4

Exchange Rates II: The Asset Approach

in the Short Run

1. Use the money market and FX diagrams to answer the following questions about the
relationship between the British pound () and the U.S. dollar ($). The exchange rate
is in U.S. dollars per British pound, E$/. We want to consider how a change in the
U.S. money supply affects interest rates and exchange rates. On all graphs, label the
initial equilibrium point A.
a. Illustrate how a temporary decrease in the U.S. money supply affects the money
and FX markets. Label your short-run equilibrium point B and your long-run
equilibrium point C.
Answer: See the diagram below.
MS 1

iRs

i 1 Rs

MS 2

ER

i 1 R$

C
DR 1

i 2 Rs

i 2 R$

DR 2
FR 2

MD 1

M 2IN

M 1IN

M2IN

2
IN

P 1IN

P 1IN

FR 1
E1

E3

E 2 E Rs/$

S-23

S-24

Solutions

Chapter 4

Exchange Rates II: The Asset Approach in the Short Run

b. Using your diagram from (a), state how each of the following variables changes
in the short run (increase/decrease/no change): U.S. interest rate, British interest
rate, E$/, Ee$/, and the U.S. price level.
Answer: The U.S. interest rate increases, the British interest rate does not
change, E$/ decreases, Ee$/ does not change, and the U.S. price level does not
change.
c. Using your diagram from (a), state how each of the following variables changes
in the long run (increase/decrease/no change relative to their initial values at
point A): U.S. interest rate, British interest rate, E$/, Ee$/, and U.S. price level.
Answer: All of the variables return to their initial values in the long run. This is
because the shock is temporary, implying the central bank will increase the
money supply from M2 to M1 in the long run.
2. Use the money market and FX diagrams from (a) to answer the following questions.
This question considers the relationship between the Indian rupees (Rs) and the U.S.
dollar ($). The exchange rate is in rupees per dollar, ERs/$. On all graphs, label the initial equilibrium point A.
a. Illustrate how a permanent increase in Indias money supply affects the money and
FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C.
Answer: See the following diagram.
MS 1

iRs

i 1 Rs

MS 2

ER

i 1 R$

C
DR1

i 2 Rs

i 2 R$

DR2
FR 2

MD1

M 2IN

M 1IN

M 2IN

2
IN

P 1IN

P 1IN

FR 1
E1

E3

E 2 E Rs/$

S-26

Solutions

Chapter 4

Exchange Rates II: The Asset Approach in the Short Run

3. Is overshooting (in theory and in practice) consistent with PPP? Consider the reasons for the usefulness of PPP in the short run versus the long run and the assumption weve used in the asset approach (in the short run versus the long run). How
does overshooting help to resolve the empirical behavior of exchange rates in the
short run versus the long run?
Answer:Yes, overshooting is consistent with PPP. Investors forecast the expected exchange rate based on the theory of PPP. When there is some change in the market,
the investors know the exchange rate will change to equate relative prices in the long
run. This is why we observe overshooting in the short runthe investors incorporate this information into their short-run forecasts. Exchange rates are volatile in the
short run. The theorys implication that there is exchange rate overshooting (in response to permanent shocks) is one explanation for short run volatility in exchange
rates.
4. Use the money market and foreign exchange (FX) diagrams to answer the following
questions. This question considers the relationship between the euro () and the U.S.
dollar ($). The exchange rate is in U.S. dollars per euro, E$/. Suppose that with financial innovation in the United States, real money demand in the United States decreases. On all graphs, label the initial equilibrium point A.
a. Assume this change in U.S. real money demand is temporary. Using the FX and
money market diagrams, illustrate how this change affects the money and FX
markets. Label your short-run equilibrium point B and your long-run equilibrium point C.
Answer: See the following diagram. The long-run values are the same as the initial values because the shock is temporary. Also because the shock is temporary,
we assume that the reversal of real money demand occurs before the price level
adjuststhat is, MD returns from MD2 to MD1 before the price level changes.
i$

i 1$

i 2$

MS1

ER

i 1$

DR1
B

i 2$
MD1

DR2

FR1

MD 2
M 1US / P 1US

E1

E2

E $/

b. Assume this change in U.S. real money demand is permanent. Using a new diagram, illustrate how this change affects the money and FX markets. Label your
short-run equilibrium point B and your long-run equilibrium point C.
Answer: See the following diagram. In this case, the expected exchange rate
changes because the shock is permanent. In the long run, the price level will have
to increase to adjust for the drop in real money demand (assuming the central bank
does not change the money supply, M). That is, the nominal interest rate returns to
its initial value in the long run. This requires that the price level increase to re-

