PSU
Winter 2016
Hiro Ito
ECON441/541
Homework Assignment #1
Answer Keys
Question 1:
Below is a roster of transactions for the mythical economy of Freedonia. Use this roster of
transactions to complete the balance of payments chart which follows. (All transactions are in
millions of Freedonian dollars.)
Description
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
l.
m.
n.
o.
p.
q.
r.
s.
t.
u.
Amount
Sale of stock in the Freedonian Balloon Company to U.S. investors
Payment of dividends to Italian shareholders in Freedonia Balloon Co.
Purchase of British tea sets
Purchase of American cowboy hats
Sale of Freedonian cigars to Belgium
Sale of Freedonia’s largest hotel to Japanese investors
Purchase of IBM stock by several Freedonian investors
Sale of Freedonian harps to Switzerland
Purchase of Canadian hockey sticks
Rental of hotel rooms by German tourists in Freedonia
Sale of Freedonian croquet mallets to Great Britain
Purchases of French Francs by Freedonian Central Bank
Foreign aid to Freedonia from Bolivia
Purchases of beef from Argentina
Sale of Freedonian dollars to the U.S. Federal Reserve
Remittance of dividends to Freedonian shareholders of Chrysler stock
Purchase of cars from Yugoslavia
Sale of socks to Australia
Sale of a large Freedonian farm to a British citizen
Purchase of restaurant meals in Israel by Freedonian tourists
Freedonian foreign aid to Mongolia
1
$ 8
$ 9
$ 5
$ 8
$ 3
$14
$10
$22
$ 5
$ 3
$11
$18
$ 5
$ 4
$ 8
$ 3
$12
$ 6
$ 2
$ 1
$ 1
The Freedonia Balance of Payments Account (Millions of Freedonia Dollars)
Current Account
1. Exports of which:
2. Merchandise
3. Investment Income Received
4. Imports of which:
5. Merchandise
6. Investment Income Paid
7. Net Unilateral Transfers
8. Balance on Current Account
Financial Account
9. Freedonian assets held abroad
(increase –) of which:
10. Official Reserve Assets
11. Other Assets
12. Foreign assets held in Freedonia of which:
13. Official Reserve Assets
14. Other Assets
15. Balance on Financial Account
16. Statistical Discrepancy
$48
e + h + j + k +r
p
-$44
c+d+i+n+q+t
b
m–u
$8
+$28
l
g
$32
o
a+f+s
$4
-$12
Question 2:
<Problem #4 at the end of KOM’s Ch. 13.>
A New Yorker travels to New Jersey to buy a $100 telephone answering machine. The New Jersey
company that sells the machine then deposits the $100 check in its account at a New York bank. How
would these transactions show up in the balance of payments accounts of New York and New Jersey?
What if the New Yorker pays cash for the machine?
The purchase of the answering machine is a current account debit for New York, and a current account
credit for New Jersey (i.e., it is the imports for the former and the exports for the latter). When the New
Jersey company deposits the money in its New York bank, there is a financial account credit for New York
and a corresponding debit for New Jersey (i.e., it is the exports of financial assets for the former and the
imports for the latter). If the transaction is in cash then the corresponding debit for New Jersey and credit
for New York also show up in their financial accounts. New Jersey acquires dollar bills (an import of
(financial) assets from New York, and therefore a debit item in its financial account); New York loses the
dollars (an export of dollar bills (=financial assets), and thus a financial account credit).
Question 3:
<Problem #5 at the end of KOM’s Ch. 13>
The nation of Pecunia had a current account deficit of $1 billion and a nonreserve financial account
surplus of $500 million in 2008.
a. What was the balance of payments of Pecunia in that year? What happened to the country’s net
foreign assets?
b. Assume that foreign central banks neither buys nor sell Pecunian assets. How did the Pecunian
central bank’s foreign reserves change in 2008? How would this official intervention show up in
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the balance of payments accounts of Pecunia?
c. How would your answer to (b) change if you learned that foreign central banks had purchased
$600 million of Pecunian assets in 2008? How would these official purchase enter foreign balance
of payments accounts?
d. Draw up the Pecunian balance of payments accounts for 2008 under the assumption that the event
described in (c) occurred in that year.
<Answers>
a. Since non-central bank financial inflows fell short of the current-account deficit by $500 million,
the balance of payments of Pecunia (official settlements balance) was –$500 million. The country
as a whole somehow had to finance its $1 billion current-account deficit, so Pecunia’s net foreign
assets fell by $1 billion.
b. By dipping into its foreign reserves, the central bank of Pecunia financed the portion of the
country’s current-account deficit not covered by private financial inflows. Only if foreign central
banks had acquired Pecunian assets could the Pecunian central bank have avoided using $500
million in reserves to complete the financing of the current account. Thus, Pecunia’s central bank
lost $500 million in reserves, which would appear as an official financial inflow (of the same
magnitude) in the country’s balance of payments accounts.
c. If foreign official capital inflows to Pecunia were $600 million, the Central Bank now increased its
foreign assets by $100 million. Put another way, the country needed only $1 billion to cover its
current-account deficit, but $1.1 billion flowed into the country (500 million private and 600
million from foreign central banks). The Pecunian central bank must, therefore, have used the
extra $100 million in foreign borrowing to increase its reserves. The balance of payments is still –
500 million, but this is now comprised of 600 million in foreign Central Banks purchasing Pecunia
assets and 100 million of Pecunia’s Central Bank purchasing foreign assets, as opposed to Pecunia
selling 500 million in assets. Purchases of Pecunian assets by foreign central banks enter their
countries’ balance of payments accounts as outflows, which are debit items. The rationale is that
the transactions result in foreign payments to the Pecunians who sell the assets.
d. Along with non-central bank transactions, the accounts would show an increase in foreign official
reserve assets held in Pecunia of $600 million (a financial account credit, or inflow) and an
increase Pecunian official reserve assets held abroad of $100 million (a financial account debit, or
outflow). Of course, total net financial inflows of $1 billion just cover the current-account deficit.
Question 4: Required for graduate students and a bonus question for undergraduate students
Graphically, show how intertemporal trade can be welfare increasing. Draw two graphs, one for the
current account surplus country and the other for the deficit country.
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