# The current account

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```					              Exercises to《International Finance》

Chapter 1

Exercise:

1. Main concept:

1) Foreign exchange market          2) Direct quotation system    3)

Indirect quotation system 4) The bid rate 5)The offer rate 6) The

bid-offer spread     7) Bull/bullish   8) Bear/bearish   9) Long position

10) Short position    11) Arbitrage 12) Financial center arbitrage    13)

Cross-currency arbitrage 14) The spot exchange rate       15) The forward

exchange rate 16) The nominal exchange rate        17) The real exchange

rate 18) The nominal effective exchange rate 19) The real effective

exchange rate 20) Fixed exchange rate regime        21) Floating exchange

rate regime   22) Hedger 23) Arbitrageur 24) Speculator

2. Calculation:

2.1 In London foreign exchange market, one day one bank provides

the quotation of £1=\$1.8220/1.8280. One customer has £1million and

wants to exchange them into US dollar with the bank. How much US

dollar can he exchange?

2.2 Suppose that £1=\$1.8220/1.8280, \$1=DM2.1400/2.2000. Please

calculating the cross rate for DM/£.

2.3 Suppose that \$1=J ￥ 102.20/104.50, \$1=DM1.9550/1.9680.
please calculating the cross rate for DM/J￥.

2.4 The quotations in New York and in Paris foreign exchange

market are listed below. If one arbitrageur trades with \$1million, how

much can he earn?

New York: \$1=FF6.7010/20

Paris: \$1=FF6.6850/60

2.5 The quotations of \$, FF and J￥ in three different foreign

exchange market are listed below. If one arbitrageur trades with

\$10million, how much can he earn?

Paris: J￥100=FF6.3820/6.3840

Tokyo: \$1=J￥108.30/108.50

New York: \$1=FF6.6820/6.6880

2.6 All the data are listed in the table below. Finish the blank table

below and explain them briefly.

Period    Nomin      Nominal      Nominal     UK      US      Germany Franc

al     exchange      exchang     price   price    price      e

exchan      rate of     e rate of   index index      index    price

ge rate     DM/£         FF/£                                 index

of \$/£

1         1.5        2.4          7.8       100     100       100      100

2         1.6        2.2          7.5       112     120       105      110

3         1.4        2.5          7.7       108     110       98       130
Trade       30%            50%          20%        -          -      -          -

weight      (US)         (Germany     (France)

)

Table 1.

Perio       Nominal               Nominal         Nominal         Nominal

d       exchange rate        exchange rate    exchange rate      effective

index of \$/£        index of DM/£    index of FF/£ exchange rate

index of £

1

2

3

Table 2.

Period            Real          Real exchange          Real       Real effective

exchange rate         rate index of   exchange rate    exchange rate

index of \$/£            DM/£         index of FF/£     index of £

1

2

3

2.7 The \$/£ spot exchange quotation and UK and US interest rates

in January 2004 are listed in the table below. Calculating the forward

exchange rate and the annual rate of forward premium/discount and

filling in the blanks in the table.
\$/£ exchang    Annual rate of    £ Eurocurrenc     \$ Eurocurrenc

e rate          forward       y interest rate   y interest rate

t

Spot         1.8000             -                 -                 -

rate

1                                             7.50             8.125

mont

h

3                                             7.25              8.25

mont

h

6                                            7.125              8.00

mont

h

12                                             7.75              8.50

mont

h

3. Thinking and understanding:

3.1 Why we need to differ the direct quotation system from the

indirect quotation system?

3.2 What participants made up of the exchange market?
3.3 How to understand the determination of the spot exchange rate

with the simple model presented in Chapter 1?

3.4 How to explain the basic differences between the fixed and

floating exchange regimes using the supply and demand framework?

3.5 How to understand the determination of the forward exchange

rate?

3.6 How to understand the relationship between the spot and

forward exchange rate?

