International Economics Study Set 8

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Quiz 18 :

International Monetary Systems: an Historical Overview

Quiz 18 :

International Monetary Systems: an Historical Overview

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If you were in charge of macroeconomic policies in a small open economy, what qualitative effect would each of the following events have on your target for external balance? a. Large deposits of uranium are discovered in the interior of your country. b. The world price of your main export good, copper, rises permanently. c. The world price of copper rises temporarily. d. There is a temporary rise in the world price of oil.
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Refer to the following information to answer the following as follows:
The external balance refers to the current account balance that is the inflow of the money from the exports and the amount of expenses that are incurred on the imports.
The policy makers always aim at achieving the external balance while formulating broad economic policies.
There are some factors that leads to the disruption of the balance of the current account which leads to the surplus or deficit in account.
a)the first case is of the large deposits found in the interior of the country.
When large deposits are discovered in the interiors of the country, the country needs huge capital requirements which leads to huge borrowings.
Hence, it leads to capital movements from the foreign country to home country.
Since, the capital movements are from the foreign country to home country therefore the current account gets imbalanced and the deficit occurs.
b)if the prices of the copper increases, the returns from it exceeds and leads to the surpluses in the current account. However, one must consider the cost of the copper mining for which huge capital investments are required.If the returns exceed the cost of investment, it will add to the current account surplus.
c)when the prices of the copper increase temporarily, the amount of the surplus increases as the number of exports are increased.d)a temporary shoot up in the oil prices leads to a current account deficit for the country which imports oil but leads to a surplus which exports oil.
But the exporting oil country the cost of the investment must be considered.If the costs exceed the returns, it will lead to the current account deficit and if the returns exceed the costs, then it will lead to surplus.

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Under a gold standard of the kind analyzed by Hume, describe how balance of payments equilibrium between two countries, A and B , would be restored after a transfer of income from B to A.
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According to Hume, under gold standard a balance of payment disequilibrium between two countries A and B can be restored by an adjustment mechanism called
Price-Specie-Flow Mechanism. It is an automatic mechanism which adjusts the external balance deficits that arises due to international trade.
Under the gold standard, gold is the only means of international payments. When income is transferred from B to A, country B will experience a current account deficit while country A will have a current account surplus.
Consequently, a corresponding gold flow from B to A restores balance of payment equilibrium between two countries A and B. When gold is transferred from B to A, B will experience a decrease in money supply and that A will experience an increase in money supply. As a result, price level will tend to fall in B and rise in A; B's products become more competitive in the export market while that of A will be less competitive. This change will improve B's balance of payments and deteriorates that of A; thus eliminating the initial disequilibrium in the balance of payment.

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Despite the flaws of the pre-1914 gold standard, exchange rate changes were rare for the "core" countries (including the richer European countries and the United States). In contrast, such changes became frequent in the interwar period. Can you think of reasons for this contrast?
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Under the Classical Gold Standard (1870s - 1914), exchange rate stability was unprecedented for many countries including the United States and the European countries.
Under this system, the external value of all currencies is denominated in terms of gold.Thus, central banks must maintain gold reserves to facilitate purchase and sale of unlimited quantities of gold at the designated exchange rate.
By maintaining gold reserves, the central bank, upon demand, can give out gold in exchange for coin and currency.
Thus, this system ensures that the exchange rate between currencies remains fixed.
Moreover, in the gold standard system, there is free capital mobility or export of gold by private individuals across countries.
However, during the interwar period:
• High exchange rate volatility became frequent among the core countries.
• There was instability in the exchange rate
• The classical gold standard ceased to function.
The war has reduced the GDP drastically among different countries. Thus, countries deviated as per their economic requirements and developed in different directions.
Thus, they were concentrating more on their macroeconomic policies to get the home economy on right track.
The excess pressure due to fiscal deficit has made them to print more money to finance war and other needs.
This resulted in high inflation and lead to devaluation of the currency. Indeed, lead to a greater monetary instability, which resulted in ignoring the objective of exchange rate stability.

