MGEC61 Assignment 1 (Summer 2024)

Question 1 (15 points) (save your answer as HW1-Q1.pdf)

The world consists of three open economies, A, B and C, only. The table below provides  some macroeconomic data for these three countries last year.

Note:  Empty cells mean the data is not given in the question. All terms are measured in dollars.

Country A:

• Consumption represented 56% of national income.

• The current account surplus reached 15% of GDP, while the budget deficit was equal to 120.

• Financial assets purchased from residents of B and C were worth 768 and 2234 respectively.

• New private outflows of (financial) capital totaled 433.

• Asset transfers paid out by residents of A to the residents of C equal to 747. These transfers were non-market transactions and were the only asset transfers conducted by residents of all these three countries (i.e., there were no (net) asset transfers between residents of B and C).

Country B:

• B’s level of national income was 90% of A’s total output.

• The government collected 17.5% of output from households as (income) taxes.

• The country allocated 32.5% of output to accumulate (physical) capital and replace depreciated capital.

• The country imported 1193 worth of goods & services from A.

Country C:

• The level of C’s GDP was 25% higher than A’s

• The government consumed 22.5% of total output on final products, and the budget  surplus was 2.5% of GDP.

• Exports of goods & services to B reached 1174, and it ran a trade deficit of 233 with B.

• Residents had acquired financial assets worth 1748 from residents of A.

• The stock of official reserves decreased by 650. Additional Information:

• The central banks of all three countries only made transactions with other countries’ monetary authorities.

Complete the above table. You are not required to provide any explanation or show your work in this question; however, you should understand the logic behind the entry of each cell so that you can work on similar questions in the future.

Note: The table is reprinted on page 7 of this assignment. You MUST submit that page for grading; otherwise, you will be receiving a grade of zero for this question.

Question 2 (20 points) (save your answer as HW1-Q2.pdf)

Suppose you are working for an international investment firm, and you observe that the annualized interest rate on 2-year  Singaporean corporate bonds is  3.41%, while the annualized 2-year British corporate bonds is 4.36%.

a)   Suppose the S$/£ spot rate (ES$/£) and the 2-year forward rate (ES$/£, 2-year) are 1.6978 and 1.7241 respectively.  Is there any arbitrage opportunity? If yes, what would you do?  If not, why?  Explain. (8 points)

Note: Assume your firm does not have any funds denominated in Singapore dollar (S$) and British pound  (£). Remember to convert  the interest rates into the appropriate time period and take compounding into account.

b)  Suppose your firm can move the markets (i.e., change the spot exchange rate, the forward exchange rate, and the corporate bond rates in both countries), what happens to these four terms after the transactions you carried out in part (a)?  Explain in words.  (8 points)

c)  Find the S$/£ spot rate such that your firm will be indifferent between holding Singaporean corporate bonds and British corporate bonds.  (4 points)

Note:

1)  Keep your answers to 4 decimal points if needed.

2)  This question requires you to use the precise form of covered interest rate parity.

3)  Instead of the assumptions made in class (individuals are small players and cannot affect  the exchange rates and interest rates), the firm in this question is a LARGE player that can affect the exchange rates and the corporate interest rates when it conducts transactions in the spot exchange market, the forward exchange market, and corporate bonds markets in Australia and France.

4)  Use the subscripts “S” and “B” to represent all the terms used for Singapore and Britain e respectively in your written explanation. You must use these notations; otherwise, you will receive a grade of ZERO for the whole question.

Question 3 (20 points) (save your answer as HW1-Q3.pdf)

Consider two economies, Home and Foreign. The DC/FC exchange is determined by the asset approach to the exchange rate.

In the initial long-run equilibrium, both countries are identical in the following ways:

• The (real) money demand is given by hY – kR,

where  h = fraction of income held in the form of money, and it is equal to 30%

k = sensitivity of money demand (MD) to a change in (nominal) interest rate, and it is equal to 8000

• The long-run (nominal) interest rate is 20%. Home and Foreign differ in the following ways:

Note:

1)  Quote the exchange rate as EDC/FC.

2)  Interest rates are expressed in decimal points (e.g., ifR = 0.1, then it is interpreted as 10%).

3)  Keep your answer to at least 4 decimal points.

a)   Initially, both countries are in their respective long-run equilibria.  Find the long-run levels of prices in both countries and the DC/FC exchange rate if the (initial) expected DC/FC exchange rate is given by the ratio of domestic price level to foreign price level.  (6 points)

Suppose both Home and Foreign experience permanent changes in the money market. Improvement in Hone’s payment technology causes the fraction of income held in the form of money drops by 1 percentage point, while a series of credit card fraudslower the desirability of foreign households using money to facilitate their daily transaction, causing the fraction of income held in the form of money in the foreign money market to increase by 2 percentage points.  In addition, any permanent change in the money market will cause the market participants to revise their expected exchange rate by 0.0578 DC per FC.

b)  Find the short-run equilibrium DC/FC exchange rate.  (5 points)

c)  Find the new long-run equilibrium levels of prices in both countries and the DC/FC exchange rate. (4 points).

d)  Now, suppose the central bank of Foreign finds the change in the short-run exchange rate in part (b) undesirable and wants to keep it at 0.4875 via a temporary change in monetary policy. Is  it possible for the foreign central bank to achieve this goal?  Yes/No, explain.  (5 points)

Question 4 (20 points) (save your answer as HW1-Q4.pdf)

Suppose the foreign government lowers the legal working age. As a result, there is a one-time (permanent) increase in the level of foreign labour force. According to the asset approach to the exchange rate, what happens to the (nominal) DC/FC exchange rate in both the short run and long run? What happens to the domestic real money balance in both the short run and long run?  Explain with the support of ONE foreign exchange market diagram.

Note:

• Quote the exchange rate as EDC/FC.

• Assume that this change in the size of the foreign labour force has an immediate effect on output.

• DO NOT write “let Foreign be the home country and its currency be DC” to start your analysis; doing so will result in a grade of ZERO for the whole question.

• Compare your answer to initial long-run equilibrium.

Question 5 (25 points) (save your answer as HW1-Q5.pdf)

This question is related to the article “Japan’s yen surges against U.S. dollar on suspected intervention” The Globe and Mail, April 29, 2024.

Source: https://www.theglobeandmail.com/business/international-business/article-japans-yen-jumps- against-the-us-dollar-on-suspected-intervention

Note:

1)  Use your own words; DO NOT PLAGIARIZE from the article.

2)  In this question, quote the exchange rate as E¥/US$ .

Failure to do one of the above may result in a grade of ZERO for the whole question.

a)   The article mentioned the currency traders have been waiting for any signs or signals from Tokyo to act in the currency market.  What does this mean?  Explain.  (5 points)

b)  The Japanese yen has tumbled against the U.S. dollar, and there are several contributing factors to drop of the yen.  One explanation was provided by Joseph Trevisani, a senior analyst at FX Street in New York. He stated, “Over time with this interest differential between the BoJ and the Fed and the obvious reluctance of the BoJ to do anything about that … it’s tough to build up any momentum for the Japanese yen going the other way to strengthen”. In the context of the asset approach to the exchange rate, explain his argument. Also, support your answer with the aid of ONE foreign exchange market diagram.  (10 points)

c)  The article stated, “A weaker yen is a boon for Japanese exporters, but a headache for policymakers as it increases import costs, adds to inflationary pressures and squeezes households.” Explain the logic behind this statement. (10 points)