S-32

Solutions

Chapter 4

Exchange Rates II: The Asset Approach in the Short Run

The U.S. dollar was pegged to the value of gold along with other major currencies,
including the British pound, the French franc, and so on. Many researchers have
blamed the severity of the Great Depression on the Federal Reserve and its failure to
react to economic conditions in 1929 and 1930. Discuss how the policy trilemma applies to this situation.
Answer: The United States was committed to the fixed exchange rate with gold;
consequently, policy makers had to sacrifice either monetary policy autonomy or capital mobility, just as the trilemma suggests. Based on the information given in the
question, we can assume that the policy did not respond to the U.S. business cycle
(policy makers did not exercise monetary policy autonomy). Thus, if we assume international capital mobility, the United States could not react to the business cycle
with a monetary expansion until it abandoned the gold standard.
9. On June 20, 2007, John Authers, investment editor of the Financial Times, wrote the
following in his column, The Short View:
The Bank of England published minutes showing that only the narrowest possible margin, 54, voted down [an interest] rate hike last month. Nobody foresaw this. . . . The news took the sterling back above $1.99, and to a 15-year high
against the yen.
Can you explain the logic of this statement? Interest rates in the United Kingdom
had remained unchanged after the vote and were still unchanged after the minutes
were released. What was contained in the news that caused traders to react? Use the
asset approach.
Answer: The news item indicates that investors did not expect the decision to leave
interest rates unchanged would be divisive. They thought that any increases in interest rates would happen further in the future. Higher interest rates would lead to an
appreciation in the pound sterling. When the minutes showed that interest rate increases were more likely than previously thought, investors came to expect an appreciation sooner rather than later. This caused an appreciation in the current spot exchange rate.
10. We can use the asset approach both to make predictions about how the market will
react to current events and to understand how important these events are to investors.
Consider the behavior of the Union/Confederate exchange rate during the Civil
War. How would each of the following events affect the exchange rate, defined as
Confederate dollars per Union dollar, EC$/$?
a. The Confederacy increases the money supply by 2,900% between July and December of 1861.
Answer: The home money supply increases, the exchange rate increases, and the
Confederate dollar depreciates.
b. The Union Army suffers a defeat in Battle of Chickamauga in September 1863.
Answer: Appreciation in the Confederate dollar is expected because a military
victory means decreased risk, the exchange rate decreases, and the Confederate
dollar appreciates.
c. The Confederate Army suffers a major defeat with Shermans March in the autumn of 1864.
Answer: Depreciation in the Confederate dollar is expected because of military
defeat/increased risk; the exchange rate increases, and the Confederate dollar
depreciates.

S-36

Solutions

Chapter 5

National and International Accounts

3. Show how each of the following would affect the U.S. BOP. Include a description of
the debit and credit items, and in each case say which specific account is affected (e.g.,
imports of goods and services, IM; exports of assets, EXA; and so on).
a. A California computer manufacturer purchases a $50 hard disk from a Malaysian
company, paying the funds from a bank account in Malaysia.
Answer:
Description

BOP Account

Account (detail)

Credit/Debit

Hard disk imported from Malaysia

Decrease in Malaysian deposits owned by U.S. firm

CA ()
FA ()

IM (), TB ()
IMFA ()

$50
$50

b. A U.S. tourist to Japan sells his iPod to a local resident for yen worth $100.
Answer:
Description

BOP Account

Account (detail)

Credit/Debit

iPod exported to Japan

Increase in Japanese currency owned by U.S. tourist

CA ()
FA ()

EX (), TB ()
IMFA ()

$100
$100

c. The U.S. central bank sells $500 million of its holdings of U.S. Treasury bonds to
a British financial firm and purchases pound sterling foreign reserves.
Answer:
Description
U.S. bonds sold to British firm
Pound-sterling reserves imported from Britain

BOP Account

Account (detail)

Credit/Debit

FA ()
FA ()

EX ()
IM ()

$500 mil.
$500 mil.