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Under a gold standard, countries may adopt excessively contractionary monetary policies as all countries scramble in vain for a larger share of the limited supply of world gold reserves. Can the same problem arise under a reserve currency standard when bonds denominated in different currencies are all perfect substitutes?
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A central bank that adopts a fixed exchange rate may sacrifice its autonomy in setting domestic monetary policy. It is sometimes argued that when this is the case, the central bank also gives up the ability to use monetary policy to combat the wage-price spiral. The argument goes like this: "Suppose workers demand higher wages and employers give in, but the employers then raise output prices to cover their higher costs. Now the price level is higher and real balances are momentarily lower, so to prevent an interest rate rise that would appreciate the currency, the central bank must buy foreign exchange currencies and expand the money supply. This action accommodates the initial wage demands with monetary growth, and the economy moves permanently to a higher level of wages and prices. With a fixed exchange rate, there is thus no way of keeping wages and prices down." What is wrong with this argument?
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Suppose the central bank of a small country with a fixed exchange rate is faced by a rise in the world interest rate, R *. What is the effect on its foreign reserve holdings? On its money supply? Can it offset either of these effects through domestic open-market operations?
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How might restrictions on private financial account transactions alter the problem of attaining internal and external balance with a fixed exchange rate? What costs might such restrictions involve?
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In the box on New Zealand, we derived an equation showing how the IIP changes over time: IIP t +1 = (1 + r ) IIP t + NX t. Show that if g = ( GDP t + 1 ? GDP t )/ GDP t is the growth rate of nominal output ( GDP ), and lower-case variables denote ratios to nominal GDP (as in the chapter), we can express this same equation in the form: img Use this expression to find the ratio of net exports to GDP that holds the IIP to GDP ratio iip constant over time.
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You are an economic adviser to the government of China in 2008. The country has a current account surplus and is facing gathering inflationary pressures. a. Show the location of the Chinese economy on a diagram like Figure. img Figure Internal Balance ( II ), External Balance ( XX ), and the "Four Zones of Economic Discomfort" The diagram shows what different levels of the exchange rate, E , and overall domestic spending, A , imply for employment and the current account. Along II , output is at its full-employment level, Y f. Along XX , the current account is at its target level, X. b. What would be your advice on how the authorities should move the yuan renminbi's exchange rate? What would be your advice about fiscal policy? In that regard, you have three pieces of data: First, the current account surplus is big, in excess of 9 percent of GDP. Second, China currently provides a rather low level of government services to its people. Third, China's government would like to attract workers from the rural countryside into manufacturing employment, so Chinese officials would prefer to soften any negative impact of their policy package on urban employment.
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Use the DD-AA model to examine the effects of a one-time rise in the foreign price level, P *. If the expected future exchange rate E e falls immediately in proportion to P * (in line with PPP), show that the exchange rate will also appreciate immediately in proportion to the rise in P *. If the economy is initially in internal and external balance, will its position be disturbed by such a rise in P *?
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If the foreign inflation rate rises permanently, would you expect a floating exchange rate to insulate the domestic economy in the short run? What would happen in the long run? In answering the latter question, pay attention to the long-run relationship between domestic and foreign nominal interest rates.
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Imagine that domestic and foreign currency bonds are imperfect substitutes and that investors suddenly shift their demand toward foreign currency bonds, raising the risk premium on domestic assets (Chapter 7). Which exchange rate regime minimizes the effect on output-fixed or floating?
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The Case Study starting on page 275 discussed the big global imbalances of the 2000s and suggested that one can analyze factors determining world real interest rates in terms of the balance between the world demand for savings (in order to finance investment) and the world supply of savings (just as in a closed economy- which the world is). As a first step in formalizing such an analysis, assume there are no international differences in real interest rates due to expected real exchange rate changes. (For example, you might suppose that yours is a long-run analysis in which real exchange rates are expected to remain at their long-run levels.) As a second step, assume that a higher real interest rate reduces desired investment and raises desired saving throughout the world. Can you then devise a simple supply- demand picture of equilibrium in the world capital market in which quantities (saved or invested) are on the horizontal axis and the real interest rate is on the vertical axis? In such a setting, how would an increase in world saving, defined in the usual way as an outward shift in the entire supply-of-savings schedule, affect equilibrium saving, investment, and the real interest rate? Relate your discussion to the last Case Study in the chapter and to the paper by Ben S. Bernanke in Further Readings. [For a classic exposition of a similar model, see Lloyd A. Metzler, "The Process of International Adjustment under Conditions of Full Employment: A Keynesian View," in Richard E. Caves and Harry G. Johnson, eds., Readings in International Economics (Homewood, IL: Richard D. Irwin, Inc. for the American Economic Association, 1968), pp. 465-486.]
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The chapter suggested that because large increases in oil prices transfer income to countries that cannot rapidly increase their consumption or investment and therefore must save their windfalls, world real interest rates fall in the short run. Put together data on the U.S. real interest rate for 1970-1976, a period that includes the first OPEC oil shock. How did the U.S. real interest rate behave? (You may assume that expected inflation rates equal actual inflation rates.)
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We noted in this chapter that foreign central banks, especially in Asia, accumulated large dollar foreign reserves after 2000. One persistent worry was that those central banks, fearing dollar depreciation, would shift their reserve holdings from dollars to euros. Show that this action would be equivalent to a huge sterilized sale of dollars in the foreign exchange market. What might be the effects? Be sure to spell out your assumption about perfect versus imperfect asset substitutability.
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Like its neighbor New Zealand, Australia has had a long string of current account deficits and is an international debtor. Go to the Australian Bureau of Statistics website at http://www.abs.gov.au/AUSSTATSand find the data you need to carry out an "external sustainability" analysis of the current account such as the one for New Zealand in the chapter. You will need data starting in 1992 for nominal GDP, the IIP, the current account, and the balance on goods and services NX (from "time series spreadsheets"). The goal of the exercise is to find the interest rate r on the IIP that stabilizes the ratio IIP/GDP at its most recent value given the historical average of NX and the historical average of nominal GDP growth (all since 1992). Warning: This is a challenging exercise that requires you to navigate the Australian data system and judge the most appropriate data to use in light of what you learned in Chapter 2.
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