ECON 332 INTERNATIONAL FINANCE
Chapter 13 National Income Accounting and Balance of Payments, Chapter 14 Exchange
Rates and the Foreign Exchange Market: An Asset Approach, Chapter 15 Money, Interest
17 Output and Exchange Rate in Short Run, Chapter 18 Fixed Exchange Rates and Foreignpter
Exchange Intervention, and Chapter 19 International Monetary Systems: An Historical
U n i v e r s i t y o f W a t e r l o o OPTIONAL ASSIGNMENT 1
According to asset approach to exchange rate determination, other things remaining constant, an increase in UK
nominal interest rate causes US dollar to appreciate against British pound.
FALSE Increase in UK nominal interest causes US dollar to depreciate against British pound
Uncovered Interest Parity (UIRP): R$= R +£E $/£E )$/£ $/£
R Return to dollar deposits
R +(E e -E )/E Expected dollar return on pound deposits
£ $/£ $/£ $/£
Initially, foreign exchange rate
market is in equilibrium at
Rise in pound interest rate
increases expected dollar
return on pound deposits.
At initial exchange rate,
expected depreciation rate of
$ is same as before rise inR
Expected $ return on £
deposits now exceeds that on
Those holding $ deposits want
to sell for £ deposits
Return on $ is lower than £
deposits at exchange rate
no holder of £ deposit willing
to sell for $ at that rate
Creates excess supply of $ in
foreign exchange market
$ holders trade by offering better price for £ $/£ rate rises to point 2 £ becomes more expensive in terms of $
At point 2, no more excess supply of $ $ holders no longer have incentive to try to sell them for pounds since both
deposits offer equal returns
Foreign exchange market at equilibrium at point 2
In rising from point 1 to 2, equalizes expected returns of both types by reducing rate at which $ is expected to
depreciate in future making £ deposits less attractive relative to $ deposits According to asset approach to exchange rate determination, all else equal, a rise in expected future exchange rate
causes rise in current equilibrium exchange rate in short run.
TRUE Uncovered interest parity (UIRP) condition between US and EU: R $ R +(¬ $/¬-E )$/¬ $/¬
Initially, foreign exchange rate market in
equilibrium at point 1.
Rise in expected future exchange rate from 1
to 2 increases expected depreciation rate of $
increases expected $ return on € deposits
Expected $ return on € exceeds that of $
deposits -> anyone holding $ want to sell for €
No wants to buy $ at that rate excess
supply of $
$ holders offer better price for € $/€
exchange rate rises towards 2, and € becomes
expensive in terms of $
At point 2, $ and € offer equal returns (no
more excess supply of $)
In short run, rise in expected future exchange
rate causes rise in current equilibrium
Explain following transactions entering Canadian balance of payment accounts.
(I) Canadian government sells military equipment to foreign government.
Export of merchandise: credit (+) entry in current account
EX. Canadian gov’t buys cars from foreign country: debit (-) entry into current account
(II) Bank of Canada sells yen to, and buys dollars from, a Swiss bank.
Decrease in Canadian official reserve assets: credit (+) entry into financial account
Bank of Canada sells dollars to, and buys deutsche marks from, the Bundesbank
Debit (-) entry in financial account
(II) Canadian bank receives interest on loans to Brazil.
Investment income receipt from abroad: credit (+) entry into current account
Canadian bank re-invests interest earnings and buys more Brazillian bonds
Debit (-) entry in financial account OPTIONAL ASSIGNMENT 2
In the short run a temporary increase in home real money supply leads to appreciation of home currency against
Simultaneous equilibrium of US money market and
At initial interest rate excess supply of money in US
market, $ interest rate falls as money market reaches
Given the initial exchange rate and new, lower interest
rate on $ expected return on € deposits > than $
Holders of $ deposits try to sell for € deposits
$ depreciates to point 2, as holders of $ bid for €
Foreign exchange market at eq’m at point 2
exchange rate’s move to 2 caused fall in $ expected
future depreciation rate to offset fall in $ interest rate
In short run, increase in US money supply causes its
currency to depreciate in foreign exchange market. A permanent decrease in domestic money supply results in overshooting of domestic exchange rate in SR.
Because US money supply change is permanent, people expect LR increase in all $ prices, including exchange rate
Rise in expected future $/€ rate (future dollar depreciation) raises expected $ return on € deposits $ depreciates
against €, moving exchange rate from 1 to 2.
In the LR, increase in price level proportional to increase in money supply final real money supply shown equal to
initial real money supply.