H
A
F
A

d. A foreign owner of Apple shares receives $10,000 in dividend payments, which

are paid into a New York bank.
Answer:
Description

BOP Account

Account (detail)

Credit/Debit

Import of factor service (ownership) from ROW

New York bank deposits paid to ROW

CA ()
FA ()

IMFS (), NFIA ()

EXHA ()

$10,000
$10,000

e.

The central bank of China purchases $1 million of export earnings from a firm
that has sold $1 million of toys to the United States, and the central bank holds
these dollars as reserves.
Answer:

Description

BOP Account

Account (detail)

Credit/Debit

Import of toys from China

China central bank buys U.S. dollars

CA ()
FA ()

IM (), TB ()
EXHA ()

$1 mil.
$1 mil.

Solutions

f.

Chapter 5 National and International Accounts

The U.S. government forgives a $50 million debt owed by a developing country.
Answer:

Description

BOP Account

Account (detail)

Credit/Debit

Debt forgiveness (gift)

Decrease in external assets owned by U.S. entities

KA ()
FA ()

KAOUT ()
IMFA ()

$50 mil.
$50 mil.

4. In 2010 the country of Ikonomia has a current account deficit of $1 billion and a
nonreserve financial account surplus of $750 million. Ikonomias capital account is in
a $100 million surplus. In addition, Ikonomian factors located in foreign countries
earn $700 million. Ikonomia has a trade deficit of $800 million. Assume Ikonomia
neither gives nor receives unilateral transfers. Ikonomias GDP is $9 billion.
a. What happened to Ikonomias net foreign assets during 2010? Did it acquire or
lose foreign assets during the year?
Answer: BOP
CA  FA  KA
0
CA  KA
FA
Current account deficit of $1 billion ($1,000 million) and the capital account is
in a $100 million surplus.
$1,000  $100
FA
FA
$900
EXA  IMA
The financial account records financial flows into and out of the country. In this
case, the FA surplus indicates that on net, foreigners purchased more Ikonomian
assets than Ikonomians purchased foreign assets. Therefore, net foreign assets for
Ikonomia declined by $900 million.
b. Calculate the official settlements balance. Based on this number, what happened
to the central banks (foreign) reserves?
Answer: The financial account can be split into those transactions conducted by
the central bank (official settlements balance) and those conducted by everyone
else (nonreserve financial account):
FA
Official settlements balance  Nonreserve financial account
Nonreserve financial account is a $750 million surplus.
$900
Official settlements balance  $750
Official settlements balance
$150
The official settlements balance is in a $150 million surplus. This means that foreign central banks purchased more Ikonomian assets (paid for with foreign currency) than the Ikonomian central bank purchases of foreign assets (paid for with
domestic currency, $ in this case).Therefore, Ikonomias central bank experienced
an increase in its foreign reserve holdings.

S-37

S-38

Solutions

Chapter 5

National and International Accounts

c. How much income did foreign factors of production earn in Ikonomia during
2010?
Answer: The current account can be split into three components: the trade balance (final goods and services), the net factor income from abroad (payments
to/from factor services), and the net unilateral transfers.
CA
TB  NFIA  NUT
$1000
$800  NFIA  0. In the question, we are given the
trade balance ($800 million) and the current account ($1,000 million).
NFIA
$200. Net factor income from abroad is $200 million.
This implies that foreign factors of production located in Ikonomia
earned more than Ikonomian factors abroad.
NFIA
EXFS  IMFS. We know that Ikonomian
factors abroad earned $600 million.
$200
$600  IMFS
IMFS
$800. Foreign factors located in Ikonomia earned $900 million.
d. Calculate NFIA.
Answer: See (c). NFIA
$200 million.
e.