Chapter 2

Exercises:

1. Main concepts:

1) The balance of payments        2) Economic transaction       3)

Exchange      4) Unilateral transfer   5) Resident   6) Non-resident    7)

Current account     8) Capital account   9) Autonomous transaction 10)

Accommodating transaction       11) Balance of payments surplus/deficit

12) Trade balance      13) The current account balance     14) The basic

balance 15) The official settlements balance    16) The official financing

balance     17) Above the line items     18) Below the line items      19)

Multiplier analysis    20) The government expenditure multiplier       21)

The foreign trade multiplier   22) The current account multiplier

2. Compiling and analyzing:
Suppose there are 7 transactions occurred in US. Record the 7

transactions of the US balance of payments (\$1.8/£) and analyze the

situation of the US balance of payments.

Transaction 1: The A Corporation of the US exports a \$5 million

computer to the UK which is paid for by British B Corporation debiting

its US bank deposit account by a like amount.

Transaction 2: A US travel agency credits a Japanese agency’s US

bank account \$5000 for US tourists importing travel services from Japan

by a like amount.

Transaction 3: the US investors received interest, profits and

dividends from UK of \$40 million by debiting the US bank account held

by UK residents which are then credited to the bank accounts held by the

US investors.

Transaction 4: A US investor decides to sell £1000 of UK Treasury

bills and imports machines from UK by the like amount.

Transaction 5: The US A Corporation decides to set up a branch in

the UK by exporting \$20 million machines and remitting \$30 million

cash to the branch by debiting the UK bank account held by the US A

Corporation.

Transaction 6: The US received a gift of £2 million of goods from

the UK charitable organization.

Transaction 7: The US A Corporation exports a £10 million goods to
the UK, the receipts are then sold to the US central bank which leading to

the increase in the US official reserves by the same amount.

Debit             Credit

The current account

Export of goods

Import of goods

Export of services

Import of services

Interest,   dividends,     profits

Interest, dividends, profits paid

Unilateral receipts

Unilateral payments

The current account balance

The capital account

Direct investment

Indirect investment
Other investment

Overall balance

Increase/decrease in reserves

Total

3. Thinking and analyzing:

3.1 What is the balance of payments? How to grasp the concept?

3.2 List the main accounts and sub-accounts of the balance of

payments, and how to account the balance of payments?

3.3 Why must the sum of the capital account and the current account

be equal to zero? How are statistical discrepancy accounted for? What are

the possible causes of statistical errors?

3.4 Why reserves increases are recorded as a minus and vice versa?

3.5 According to the motives underlying the transactions, what

categories can the international transactions be classified into?

3.6 What is meant by a balance-of-payments deficit or surplus?

3.7 How to look on the basic balance surplus and deficit?

3.8 Why it is said that the official settlements balance is more

important in the fixed exchange regime than in the floating exchange

regime?

3.9 Why countries whose currency is used as a reserve asset can have

a combined current and capital account deficits and yet maintain fixed
parity for their currency without running down their reserves or

borrowing from the IMF?

3.10 What is the difference between the close economy identity and

the open economy identity?

3.11 What is the relationship between the current account and a

country’s saving, investment, taxation and government expenditure? List

the possible causes of the current account deficit and the corresponding

remedy.

3.12 How to derive the government expenditure, export and the

current account multipliers in an open economy? What do they mean?

3.13 Why the multiplier in open economy is less than that in close

economy?

Chapter 3

Exercises:

1. Main concepts:

1) The elasticity approach to the balance of payments    2) The price

elasticity of demand for exports   3) The price elasticity of demand for

imports 4) The Marshall-Lerner condition       5) The price effect of a

devaluation 6) The volume effect of a devaluation      7) Elasticity

optimists 8) Elasticity pessimists   9) J-curve effect 10) The

absorption approach to the balance of payments     10) The income effect
of a devaluation 11) Employment effect of a devaluation on income

12) Terms of trade 13) Terms of trade effect of a devaluation on income

14) Real balance effect of a devaluation     15) Income redistribution effect

of a devaluation   16) Money illusion effect of a devaluation     17)

Expectational effects of a devaluation 18) Laursen-Metzler effect

2. Thinking and understanding:

2.1 What is the elasticity approach to the balance of payments? How

to derive the Marshall-Lerner condition? What does it mean? What are

the two effects in play once a currency is devalued?

