2. The value of asset is driven by its scarcity.What the monetary authorities could do is to
make money less scarce by issuing more of it.
This will lower its scarcity value. Even though its nominal value will always be the same,the
added supply will reduce the purchasing power per
unit of money.
4. The value of the dollar will drop as fears of inflation rise. Short-term U.S. interest rates
will initially fall but will then rise as
investors seek to protect themselves from higher anticipated inflation. Long-term rates will
probably rise immediately because of fears of future
inflation. If the growth in the money supply stimulated the economy to grow more rapidly
than it otherwise would, the value of the dollar
could rise, and so could the interest rates.
5.The increase in German interest rates made german assets more attractive to investors.In
process of shifting the funds from US to
Germany,investors sold dollars to buy DM they needed to invest in German
assets.Alternative explanation is that the rise in interest rates reflected a
tightening of German monetary policy,leading investors to anyicipate less German inflation
in the future, which would increase the desire to
hold DM and thereby boost its value.
7. a. The dollar rose when Greenspan indicated that he was concerned about the dollar's slide
and would not aggressively ease monetary
policy. Investors responded to his statement by lowering their expectations about future U.S.
inflation, making dollars a more
desirable asset.
b. Yes, by tightening U.S. monetary policy, he can lower investor expectations about future
U.S. inflation and raise real U.S.
interest rates (at least temporarily). Both of these effects of tighter monetary policy will boost
the dollar's value.
8.a.In order to hold down the value of their currencies, Asian central banks must buy up the
foreign exchange in the market.
the result is increase foreign reserves and expanded domestic money supply,which has
potential to increase inflation.
At the same time,lower exchange rates boost asian export competitiveness but at the
expense of lower living standards
for their populations.
b. In order to sterlize the expanded domestic money supply resulting from purchase of
foriegn exchange the asian central
bank must sell government securities to the market. The sales would drive down the price
of government bonds and drive up
domestic interest rates.Higher interest rates would attract more foreign capital which
would boost domestic
currency. Thus in long run,sterilized intervention will not affect exchange rates and export
competitiveness.
9.a. As capital flows in the currency board must exchange the foreign currency for an
equivalent amount of HK dollars this rise in dollars will lead
to higher inflation rate.Combined with fixed exchange rate ,the rise in the inflation rate will
result in increase in real exchange rate,making it less competitive.
10. An appreciation in the real value of the Colombian peso during1994. This real
appreciation reduces the competitiveness of Columbia�s
legal exports.
Problems
1.a.The U.S dollar value of the zim dollar prior to devaluation was $0.0263. Subsequent to
devaluation it was worth $0.02
b.The U.S dollar value of the zim dollar has changed by (0.02-0.0263)/0.0263 = -24%. Thus
it has devalued by 24% against USD.
Chapter 3
1. a. Free float,Managed float,Target zone arrangement,Fixed rate system, Hybrid system.
b. Free float : Exchange rates determined by interaction of currency supplies and
demands Managed float:Governments intervene actively in foreign exchange
market to smooth out exchange rate fluctuations in order to reduce economic uncertainity
associated with free float.
Target zone arrangement: Countries adjust their national economic policies to maintain
their exchange rates within
specific margin agreed upon,fixed central exchange rates.
Fixed rate system:Each bank buys or sells actively its currency,in foreign exchange market
whenever its exchange rate
threatens to deviate from its stated par value by more than an agreed upon percentage.
Hybrid system: Major currencies are floating on a managed basis.Some are freely floating
and other currencies are moving in and out of pegged exchange rate relationships.
c. Benefits of floating rate system : At the time the system was adopted proponents said it
would reduce economic volatity and facilitate free trade.It
would offset international differences in inflation rates so that trade,wages,employment and
output would not have to adjust. High inflation countries would see currencies depreciate
allowing firms to stay competitive without having to cut wages.
competitive disadvantage.Real exchange rates would stabilize even if permitted to float upon
in principle because the underlying conditions
affecting trade and relative productivity of capital would change only gradually and if
countries would coordinate their monetary policies to achieve
convergence of inflation rates then nominal rates would also stabilize. Another advantage is
that it absorbs pressures that would otherwise build up in countries that try
to peg the exchange rate while simultaneosly pursuing an independent monetary policy. It
also acts as a shock absorber to cushion real economic shocks that change
equilibrium rate.
Costs of floating rate system: Exessive volatility is one of the costs majorly due to
expectations of future government policies
Benefits of managed float: The government can reduce the volatility associated with freely
floating exchange rate.
Costs of managed float: The governments run risk of creating an exchange crises and wasting
reserves by failing to
recognize the difference between temperory exchange rate disequilibrium and a permanent
one.
Benefits of target zone: Forces convergence of monetary policy to that of the country with
anti-inflation policy and
leads to low inflation.
Costs of target zone : Requires political will to direct fiscal and monetary policies.Another
cost is that fundamental changes in
equilibrium exchange rate cannot getr reflected in actual exchange rate changes without
currency crises.
Benefits of fixed rate system: Currency stability and absence of currency crises.More
monetary discipline than in freely
floating system and lower inflation.
Costs of fixed rate system: The exchange rate cannot cushion the effects of real economic
shocks.This can result in
higher unemployment and less economic growth.
Benefits of hybrid system: Gives countries the option to select what best meets their needs.
Costs of hybrid system:There is no constraint on choices that governments can make.
d.Excessive movements would indicate that there are profits to be earned by betting against
the market.In effect excessive currency
fluctuations would exhibit the phenomenon of overshooting.
2. This should be easy to do. The trick is will be to find a coherent statement of what the
governments justification was
3. Since gold prices respond quickly to evidence of inflation, the expectation of an increase in
inflation will cause a jump in gold prices.
In this way, gold serves as a burglar alarm to warn that politicians are tampering with fiat
money.
4. Independent monetary and fiscal policies will lead to volatile exchange rates as market
participants receive and assess new information on
these policies.
5. Skip
6. Each country within the European Monetary System had to fix its exchange rate relative to
the DM.
7. A. Spain has historically pursued an easy monetary policy, with an associated high rate of
inflation. High inflation, in turn, led to
continual peseta devaluation
B. Countries that seek to participate in the EMS are effectively forced to pursue a monetary
policy consistent with
that of Germany, which eventually brings down their inflation rates.
C. By heightening the prospects for Spanish monetary stability, EMS membership has
lowered the risks associated with holding financial assets
in Spain. The result has been to make the Spanish public more willing to save and invest.
Problems
2.a.DM 1= FF 3.35386
b.Upper limit = FF 3.342933 ,Lower limit = 3.27840
c.Upper limit= FF 3.85694 and lower limit = FF 2.85078
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SUGGESTED ANSWERS TO CHAPTER 4 QUESTIONS
4. Exports Imports
a. merchandise: $300 in goods and services b. $225 in goods
c. 15 payments of dividends
d. 30 in tourist services
Balance on current account: +30