Using the identity BOP
CA  FA  KA, show that BOP
0.

Answer: To check our work, we can verify the BOP identity:
BOP
CA  FA  KA
BOP
[TB  NFIA  NUT]  FA  KA
BOP
[$800  $200  $0]  [$750  $150]  $100
0

f.

Calculate Ikonomias GNE, GNI, and GNDI.

Answer: We know that GDP
C  I  G  (EX  IM)
GNE  TB
GNE
GDP  TB
GNE
$9,000  ($800)
GNE
$9,800
GNI
GDP  NFIA
GNE  TB  NFIA
GNI
$9,000  ($200)
$9,800  (800)  ($200)
GNI
$8,800
$8,800
GNDI
GDP  NFIA  NUT
GNI  NUT.
Because NUT
$0, GNDI
GNI
GNDI
$8,800

Solutions

Chapter 5 National and International Accounts

5. To answer this question, you must obtain data from the Bureau of Economic Analysis (BEA), http://www.bea.gov, on the U.S. BOP tables. Go to interactive tables to
obtain annual data for 2008 (the default setting is for quarterly data). It may take you
some time to get familiar with how to navigate the website. You need only refer to
Table 1 on the BOP accounts. Using the BOP data, calculate the following for the
United States:
Answers will vary because of data revisions. The figures below are based on those
given in the Table 5-3.
a. TB, NFIA, NUT, and CA
Answer: TB
$375 billion (Lines 1  3)
NFIA
$121 billion (Lines 2  4)
NUT
$125 billion (Line 5)
CA
$379 billion (Lines 1  2  3  4  5)
b. FA
Answer: FA
$166 billion (Lines 7  8)
c. Official settlements balance, referred to as U.S. official reserve assets and Foreign official assets in the United States.
Answer: Official settlements balance
$398 billion (Lines 7a  8a)
d. Nonreserve financial account (NRFA)
Answer: Nonreserve financial account
$232 billion (Lines 7b  8b)
e.

BOP. Note that this may not equal zero because of statistical discrepancy. Verify
that the discrepancy is the same as the one reported by the BEA.
Answer: BOP
CA  FA  KA
$379  $166  $0
$213
(statistical discrepancy
$213 million)

6. Continuing from the previous question, find nominal GDP for the United States in
2008 (you can find it elsewhere on the BEA site). Use this information along with
your previous calculations to calculate the following:
Answers will vary because of data revisions. The figures below use data from Table 52.
a. GNE, GNI, GNDI
Answer: GNE
$14,649 billion (row 4)
GNI
$14, 362 billion (row 8)
GNDI
$14, 237 billion (row 10)
b. In macroeconomics, we often assume the U.S. economy is a closed economy
when building models that describe how changes in policy and shocks affect the
economy. Based on the previous data (BOP and GDP), do you think this is a reasonable assumption to make? Do international transactions account for a large
share of total transactions (involving goods and services, or income) involving the
United States?
Answer: Based on Table 5-2, we see that GDP
$14,257 billion, whereas the
trade balance accounts for a small share of this total (TB
$392 billion). Similarly, if we compare the share of GNI ($14,362 billion) that is attributed to the
current account (CA
$412 billion), we can see that international transactions
account for a relatively small share of U.S. production and income. Therefore, the
assumption of a closed economy is a reasonable one.

