ECMB05 (L01) â Macroeconomic Theory and Policy
MGEC61 – LEC 01and LEC 02 International Economic: Finance Assignment 1 Due: On or before Thursday, October 3, 12:00noon, IC 286 (Note: Assignment submitted after 12:00noon on October 3 WILL NOT BE accepted under ANY circumstance.) Instructions: You can submit individual or group assignment. If you submit group assignment, there should be no more than FIVE students in your group and you just have to submit ONE copy. A title page MUST be attached with your assignment; it MUST include your name(s), student number(s), and your lecture section(s). Staple your assignment (Paper clip is not accepted). A PENALTY OF 10% OF THE TOTAL MARKS WILL BE IMPOSED IF YOU DO NOT HAVE A TITLE PAGE OR STAPLE YOUR ASSIGNEMNT. No late assignment will be accepted. Label your graph; otherwise, marks will be subtracted. Do not write E/q/Ee increases/decreases (/) in your answer, you have to answer whether the currency appreciates/depreciates. POINTS WILL BE SUBTRACTED IF YOU DO NOT FOLLOW THIS INSTRUCTION. No credit will be given if you do not show your work. Your answer should be structured in a way such that those know little about economics will have no difficulty in understanding your argument/answer. Total marks: 100 points.
Question 1 (15 points) The world consists of three economies only, A, B, and C. The following table provides some macroeconomic data for these countries. A B C National Output, Y 4800 6000 Consumption, C 3600 3240 Investment, I Government spending, G 1500 Taxes, T 1450 Private saving, SP 1000 Public saving, SG National saving, S Net unilateral transfer 0 0 0 Current Account, CA 360 Non-reserve portion of financial account, KAnon-res 180 Official reserve transactions, ORT Capital account 160
MGEC61 Assignment 1 (Fall 2013)
1
Additional information given about these countries: The central banks only make transactions with other countries’ central banks. The share of consumption in GDP is the same in all three countries. Country A has twin deficits and the size of each deficit reaches 7.5% of output. Country B’s stock of official reserves decreases by 190. Total amount of asset transfers paid out by residents of B to residents of A & C reaches 370, and no market transactions are involved in these asset transfers. The governments of B and C run a budget deficit of 230 and 350 respectively. The level of national saving in country C is equal to 360. Country C experiences (net) outflows of private (financial) capital of 380. a) Complete Table 1. You are not required to provide explanation to your answer for 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. (10 points) Note: Table 1 is reproduced on page 6 of this assignment. Submit that page with your assignment for grading. b) Based on your answer in part (a), in the absence of central bank intervention, which country/countries find their currencies under pressure to appreciate? Explain. (5 points)
Question 2 (15 points) This question are related to the article “Carry on trading: Why nominal interest-rate differentials are important to currency markets”, The Economist, August 10th, 2013 (pages 7 & 8 of this assignment). When answering the following questions, make sure to use your own words to answer the questions, DO NOT PLAGIARIZE from the article; otherwise, you will receive a grade of ZERO for the whole question. a) The article mentioned that in theory carry trade does not work. Explain the logic behind. (5 points) b) Explain the logic behind the following sentences “countries with persistent current-account deficits tend to have higher real interest rates than surplus countries. In other words, countries with an addiction to imports have to pay a risk premium to investors to hold their currency.” (6th paragraph of the article on page 7). (5 points) c) At the end of the article it mentioned that carry trade is a simple but working strategy that currency traders could use to make profit. Explain the logic behind. (5 points)
Question 3 (15 points) Suppose you are working for a large, international investment bank, and you observe the annual yields on Japanese corporate bonds and Australian corporate bonds are 2.28% and 3.72% respectively. In addition, the current (spot) ¥/A$ exchange rate is 100.6, and the Australian dollar is traded at a forward premium of 1.1% against the Japanese yen. a) You realize that there is an arbitrage opportunity; however your bank does not have any funds denominated in Japanese yen and/or Australian dollar (A$). What would you do to
MGEC61 Assignment 1 (Fall 2013)
2
