Project 3
Carefully provide complete answers to each of the following questions. Be sure to
show all your work so that partial credit can be awarded when you make
mistakes but follow the proper analytical procedures. There are 25 total possible
points for this assignment. Save your work as an .rtf document.
1. (5 pts.) In Chapter 10, there is a simple two-period model of intertemporal
trade. In that example for a small country, it was assumed that r* > r; that is, the
interest rate in the rest of the world was higher than in the small economy.
Now, on a sheet of paper, draw the diagram similar to Figure 10.3 for the case of
r*< r, and use the diagram to describe in writing exactly how the free flow of
intertemporal trade (borrowing and lending as well as the exchange of goods
over two periods) affects production and consumption in each period,
compared to no international exchanges of any sort. Also be sure to describe
how national welfare is affected by the opportunity for intertemporal trade
when r*< r.
2. (5 pts.) Write a brief essay summarizing the conclusions of the two-period
general equilibrium model of international investment described in Section 2 of
this chapter.
3. (5 pts.) The diagram below shows the equilibrium in the markets for loanable
funds (savings) in two isolated countries, Ecuador and Peru. Describe the
international investment that would result if the governments of the two
countries permit their citizens and firms to borrow and lend with people and
firms in the other country. (Hint: Use the two-country partial equilibrium
model of international investment as given in Figure 10.7, with a center
diagram describing international investment and specific areas that represent
the gains and losses to savers and borrowers in each country.
Instructions for Project 3 1
Five-Country Example of Cross Rates
US$ ¥ £ AUS$ SFr
US$ per ___ .02 2.00 .75 .67
¥ per ___ ___ ___ ___ ___
£ per ___ ___ ___ ___ ___
AUS$ per ___ ___ ___ ___ ___
SFr per ___ ___ ___ ___ ___
Ecuador Peru
% %
SP
EE
20%
10%
DP
DE
Loanable Funds Loanable Funds
4. (3 pts.) Under the assumption that there are no restrictions on the movement of
savings between countries and the exchange rates shown are equilibrium rates
that are compatible with all the other equilibrium exchange rates in the world
foreign exchange market, fill in all the missing exchange rates between the U.S.
dollar, the Japanese yen, the British pound, the Australian dollar, and the Swiss
franc in the table below:
5. (2 pts.) Suppose that the interest rate in the United States is higher at 15 percent
per year than the interest rate on Canadian assets at 5 percent. Suppose also that
2 ECON 321
economic conditions and policies in the two countries lead investors to expect
that the exchange rate will be 1 U.S. dollar = 1 Canadian dollar one year from
now, so that Etet+1 = $1. What must the spot exchange rate be given that there is
perfect intertemporal arbitrage?
6. (5 pts.) Use the exchange rate model developed in Chapter 13 to explain what
will happen to a country’s exchange rate in the long run if (1) its central bank
increases the money supply faster than the economy’s rate of growth of real
output and (2) there will be zero inflation in the rest of the world. Set up the
exchange rate model, explaining each of the three components of the model and
then explaining how the expansionary monetary policy is likely to affect the
model and, hence, the exchange rate.
Project #3 should be completed and submitted to your instructor before you
continue onto Lesson 14. To submit your project, go to the Project 3 link in the
course, upload your .rtf document, and submit the document to your instructor.
Instructions for Project 3 3