S-39

S-40

Solutions

Chapter 5

National and International Accounts

7. During the 1980s, the United States experienced twin deficits in the current account and government budget. Since 1998, the U.S. current account deficit has
grown steadily, along with rising government budget deficits. Do government budget deficits lead to current account deficits? Identify other possible sources of the current account deficits. Do current account deficits necessarily indicate problems in the
economy?
Answer: Twin deficits are possible, but there are other factors that influence the
current account. Since 1998, the decline in the current account has been associated
with movements in investment and national savings. Note the following expression
from the textbook:
CA
SP  SG  I
It is not clear that budget deficits cause current account deficits. There are two possibilities besides a budget deficit (SG  0):
Private savings (SP) may change when the government changes taxes (e.g., tax
rates). Suppose tax rates decrease, causing a decrease in government saving. According to Ricardian equivalence, households will respond to a tax cut today by
increasing savings in anticipation of a future tax increase needed to finance the
current budget deficit. This implies private savings will increase, possibly offsetting the effect on national saving.
The current account may move independently of saving, namely because of
changes in investment (I). An increase in domestic investment opportunities
could lead to current account deficits.
8. Consider the economy of Opulenza. In Opulenza, domestic investment of $400 million earned $20 million in capital gains during 2009. Opulenzans purchased $120
million in new foreign assets during the year; foreigners purchased $160 million in
Opulenzan assets. Assume the valuation effects total $1 million in capital gains.
Note that we need to assume a value for the capital account. We will assume KA

0 in the following transactions.
a. Compute the change in domestic wealth in Opulenza.
Answer: The change in domestic wealth is the sum of additions to the capital
stock plus capital gains earned on domestic assets:
Change domestic wealth
I  Capital gains on K
$400  $20
$420 million
b. Compute the change in external wealth for Opulenza.
Answer: The change in external wealth is:
W
Valuation effects  (FA)
$1  ($160 $120)
$39 million
c.

Compute the total change in wealth for Opulenza.

Answer: The change in total wealth is:
Change total wealth
Change domestic wealth 
Change in external wealth
$420  ($39)
$381 million

d. Compute domestic savings for Opulenza.

To calculate national savings, note that the change in total wealth is:
Change total wealth
S  KA  Capital gains on K  Capital gains on (A  L)
$381
S  $0  ($20  $1)
S
$360 million

Solutions

e.

Chapter 5 National and International Accounts

Compute Opulenzas current account. Is the CA in deficit or surplus?

Answer: Using the current account identity: S
I  CA:
S
I  CA
$360
$400  CA
CA
$40 million
Or, we could use the definition of the change in total wealth:
Change total wealth
I  (CA  KA)  Capital gains on K  Capital gains
on (A  L)
$381
$400  CA  $0  $20  $1
CA
$40 million

f.

Explain the intuition for the CA deficit/surplus in terms of savings in Opulenza,

financial flows, and its domestic/external wealth position.
Answer: We see that Opulenza experienced a $420 million increase in its domestic wealth while losing $39 million in external wealth. $360 million of this
increase in domestic wealth was financed through domestic savings, plus wealth
grew because of capital gains on the existing stock of wealth ($20). This leaves
$20 million financed from foreign sources. The way that Opulenza pays for this
growth in domestic wealth is through borrowing from abroadthis is why its
external wealth declined. It is also the reason for the CA deficit. Opulenzans enjoy relatively high spending (GNE  GDP) through running a CA deficit and
through borrowing from abroad (W  0).

g. How would a depreciation in Opulenzas currency affect its domestic, external,

and total wealth? Assume that foreign assets owned by Opulenzans are denominated in foreign currency.
Answer: The answer to this question depends on how Opulenzan external assets and external liabilities are denominated. If, as in the case of the United States,
most liabilities are denominated in the home currency whereas a smaller share is
denominated in the foreign currency, then a depreciation leads to a larger increase in external liabilities than assets. In turn, this would decrease in financial
account. This would improve Opulenzas external wealth position, reducing its
CA deficit. Note that this implies they will have to cut back on spending (reducing the CA deficit).
9. This question asks you to calculate valuation effects for the United States in 2004
using the same methods mentioned in the chapter. Use the http://www.bea.gov
website to collect the data needed for this question: look under the International
heading.
Visit the BEAs balance of payments data page and obtain the U.S. BOP for 2004
in billions of dollars. Be sure to get the annual data, not quarterly.
Visit the BEAs net international investment position data page and obtain the U.S.
net international investment position for end 2003 to end 2004.
Answers may vary based on data revisions. The data below were obtained in November 2007:
a. What was the U.S. current account for 2004?
Answer: CA
$640,148 million
b. What was the U.S. financial account for 2004?
Answer: FA
$556,742 million

