TUTORIAL 1 (GROUP 1)

Tutorial 1
EIG 3001 - International Finance Semester 2, Session 2022/2023
Topic: Balance of Payments

1. What are the major accounts of the balance of payments, and what transactions are
recorded on each account?

The balance of payments (BOP) is a record of all the economic transactions between a
country and the rest of the world over a specified period of time, usually one year. The BOP
is divided into three major accounts:

1. Current Account:
The current account records transactions that involve the import and export of goods and
services, income received from investments, and unilateral transfers (gifts, grants, and
remittances). Specifically, the current account includes:
- Merchandise trade: the import and export of physical goods such as raw materials, finished
goods, and services.
- Services trade: the import and export of services, such as tourism, transportation, and
financial services.
- Income: the income earned from investments in foreign countries, such as dividends,
interest, and wages.
- Transfers: unilateral transfers are gifts, grants, and remittances from individuals or
governments.

2. Capital Account:
The capital account records capital transactions such as the purchase and sale of assets
(both financial and non-financial) between a country and the rest of the world. Specifically,
the capital account includes:
- Foreign direct investment (FDI): investments made by foreign companies into a domestic
economy or vice versa.
- Portfolio investment: investments made in the stock and bond markets of other countries.
- Other investment: loans, deposits, and other short-term capital flows.
- Reserve assets: changes in a country's foreign exchange reserves held by the central
bank.

3.Official settlements / reserves account

● captures transactions related to changes in a country's official reserve assets, which

typically include foreign exchange reserves held by the central bank. The reserve
 assets serve as a buffer to meet international payment obligations and maintain
stability in the foreign exchange market.
● Acquisitions or disposals of foreign currencies: These transactions involve the
purchase or sale of foreign currencies by the central bank to manage the country's
exchange rate or fulfill international payment needs.
● Changes in holdings of international reserve assets: This includes changes in
holdings of assets like gold, Special Drawing Rights (SDRs) allocated by the
International Monetary Fund (IMF), reserve positions in the IMF, and other reserve
assets.

2. What are the causes of Current Account surplus?

The causes of a Current Account surplus can be attributed to various factors, including:

1. High savings rate: A country with a higher savings rate relative to its investment rate is
likely to have a Current Account surplus. When domestic savings exceed domestic
investment, there is a surplus of funds available for lending or investment to other countries,
resulting in a Current Account surplus.

2. Export competitiveness: A country's ability to produce goods and services at competitive

prices and of high quality can lead to increased exports. If a country's exports exceed its
imports, it will generate a surplus in the Current Account.

3. Strong foreign investment: Foreign direct investment (FDI) inflows can contribute to a
Current Account surplus. When foreign investors bring capital into a country by investing in
businesses or infrastructure projects, it can lead to increased production, exports, and a
surplus in the Current Account.

4. Current Account policies: Certain policies or measures implemented by the government or

central bank can influence the Current Account balance. For instance, policies that promote
export-oriented industries, attract foreign investment, or control imports can contribute to a
Current Account surplus.

3. What are the causes of Current Account deficits?

● Economic instability.
Economic instability, such as high inflation, political turmoil, or currency fluctuations, can
make a country less attractive to foreign investors, leading to capital outflows and a capital
account deficit.

● High interest rates.

When a country has high interest rates, it can make it less attractive for foreign investors to
invest in its financial markets, resulting in capital outflows and a deficit on the capital
account.

● Currency devaluation.
If a country's currency is devalued, it can make its assets cheaper for foreign investors to
purchase, but it can also result in capital outflows as investors seek to move their
investments to more stable currencies.

4. If you add up all the current accounts of all countries in the world, the sum should
be zero. Yet this is not so. Why?

● It will be theoretically impossible for the current account to be zero. It will either be
surplus or deficit. This is because to achieve the sum of zero there should be record
for each and every single transaction but for international trade for goods and
services there will be statistical error since it is hard to keep track of bookkeeping
records with every single receipt especially in a global economy.
● Other than that, there will also be trade barriers from tariff and taxes. The tax from
the goods and services makes it impossible to have the perfect amount to sum it all
up to zero where each cent counts so there will probably be a mismatched error in
the account from the tax for export and import trade.
● Global deficit. Possibly due to the underreporting of foreign investment income by
rich countries (due to tax evasion) and to the under-reporting of freight receipts
● Global surplus. Possibly due to current account transactions being used to dodge
capital controls in emerging economies (ie China) since investors cannot invest in
China, exporters may have over-invoiced to bring money into the country

5. Explain why private national saving plus government saving equals the current
account of the balance of payments.

The equation 𝐺𝐷𝑃 + 𝑁𝐹𝐼 – (𝐶 + 𝐼 + 𝐺) = NX + 𝑁𝐹𝐼 represents the current account of the
balance of payments, where GNP is gross national product, NFI is net income from abroad,
C is consumption, I is investment, G is government spending, and NX is net exports.

We can rearrange the equation to isolate the net exports term (NX):

NX = (𝐺𝐷𝑃 + 𝑁𝐹𝐼) – (𝐶 + 𝐼 + 𝐺) + 𝑁𝐹𝐼

Let’s express national saving (S) as the sum of private national saving (S private) and
government saving (S government):

S = S private + S government

National saving (S) can also be expressed as S = GNP - C - I, which gives us:

S private + S government = GNP - C - I - S government

If we substitute this expression for private national saving and government saving in the
equation for net exports, we get:
NX = (𝐺𝐷𝑃 + 𝑁𝐹𝐼) – (𝐶 + 𝐼 + 𝐺) + 𝑁𝐹𝐼
= (GNP - C - I - S government + 𝑁𝐹𝐼) – (𝐶 + 𝐼 + 𝐺) + 𝑁𝐹𝐼
= (GNP - C - I - (S government - 𝑁𝐹𝐼)) – (𝐶 + 𝐼 + 𝐺)

The term in parentheses is the current account balance of payments (CAB), which is equal
to the sum of net exports (NX) and net transfer payments (NTP). Therefore, we can rewrite
the equation as:

CAB = (GNP - C - I - (S government - 𝑁𝐹𝐼)) – (𝐶 + 𝐼 + 𝐺)

Simplifying the terms, we get:

CAB = S + (𝑁𝐹𝐼 - NTP) - (C + I + G)

Since private national saving plus government saving is equal to national saving (S), we can
substitute S with S private + S government to get:

Current Account Balance = (S private + S government) + (NFI - NTP) - (C + I + G)

Therefore, we can see that private national saving plus government saving equals the
current account of the balance of payments, which includes the balance of trade in goods
and services (NX), net income from abroad (NFI), and net transfer payments (NTP). This is
because any excess of national saving over domestic investment must be offset by a surplus
on the current account, and any shortfall must be offset by a deficit on the current account.

