CHP1

2.

Explainhoweachofthefollowingtransactionsgeneratestwoentriesa
creditandadebitintheAmericanbalanceofpaymentsaccounts,and
describehoweachentrywouldbeclassified:a.AnAmericanbuysashareof
Germanstock,payingbywritingacheckonanaccountwithaSwissbank.b.
AnAmericanbuysashareofGermanstock,payingthesellerwithacheckon
anAmericanbank.
c.TheKoreangovernmentcarriesoutanofficialforeignexchange
interventioninwhichitusesdollarsheldinanAmericanbanktobuyKorean
currencyfromitscitizens.
d.AtouristfromDetroitbuysamealatanexpensiverestaurantinLyons,
France,payingwithatravelerscheck.
e.ACaliforniawinemakercontributesacaseofcabernetsauvignonfora
Londonwinetasting.
f.AU.S.ownedfactoryinBritainuseslocalearningstobuyadditional
machinery.

4.

ANewYorkertravelstoNewJerseytobuya$100telephoneanswering
machine.TheNewJerseycompanythatsellsthemachinethendepositsthe
$100checkinitsaccountataNewYorkbank.Howwouldthesetransactions
showupinthebalanceofpaymentsaccountsofNewYorkandNewJersey?
WhatiftheNewYorkerpayscashforthemachine?

CHP2
4. Calculatethedollarratesofreturnonthefollowingassets:
a.

Apaintingwhosepricerisesfrom$200,000to$250,000inayear.
($250,000$200,000)/$200,000=0.25

b.

AbottleofarareBurgundy,DomainedelaRomaneConti1978,whose
pricerisesfrom$255to$275between2013and2014.
($275$225)/$225=0.22.

c.

A10,000depositinaLondonbankinayearwhentheinterestrateon
poundsis10percentandthe$/exchangeratemovesfrom$1.50perpound
to$1.38perpound.
Therearetwopartstothisreturn.Oneisthelossinvolvedduetotheappreciationofthe
dollar;thedollarappreciationis($1.38$1.50)/$1.50=0.08.Theotherpartofthe
returnistheinterestpaidbytheLondonbankonthedeposit,10percent.(Thesizeofthe
depositisimmaterialtothecalculationoftherateofreturn.)Intermsofdollars,the
realizedreturnontheLondondepositisthus2percentperyear.

5. Whatwouldbetherealratesofreturnontheassetsinthepreceding

questionifthepricechangesdescribedwereaccompaniedbya
simultaneous10percentincreaseinalldollarprices?
Noteherethattheorderingofthereturnsofthethreeassetsisthesamewhetherwe
calculaterealornominalreturns.
a.Therealreturnonthehousewouldbe25%10%=15%.Thisreturncouldalsobe
calculatedbyfirstfindingtheportionofthe$50,000nominalincreaseinthehousesprice
duetoinflation($20,000),thenfindingtheportionofthenominalincreaseduetoreal
appreciation($30,000),andfinallyfindingtheappropriaterealrateofreturn
($30,000/$200,000=0.15).
b.Again,subtractingtheinflationratefromthenominalreturn,weget20%10%=
10%.
c.2%10%=8%.

6. Supposethedollarinterestrateandthepoundsterlinginterestrateare
thesame,5percentperyear.Whatistherelationbetweenthecurrent
equilibrium$/exchangerateanditsexpectedfuturelevel?Suppose
theexpectedfuture$/exchangerate,$1.52perpound,remains
constantasBritainsinterestraterisesto10percentperyear.Ifthe
U.S.interestratealsoremainsconstant,whatisthenewequilibrium$/
exchangerate?
Thecurrentequilibriumexchangeratemustequalitsexpectedfuturelevelsince,with
equalityofnominalinterestrates,therecanbenoexpectedincreaseordecreaseinthe
dollar/poundexchangerateinequilibrium.Iftheexpectedexchangerateremainsat$1.52
perpoundandthepoundinterestraterisesto10percent,theninterestparityissatisfied
onlyifthecurrentexchangeratechangessuchthatthereisanexpectedappreciationof
thedollarequalto5percent.Thiswilloccurwhentheexchangeraterisesto$1.60per
pound(adepreciationofthedollaragainstthepound).