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Solutions

Chapter 6 Balance of Payments I: The Gains from Financial Globalization

Therefore, the countrys initial external wealth, W0  (1  r*)W1, is equal to

the present value of the countrys future trade deficits.
d. How would the expressions in (a) and (b) change if the economy had net labor
income (positive or negative) to or from abroad or net unilateral transfers? Explain briefly.
Answer: Net labor income to or from abroad would affect the stock of external
wealth each period through changing the NFIA from NFIA  r*W0 (with only
capital) to NFIA  r*K0  net labor income from abroad, in which K denotes
initial capital held abroad. Assume that labor abroad, Lx is paid a world wage, w*:

W0  TB0  r*K1  w*L0  NUT
The country can effectively finance trade deficits through both capital income
(as in the standard model) and labor income from abroad. Similarly, if the country receives net unilateral transfers, this would also add to the countrys initial
wealth.
3. In this question assume all dollar units are real dollars in billions, so $150 means $150 billion. It is year 0. Argentina thinks it can find $150 of domestic investment projects
with an MPK of 10% (each $1 invested pays off $0.10 in every later year). Argentina
invests $84 in year 0 by borrowing $84 from the rest of the world at a world real interest rate r* of 5%. There is no further borrowing or investment after this.
Use the standard assumptions: Assume initial external wealth W (W in year 1) is 0.
Assume G  0 always; and assume I  0 except in year 0. Also, assume
NUT  KA  0 and that there is no net labor income so that NFIA  r*W.
The projects start to pay off in year 1 and continue to pay off all years thereafter. Interest is paid in perpetuity, in year 1 and every year thereafter. In addition, assume that
if the projects are not done, then GDP  Q  C  $200 in all years, so that
PV(Q)  PV(C)  200  200/0.05  4,200.
a. Should Argentina fund the $84 worth of projects? Explain your answer.
Answer: Yes. The criterion for undertaking an investment project is:

Q
  r*

K
Because MPK  10%  r* ( 5%), the country will benefit from the investment
project.
b. Why might Argentina be able to borrow only $84 and not $150?
Answer: Argentina may face borrowing limits. Because 150 units of output accounts for three fourths of the countrys total production, lenders might be unwilling to lend this much, even for a productive investment project (e.g., a sudden stop).
c. From this point forward, assume the projects totaling $84 are funded and completed in year 0. If the MPK is 10%, what is the total payoff from the projects in
future years?
Answer: The project will result in an 8.4 increase in Q each period
( MPK
K  0.10 84).
d. Assume this is added to the $200 of GDP in all years starting in year 1. In dollars, what is Argentinas Q  GDP in year 0, year 1, and later years?
Answer: Q0  200, Q  208.4 in subsequent years.

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S-46

Solutions

Chapter 6 Balance of Payments I: The Gains from Financial Globalization

e.

At year 0, what is the new PV(Q) in dollars? Hint: To simplify, calculate the value
of the increment in PV(Q) due to the extra output in later years.
Answer: The present value of output is:

f.

Q
208.4
PV(Q)  Q0    200    4,368
r*
0.05
At year 0, what is the new PV(I) in dollars? Therefore, what does the LRBC say
is the new PV(C) in dollars?
Answer: The present value of investment is:
PV(I) 
K  84
Using the LRBC, we can calculate the present value of consumption:
PV(C)  PV(Q)  PV(I)  4,368  84  4,284

g. Assume that Argentina is consumption smoothing. What is the percent change in

PV(C)? What is the new level of C in all years? Is Argentina better off?
Answer: The percent change in the present value of consumption (compared
with the case with no investment project) is 2% ( 84 / 4,200). The new level
of consumption in all years is:
C
PV(C)  C  
r*
C
4,284  C   C  204
0.05
Yes, Argentina is better off because consumption increases from 200 to 204 in
every period.
h. For the year the projects go ahead, year 0, explain Argentinas balance of payments as follows: State the levels of CA, TB, NFIA, and FA.
Answer: In year 0, the values are as follows:
TB = Q  C  I  200  204  84  88
NFIA  0
CA  88
FA  88 (from the balance of payments, CA  FA  KA and KA  0 by assumption in this question)
i.