6. What are the effects on the French balance of payments of the following set of
transactions? Les Fleurs de France, the French subsidiary of a British company, The
Flowers of Britain, has just received €4.4 million of additional investment from its
British parent. Part of the investment is a €0.9 million computer system that was
shipped from Britain directly. The €3.5 million remainder was financed by the parent
by issuing euro denominated Eurobonds to investors outside of France. Les Fleurs de
France is holding these euros in its Paris bank account.

Answer:
The €4.4 million of additional investment from the British parent to the French subsidiary is
an increase in the foreign ownership of French assets, which is a credit on the French
balance of payments. There is an import of €0.9 million for the computer system that is a
debit on the French balance of payments. The remaining €3.5 million, corresponding to the
funds that were borrowed abroad by Flowers of Britain and are now being held by Fleur de
France, represents a decrease in foreign ownership (or more specifically, ownership by
Flowers of Britain) of French assets. (Remarks: here we do not further track down who
bought the Eurobonds)

French BOP Credit (€ Million) Debit (€ Million)

Increase in the direct foreign ownership of 4.4

French assets by
Flowers of Britain
(Capital account; French Capital inflow)

Computer system that was shipped from 0.9

Britain to France
(Current account; French import)

Decrease in Foreign ownership of French 3.3

assets by Flowers of
Britain
(Capital account; French Capital outflow)
TUTORIAL 2 (GROUP 2)

1. Why is the demand curve of foreign exchange negatively sloped and supply curve
of foreign exchange positively sloped?

The demand curve for foreign exchange is negatively sloped because as the price of foreign
currency decreases, it becomes cheaper to purchase goods and services from that country,
leading to an increase in demand. Conversely, as the price of foreign currency increases, it
becomes more expensive to buy goods and services from that country, leading to a
decrease in demand.

The supply curve for foreign exchange is positively sloped because as the price of foreign
currency increases, it becomes more profitable for individuals and businesses in that country
to sell their currency in exchange for other currencies, leading to an increase in supply.
Conversely, as the price of foreign currency decreases, it becomes less profitable to sell
their currency, leading to a decrease in supply.

2. Relative Purchasing Power Parity. The inflation rate in the United States Is projected
at 3 percent per year for the next several years. The New Zealand inflation rate is
projected to be 5 percent during that time. The Exchange rate is currently NZ$ 1.66.
Based on relative PPP, what is the expected exchange rate in two years?

We- United States

Foreign - New Zealand
Diff inflation: 5%-3%=2%
R0: NZ$1.66
R1: NZ$ 1.66 x [1 + (0.05 - 0.03)]^2
= NZ$ 1.66 x (1.02)^2 *FYI: (square [^2] cause 2 years)*
=NZ$ 1.73

3. Uncovered Interest Parity. The spot exchange rate quote for the Kenyan Shilling
(KES) versus the U.S. dollar is 110.125 (KES/USD = 110.125, where USD is the base
currency). The one-year nominal rate in the U.S. is 8%, while the one-year nominal
rate in Kenya is 12%. Using uncovered interest rate parity, what is the expected
percentage change in the
4. Covered Interest Arbitrage. The spot and 360-day forward rates on Swiss franc are
SF 2.1 and SF 1.9, respectively. The risk-free interest rate in the United States is 6
percent, and the risk-free rate in Switzerland Is 4 Percent. Is there an arbitrage
opportunity here? How would you exploit it?

Yes there an arbitrage opportunity because the differences of the spot rate and forward rate.

Firstly, invest $1000 in the EU at spot rate SF2.1 and you will get ($1000xSF2.1=SF2100).
Secondly, you want to invest SF2100 in Switzerland for one year at an interest rate of 4%.
Therefore, you initiate a forward contract at Switz Bank. The value of the forward contract is
(SF2100+(SF2100x4%)]=SF2184. At the end of investment you will get SF2184.
Thirdly, convert SF to $ (SF2184x$1/SF1.9) and now you have $1149.47. So your profit of
covered interest arbitrage is ($1149.47-$1000=149.47).

5. Covered Interest Rate Parity (CIP). The U.S. dollar interest rate is 10%, and the GBP
interest rate is 8%. The spot USD/GBP exchange rate stands at $1.40 (per GBP), and
the 1-year forward rate is $1.48. Determine whether a profitable arbitrage opportunity
exists.
TUTORIAL 3 (GROUP 3)

1. What is purchasing power parity? Why might it not hold?

Purchasing Power Parity (PPP) is an economic concept that measures the relative
value of different currencies by comparing the prices of identical goods and services
in different countries. It suggests that, in an efficient market, the exchange rate
between two currencies should adjust in a way that the purchasing power of each
currency is equal.

The theory behind PPP is that in the long run, exchange rates should reflect the
differences in inflation rates between countries. If a country has a higher inflation rate
than another, its currency should depreciate to maintain parity in purchasing power.
This means that a basket of goods should cost the same when converted into a
common currency, regardless of the country in which it is purchased.

However, there are several reasons why PPP may not hold in practice:

Non-tradable goods: PPP assumes that goods and services are easily traded
between countries, but certain goods and services are not easily tradable due to
factors like transportation costs, trade barriers, and regulatory differences. This can
lead to significant price disparities for non-tradable goods, which affects PPP
calculations.

Transaction costs and barriers: Even when goods are tradable, there may be
additional costs and barriers involved in international trade, such as tariffs, taxes, and
transportation expenses. These factors can impact prices and prevent PPP from
holding accurately.

Differences in productivity: PPP assumes that factors like labor productivity,

technology, and production efficiency are the same across countries. In reality, these
factors can vary significantly, leading to differences in prices even for tradable goods.

Government interventions: Government policies and interventions, such as

exchange rate controls, capital controls, and import/export restrictions, can distort
prices and hinder the adjustment process necessary for PPP to hold.

Market imperfections: Market imperfections, such as monopolies, oligopolies, and

price regulations, can lead to price distortions and prevent PPP from being a reliable
indicator of currency value.

Time lags and expectations: PPP assumes that exchange rates adjust quickly to
maintain purchasing power parity. However, in reality, exchange rates can be
influenced by factors like investor expectations, speculation, and market dynamics,
which may lead to deviations from PPP in the short run.
2. Discuss the implications of the deviations from the purchasing power
parity for countries’ competitive positions in the world market.

Deviations from PPP make an exchange rate "cheap" or "rich", depending on the
deviation. If the exchange rate is overvalued, then the foreign exchange rate is
higher than it should be. This makes exports from that country more expensive, but
makes imports much cheaper. So, if the exchange rate changes satisfy PPP,
competitive positions of countries will remain unaffected following exchange rate
changes. Otherwise, exchange rate changes will affect the relative competitiveness
of countries. If a country's currency appreciates by more than is warranted by PPP,
that will affect (hurt) the country's competitive position in the world market.

3. Suppose consumers in Canada and the United States only consume blue
suede shoes (which are traded) and haircuts (which are not traded). The prices of
those goods in each country for two years are given in the table below. All prices
are quoted in the currency of the relevant country.

