchange rate decreases the demand for Australian dollars and increases the supply of Australian dollars, thereby lowering the Australian exchange rate b To avoid the fall in the value of the Australian dollar against the U.S dollar, what action could the central bank of Australia have taken? Would such an action signal a change in Australia’s exchange rate policy? To avoid a fall in the Australian exchange rate, the central bank of Australia could have entered the foreign exchange market to purchase Australian dollars or it could have immediately raised the exchange rate If the central bank prevented 100 percent of the change in the exchange rate, then the central bank would be pegging the exchange rate If it prevented some of the change in the exchange rate, then the central bank might be allowing the exchange rate to crawl In either case, however, the exchange rate regime would no longer be flexible Use the table to work Problems 27 and 28 The table gives some data about the U.K economy: 27 Calculate the private sector and government sector balances Item Consumption expenditure Exports of goods and services Government expenditure Net taxes Investment Saving The private sector balance equals saving (£162 billion) minus investment (£181 billion), which is £19 billion The government sector balance is equal to net taxes (£217 billion) minus government expenditures on goods and services (£230 billion), which is £13 billion 28 Billions of U.K pounds 721 277 230 217 181 162 What is the relationship between the government sector balance and net exports? The government sector balance plus the private sector balance equals net exports Therefore the net exports equals the private sector balance (£19 billion) plus the government sector balance (£13 billion), which is £32 billion The U.K had a net export deficit of £32 billion 123 124 CHAPTER Economics in the News 29 After you have studied Economics in the News on pp 270–271 (678–679 in Economics), answer the following questions a What happened to the foreign exchange value of the U.S dollar in July and August 2014? The dollar rose against the euro, the pound, and the yen b What could the Fed have done to stop the rise in the dollar? The Fed could have sold U.S dollars in the foreign exchange market by purchasing foreign reserves The Fed’s actions would have increased the supply of dollars and thereby lessened the dollar’s rise c What could the European Central Bank have done that might have stopped the fall in the Euro? The European Central Bank could have purchased euros by selling foreign reserves The European Central Bank’s actions would have increased the demand for euros and thereby lessened the euro’s fall d What can you infer about the changes in U.K pound–euro exchange rate during July and August 2014? Can you think of a reason for the behavior of that exchange rate? Stating on Jul 2, the U.K pound and the European euro depreciated an almost identical amount against the U.S dollar Therefore there was very little to no change in the U.K pound-euro exchange rate This exchange might have remained constant because there was no change in the expected future U.K pound-euro exchange rate because there was no change in the future expected U.K or European interest rates and other relevant U.K or and European factors The two exchange rates depreciated against the U.S dollar because there were changes in the future expected U.S interest rate and/or other relevant factors f If the dollar continues its upward path against the euro, what you predict will be the consequences for U.S and European relative inflation rates? Purchasing power parity implies that if the U.S dollar continues to rise, it is likely that the U.S inflation rate will fall relative to European inflation Similarly, if the euro continues to fall, it is likely that the European inflation rate will rise relative to U.S inflation T H E E X C H A N G E R AT E A N D T H E B A L A N C E O F PAY M E N T S 125 ... services Net exports is equal to the sum of government sector surplus or deficit plus the private sector surplus or deficit The government sector balance is equal to net taxes minus government... private sector balance does not change, the value of net exports becomes more negative 156 Answers to the Study Plan Problems and Applications Use the following data to work Problems to The U.S... not shift The exchange rate rises from 90 yen per Australian dollar to 95 yen per Australian dollar Use the following news clip to work Problems 18 and 19 Indian Entrepreneur Seeks Opportunities
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