Assignment 5 -- Chapters 11 and 12.

Chapter 11, page 290.

1. a. $1 = £0.68, 1 D.M. = $0.59, 1 F.F. = $0.17, ¥1 = $0.0093.

b. £1 is equal to 2.52 D.M., 8.58 F.F., and ¥159.84.

1 D.M. is equal to £.40, 2.32 F.F., and ¥63.72.

1 F.F. is equal to £.12, .29 D.M. and ¥18.36.

¥1 is equal to £0.0063, 0.01581 D.M., and 0.059 F.F.

c. If $1 = 2 D.M. and the $1 = 6 F.F., then using cross rates 1 D.M. = 3 F.F. Both 1 D.M. = 4 F.F. and 1 D.M. = 2 F.F. are too wide variations to be sustained. Arbitragers would move in to restore equilibrium values.

2. a. The diagram should resemble Figure 11.1, p. 266, except that the y axis should be marked "price of one french franc in terms of dollars." This will ensure that rises and falls in the value of the franc, the main interest of example, are in the right direction. The initial equilibrium value should be marked 1 F.F. = $0.17, the inverse of $1 = 5.8 F.F. The downward sloping demand curve should be labelled "demand for francs (franc inpayments)" and the upward sloping supply curve "supply of francs (franc outpayments)."

b.i. A rise in French interest rates increase in capital flows into the franc outward shift in demand curve rise in the value of the franc.

bii. Higher prices will lead to a fall in French competitiveness fall in exports and rise in imports inward shift of the demand curve and outward shift of the supply curve fall in the value of the franc.

biii. The most direct effect is a fall in French exports downward shift in the demand curve lower value of the franc. (Subsequently, lower incomes may cut imports, and worsening expectations may reduce capital inflows.)

biv. Usually socialist administrations are thought to be unattractive to capital and that a conservative successor government will be kinder in terms of taxation, capital mobility policy, and wage restraint. Hence capital inflow upward shift in demand curve higher value of the franc.

bv. This will have an effect both on capital flows and competitiveness. Lower interest rates reduced capital inflows, increased capital outflows inward shift in demand, outward shift in supply lower value of franc. This will be reinforced by rise in prices fall in competitiveness fall in exports and rise in imports fall in demand, rise in supply fall in value of franc.

c.i. French competitiveness will be harmed by the higher franc.

cii. The effect of the currency depreciation will be to restore the competitiveness that had been eroded by inflation.

c.iii. If the lower exchange rates persist beyond the end of the strike, French competitiveness will probably have been improved, depending on the nature of the strike settlement.

c.iv. The higher exchange rate will reduce competitiveness.

c.v. In so far as the depreciation is caused primarily by capital flows manufacturing and service competitiveness will be enhanced.

d. Because the demand for the franc, or any other currency is a derived demand for French goods and services, and the supply of francs is derived from French demand for many activities, the issue of the slopes of the demand and supply curves is a complex one. However we can heuristically approach it if we assume that foreign exchange transactions are related to commodity trade alone. Consider now a fall in the value of the franc. This will increase the franc cost of foreign goods and will reduce both the demand for the goods and the demand for foreign currency. Therefore the supply of francs in the exchange market is reduced as the value of the franc falls. Demand for francs will be a function of the demand for french products abroad. A fall in the value of the franc will reduce the cost of french goods abroad and if the demand for these goods is elastic the demand for francs will rise.

3. Higher interest rates attracted capital into Canada, boosting the value of the Canadian dollar and making Canadian goods more expensive on world markets. Canadian exporters either had to lose market share or reduce the price of their products in Canadian dollar terms, cutting profits.

4. a. Both policies tended to raise interest rates.

b. The price of the dollar appreciated considerably.

c. The U.S. competitive position was eroded both at home and abroad. The high value of the dollar made imports cheap and exports expensive. The U.S. trade balance moved sharply into deficit.

d. No. In the short run there was a sharp deviation from purchasing power parity. The $ was trading at a price of over 3 DM, while in terms of what it would buy domestically it was worth only 2 DM (see p. 277).

e. After 1985, interest rates fell as fiscal policy tightened and monetary policy was relaxed. Interest rates fell and with them the exchange value of the $.