capture the arbitrage profit? Calculate the arbitrage profit (measured in Japanese yen). Explain. (5 points) b) Suppose your bank has the ability to change the spot exchange rate, the forward exchange rate, and the corporate bond yields in both countries, what happens to these four variables after the transactions you carried in part (a)? Explain in words. (8 points) c) Now, suppose the spot ¥/A$ exchange rate bear all the burden of adjustment. Find the spot ¥/A$ exchange rate that would make your boss indifferent between investing in Japanese corporate bonds and Australian corporate bonds. Compare to the initial spot ¥/A$ exchange rate, what happens to the value of ¥ in the spot market (i.e., does ¥ appreciate or depreciate)? (2 points) Note: 1) Quote the exchange rates as E¥/A$ and F¥/A$. 2) Interest rates are expressed in decimal points (i.e., if R = 0.1, then R = 10%). Keep your answer to at least 4 decimal points. 3) This question requires you to use covered interest rate parity. 4) Instead of the assumption made in class (individuals are small players and cannot affect the exchange rates and interest rates), the investment bank in this question is a LARGE player which has the ability to change the exchange rates and the corporate interest rates when it carries transactions in the spot exchange market, the forward exchange market, and corporate bonds markets in Japan and Australia. 5) Use the subscripts “J” and “A” to represent all the variables and terms used for Japan and Australia respectively in your written explanation. You must use these notations; otherwise, you will receive a grade of ZERO for the whole question.
Question 4 (25 points) Consider two economies, Home and Foreign. The exchange rate between domestic currency (DC) and foreign currency (FC) is determined by the asset approach to the exchange rate. Both countries are identical in the following ways: Production function is given a typical Cobb-Douglas function: Y = 2K1/4L3/4. The (real) money demand is given by hY – kR, where h = fraction of income held in the form of money, 1> h > 0 k = sensitivity of money demand (MD) to a change in (nominal) interest rate. The long-run (nominal) interest rate = 4.5%. Home and Foreign differ in the following ways: Supply of capital Supply of labour Fraction of income held in the form of money Sensitivity of MD to a change in (nominal) interest rate (Nominal) Money supply Note: 1) Quote the exchange rate as EDC/FC.
MGEC61 Assignment 1 (Fall 2013)
Home 50625 20736 10% 18000 21870
Foreign 20736 10000 15% 15000 11700
3
2) Interest rates are expressed in decimal points (i.e., if R = 0.1, then R = 10%). 3) Keep your answer to at least 4 decimal points. a) Initially, both countries are in their respective long-run equilibrium. Find the long-run equilibrium 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) Now suppose there are permanent changes in the domestic money market such that the sensitivity of money demand to a change in interest rate falls by 4500. In addition, studies show that when agents revise their expectation, the expected change rate (Ee) would change by 0.06 DC per FC. b) Find the short-run equilibrium DC/FC exchange rate. (5 points) c) Find the domestic price level and the DC/FC exchange rate in the long run? (4 points) d) Show your answers from parts (a) to (c) in a well-labeled diagram for the asset approach. Be sure to identify the equilibrium points from parts (a) to (c) on the foreign exchange market diagram. No written explanation is required. (5 points) e) Now, suppose the central bank of Home finds the change in the short-run exchange rate in part (b) undesirable and wants to keep it at the initial level via a temporary change in monetary policy. Is it possible for the domestic central bank to achieve this goal? Explain. (5 points)
Question 5 (30 points) Consider two open economies, Canada and the U.S. In the past few months, there were talks from the Federal Reserve (The Fed) about “withdrawing” its purchase of long-term assets such as long-term treasury bills. Now, suppose the Fed begins tapering of its purchases of long-term assets. The following questions ask you to evaluate the effect of this change in the policy by the Fed using different theories of exchange rate determination. You can assume the change in Fed’s policy has permanent impact on the economy. a) In the context of the asset approach to the exchange rate, examine the effect of the change in Fed’s policy on the C$/US$ exchange rate in both short run and long run. Explain in words and ONE foreign exchange market diagram (only the first diagram will be graded). (15 points). b) Based on your answer in part (a), what happens to the current account and financial account balances in Canada in the short run? Explain. (5 points) c) In the context of the monetary approach to the long-run exchange rate, explain how the change in the policy by the Fed would affect the C$/US$ exchange rate in nominal terms. (5 points) d) Continued from part (c). If the Bank of Canada wants to keep the nominal value of the C$ against US$ from changing, what should it do? Explain. (5 points) Note: 1) Quote the exchange rate as EC$/US$.
