AP Macroeconomics Unit 7 Review Session. The Foreign Exchange Market

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1 AP Macroeconomics Unit 7 Review Session The Foreign Exchange Market 1. Draw a graph of the markets for pesos and U.S. dollars. On your graph, show the initial equilibrium exchange rate and the effect in each market if U.S. investors decide to invest more in Mexico. 2. Assume the United States and China are trading partners. Given inflation and the change in the nominal exchange rate in each scenario, which country s goods become more attractive? a. Inflation is 2% in China and 5% in the United States; the U.S. dollar-chinese yuan exchange rate stays the same. China b. Inflation is 3% in the United States and 8% in China; the price of the U.S. dollar falls from 6.25 to 5.15 Chinese yuan. U.S. c. Inflation is 5% in the United States and 3% in China; the price of the yuan falls from $.15 to $.10. China d. Inflation is 5% in the United States and 4% in China; the price of Chinese yuan rises from $.10 to $.50. U.S. 3. Disregard this question. 4. Suppose, initially, the nominal exchange rate is 20 Macroland dollars per 1 Funland dollar, and the aggregate price index in both countries has a value of 100. Real exchange rate = nominal exchange rate x price index of Funland price index of Macroland a. What is the real exchange rate expressed as Macroland dollars per Funland dollar? 20 x 100/100 = 20 macro$/fun$ b. Suppose the real exchange rate increases to 25 Macroland dollars per Funland dollar when the aggregate price index in Funland increases to 150. Assuming the nominal exchange rate is unchanged, what is the aggregate price index in Macroland? 20 x 150 = 25, 3000 =25m, m=120 1 m 1 c. Suppose the aggregate price index in Funalnd is 150 and the aggregate price index in Macroland is 125. If the nominal exchange rate increases to 25 Macroland dollars per Funland dollar, what is the real exchange rate? 25 x 150 = 30 m$/f$ d. If the real exchange rate measured as Macroland dollars per Funland dollar increases, holding everything else constant, what happens to the level of exports and imports in Funland? Funland s currency appreciates, making products more expensive to foreigners; exports decrease and imports increase 5. Suppose that currently the cost of a standardized market basket in Macroland in 300 Macroland dollars, while the same market basket in Funland costs 150 Funland dollars. a. If purchasing power parity holds for the two countries, what must the nominal exchange rate be, expressed as Macroland dollars per Funland dollar? Explain. If purchasing power parity holds in the two countries, then the price of the market basket in the two countries is 300 Macroland dollars and 150 Funland dollars. This implies that the exchange rate must equal 2 Macroland dollars per Funland dollar or, equivalently, 1 Macroland dollar per 0.5 Funland dollar. b. If the actual nominal exchange rate is 4 Macroland dollars per 1 Funland dollar, what do you expect will happen to the nominal exchange rate over the long run, holding everything else constant? Explain your answer. One would

2 anticipate the exchange rate will fall over time because nominal exchange rates between countries at similar levels of economic development tend to fluctuate around levels that lead to similar costs for a given market basket. 6. Compare and contrast the advantages and disadvantages of a fixed exchange rate regime and a floating rate regime. A fixed exchange rate regime provides certainty about the value of a country s currency. This certainty facilitates transactions between countries. In addition, adoption of a fixed exchange regime may help a country commit to not engaging in inflationary policies. But, adherence to a fixed exchange rate presents challenges as well as benefits to the country. In order to fix the exchange rate, the country will find that it must hold large amounts of foreign currency this is typically a low-return investment for the country. In addition, a country with a fixed exchange rate will find that it can no longer use monetary policy to pursue macroeconomic goals such as output stabilization and inflation rate control. Finally, the adoption of a fixed exchange rate potentially distorts the incentives for importing and exporting goods and services. A floating exchange rate regime neither requires the country to hold large amounts of foreign currency nor constrains the country with regard to monetary policy. It does, however, introduce uncertainty about the value if the country s currency, and that may hinder the level of international trade between the country and other countries. A floating exchange rate does provide very clear price incentives for the determination of the level of exports and imports at any particular point in time. 7. Suppose Macroland has adopted a fixed exchange rate regime and wishes to target the exchange rate to U.S. $2.25 for each Macroland dollar. a. The following figure represents the current situation in Macroland. Describe the situation depicted in that figure, given that Macroland would like to maintain a fixed exchange rate of U.S. $2.25. Macroland finds there is a shortage of Macro$ at target exchange rate of $2.25US/macro$. Quantity demanded of macroland dollars is greater than quantity supplied. (Shortage) b. Given the graph in part (a), what policies are available to Macroland if it is determined to maintain the exchange rate at U.S. $2.25? Explain each option. When there is a shortage of macro dollars, the government can intervene in the foreign exchange market and sell macro$ and acquire US$ to add to its foreign exchange reserves. Gov can act to reduce interest rates in order to increase the supply of Macro$ while reducing the demand for macro$. By reducing the interst rate, the gov will decrease capital flows into Macroland, thus reducing the demand for macro$, and increase capital flows out of Macroland, thereby increasing the supply of macro$. Gov can impose foreign exchange controls that limit the ability of Macroland residents to sell currency to foreigners. Each of these policies will reduce the value of the Macroland dollar. c. The following figure represents the situation in Macroland six months later.