Year Shoes Haircuts in Shoes in

in Canada (CDN U.S. Haircuts in
Canada $) (USD $) U.S.
(CDN $)
(USD $)

2001 100
30 80 28

2002 120 28.67

35 85

For each year, the statistical agency in each country constructs a consumer price
index which is a weighted average of the prices of the two goods in that country. The
weights in the price indexes are given by the share of each good in the consumers’
consumption baskets. Assume that Canadians spend 60% of their consumption
expenditures on shoes while Americans spend 70% of their consumption
expenditures on shoes.

Assume that the nominal exchange rate is such that the Law of One Price holds for
traded goods in every year.

a. Determine the nominal exchange rate (CDN$ per US$) in each year.
b. Determine the real exchange rate in each year.

c. Determine if absolute purchasing power parity holds and justify your

answer. If it does not hold, give two reasons why it does not hold.

Absolute purchasing power parity does not hold.

Two reasons why absolute PPP does not hold could be:
1. Non-traded goods: Absolute PPP assumes that all goods are
tradable and subject to arbitrage. However, in this scenario,
haircuts are not traded goods, so their prices are not influenced
by the exchange rate. This leads to differences in price levels
 between the two countries, causing deviations from absolute
PPP.
2. Market imperfections and transportation costs: Absolute PPP
assumes frictionless markets and zero transportation costs. In
reality, market imperfections, trade barriers, and transportation
costs can prevent perfect arbitrage, leading to differences in price
levels and deviations from absolute PPP.

d. Determine if relative purchasing power parity holds and justify your

answer.

Relative purchasing power parity holds because the nominal exchange rate
changes in proportion to the difference in price levels between the two countries. It
can be proved by the the value of real exchange rate in both years, 2001 and 2002
where the value are constant over those 2 years.

The following table gives the nominal exchange rate, consumer price indexes,
and the real exchange rate in each year.

Year Nominal Canadian U.S. CPI Real

Exchange Rate CPI (CDN $) (USD $) Exchange
( ECDN$/US $ ) Rate

2001 64.4
1.25 72 1.12

2001 68.1
1.41 86 1.12

4. What is meant by the asset market or portfolio balance approach? In what

ways does it differ from the monetary approach?

Asset market or portfolio balance approach is a theory based on the relationship

between relative price of bond and exchange rates. This approach holds that shifts in the
supply and demand for domestic and foreign bonds, as well as their impact on currency
rates, are caused by the economy.

In contrast to monetary theory, which holds that domestic and foreign bonds are
perfect substitutes, portfolio balance theory assumes that domestic and international bonds
are imperfect substitutes. It indicates that holding a foreign bond involves a higher level of
risk than holding a domestic bond. Individuals and businesses who use the asset market
approach keep their financial assets in a mix of local money (M), domestic bonds (D), and
foreign bonds (F) denominated in foreign currencies.

Examples :

1. Domestic interest rate increase (i)

- Purchase more on domestic bonds, hold less domestic money, and sell
foreign bonds, demand for domestic currency increased, domestic currency
appreciates.

2. Foreign interest rate increase (i*)

- Purchase more on foreign bonds, hold less domestic money and domestic
bonds, demand for foreign currency increases, domestic currency
depreciates.

3. Wealth increase (W)

- money demand, D, and F. Exchange rate rises if investors buy foreign currency to
have more foreign bonds. It means that the domestic currency depreciates.
TUTORIAL 4 (GROUP 4)

1. How does a depreciation or devaluation of a nation’s currency operate to eliminate

or reduce a deficit in its current account or balance of payment?

Devaluation reduces the cost of a country’s exports, rendering them more competitive in the
global market which increases the cost of imports. If imports are more expensive, domestic
consumers are less likely to purchase them, further strengthening domestic businesses.

When exports increase and imports decrease, there is typically a better balance of payment
because of the trade deficit. So, a country that devalues its currency can reduce its deficit
because there is greater demand for cheaper exports.

The price of goods and services in that country becomes relatively cheaper compared to
other countries. So, foreign buyers are likely to buy more of its exports, increasing the
demand for its goods and services. This increase in demand export will lead to an increase
in the nation’s export learning.

2. Balance of payments adjustment with exchange rate changes depends on elasticity

of demand and supply of foreign currency. Discuss the validity of this statement.

3. Discuss derivation of the demand curve for foreign exchange.

On the left side, there is a balance of payment adjustment with exchange rate changes
graph, given the demand curve for foreign exchange is euro. The point that connects the
demand curve is point B to point E. The derivation of this demand curve will be discussed
based on the U.S import market graph on the right. It is because when americans demand
for import their goods from european, european will supply for US dollar to sell the goods
that american has imported. In order to fulfil that, Americans must first demand the dollar to
Europeans.

Balance of payment graph (left side) consists of the quantity of euros on the x axis and the
exchange rate of R=$1/€1 on the y axis. Point B in the balance of payment graph recorded
the quantity demand at 12 billions with exchange rate at R = $/€. Looking at the US import
market graph, at point B’, the euro price of US imports is at Px = euro 1 while the quantity of
US imports is Qm= 12 billion units. Hence, the US quantity of euros demand is euro 12
billion ( euro 1 x 12 billion units). This point B’ in the US import market graph corresponds to
point B in the balance of payment graph where the quantity demand is at euro 12 billion.

However, between A and B in the balance of payment graph, there is a trade deficit. To
correct the imbalance in the balance of payment, dollars are allowed to depreciate or
devalue. Let say if the dollar devalues or is allowed to depreciate by 20 percent to R
=$1.20/euro 1. In the US import market graph, the Sm curve remains unchanged. But, the
Dm curve shifts to the left (shift down) from Dm to D’m by 20 percent. The US now will
import 11 billion units at the euro price of Px= euro 1 compared to before the depreciation of
the dollar, at Px = euro 2. The 20 percent distance can be shown by this [ 2.0 - 1.6 / 2.0 =
20% ]

The reason is that for the United States to continue to demand 12 billion units of imports (as
at point B’ on Dm ), the euro price of U.S. imports would have to fall from Pm = €1 to Pm =
€0.8, or by the full 20 percent of the depreciation of the dollar, in order to leave the dollar
price of imports unchanged (point H on D’m ). However, at euro prices below Pm = €1, the
United States will demand smaller quantities of imports at euro prices above PM = €0.8 ( the
United States will move up along), until a compromise on price at the new equilibrium point
E’ is reached.

Note that D’m is not parallel to Dm because the shift is of a constant percentage. Thus, a 20
percent downward shift from point B’(€1.00) is only €0.20, while the same 20 percent
downward shift from point G (€1.25) is €0.25. With D’m and Sm , Pm = €0.9 and Qm = 11
billion, so that the quantity of euros demanded by the United States falls to €9.9 billion (point
E’ in the left panel). This corresponds to point E (with €9.9 billion rounded to €10 billion) on
D€ in Figure 16.1. Thus, the quantity of euros demanded by the United States falls from €12
billion (given by point B’ in the left side) at R = $1/€1 to €10 billion (given by point E’ ) at R =
$1.20/€1. This corresponds to a movement from point B to point E along D’ in Figure 16.1
4. Discuss derivation of the supply curve for foreign exchange

On the left, there is a balance of payment graph, given the supply curve for foreign
exchange is Seuro. The point that connects the supply curve is point A to point E. The
derivation of this supply curve will be discussed based on the U.S export market graph on
the right. It is because when americans export their goods to european, european will
demand for US dollar to buy the goods that american has exported. In order to fulfil that,
Americans must first supply the dollar to Europeans.