5. In the U.S. fiscal contraction led to lower dollar interest rates, while in Japan fiscal expansion led to an increase in the yen interest rate. The short term effect of these policies was to lower the value of the dollar in terms of yen, as investors sought the relatively higher yields in yen.

6. Exporters were happy because a lower value of the US dollar cut the foreign currency price of US goods on foreign markets and made exporting easier. It also gave exporters the option of taking some of the currency advantage in terms of higher dollar prices and increased profits.

7. The interaction of income determination and the exchange rate is not dealt with until Chapter 13. This chapter emphasizes the impact on the exchange rate through the money market and the interest rate only. Therefore what is relevant here is:

i. Expansionary monetary policy increases the money supply and cuts interest rates. This results in a situation less attractive for capital and the exchange rate depreciates.

ii. Expansionary fiscal policy on the other hand increases aggregate demand, raising the demand for money and increasing interest rates. This will cause the exchange rate to appreciate.

8. a. Arbitrage: taking advantage of price differentials in exchange rates between geographical locations or points of time. Arbitrage involves no risk.

b. Triangular arbitrage: involves taking advantage of inconsistencies between the exchange rate of three currencies, and thereby eliminating them. This ensures the establishment of orderly cross rates.

c. Speculation: the assumption of an open position in the foreign exchange market in the expectation that an exchange rate will move in a particular direction. Speculation does involve the assumption of risk.

d. The spot exchange rate is the rate applicable for the immediate delivery of a currency - usually within one or two days.

e. The forward exchange rate is the rate for a currency to be delivered after a specified period of time - usually 30, 60 or 90 days.

f. The future market is a sub-branch of the forward exchange market. The forward exchange market determines the rates for currency at periods into the future. It generally allows trading in contracts of any amount. Futures contracts are offered in standardized amounts with standardized delivery dates.

g. A short position involves a speculator selling currency in the forward market when she does not hold an equivalent amount of the currency. This is done in expectation of a price fall before the contract is due in order that she may buy to cover her position.

h. A long position is the purchase of currency for future delivery in excess of needs in expectation of a price rise.

i. Exchange rate overshooting occurs when the short-run response of an exchange to a disturbance is greater than the long-run response.

j. A vehicle currency is used as an intermediary to convert funds between two currencies when no market exists between them. The dollar which has a market with all currencies is the most frequently used vehicle.

k. Portfolio investment is the purchase of marketable securities, generally bonds and stocks. British purchases of shares in U.S. companies, or Japanese purchases of U.S. treasury bills are examples of international portfolio investment.

l. Direct investment consists of the purchase of a substantial part of firm, enough to give control, or the setting up of a subsidiary.

9. The basic relationship is laid out formally for the dollar/pound case in the Additional Insight section on page 286. More generally the relationship may be expressed:

where r_f is the forward rate, r_p is the spot rate and i_a and i_b are the interest rates in New York and London respectively for the period of time between the spot and the forward rate. If for example the spot rate between the D.M. and the dollar is 2 D.M. = $1, and the interest rate in Germany is 5% and in the US was 10%, then the 12 month forward rate would be 2.09 D.M. to the dollar.

10. a. This is a capital inflow into Canada. It would increase the value of the Canadian dollar and worsen Canada's manufacturing competitive position.

b. This is another form of capital inflow. It too would worsen the competitive position.

c. This would lower the value of the Canadian dollar through its effect on the merchandise trade balance, and it would improve manufacturing's competitive position.

d. The decline in gas exports would lower the value of the Canadian dollar and improve the manufacturing competitive position.

11. Expansionary monetary policy can, for example, effect the interest rate through both a direct channel, a lower discount rate, and through its impact on the supply of money. (See the Additional Insight section on p. 273.)

12. Overshooting occurs when the immediate response to a disturbance is greater in magnitude than the long-term response. The real key to understanding this phenomenon lies in the interest rate parity conditions that are discussed in the Additional Insight section on page 286. Consider, for example, a 10% increase in the money supply by the US Federal Reserve. This move will cause US interest rates to fall below, say, the rate on deutschemark deposits, and remain below until US prices have risen to adjust to the new equilibrium level. In the short-term, however, equilibrium in the financial markets requires that lower US interest rates be offset by an expectation that the dollar will appreciate in value. Therefore the short-run response is excessive, say a depreciation of 16%, and the value of the dollar subsequently rises to its long-run equilibrium level (ceteris paribus 10% below its original value) as the US price level adjusts.

