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(Solved) ECON 424: International Payments (Winter 2016) ASSIGNMENT # 1

I have attached a pdf file that has my assignment for econ 424. I need help with question 4 part "b".PLEASE HELP!

ECON 424: International Payments (Winter 2016)

ASSIGNMENT # 1 (Total 100 points)

Due on Thursday 10th March at 4pm

Instructions:

There are 5 questions and 7 pages

Only hard copy ? one per group

Staple all pages of the solutions together (no paper clips)

Write the names and ID #s of all members clearly up on the cover page

You can type or handwrite (legible!)

You can submit it in my office (Leacock Building Rm#315) or in class

Name

ID number

1.

2.

3.

4.

1

Question 1 (10 points)

Tick the relevant cells in the tables below as to how each of the following transactions affects the

U.S. Balance of Payments.

(Recall that each transaction generates two entries ? a credit and a debit ? in the U.S. Balance of

payment accounts so you need to tick 2 cells for each transaction)

(1a) The U.S. imports a camera from Japan and pays by a check written on his U.S. Bank

account.

Current Account

Goods Services

Financial

Account

Capital

Account

Income Unilateral

Transfers

Debit

Credit

(1b) An American investor purchases a share of German stock and pays by writing a cheque on

account with a Swiss bank in New York City.

Current Account

Goods Services

Financial

Account

Income Unilateral

Transfers

Debit

Credit

2

Capital

Account

(1c) U.S. treasury pays $30 worth of interest of Treasury bonds to a Chinese investor into his

dollar account at the bank in New York City.

Current Account

Goods Services

Financial

Account

Capital

Account

Income Unilateral

Transfers

Debit

Credit

(1d) An American tourist spends $50 on a meal at expensive restaurant in Spain by using his

VISA card.

Current Account

Goods Services

Financial

Account

Capital

Account

Income Unilateral

Transfers

Debit

Credit

(1e) A Canadian friend of an American student comes to visit her in Miami and stays at a Miami

Hotel by paying with her Master card.

Current Account

Goods Services

Financial

Account

Income Unilateral

Transfers

Debit

Credit

3

Capital

Account

Question 2 (12 points) Interest Parity Relationships

(2a) The one-year interest rate on Swiss francs is 5%, and the dollar interest rate is 8%. If the

current $/sf spot rate is $1.085, what would you expect the spot rate to be in one year, assuming

no risk premium?

(2b) Suppose that the U.S. nominal interest rate is 9% per year and Japan?s nominal interest rate

is 6%. What is then the expected behavior of the exchange rate if uncovered interest rate parity

holds (i.e., will dollar depreciate or appreciate and if so by how much)?

(2c) Suppose that the U.S. nominal interest rate is 10% and the U.K rate is 8%, and the spot

exchange rate is E$/? = 0.60 and the one year forward is F$/? = 0.7. Does covered interest rate

parity hold?

(2d) The interest rate on euro denominated assets maturing in one year is 11% and the interest

rate on comparable Canadian dollar denominated assets is 6%. If the spot exchange rate between

the Canadian dollar and the euro (Canadian dollars per euro) in one year is expected to fall by 10

Canadian cents compared to today, what is the current exchange rate? Assume that uncovered

interest rate parity holds.

4

Question 3 (36 points)

(3a) (12 points) Describe the short-run effect on the exchange rate of an increase in domestic

real GNP, given expectations about future exchange rate. How would your answer change if

foreign real GNP increases? Explain (Diagrams required)

(3b) (12 points) Use the asset approach to exchange rate determination to explain what happens

to the exchange rate if there is a permanent decrease in the nominal money supply in the

domestic country. (Diagrams required)

(3c) (12 points) Use the Flexible Price Monetary Model of the Exchange Rate to explain the

effects of a permanent increase in the growth rate of the domestic money supply on:

(1) the domestic interest rate,

(2) the domestic price level, and

(3) the nominal exchange rate.

While answering the above questions, assume that all prices are flexible; output is constant;

purchasing power parity holds; and money neutrality holds. All effects in this model are long-run

effects (Diagrams required).

5

Question 4 (30 points) Real exchange rate and Balassa-Samuelson Model

There are two countries, Domestic and Foreign (denoted by * for Foreign).

Assume that the domestic price level is given by P = ( ) ( )1? and that the foreign price

level P* is given by P* = (? ) (? )1?

where (? ) is the domestic (foreign) price index for non-traded goods,

(? ) is the domestic (foreign) price index for traded goods;

a is the share of nontraded goods sector in domestic country;

1-a is the share of traded goods sector in domestic country;

b is the share of nontraded goods sector in foreign country;

1-b is the share of traded goods sector in foreign country;

and 0 < a, b < 1.

(4a) (8 points) Assuming that the law of one price holds for traded goods sector, find an

expression for the real exchange rate (RER) in terms of PN/PT and ? /? .

(4b) (12 points) The presence of non-traded goods suggests that international variations in the

prices of non-traded goods sector could be a source of international differences in price levels

between domestic and foreign countries. Assume that labor is the only factor of production and is

perfectly mobile within countries but completely immobile between countries. The production

function for traded goods sector is identical in both countries and is given by

*

*

QN AN LN , QN AN L* ,

N

*

*

QT AT LT , QT AT L* ;

T

*

AN AN ;

AT , AN 0;

where Q is the production function, A is its productivity, and L is the labor input. The law of one

price holds for traded goods sector.

Based on your answer of (4a), derive an expression for the real exchange rate between the

domestic and the foreign countries as a function of the relative productivity.

6

(4c) (5 points) Using your expression for RER from (4b), determine the rate of depreciation for

the domestic country if a = b = 0.2, the growth rate of AT is 2%, and the growth rate for ? is

1%. What is happening to the real exchange rate in this case?

(4d) (5 points) Based on your answer of (4b), suppose that both AT and ? are growing at 4%

and a = b = 0.5. What is the rate of growth of the real exchange rate? Do absolute PPP and

relative PPP hold? Explain your findings.

Question 5 (12 points)

Summarize the main conclusions of the paper by Taylor and Taylor (2001)*. Limit your answer

strictly to 2-pages, 1.5 spacing, (at least) 12 times new roman font size. You can use bullet point

also for your summary.

*The Purchasing Power Parity Debate. Alan M. Taylor; Mark P. Taylor. The Journal of

Economic Perspectives, Vol. 18, No. 4. (Autumn, 2004) (you can download it from Mycourses)

7

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