3 Describe the situation depicted in this graph, given that Macroland would like to maintain a fixed exchange rate of U.S. $2.25. Macroland finds a surplus of macro$. Quantity supplied is greater than quantity demanded. d. Given the graph in part (c), what policies are available to Macroland if it is determined to maintain the exchange rate at U.S. $2.25? Explain each option. When there is a surplus of macro dollars, the government can intervene in the foreign exchange market and buy macro$ and sell US$ from its foreign exchange reserves. Gov can act to increase interest rates in order to decrease the supply of Macro$ while increasing demand for macro$. By increasing the interest rate, the gov will increase capital flows into Macroland, thus increasing the demand for macro$, and decrease capital flows out of Macroland, thereby decreasing the supply of macro$. Gov can impose foreign exchange controls that limit the ability of Macroland residents to buy currency to foreigners. Each of these policies will increase the value of the Macroland dollar. Capital Flows and Balance of Payments 8. Use the following table of information to answer this question. Payments from foreigners Payments to foreigners Sales of assets to foreigners Purchases of assets from foreigners Goods $200 $ Services Factor income Transfer payments Official sales and $100 $300 purchases Private sales and purchases a. Provide a definition or an equation for each of the following items, then compute the value of each. i. Merchandise trade balance: (exports of goods) (imports of goods) = (payments from foreigners for goods) (payments to foreigners for goods) $ $800 = $120 million ii. Balance of payments on goods and services: (exports of goods and services) (imports of goods and services) = (payments from foreigners for goods and services) (payments to foreigners for goods and services) $250 --$100 = $150 million iii. Net international factor income: (factor income payments from foreigners) (factor income payments to foreigners) $70 -- $10 = $60 million iv. Net international transfer payments: (transfer payments from foreigners) (transfer payments to foreigners) $10 -- $20 = --$10 million

4 v. Balance of payments on the current account: (balance of payments of goods and services) + (net international factor income) + (net international transfer payments) $150 + (--$10) + ($60) = $200 million vi. Balance of payments on the financial account: (sale of assets to foreigners) (purchases of assets from foreigners) = --$200 million b. Explain why the sum of the balance of payments on the current account and the balance of payments on the financial account must equal zero. 9. The following graphs represent the loanable funds market in Macroland and Funalnd, the only two economies in the world. Residents in Macroland and Funland believe that foreign assets and liabilities are as good as domestic assets and liabilities. a. Given the two graphs, which country is likely to attract capital? Why? Funland will attract capital because its equilibrium interest rate is higher than the equilibrium interest rate in Macroland. b. Describe and use the graph to show the effects of capital flows you determined in part (a) on the graphs. Capital will flow out of Macroland and into Funland. Thus, Macroland will experience capital outflows, while Funland will experience capital inflows. What will happen to the interest rate in Macroland over time? Over time, the interest rate in Macroland will rise due to capital outflows. Because Macroland initially has a lower equilibrium interest rate than Funland, some Macroland lenders will decide to send their funds to Funland to take advantage of the higher interest rate. Over time, this will cause the interest rate in the two countries to equalize. c. What will happen to the interest rate in Funland over time? Over time, the interest rate in Funland will fall due to capital inflows from Macroland. As funds from Macroland are attracted to Funland s loanable funds market, due to its initially higher equilibrium interest rate, the interest rate will fall in Funland. Eventually, the interest rates in the two countries will equalize. 10. Suppose you are shown the information in the following table. Assume net international transfers and factor income equal zero for this problem. Funland purchases of Macroland dollars in the foreign exchange market to 3.0 million Macroland dollars buy Macroland goods and services Funland total purchases in the foreign exchange market of Macroland 5.0 million Macroland dollars dollars Macroland sales of Macroland dollars in the foreign exchange market to 1.5 million Macroland dollars buy Funland assets Macroland sales of Macroland dollars in the foreign exchange market to 3.5 million Macroland dollars buy Funland goods and servies a. Given the information in the table above, compute the values in the following table. Funland purchases of Macroland dollars in the foreign exchange market to buy Macroland assets Total sales of Macroland dollars in the foreign exchange market Macroland balance of payments on the current account = 2 million Macroland dollars = 5 million Macroland dollars = million Macroland dollars

