A. a House in London Whose Price Appreciates from 200,000 to 300,000 in a Year

Economics 181

Homework # 1

We know for a country to reduce a current account deficit, the country can increase private spending, cut domestic investment, or reduce its government budget deficit. Yet, when the U.S was in this situation during the 1980’s, many officials suggested a restriction on imports from Japan and other countries to bring relief to the U.S.’s current account deficit. How would the U.S.’s increased barriers to imports affect each of its private savings, domestic investment, and government deficit? Do you agree that import restrictions would necessarily reduce the U.S.’s current account deficit?

One strategy for growth that developing countries have used is to encourage large inflows of foreign capital. Additionally, some analysts of developing countries hold the notion that exports should be encouraged and imports discouraged in order to promote growth. Is it possible to undertake both of the above strategies simultaneously? Show why or why not using your knowledge of national income accounts and balance of payments accounts.

Calculate the dollar rates of return on the following assets, where the $/£ exchange rate is constant at $1.30 per pound:

a. A house in London whose price appreciates from £200,000 to £300,000 in a year.

b. A £100,000 deposit in a European bank where you are guaranteed return of 10% at the end of the year.

Now, do the two cases above, but assume that the $/£ exchange rate moves from $1.30 per pound to $1.57 per pound by the end of the year for part a, and $1.25 per pound in part b. What are the new dollar rates of return on the above assets over the one-year period?

Suppose you have $50,000 you wish to invest. For each of the following scenarios explain whether you would be better off putting your money in the foreign or domestic alternative presented. Assume that the level of risk is same for the two alternatives in each case.

a. You don’t anticipate needing your money for 10 years. Historically the US stock market has a long run return of about 15% per year. You expect that trend to continue. The stock market in Taiwan has historically yielded a return of 22% per year, though you expect only half that return over the next ten years due to the financial turmoil in Asia. A US dollar is currently worth 33 Taiwanese dollars. You expect the exchange rate to hold steady over the next ten years.

b. You know you will need your money in 2 years. The interest rate on corporate bonds in the US is 5% while corporate bonds in Peru carry an interest rate of 14%. The current exchange rate is 3.34 New Sol per dollar. You expect that in two years the exchange rate will be 4.8 New Sol per dollar.

c. You only want to invest for four months. The interest rate on bank deposits on Euros is 4.5% while that on dollar deposits is 3.5%. The current exchange rate is 0.92 Euros per dollar. You expect the exchange rate to be 0.93 Euros per dollar four months from now.

Suppose that the South African interest rate is 4% and the US interest rate is 6%.

a. If the expected future spot exchange rate one year from now is 6.05 Rand per dollar, what must the current spot exchange rate be in order to clear the foreign exchange market?

b. Suppose that the expected future spot rate is 6.25 rather than 6.05. How does that alter the equilibrium exchange rate you calculated in part a?

c. Using the expected exchange rate from part b, explain what would happen if the South African interest rate happened to be 6.7%. Can your answer to part b also be the answer to this question? Explain.

d. (A bit more advanced) Ignoring your expectations about the future spot rate, what would be the equilibrium forward exchange rate using the information given in part c if there is no risk premium and covered interest rate parity (see Appendix to Ch. 13) holds?