ECO610 Week 5 Assignment­Five Problems

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ECO610

07/11/2022

Week 5 Assignment­Five Problems

Chapter 19 Questions one

If you were in charge of macroeconomic policies in a small open economy, what qualitative effect would each of the following events have on your target for external balance?

a.   Large deposits of uranium are discovered in the interior of your country.

Despite the great news, the current account’s big swing will result in a deficit. This is so the nation won’t have to borrow money from abroad to pay for its mining needs.

b.  The world price of your main export good, copper, rises permanently.

If we assume that the current accounts are kept in check, then this will result in a current account surplus.

c.   The world price of copper rises temporarily.

When the price of copper rises, there will be an increase in exports, resulting in a temporary surplus increase.

d.  There is a temporary rise in the world price of oil.

No information is supplied regarding whether or not the nation ships oil abroad or brings it in. If it is an importer, the current account deficit will increase; if it is an exporter, the deficit will decrease.

Chapter 19 Question two

Under a gold standard of the kind analyzed by Hume, describe how the balance of payments equilibrium between two countries, A and B, would be restored after a transfer of income from B to A.

The gold standard has reliable automated systems that assist all nations in concurrently achieving a balance of payments equilibrium (Johnson, 2020). The most significant of them all is the price­specie­flow mechanism. It follows that a current account deficit will be created in country B when income is moved to country A, while a current account surplus will be created in country A. Therefore, transferring gold from country B to country A will equalize trade surpluses and deficits. Therefore, as a result of this transfer of gold, B will have less, and A will have more, which will enhance B’s balance of payments by making B’s export market more competitive and A’s less so. The international payments balance is thereby restored to its starting point. There will be an increase in the money supply and A. As a result, in B, we expect a general price lowering.

Chapter 19 Question Three

Despite the flaws of the pre­1914 gold standard, exchange rate changes were rare for the “core” countries (including the richer European countries and the United States). In contrast, such changes became frequent in the interwar period. Can you think of reasons for this contrast?

During the period from the beginning of time until 1914, the value of currencies was measured in terms of their weight in gold (the classic gold standard). The central banks kept gold reserves, which may be traded in for other currencies if necessary. As a result, the rate at which one currency can be exchanged for another did not change. However, throughout the time between the wars (1914–1945), the traditional gold standard was no longer in use. The war’s rising fiscal imbalance also compelled governments to increase money printing, which led to substantial inflation and currency devaluation. This is the primary factor that contributes to the fluctuation of exchange rates.

Chapter 19 Question Four

Under a gold standard, countries may adopt excessively contractionary monetary policies as all countries scramble in vain for a larger share of the limited supply of world gold reserves. Can the same problem arise under a reserve currency standard when bonds denominated in different currencies are all perfect substitutes?

Contractionary monetary policy, which results in a smaller money supply, leads to a rise in gold holdings since there is less spending. However, given that the global oil reserves are limited (at least shortly), this is not something that all nations can do.

The gold and reserve currency standards have the same underlying idea. International reserves will rise as a result of a contractionary monetary policy (Johnson, 2020). If any currency­denominated bonds are successful, domestic and foreign bonds will achieve the same goal. As a result, the nation’s foreign exchange reserves have increased. On the other hand, if all nations adopt a contractionary strategy, they can build up their foreign currency reserves (given that there is no distinction between domestic and international assets when stated in local or foreign currency).

Chapter 19 Question 5 five

A central bank that adopts a fixed exchange rate may sacrifice its autonomy in setting domestic monetary policy. It is sometimes argued that when this is the case, the central bank also gives up the ability to use monetary policy to combat the wage­price spiral. The argument goes like this: “Suppose workers demand higher wages and employers give in, but the employers then raise output prices to cover their higher costs. Now the price level is higher and real balances are momentarily lower, so to prevent an interest rate rise that would appreciate the currency, the central bank must buy foreign exchange currencies and expand the money supply. This action accommodates the initial wage demands with monetary growth, and the economy moves permanently to a higher level of wages and prices. With a fixed exchange rate, there is thus no way of keeping wages and prices down.” What is wrong with this argument?