Balance of payment graph [ left ] consists of the quantity of euros on the x axis and the
exchange rate of R=$1/euro1 on the y axis. Point A in the balance of payment graph
recorded the quantity supplied at 8 billions with exchange rate at R = $/euro. Looking at the
US export market graph, at point A’, the euro price of US exports is at Px = euro 2 while the
quantity of US exports is Qx= 4 billion units. Hence, the US quantity of euros supplied is euro
8 billion ( euro 2 x 4 billion units). This point A’ in the US export market graph corresponds
to point A in the balance of payment graph where the quantity supplies is at euro 8 billion.

However, between A and B in the balance of payment graph, there is a trade deficit. To
correct the imbalance in the balance of payment, dollars are allowed to depreciate or
devalue. Let say if the dollar devalues or is allowed to depreciate by 20 percent to R
=$1.20/euro 1. In the US export market graph, the Dx curve remains unchanged. But, the Sx
curve shifts downward from Sx to S’x by 20 percent. The US now will export 4 billion units at
the euro price of Px= euro 1.6 compared to before the depreciation of the dollar, at Px = euro
2. The 20 percent distance can be shown by this [ 2.0 - 1.6 / 2.0 = 20% ]

But at euro prices below Px = euro 2, the European Monetary Union will now demand for
greater quantities of US exports in favour of each euro that is now worth 20 percent more in
terms of dollar 9 ( DD>SS ). But at the same time, the US will just supply greater quantities
of exports at euro price above Px = euro 1.6. So in this case, to make the trade happen,
these two countries must discuss and forego their interest.

Therefore, the euro price has to increase from Px = euro 1.6 to Px = euro 1.8. Hence,
quantity demanded of US exports now decreases and quantity supplied of US exports
increases. Equilibrium is achieved at point E’ in the US export market graph at euro price, Px
= euro 1.8 and quantity supply of US exports at euro 5.5 billion ( euro 1.8 x euro 5.5 = 9.9
billion ). This point E’ on the right corresponds to point E in the balance of payment graph
where now the quantity of euros supplied to the United States rose from euro 8 billion at
R=$1/ euro 1 to euro 10 billion at R = $1.2=euro 1.

5. What are factors that affect the terms of trade?

Terms of trade are defined as the ratio between the index of export prices and the index of
import prices. If the export prices increase more than the import prices, a country has a
positive terms of trade, as for the same amount of exports, it can purchase more imports.

The terms of trade refer to the ratio at which a country can exchange its exports for imports.
Various factors can influence the terms of trade, including:

Firstly, supply and demand conditions. Any changes in the relative supply and demand for a
country's exports and imports can impact the terms of trade. If a country's exports are in high
demand while its imports are less in demand, the terms of trade may improve.

Secondly, exchange rates. The fluctuations in exchange rates can affect the terms of trade.
A depreciation in a country's currency can improve the terms of trade by making its exports
relatively cheaper and imports relatively more expensive. Conversely, an appreciation of the
currency can worsen the terms of trade.

Lastly, trade policies. The government policies such as tariffs, quotas, and subsidies can
influence the terms of trade. Protectionist measures, like high import tariffs, can improve a
country's terms of trade by making imports more expensive. Conversely, liberalization of
trade can lead to a decline in the terms of trade if imports become relatively cheaper.
TUTORIAL 5 (GROUP 1)

1. As long as demand and supply curves of foreign exchange are intersected, the
foreign exchange market will stable. Are you agreed? Why?

Figure 1 Figure 2 Figure 3

Disagree.

Based on Figure 3, A foreign exchange market is unstable if the supply curve is negatively
sloped and more elastic (flatter) than the demand curve of foreign exchange. In this case,
when the, a depreciation to offset the excess demand in the foreign market resulted the
equilibrium point archive at far away from the initia equilibrium point. Likewise, an
appreciation to offset the excess supply resulted in the equilibrium point archive at far away
from the initia equilibrium point. In order to attain the initial equilibrium point, the foregien
market needs a depreciation for excess supply and appreciation for excess demand.

2. What do you understand about Marshall-Lerner condition and the reasoning behind
it?

The marshall lerner condition tells us whether to foreign exchange market is stable or
unstable is.

1. The supply curves of imports and exports (i.e., SM and SX ) are both infinitely elastic,
or horizontal.
2. A stable foreign exchange market if the sum of the price elasticities of the demand for
imports (DM) + the demand for exports (DX), in absolute terms, > 1
3. A unstable foreign exchange market if the sum of the price elasticities of the demand
for imports (DM) + the demand for exports (DX), in absolute terms, < 1
4. If the sum of these two demand elasticities is equal to 1, a change in the exchange
rate will leave the balance of payments unchanged
3. What does the J-curve represent?

The J-curve is a concept commonly used in economics and finance to describe the pattern
of change in a country's trade balance or exchange rate following a depreciation of its
currency. It illustrates the short-term effect of a currency devaluation on a country's balance
of trade. Besides, in a J-curve scenario, the letter "J" represents the shape of the curve
when plotted on a graph. The horizontal axis represents time, and the vertical axis
represents the trade balance or exchange rate.

● Devaluation: The country decides to devalue its currency, which means intentionally
lowering the value of the currency relative to other currencies. A devaluation makes
the country's exports relatively cheaper for foreign buyers and imports relatively more
expensive for domestic consumers.
● Short-Term Adjustment: In the short term following the devaluation, the graph shows
a decline in the trade balance. This happens because it takes time for the effects of
the devaluation to fully manifest. Initially, the country's exports may not increase
significantly, and imports may remain expensive due to existing contracts or
inventory. As a result, the trade balance deteriorates, moving further into a deficit.
● Long-Term Adjustment: Over time, as the effects of the devaluation start to take hold,
the graph shows a recovery in the trade balance. The depreciation of the currency
makes exports more competitive in international markets. As a result, the country's
exports increase, while imports decrease due to their relatively higher cost. This
improves the trade balance and starts moving it back towards equilibrium.
● J-Curve Effect: When the short-term decline in the trade balance is followed by a
long-term recovery, the overall shape of the graph resembles a "J." Initially, the trade
balance moves downward, forming the upper part of the J, and then it starts to rise
again, forming the lower part of the J.

4. Explain the concept of “Pass-Through effect” of the exchange rate.

The term pass through effect (PTE) means when there is an effect of changes in the
exchange rate of a domestic currency for foreign currency in the country’s domestic prices
for traded and non-traded goods. PTE is when the domestic price of an imported good rises
following depreciation of domestic currency. It also refers to the elasticity of local-currency
import prices with respect to the local-currency import prices of foreign currency.

