ECOS3010: Tutorial 6 (Answer Key)
Question 1-5. Answer True, False or Uncertain. Brieáy explain your answer.
1. The exchange rate is determined in the foreign exchange rate market. So the gov- ernment cannot impose a Öxed exchange rate at which one currency can be exchanged for another.
False. Without foreign currency controls, the exchange rate is indeterminate. In our two-country OLG model, one world money market clearing condition cannot determine the values of two monies. Therefore, any exchange rate is possible in equilibrium. In this case, the government can impose a Öxed exchange rate as long as the government can defend the Öxed exchange rate through either cooperative stabilization or unilateral defense.
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2. While maintaining a Öxed exchange rate through cooperative stabilization, countries cannot choose its preferred level of seigniorage.
Uncertain. If two countries choose to Öx the exchange rate through cooperative stabiliza- tion, the Öxed exchange rate and the world money market clearing condition will determine the values of two monies. When one country chooses to use money creation to generate seigniorage revenue, the values of both monies will decrease and citizens of both countries will be taxed. Countries may still choose its level of seigniorage, but countries need to agree to limit the growth rate of money supply. Such coordination is important in maintaining the Öxed exchange rate through cooperative stabilization.
(Note that if a country imposes foreign currency controls and wants to Öx the exchange rate, then it is not possible to both Öx the exchange rate and choose a preferred level of seigniorage. In this question, there is no foreign currency controls in e§ect.)
3. Suppose that country a Öxes its exchange rate with country b through a unilateral defense. Whenever people turn in country a currency to country a government for country b currency, country a essentially transfer resources to country b.
True. Whenever people turn in country a currency for country b currency, country a government needs to tax its own citizens to purchase country b currency to meet the demand for country b currency. The unilateral defense implies that the stock of country a currency will decrease while the stock of country b currency stays the same. As a result, the values of both currencies will increase. Citizens of country b beneÖt because their consumption will increase, but citizens of country a are worse o§ because their after-tax consumption is lower. Overall, country a citizens e§ectively make a transfer to country b citizens.
4. The main cause of the Asian Financial Crisis was the speculative attack on the Thai baht.
False. The Asian Financial Crisis started from the speculative attack on Thai baht, but this is the symptom rather than the cause of the Asian Financial Crisis. The main reason that triggered the Asian Financial Crisis is the investorsíconcern about the economic growth in the south east countries. Prior to the crisis, all these countries grew very fast and attracted a huge amount of capital ináow. Due to the ine¢ cient use of the capital ináow and the decline of competitiveness of these countriesíproducts in the world market, investors began to worry about the values of these countriesícurrencies, which eventually triggered the speculative attack on Thai baht.
5. The optimal international monetary system is to form a currency union and adopt a single currency for all countries.
Uncertain. To reduce the costs of money changing and facilitate international trade, adopting a single currency for all countries might be optimal. However, since di§erent countries have di§erent economic conditions, adopting a single currency might not be suit-
able to all countries. In general, it is more beneÖcial for countries with similar economic backgrounds to adopt a single currency. For example, it might be optimal for the European countries to adopt a single currency and relegate monetary policy to a single central bank. But for small countries like Panama or Ecuador, it is optimal for them to simply dollarize. So there is no single optimal international monetary system that suits all countries.
6. Consider two identical countries in our standard OLG model. In each country, the population of every generation is 100, and each young person wants money balances worth 10 goods. There are $400 of country a money and £ 100 of country b money. Country b unilaterally Öxes its exchange rate with country a at e = 1. There are no foreign currency controls, and the monetary authorities do not cooperate. Country b is willing to raise up to 500 goods in taxes on their old citizens to defend the exchange rate.
(a) What is the value in goods of a dollar? Of a pound? From the world money market clearing condition
evtbMta + vtbMtb = Na (ya ca1) + Nb(yb cb1); we can derive the value of country b money as
vtb = Na(ya ca1)+Nb(yb cb1) = 10010+10010 =4: eMta + Mtb 1 400 + 100
From the deÖnition of the exchange rate,
vta =evtb =14=4:
(b) Find the value of a dollar if people abandon use of the pound.