Chapter 12

1. The French government will maintain a fixed exchange rate between the franc and the dollar by intervening in the foreign exchange market to buy francs, and support the value of the franc, each time it tends to fall outside its limits, and sell francs each time it tends to rise outside the limits. The diagram used in Chapter 11, question 2 should be modified to show limits at which the French monetary authorities must intervene to buy or to sell the franc to keep the exchange value within those limits. In the text these limits are taken, for instructional purposes, to be 10% either side of par, which in this case is $0.17 per franc. Therefore the limits would be roughly $0.187 per franc on the upside and $0.153 on the downside.

a. i. An interest rate increase will tend to cause the franc to rise. French monetary authorities therefore intervene by selling francs. If unsterilized this leads to an increase in the domestic money supply, and there would be now a downward pressure on interest rates. Sterilization would result in a domestic open market operation consisting of buying francs and selling bonds equal in magnitude to the foreign exchange operation. Sterilization always leaves the domestic money supply unchanged.

ii. In this case the tendency is for the franc to fall out of its limits against the dollar. The authorities must therefore buy francs to support the exchange value. If unsterilized this would result in a decrease in the money supply. Sterilization would consist of the buying of bonds.

iii. Here the pressure on the franc is downward. The franc must be bought in the exchange markets and the money supply would contract without sterilization. Sterilization would consist of the buying of bonds.

iv. In the case of the expected downfall of the Socialist government the franc would tend to fall. Foreign exchange intervention is to draw on reserves to buy francs. The money supply would contract. Sterilization consist of buying bonds.

v. The initial increase in the money supply would lower interest rates. This would cause the value of the franc to fall. Intervention is required to draw on reserves and buy francs. If unsterilized this would result in the domestic contraction of the money supply. Sterilization would require an open market operation to buy bonds ensuring that the initial increase of 20% in the money supply is preserved.

b. Devaluation is the likely result.

c. The two historical periods of fixed exchange rates were the gold standard, which operated from about 1870 to the start of the First World War, and the Bretton Woods system, in force from the end of the Second World War to its collapse in 1973. Both are described on p. 299. Students might also discuss the operation of the EMS (pp. 302-304).

2. a. There are three types of regime. They are freely floating, fixed and managed floating exchange rates.

b. i. Freely floating currencies - a deficit is reflected in the depreciation of the currency with no change in reserves.

ii. Fixed exchange rates - a deficit causes the reduction of reserves to maintain through intervention the parity of the currency.

iii. Managed floating currencies - a deficit is reflected in some combination of exchange rate change and reserve change.

c. The dollar does still retain a special role in the international system because it is

i. the reference currency against which other rates are measured.

ii. the most common vehicle currency through which thinly traded currencies can be converted.

iii. the most common intervention currency and other nations interventions affect the value of the dollar.

iv. the most widely used reserve currency.

v. the common unit of account in many compilations of international statistics.

3. The rise in interest rates in Germany, largely caused by the need to finance East German reconstruction, led to a sharp rise in the value of the mark. The only way the other member currencies of the EMS could combat this was by raising their own rates, but this would have a deflationary impact on economies that were already stagnating. Italy and the U.K were unwilling and unable to live with the higher rates and withdrew from the system. The general lesson is that policy between countries must be coordinated if a system of fixed exchange rates and free capital flows is to survive.

4. a. A bilateral exchange rate is the measure of the relative value of two currencies. An effective exchange rate measures a currency's value against the movements of all other currencies weighted by their importance to the home currency. Four weighting systems may be used: export-weighted, import-weighted, total bilateral trade flows and the share in worldwide trade.

b. Nominal exchange rates measure are rates unadjusted for differential changes in prices or costs. Real exchange rates adjust for inflation differentials using price or cost indices.

c. Basket-peggers are nations that tie their currency to a weighted index of several currencies. Single-currency peggers tie their currency to one leading currency alone.

