Practice Questions For

Practice Questions for

International Trade Theory for the Determination of FOREX Rate in the Short- and Long-Run.

(We will discuss some of these questions, but it would be critical that you try beforehand)

Suppose that the Purchasing Power Parity holds for a new ‘I Phong 7’ by Appule in the world. Suppose that it costs $1000 in U.S.

Country / Local Price / PPP Equilibrium FOREX Rate for a US citizen ( so many units of USD for 1 local currencies) / Actual FOREX rate for a U.S. citizen / Is the local currency Overvaluaed(+) or Undervalued)-)?
U.S. / 1000 Dollars / 1 / 1 / 0
Canada / 1300 / 1/1.4
U.K. / 500 / 2
Japan / 100,000 / 1/110
China / 7000 / 1/6
Formula?

(Hint: It would be easier if you insert one more column of the U.S. price of the I Phong. It is because all FOREX rates are here expressed against ‘I USD’ or E = # Local Currencies per 1 USD:

Answer:

Country / PPP eq.
Price in USD
P / Actual
Local Price
Pf / PPP eq.
US FOREX Rate
E / Actual Local FOREX rate
E’ / Is the local currency Overvaluaed(+) or Undervalued)-)?
If E’<E, then
“USD gets more local currencies than it should”:
USD is overvalued, and
Local Currency Undervalued
U.S. / USD 1000 / 1000 / 1/1 / 1 / 0
Canada / USD 1000 / 1300 / 1/1.3 / 1/1.4 / CAD undervalued
U.K. / USD 1000 / 500 / 2 / 2 / 0
Japan / USD 1000 / 100,000 / 1/100 / 1/110 / overvalued
China / USD 1000 / 7000 / 1/7 / 1/6 / Overvalued
“According to PPP, 1 USD should get 7; In reality 1USD gets 6”.
Formula? / P/Pf = E;
E Pf = P

The Purchasing Power Parity itself concerns the Long-run and the Flexible Price Level.

All goes through its impact on the Price Level in the long-run:

Absolute version of PPP: E = P/Ff; or

Relative Version of PPP:

%d E =% dP - % dPf ------(1)

%d E = %dM- % dy+ %dv - { %dMf - %d yf + %dvf} by Monetarists Theory

%d E = %dM- % dy - %dMf + %d yf by assuming %d v and %d vf are zero------(2)

It is convenient to use the Relative Version of the PPP as we are mainly interested in the change in E.

Use the following table for the start of your analysis:

%d E = / %d P (+) / %d Pf (-)

d% E = / d% M (+) / d% y
(-) / d% M
(-) / d% y
(+)

1)Inflation in this economy gets accelerated. What will happen to E on PPPin the long-run?;

Answer:

%d E = / %d P (+) / %d Pf (-)
Up / Up / No change

E will rise;

Domestic Currency depreciates/Foreign Exchange appreciates.

(Note: what will happen to interest rate? According to Irving Fisher, nominal interest rate = real interest rate + expected rate of inflation. The accelerated inflation means an ever increasing inflation rate. Thus, the nominal interest rate goes up even if the real interest rate does not change. Here, E and I are moving in the same direction in the long-run)

2)The monetary authority adopts expansionary monetary policy one time only, and its impact on the price level is insignificant due to the on-going weakness of the economy. Here, please, focus on trade, and ignore the impact on international financial market and investment.

One Time:

(Hint: as there is no change in P or Pf, the purchasing power parity theory would not tell anything about a possible change in E. This is only a temporary change, which in time will wear out).

Answer:

In short-run: … (1)

Expansionary monetary policy will lead, in the short-run, a large national income.

What will be the impact of an increase in national income on trade and trade balance? Imports will rise as income rises. Thus Trade Account/Balance X-M will go down.

Net supply of FOREX will go down. An excess demand for FOREX occurs.

Thus, E will go up. There will be depreciation of domestic currency.

In the long run equilibrium….(2)

A one-time expansionary monetary policy may not lead to any change in P if there is room in the economy and national income is below the full employment level. It will push up the price level if the economy is at the full employment level. Even for this case, it will have insignificant impacts on the price level(except for one time increase in P). Thus, E = P/Pf means no significant change in E(except for one time increase in E).

However, if it is repeated over and again, it is a different story where inflation may develop. Thus, there is no reason why E = P/Pf should change in the long-run.

How to reconcile between (1) and (2)?

As E rises, dE =1 up on the cost side (immediately) but dX –dM up on the benefit side(eventually) as is suggested by the J curve theory. As X up and M down, or dX-dM UP, the supply of FORX rises and thus E starts falling back. This partially or totally offset the initial E up. Thus, in the end, the net change in E is not that significant for a one-time increase in MS. Recall that a repeated or continuous increases in MS lead to inflation and depreciation of FOREX in the long-run.

3)The fiscal authority adopts fiscal monetary policy one time only, and its impact on the price level is insignificant due to the on-going weakness of the economy.

In the short-run:

(Hint: as there is no change in P or Pf, the purchasing power parity theory would not tell anything about a possible change in E. This is only a temporary change, which in time will wear out).