The current account balance of an economy may be affected when wage increases do not translate into price increases. When domestic prices rise, the cost of manufacturing domestically and exporting those items rises, which causes a drop in exports. Because of this, there is a possibility of a current account deficit. A decrease in money supply is consistent with having a current account deficit (as more is spent on foreign goods). A reduction in the money supply causes a decline in price levels, leading to a decrease in wage levels due to the appreciation of the currency.

Chapter 20 – Problem 1

Which portfolio is better diversified, one that contains stock in a dental supply company and a candy company or one that contains stock in a dental supply company and a dairy product company?

The stocks in a diversified portfolio of two should either have no correlation or an inverse correlation to one another. It is impossible to create a diversified portfolio if the assets all have a positive correlation with one another. In this particular scenario, it is obvious that if more candy is sold, increasing the stock of candy companies may increase the number of dental problems, which may lead to an increase in the stock price of companies that provide dental supplies. In the event of a recession, the outcomes are identical: both will become worse. Because of this, the equities have a high degree of correlation, which increases the risk that the portfolio is not diversified. A portfolio that includes both kinds of businesses might be thought of as having a higher level of diversification because the stocks of dairy and dental supply companies, on the other hand, have little to no correlation.

Chapter 20 – Problem 2

Imagine a world of two countries in which the only causes of fluctuations in stock prices are unexpected shifts in monetary policies. Under which exchange rate regime would the gains from international asset trade be greater, fixed or floating?

Because asset values are more stable (less volatile) under a system with a fixed exchange rate, a change in monetary policy has less of an impact on the economy. This is especially true for the asset prices of international assets. However, under a system with a floating exchange rate, changes in monetary policy are more effective because they have a greater direct impact on the values of assets. This is because market forces are the primary factor in determining the exchange rate under such a system. As a result, the advantages of international asset trade are increased by any favorable change in monetary policy and vice versa.

Chapter 20 – Problem 3

The text points out that covered interest parity holds quite closely for deposits of differing currency denominations issued in a single financial center. Why might covered interest parity fail to hold when deposits issued in different financial centers are compared?

The covered exchange rate principle protects the business from the unpredictability of future exchange rates. This covered interest parity only works properly when the same financial center issues various deposits in foreign currency. This is a result of the fact that there will be variances existing in the covered interest parity if deposits from various financial centers of various countries are compared to one another. The covered interest parity can also be affected by factors such as political risk and the likelihood of the bankruptcy of the banking system in the other country.

Chapter 20 – Problem 4

When a U.S. bank accepts a deposit from one of its foreign branches, that deposit is subject to the Fed’s reserve requirements. Similarly, Fed reserve requirements are imposed on any loan from a U.S. bank’s foreign branch to a U.S. resident, or on any asset purchase by the branch bank from its U.S. parent. What do you think is the rationale for these regulations?

Reserve requirement contributes to the continued security and liquidity of a bank. As a result of this condition, financial institutions are obligated to hold an average percentage of their demand deposits and loans. This is something that the central bank decides upon for each commercial bank branch. The purpose of these reserves is to offer liquidity while also acting as a safety net against potential losses. This rule may have a minimally negative effect on the bank’s profitability. Still, it does a great deal to increase customer confidence and ensure that the banks remain solvent, especially during times when withdrawals exceed deposits. Additionally, it can be useful in situations with a “run” on banks due to a “black swan” catastrophe.

Chapter 20 – Problem 5

The Swiss economist Alexander Swoboda has argued that the Eurodollar market’s early growth was fueled by the desire of banks outside the United States to appropriate some of the revenue the United States was collecting as issuer of the principal reserve currency. (This argument is made in The EuroDollar Market: An Interpretation , Princeton Essays in International Finance 64, International Finance Section, Department of Economics, Princeton

University, February 1968.) Do you agree with Swoboda’s interpretation?

At the very least, to a certain extent, I concur with Swoboda’s assessment. This is because foreign central banks should maintain reserves of a stable international currency (the United States Dollar is the default choice). Stable international currency reserves are vital to combat a country’s currency volatility. As a result, there was a rise in activity in the

Eurodollar market.

References

Johnson, H. (2020). Economic Expansion and International Trade. In International Trade and Economic Growth (Collected Works of Harry Johnson). https://doi.org/10.4324/9780203640289­13