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Solutions to Even-Numbered, End-of-Chapter Questions, Problems, and Exercises
Chapter 16 Exchange Rates and Macroeconomic Policy
Review Questions
2. Foreigners supply foreign currency (say, in the market where their currency is exchanged for U.S. dollars) because they want to buy U.S. goods and services or U.S. assets. In general economists believe that the supply curve for foreign currency is upward sloping. As the price of foreign currency increases, U.S. goods and services become cheaper. Foreigners buy more U.S. goods and services, and supply more foreign currency to get the dollars with which to buy the goods. The following shift the supply of foreign currency schedule to the right: an increase in foreign GDP, an increase in the relative interest rate in the United States, a change in tastes that makes U.S. goods more desirable to foreigners, a relative decrease in prices in the United States, and an expectation that the foreign currency will depreciate. The following shift the supply of foreign currency curve to the left: a decrease in foreign GDP, a decrease in the relative interest rate in the United States, a change in tastes that makes U.S. goods less desirable to foreigners, a relative increase in prices in the United States, and an expectation that the foreign currency will appreciate.
4. In the very short run, exchange rates move mainly due to changes in interest rates and expectations of future exchanges rates since these forces drive hot money. In the short run, business cycles account for most of the change in exchange rates. Countries with higher relative GDPs demand more foreign currency, causing their own currencies to depreciate.
6. Purchasing power parity says that the exchange rate between two countries should adjust until the average price of goods is approximately the same in the two countries. Exchange rates might deviate from purchasing power parity because of high transportation costs, barriers to trade, and the inherent difficulty in trading some goods.
8. A managed float is when the central bank intervenes in the foreign currency market to prevent an appreciation or depreciation of its currency. Governments use a managed float to help their export-oriented industries, to keep costs down for firms that import inputs, or to decrease the risks of international trade that arise from exchange rate changes.
10. During the 1980s interest rates rose due to the rising budget deficit, a burst of investment spending, and a drop in the private saving rate. All of these contributed to a higher U.S. interest rate, and a capital inflow, as foreigners purchased more U.S. assets than Americans purchased of foreign assets. The dollar appreciated making American goods more expensive to foreigners, and foreign goods cheaper to Americans, and a trade deficit resulted. The trade deficit persisted in the 1990s because of the continuing budget deficit, strong investment spending, and relatively low private savings.
12. Managed floats are controversial because countries often intervene when the forces behind an appreciation or depreciation are strong, which only serves to delay inevitable changes in the exchange rate—sometimes at great cost to a country’s currency reserves.
Problems and Exercises
2. a. Setting the quantity of pounds demanded equal to the quantity supplied, we have
10 – 2e = 4 + 3e Þ 6 = 5e Þ e = 6/5, or 1.2 dollars per pound.
b. After the U.S. government intervenes, the demand for pounds equation becomes
12 – 2e. Resolving for equilibrium, the exchange rate climbs to 1.6 dollars per pound, a depreciation of the dollar. The U.S. government might intervene in this way if it wanted to help its export-oriented industries.
4.
a. As the money supply decreases, the interest rate rises, causing a and I to fall, and, therefore, decreasing GDP. As the interest rate rises, U.S. assets are more attractive to Americans and Mexicans. This, combined with the fall in U.S. GDP, causes the demand curve for Mexican pesos to shift leftward and the supply curve to shift rightward. The U.S. dollar appreciates.
b. The U.S. dollar appreciation causes net exports to fall, further shrinking equilibrium GDP in the U.S.
c. If the Mexican central bank raised its interest rates just as much as the United States, then the dollar would not appreciate as much. (It might still appreciate somewhat, depending on the relative decline in U.S. and Mexican GDP, and the impact of these declines on U.S. net exports). While U.S. output would still fall, it would not fall as much as in the initial analysis.
6. a.
b. A fixed rate of 1.41 dinars per dollar is the equivalent of $0.71 per dinar. Since this is higher than the market equilibrium price of $0.50 per dinar, Jordan’s central bank must buy dinars to keep the dinar from depreciating.
c. Jordan would eventually run out of foreign reserves, and so could not buy dinars forever.
d.
An expected fall in the dinar causes the supply curve for dinars to shift rightward from S1 to S2and the demand curve to shift leftward D1 to D2.
e. The end result is that Jordan’s central bank must buy even more dinars to maintain the fixed rate
8. Since Country B has the higher inflation rate, its relative price level is rising. As its basket of goods becomes relatively more expensive, only a depreciation of its currency can restore purchasing power parity. Traders would buy Country A’s currency in order to buy its goods for resale in Country B. Country A’s currency will appreciate relative to Country B’s (alternately stated: Country B’s currency will depreciate relative to Country A’s).