What happens in later years? State the levels of CA, TB, NFIA, and FA in year 1
and every later year.
Answer: In subsequent years, the values are as follows:
TB  Q  C  I  208.4  204  0  4.4
NFIA  4.4 ( r*
K  0.05 88)
CA  0  FA

4. Continuing from the previous question, we now consider Argentinas external wealth
position.
a. What is Argentinas external wealth W in year 0 and later? Suppose Argentina has
a one-year debt (i.e., not a perpetual loan) that must be rolled over every year.
After a few years, in year N, the world interest rate rises to 15%. Can Argentina
stick to its original plan? What are the interest payments due on the debt if
r* 15%? If I  G  0, what must Argentina do to meet those payments?
Answer: Argentina borrows $88 in year 0, so its external wealth is $88 in year
0 and thereafter. The interest payments needed to service its debt rise from $4.4
to $13.2 ( 0.15 88). The only way that Argentina can make these payments
is through reducing consumption.

Solutions

Chapter 6 Balance of Payments I: The Gains from Financial Globalization

b. Suppose Argentina decides to unilaterally default on its debt. Why might Argentina do this? State the levels of CA, TB, NFIA, and FA in year N and all subsequent years. What happens to the Argentine level of C in this case?
Answer: If Argentina defaults on this debt, NFIA  0 because external wealth
rises to 0.This means Argentina no longer needs to run a trade surplus, so its consumption can increase by the $4.4 that was previously paid on its debt. TB 
NFIA  CA  FA  0 and C  $208.4.
c. When the default occurs, what is the change in Argentinas external wealth, W?
What happens to the rest of the worlds (ROWs) external wealth?
Answer: External wealth rises to 0.The rest of the world experiences an $88 decrease in wealth.
d. External wealth data for Argentina and ROW are recorded in the net international investment position account. Is this change in wealth recorded as a financial flow, a price effect, or an exchange rate effect?
Answer: In the net international investment position, this is recorded as a financial flow.
5. Using production function and MPK diagrams, answer the following questions. For
simplicity, assume there are two countries: a poor country (with low living standards)
and a rich country (with high living standards).
a. Assuming that poor and rich countries have the same production function, illustrate how the poor country will converge with the rich country. Describe how
this mechanism works.
Answer: See the following figure.
q
A

qR

B
qP

kP and qP rise
until qP qR.

kP

kR

MPK

B
MPKP

Because MPKP MPKR,

capital flows into P.

MPKR

kP

kR

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Chapter 6 Balance of Payments I: The Gains from Financial Globalization

b. A strike in France leads to a reduction in French income.

Answer: This is an idiosyncratic shock to Frances output (from a reduction in labor production). France can buffer the effects on income through diversifying. In
this case, France experiences a decline in output (from the labor stoppage), but still
continues to enjoy relatively high capital income from its portfolio investment in
the Czech Republic. This income can finance Frances GNE. Likewise, the Czech
Republics output is relatively high (compared with France), so its GNI  GNE,
with the difference flowing to France in the form of capital income.
c. Floods destroy a portion of the Czech capital stock, lowering Czech income.
Answer: This is a negative idiosyncratic shock to the Czech Republic. The
Czech Republic continues to earn income from its capital investments in France,
buffering its total income against the shock. In this case, capital income flows
from France to the Czech Republic.
10. Assume that a country produces an output Q of 50 every year. The world interest rate
is 10%. Consumption C is 50 every year, and I  G  0.There is an unexpected drop
in output in year 0, so output falls to 39 and is then expected to return to 50 in every
future year. If the country desires to smooth consumption, how much should it borrow in period 0? What will the new level of consumption be from then on?
Answer: There is a one-time decrease in output of 11 units. Therefore, the present
value of consumption is:
50
PV(C)  PV(Q)  PV(G)  39    539
0.10
To determine the level of consumption each period, we know that the countrywants
to maintain a given level of consumption:
C
PV(C)  C  
r*
C
539  C   C  49
0.10
Note that for every 10 units borrowed, consumption is reduced by one unit, as NFIA 
0.10 10 in subsequent periods.Therefore, C  49 in period 0 and thereafter. Alternatively, the change in consumption can be calculated using the following:
r*
0.10

