1. What is net foreign wealth and what is its relationship to the current account? Suppose that a country starts with $10B in net foreign wealth and its exports and imports in the following three years are $2B and $4B, $1B and $5B, and $2B and $6B, respectively. What is the country's net foreign wealth after three years? Should the country's government worry about this trend? What could it do about it? Does your answer depend on the exchange rate regime? Explain.
- Net foreign wealth is defined as the difference between the foreign assets owned by home country (ex. U.S.) and home country assets (U.S. assets) owned by foreigners. The relationship of net foreign wealth and current account ...view middle of the document...
Because current account depends on exchange rate, increase in monetary policy (Ms) would increase output and exchange rate, and the effects of increase in exchange rate (E) will fix the current account deficit, as the domestic currency depreciates when demand for domestic goods fall. This means that domestic goods will become cheaper than foreign goods, which would increase exports and fix the country’s current account balance.
- This scenario will depend on the exchange rate regime. Because in the fixed exchange rate regime, when they are faced with a current account deficit, the government must intervene in the foreign exchange market by buying the domestic currency with its reserves of foreign currencies. In this regime, it is important for a government to have significant foreign exchange reserve balance. If it does not, it may be unable to buy back its domestic currency and will be forced to devalue.
2. In the floating exchange rate regime, interest rate parity is the most important determinant of the exchange rate in the short run. Why must this condition be satisfied and what happens if it is not? Does it have to be satisfied in the long run as well? Does this condition play a role in the fixed exchange rate regime? Explain.
- Interest rate parity is the “expected returns on deposits of any two currencies that are equal when measured in the same currency”. If interest parity does not hold in the floating exchange rate regime, that is, if the difference in interest rates between two countries is not equal to the expected change in exchange rates between the countries' currencies, there will be an opportunity to make a profit through arbitrage, buying a currency cheap and selling it dear. If for example dollar were selling for 100 Japanese Yen in Tokyo and ¥102 in New York, a trader could purchase $1 million in Tokyo for ¥100 million and sell it in New York for ¥102 million, making a profit of ¥2 million. However with the interest rate parity condition, the demand for dollars in Tokyo would increase the yen price of dollars and the supply of dollars in New York would decrease the yen price of dollars. Thus when this scenario happens and interest rate parity holds, equilibrium will be restored quite quickly and difference between Tokyo and New York exchange rates will disappear.
- Interest rate parity has to be satisfied in the long run. When the exchange rate is fixed at E0, the expected rate of domestic currency depreciation is zero. Therefore, interest parity in fixed exchange rate regime must hold because participants in foreign exchange market do not expect exchange rate change, requiring domestic and foreign currency to offer same interest rate (R = R*). In this regime, when domestic currency appreciate as a result of increase in output and demand for domestic currency, the central bank has to intervene in the foreign exchange market by purchasing foreign assets. As a result, excess demand for domestic currency will decrease, and...