10.
(a) (b)
(c)
The initial increase in the money supply causes the interest rate to fall (panel (a)), which increases investment and consumption spending, which shifts the AD curve rightward from AD1 to AD2 in panel (b). The lower interest rate also shifts the supply of pounds curve leftward, and the demand for pounds curve rightward in panel (c). The price per pound measured in U.S. dollars rises, and this dollar depreciation causes net exports to rise. This shifts the AD curve rightward from AD2 to AD3 in panel (b). Monetary policy is more effective when the effects on exchange rates are included.
Challenge Questions
2. More spending by the U.S. government causes U.S. interest rates to rise. This makes U.S. assets more attractive, increasing the supply and decreasing the demand for foreign currency. The dollar appreciates, causing net exports to fall, thus reducing real GDP. This makes fiscal policy less effective in changing equilibrium GDP than it would be if the effects on exchange rates were excluded.
Economic Applications Exercises
2. a. Virtually all economists argue that free international trade increases the total consumption possibilities for all trading partners. Adam Smith noted in The Wealth of Nations, total output increases in an economy as a result of specialization and division of labor. It is argued that countries gain in a similar manner as a result of international specialization and division of labor. David Ricardo elaborated on this argument by noting that gains from international trade will always occur when each country specializes in the production of those goods and services in which it possesses a comparative advantage. A comparative advantage exists when the opportunity cost of producing a good is lower in the domestic economy than in foreign economies. The gains from trade occur because each country is able to import goods at a lower opportunity cost than it would face if it produced these goods domestically. If each good is produced in the country in which the opportunity cost is lowest, the total output of the world economy is greater.
b. Following Smith and Ricardo, most economists support free international trade and recognize only a few possible rationales for trade barriers:
· to protect “infant industries” that cannot compete effectively during their formative period but will acquire a comparative advantage in the future once a trained labor force and the necessary infrastructure has been developed,
· to protect industries that are important for national security reasons (to prevent political pressure from countries or cartels - such as OPEC - that might be able to exert control over a critical commodity or resource),
· as a mechanism for correcting for differences in environmental and labor laws that result in lower production costs in countries with fewer environmental and safety regulations, and
· as a temporary measure to reduce the adjustment costs associated with job losses due to the loss of comparative advantage in a particular industry.
The political reasons for trade barriers include:
· While consumers always gain from the reduction of trade barriers, firms and workers in specific industries are better off when substantial trade barriers exist. The owners of firms and workers in these industries receive very large losses if trade barriers are eliminated; each individual consumer tends to receive relatively small gains from the elimination of these barriers. If trade barriers are eliminated, the dollar value of the gains to consumers will always outweigh the dollar value of the losses to producers and workers. Each individual consumer, though, has little incentive to lobby for a reduction in specific trade barriers (nor is even aware of most such trade barriers). Each individual worker and owner, however, has a substantial incentive to lobby for such trade restrictions. This “special-interest” effect often results in the passage of laws resulting in trade barriers.
· There is also a concern that free trade with low-wage economies will reduce the wage of high-wage U.S. workers. In specific industries, such an effect is likely. This argument was at the heart of much of the opposition to NAFTA (since wage rates are generally lower in Mexico).
4. a. When the value of the dollar falls relative to the yen (the number of yen per dollar decreases), Japanese goods become relatively more expensive for the U.S. to import, while U.S. goods become relatively less expensive for Japanese to import. Thus when exchange rates drive the current account, the U.S. current account balance should rise when the value of the dollar decreases relative to the yen. As one can see in the diagram and the data table below, throughout the 1980’s and into the early 1990’s there tended to be an inverse relationship between changes in the U.S. current account balance and changes in the value of the dollar. Interestingly, since the mid-1990’s there has been a direct rather than an inverse relationship between current account and the value of the dollar in terms of yen.
b. One can see in the diagram on the Web site that rising real disposable personal income in the U.S. has helped fuel our consumption of imports. Specifically, the current account tended to be in deficit (imports exceeding exports) during times of growing real personal income as Americans used their rising affluence to finance the purchase of imports. Note that in each of the four recessions since 1980 (1981, 1982, 1990-91, and 2001, as well as the near-recession in 1995), the current account balance tended to increase, or at least decline more slowly, indicating that imports tend to decline during recessions. It is interesting to note that real personal disposable income has continued to grow even through our most recent recession, spurring greater consumption of imported goods.