In short-run:

Expansionary fiscal policy will lead, in the short-run, a large national income.

On Trade Account, Imports will rise as income rises. X-M will go down.

And net supply of FOREX will go down.

Thus, E will go up. This is a depreciation of domestic currency

In long-run:

A one-time expansionary monetary policy may not lead to any change in P if there is room in the economy and national income is below the full employment level. It will push up the price level if the economy is at the full employment level. In any case, it will have insignificant impacts on the price level. If it is repeated over and again, it is a different story where inflation may develop. Thus, for once-for-all change in G, there is no reason why E = P/Pf should change in any significant manner in the long-run. The permanent impact on E would again insignificant.

4)The strong economic growth starts due to healthy change/turn-around of the fundamentals of the economy such as on-going technical innovation

In short-run:

We have already seen an increase in Y leads to M up; X-M down; ED of FOREX, and thus E Up….(1)

In the long-run:

A strong economic growth in the long-run cause the price level to fall without any decrease in Y.

%d E = / %d P (+) / %d Pf (-)
Down / Down
d% E = / d% M (+) / d% y
(-) / d% M
(-) / d% yf
(+)
Down / Up

….(2)

Which one will the bigger, out of (1) or (2)? It really depends on the magnitude of the strength or improvement/innovation of the real sector. If technical innovation is strong and the improvement of economic fundamentals, including productivity, is substantial, then on the net basis, E may go down over time in the long-run.

5)The monetary authority starts expansionary monetary policy, which increases real national income (y) but not the price level due to the ongoing recession in the economy.

This is the Same as 2.2)

In the short-run.

Y up; M Up; X-M Down; Supply of FOREX down; E will go Up.

In the long-run:

%d E = / %d P (+) / %d Pf (-)
0 / 0

Again, in between the above short-run and the long-run, there is a period of adjustment:

A rising E encourages X, and an increasing X means a falling E. Thus the initial rise of E is at least partially offset by a falling E. No significant change in E in the long-run.

6)*The monetary authority starts expansionary monetary policy, which raises the price level but not real national income as the economy is close to the full employment level.

In short-run, no real impact on Y or thus on X-M,

In long-run, P eventually rises, and thus E eventually rises as well one-time only.

%d E = / %d P (+) / %d Pf (-)
Up / Up

In the International Trade Approach to FOREX rate, we can think of the Short-term direct impact on Supply and Demand of FOREX, and its impact on FOREX rates. In an exact sense, this is only a Trade Approach to FOREX rate, not exactly the Purchasing Power Parity Theorem because the Price Level is assumed to be constant, which may be the case in the short-run. For each one, use the following table of the Current Account portion of the Above-the-line Balance of Payment Table:

Supply of FOREX(+) / Demand for FOREX(-) / Net: Excess Supply
Exports(X) / Imports(M) / X-M
Up or Down / Up or Down / Up or Down
Impact on Price of FREX / Down or Up

1)International Demand for domestic goods (Exports) falls (the price level remains unchanged).

In short-run

Supply of FOREX / Demand for FOREX / Excess Supply
Exports / Imports / X-M
Down / 0(no change) / Down
Impact on Price of FOREX or E / Up

2)Domestic Demand for domestic investment (such as construction) falls. And the national income falls (the price level remains unchanged).

In short-run….(1)

As Y falls, M falls. X-M improves. ES of FOREX. E should fall.

Supply of FOREX / Demand for FOREX / Excess Supply
Exports / Imports / X-M
No change / Down / Up
Impact on Price of FOREX or E / Down

*We do not have to think of this for now, but In long-run….(2)

Unless it pushes up Price Level significantly, E would not change significantly.

How to reconcile (1) and (2): In the midterm, the falling E as shown in (1) may lead to M up and M down. If dX – dM> 1, then Trade Account X- E M rises back and partially offset the falling X-M. In the end, not much change in E.

3)Economy booms and national income rises (the price level remains unchanged).

In short-run.

Supply of FOREX / Demand for FOREX / Excess Supply
Exports / Imports / X-M
Up / Down
Impact on Price of FOREX or E / Up

In long-run, no significant change in E

4)Suppose that international demand for export goods rises for the reasons to be found in the Japanese economy, such as ever improving quality or ever rising productivity.

In the short-run

Supply of FOREX / Demand for FOREX / Excess Supply
Exports / Imports / X-M
Up..Up…Up / Up
Impact on Price of FOREX or E / Down..Down---Down

5)A one-time Fiscal Policy increases national income.

The same as 2.3).

Supply of FOREX / Demand for FOREX / Excess Supply
Exports / Imports / X-M
Up / Down
Impact on Price of FOREX or E / Up

(Hint: it may not matter whether it is fiscal or monetary policies; what matters is Imports which is a function of domestic national income (and relative price which is assumed to be constant for now), Exports, which is a function of foreign national income (and relative price which is assumed to be constant here).

6)A one-time expansionary monetary policy increases national income.

Refer to 2.1), 2.2), 2.3) and 2.5).