MGEC61 Assignment 1 (Fall 2013)
4
2) DO NOT ANSWER the question by letting the U.S. be the home country and its currency be DC and then start your analysis (i.e., we treat Canada as the home country). If you do that, you will receive a grade of ZERO for the whole question. 3) Use the subscripts “C” and “US” to represent all the variables and terms used for Canada and the U.S. respectively in your written explanation and diagram. You must use these notations; otherwise, you will receive a grade of ZERO for the whole question.
MGEC61 Assignment 1 (Fall 2013)
5
Answer for Question 1 Part a (Submit this page with your answers in your assignment for grading)
National Output, Y
A
B
4800
6000 3600
Consumption, C
C
3240
Investment, I 1500
Government spending, G
1450
Taxes, T Private saving, SP
1000
Public saving, SG National saving, S Net unilateral transfer
0
0
0 360
Current Account, CA 180
Non-reserve portion of financial account, KAnon-res Official reserve transactions, ORT Capital account
MGEC61 Assignment 1 (Fall 2013)
160
6
Carry on trading Why nominal interest-rate differentials are important to currency markets Aug 10th 2013 |From the print edition AROUND $5 trillion is traded on the foreign-exchange markets every single day, according to a recent survey sponsored by the world’s big central banks. That compares with global trade in goods and services of $18.3 trillion a year, or about $50 billion a day. In other words, the currency markets are not solely devoted to helping German carmakers turn their export earnings back into euros. Even if you exclude deals made between banks, financial institutions account for a much larger chunk of foreign-exchange transactions than other businesses. Shifting capital around the world moves currencies more than shifting goods does. What inspires investors to favour one currency over another? Perhaps the most consistent factor over the past 20 years has been the “carry trade”. This involves a trader borrowing in a country with low interest rates and investing the proceeds of the loan in a country with higher rates, and pocketing the difference. In theory, it seems odd that the carry trade works. The most likely reason for one country to have higher nominal interest rates than another is because it has persistently higher inflation. Over time you would expect to see currency depreciation in the high-inflation nation because its exports will gradually become less competitive. In the forward markets, which set prices for specified future dates, this rule is rigidly observed. When one country has a higher interest rate than another, its currency will trade at a discount to that of the other nation in the forward market. That discount will exactly offset the rate differential. So if euro-zone interest rates were two percentage points higher than those in America, the euro will trade at a 2% discount to the dollar in the 12-month forward market. If it did not do so, traders would be able to make a risk-free profit. The forward market is a naive “forecast” of future currency movements. But an analysis by Record Currency Management of 33 years of data on five big currencies shows that the currency in the country with the higher interest rate outperforms the forward exchange rate slightly more often than not. This translates into a small monthly gain for investors. Why is this the case? Neil Record, the founder of the currency-management firm, finds that, with the exception of America (which has the privilege of issuing the world’s reserve currency), countries with persistent current-account deficits tend to have higher real interest rates than surplus countries. In other words, countries with an addiction to imports have to pay a risk premium to investors to hold their currency.
