International Finance

2. 34 International Finance CHECKPOINTS

3. Checkpoint 34.1 Checkpoint 34.2 Problem 1 Problem 1 Clicker version Problem 2 Problem 2 Clicker version In the news Problem 3 Clicker version In the news 1 In the news 2

4. Practice Problem 1 The table set out an economy’s transactions in in 2008. Calculate The current account balance The capital account balance The official settlements account balance Exports of goods and services CHECKPOINT 34.1 • Imports of goods and services: $2,000 billion • Interest paid to the rest of the world: $500 billion • Interest received from the rest of the world: $400 billion • Decrease in official U.S. reserves: $10 billion • Government sector balance: $200 billion • Saving: $1,800 billion • Investment: $2,000 billion • Net transfers: zero.

5. Solution The current account balance equals net exports plus net interest from abroad (–$100 billion) plus net transfers (zero). Net exports equal the government sector balance ($200 billion) plus the private sector balance. CHECKPOINT 34.1 • Imports of goods and services: $2,000 billion • Interest paid to the rest of the world: $500 billion • Interest received from the rest of the world: $400 billion • Decrease in official U.S. reserves: $10 billion • Government sector balance: $200 billion • Saving: $1,800 billion • Investment: $2,000 billion • Net transfers: zero.

6. The private sector balance equals saving ($1,800 billion) minus investment ($2,000 billion. The private sector balance is–$200 billion. Net exports equal the government sector balance ($200 billion) plus the private sector balance (–$200 billion). So net exports are zero. CHECKPOINT 34.1 • Imports of goods and services: $2,000 billion • Interest paid to the rest of the world: $500 billion • Interest received from the rest of the world: $400 billion • Decrease in official U.S. reserves: $10 billion • Government sector balance: $200 billion • Saving: $1,800 billion • Investment: $2,000 billion • Net transfers: zero.

7. The current account balance equals net exports (zero) plus net interest from abroad (–$100 billion) plus net transfers (zero). The current account balance is–$100 billion. CHECKPOINT 34.1 • Imports of goods and services: $2,000 billion • Interest paid to the rest of the world: $500 billion • Interest received from the rest of the world: $400 billion • Decrease in official U.S. reserves: $10 billion • Government sector balance: $200 billion • Saving: $1,800 billion • Investment: $2,000 billion • Net transfers: zero.

8. The capital account balance is the negative of the sum of the current account and official settlements account balances, which is $90 billion. The official settlements account balance is a surplus of $10 billion. Exports equal net exports (zero) plus imports ($2,000 billion), which equals $2,000 billion. CHECKPOINT 34.1 • Imports of goods and services: $2,000 billion • Interest paid to the rest of the world: $500 billion • Interest received from the rest of the world: $400 billion • Decrease in official U.S. reserves: $10 billion • Government sector balance: $200 billion • Saving: $1,800 billion • Investment: $2,000 billion • Net transfers: zero.

9. Practice Problem 2 Is the economy a debtor or a creditor nation in 2008? CHECKPOINT 34.1 • Imports of goods and services: $2,000 billion • Interest paid to the rest of the world: $500 billion • Interest received from the rest of the world: $400 billion • Decrease in official U.S. reserves: $10 billion • Government sector balance: $200 billion • Saving: $1,800 billion • Investment: $2,000 billion • Net transfers: zero.

10. Solution The economy is a debtor nation in 2008 because it pays more in interest to the rest of the world than it receives in interest from the rest of the world. CHECKPOINT 34.1 • Imports of goods and services: $2,000 billion • Interest paid to the rest of the world: $500 billion • Interest received from the rest of the world: $400 billion • Decrease in official U.S. reserves: $10 billion • Government sector balance: $200 billion • Saving: $1,800 billion • Investment: $2,000 billion • Net transfers: zero.

11. In the news Something has got to give As the recovery takes hold, the U.S. government must reduce its expenditure to trim its huge budget deficit. To keep aggregate demand growing, consumption, investment, or exports must grow. U.S. consumers are burdened with debt, U.S. firms have unused capital, so exports must grow. Source: USA Today, September 3, 2009 Explain why a cut in government expenditure to trim the budget deficit will require exports to grow. CHECKPOINT 34.1

12. Solution The link between the government sector balance and the private sector balance is given by the equation: (X– M) = (S – I) + (NT – G) Rewrite the equation as (NT – G) = (S – I) – (X– M) A cut in G will decrease the left side of the equation. If consumption does not increase, then S will increase. To make the right side of the equation decrease, X must increase. CHECKPOINT 34.1