2.2 What is meant by the J-curve effect? Why there exists the effect?

2.3 What is the absorption approach to the balance of payments?

According to the approach, what do the effects of a devaluation on the

current account depend upon? What are the factors that need to be

examined when considering the impact of devaluation?

2.4 How does devaluation affect national income?

2.5 Is the marginal propensity to absorb always less than unity?

Why?

2.6 How does devaluation affect direct absorption?

2.7 What is the overall conclusion of the absorption approach? What

is the policy implication of the approach?

2.8 What is the relationship between the elasticity and the absorption

approach? How to understand the relationship?
Chapter 4

Exercises:

1. Main concepts:

1) Internal balance 2) External balance 3) Expenditure changing

policy 4) Expenditure switching policy        5) Tinbergen’s

instrument-targets rule 6) The IS curve 7) The LM curve 8) The BP

curve 9) Sterilized intervention     10) Non-sterilized intervention 11)

The principle of effective market classification    12) Assignment problem

13) Wealth effect 14) Static expectation

2. Understanding and thinking:

2.1 What are the main macroeconomic objectives and the main

policy instruments for economic policy-makers?

2.2 How to derive the IS schedule? What type of schedule it is?

2.3 How to derive the LM schedule? What type of schedule it is?

2.4 How to derive the BP schedule? What type of schedule it is? By

which the slope of the BP schedule is determined? Why? In which case

that the BP schedule is a horizontal line or a vertical line?

2.5 List the factors shifting the IS, LM and BP schedules.

2.6 How fiscal policy, monetary policy and sterilized and

non-sterilized intervention influence economic activities?

2.7 What is the difference between sterilized and non-sterilized
intervention?

2.8 Is the monetary policy effective under the floating exchange rate?

Why?

2.9 Is the fiscal policy effective under the floating exchange rate?

Why?

2.10 Are the monetary policy and the fiscal policy effective for a

small open economy with perfect capital mobility and a fixed exchange

rate? Why?

2.11 What are meant by the “principle of effective market

classification” and the “assignment problem”? According to Mundell,

which policy instrument should be assigned to which policy target? Why?

2.12 Is there unambiguous answer to the assignment problem? Upon

what does the appropriate pairing of instruments and targets depend?

2.13 What do a number of criticisms on the IS-LM-BP model relate

to? According to the text, what are the main limitations of the model?

2.14 Upon what does the effectiveness of fiscal and monetary

policies depend? What is the most significant contribution of the

Mundell-Fleming model?

Chapter 5

1. Main concepts:

1)The monetary approach to the BOP             2)PPP     3)The PPP
schedule      4)OMO    5)FXO   6)Imported inflation/deflation   7)Offset

coefficient

2. Understanding and thinking:

2.1 Why the monetarists think the BOP is essentially a money

phenomenon?

2.2 What are meant by the three key assumptions of the monetary

approach to the BOP?

2.3 What is the domestic money base made up of? In which ways

can the domestic money base come into circulation?

2.4 What is meant by the monetarists concept of a BOP

disequilibrium? What are the differences between the monetarists and the

Keynesians concerning the BOP disequilibrium?

2.5 When does the monetary model attain equilibrium?

2.6 How does the devaluation affect the BOP according to the

monetary approach? Why the devaluation has only a transitory effect on

the BOP under fixed exchange rate?

2.7 By which the exchange rate is determined in the framework of

the monetarists model?

2.8 How does the expansionary OMO affect the BOP under fixed

exchange rate? Why there is no effect on the BOP in the long run?

2.9 Is there any effect of the expansionary OMO on the BOP under

floating exchange rate? How does the expansionary OMO affect the BOP?
Why there is no effect on the BOP in the long run? What can be derived

from the analysis of expansionary OMO under different exchange rate

regimes?

2.10 What is the difference of the analysis of the effects of an

increase in income under different exchange rate regimes?

