International Economics - Assignment Example

 QUESTION 1 If a small open economy cuts defense spending, what happens to saving, investment, the trade balance, the interest rate and the exchange rate? Represent graphically and briefly explain your answers. When a government cuts on spending, it increases its savings. Government investments depend on the state of the government and world interest rates and in this case, it will remain unchanged (Bento 2009). On the other hand, an increase in government savings will have appositive impact on trade balance and thus it will rise. In addition to that, such an increase in savings will cause a decrease in the exchange rates (Feenstra and Taylor 2008). QUESTION 2 European Multinational firms outsource part of their production abroad. If the euro depreciates, what would you expect to happen to outsourcing by European firms? Explain. Depreciation of the euro will cause the European multinationals to reduce on outsourcing. This is because depreciation increases the amount payable to the outsourced employees. Depreciation increases operation and running costs of an organization, especially if it has a lot of imports or outsourced employees (Feenstra and Taylor 2008). QUESTION 3 The real exchange rate between the United States and Europe is given by ε. Consider a scenario in which the nominal exchange rate (i.e. the price of one Euro in terms of U.S. Dollars) depreciates by 3%, while the price level in Europe increase by 5% and in the United States, it goes up by 2%. What happens to the real exchange rate (Calculate and briefly explain)? Real exchange rate = nominal exchange rate * domestic price Foreign price Real exchange rate (E) = 3*2/5 =6/5 =1.2 percentage change In this case, the real exchange rate will increase by a threshold of 1.2%. This will cause the importation of goods from Europe to USA to be cheaper by 1.2% (Kerr and Gaisford 2007). QUESTION 4 In Munich a bratwurst costs 5 euros, a hot dog costs 4$ at Boston’s Fenway Park. At an exchange rate of 1.05 $ per euro, what is the price of a bratwurst in terms of a hot dog? All else equal, how does this relative price change if the dollar depreciates to 1.25$ per euro? Compared with the initial situation, has a hot dog become more or less expensive relative to a bratwurst? 1 euro =1.05$ 5 euro (bratwurst) = 5*1.05 =5.25 euro Therefore= (5.25*1.05)/4 = 1.378 hot dogs Therefore, one bratwurst is 1.378 hot dogs. QUESTION 5 a. Spain and Germany trade a lot between each other. Germany is running an inflation – low, but inflation – and Spain a deflation. Discuss what is expected to happen with the nominal and the real exchange rates between them. The nominal exchange rates of Germany will decrease while the nominal exchange rates for Spain will increase. This is because an increase in commodity prices will cause an increase in the foreign income that is required to purchase local products. The vice versa is true for Spain where a decrease in the price of commodities will reduce the amount of income earned from foreign countries to buy local products (Kerr and Gaisford 2007). The real exchange rates of Germany will increase. This is because the real exchange rates appreciate with increase in product prices. On the other hand, the real exchange rates of Spain will decrease. This is because real exchange rates depreciate with increase in product prices. b. Up to today, the US has been conducting an expansionary monetary policy. Assuming that the PPP holds, discuss what do you expect to happen – if anything – to the nominal exchange rate between the euro and the dollar. The nominal exchange rates for the dollar against the euro will reduce. There will be need for more dollars to purchase the same quantity of goods purchased by few euros. This is because inflation weakens a country’s monetary value thus reducing the nominal exchange rate (Kerr and Gaisford 2007). QUESTION 6 The government of China, a large open economy, has decided to increase its expenditure. Represent graphically the impact of this decision for Spain, a small open economy and discuss: a. What do you expect to happen with the real and the nominal exchange rates between the Yuan and the euro. The nominal exchange rates for the yuan will reduce. This is because less yuan currency will be able to purchase more products from Spain due to strengthening of the yuan currency. Investments reduce money supply in the economy leading to a deflation in the economy. A deflation leads to a reduction in the nominal exchange rates (Bento 2009). On the other hand, the real exchange rates for the yuan will reduce. Increase in investments strengthens a country’s cash value, which causes the real exchange rates to reduce (Reuvid and Sherlock 2011). b. What do you expect to happen with the real and the nominal exchange rates between the Yuan and the Euro if the PPP theory holds. If the PPP holds, the real exchange rates of the yuan will reduce. This is because investments reduce money supply in the economy leading to a deflation. A deflation in the economy leads to a reduction in the real exchange rates (Reuvid and Sherlock 2011). On the other hand, the nominal exchange rates for the yuan currency will reduce. This is because the value of the currency appreciates with increase in government investments, which reduces amount of local currency required to balance in value with foreign currency. c. Discuss how your answers would change – in case they would – if the decision to increase the expenditure was adopted by the Spanish government, the government of a small open economy. In case the Spanish government increased its expenditure, the nominal exchange rates for the euro will reduce. An increase in investments reduces capital flow in any economy and thus raises a country’s cash value, which reduces the nominal rates. On the other hand, the real exchange rates for the euro will reduce. This is because the euro will increase in value to its scarcity thus causing a reduction in the nominal exchange rates (Reuvid and Sherlock 2011). QUESTION 7 Based on the class readings, we say that the Yuan is not a reserve currency. Considering China’s view on the issue, provide two arguments in favor of the Yuan becoming a reserve currency and three arguments against it. Factors favoring the yuan as the reserve currency: i. China, which is a rapidly growing economy, is taking over most of the markets and economies initially dominated by USA. This scenario will make the yuan more common and popular than the US dollar making it the reserve currency (Feenstra and Taylor 2008). ii. From analysis and statistics as given by the International monetary fund, the US dollar had recently slumped to a 15-year low, which gives it high chances of losing the status as a global reserve (Reuvid and Sherlock 2011). iii. Another thing that is giving the yuan competitive advantage in the market is the strategy used by China officials to market their currency. China officials are targeting to promote their currency beyond the frontier thus giving the US dollar high competition in the market (Bento 2009). Factors not favoring the yuan as the reserve currency: i. The first fact is that none of the countries, USA and China wants to be the reserve currency. This is because being a reserve currency has its challenges. Being a reserve currency has a lot of export price issues which makes most countries to fear being in the reserve currency position. ii. Another important fact to consider is that Chinas markets and investments in other regions and countries are not big enough for the yuan to take over the market and replace the US dollar. iii. Another factor that will prevent the yuan from becoming a world reserve currency is china’s image. Mao who is the first president and founder of the China republic led to the largest mass murder in china. As a result, other nations might not accept to use the yuan with Mao’s image on it (Feenstra and Taylor 2008). References Bento, J. P. C., 2009. Economic integration, international trade and the role of foreign direct investment: the case of Portuguese manufacturing. Berlin: Distributed in North America by Transaction Publishers. Feenstra, R. C. & Taylor, A. M., 2008. International trade. New York: Worth Publishers. Kerr, W. A. & Gaisford, J. D., 2007. Handbook on international trade policy. Cheltenham: Edward Elgar. Reuvid, J. & Sherlock, J., 2011. International trade: an essential guide to the principles and practice of export. London: Kogan Page. Read More