ECO365H5 Study Guide - Foreign Exchange Spot, Capital Outflow, Arbitrage
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UNIVERSITY OF TORONTO
DEPARTMENT OF ECONOMICS
ECO365 ± INTERNATIONAL MONETARY ECONOMICS
MID-TERM TEST ± SOLUTIONS
DURATION: 90 MINUTES
MAY 30, 2011
(i) This test should be answered in BALLPOINT PEN and students who attempt the test in pencil would
surrender their right to request for re-assessment.
(ii) Only NON-PROGRAMMABLE CALCULATORS are permitted. Other electronic devices with
calculator functions are not allowed.
(iii) Answer ALL questions ONLY in the designated pages and use the last page for ROUGH WORK.
Clearly LABELED the answer to EACH PART of every question. Make sure your HANDWRITING
(iv) Do NOT SEPARATE any page from this test.
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1. Assume there are only two countries in the world, Canada and U.S., and Canada is a small open economy.
At world real interest rate N4, Canada has positive net capital outflow 0%14Pr. The foreign exchange
market is in equilibrium with real exchange rate 34. Suppose the Canadian government suddenly runs a
huge budget surplus. Use two properly-labeled diagrams to help you explain (a) the step-by-step analysis
on the impacts of this huge budget surplus through the loanable funds market and the foreign exchange
market according to lecture discussion (no need to explain the setup of the model). (b) What is the
relationship between government budget position and the current account balance?
Diagrams: 6 marks
Explanation: (a) 8 marks and (b) 4 marks
(a) The Canadian government suddenly runs a huge budget surplus (the horizontal distance between point t
and point u in the left-hand-side diagram) would raise the supply of loanable funds and shifting the
domestic saving curve from 5L54
Ú to the right to a position like 5ñL54
Ú. Now, the domestic
savings increases to 55 at N4. With the demand for loanable funds in the domestic economy remains at +4
at N4 while 55P54, net capital outflow (the horizontal distance between point s and point u) increases
55F+4L0%15P0%14L54F+4ä When net capital outflow increases, the supply of Canadian dollars
in the foreign exchange market (the right-hand-side diagram) also increases 5Ö
At the initial equilibrium real exchange rate 34, the increase in net capital outflow results in excess supply
of Canadian dollars :5Ö (the horizontal distance between point s" and point t"), which inserts downward
pressure on the real exchange rate (depreciation). As real exchange rate falls, it makes Canadian goods
relatively cheaper to the Americans (exports will rise) and U.S. goods relatively more expensive to
Canadians (imports will fall). This leads to increase in net exports (the quantity demand for Canadian
dollars) and the current account balance will improve, which helps reduce the excess supply of Canadian
dollars (the movement along &Ö from point s" and point u"). As long as there is excess supply of
Canadian dollars, the real exchange rate will continue to depreciate until 35 is reached where 5Ö
4 and the equilibrium in the foreign exchange market is restored.
(b) Private saving 54
ã remains unchanged at N4, the change in domestic savings is due to the huge government
budget surplus 55
ÚL55F54, which leads to larger net capital outflow 0%15. Hence, the
government budget surplus equals to the change in net capital outflow 55
Foreign exchange market equilibrium requires 0%14L%#4 or 0%15L%#5 in which 55
%#4. Hence, the government budget surplus is completely reflected in the improvement of the current
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2. Suppose China only produces T-shirts and U.S. only produces Microsoft Windows 7. Assume the price of
T-shirt in China is Nsr (N represents the Chinese currency yuan or renminbi) and the price of Microsoft
Windows 7 in U.S. is Dsrr in which these prices will remain unchanged throughout the analysis. If China
has Dvrárrr in its foreign exchange reserves while U.S. has Nzrárrr in its foreign exchange reserves on
December 31, 2011. (a) Which country has a neWFODLPRQWKHRWKHU¶VFRXQWU\RXWSXWRQ'HFHPEHU
2011 under the exchange rate of DsãNw? (b) Repeat part (a) with dollar depreciates to DsãNv, how much
would U.S. gain or lose? (c) Use the economic intuition discussed in lecture to explain how the change in
exchange rate from part (a) to part (b) makes one country better off at the expense of the other country
through the concept of asset and liability in terms of the foreign exchange reserves that countries hold.
Explanation: (a) 6 marks; (b) 6 marks; and (c) 7 marks
(a) If China has Dvrárrr in its foreign exchange reserves while U.S. has Nzrárrr in its foreign exchange
reserves on December 31, 2011 and the exchange rate is at DsãNw, then China can use Dsxárrr of its
foreign exchange reserves to redeem the Nzrárrr that U.S. has in its foreign exchange reserves. After
this transaction, U.S. no longer holds any foreign exchange reserves while China still has Dtvárrr left in
its foreign exchange reserves, which can be used to purchase tvr copies of the Microsoft Windows 7
from the U.S., which can be interpreted as the net claim on U.S. output.
(b) If dollar depreciates to DsãNv, then China will have to use Dtrárrr of its foreign exchange reserves to
redeem the Nzrárrr that U.S. has in its foreign exchange reserves. After this transaction, U.S. no longer
holds any foreign exchange reserves while China still has Dtrárrr left in its foreign exchange reserves,
which can be used to purchase trr copies of the Microsoft Windows 7 from the U.S., which can be
interpreted as the net claim on U.S. output. U.S. gains with dollar depreciation because the net claim on
its output by China drops from tvr to trr copies of Microsoft Windows 7.
(c) The Dvrárrr LQ&KLQD¶VIRUHLJQH[FKDQJHUHVHUYHVUHSUHVHQWVDVVHWWR&KLQa but liability to U.S. On the
other hand, the Nzrárrr in U.S. foreign exchange reserves represents asset to U.S. but liability to China.
Dollar depreciation is equivalent to yuan appreciation. Dollar depreciation will reduce the value of
&KLQD¶V IRUHLJn exchange reserves (asset) and at the same time also reduces the value of U.S. liability.
Yuan appreciation will raise the value of U.S. foreign exchange reserves (asset) and at the same time also
the difference in value between the asset and liability. U.S. is better off with dollar depreciation because
the value of its asset appreciates (yuan appreciation) while the value of its liability depreciates (dollar
&KLQD¶V DVVHW GHSUHFLDWHV GROODU GHSUHFLDWHV DQG WKH YDOXH RI&KLQD¶V OLDELOLW\ DSSUHFLDWHV\XDQ