5 Macroland balance of payments on the financial account = 0.5 million Macroland dollars Suppose capital flows to Macroland from Funland decrease and this causes Macroland s currency to depreciate against Funland s currency, holding everything else constant. b. Use a graph to illustrate how this will affect the supply and demand of Macroland dollars in the foreign exchange market. c. How will this depreciation affect Macroland s balance of payments on the current account? Explain. This depreciation of Macroland s currency against Funland s currency will cause Macroland s balance pf payments on the current account to increase because Funland will now find Macroland goods and services relatively cheaper. d. How will this depreciation affect Macroland s balance of payments on the financial account? Explain. This depreciation of Macroland s currency against Funland s currency will cause Macroland s balance pf payments on the financial account to decrease because any increase in Macroland s current account must be offset by an equal and opposite reaction in the balance of payments of the financial account. 11. Suppose there are only two countries Macrobia and Tacrobia that investors view as being equally attractive for investment. The equilibrium interest rate in Macrobia is 5% and the equilibrium quantity of loanable funds is $500. The equilibrium interest rate in Tacrobia is 4% and the equilibrium quantity of loanable funds is $1,200. a. If these two countries decide to allow capital flows, what do you predict will happen? Which country will provide capital outflows and which country will provide capital inflows? Explain your answer. Because the interest rate is higher in Macrobia than in Tacrobia, you would expect loanable funds to be attracted to the higher interest rate. Tacrobia would experience capital inflow and Macrobia would experience capital inflow. b. What will be the effect of these capital flows on interest rates in each country? Illustrate your answer with loanable funds market graphs showing capital flows in each country. Over time, the interest rate in Macrobia will fall due to capital inflows from Tacrobia. As funds from Tacrobia are attracted to Macrobia s loanable funds market, due to its initially higher equilibrium interest rate, the interest rate will fall in Macrobia. Eventually, the interest rates in the two countries will equalize. 12. Consider each of the following transactions and identify how the transaction would be categorized in the U.S. balance of payments accounts. For each transaction, identify whether it would be counted as part of the balance of payments in the current account or the financial account and whether it would be a credit or debit to that account. a. A U.S. company purchases machinery produced in Germany by a German company. When the U.S. company purchases machinery produced in Germany by a German company, this transaction enters the U.S. balance of payments current account as an import. This transaction will reduce the balance of payments on the U.S. current account. b. A U.S. citizen donates money to the foreign group organizing an international sporting event in another country. When the U.S. citizen donates money to the foreign group organizing an international sporting event, this enters the current account as a transfer payment to a foreigner. This transaction will reduce the balance on the U.S. current account. c. A French citizen purchases chees produced in the United States. When a French citizen purchases cheese produced in the U.S., this transaction enters the U.S. balance of payments on the current account as an export. The U.S. financial account will fall. d. A U.S. citizen purchases 100 shares of a Swiss company. When the U.S. citizen purchases 100 shares of a Swiss company, this transaction is categorized as part of the U.S. balance of payments on the financial account and it will fall.

6 Adapted from Strive for a 5: Preparing for the Macroeconomics AP Examination (Margaret Ray and David Mayer)

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