As an example, Full pass through = 1% depreciate / (appreciate) currency will cause 1%

increase / (decrease) in import prices.

Partial pass through = 1% depreciate / (appreciate) currency will cause 0.5% increase /
(decrease) in import prices.

5. Explain the mechanism which restores the balance of payments equilibrium when it
is disturbed under the gold standard.

6. Suppose that the pound is pegged to gold at 6 pounds per ounce, whereas the
franc is pegged to gold at 12 francs per ounce. This, of course, implies that the
equilibrium exchange rate should be two francs per pound. If the current market
exchange rate is 2.2 francs per pound, how would you take advantage of this
situation? What would be the effect of shipping costs?

1 ounce of gold= 12 franc

Sold 1 ounce in the uk = 6 pound
Convert it with 2.2 france: 1 pound
2.2 france x 6 pounds = 13.2 franc
Profit: 13.2 franc - 12 franc = 1.2 franc
TUTORIAL 6 (GROUP 2)

1. In a closed economy with no government, the equilibrium level of income is

£22 billion, the full employment level of income is £25 billion. To reach full
employment would require an injection of £1 billion. What can be deduced from
this information?
2. How is the equilibrium level of national income determined in a small open
economy? What is the value of the foreign trade multiplier (k’)?
Foreign trade multiplier, k,
3. Show with calculation example the multiplier for Norway with foreign
repercussion for an autonomous increase in its exports that replaces
domestic production in Uruguay.

4. The data in columns 1 and 2 of the table below are for a private closed
Economy.

(2) (3) (4) (5) (6)

(1)

Real Aggregate Exports, Imports, Net Aggregate

domestic expenditures $’ $’ exports, expenditures,
output private billions billions private open
(GDP=DI) closed economy, economic,
$’ billions economy, $’ $ billions $ billions
billions

240
200
 280
250

320
300

360
350

400
400

440
450

480
500

520
550

a. Use columns 1 and 2 to determine the equilibrium GDP for this

hypothetical economy.

b. Now open this economy for international trade by including the export and
import figures of columns 3 and 4. Calculate net exports and determine the
equilibrium GDP for the open economy. Explain why equilibrium GDP differs
from the closed economy.

(1) (2) (3) (4) (5) (6)

Real Aggregate Exports, Imports, Net exports, Aggregate

domestic expenditure s $’ $’ private expenditures
output private billions billions economy, , open
(GDP=DI) closed $ billions economic,
$’ billions economy, $’ $ billions
billions
 240 30
200

280 30
250

320 30
300

360 30
350

400 30
400

440 30
450

480 30
500

520 30
550

c. Given the original $20 billion level of exports, what would be the
equilibrium GDP if imports were $10 billion greater at each level of GDP?
Or $10 billion less at each level of GDP? What generalization concerning
the level of imports and the equilibrium GDP do these examples illustrate?

d. What is the size of the multiplier in these examples?

5. In a closed economy, the marginal propensity to save increases and tax
rates remain unchanged. What effect will this have on the marginal propensity to
consume and on the multiplier?
6. In a closed economy with no government, a £1 billion increase in
investment leads to a £5 billion increase in consumption. What is the value of
the marginal propensity to consume?
TUTORIAL 7 (GROUP 3)

1. Using the SWAN Diagram, illustrate the economy that has inflation, surplus balance
of payments and suggests the policies to adjust the economy to achieve internal and
external balance.

Area II ilustrate the economy that has inflation and surplus balance of payment. To achieve
internal and external balance in an economy facing inflation and a surplus balance of
payments, the following policy suggestions can be considered. For Internal Balance, to
address inflation and achieve internal balance, the following policies can be implemented.

First, is monetary policy. The central bank can adopt a tighter monetary policy by increasing
interest rates. This reduces the money supply, curbs aggregate demand, and helps control
inflationary pressures. Second, fiscal policy. The government can implement contractionary
fiscal measures such as reducing government spending, cutting subsidies, or increasing
taxes. These measures reduce aggregate demand, curb inflation, and promote internal
balance. Third, supply-side policies. The government can focus on improving productivity,
efficiency, and competitiveness through measures such as labor market reforms, investment
in infrastructure, and encouraging innovation. Enhancing supply-side factors can help control
inflation and promote sustainable economic growth.

For External Balance, to address the surplus balance of payments and achieve external
balance, the following policies can be implemented. First, is the exchange rate policy. The
central bank can consider a managed exchange rate regime, allowing the currency to
appreciate. A stronger currency makes imports relatively cheaper and exports relatively
more expensive, helping reduce the surplus in the balance of payments. Second, is export
diversification. The government can promote export diversification by supporting the
development of new industries and exploring new markets. This reduces reliance on a
narrow range of exports, making the economy less vulnerable to external shocks. Third,
import substitution. The government can encourage domestic production and reduce
dependence on imports by providing incentives for domestic industries. This promotes
import substitution, reduces imports, and improves the balance of payments. Lastly, Foreign
direct investment (FDI). Encouraging FDI inflows can help boost exports, improve the
balance of payments, and enhance economic competitiveness. The government can offer
incentives, improve the investment climate, and develop infrastructure to attract foreign
investors.
2. (a) Draw a diagram that typically illustrates the IS-LM-BP model, with the slope of
the BP curve flatter than that of the LM curve. Label the axes properly and reflect
equilibrium.

Starting from point E with domestic unemployment and external deficit, the nation can reach
full employment level of national income of YF = 1500 with external balance by pursuing the
expansionary fiscal policy that shifts the IS curve to the right to IS' and the easy monetary
policy that shifts the LM curve to the right to LM', while keeping the exchange rate fixed. All
three markets are then in equilibrium at point F, where curves IS' and LM' cross on the
unchanged BP curve at I= 6.0% and YF = 1500. Since international capital flows are now
much more elastic than the interest rate needs only to rise from I = 5.0% to I = 6.0% thus,
facing domestic unemployment and an external deficit, the nation will require an
expansionary fiscal policy but a tight or easy monetary policy to achieve both internal and
external balance, depending on whether the BP curve is to the left or to the right of the LM
curve at the full employment level of national income.

(b) How was the LM curve derived and defined, what does the slope of the curve depend on
and what changes in what variables will shift the curve to the right?

● The LM (Liquidity-Money) curve shows the relationship between interest rates and
real income or output in an economy. It was derived from the Keynesian theory of
liquidity preference and the money market equilibrium.
● The LM curve is upward sloping, indicating that as real income or output increases,
the demand for money increases, leading to higher interest rates. Conversely, as real
income or output decreases, the demand for money decreases, resulting in lower
interest rates.
● The slope of the LM curve depends on the responsiveness of the demand for money
to changes in interest rates. This responsiveness is often referred to as the liquidity
 preference or the interest elasticity of money demand. If the demand for money is
highly sensitive to changes in interest rates, the LM curve will be relatively steep. On
the other hand, if the demand for money is less responsive to interest rate changes,
the LM curve will be flatter.
● Changes in several variables can shift the LM curve to the right, indicating a higher
level of real income or output at each interest rate:

1. Increase in money supply: An expansionary monetary policy that increases the money
supply will shift the LM curve to the right. This occurs because a higher money supply lowers
interest rates at each level of income, thereby stimulating higher investment and
consumption.

