MGEC61 – LEC 01and LEC 02

| September 27, 2015

MGEC61 – LEC 01and LEC 02
International Economic: Finance
Assignment 1

Instructions:
•    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        12000
Consumption, C
Investment, I
Government spending, G
Taxes, T
Private savings, SP    3840    1680
Public savings, SG
National savings, S            290
Net unilateral transfer    0    0    0
Current Account, CA    1050
Non-reserve portion of financial account, KAnon-res            790
Official reserve transactions, ORT
Capital account

Additional information given about these countries:
•    The central banks only make transactions with other countries’ central banks.
•    All three countries have the same level of output.
•    The share of consumption in GDP is equal to 50%, 60%, and 72.5% in A, B, and C respectively.
•    In A, a quarter of the output is allocated for the accumulation of physical capital.
•    Country A has a financial account deficit of 940, and the central bank of A finds its stock of official reserves increases by 430.
•    The national savings rate in B reaches 28% of national income.
•    Country C has twin deficits and the size of each deficit is equal to 8.75% of GDP
•    Residents of B received a total of asset transfers of 280 from residents of A and C, and these are non-market transactions.

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.  (15 points)
Note:  Table 1 is reproduced on page 7 of this assignment.  You must submit that page for grading; otherwise you will receive a grade of zero for this question.

Question 2 (20 points)
Suppose you are working for a large, international investment bank, and you observe the annual yields on the Japanese yen-denominated corporate bonds and the euro-denominated corporate bonds are 2.56% and 3.19% respectively.  In addition, the current (spot) ¥/€ exchange rate is 202.345, and the euro is traded at a forward discount of 0.5% 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 euro.  What would you do to capture the arbitrage profit?  Calculate the arbitrage profit (measured in Japanese yen).  Explain.  (8 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 ¥/€ exchange rate bear all the burden of adjustments.  Find the spot ¥/€ exchange rate that would make your boss indifferent between investing in the Japanese yen-denominated corporate bonds and the euro-denominated corporate bonds.  Compare to the initial spot ¥/€ exchange rate, what happens to the value of € in the spot market (i.e., does € appreciate or depreciate)? (4 points)

Note:
1)    Quote the exchange rates as E¥/€ and F¥/€.
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 “¥” and “€” to represent all the variables and terms used for the Japanese yen-denominated corporate bonds and the euro-denominated corporate bonds respectively in your written explanation.  You must use these notations; otherwise, you will receive a grade of ZERO for the whole question.

Question 3 (20 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 = AKaL(1-a).
•    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.

Home and Foreign differ in the following ways:
Home    Foreign
Level of total factor productivity    6    3
Supply of capital    1000    15625
Supply of labour    27000    27000
Capital’s share of income    ?    ?
Long-run (nominal) interest rate    6%    5%
Fraction of income held in the form of money    17.5%    12%
Sensitivity of MD to a change in (nominal) interest rate    15000    10000
(Nominal) Money supply    30780    22800
Note:
1)    Quote the exchange rate as EDC/FC.
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)

Studies show that any permanent change from Home and/or Foreign will cause the expected change rate (Ee) to change by 0.16 DC per FC.  Now, suppose the fraction of income held in the form of money by Home’s money holders increases by 2.5 percentage points permanently.
b)    Find the short-run equilibrium DC/FC exchange rate. (5 points)
c)    Find the long-run equilibrium foreign price level and the DC/FC exchange rate.  (4 points)
d)    Now, suppose the central bank of Home finds the change in the short-run exchange rate in part (b) undesirable and wants to keep the DC/FC exchange rate at par via a temporary change in monetary policy.  Is it possible for the central bank of Home to achieve this goal?  If yes, find the level of money supply that would achieve the goal; if no, explain the reason behind.  (5 points)

Question 4 (20 points)
Consider two small, open economies, Canada and Australia.  Suppose the Reserve Bank of Australia (RBA), the central bank of Australia, makes a once-and-for-all transfer of the Australian government deposit from the RBA to the Australian commercial banks.

The following questions ask you to evaluate the effect of the changes in monetary policy on the C$/A$ exchange rate under different theories on exchange rate determination.

a)    In the context of the asset approach to the exchange rate, what happens to the short-run and long-run C$/A$ exchange rate?  Explain in words and ONE foreign exchange market diagram (only the first diagram will be graded).  (15 points).
Note:  You need to determine what happens to the level of money supply in Australia.
b)    Use the monetary approach to the long-run exchange rate to determine what happens to the (nominal) C$/A$ exchange rate in the long run?  Explain.  (5 points)

Note:
1)    Quote the exchange rate as EC$/A$.
2)    DO NOT ANSWER the question by letting Australia 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 “A” to represent all the variables and terms used for Canada and Australia respectively in your written explanation and diagram.  You must use these notations; otherwise, you will receive a grade of ZERO for the whole question.