MGEC61 Assignment 1 (Fall 2013)
7
But the carry trade is based on exploiting the difference between nominal, not real, interest rates. Figures from the Royal Bank of Canada (RBC) show a strategy of being long the currency with the highest yields (ie, betting on a price increase) and short the currency with the lowest yields. The most profitable approach over the past 20 years has been to focus on nominal rates (see chart). One explanation is that nominal rates are a lot easier to target than real ones. Some governments issue inflation-linked bonds, which pay real rates, but these securities are not that liquid. For other bonds the true real rate can only be known in retrospect. Elsa Lignos, a currency strategist at RBC, calculated the returns investors would have received had they possessed foresight of the rate differentials between currencies. Even on this basis, knowledge of nominal-rate changes was more important than shifts in real rates. One reason might be that currencies move in line with relative inflation rates (a theory called purchasing power parity, or PPP) only over the very long run. In the short term they can depart a long way from PPP levels. Currency traders are more concerned about the next few weeks than about long-term exchangerate movements. If one country has an extremely high inflation rate relative to the rest of the world, its currency will depreciate very rapidly (Zimbabwe is an obvious recent example of the effect of hyperinflation). But the differences between inflation rates across the developed world are very small and so will not have much of an impact on a country’s competitiveness. Traders who look at differentials between nominal rates know exactly what they are getting and do not have to worry about such complexities as whether different countries are using compatible inflation measures. The carry trade may be simple, but it works. From the print edition: Finance and economics
MGEC61 Assignment 1 (Fall 2013)
8
Question 1 (15 points) The world consists of three economies only, A, B, and C. The following table provides some macroeconomic data for these countries. A B C National Output, Y 4800 6000 Consumption, C 3600 3240 Investment, I Government spending, G 1500 Taxes, T 1450 Private saving, SP 1000 Public saving, SG National saving, S Net unilateral transfer 0 0 0 Current Account, CA 360 Non-reserve portion of financial account, KAnon-res 180 Official reserve transactions, ORT Capital account 160
MGEC61 Assignment 1 (Fall 2013)
1
Additional information given about these countries: The central banks only make transactions with other countries’ central banks. The share of consumption in GDP is the same in all three countries. Country A has twin deficits and the size of each deficit reaches 7.5% of output. Country B’s stock of official reserves decreases by 190. Total amount of asset transfers paid out by residents of B to residents of A & C reaches 370, and no market transactions are involved in these asset transfers. The governments of B and C run a budget deficit of 230 and 350 respectively. The level of national saving in country C is equal to 360. Country C experiences (net) outflows of private (financial) capital of 380. a) Complete Table 1. You are not required to provide explanation to your answer for 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. (10 points) Note: Table 1 is reproduced on page 6 of this assignment. Submit that page with your assignment for grading. b) Based on your answer in part (a), in the absence of central bank intervention, which country/countries find their currencies under pressure to appreciate? Explain. (5 points)
Question 2 (15 points) This question are related to the article “Carry on trading: Why nominal interest-rate differentials are important to currency markets”, The Economist, August 10th, 2013 (pages 7 & 8 of this assignment). When answering the following questions, make sure to use your own words to answer the questions, DO NOT PLAGIARIZE from the article; otherwise, you will receive a grade of ZERO for the whole question. a) The article mentioned that in theory carry trade does not work. Explain the logic behind. (5 points) b) Explain the logic behind the following sentences “countries with persistent current-account deficits tend to have higher real interest rates than surplus countries. In other words, countries with an addiction to imports have to pay a risk premium to investors to hold their currency.” (6th paragraph of the article on page 7). (5 points) c) At the end of the article it mentioned that carry trade is a simple but working strategy that currency traders could use to make profit. Explain the logic behind. (5 points)
Question 3 (15 points) Suppose you are working for a large, international investment bank, and you observe the annual yields on Japanese corporate bonds and Australian corporate bonds are 2.28% and 3.72% respectively. In addition, the current (spot) ¥/A$ exchange rate is 100.6, and the Australian dollar is traded at a forward premium of 1.1% against the Japanese yen. a) You realize that there is an arbitrage opportunity; however your bank does not have any funds denominated in Japanese yen and/or Australian dollar (A$). What would you do to
MGEC61 Assignment 1 (Fall 2013)
2
capture the arbitrage profit? Calculate the arbitrage profit (measured in Japanese yen). Explain. (5 points) b) Suppose your bank has the ability to change the spot exchange rate, the forward exchange rate, and the corporate bond yields in both countries, what happens to these four variables after the transactions you carried in part (a)? Explain in words. (8 points) c) Now, suppose the spot ¥/A$ exchange rate bear all the burden of adjustment. Find the spot ¥/A$ exchange rate that would make your boss indifferent between investing in Japanese corporate bonds and Australian corporate bonds. Compare to the initial spot ¥/A$ exchange rate, what happens to the value of ¥ in the spot market (i.e., does ¥ appreciate or depreciate)? (2 points) Note: 1) Quote the exchange rates as E¥/A$ and F¥/A$. 2) Interest rates are expressed in decimal points (i.e., if R = 0.1, then R = 10%). Keep your answer to at least 4 decimal points. 3) This question requires you to use covered interest rate parity. 4) Instead of the assumption made in class (individuals are small players and cannot affect the exchange rates and interest rates), the investment bank in this question is a LARGE player which has the ability to change the exchange rates and the corporate interest rates when it carries transactions in the spot exchange market, the forward exchange market, and corporate bonds markets in Japan and Australia. 5) Use the subscripts “J” and “A” to represent all the variables and terms used for Japan and Australia respectively in your written explanation. You must use these notations; otherwise, you will receive a grade of ZERO for the whole question.