If people abandon use of the pound, people will exchange £ 100 for $100. Country b government needs to raise resources to purchase $100 to meet the demand for dollar. It implies that Mtb = 0 and Mta = 400. The world money market clearing condition becomes
It follows that
v ta M ta = N a ( y a c a1 ) + N b ( y b c b1 ) :
va = Na (ya ca1) + Nb(yb cb1) = 2000 = 5:
(c) To be free from a speculative attack, a countryís commitment to defend the exchange rate must be su¢ cient to purchase all of its currency if it is o§ered for foreign exchange. Is country bís commitment su¢ cient to defend its exchange rate from a speculative attack? (Hint: in answering, you will need to use your answers to part (b).)
If there is a speculative attack on country b money ñthe pound, the maximum amount of pound that will be exchanged for dollar is £ 100. The government of country b needs to raise resources to purchase $100. When all people turn in pound for dollar, $100 is worth of 100vta = 500 goods. That is, country b government needs to tax 500 goods to purchase $100 to meet the demand for dollar. Since country b government is willing to tax 500 goods from its citizen, country b government can successfully defend its Öxed exchange rate.
7. Late in the afternoon of 1 July 1997, the Thai baht exchange rate was 25 baht per U.S. dollar. Twenty-four hours later, late in the afternoon of 2 July 1997, the exchange rate was 28.8 baht per U.S. dollar.
(a) Has the baht appreciated or depreciated? Has the U.S. dollar appreciated or depre- 2
The baht has depreciated. The U.S. dollar has appreciated.
(b) Letís imagine a (typical?) day in the life of . Suppose that it is late
in the afternoon 1 July 1997 and some of his wealth is held in the form of baht currency. Imagine that on 1 July 1997 he sells all the baht he owns (25 billion baht). How many U.S. dollars will he receive? Imagine that 24 hours later, i.e., late in the afternoon of 2 July 1997, he then sells that amount of U.S. dollars and buys baht. How many baht will he receive? Measured in bahts, has he gained or lost by these transactions? How much?
On 1 July he will he receive 1 billion U.S. dollar. On 2 July he will receive 28.8 billion baht. He has gained 3.8 billion baht.
(c) Maybe Mr. Soros is not all that interested in buying houses in Bangkok (i.e., holding his wealth in Thai currency or other assets) and is more concerned about how many houses he can buy in Manhattan (i.e., he is concerned about his wealth in U.S. dollars). Imagine that late in the afternoon on 1 July 1997 he takes 1 billion of his many billions of U.S. dollars and buys baht. How many baht will he receive? Imagine that 24 hours later, i.e., late in the afternoon of 2 July 1997, he then sells that amount of baht and buys U.S. dollars. How many U.S. dollars will he receive? Measured in U.S. dollars, has he gained or lost by these transactions? How much?
On 1 July he will receive 25 billion baht. On 2 July he will receive 0.868056 billion U.S. dollar. He has lost 0.131944 billion U.S. dollar. Clearly he would not behave this way.
(d) Maybe (for obvious. reasons), it would not be a smart idea for Mr. Soros to proceed along the lines set out in (c). So letís consider an alternative. We continue on the assumption that he is not all that interested in buying houses in Bangkok and is more concerned about his wealth in U.S. dollars. Imagine that late in the afternoon on 1 July 1997 he borrows 25 billion baht from a bank in Thailand and promises to pay them back their 25 billion baht in 24 hours time. If he immediately (i.e., late in the afternoon of the 1st of July, immediately after the Thai bank has deposited the baht in his account) buys U.S. dollars, how many U.S. dollars will he receive? Now, lets move on 24 hours to late in the afternoon of 2 July 1998. Mr. Soros has to pay back the loan this afternoon ña loan denominated in baht. In other words, on 2 July he has to obtain 25 billion baht and transfer that amount of baht to the bank in Thailand. How many U.S. dollars will he have to sell in order to raise that amount of baht? Measured in U.S. dollars, has he gained or lost by these transactions? How much?
On 1 July he will he receive 1 billion U.S. dollar. On 2 July he will need 0.868056 billion U.S. dollar to repay the loan. He has gained 0.131944 billion U.S. dollar.
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