Question 5 (25 points)
This questions are related to the article “Asian currencies: Plunging like it’s 1998”, The Economist, May 2nd, 2015 (pages 5 & 6 of this assignment).

When answering 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 Indonesian rupiah and Malaysian ringgit have been falling rapidly against the U.S. dollar in 2015.  Several factors were identified as the causes, these factors include:
1)    Declining commodity prices
2)    Slower growth in China
3)    The growing likelihood of an interest rate hike in the U.S.
Explain how each of the above factors causes these currencies to depreciate.  (10 points)
b)    In response to their woes, what did Indonesia do?  Explain why the government believes these measures might help to slow down the depreciation of the rupiah.  (5 points)
c)    In response to their woes, what did Malaysia do?  Name one of the potential dangers of the adopted measure might have on the Malaysian economy.  Explain.  (5 points)
d)    Explain the logic behind the following sentence “In the meantime, depreciation should make their exports more competitive, but low commodity prices seem to be offsetting that gain.” (Last paragraph of the article on page 6).  (5 points)
Asian currencies
Plunging like it’s 1998
The rupiah and ringgit plumb depths unseen since the Asian financial crisis
Aug 8th 2015 | SINGAPORE | From the print edition

NOT since Bill Clinton was president and Barack Obama was a law professor with a sideline in local politics have the beaches of Bali and Langkawi looked so inviting to Americans. Four years ago, a dollar fetched just over 8,500 Indonesian rupiah, and just under three Malaysian ringgit. Today a dollar is worth nearly 14,000 rupiah and almost four ringgit. Both currencies hit 17-year lows this summer, and kept falling (see chart).
In one sense, Indonesia and Malaysia are far from unique: declining commodity prices, the slowdown in China and the growing likelihood of an interest-rate rise in America have combined to make 2015 a miserable year for emerging-market currencies. Brazil and Russia are in recession, sending the real and the rouble falling. Turkey, with its slowing economy, huge current-account deficit and growing political instability, has seen the lira decline steeply; the Chilean, Colombian and Mexican pesos have all drooped.
But in Asia the rupiah and ringgit lead the race downwards, having fallen by 8.4% and 9.8% against the dollar this year—much further than the Thai baht (6.4%) and the Philippine peso (2.2%). Their problems are exacerbated not just by the Indonesian and Malaysian economies’ heavy dependence on commodities, but also by political ructions in both countries.
Start with commodities. The halving of oil prices over the past year has harmed Malaysia, which depends on oil for about 30% of its revenue. Indonesia is a net importer of oil, but other commodities still comprise around 60% of its exports—a worry, given that The Economist’s commodity index, which excludes oil, has declined by almost 20% over the past year. Thailand and the Philippines, in contrast, both have sizeable advanced manufacturing sectors: their top exports are computers and electronic components.
China’s slower growth and waning appetite for commodities have also been a drag on Malaysia and Indonesia. China is the top destination for exports from the Philippines too, but remittances from the millions of Filipinos working abroad have helped prop up domestic demand, thus cushioning the blow of falling income from exports.
Indonesia’s current-account deficit and the big share of its government debt in foreign hands will make it particularly susceptible to capital outflows in the event of a rate rise in America. (Foreigners also own a lot of Malaysia’s debt.) Even more worrying, much Indonesian borrowing, both corporate and sovereign, is dollar-denominated, meaning that as the rupiah falls the cost of debt service rises.
In response to these woes, Indonesia has fallen back on protectionism, as usual: in July it imposed import tariffs on a range of consumer goods, including coffee, cars and condoms. Despite much talk from the president, Joko Widodo, about upgrading his country’s infrastructure, little has been done. He came into office nearly a year ago with great promise, but some investors have started to wonder whether he is up to the job of pushing through the reforms his country desperately needs.
As for Malaysia, its foreign reserves look set to drop below $100 billion, depriving it of a much-needed buffer, and suggesting the government may have tried to prop up the ringgit. The woes of its prime minister, Najib Razak, who for months has been trying to dispel allegations of corruption, may intensify investors’ jitters.
The question now, for both countries, is how long the pain will last. Many predict that commodity prices will rebound; fewer predict when. In the meantime, depreciation should make their exports more competitive, but low commodity prices seem to be offsetting that gain. Indonesia is growing at the slowest pace since 2009. The falling currencies in both places are also stoking inflation. Whenever the Fed gets around to raising rates, these ailments will presumably worsen.

Answer for Question 1 Part a
(Submit this page with your answers in your assignment for grading)

A    B    C
National Output, Y        12000
Consumption, C
Investment, I
Government spending, G
Taxes, T
Private savings, SP    3840    1680
Public savings, SG
National savings, S            290
Net unilateral transfer    0    0    0
Current Account, CA    1050
Non-reserve portion of financial account, KAnon-res            790
Official reserve transactions, ORT
Capital account

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