Output is given and real money supply returned to original level eq’m interest rate rises from Point 2 to 4 as price
level rises from P1 to P2
$ gradually appreciates against €
LR eq’m exchange rate is lower than SR eq’m exchange rate
Therefore SR exchange rate overshoots when its immediate response to disturbance Is greater than LR response OPTIONAL ASSIGNMENT 3
In the LR, under flexible-price monetary approach, rise in future rate of domestic money supply growth rate leads
to increase in domestic interest rates and price level, and results in appreciation of domestic currency.
Rise in future rate of domestic money supply growth rate increase in domestic interest rates and price level
Results in depreciation of domestic currency
Raises dollar interest rate in line with Fisher effect
Causes US price level to jump upward requires depreciation of $ against €
Money market equilibrium moves from point 1 to 2
In foreign exchange market, $ depreciates despite rise in $ exchange rate heightened expectation of future $
depreciation against € cause an outward shift
Nominal interest rate rises because higher expected future money supply growth, home currency will depreciate,
not appreciate, thanks to expectations of more rapid future depreciation. According to general model of LR exchange rates which accounts for possible deviations from PPP by adding real
exchange rate as additional determinant of nominal exchange rate, an increase in relative US output supply leads
to nominal depreciation of dollar against euro in the LR.
(I) Interest rate, not money supply, is prime instrument of monetary policy.
If there is excess demand of money, central bank sets interest rate so people will sell bonds
Until money supply has expanded and excess demand is gone
(II) Most central banks adjust policy interest rates expressly so to keep inflation in check.
Rise in interest rate causes currency to appreciate
Controls demand for country’s products by making them more expensive relative to foreign goods
Cannot know how a rise in $ interest rate will affect $’s exchange rate without knowing WHY nominal interest rate
has risen OPTIONAL ASSIGNMENT 4
In an open economy IS-LM model, a permanent increase in domestic government purchases leads to increase in
domestic equilibrium interest rate and output, and results in depreciation of domestic currency against foreign
currency in short run.
Permanent increase in government spending fall in LR equilibrium exchange rate
Therefore causes fall in expected exchange rate
IS does not shift permanent fiscal expansion has no effect on output or home interest rate
NOTE: temporary fiscal expansion has positive effect on output while permanent fiscal expansion has none Consider the AA-DD model. Suppose economy begins at its LR level with output at its full-employment level.
Compare and contrast SR effects of temporary policies by home gov’t on:
Home current account
Nominal exchange rate
under floating exchange rate regime to the effects on these variables under a fixed exchange rate regime.
I. An increase in home money supply.
Increase in home money supply excess supply in money market + fall in home interest rate
Decreases return on home assets rise in nominal exchange rate to satisfy UIRP
Figure B1.I.a: shift in AA curve to AA’
Under Floating Rates
Rise in nominal exchange rate rise in real exchange rate increase in current account
Increase in current account stimulates aggregate demand for home output home output increase
Rise in imports decreases current account balance
Cannot fully offset increase in CA (results from depreciation of nominal exch rate)
Net effect on CA increase Figure B1.I.a: original eq’m at 1 new eq’m at 2 (lies above XX curve)
Note: along XX curve, CA is constant at CA=X
Below XX curve, CA balance < level of X
Above XX curve, CA balance > level of X
Under Fixed Rates
Home central bank cannot allow nominal exchange to rise
Reverse increase in money supply through contraction of money supply
Exchange rate, CA, and output do NOT change
Figure B1.I.b: new eq’m same as original eq’m
In comparing effects under two exchange rate regimes, under floating rates an
increase in home money supply is effective in increasing all three variables, while it has no effect on any
variables under fixed rates.
II. A decrease in home government taxes.
Increases home disposable income
Raises home demand for home goods increases home aggregate demand
Raises home demand for foreign goods decreases home aggregate demand
ASSUME FIRST EFFECT DOMINATES
Raises aggregate demand DD curve shifts right
Rise in AD increase in output, demand for real balances, and home interest rate
Fall in nominal exchange rate
Under Floating Rates
Fall in nominal exchange rate fall in real exchange rate decreases CA and output
Overall output increases because rise in output due to rise in AD > fall in output
Overall CA falls
Rise in imports induced by increase in disposable income
Decrease in real exchange rate
Rise in imports induced by increase in eq’m output
Under Fixed Rates
Central bank must expand home money supply to prevent exchange rate from falling
Shift in AA curve to right to AA’
Output increases because of rise in AD
CA falls because:
Rise in imports induced by rise in disposable income
Rise in imports induced by increase in eq’m ou