Econ 371: Answer Key for Problem Set 1 (Chapter 12-13)

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1 con 37: Answr Ky for Problm St (Chaptr 2-3) Instructor: Kanda Naknoi Sptmbr 4, (2 points) Is it possibl for a country to hav a currnt account dficit at th sam tim and has a surplus in its balanc of paymnts? xplain your answr using hypothtical figurs. ANSW: ( point) Ys. Th balanc of paymnts (BoP) is th sum of currnt account (CA), capital account (KA) and financial account (FA). Thortically, bcaus of th doubl-ntry bookkping practic, th sum is supposd to b zro. BoP = CA KA FA = 0 ( point) Givn a currnt account dficit, th thory prdicts that th sum of th capital account and th financial account must b surplus. Howvr, in practic, th balanc of paymnts may dviat from zro bcaus of statistical discrpancy, particularly in rcording financial transactions in th financial account. Suppos th currnt account dficit is 00 billion dollars, a combind surplus of th capital account and th financial account must b gratr than 00 billion dollars to produc a surplus in th balanc of paymnts. (Optional not) Somtims th trm balanc of paymnts is usd to dscrib th official sttlmnts balanc with th opposit sign. This balanc indicats th paymnts gap covrd by th official rsrv transactions. For xampl, th U.S. official sttlmnts balanc in 2003 is 250 billion dollars. In this cas, som nwspaprs may say that th U.S. balanc of paymnts in 2003 is -250 billion dollars. Whn it is a larg ngativ numbr, it is oftn a subjct of concrn bcaus it indicats an xcssiv rol of th cntral bank in financing th currnt account dficit. 2. (2 points) Suppos that th U.S. nt forign dbt is 25 prcnt of U.S. GDP and that forign assts and liabilitis alik pay an intrst rat of 5 prcnt pr yar. What would b th drain on U.S. GDP (as a prcntag) from paying intrst on th nt forign dbt? What if th nt forign dbt wr 00 prcnt of GDP? At what point do you think a country s govrnmnt should bcom worrid about th

2 siz of its forign dbt? ANSW: ( point) 25 prcnt dbt-to-gdp ratio and 5 prcnt intrst rat implis that th intrst paymnt as th ratio to GDP is 0.25x0.05 = =.25 prcnt of GDP. If th dbt-to-gdp ratio is 00 prcnt, thn th intrst paymnt willl bcom x0.05 = 0.05 = 5 prcnt of GDP. ( point) Intuitivly, th govrnmnt should b concrnd about th nt forign dbt whn paying back th dbt bcoms difficult. W can us th balanc of paymnts accounting to find out how much output ndd to pay back th dbt. CA = savings - invstmnt Whn a country run a currnt account surplus, thir rsidnts hav mor savings than th domstic invstmnt and so thy also invst ovrsas. That is how a country with a currnt account surplus can accumulat nt forign assts. In contrast, a country that runs a currnt account dficit dos not hav nough savings for its domstic invstmnt, so it must borrow from abroad and accumulat nt forign dbts. In othr words, th stock of nt forign dbts ar a rsult of past capital inflows triggrd by currnt account dficits. Th only way to rduc th forign dbt is to rvrs th dirction of capital flows. So, w must run a currnt account surplus from now, and us th surplus to pay back th dbt. Th siz of forign dbt coms to play a rol bcaus th largr it is, th largr th intrst paymnt and th largr futur currnt account surpluss nd to b. This can also b xplaind using anothr currnt account accounting. (S Tabl 2-2 for an xampl.) CA = xport - import nt incom transfr from abroad In this cas, th nt incom transfr is th ngativ valu of th intrst paymnt w calculatd abov. In ordr to run a currnt account surplus in th futur, th U.S. will hav to run a trad balanc surplus which is gratr than th amount of th intrst paymnt. Whn th dbt-to-gdp ratio is 25 prcnt, to rduc and pay back th dbt, th U.S. will hav to run th trad surplus of mor than.25 prcnt of GDP for a numbr of yars in th futur. But whn th dbt-to-gdp ratio is 00 prcnt, th trad surplus has to b mor than 5 prcnt of GDP. This cannot happn without strong xport growth. So, a country s govrnmnt should bcom worrid whn its forign dbt is so larg that it rquirs unralistically high xport growth in th futur. (Optional not) W can also considr th rlationship of nt forign assts (NFA) and currnt account (CA). 2