C  
Q  (11)  1
1  r*
1  0.10
Consumption decreases by one unit, to C  49.
11. Assume that a country produces an output Q of 50 every year.The world interest rate
is 10%. Consumption C is 50 every year, and I  G  0. There is an unexpected war
in year 0, which costs 11 units and is predicted to last one year. If the country desires
to smooth consumption, how much should it borrow in period 0? What will the new
level of consumption be from then on?
The country wakes up in year 1 and discovers that the war is still going on and will
eat up another 11 units of expenditure in year 1. If the country still desires to smooth
consumption looking forward from year 1, how much should it borrow in period 1?
What will be the new level of consumption from then on?
Answer: If the war is temporary, the increase in G should be financed through borrowing (e.g., running a current account deficit). To determine how much the country
should borrow, we first must calculate the change in the present value of consumption.
The present value of government spending is equal to 11, as this is a one-time increase
in government spending. Therefore, the present value of consumption is:

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Chapter 6 Balance of Payments I: The Gains from Financial Globalization

50
PV(C)  PV(Q)  PV(G)  50    11  539
0.10
To determine the level of consumption each period, we know that the country wants
to maintain a given level of consumption:
C
PV(C)  C  
r*
C
539  C   C  49
0.10
If the government needs to borrow again, then we can use the same approach to find
consumption each period. Note that for every 10 units borrowed, consumption is reduced by one unit, as NFIA  0.10 10 in subsequent periods. Therefore, in period 0, C  49. Thereafter, when the government needs another 11 units, beginning
in period 1, C  48 (as NFIA increases by one additional unit).
12. Consider a world of two countries, Highland (H) and Lowland (L). Each country has
an average output of 9 and desires to smooth consumption. All income takes the form
of capital income and is fully consumed each period.
a. Initially there are two states of the world, Pestilence (P) and Flood (F). Each happens with 50% probability. Pestilence affects Highland and lowers the output there
to 8, leaving Lowland unaffected with an output of 10. Flood affects Lowland and
lowers the output there to 8, leaving Highland unaffected with an output of 10.
Devise a table with two rows corresponding to each state (rows marked P, F). In
three columns, show income to three portfolios: the portfolio of 100% H capital,
the portfolio of 100% L capital, and the portfolio of 50% H  50% L capital.
Answer: See the following table.
State
P
F

100% L Capital
10
8

100% H Capital

50-50 portfolio

8
10

9
9

b. Two more states of world appear: Armageddon (A) and Utopia (U). Each happens
with 50% probability but is uncorrelated with the P-F state. Armageddon affects
both countries equally and lowers income in each country by a further 4 units,
whatever the P-F state. Utopia leaves each country unaffected. Devise a table with
four rows corresponding to each state (rows marked PA, PU, FA, FU). In three
columns, show income to three portfolios: the portfolio of 100% H capital, the
portfolio of 100% L capital, and the portfolio of 50% H  50% L capital.
Answer: See the following table.
State
PU
FU
PA
PA

100% L Capital
10
8
6
4

100% H Capital
8
10
4
6

50-50 portfolio
9
9
5
5

c. Compare your answers to (a) and (b) and consider the optimal portfolio choices.
Does diversification eliminate consumption risk in each case? Explain.
Answer: In (a), Lowland and Highland are each able to eliminate exposure to
risk through investing equally in capital at home and abroad. This is because all
shocks in this part are idiosyncratic and are negatively correlated. In (b), the

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Chapter 6 Balance of Payments I: The Gains from Financial Globalization

countries are able to reduce some of the volatility in capital income through diversification, but not completely. This is because both countries are subject to
common shocks (Armageddon) that cannot be diversified away. This state uniformly reduces capital income in both countries.