Bagian A

1. The Trilemma and Exchange Rate Regime Choice

a. Capital controls are established to regulate financial flows from capital markets into and out
of a country's capital account. These controls can be economy-wide or specific to a sector or
industry. Capital controls are enacted by government policy and can restrict the ability of
domestic citizens to acquire foreign assets, referred to as capital outflow controls, or
foreigners' ability to acquire domestic assets, known as capital inflow controls.
Countries such as China that favor monetary independence and exchange rate stability must
impose capital controls. This means that government may exert its power to control over the
money supply and interest rates to help stabilize the economy as well as to limit the
movement of the exchange rate to ensure that it stays stable. This will result in, expectedly,
less volatile exchange and a more stable domestic economy. However, capital controls
exerted by the government limit the outflow and inflow of foreign capital within the
country. For example, Chinese citizens are thus restricted in their ability to diversify their
portfolios by investing abroad. Along with China, economies under the former Bretton
Woods system, Argentina, and Malaysia among others lie on the top vertex of the triangle.
b. Pure float means that a nation’s currency is determined purely by supply and demand in the
foreign exchange market. Countries that pursue monetary independence and allow for the
free movement of capital across its borders, will have to let their exchange rate to float in
the market. For example, US’s The Fed is “not obligated” to maintain US dollar stability.
Instead, it just has to use its monetary policy to fight inflation and stimulate domestic
economic growth. The nation also lets its citizens to invest abroad while also letting
foreigners to buy US stocks and bonds. As a result of pursuing those two, dollar value is
vulnerable in the market, making it fluctuates time over time.
c. Credibly fixed exchange rate may occur when a country decides to have stable exchange rate
and integrated capital market, letting the government to have no monetary independence.
As a result, it has to “adopt” other country’s monetary policy as it is or what we called as to
peg the monetary policy against the country it chooses. For example, Hongkong chooses to
peg against US monetary policy, resulting in a situation where it has to inherit all the
consequences as well. Another example is when EU countries giving up their national
monetary policy to use euro. The new currency guarantees free movement around the zone,
but all member countries can no longer use their national monetary policy to address other
economic problems.

2. China has been strictly regulating its currency or peg its currency against US dollar since long
time ago. However, since 2005, it started to follow a floating exchange rate and letting its
currency to devaluate. While this may induce the exports of the nation, there are other
indicators that have to be considered of.
a. By devaluing its RMB against US$, China could boost its exports. If the value of RMB
decreases against US$, the price of the goods sold by Chinese manufacturers in America, in
dollars, will be effectively less expensive than they were before.
b. However, as the export sees a significant increase, China has to understand that at some
point the price of the export goods may increase as well to reach the new equilibrium, thus,
normalizing the effect of devaluation.
c. Devaluation in RMB will also lead to currency war since other countries don’t want to be
defeated by China in term of exports. Thus, other countries will devalue their currencies
following China’s move.
 d. As exports increases due to the cheaper price abroad, imports will decrease as the price in
domestic market gets more expensive. This favors an improved balance of payments as
exports increase and imports decrease, shrinking trade deficits.
e. The decrease in imports may actually expose the nation to a new risk of inflation. Since
goods are more expensive, people are reluctant to spend their money. Thus, the amount of
money in the market gets larger. If it continues, the economic growth may be at risk.
f. Moreover, devaluation may actually increase the debt burden of Chinese government’s
foreign-denominated loans when priced in RMB.
g. People will also move all their money and exchange it into US$

3. Explain
a. Parity condition presents a set of equilibrium relationships that should apply to product
prices, interest rates, and spot and forward exchange rates if markets are not impeded.
b. Arbitrage is simultaneous purchase and sale of the same assets or commodities on different
markets to profit from price discrepancies.
c. In competitive markets, characterized by numerous buyers and sellers having low-cost
access to information, exchange adjusted prices of identical tradable goods and financial
assets must be within transaction costs of equality worldwide. This is referred to as the law
of one price which is enforced by international arbitrageurs who follow the profit-
guaranteeing dictum of “buy low, sell high” and prevent all but trivial deviations from
equality. Similarly, in the absence of market imperfections, risk adjusted expected returns on
financial assets in different markets should be equal.
If international arbitrage enforces the law of one price, then the exchange rate between the
home currency and domestic goods must equal the exchange rate between the home currency
and foreign goods.

4. Theoretically, increase in inflation in A will create depreciation in exchange rate of A against B’s.
Inflation is closely related to interest rates, which can influence exchange rates. Countries
attempt to balance interest rates and inflation, but the interrelationship between the two is
complex and often difficult to manage. Low interest rates spur consumer spending and
economic growth, and generally positive influences on currency value. If consumer spending
increases to the point where demand exceeds supply, inflation may ensue, which is not
necessarily a bad outcome. But low interest rates do not commonly attract foreign investment.
Higher interest rates tend to attract foreign investment, which is likely to increase the demand
for a country's currency. At the same time, when inflation occurs, people will hold more money
while the goods available in the market is not sufficient, meaning that the demand for goods has
increased as well. To ensure that the demand is fulfilled, the domestic industries have to boost
their production while importers may take this opportunity to sell more overseas goods
domestically. The increase in imports induces another increase in foreign currency, which at the
same time may decrease the value of the currency.

5. Capital flight refers to the export of savings by a nation’s citizens because of fears about the
safety of their capital. The World Bank methodology estimates capital flight as ‘‘the sum of gross
capital inflows and the current account deficit, less increases in foreign reserves.’’5 These
estimates indicate that capital flight represents an enormous outflow of funds from developing
countries. Capital flight occurs for several reasons, most of which have to do with inappropriate
economic policies: government regulations, controls, and taxes that lower the return on
 domestic investments. In countries in which inflation is high and domestic inflation hedging is
difficult or impossible, investors may hedge by shifting their savings to foreign currencies
deemed less likely to depreciate. They may also make the shift when domestic interest rates are
artificially held down by their governments or when they expect a devaluation of an overvalued
currency. Yet another reason for capital flight could be increases in a country’s external debt,
which may signal the likelihood of a fiscal crisis. Perhaps the most powerful motive for capital
flight is political risk. In unstable political regimes (and in some stable ones), wealth is not secure
from government seizure, especially when changes in regime occur. Savings may be shifted
overseas to protect them. Common sense dictates that if a nation’s own citizens do not trust the
government, then investment there is unsafe. After all, residents presumably have a better feel
for conditions and government intentions than do outsiders. Thus, when analyzing investment
or lending opportunities, multinational firms and international banks must bear in mind the
apparent unwillingness of the nation’s citizens to invest and lend in their own country. Between
1997 to 1998, Indonesia was facing a severe financial crisis which was accompanied with the
unstable political situation where people were doing demonstration to overthrow the current
regime. Indonesian currency was depreciating too rapidly that everyone starts to exchange it for
dollars resulting in a disastrous financial crisis.

6. Monetizing the deficit is a government’s action to print money to cover the government’s
deficit. This will usually result in monetary instability, high inflation, high interest rates, and
currency depreciation.