International Economics: EC315 Lent Term, 2002 Suggested Solutions to Problem Set 1 Question 1: The Balance of Payments: Two

types of transactions are recorded in the balance of payments: - transactions that involve exports or imports of goods and services (CA) - transactions that involve the purchase or sales of assets (KA) Every transaction is automatically entered twice as a credit (+) and as a debit (-) (double entry book-keeping) Fundamental identity: CA + KA = 0 Transaction classification: Current account: Merchandise trade Investment income Other service Capital account: US assets held abroad (capital outflows): Foreign assets held in the US (capital inflows): Official Reserve Transaction Domestic central bank increases the amount of international reserve assets or assets in the rest of the world: debit (-) Foreign central bank increases assets in the domestic economy: credit (+) Exercise 3 (Krugman and Obstfeld chapter 12) US balance of payments entries: (a) An American purchases a share of German stock and pays by writing a cheque on an account with a Swiss bank. Debit the Capital A/C (the purchase of German stock increases US assets held abroad) Credit the Capital A/C (payment by the Swiss bank decreases US assets held abroad) increase (-) increase (+) credit export received received debit import paid paid

(b) An American purchases a share of German stock and pays by writing a cheque on an American bank. Debit the Capital A/C (the purchase of German stock increases US assets held abroad) Credit the Capital A/C (payment by American bank increases foreign assets held in US) (c) The French government carries out an official foreign exchange intervention in which it uses dollars held in an American bank to buy French currency from its citizens. Debit the Capital A/C (sale of $ by French government decreases foreign assets held in US) Credit the Capital A/C (purchase of $ by French citizens increases foreign assets held in US) (d) A tourist from Detroit buys a meal at an expensive restaurant in France, paying with a travelers check. Debit the Current A/C (US imports a service) Credit the Capital A/C (travelers cheque written implies a US asset export) (e) A Californian winegrower contributes a case of wine for a London wine-tasting (a gift) Debit the Current A/C (unilateral transfer) Credit the Current A/C (US exports a good) (f) A US-owned factory in Britain uses local earnings to buy additional machinery. Debit the Current A/C (investment income decreases) Credit the Capital A/C (increase in FDI) Note: Investment income is made up of international interest and dividend payments as well as the earnings of domestically owned firms operating abroad (the latter is perceived as compensation for the services provided by foreign investments). Exercise 5 (Krugman and Obstfeld chapter 12) (a) Let us define the Balance of Payments as in K& O i.e. Balance of Payments = Current A/C + Non-reserve Capital A/C So: Balance of Payments = -$1bn + $0.5bn = -$0.5bn i.e. a deficit

This implies net foreign assets are decreasing. Pecunia is running down its official international reserves or borrowing from foreign central banks. (b) Note that: Balance of Payments = Current A/C + Non-reserve Capital A/C = - (Change in official reserves) Thus the change in official reserves is +$0.5bn. This implies a net decrease of official foreign reserves which enters as a credit in the Balance of Payments. (c) and (d) Now we learn that foreign central banks have purchased $0.6bn of Pecunian assets in 1998. Pecunia: Capital inflows: increase in foreign assets held in Pecunia (+$0.6bn) Official reserve transaction: decrease in foreign central bank holdings of Pecunian official reserve (-$0.6bn) Foreign: Capital inflows: increase in assets held in Pecunia (-$0.6bn) Official reserve transaction: decrease in official reserve assets held abroad (+$0.6bn) Thus the Balance of Payments for Pecunia in 1998 is: Billion $ Credits Debits -1 +0.5 +0.6

Current A/C Non-reserve Capital A/C Pecunian official reserves held abroad Foreign official reserve assets held in Pecunia

-0.1 +1.1 -1.1

Question 2: Twin deficits Current Account = CA = X-M Y = C + I + G + CA Y C G = S = I + CA Now we decompose savings S into private and governmental savings:

S = Sp + Sg = (Y T C) + (T G) Note that Sg = (T G) = - (G T) = - (budget deficit) So substituting we get: Sp + Sg = I + CA CA = Sp I Sp CA = Sp I (G-T) Interpretation: For a given level of Sp and I, an increase in the budget deficit must be accompanied by a decrease in the CA surplus (or increase in the CA deficit). For example, consider an increase in government expenditure (G) such as the building of a bridge. If imported materials etc. are employed for the construction of the bridge there is an increase in M giving rise to the twin deficits phenomenon. Empirical studies reveal a correlation between the budget deficit and the CA deficit. However, the relationship is not as simple as it looks; Sp, Sg,, I and CA are jointly determined so the relationship does not give a clear theoretical causal link. Read the empirical discussion found in Krugman & Obstfeld Chapter 12. Question 3: Triangular arbitrage Consider e/$ = 0.6, e/$ = 120 and e/ = 180. (a) An arbitrage opportunity arises when the system of exchange rates is internally inconsistent. That is, assuming negligible transaction costs, one can end up with more money than he started with by exchanging his currency with foreign currency and back again. Under the assumption of negligible transaction costs any arbitrage opportunity will be exploited through buying and selling of currencies since such opportunities yield a riskless profit (unlike profits earned by speculation which are associated with risk where the extent of investor speculation depends on risk preference) With significant transaction costs, arbitrage opportunities will be exploited up to the point where the marginal benefit of taking the opportunity is equal to the marginal transaction cost involved. The exploitation of an arbitrage opportunity induces adjustment in the exchange rates until the internal inconsistency and thus arbitrage opportunity disappears. Under negligible transaction costs, there is no arbitrage opportunity when:

e/$ = e/ e/$ (b) Checking to see whether the relationship holds we find that: e/$ = 120 e/ e/$ = 108 Therefore we can find a profitable strategy. Starting with 1,000,000 one can convert the to $ yielding $1,666,666.667. Converting the $ to yields 200,000,000 which when converted back into give 1,111,111.111, and amount greater than the original. This strategy of converting to $ to and back to will be repeated until there is no further arbitrage opportunity. Question 4: interest parity relationships (a) Uncovered interest parity (UIP): the domestic interest rate must be higher (or lower) than the foreign interest rate by an amount equal to the expected depreciation (appreciation) of the domestic currency. i = i* + [E(et+1) et]/ et Assume this holds. Suppose i = iUK = 9% and i* = iUS = 6% From UIP, 9% = 6% + expected depreciation Thus the is expected to depreciate by 3%. (b) CIP: the domestic interest rate must be higher (or lower) than the foreign interest rate by an amount equal to the forward discount (premium) on the domestic currency. i = i* + [ft+1 et]/ et Suppose i = iUK = 12% and i* = iUS = 8% while the spot exchange rate is e/$ = 0.48 and the one year forward rate is f/$ = 0.5. Applying the CIP relationship: 12% 8% + [0.5 -0.48]/0.48 = 12.16% Therefore CIP does not hold. There is thus an opportunity for arbitrage. (c) e/$ = 0.48

3 month iUK = 12% 6 month iUK = 10% 1 year iUK = 8% 3 month iUS = 8% 6 month iUS = 10% 1 year iUS = 12%

On a yearly basis

Assume UIP holds: iUK - iUS = [E(et+1) et]/ et Since the interest rates are calculated on a yearly basis we have to convert them back to 3 month, 6 month and 1 year rates in order to describe the expected future path of the exchange rate. 3 months: t = today, t+1 is in 3 months. [E(et+1) et]/ et = [12/4]% - [8/4]% = 1% There is an expected depreciation of 1% over 3 months E(e/$3 months) = 0.4848 6 months: t = today, t+1 is in 6 months. [E(et+1) et]/ et = [10/2]% - [10/2]% = 0% There is no expected depreciation or appreciation over 6 months. E(e/$6 months) = 0.48 1 year: t = today, t+1 is in 1 year. [E(et+1) et]/ et = 8% - 12% = -4% There is an expected appreciation of 4% in 1 year. E(e/$1 year) = 0.4608 Thus the exchange rate is expected to depreciate in 3 months, appreciate back to its original level in 6 months and then appreciate by a further 4% in 1 year. Note that the above calculations of the 3 month and 6 month interest rates are approximations. For more accuracy one could use compounding: 3 months: (1.12)1/4- 1 = 0.028 and (1.08)1/4- 1 = 0.019

The difference is 0.009 = 0.9% which is very close to the 1% found above using the simple approximation. 6 months: (1.10)1/2- 1 = 0.0488 for both the UK and US