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
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
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
(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.
(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.
(1d) An American tourist spends $50 on a meal at expensive restaurant in Spain by using his
(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.
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
(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.
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).
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* ,
QT AT LT , QT AT L* ;
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.
(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)
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