Supply of FOREX / Demand for FOREX / Excess Supply
Exports / Imports / X-M
Up / Down
Impact on Price of FOREX or E / UP

7)What will happen to the Canadian FOREX rate if the U.S. economy is expected to boom?

Supply of FOREX / Demand for FOREX / Excess Supply
Exports / Imports / X-M
Up / Up
Impact on Price of FOREX or E / Down

4. We may combine the above 3. and 2. in the short-run (P is assumed to be fixe) and the long-run (P is now fully flexible) respectively. Still let us focus on Trade Account.

What will be impacts on FREX rate in the short-run (with rigid level) and in the long-run (with flexible price level) respectively? Obviously you will have to use the Trade Approach. Specify what theories you are using for the analysis of the short- and the long-term impacts.

1)The government applies Monetary Policy, one time only, to increase national income.

In the short-run, an increased national income will lead to more consumption of all goods, including Imports. As there is no reason why exports should change as there is no change in foreign country’s national income. Thus X-M falls, and E may rise. (however, the rising E will be worn out as the compensating changes happen over time: X-M rebounds and E falls to some extent).

Supply of FOREX / Demand for FOREX / Excess Supply
Exports / Imports / X-M
No change / Up / Down
Impact on Price of FOREX or E / Up
(later falling back to an extent)

In the long-run, we use the PPP

%d E =% dP - % dPf

%d E = %dM- % dy + %dv - { %dMf - %d yf + %dvf} by Monetarists Theory

%d E = %dM- % dy - %dMf + %d yf by assuming %d v and %d vf are zero.

In this case, there is some ambiguity on what will happen to the price level. It depends whether the current national income is at and above, or below, the full employment level.

However, we can deduct that no rational government would apply Expansionary Monetary Policy if there is a real danger of imminent inflation or touching it off. Beside, even if the economy is at the full employment level, a one-time-only increase in money supply would not lead to on-going inflation as is specified in the PPP. Thus, it would be safe to assume that there is no permanent change in inflation rates, or money creation rate, or long-term growth rate. E would not move around.

%d E = / %d P (+) / %d Pf (-)
None / None
d% E = / d% M (+) / d% y
(-) / d% M
(-) / d% y
(+)
None / None / None / None

2)The government adopts Expansionary Fiscal Policy one time only to increase national income.

Supply of FOREX / Demand for FOREX / Excess Supply
Exports / Imports / X-M
No change / Up / Down
Impact on Price of FOREX or E / Up
(later falling back to an extent)

In the long-run, we use the PPP

%d E =% dP - % dPf

%d E = %dM- % dy + %dv - { %dMf - %d yf + %dvf} by Monetarists Theory

%d E = %dM- % dy - %dMf + %d yf by assuming %d v and %d vf are zero.

In this case, there is some ambiguity on what will happen to the price level. It depends whether the current national income is at and above, or below, the full employment level. And how the government expenditure is funded.

However, we can deduct that no rational government would apply Expansionary Fiscal Policy if there is a real danger of imminent inflation or touching it off.

If government expenditure is funded by issues of bonds and bonds are purchased by the central bank with fresh new notes of money, Money Supply rises. However, a one-time-only increase in money supply would not lead to on-going inflation as is specified in the PPP. Thus, it would be safe to assume that there is no permanent change in inflation rates, or money creation rate, or long-term growth rate. E would not move around.

%d E = / %d P (+) / %d Pf (-)
None / None
d% E = / d% M (+) / d% y
(-) / d% M
(-) / d% y
(+)
None / None / None / None

It will be a completely different story if government expenditures will be fully funded by issues of bonds to be purchased by the central bank, not the general public, repeatedly on a on-going basis. Then, government expenditure may cause inflation and E should rise in the long-run.

If the bonds are purchased by the general public, government expenditures should not increase money supply (initially money supply falls as government sells bonds to the general public and then government expenditure puts money back to the private sector’s money supply- no net change in MS). And thus no inflation and no sustained changes in E in the long-run.

3)The monetary authority adopts Expansionary Monetary Policy over and again. And people think that this is only a start of continuous Expansionary Monetary Policy for the future.

(Hint: In the long run, %d P will change as does %d M, but %d y would not change. Why? What do the Monetarists say about the d%y and their contributing factors?)

You answer:

In the short-run

Supply of FOREX / Demand for FOREX / Excess Supply
Exports / Imports / X-M
Up / Down
Impact on Price of FOREX or E / Up

In the long-run,

%d E = / %d P (+) / %d Pf (-)
Up / Up
d% E = / d% M (+) / d% y
(-) / d% Mf
(-) / d% yf
(+)
Up / Up

4)The national income starts growing strongly (continuously) due to the improvement of the economy’s fundamentals, including productivity in general.

In the short-run

Supply of FOREX / Demand for FOREX / Excess Supply
Exports / Imports / X-M
Up / Down
Impact on Price of FOREX or E / Up

In the long-run,

%d E = / %d P (+) / %d Pf (-)
Down
d% E = / d% M (+) / d% y
(-) / d% Mf
(-) / d% yf
(+)
Up
Down

Which one would be larger? Most likely, the long-term force of E down would dominate the short-term force of E up.