3 CA this priod = chang in NFA = NFA nxt priod - NFA this priod Currnt account rflcts th dirction of capital flows and as a rsult indicats whthr a country is accumulating mor dbts or assts in a particular priod. It is a flow concpt. Howvr, NFA is a stock concpt, maning it is th accumulatd balanc of a flow variabls. Whn NFA is ngativ, it indicats that th nation is a nt dbtor country. Whn it is positiv, it indicats that th nation is a nt crditor country. W can also us this rlationship to track th path of NFA. NFA nxt priod = NFA this priod CA this priod Considr a cas whr w start out with a ngativ numbr of NFA. So, this rlationship tlls us that th only way to rduc and vntually pay back th forign dbt is to kp running currnt account surplus in th futur. 3. (2 points) Calculat th dollar rats of rturn on a dposit 0,000 pounds in a London bank in a yar whn th intrst rat on pounds is 0 prcnt and th dollar/pound xchang rat movs from.50 dollars pr pound to.38 dollars pr pound. What is th intrst rat a U.S. bank nds to offr to attract capital flows from London? ANSW: ( point) Today dollar givs us /.50 pounds. With 0 prcnt intrst rat, th nxt priod gross rturn is (0.0) x /.50 pounds. Thn convrt this back to th U.S. dollar with th rat.50 dollar pr pound. So, th th gross rturn bcoms (0.0) x /.50 x.38 dollars. Subtracting dollar from this will giv th nt dollar rturn on th London dposit of 0.02 or.2 prcnt. Not that th total of 0,000 pounds is irrlvant, bcaus th intrst rat is in prcnt. W can us th uncovrd intrst parity to approximat th rturn. Th dollar rturn on th London dposit = th pound intrst rat th dprciation of U.S. dollar. Th dprciation of U.S. dollar = ( )/.50 = = 8 prcnt apprciation. Th ngativ sign indicats that th U.S. dollar dos not dprciat but apprciats. Th dollar rturn on th London dposit = = 0.02 = 2 prcnt. ( point) A U.S. bank nds to offr mor than.2 (2 if w us th approximation mthod) prcnt intrst rat to attract capital flows from London. A U.S. bank dos not nd to pay as much as th London bank bcaus of th futur apprciation or capital gain of th U.S. dollar. 4. (2 points) Suppos tradrs in asst markts suddnly larn that th intrst rat on dollars will dclin in th nar futur. Us th diagrammatic analysis of Chaptr 3 to dtrmin th ffcts on th currnt dollar/uro xchang rat, assuming currnt intrst rats on dollar and uro dposits do not chang. 3

4 ANSW: ( point) Figur 4. indicats th tradrs anticipation aftr thy hard th nws. If th intrst rat dclins in th futur from to, thy fors that th dollar will dprciats from to 2. Givn this anticipation, th tradrs adjust thir xpctation right away. Such an xpctation shift will chang th currnt xchang rat as dpictd in Figur 4.2. ( point) In Figur 4.2, th initial quilibrium is at Point. Th nw xpctd dprciation is highr than th original. Such an xpctation shift raiss th dollar rturn of uro dposits, and causs th dollar/uro rat to dprciat as popl incras thir dmand for th uro dposits. Th forign xchang markt will obsrv 3, which is highr than. If th tradrs hav prfct forsight, thn 3 = (2 points) Suppos th U.S. congrss is concrnd with th dollar-uro xchang rats and wishs to prvnt tradrs from affcting th xchang rat in Qustion 4. xplain how th congrss can achiv its goal using a tax policy. ANSW: Th congrss can do many things. You gt points for discussing only on cas. First, th congrss can incras th rat of rturn on U.S. dollar assts today by subsidizing dollar savings. If thr is currntly a tax on intrst arnings, th congrss can cut th tax. This policy chang will shift in th schdul to th right today, so that th xchang rat rmains unchangd at Point 4 in Figur 5. Altrnativly, th congrss can announc th nws of a futur subsidy or tax cut on intrst arnings. Such an announcmnt will shift th xpctation among th tradrs back from in Figur 4.2 to th original. This is bcaus th tradrs anticipat Figur 5 right away, vn if th congrss dos not actually implmnt th policy today. Such a shift will bring back th original dollar rturn on uro dposits and kp th xchang rat unchangd. In this cas, w will obsrv Point instad of Point 4 today. Or, th congrss can also tax on forign xchang transactions to prvnt th U.S. rsidnts from moving thir funds to uro dposit accounts. If th tax is so high that it prohibits forign xchang transactions, it will prvnt th xpctation among tradrs from shifting in Figur 4.2. This works in th sam way as capital controls dsignd to limit fr flows of funds so that th quilibrium stays at Point. 4

5 Figur 4.: Tradrs anticipation $/ 2 2 $ $ xpctd $ rturn on dposits

6 Figur 4.2: Today forign xchang markt quilibrium $/ 3 3 ' $ xpctd $ rturn on dposits

7 Figur 5: ffcts of a subsidy for savings on xchang rat $/ 3 3 ' 4 = 4 $ '' = $ $ xpctd $ rturn on dposits

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