CHP3

1. Supposethereisareductioninaggregaterealmoneydemand,thatis,a
negativeshiftintheaggregaterealmoneydemandfunction.Tracethe
shortrunandlongruneffectsontheexchangerate,interestrate,and
pricelevel.
Areductioninrealmoneydemandhasthesameeffectsasanincreaseinthenominal
moneysupply.InFigure14.1,thereductioninmoneydemandisdepictedasa
backwardshiftinthemoneydemandschedulefromL1toL2.Theimmediateeffect
ofthisisadepreciationoftheexchangeratefromE1toE2,ifthereductioninmoney
demandistemporary,oradepreciationtoE3ifthereductionispermanent.Thelarger
impacteffectofapermanentreductioninmoneydemandarisesbecausethischange
alsoaffectsthefutureexchangerateexpectedintheforeignexchangemarket.Inthe
longrun,thepricelevelrisestobringtherealmoneysupplyintolinewithrealmoney
demand,leavingallrelativeprices,output,andthenominalinterestratethesameand
depreciatingthedomesticcurrencyinproportiontothefallinrealmoneydemand.
Thelongrunlevelofrealbalancesis(M/P2),alevelwheretheinterestrateinthe
longrunequalsitsinitialvalue.Thedynamicsofadjustmenttoapermanent
reductioninmoneydemandarefromtheinitialPoint1inthediagram,wherethe
exchangerateisE1,immediatelytoPoint2,wheretheexchangerateisE3andthen,
asthepricelevelfallsovertime,tothenewlongrunpositionatPoint3,withan
exchangerateofE4.

3.

Thevelocityofmoney,V,isdefinedastheratioofrealGNPtorealmoney
holdings,V=Y/(M/P)inthischaptersnotation.Useequation(154)toderive
anexpressionforvelocityandexplainhowvelocityvarieswithchangesinR
andinY.(Hint:TheeffectofoutputchangesonVdependsontheelasticityof
aggregatemoneydemandwithrespecttorealoutput,whicheconomists
believetobelessthanunity.)Whatistherelationshipbetweenvelocityand
theexchangerate?
Equation144isMs=P=L(R,Y).Thevelocityofmoney,V=Y=(M=P).Thus,when
thereisequilibriuminthemoneymarketsuchthatmoneydemandequalsmoneysupply,
V=Y=L(R,Y).WhenRincreases,L(R,Y)fallsandthusvelocityrises.WhenY
increases,L(R,Y)risesbyasmalleramount(sincetheelasticityofaggregatemoney
demandwithrespecttorealoutputislessthanone)andthefractionY/L(R,Y)rises.
Thus,velocityriseswitheitheranincreaseintheinterestrateoranincreaseinincome.
Sinceanincreaseininterestratesaswellasanincreaseinincomecausetheexchange
ratetoappreciate,anincreaseinvelocityisassociatedwithanappreciationofthe
exchangerate.

9. Continuingwiththeprecedingquestion,notethatthemonetary
valueofoutputin1985was$4,010billionintheUnitedStatesand
1,418billioncruzadosinBrazil.Referbacktoquestion3and
calculatevelocityforthetwocountriesin1985.Whydoyouthink
velocitywassomuchhigherinBrazil?
Velocityisdefinedasrealincomedividedbyrealbalancesor,equivalently,
nominalincomedividedbynominalmoneybalances(V=PxY/M).Velocityin
Brazilin1985was13.4(1418/106.1),whilevelocityintheUnitedStateswas6.3
(4010/641).Thesedifferencesinvelocityreflectedthedifferentcostsofholding
cruzadoscomparedtoholdingdollars.Thesedifferentcostswereduetothehigh
inflationrateinBrazilwhichquicklyerodedthevalueofidlecruzados,whilethe
relativelylowinflationrateintheUnitedStateshadamuchlessdeleteriouseffect
onthevalueofdollars.