Question 4 (25 points) Consider two economies, Home and Foreign. The exchange rate between domestic currency (DC) and foreign currency (FC) is determined by the asset approach to the exchange rate. Both countries are identical in the following ways: Production function is given a typical Cobb-Douglas function: Y = 2K1/4L3/4. The (real) money demand is given by hY – kR, where h = fraction of income held in the form of money, 1> h > 0 k = sensitivity of money demand (MD) to a change in (nominal) interest rate. The long-run (nominal) interest rate = 4.5%. Home and Foreign differ in the following ways: Supply of capital Supply of labour Fraction of income held in the form of money Sensitivity of MD to a change in (nominal) interest rate (Nominal) Money supply Note: 1) Quote the exchange rate as EDC/FC.
MGEC61 Assignment 1 (Fall 2013)
Home 50625 20736 10% 18000 21870
Foreign 20736 10000 15% 15000 11700
3
2) Interest rates are expressed in decimal points (i.e., if R = 0.1, then R = 10%). 3) Keep your answer to at least 4 decimal points. a) Initially, both countries are in their respective long-run equilibrium. Find the long-run equilibrium 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) Now suppose there are permanent changes in the domestic money market such that the sensitivity of money demand to a change in interest rate falls by 4500. In addition, studies show that when agents revise their expectation, the expected change rate (Ee) would change by 0.06 DC per FC. b) Find the short-run equilibrium DC/FC exchange rate. (5 points) c) Find the domestic price level and the DC/FC exchange rate in the long run? (4 points) d) Show your answers from parts (a) to (c) in a well-labeled diagram for the asset approach. Be sure to identify the equilibrium points from parts (a) to (c) on the foreign exchange market diagram. No written explanation is required. (5 points) e) Now, suppose the central bank of Home finds the change in the short-run exchange rate in part (b) undesirable and wants to keep it at the initial level via a temporary change in monetary policy. Is it possible for the domestic central bank to achieve this goal? Explain. (5 points)
Question 5 (30 points) Consider two open economies, Canada and the U.S. In the past few months, there were talks from the Federal Reserve (The Fed) about “withdrawing” its purchase of long-term assets such as long-term treasury bills. Now, suppose the Fed begins tapering of its purchases of long-term assets. The following questions ask you to evaluate the effect of this change in the policy by the Fed using different theories of exchange rate determination. You can assume the change in Fed’s policy has permanent impact on the economy. a) In the context of the asset approach to the exchange rate, examine the effect of the change in Fed’s policy on the C$/US$ exchange rate in both short run and long run. Explain in words and ONE foreign exchange market diagram (only the first diagram will be graded). (15 points). b) Based on your answer in part (a), what happens to the current account and financial account balances in Canada in the short run? Explain. (5 points) c) In the context of the monetary approach to the long-run exchange rate, explain how the change in the policy by the Fed would affect the C$/US$ exchange rate in nominal terms. (5 points) d) Continued from part (c). If the Bank of Canada wants to keep the nominal value of the C$ against US$ from changing, what should it do? Explain. (5 points) Note: 1) Quote the exchange rate as EC$/US$.
MGEC61 Assignment 1 (Fall 2013)
4
2) DO NOT ANSWER the question by letting the U.S. be the home country and its currency be DC and then start your analysis (i.e., we treat Canada as the home country). If you do that, you will receive a grade of ZERO for the whole question. 3) Use the subscripts “C” and “US” to represent all the variables and terms used for Canada and the U.S. respectively in your written explanation and diagram. You must use these notations; otherwise, you will receive a grade of ZERO for the whole question.