13. Practice Problem 1 Suppose that yesterday, the U.S. dollar was trading on the foreign exchange market at 100 yen per dollar. Today, the U.S. dollar is trading at 105 yen per dollar. Which of the two currencies (the dollar or the yen) has appreciated, and which has depreciated today? CHECKPOINT 34.2

14. Solution Because the price of the U.S. dollar is a larger number of yen, the U.S. dollar has appreciated. The yen has depreciated because it buys fewer U.S. dollars. CHECKPOINT 34.2

15. CHECKPOINT 34.2 Study Plan ProblemSuppose that yesterday, the U.S. dollar was trading on the foreign exchange market at 100 yen per dollar. Today, the U.S. dollar is trading at 105 yen per dollar. Which of the two currencies (the dollar or the yen) has appreciated and which has depreciated today? • Both currencies depreciated. • Both currencies appreciated. • The dollar appreciated and the yen depreciated. • The dollar depreciated and the yen appreciated.

16. Practice Problem 2 Suppose that yesterday, the U.S. dollar was trading on the foreign exchange market at 100 yen per dollar. Today, the U.S. dollar is trading at 105 yen per dollar. List the events that could have caused today’s change in the value of the U.S. dollar on the foreign exchange market. Did these events on your list change the demand for U.S. dollars, the supply of U.S. dollars, or both the demand for and supply of U.S. dollars? CHECKPOINT 34.2

17. Solution The main events might be An increase in the U.S. interest rate A decrease in the Japanese interest rate A rise in the expected future exchange rate of the U.S. dollar. The events listed change both the demand for and supply of U.S. dollars. These events increase the demand for and supply of U.S. dollars. CHECKPOINT 34.2

18. CHECKPOINT 34.2 Study Plan Problem The value of the U.S. dollar on the foreign exchange market rose from 100 yen 105 yen per dollar. _____ could have caused this rise because ______ U.S. dollars changed. • A fall in the U.S. interest rate and a fall in the expected future exchange rate of the U.S. dollar; only the demand for. • A rise in the expected future exchange rate of the U.S. dollar and a fall in the U.S. interest rate; both the demand and supply of. • A rise in the expected future exchange rate of the U.S. dollar and a rise in the U.S. interest rate; both the demand and supply of. • A rise in the U.S. interest rate and a fall in the expected future exchange rate of the U.S. dollar; only the supply of.

19. Practice Problem 3 Suppose that yesterday, the U.S. dollar was trading on the foreign exchange market at 100 yen per dollar. Today, the U.S. dollar is trading at 105 yen per dollar. If the Fed had tried to stabilize the value of the U.S. dollar at 100 yen per dollar, what action would the Fed have taken? What effect would the Fed’s actions have had on U.S. official reserves? CHECKPOINT 34.2

20. Solution To stabilize the value of the U.S. dollar, the Fed would have sold U.S. dollars to increase the supply of U.S. dollars in the foreign exchange market. When the Fed sells U.S. dollars, it buys foreign currency. U.S. official reserves would have increased. CHECKPOINT 34.2

21. CHECKPOINT 34.2 Study Plan Problem The value of the U.S. dollar on the foreign exchange market rose from 100 yen 105 yen per dollar. If the Fed tried to stabilize the value of the U.S. dollar at 100 yen per dollar, it would _______. U.S. official reserves would _________. • buy both dollars and yen; increase • sell dollars and buy yen; decrease • buy dollars and sell yen; increase • sell dollars and buy yen; increase • buy dollars and sell yen; decrease

22. In the news Dollar up vs euro and yen after Fed signals higher interest rate The dollar rose against the euro and the yen, bouyed by the appeal of higher short-term interest rates after the Fed chose tnot to increase the money supply. Source: Reuters, September 20, 2011 Did the dollar appreciate or depreciate against the euro and the Japanese yen? Did the euro and the yen appreciate or depreciate against the dollar? CHECKPOINT 34.2

23. Solution Because the dollar buys more euros, the euro has depreciated and the dollar has appreciated. Because the dollar buys more yen, the dollar appreciated against the yen and the yen depreciated against the dollar. CHECKPOINT 34.2

24. In the news Dollar up vs euro and yen after Fed signals higher interest rate The dollar rose against the euro and the yen, bouyed by the appeal of higher short-term interest rates after the Fed chose tnot to increase the money supply. Source: Reuters, September 20, 2011 What actions in the foreign exchange market produced the depreciation of the dollar? CHECKPOINT 34.2

25. Solution As the Fed signaled that U.S. short-term interest rates would rise, the U.S. interest rate differential increased. The demand for U.S. dollars increased and the supply of U.S. dollars on the foreign exchange market decreased. The value of the U.S. dollar on the foreign exchange market increased. CHECKPOINT 34.2