International Finance
Fall 2018
Homework 2: Solution Outline
1. Explain the J-curve.
Current account, measured in domestic output, can deteriorate sharply right after a real currency
depreciation because most import and export orders are placed several months in advance. It
takes time for new shipments to adjust fully to the relative price change. The result of these lags
in adjustment is the gradually improving current account, before it eventually tapers off as the
adjustment to the real depreciation is completed. You also need to draw Figure 17.18 from page
516 in the text.
2. What is purchasing power parity? Explain its two forms.
Purchasing power parity is an extension of of the law of one price which shows that in the absence
of trade costs the price of a basket of goods in two markets when expressed in the same currency
must be the same. Suppose P1 is the price level in country 1, P2 is the price level in country 2,
and E is the exchange rate between the currencies of the two countries, then absolute purchasing
power parity states that:
P1 = E × P2 .
Relative purchasing power parity takes this a bit further and states that changes in price levels
in the two countries would cause a similar change in the value of their currencies. Suppose π1e
is the expected inflation in country 1, π2e is the expected inflation rate in country 2, and E e is
the expected exchange rate between the two currencies, then
π1e − π2e =
Ee − E
.
E
Thus, while absolute PPP refers to actual price level, relative PPP only deals with changes. One
advantage that relative PPP therefore has over absolute PPP is that the former can counter part
of the problems brought on by trade costs. Assuming trade costs do not change over a period of
time, if there are changes in the price of baskets they will directly point to changes in purchasing
power of the currencies, and hence their exchange rates. It is therefore more likely to hold in
practice than absolute PPP.
3. Derive the Fisher open condition from interest parity and purchasing power parity conditions.
The Fisher open condition states that real interest rates must be equal across countries, that is,
rH = rF ,
where terms have their usual meaning.
It is derived using the interest parity and relative purchasing power parity condition. The interest
parity condition is:
Ee − E
RH = RF +
,
E
and the relative purchasing power parity condition is:
e
πH
= πFe +
Ee − E
.
E
Relative PPP in turn is derived from the law of one price which states that
pH = pF × E,
1
and for small changes:
peH − pH
pe − pF
Ee − E
= F
+
,
pH
pF
E
or
e
πH
= πFe +
Ee − E
.
E
Use this with the interest parity condition to get:
e
RH − RF = πH
− πFe ,
or, rewriting this we get:
e
RH − πH
= RF − πFe .
The above equation is the same as the Fisher open condition: rH = rF .
4. Why does the BP curve move in the same direction as the IS curve?
The BP curve of balance of payments curve represents the locus of points where the balance of
payments accounts are in balance, or where the current account is exactly offset by the capital
account. A given BP curve is drawn by taking the exchange rate and foreign interest rate as
exogenous variables. If there are any changes in either of these, the BP curve will change.
The IS curve will shift to the right if there is an expansionary fiscal policy, or net exports rise
(thus current account improves) due to a currency depreciation. This improving current account
will reduce the need of foreign capital flows to fund the deficit, and hence shift the BP curve to
the right. Similarly, a worsening current account will shift both IS and BP to the right.
5. How does the gold exchange standard differ from the gold standard?
The gold exchange standard is midway between a reserve currency standard, and a gold standard.
Under this standard the central bank reserve consists of gold, and currencies whose price in terms
of gold are fixed. Each central bank fixes its exchange rate to a currency with fixed gold price. A
gold exchange standard can operate like gold standard in restraining excessive monetary growth
throughout the world, but it allows more flexibility in the growth of international reserves, which
can consist of assets besides gold. The Bretton-Woods system was set up as a gold exchange
standard where currencies were pegged against the US dollar, and the Fed was responsible for
holding the dollar price of gold at $35 per ounce.
The gold standard limits the amount of money that can be printed to the amount of gold that is
available with the central bank. Any increase in money supply would then have to be augmented
by an equivalent increase in the gold holdings of the central bank. This may not always be feasible
given the geographic availability of gold, and the finite amount that is available.
The gold exchange standard comes with the same problems as the gold standard. It puts undesirable constraints on the use of monetary policy (though, not as strictly as a gold standard).
It will bring price stability if the relative price of gold does not change. Money supply cannot
grow to account for economic growth, but is tied to the amount of gold that is available. Like the
reserve currency standard it provides privileged position to countries with large gold deposits or
reserves.
6. Illustrate the impact of contractionary fiscal policy in an economy with mobile capital and flexible
exchange rates.
Suppose you start with equilibrium E1 . A contractionary fiscal policy shifts the IS curve to left
to IS2 (movement 1). The internal equilibrium shifts to a point like E2 , which is below the BP
curve. This puts pressure on the domestic currency to depreciate. A currency depreciation leads
to an increase in exports, a decrease in imports, and an improving current account deficit. This
shifts the IS to IS3 (movement 2a). Thus, for any given level of real GDP, the country now
needs to fund a smaller current account deficit, that shifts the BP curve to the right to BP3
(movement 2b), and the economy eventually ends at an equilibrium like E3 .
2
Interest Rate
LM
2b
E1
BP1
BP3
E3
1
E2
2a
IS2
IS3
IS1
Real GDP
Figure 1: Monetary Policy Ineffectiveness
7. Illustrate how a self-fulfilling currency can unfold.
Suppose a country is on a fixed exchange rate regime, and is facing some fundamental issues
with regards to its competitiveness or some other issue. In such a case the country has to do
something to make it competitive again, and one of the easiest things to do would be to devalue
the domestic currency. Market participants know this, and they will adjust their expected returns
from foreign assets accordingly. A devaluation at home will increase the expected returns on
foreign assets, and move the curve to the right. This indicates a new equilibrium in the foreign
exchange market with lower value of the domestic currency. If the authorities are not ready
for this they may try to fight market forces, and they may do so either by buying all domestic
currency being sold in the market, and/or, increase domestic interest rates to provide more
incentives to the foreign and/or domestic investors. If that increased interest rate is not enough
of an incentive the expected returns on foreign assets will rise further. This is how a classic
self-fulfilling currency crisis unfolds. It can be illustrated in Figure 18.5 on page 549 in the text.
8. Explain the benefits and drawbacks of the gold standard.
There are two main benefits that supporters tout about the gold standard:
• First, it allows the use of a fixed exchange rate system (with the resulting stability in international transactions) without giving any country the undue advantage of hosting the
reserve currency; and,
• Second, it limits the central banks’ ability to increase money supply indiscriminately, and
thus prevents unlimited increases in price levels.
The drawbacks are the following:
• Use of gold standard limits the use of monetary policy as a stabilization tool.
• The price stability part of gold standard would work if, and only if, the price of gold is stable
relative to other goods.
• It gives undue advantage to countries which have large gold production.
• Central banks cannot increase money supply with rising economy, and can thus lead to
deflation.
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