MGEC61 Assignment 1 (Fall 2013)
5
Answer for Question 1 Part a (Submit this page with your answers in your assignment for grading)
National Output, Y
A
B
4800
6000 3600
Consumption, C
C
3240
Investment, I 1500
Government spending, G
1450
Taxes, T Private saving, SP
1000
Public saving, SG National saving, S Net unilateral transfer
0
0
0 360
Current Account, CA 180
Non-reserve portion of financial account, KAnon-res Official reserve transactions, ORT Capital account
MGEC61 Assignment 1 (Fall 2013)
160
6
Carry on trading Why nominal interest-rate differentials are important to currency markets Aug 10th 2013 |From the print edition AROUND $5 trillion is traded on the foreign-exchange markets every single day, according to a recent survey sponsored by the world’s big central banks. That compares with global trade in goods and services of $18.3 trillion a year, or about $50 billion a day. In other words, the currency markets are not solely devoted to helping German carmakers turn their export earnings back into euros. Even if you exclude deals made between banks, financial institutions account for a much larger chunk of foreign-exchange transactions than other businesses. Shifting capital around the world moves currencies more than shifting goods does. What inspires investors to favour one currency over another? Perhaps the most consistent factor over the past 20 years has been the “carry trade”. This involves a trader borrowing in a country with low interest rates and investing the proceeds of the loan in a country with higher rates, and pocketing the difference. In theory, it seems odd that the carry trade works. The most likely reason for one country to have higher nominal interest rates than another is because it has persistently higher inflation. Over time you would expect to see currency depreciation in the high-inflation nation because its exports will gradually become less competitive. In the forward markets, which set prices for specified future dates, this rule is rigidly observed. When one country has a higher interest rate than another, its currency will trade at a discount to that of the other nation in the forward market. That discount will exactly offset the rate differential. So if euro-zone interest rates were two percentage points higher than those in America, the euro will trade at a 2% discount to the dollar in the 12-month forward market. If it did not do so, traders would be able to make a risk-free profit. The forward market is a naive “forecast” of future currency movements. But an analysis by Record Currency Management of 33 years of data on five big currencies shows that the currency in the country with the higher interest rate outperforms the forward exchange rate slightly more often than not. This translates into a small monthly gain for investors. Why is this the case? Neil Record, the founder of the currency-management firm, finds that, with the exception of America (which has the privilege of issuing the world’s reserve currency), countries with persistent current-account deficits tend to have higher real interest rates than surplus countries. In other words, countries with an addiction to imports have to pay a risk premium to investors to hold their currency.
MGEC61 Assignment 1 (Fall 2013)
7
But the carry trade is based on exploiting the difference between nominal, not real, interest rates. Figures from the Royal Bank of Canada (RBC) show a strategy of being long the currency with the highest yields (ie, betting on a price increase) and short the currency with the lowest yields. The most profitable approach over the past 20 years has been to focus on nominal rates (see chart). One explanation is that nominal rates are a lot easier to target than real ones. Some governments issue inflation-linked bonds, which pay real rates, but these securities are not that liquid. For other bonds the true real rate can only be known in retrospect. Elsa Lignos, a currency strategist at RBC, calculated the returns investors would have received had they possessed foresight of the rate differentials between currencies. Even on this basis, knowledge of nominal-rate changes was more important than shifts in real rates. One reason might be that currencies move in line with relative inflation rates (a theory called purchasing power parity, or PPP) only over the very long run. In the short term they can depart a long way from PPP levels. Currency traders are more concerned about the next few weeks than about long-term exchangerate movements. If one country has an extremely high inflation rate relative to the rest of the world, its currency will depreciate very rapidly (Zimbabwe is an obvious recent example of the effect of hyperinflation). But the differences between inflation rates across the developed world are very small and so will not have much of an impact on a country’s competitiveness. Traders who look at differentials between nominal rates know exactly what they are getting and do not have to worry about such complexities as whether different countries are using compatible inflation measures. The carry trade may be simple, but it works. From the print edition: Finance and economics
MGEC61 Assignment 1 (Fall 2013)
8
