MGEC61 – LEC 01and LEC 02
International Economic: Finance
Due: On or before Thursday, October 3, 12:00noon, IC 286
(Note: Assignment submitted after 12:00noon on October 3 WILL NOT BE accepted
under ANY circumstance.)
You can submit individual or group assignment.
If you submit group assignment, there should be no more than FIVE students in your
group and you just have to submit ONE copy.
A title page MUST be attached with your assignment; it MUST include your name(s),
student number(s), and your lecture section(s).
Staple your assignment (Paper clip is not accepted).
A PENALTY OF 10% OF THE TOTAL MARKS WILL BE IMPOSED IF YOU DO
NOT HAVE A TITLE PAGE OR STAPLE YOUR ASSIGNEMNT.
No late assignment will be accepted.
Label your graph; otherwise, marks will be subtracted.
Do not write E/q/E increases/decreases (/) in your answer, you have to answer
whether the currency appreciates/depreciates. POINTS WILL BE SUBTRACTED IF
YOU DO NOT FOLLOW THIS INSTRUCTION.
No credit will be given if you do not show your work.
Your answer should be structured in a way such that those know little about economics
will have no difficulty in understanding your argument/answer.
Total marks: 100 points.
Question 1 (15 points)
The world consists of three economies only, A, B, and C. The following table provides some
macroeconomic data for these countries.
A B C
National Output, Y 4800 6000
Consumption, C 3600 3240
Government spending, G 1500
Taxes, T 1450
Private saving,GS 1000
Public saving, S
National saving, S
Net unilateral transfer 0 0 0
Current Account, CA 360
Non-reserve portion of financial account, Knon-res 180
Official reserve transactions, ORT
Capital account 160
MGEC61 Assignment 1 (Fall 2013) 1 Additional information given about these countries:
The central banks only make transactions with other countries’ central banks.
The share of consumption in GDP is the same in all three countries.
Country A has twin deficits and the size of each deficit reaches 7.5% of output.
Country B’s stock of official reserves decreases by 190.
Total amount of asset transfers paid out by residents of B to residents of A & C reaches 370,
and no market transactions are involved in these asset transfers.
The governments of B and C run a budget deficit of 230 and 350 respectively.
The level of national saving in country C is equal to 360.
Country C experiences (net) outflows of private (financial) capital of 380.
a) Complete Table 1. You are not required to provide explanation to your answer for this
question; however, you should understand the logic behind the entry of each cell so that you
can work on similar questions in the future. (10 points)
Note: Table 1 is reproduced on page 6 of this assignment. Submit that page with your
assignment for grading.
b) Based on your answer in part (a), in the absence of central bank intervention, which
country/countries find their currencies under pressure to appreciate? Explain. (5 points)
Question 2 (15 points)
This question are related to the article “Carry on trading: Why nominal interest-rate differentials
are important to currency markets”, The Economist, August 10 , 2013 (pages 7 & 8 of this
When answering the following questions, make sure to use your own words to answer the
questions, DO NOT PLAGIARIZE from the article; otherwise, you will receive a grade of
ZERO for the whole question.
a) The article mentioned that in theory carry trade does not work. Explain the logic behind. (5
b) Explain the logic behind the following sentences “countries with persistent current-account
deficits tend to have higher real interest rates than surplus countries. In other words, countries
with an addiction to imports have to pay a risk premium to investors to hold their currency.”
(6 paragraph of the article on page 7). (5 points)
c) At the end of the article it mentioned that carry trade is a simple but working strategy that
currency traders could use to make profit. Explain the logic behind. (5 points)
Question 3 (15 points)
Suppose you are working for a large, international investment bank, and you observe the annual
yields on Japanese corporate bonds and Australian corporate bonds are 2.28% and 3.72%
respectively. In addition, the current (spot) ¥/A$ exchange rate is 100.6, and the Australian
dollar is traded at a forward premium of 1.1% against the Japanese yen.
a) You realize that there is an arbitrage opportunity; however your bank does not have any
funds denominated in Japanese yen and/or Australian dollar (A$). What would you do to
MGEC61 Assignment 1 (Fall 2013) 2 capture the arbitrage profit? Calculate the arbitrage profit (measured in Japanese yen).
Explain. (5 points)
b) Suppose your bank has the ability to change the spot exchange rate, the forward exchange
rate, and the corporate bond yields in both countries, what happens to these four variables
after the transactions you carried in part (a)? Explain in words. (8 points)
c) Now, suppose the spot ¥/A$ exchange rate bear all the burden of adjustment. Find the spot
¥/A$ exchange rate that would make your boss indifferent between investing in Japanese
corporate bonds and Australian corporate bonds. Compare to the initial spot ¥/A$ exchange
rate, what happens to the value of ¥ in the spot market (i.e., does ¥ appreciate or depreciate)?
1) Quote the exchange rates as E ¥/A$nd F ¥/A$
2) Interest rates are expressed in decimal points (i.e., if R = 0.1, then R = 10%). Keep your
answer to at least 4 decimal points.
3) This question requires you to use covered interest rate parity.
4) Instead of the assumption made in class (individuals are small players and cannot affect the
exchange rates and interest rates), the investment bank in this question is a LARGE player
which has the ability to change the exchange rates and the corporate interest rates when it
carries transactions in the spot exchange market, the forward exchange market, and corporate
bonds markets in Japan and Australia.
5) Use the subscripts “J” and “A” to represent all the variables and terms used for Japan and
Australia respectively in your written explanation. You must use these notations; otherwise,
you will receive a grade of ZERO for the whole question.
Question 4 (25 points)
Consider two economies, Home and Foreign. The exchange rate between domestic currency
(DC) and foreign currency (FC) is determined by the asset approach to the exchange rate.
Both countries are identical in the following ways: 1/4 3/4
Production function is given a typical Cobb-Douglas function: Y = 2K L .
The (real) money demand is given by hY – kR,
where h = fraction of income held in the form of money, 1> h > 0
k = sensitivity of money demand (MD) to a change in (nominal) interest rate.
The long-run (nominal) interest rate = 4.5%.
Home and Foreign differ in the following ways:
Supply of capital 50625 20736
Supply of labour 20736 10000
Fraction of income held in the form of money 10% 15%
Sensitivity of MD to a change in (nominal) interest rate 18000 15000
(Nominal) Money supply 21870 11700
1) Quote the exchange rate as EDC/FC.
MGEC61 Assignment 1 (Fall 2013) 3 2) Interest rates are expressed in decimal points (i.e., if R = 0.1, then R = 10%).
3) Keep your answer to at least 4 decimal points.
a) Initially, both countries are in their respective long-run equilibrium. Find the long-run
equilibrium DC/FC exchange rate if the initial expected DC/FC exchange rate is given by the
ratio of domestic price level to foreign price level. (6 points)
Now suppose there are permanent changes in the domestic money market such that the
sensitivity of money demand to a change in interest rate falls by 4500. In addi