2. Increase in investment: Higher levels of investment increase the demand for money,
shifting the LM curve to the right. This can happen due to improved business confidence,
technological advancements, or favourable investment conditions.

3. Increase in government spending: Higher government spending can lead to increased

income and output, which raises the demand for money, shifting the LM curve to the right.

4. Decrease in taxes: A decrease in taxes increases disposable income and consumption,

which raises the demand for money and shifts the LM curve to the right.

5. Improvement in business expectations: If businesses become more optimistic about

future economic prospects, they may increase investment and expand operations, resulting
in a rightward shift of the LM curve.

(c) How was the IS curve derived and defined, what does the slope of the curve depend on
and what changes in what variables will shift to the curve?

● The IS curve shows combinations of interest rates and real income at which
aggregate demand equals aggregate supply. It represents the equilibrium in the
goods market, where planned investment equals planned saving.
● The slope of the IS curve depends on the responsiveness of investment and saving
to changes in real interest rates. Specifically, it depends on the interest rate elasticity
of investment and the interest rate elasticity of saving.

1. Interest rate elasticity of investment:

● If investment is highly sensitive to changes in real interest rates, the IS curve will be
relatively steep. This means that a small change in interest rates will have a
 significant impact on investment and, subsequently, on the level of real income or
output.

2. Interest rate elasticity of saving:

● If saving is highly responsive to changes in real interest rates, the IS curve will be
relatively flat. This suggests that changes in interest rates will have a relatively small
effect on saving and, therefore, on the level of real income or output.

❖ Changes in various variables can shift the IS curve:

1. Fiscal policy: Changes in government spending and taxation policies can shift the IS
curve. An increase in government spending or a decrease in taxes will stimulate aggregate
demand, shifting the IS curve to the right. Conversely, a decrease in government spending
or an increase in taxes will reduce aggregate demand, shifting the IS curve to the left.

2. Investment demand: Any factors that affect investment demand, such as changes in
business confidence, technological advancements, or changes in expectations about future
profitability, can shift the IS curve. An increase in investment demand will shift the IS curve to
the right, while a decrease will shift it to the left.

4. Monetary policy: Changes in monetary policy can indirectly impact the IS curve. For
instance, if the central bank raises interest rates to control inflation, it may reduce investment
and aggregate demand, shifting the IS curve to the left.

(d) What does the BP curve reflect and what do points on, below and above the BP curve
indicate?

● The BP (Balance of Payments) curve reflects the relationship between the exchange
rate and the balance of payments in an economy. It represents the equilibrium points
where the supply and demand for a country's currency in the foreign exchange
market are balanced.
● Points on the BP curve: Points on the BP curve represent equilibrium positions in
the foreign exchange market where the demand for a country's currency equals the
supply. At these points, the balance of payments is in equilibrium. The exchange rate
associated with each point on the curve indicates the rate at which the supply and
demand for the currency are balanced.
● Points below the BP curve: Points below the BP curve represent a deficit in the
balance of payments. In other words, the demand for the country's currency in the
foreign exchange market exceeds the supply. This indicates that the country is
 experiencing a net outflow of currency or a trade deficit. To restore equilibrium, the
exchange rate may adjust to make the country's exports relatively cheaper and
imports relatively more expensive.
● Points above the BP curve: Points above the BP curve represent a surplus in the
balance of payments. Here, the supply of the country's currency exceeds the
demand. This indicates a net inflow of currency or a trade surplus. The exchange
rate may adjust to make the country's exports relatively more expensive and imports
relatively cheaper, aiming to restore equilibrium.

3. The IS-LM-BP model defines six regions, each corresponding to disequilibrium in

the money market, goods market and/or the balance of payments. Identify and
describe each of these when capital is perfectly mobile, and when capital is perfectly
immobile.

Area 1: Money market disequilibrium, goods market equilibrium, and balance of payments
equilibrium.
- There is excess demand or excess supply of money in the economy (monetary
disequilibrium), but the GM is in equilibrium, and the BoP is also in deficit (r < r*). The
central bank can adjust monetary policy to restore equilibrium in the money market.

Area 2: Money market equilibrium, goods market disequilibrium, and balance of payments
equilibrium.
- The money market is in equilibrium, but there is a mismatch between the demand
and supply of goods (goods market disequilibrium). The balance of payments,
however, remains in equilibrium and having surplus (r > r*). Fiscal policy measures,
such as government spending or taxation, can be used to bring the goods market
back into equilibrium.

Area 3: Money market disequilibrium, goods market disequilibrium, and balance of payments
equilibrium.
- Both the money market and goods market are in disequilibrium, but the balance of
payments remains in equilibrium. Both monetary and fiscal policy measures need to
be employed simultaneously to restore equilibrium in both the money and goods
markets.

Area 4: Money market equilibrium, goods market equilibrium, and balance of payments
disequilibrium.
 - The money market and goods market are in equilibrium, but there is an imbalance in
the balance of payments. This imbalance indicates a surplus or deficit in the current
account of the balance of payments. To restore balance, exchange rate policy
measures, such as currency devaluation or revaluation, can be implemented.

Area 5: Money market disequilibrium, goods market equilibrium, and balance of payments
disequilibrium.
- The money market is in disequilibrium, but the goods market is in equilibrium.
Additionally, the balance of payments is in disequilibrium and deficit. In this case, a
combination of monetary policy measures (to address the money market
disequilibrium) and exchange rate policy measures (to correct the balance of
payments disequilibrium) are required.

Area 6: Money market equilibrium, goods market disequilibrium, and balance of payments
disequilibrium.
- The money market is in equilibrium, but the goods market is in disequilibrium.
Simultaneously, there is also an imbalance in the balance of payments. To restore
equilibrium, both fiscal policy measures (for the goods market) and exchange rate
policy measures (for the balance of payments) need to be employed.

Area 1: Money market disequilibrium, goods market equilibrium, and balance of payments
equilibrium.
- Since capital is immobile, the adjustment to monetary disequilibrium is limited. The central
bank can still use monetary policy measures, such as open market operations, to influence
interest rates and money supply, but the impact on the money market may be limited due to
the immobility of capital.

Area 2: Money market equilibrium, goods market disequilibrium, and balance of payments
equilibrium.

- Fiscal policy measures, such as changes in government spending or taxation,

become the primary tool for adjusting the goods market, as capital mobility is
restricted. The limited mobility of capital constrains the effectiveness of monetary
policy in this region.
Area 3: Money market disequilibrium, goods market disequilibrium, and balance of payments
equilibrium.

