MID TERM EXAMINATION Course International Finance Using the diagrams on the money market and foreign exchange market, explain the impact of an decrease in US output and decrease in EU money supply on exchange rate E(USDEUR). Based on the monetary model to exchange rates, explain the impact of an increase in U.S interest rate and increase in EU output on exchange rate E(USDEUR).
Full name: Nguyễn Thị Hoạt Class: QH – 2019 – E KTQT CLC6 Student ID: 19051088 MID-TERM EXAMINATION Course: International Finance Answer Question 1: US Balance of Payments, 2011 (billions of dollars) Current Account Merchandise trade Exports Imports Capital and Financial Account Capital account transactions, net 1,497.4 -2,235.8 Services Balance Travel and Transportation, net Military transaction, net Other services, net 178.5 31.3 -11.6 158.8 Income receipts and payments balance 227.0 Unilateral transfers balance U.S.-owned assets abroad U.S official reserve assets U.S other assets abroad Foreign-owned assets in the U.S Foreign official assets in the U.S Other foreign assets in the U.S Financial derivatives, net Statistical discrepancy -133.0 -1.2 -483.6 -16 -467.6 1,000.9 211.9 789.0 39.0 -89,2 Given the items shown in the above table, calculate the U.S Current account balance, Financial account balance and Official settlement balance Net export = EX – IM = 1,497.4 – 2,235.8 = -738.4 (billions of dollars) - - Current account balance = Net export + Services balance + Income receipts and payments balance + Unilateral transfers balance = -738.4 + 178.5 + 227 + (– 133) = - 465.9 (billions of dollars) Financial account balance = U.S.-owned assets abroad + Foreign-owned assets in the U.S + Financial derivatives, net + Statistical discrepancy = -483.6 +1,000.9 + 39 – 89.2 = 467.1 (billions of dollars) Reserve assets = U.S official reserve assets + Foreign official assets in the U.S = -16 + 211.9 = 195.9 (billions of dollars) - Official settlement balance = CA + KA + FA (non-reserve assets + statistical discrepancy) = - Reserve assets = -195.9 (billions of dollars) Question Using the diagrams on the money market and foreign exchange market, explain the impact of an decrease in US output and decrease in EU money supply on exchange rate E(USD/EUR) E$/€ Return on dollar deposits 1’ E1$/€ Expected return on euro deposits 𝑅$1 𝑆 𝑀𝑈𝑆 𝑃𝑈𝑆 Rates of return (in dollar terms) L(R$, 𝑌1 US) US real money supply US real money holdings - Decrease in US output and Decrease in EU money supply: E$/€ E2$/€ Return on dollar deposits 2’ 1’ E1$/€ Expected return on euro deposits 𝑅$2 𝑅$1 Rates of return (in dollar terms) L(R$, 𝑌 US) L(R$, 𝑌1 US) 𝑆 𝑀𝑈𝑆 𝑃𝑈𝑆 2 US real money holdings US real money supply Decrease in US output: - Decrease in US output → YUS decrease → L(R$, YUS) decrease → The expected return on dollar-denominated assets falls due to the lower US interest rate → Return on dollar deposits curve shifts to the left Decrease in EU money supply: - Decrease in European money supply causes a decrease supply of money in Europe and increases European interest rates The higher European interest rate increases the expected return on eurodenominated assets, thus increasing the demand for the euro and causing a appreciation of the euro against the US dollar In conclusion, decrease in US output and decrease in EU money supply → E$/€ increase causing a proportional depreciation of US dollar, appreciation of EU currency Question Based on the monetary model to exchange rates, explain the impact of an increase in U.S interest rate and increase in EU output on exchange rate E(USD/EUR) E = P/P* P: the domestic price level P*: the foreign price level E: the exchange rate Increase in U.S interest rate: - Increase in U.S interest leads to the lower domestic money demand, raise the US price level and cause a proportional depreciation of the US dollar P = Ms/L(Y,R), R↑ → L↓ → P↑ → E↑ Increase in EU output: - An increase in the EU output raises the foreign money demand, decrease the EU price level and cause a proportional increase of the exchange rate E$/€ - P* = Ms*/L(Y*,R*), Y*↑ → L*↑ → P*↓ → E↑ In conclusion, increase in U.S interest rate and increase in EU output → E$/€ increase Question Based on the real exchange rate approach to exchange rates, explain how does an increase in the real exchange rate affect exports and imports? The real exchange rate is defined as follows: q = (E x P*)/P P and P* are the price levels at home and abroad q and E are the real and nominal exchange rate respectively - The real exchange rate increases, indicating the real depreciation of domestic currency and the appreciation of the foreign currency Thus the domestic goods and services less expensive and less valuable relative to the foreign goods The domestic goods and services → increase competition, quickly consume goods → Export increase The foreign goods and service → reduce competition, limit consumption → Import decrease - The real exchange rate decreases, indicating the appreciation of domestic currency in real terms and the depreciation of the foreign currency Because of this, the domestic goods and services become more expensive than the foreign goods and services The domestic goods and services → reduce competition, limit consumption → Export decrease The foreign goods and service → increase competition, quickly consume goods → Import increase In conclusion, when the real exchange rate increases, exports increase and imports decrease On the other hand, when the real exchange rate falls, exports decrease and imports increase