2.11 Why a country that decides to peg its exchange rate therefore

runs the risk of imported inflation/deflation?

2.12 Why countries that opt to fix their exchange rates have to give

up their monetary autonomy?2.13 Why the floating exchange rates can

insulate the domestic economy from the foreign price shock, so the

authorities are able to operate an independent monetary policy?

Chapter 6
Exercises:

1. Main concepts:

1)PPP theory 2)the law of one price 3)absolute PPP 4)relative

model

2. Analyzing and understanding:

2.1 What is the PPP theory? What two forms does the PPP theory

come into? Does the absolute PPP necessarily hold if the relative PPP

holds? Why should we use a more generalized version of PPP? What
does it mean?

2.2 What are measurement problems in testing for PPP?

2.3 What conclusions can we draw from the empirical evidence on

PPP?

2.4 How to explain the poor performance of PPP theory?

2.5 How to derive the Balassa-Samuelson model? What does it mean?

What is the significances and limitations of the model?

Chapter 7
Exercises:

1. Main concepts:

1) Uncovered interest rate parity 2) flexible-price monetary model

3) sticky-price monetary model 4) exchange rate overshooting 5) real

interest-rate differential model

2. Analyzing and understanding:

2.1 Derive the UIP condition and specify it.

2.2 What are the similarities and differences of the monetary models

of exchange-rate determination?

2.3 How to derive the flexible-price monetary model and what is its

rationale?

2.4 Explain the sticky-price monetary model simply and its

importance.
2.5 What are the implications of the Monetary Views of

Exchange-Rate Determination?

Chapter 8
Exercises:

1. Main concepts:

1)risk premium 2)risky assets 3)inflation risk 4)exchange risk

5)exchange control risk 6)default risk 7)political risk 8)the money

market schedule within the portfolio balance model       9)the domestic

bonds market schedule within the portfolio balance model           10)the

foreign bonds market schedule within the portfolio balance model

11)acceleration     hypothesis     12)money-financed   fiscal   expansion

13)bond-financed fiscal expansion

2. Questions:

2.1 What is risk premium? For a risk premium to exist, what

conditions must be fulfilled?

2.2 Typically, how many types of risk do there have in international

financial market?

2.3 What about the operation of the portfolio balance model?

2.4 How to derive the asset demand functions and schedules within

the portfolio balance model?

2.5 On what assumption that the FF schedule is steeper than the BB
schedule? What does this mean?

2.6 Analyze the effects of a FXO, OMO and SFXO on the domestic

interest rate and exchange rate within the context of the portfolio balance

model, then compare their effects.

2.7 Analyze the dynamics of the portfolio model from short-term to

long-term, and explain why the long run exchange rate lies below the

initial exchange rate.

2.8 What stability conditions must be fulfilled to attain stable

transition to long run equilibrium within the context of the portfolio

balance model?

2.9 How does the fiscal expenditure be financed? Is there any

different effect on the domestic interest rate and exchange rate between

money-financed expenditure and bond-financed expenditure?

2.10 Why the domestic interest rate could diverge from the foreign

interest rate within the portfolio balance model?

Chapter 9
Exercises:

1. Main concepts:

1) An efficient market 2) The rational expectation hypothesis(REH)

3) “news” approach of modeling exchange rate             4) chartists   5)

fundamentalists
2. Analyzing and understanding:

2.1 How to test whether or not the foreign exchange market is

efficient?

2.2 What conclusions can be drawn from exchange market efficiency

tests by applying REH?

2.3 What are the implications of REH for exchange-rate movement?

2.4 What conclusions can be drawn from alternative tests of the

exchange market efficiency?

2.5 What conclusions can be drawn from empirical test of exchange

rate models?

2.6 How to explain the poor results of exchange rate models?

2.7 Specifying a “news” model of exchange rate determination.

2.8 specifying the six plausible theoretical methods for modeling the

expected future exchange rate.