- With immobile capital, the adjustment to both the money and goods markets
becomes more challenging. A combination of fiscal policy measures (for the goods
market) and limited monetary policy measures may be necessary to address the dual
disequilibriam.

Area 4: Money market equilibrium, goods market equilibrium, and balance of payments
disequilibrium.

- Capital immobility restricts the adjustment mechanisms, making it difficult to address

the balance of payments disequilibrium. The authorities may need to rely on
exchange rate policy measures, such as currency devaluation or revaluation, to
restore equilibrium in the balance of payments.

Area 5: Money market disequilibrium, goods market equilibrium, and balance of payments
disequilibrium.

- Given the immobility of capital, the adjustment options are limited. Authorities may
need to implement a combination of limited monetary policy measures (for the money
market) and exchange rate policy measures (for the balance of payments) to restore
equilibrium.

Area 6: Money market equilibrium, goods market disequilibrium, and balance of payments
disequilibrium.

- Limited capital mobility hampers the adjustment process, making it challenging to

simultaneously restore equilibrium in both the goods market and the balance of
payments. Fiscal policy measures (for the goods market) and exchange rate policy
measures (for the balance of payments) may be required to address the dual
disequilibriam.
4. Using the IS-LM-BP model with a low degree of capital mobility, what will be the
effects of the following?

a. A deterioration in business optimism with fixed exchange rates

A fall in business optimism sees a contraction in investment which causes the IS curve shift
to the left.

At point b, the balance of payments has moved into surplus. Although the domestic interest
rate has fallen (from r1 to r2), which encourages capital outflows; these have a small effect
because capital mobility is low. The fall in income (from y1 to y2) on the overhand reduces
the level of imports, and this is relatively more important.

In addition, the surplus on the balance of payments highlights demand and supply
movements in currency markets that will lead to an exchange rate appreciation.

To prevent this, policy makers must expand the money supply (easy monetary policy) until
the balance of payments has been returned to equilibrium at point c, which LM curve shifts
to the right. The expansion in the money supply reduces interest rates so encourages capital
outflows, but also raises domestic output increasing imports- both effects offset the surplus
and the pressure for appreciation. Lastly, BP curve no change because exchange rate is
fixed.

b. An increase in the money supply with floating exchange rates

A monetary expansion or easy monetary policy which increases the money supply in the
market will shift the LM curve to the right (from LM1 to LM2).

At point b, we could see the reduction in interest rates (from r1 to r2) and increased income
(from y1 to y2) - both of which lead to a balance of payments deficit.

Under the flexible exchange rate system, the nation's currency depreciates, and the BP
curve shifts to the right (from BP1 to BP2). The depreciation improves the nation's trade
balance and the IS curve will shift to the right.

It shows that the deficit will make the exchange rate depreciate and the improvement in
competitiveness that shifts both the BP and IS curves to the right. The new equilibrium of the
economy is at point c.

c. A rise in taxes with floating exchange rates

The rise in taxes reduces disposable incomes and leads to a fall in consumption.

At point b, it shows that the IS curve shifts to the left because consumption and investment
will decrease due to the lower disposable income. As a result, the interest rate in the
short-run will increase resulting in a level of output lower than the initial level. The fall in
output will lower the imports and the balance of payments moves into surplus.

This surplus position reflects a fall in the demand for overseas currency, and also a fall in the
supply of domestic currency. Both these movements lead to an exchange rate appreciation,
the competitiveness effects of which shift both the IS and BP curves to the left.

With a floating exchange rate, the exchange rate will depreciate as the interest rate
increases, which will help to offset the negative effects of the tax increase on net exports.
Therefore, output falls further and the economy moves to point c.

d. A fall in the money supply with fixed exchange rates

A fall in the money supply with a fixed exchange rate in the IS-LM-BP model with a low
degree of capital mobility will cause a contractionary effect on the economy. The fall in the
money supply will cause LM curve shifts to the left (from LM1 to LM2) since the higher
interest rates will reduce investment and consumption.

The result will be a reduction in output levels in the short run. With a fixed exchange rate, the
decrease in the money supply will be reflected in the BP curve as the currency appreciates.
(combination of raising the domestic interest rate and reducing income moves the balance of
payments into surplus and creates pressure for an exchange rate appreciation).

The increase in the currency value will offset the negative shock on net exports. This
however, cannot be allowed to persist if the fixed exchange rate is to be maintained.

Therefore, an offsetting monetary expansion is required to return the economy to its original
position (point c).

5. In what circumstance is fiscal policy effective but monetary policy ineffective under
fixed exchange rates to achieve external and internal balances?
 6. In what circumstance is monetary policy effective but fiscal policy ineffective
under flexible exchange rates to achieve external and internal balances?
TUTORIAL 8 (GROUP 4)

1. (a) Why does the AD curve shift to the right? Mention possible reasons.

(b) What happens to inflation and to unemployment (comparison B with A)?

2. Starting from the long-run equilibrium, show the short-run effects of a

stock market crash on AD, inflation and unemployment by using a graph.
Give a reason for the change in AD.

- Since the stock market crashed in AD, this led to decrease in consumer
spending and investment. This reduction in spending will cause a decrease in
AD, so the AD curve shifts to the left from AD1 to AD2.
- Decrease in AD, make businesses find it difficult to sell their product and lead
to excess inventories. To reduce this, firms need to reduce price, short run
effect of a stock market crash is a decrease in inflation.
 - Decrease in AD, will make firms experience a decrease in sales and revenue.
To adjust lower demand, businesses may reduce their production level. This
reduction in production will lead to decrease in demand for labour, making it
increase in unemployment.
- In summary, a stock market crash will shift the AD curve to the left. Decrease
in AD causes decrease in price level (inflation) and increase in unemployment
in the short run.

3. There are the following even

(a) A reduction in income taxes
-a shift of AD curve to the right

(b) A higher price level (inflation)

-no shift of any curve but rather a movement along a curve

(c) A technological progress in production

-a shift of the SRAS curve to the right

(d) An additional government spending

-a shift of the AD curve to the right

(e) A strong increase in wages

-a shift of the SRAS curve to the left

Is there a shift of the AD curve or the SRAS curve? If so, does the curve shift to the
right or to the left?

4. How can an economy return to the long-run equilibrium if it faces a boom

and if wages are flexible? Answer with a graph and justify your answer
5. How can the following results be obtained by shifting the AD curve or the
SRAS curve or both curves? Answer with graphs.
Results to be shown in two graphs:

(a) Unemployment and price level lower (deflation)

● When the deflation happen, the unemployment will decrease

● The supply of goods and services in the short run will increase
● Causes the SRAS shift to the left from SRAS to SRAS'
● The shift of SRAS cause the price level to fall from P0 to P1
● Which then lead to the increment of output from Y0 to Y1

(b) Unemployment higher, price level unchanged

 ● When the unemployment is higher, the labor hired are low causes the AD to
shift to the left from AD to AD'
● Since the price remain constant, the firm decreased the supply in the short
run
● Causes the SRAS shift to the left from SRAS to SRAS'
● Which then lead the output to fall from Y0 to Y1

6. The economy of Petmeckistan is initially in long-run macroeconomic

equilibrium. Then, the stunning defeat of the Petmeckistan synchronized skating
team at the Winter Olympics by their arch rival, Lizania, causes widespread
pessimism among consumers.

