Problem Set 4 Answers. The real exchange rate is 1 Taiwanese box of chocolates per Thai box of chocolates.

Transcription

1 Social Analysis 10 Spring 2006 Problem Set 4 Answers Question 1 The real exchange rate is 1 Taiwanese box of chocolates per Thai box of chocolates. The exchange rate formula is e = (P domestic )(E) / P foreign, where E is the nominal exchange rate and e is the real exchange rate. The nominal exchange rate from the Taiwanese perspective is ½ bhat per NT, so the nominal exchange rate from the Thai perspective is the reciprocal, which is 2 NT per bhat. Therefore, e=(100 bhat)(2 NT per bhat) / 200 NT = 1. This represents the number of Taiwanese boxes of chocolate it takes to buy one Thai box of chocolates. Both the economic slowdown and the fall in the real interest rate cause a trade surplus and a positive capital outflow in Taiwan. The effect on the real exchanger ate is instead ambiguous: while the economic slowdown leads to an appreciation of the real exchange rate, the fall in the real interest rate leads to a depreciation of the real exchange rate. Here is why. The economic slowdown lowers domestic income or output, which decreases imports since domestic income is one of the determinants of import demand. Since net export is equal to exports minus imports, a decrease in imports increases net exports, which leads to a trade surplus. The increase in net exports increases the demand for the Taiwanese currency in the foreign exchange market and the real exchange rate appreciates. The falling Taiwanese interest rates decrease the attractiveness of Taiwanese or NTdenominated assets compared to foreign assets. The NT depreciates relative to other currencies, causing a fall in the nominal exchange rate. Therefore, the real exchange rate also falls (we are assuming prices do not change). A decrease in the real exchange rate makes Taiwanese exports relatively less expensive to foreigners and makes foreign imports relatively more expensive to the Taiwanese. This increases exports and decreases imports, which increases net exports. Thus, the fall in interest rates also contributes to a Taiwanese trade surplus. The trade surplus is associated with a positive net capital outflow. In fact, all else equal, in the presence of a trade surplus (i.e.: positive net export) saving is greater than investment and the net capital outflow must be positive. 1

2 (c) From we do not know whether the NT depreciates or apreciates. In part you could exchange 0.5 bhat for 1 NT. If you assume it depreciates, after the 50% depreciation of the NT, the value of the nominal exchange rate is 0.25 bhat per NT (E=0.25 bath/nt). You can now exchange 0.25 bhat for 1 NT. If you assume it appreciates, after the 50% appreciation of the NT, the value of the nominal exchange rate is 0.75 bhat per NT (E=0.75 bath/nt). You can now exchange 0.75 bhat for 1 NT. Question 2 The formula for the real exchange rate is: e = (E *P Domestic )/(P Foriegn ) In this case, P Foriegn = P Homerland =20 homies and P Domestic = P Krustyland =5 krusties and e, the real exchange rate, is 1. Thus, e = (E*P Domestic )/(P Foriegn ) 1 = (E*5 krusties/book)/(20 homies/book) E*5 krusties/book=20 homies/book E=(20 homies/book)/(5 krusties/book) E=4 homies/ krusty Therefore, expressed it in terms of homies/krusty, the nominal exchange rate is 4 homies/krusty. (Note: you would get the correct answer also if you set P Domestic = P Homerland =20 homies and P Foriegn = P Krustyland =5 krusties.) If the nominal interest rate rises, and expectations about inflation remain unchanged, then we know that the real interest rate in Krustyville has also risen. At a higher real interest rate, assets denominated in krusties increase in value relative to foreign assets. This leads to an increase in capital inflows in Krustyville, and hence, a 2

3 decrease in net capital outflows. In the foreign exchange market, the supply of domestic currency falls (the schedule shifts to the left) and both the nominal and the real exchange rates increase under the assumption that prices in the two countries do not change, Thus, the nominal exchange rate increases to a level above 4 homies per krusty, and the krusty appreciates. This, however, means that the real exchange rate will also increase. Hence, the real exchange rate is greater than 1 Homerland comic book per Krustyville comic book, and therefore Bart will import his comic books from Homerland. (c) No, President Krusty s concern is not justified. As described above, the increase in the nominal interest rate, with expectations about inflation unchanged, leads to an increase in the real interest rate relative to the foreign real interest rate. Demand for domestic assets rises and net capital outflows decreases. Hence, in the foreign exchange market, the supply of domestic currency falls (the schedule shifts to the left) and the real exchange rates increase. The real appreciation of the exchange rate leads to a fall of NX because imports become cheaper for domestic consumers, while exports of domestic goods become now more expensive. As a matter of fact, we know that a fall in NCO corresponds to a fall in NX. Hence, as a result of the increase in nominal interest rates the net capital outflow falls and the trade balance moves in the same direction. Thus, Krusty is wrong to think that the net capital outflow will increase. Question 3 Because the central bank of Japan has been buying large amounts of US Treasury bonds, capital inflows into the US increase, and hence, net capital outflows decrease. In order for the central bank of Japan to buy large amounts of US Treasury bonds, it must first buy US dollars with which to purchase the bonds. This leads to a fall in the supply of $ in the foreign exchange market, causing a nominal appreciation of the dollar, and thus a nominal depreciation of the Yen, all else equal. This means that it will take increasingly more Yen to buy a US dollar, so the Yen/Dollar nominal exchange rate will rise. Assuming price levels in Japan and the US are fixed, a nominal rise in the Yen/Dollar exchange rate will translate into a real appreciation as well. A real appreciation from the US perspective means more Japanese goods and services can be exchanged for the same amount of US goods and services. Thus Japanese exports become relatively cheaper to the US, and US exports become relatively more expensive to Japan. So US exports to Japan decrease, and US imports from Japan increase (or from Japan s perspective, exports to the US increase, and imports from the US decrease). Thus US net exports to Japan will decrease. 3

4 Question 4 When US investors decide to invest in Ectenia, Ectenia s net capital outflow declines. The demand for loanable funds in Ectenia falls and the demand for loanable funds curve shifts to the left. This leads to a decrease in the real interest rate. Because net capital outflow is lower for any interest rate, the net capital outflow curve shifts to the left too. In the market for foreign currency exchange, the supply of the Ectenia s currency ( $ ) falls causing the currency to appreciate relative to other currencies. Assuming that prices do not change an appreciation of the nominal exchange rate results in an appreciation of the real exchange rate too. Question 5 An export subsidy increases net exports at any given real exchange rate. All else equal, this causes the demand for the Italian currency (the Euro) to shift to the right in the 4

5 market for foreign exchange. Assuming that prices do not change, this leads to a higher real exchange rate. The appreciation of the real exchange rate reduces net exports, offsetting the direct effect of the export subsidy. Hence, overall, there is no change in net exports. The policy also has no consequence in the market for loanable funds or to the net capital outflow. Euro 5