Chapter 12: ANSWERS TO "DO YOU UNDERSTAND" TEXT QUESTIONS
DO YOU UNDERSTAND?
1. Why should purchasing power parity exist? Why might it not hold?
Solution: (a)Becauseofthelawofoneprice,thesamegoodorequivalentgoodsshouldcostthesameamountexceptfortransportationcostdifferencesifthegoodsareindifferentplaces.Thus,exchangeratesbetweencurrenciesshouldbesuchthatequivalentsetsofgoodsshouldcostapproximatelythesameindifferentcountriesafterconvertingtheirpricesfromonecurrencytotheother.(b)Short-term,long-term,orpoliticallymotivatedcapitalflowscancauseexchangeratestodivergeasfundsflowfromonecountrytoanother.Furthermore,tariffs,quotas,exportandimportfees,andothernontariffbarriersmaypreventgoodsfrombeingtransferredfromonemarkettoanotherwithoutincurringsubstantialcoststhatrequirethattheybesoldatahigherprice.Asaresult,pricesforsimilargoodsindifferentmarketsmayneverbeequalized.
2. What can cause a country to have a deficit in its current account balance of payments?
Solution: A deficit on its balance of trade in goods and services that results from importing more goods and services from abroad than it exports, a deficit on its investment income balance caused by paying more interest and dividends to foreigners than it receives from abroad, or a deficit caused by net flows of unilateral transfers abroad in the form of gifts, aid, and other unilateral transfer payments.
3. Is it always true that when a country has a deficit in its trade balance, the value of its currency will decline? Explain.
Solution: Two types of funds flow impact foreign exchange rates: trade flows and capital flows. If as in the U.S. for many years, there is a deficit in the trade and current account, foreign investors may demand the glut of dollars supplied from trade for the purchase of dollar denominated U.S. securities. For many years in the U.S. growing trade deficits and a strengthening dollar existed.
4. What types of capital flows exist between countries and what can motivate each type of flow?
Solution: Capital flows may be made in the form of direct investment (purchase of a plant), direct financial investment (purchase of stock in a company), or from inter-governmental capital flows.
5. Why must the balance of payments always balance?
Solution: Just as "purchase" of assets (balance sheet) must be matched by "payments" of cash or an IOU, so the balance of payments accounts must theoretically balance.
DO YOU UNDERSTAND?
1. What could a government do to support the value of its currency in the foreign exchange market?
Solution: It could buy its currency by selling some of its stock of reserve currencies or gold, or it could borrow currencies from foreign countries and use the borrowed currencies to buy its domestic currency in the exchange markets. Such interventions might only have a temporary effect, however, unless it addressed its major problems by reducing its money supply to raise interest rates to attract foreign capital inflows and restrain domestic inflation.
2. How can a firm reduce its risk by engaging in forward currency transactions? Why are losses on such transactions often more apparent than real?
Solution: It can reduce its risk that foreign currency values change adversely prior to the time it must make payments in or receive a foreign currency by prearranging the exchange rate for that currency into or out of its domestic currency. Thus, a firm that expects to receive British pounds in the future may sell the pounds forward at a prearranged price, such as $1.58 per pound, in order to assure itself that the dollar revenues it receives will guarantee a profit on the transaction. If the British pound were currently trading at $1.60 per pound, some might say that it would lose on the forward transaction. However, the forward exchange rate will be lower than the spot rate primarily because British interest rates are higher than domestic rates—usually because expected inflation is greater in Britain than in the United States. If inflation is high, the pound will be losing purchasing power over time—thus, pounds received in the future will be worth less than pounds received now. Consequently, it is only logical that the future receipt of pounds should be worth less than current pound holdings— and that difference is reflected in the difference in the spot and forward exchange rates.
3. When a country has high inflation, why is it risky for a foreigner to invest in that country?
Solution: Because, over time, sustained inflation will cause the value of that country’s currency to decline. Unless it is possible to earn returns that are higher than the possible loss in value caused by currency devaluations, investments in that country may not earn positive net returns after accounting for currency exchange losses. Furthermore, countries that experience balance of payments problems often impose capital controls so people cannot take their funds out of the country easily just because they fear the currency will be devalued. Thus, it may be easier to invest in the rapidly inflating country than to repatriate the principal invested or earnings on the investment.
4. Why might consumer groups support government policies that maintain a “strong” U.S. dollar?
Solution: A "strong" dollar buys more foreign consumer goods (clothing) and services (travel abroad) than a "weak" dollar, but at the same time encourages the exportation of
manufacturing jobs out of the country. Those consumers that are working want a strong dollar.
5. If the United States has a high rate of inflation, what will likely happen to the value of the dollar? Why?
Solution: A rate of inflation higher than that of trading partners should, everything else the same, produce a glut of dollars on the forex market and the dollar should depreciate. With higher inflation, foreign prices are cheaper, creating a trade and service deficit, and depreciating the dollar on forex markets.