In a correctly labeled graph of the long-run aggregate supply, short-run aggregate

supply, and aggregate demand, show each of the following:

● l Initial equilibrium output and price level, labeled as Y1 and PL1

● l The new equilibrium output and price level, labeled as Y2 and PL2
● l Full employment output, labeled as Yt
 TUTORIAL 9 (GROUP 1)

1. The three figures below show supply and demand for the currencies of
three countries, A, B, and C, in their respective foreign exchange markets
vis a vis the dollar. The currencies are represented as §A, §B , etc. (say
“A-notes,” etc.). Countries A and B have pegged exchange rates to the
dollar at the rates shown as ĒA and ĒB respectively, while country C has a
floating rate.

Suppose now that you are a speculator with ample resources in each of
these countries as well as in the U.S. You are trying to pick one of these
currencies on which to speculate by either buying it or selling it, hoping that
the exchange rate will later move to your advantage.

a. Which one currency would you choose to speculate on?

Country B

b. Would you buy it or sell it?

Sell

c. Why would you pick the currency you picked in part (a)?

Country A

Unlikely to revalue its currency since it is gaining reserves.

Country C

It hard to speculate in which direction the currency will move.

Country B

The country is loosing reserves. Morelikely to devalue its currency.

 From an American perspective, Country B’s currency speculated to devalue
means dollar will appreciate against the currency country B. So, it is
profitable for me to sell currency B when the exchange rate is high.

2. Which are the advantages of floating exchange rates compared to

fixed exchange rates?

● Protection from external shocks and automatic adjustment in balance of

payments
● Large foreign exchange reserves are not required
● Independent monetary policy

3. Assume we live in the 1980s. Assume that Italy had an inflation rate of 5%
annually, whereas West Germany has a 2% annual inflation rate. Assume
Italy has pegged its currency (Italian lira) to the German Deutsch Mark (DM).

a. What do investors actually do when they speculate against a currency?

b. Explain why the Italian lira may be a target for speculators if the above
situation persist. Include in your answer the expected annual rate of
depreciation in case the lira would have been floating against the DM.

a)

● Short Selling: Investors could borrow Italian lira from a lender and sell it in the
foreign exchange market, expecting the lira to weaken against the DM. If their
speculation turns out to be correct, they can repurchase the lira at a lower
exchange rate, return it to the lender, and pocket the difference as profit.

● Carry Trade: In a pegged currency system, interest rates could differ between
countries. If Italy has higher interest rates than West Germany, investors
might borrow in the lower-interest-rate currency (DM) and invest the funds in
the higher-interest-rate currency (lira).

● Capital Flight: Speculators may choose to move their investments out of Italy
and into West Germany or other countries with more stable currencies. By
converting their Italian lira holdings into Deutsch Marks or other stronger
currencies, they can protect their wealth from potential devaluation.
b)

Under floating rates, the expected annual rate of depreciation would have been 3%.
This estimation is based on the principle of purchasing power parity (PPP), which
suggests that over time, the exchange rate should adjust to equalize the relative
purchasing power of two currencies. It's important to note that the actual exchange
rate movements and the rate of depreciation can be influenced by various factors
beyond inflation differentials, such as economic growth, interest rate differentials,
political developments, market sentiment, and central bank interventions.
Speculators need to carefully assess and manage the risks associated with currency
speculation, as the currency markets can be highly volatile and unpredictable.

4. What is meant by a crawling peg system? How can such a system

overcome the disadvantage of an adjustable peg system?

A crawling peg system is a way for a country to control the value of its currency.
Instead of making big changes in par values all at once, the country makes small
adjustments at regular intervals, like every month, until the currency reaches the
desired value.

The crawling peg system overcomes the problems of the adjustable peg
system in the following ways. In the adjustable peg system, big changes in the
currency's value can cause instability and speculation. The crawling peg system
avoids this by making small changes at frequent intervals, which creates a more
stable environment.

To discourage people from trying to take advantage of expected changes

in the exchange rate, the crawling peg system can adjust short-term interest
rates. This makes it less profitable for speculators to engage in risky currency
trading.

Crawling peg system can also help avoid political stigma. Large
devaluations or revaluations in the adjustable peg system can harm a country's
reputation. The crawling peg system eliminates this stigma by making gradual
adjustments that are less noticeable and less controversial.

Other than that it has the flexibility with wider range as the crawling peg
system can be more flexible by allowing wider ranges of fluctuation in the
exchange rate. This gives the country more room to adjust its currency's value
based on economic conditions.
5. Compare a free-floating exchange rate system with a managed-floating
exchange rate system.

Free-Floating Exchange Rate System Managed-Floating Exchange Rate System

● A monetary system, wherein the ● The exchange rate is allowed to

exchange rate is set according to fluctuate within a specified band
the demand and supply forces, is around a desired valuation. If it
known as flexible or floating goes outside of this band then
exchange rate. The economic the Central Bank will intervene to
position of the country bring it back within the band
determines the market demand ● When they want their currency to
and supply for its currency. appreciate back within the band,
● The currency price is market they buy it on forex markets
determined, concerning other using their foreign reserves, thus
currencies. increasing its demand.
● When they want their currency to
depreciate back into the band,
they sell it on forex markets,
thus increasing its supply

Advantages: Advantages:

1. Protection from external shocks 1. Stronger and more resilient

2. Lack of policy constraints monetary policy
3. Correction of balance of 2. Limited impact on the domestic
payments deficits economy
3. Control over import price
increases

Disadvantages: Disadvantages:
1. Instability 1. Competitive devaluations
2. No constraints on domestic 2. Allow a government to
policy manipulate exchange rates in a
3. Speculation manner that can benefit its own
country at the expense of others.
3. Interest rates and currency
speculation
6. Differentiate between devaluation and depreciation.

Devaluation

Devaluation specifically refers to a government or central bank's deliberate and

official reduction in the value of a currency. It is a controlled action taken by
governments to depreciate their currency in relation to other currencies. Devaluation
is commonly used when a country wants to increase exports, make domestic goods
more competitive in international markets, or address trade imbalances. Devaluation
is typically accomplished by a government actively intervening in the foreign
exchange market and lowering its currency's official exchange rate.

Depreciation

Depreciation, refers to a decrease in a currency's value in the foreign exchange

market as a result of market forces such as supply and demand. It is a natural result
of currency exchange rate fluctuations caused by economic factors, market
conditions, investor sentiment, or other external factors. Depreciation can occur on
its own without the intervention of the government or central bank. Currency values
in a floating exchange rate system can depreciate or appreciate as a result of
various economic factors and market dynamics.