Homework Assignment #3 Chapters 11-14 ECON 321B

This homework assignment must be turned in before you will be authorized to take your first unit
exam for Part II of the course.
Please note that this assignment requires several full essay answers, not just truncated or singlesentence answers. Some of these questions require you to think and bring together various
models, concepts, evidence, and ideas from the textbook. By taking the time to think out these
questions, you will gain a deeper understanding of the material covered in the textbook and the
lectures.

11. Use the circular flow diagram to illustrate the following statement: In an economy, total
lending must equal total borrowing. Does it matter whether you use a closed-economy circular
flow diagram or an open-economy circular flow diagram?
2. Discuss and provide examples of how choices by individuals, firms, organizations, government
agencies, etc. affect other parts of the economy. Specifically, discuss how these decisions affect the
circular flow. What do the diverse motivations by individuals, firms, banks, etc. imply for the

stability of the economic system?

3. The following items are from a hypothetical countrys balance of payments ($billions):
a. Imports of services: $486
b. Borrowing from private foreigners: $507
c. Exports of goods: $823
d. Net transfers: $51
e. Exports of services: $428
f. Private lending to foreigners: $443
g. Imports of goods: $537
h. Borrowing from foreign central banks: $5
i. Increase in official reserve assets: $256
Assume that these payments include all of the countrys international payments. Place each item
where it belongs in the current account or in the financial account, being sure to check that the
sum of credits is equal to the sum of debits. Does the balance of payments balance? What are
the current account and financial account balances?

4. 2 You are given four of the exchange rates between U.S. dollars, Japanese
yen, Argentinean pesos, Taiwanese dollars, and Turkish lira. Complete the
grid by filling in all the blanks, assuming triangular arbitrage is complete:
US$
US$ per
yen per
pesos per
T$s per
lira per

100
25
50

yen pesos T$
___
___
2
___
___

lira

___
___

___
___
___
___
___
___
___
___
___
___
___
___
___
___
___

Complete the grid by filling in all the blanks.

5. Explain the carry trade. Is it a rational market? Why or why not? Explain.
6. 3Suppose that there are no restrictions on international asset transactions, and people are risk
neutral. For each of the following cases, if the values for domestic and foreign interest rates and
the expected future exchange rate are as given, find the spot exchange rate:
a. r* = 10%, r = 5%, and Etet+1 = $1.00.
b. r* = 5%, r = 10%, and Etet+1 = $1.00.
c. r* = 5%, r = 5%, and Etet+1 = $1.00.
7. Explain what the presence of triangular arbitrage in the foreign exchange market means for
each individual exchange rate.
8. Explain what the interest parity condition tells us about the spot exchange rate. (Hint: set up
the interest parity condition, and move the spot rate to the left of the equation and everything else
to the right-hand side of the equation.)
9. Explain what De Grauwe (1989) meant when he described exchange rates as near-rational.
How does De Grauwes thinking relate to that of John Maynard Keynes, who described the role
of convention in determining market prices under uncertainty.
10. Explain Hyman Minskys financial instability hypothesis. Be sure to present his step by step
derivation of his conclusion, detailing the ideas that he builds on.
11. It is well known that the United States in 2010 had a government primary budget deficit of8
percent, an economic growth rate of 1 percent, a real interest rate of zero percent, and a total debt

of 100 percent of GDP. Is the U.S. budget deficit sustainable? (Hint: Use the analysis from the
section en titled Tracing the Path of Public Sector Debt: An Example.)
12. Review the conditions of the Brady Plan. Was it a fair plan for all parties concerned?