5. a. Under regular IMF procedures a country may receive automatically a loan equal to 25% of its quota. It may subsequently apply for an additional 100% of its quota in loans, in tranches of 25%. These discretionary loans are subject to conditionality criteria. All loans, even the automatic drawings, are subject to repayments, (repurchases), under an agreed schedule, usually 3 to 5 years.

b. Under SDR procedures a nation may draw another currency by exchanging SDRs for the currency it requires. Its SDR holdings are reduced and the holdings of the nation whose currency it draws are increased. The borrowing nation is not required to fulfill any fixed repurchase schedule.

6. The value of the SDR is determined by the weighted average of the five most important currencies - the dollar, the deutschemark, the French franc, the yen and the pound sterling.

7. International reserves consist of gold, special drawing rights, reserve position in the IMF and a nation's holdings of convertible foreign currencies. Members of the EMS have additional reserves in their central pool to stabilize intra-EMS exchange rates.

8. a. A free float is where the value of a currency is determined by market forces without the intervention of the central bank to influence its value.

b. A managed float occurs when the central bank seeks to control or influence the value of its currency without publicly committing itself to any set parity.

c. The European Monetary System is an arrangement whereby eight European currencies are pegged in a fixed rate relationship to each other while floating jointly against the dollar and other freely convertible currencies. EMS membership currently consists of all the European community except Italy, and the U.K. Luxembourg, uses the Belgian franc, an EMS member.

d. A reserve currency is a convertible currency which nations use as part of their international reserves. The most common reserve currency is the dollar, with the D.M. and Yen growing in importance.

e. A vehicle currency is one which is used as an intermediary in the conversion of one thinly traded currency into another. This is necessary because there is no bilateral market between many currencies.

f. An intervention currency is a currency used by central banks in transactions to support or reduce the value of their own currency in exchange market operations. The dollar, as the leading reserve currency, is also the main intervention currency.

g. The transactions currency is the currency in which international transactions are denominated. The dollar is the most common transactions currency, although others, including the European Currency Unit are increasing in importance.

h. A nation's reserve position in the IMF is represented by the value of its undrawn first tranche (25% of quota less its own automatic drawings) plus the value of other country's drawings on its currency.

9. The dollar may be freely floating. Although there is a change in a component of the official transactions balance (line e) this only reflects an increase in dollar holdings by foreign central banks. The US monetary authorities may not therefore have intervened directly to affect the dollar's value which may consequently be subject to a free float.

10. a. The first concern of the Senators was that the dollar had appreciated in value between 1980 and 1985, and that this rise in the value of the dollar was having an adverse impact on the competitiveness of US industry. Since the concern relates to the effective exchange rate, this appreciation was not with one partner alone but was an average appreciation against the U.S.' trade partners. The fact that the rise was in both the nominal and the real rate shows that this appreciation was not due to America's prices or costs rising less slowly than the competitors, but did represent an erosion of competitiveness against the 1980 position. The immediate cause for senatorial concern was probably that the current account balance had deteriorated from a modest surplus in 1980 to a deficit of $107 billion in 1984.

b. While the Bretton Woods system assured relative constancy in exchange rates, the experience with the floating rate regime since 1973 had seen the value of the dollar fall first fall sharply, to 1978, and then rise very substantially in the subsequent period. These movements, much greater than the changes in relative inflation, were what the senators considered to be excessive gyrations.

c. The senators are in effect advocating a resort to a much greater degree of currency management. While remaining with a generally floating system the working group wanted the values of currency to be in part determined by joint intervention of the US and her trading partners.

11. a. Pegging the riyal to the SDR means that the exchange value of the riyal is limited to only minor fluctuations around the value of the SDR, itself determined by the weighted sum of the five leading currencies.

b. Since the SDR is not traded on the private market intervention must be made in one of the convertible currencies, generally the dollar.

12. Sterilization is designed to nullify the impact of foreign exchange operations on the domestic money supply. If the central bank intervenes to support its currency, it draws from reserves and buys its own currency. This causes the domestic money supply to contract. Sterilization consists of an equally sized domestic open market operation. Bonds are bought and the money supply is increased by an amount equal to the exchange market intervention. The reverse analysis applies if the exchange intervention is designed to reduce the currency's value.