Chapter 10
Exercise:

1. Main concept:

1) Competitive devaluation         2) Irrational speculation      3)

Excessive risk-aversion     4) Bandwagon effect    5) Peso problem     6)

Rational     bubble    7)   Monetary   autonomy        8)   Exchange-rate

misalignment 9) Exchange rate protection
2. Thinking and understanding:

2.1 Why the advocates of fixed exchange rates argue that fixed

exchange rates provide discipline for macroeconomic policies?

2.2 Why the advocates of fixed exchange rates argue that

speculation under floating rates is likely to be destabilizing?

2.3 What are the advantages of floating exchange rates ensuring

balance-of-payments equilibrium?

2.4 Why the advocates of floating exchange rates argue that floating

exchange rates can ensure monetary autonomy?

2.5 Why the advocates of floating exchange rates argue that floating

exchange rates can insulate economies and promote economic stability?

2.6 Why the advocates of floating exchange rates argue that private

speculation is stabilizing?

2.7 How the modern model evaluates the fixed and floating

exchange rates?

2.8 What is meant by assuming that the shocks are transitory?

2.9 What is the specification of the modern model evaluating the

two regimes?

2.10 How the economy under examination will adjust when there is

an unanticipated rise in money demand under the two regimes?

2.11 How the economy under examination will adjust when there is

an unanticipated rise in aggregate demand under the two regimes?
2.12 How the economy under examination will adjust when there is

an unanticipated rise in aggregate supply under the two regimes?

2.13 Why it is said that in practice the choice between the two

regimes is even more complex?

2.14 What are the rationales for exchange market intervention?

2.15 Why the advocates of exchange market intervention argue that

authorities might be able to produce a more appropriate exchange rate?

2.16 Why the advocates of exchange market intervention argue that

intervention is needed to mitigate costs of exchange-rate overshooting?

2.17 What effects the real-exchange rate movements will exert on

the real economy?

2.18 Why the advocates of exchange market intervention argue that

intervention is needed to smooth the economic adjustment process?

2.19 What is the difference between exchange-rate protection and

tariff protection?

Chapter 13
Exercises:

1. Main concepts:

1) an open outcry system 2) currency futures 3) currency options

4) underlying currency 5) counter currency 6) a call option 7) a put

option 8) American option 9) a European option 10) the strike price
11) the option premium 12) The intrinsic value 13) the time value

14) the over-the-counter market (OTC)         15) interest-rate swaps   16)

currency swaps

2. Analyzing and understanding:

2.1 What are the reasons for the growth of derivative markets after

1970s?

options contracts?

2.3 How does the exchange limit its exposure on the futures and

options markets?

2.4 What are the main differences between futures and forwards

contracts?

2.5 How to use futures contracts to hedge exchange rate risk? And on

what scenarios imperfect hedging would happen?

2.6 What are the profiles of the profit/loss on futures/forwards

contracts?

2.7 How to price futures contracts?

2.8 Describe the profile of profit/loss for option contracts.

versus a forward contract for hedging?

2.10 What are the differences of profiles of profit/loss between the

option and the futures/forwards contracts for speculation?
2.11 What are the crucial factors determining the price of the option

contract?

2.12 Under what circumstances we say that the option contract is in

the money, out of the money or at the money?

2.13 What is the Garman and Kohlhagen option pricing formula?

over-the-counter market in options?

2.15 What are the distinguishing characteristics of the swap market

from the forward and futures markets?

Chapter 14
Exercises:

1. Main concepts:

1) International policy coordination; 2) spillover effect of

macroeconomic policy; 3) structural interdependence; 4) the Nash

non-cooperative scenario; 5) the Stackleberg scenario 6) time

inconsistency.

2. Analyzing and understanding:

2.1 What is meant by international policy coordination? How to

distinguish between a hierarchy of three types of coordination

2.2 Why does the need for international policy coordination arise?

2.3 What are the gains and losses of the international policy
coordination?

2.4 How to use the Hamada diagram to illustrate the potential gains

of international policy coordination? Are the Nash and Stackleberg

scenarios Pareto-optimal? Why?

2.5 What are the major problems and obstacles to international

policy coordination?

2.6 How to understand the move from fixed to floating exchange

rates with the game theory?

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