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Instructions Please read the following instructions carefully:
Type and print your answers. Handwritten assignments will not be marked. You may hand draw graphs and figures, but you must then scan and upload the assignment. If you do not have access to a scanner, you may use your phone to take a picture of your assignment and upload the picture. Make sure the scans and pictures are clear and of high quality.
Q1. Consider the United States and the countries it trades with the most (measured in trade volume): Canada, Mexico, China, and Japan. For simplicity, assume these four are the only countries with which the United States trades. Trade shares (trade weights) and U.S. nominal exchange rates for these four countries are as follows:
a. Compute the percentage change from 2015 to 2016 in the four U.S. bilateral exchange rates (defined as U.S. dollars per unit of foreign exchange, or FX) in the table provided. (1 mark)
b. Use the trade shares as weights to compute the percentage change in the nominal effective exchange rate for the United States between 2015 and 2016 (in U.S. dollars per foreign currency basket). (1 mark)
c. Based on your answer to (b), what happened to the value of the U.S. dollar against this basket between 2015 and 2016? How does this compare with the change in the value of the U.S. dollar relative to the Mexican peso? Explain your answer. (1 mark)
Q2. This question uses the general monetary model, where L is no longer assumed constant, and money demand is inversely related to the nominal interest rate. Consider two countries: Japan and South Korea. In 1996 Japan experienced relatively slow output growth (1%), while Korea had relatively robust output growth (6%). Suppose the Bank of Japan allowed the money supply to grow by 2% each year, while the Bank of Korea chose to maintain relatively high money growth of 15% per year. In addition, the bank deposits in Japan pay a 3% interest rate, i = 3%.
a. Compute the interest rate paid on South Korean deposits. (1 mark)
b. Using the definition of the real interest rate (nominal interest rate adjusted for inflation), show that the real interest rate in South Korea is equal to the real interest rate in Japan. (Note that the inflation rates you computed in the previous question will be the same in this question.) (1 mark)
c. Suppose the Bank of Korea decreases the money growth rate from 15% to 12% and the inflation rate falls proportionately (one for one) with this decrease. If the nominal interest rate in Japan remains unchanged, what happens to the interest rate paid on South Korean deposits? (1 mark)
d. Using time series diagrams, illustrate how this decrease in the money growth rate affects the money supply MK; South Koreas interest rate; prices PK; real money supply; and Ewon/ over time. (Plot each variable on the vertical axis and time on the horizontal axis.) (1 mark)
Q3. Use the money market and FX diagrams to answer the following questions. This question considers the relationship between the Indian rupee (Rs) and the U.S. dollar ($). The exchange rate is in rupees per dollar, ERs/$. On all graphs, label the initial equilibrium point A.
a. Illustrate how a permanent decrease in Indias money supply affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C. (1 mark)
b. By plotting them on a chart with time on the horizontal axis, illustrate how each of the following variables changes over time (for India): nominal money supply MIN, price level PIN, real money supply MIN/PIN, interest rate iRs, and the exchange rate ERs/$. (1 mark)
c. Using your previous analysis, state how each of the following variables changes in the short run (increase/decrease/no change): Indias interest rate iRs, ERs/$, expected exchange rate EeRs/$, and price level PIN. (1 mark)
d. Using your previous analysis, state how each of the following variables changes in the long run (increase/decrease/no change relative to their initial values at point A): Indias interest rate iRs, ERs/$, EeRs/$, and Indias price level PIN. (1 mark)
e. Explain how overshooting applies to this situation. (1 mark)
Q4. Show how each of the following would affect the U.S. balance of payments. Include a description of the debit and credit items, and in each case identify which specific account is affected (e.g., imports of goods and services, IM; exports of assets, EXA; and so on).
a. A California computer manufacturer purchases a $50 hard disk from a Malaysian company, paying the funds from a bank account in Malaysia. (1 mark)
b. A U.S. tourist to Japan sells his iPod to a local resident for yen worth $100. (1 mark)
c. The U.S. central bank purchases $500 million worth of U.S. Treasury bonds from a British financial firm and sells pound sterling foreign reserves. (1 mark)
d. A U.S. owner of Sony shares receives $10,000 in dividend payments, which are paid into a Tokyo bank. (1 mark)
e. The central bank of China purchases $1 million of export earnings from a firm that has sold $1 million of toys to the United States, and the central bank holds these dollars as reserves. (1 mark)
f. The U.S. government forgives a $50 million debt owed by a developing country. (1 mark)
Q5. How would a decrease in the money supply of Paraguay (currency unit: the guaran) affect its own output and its exchange rate with Brazil (currency unit: the real). Do you think this policy in Paraguay might also affect output across the border in Brazil? Explain. (2 mark)
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