Short Term Effect of a Drop in the Interest Rate Offered by Euro Deposits - Assignment Example

Show graphically the short term effect of a drop in the interest rate offered by Euro deposits, R$, and the effect on the exchange rate, . In the United States, for a given rate of interest and a given projection with respect to the future rate of exchange, a drop in the rate of interest paid by euro deposits makes the dollar to appreciate. Conversely, an increase in the rate of interest offered by Euro deposits causes the depreciation of the dollar. 9 Figure (c) Increasing the European cash supply reduces the rate of interest on the euro; this causes the expected euro return schedule, expressed in dollars ($), to move down, causing a decrease in the euro or dollar rate of exchange, i.e., an appreciation or side of the dollar. The euro devalues against the U.S. Dollar. The U.S. cash supply and cash demand are not impacted, and hence the rate of interest in the U.S. would remain the same (Gandolfo, Giancarlo, 23). 2. Suppose there is a reduction in aggregate real money demand, that is, a negative shift in the aggregate real money demand function. Trace the short and long-run effects on the exchange rate, interest rate and price levels. Use the asset approach to the balance of payments [chapters 14 (3) and 15 (4)]. A decrease in aggregate real cash demand has similar effects as a rise in the nominal cash supply. As shown in the figure below, the decrease in cash demand is a backward change in the schedule of money demand from L1 – L2. The immediate impact is a devaluation of the rate of exchange from E1 – E2, if the decrease in cash demand is short-term, or a devaluation to E3 when the decrease is permanent. The greater effect of a long-lasting decrease in cash demand arises since this shift also influences the future rate of exchange anticipated in the overseas exchange marketplace. In the end, the level of prices increases to take the real cash supply in line with the real cash demand, leaving all comparative output, prices, and the nominal rate of interest the same and devaluing the domestic exchange in ratio with the decline in real cash demand (Gandolfo, Giancarlo, 27). The long run level of actual balances is (M/P2), a point where the rate of interest in the long run is equivalent to its original value. The adjustment dynamics to a permanent decrease in cash demand are from the original Point 1 (in the figure), where the rate of exchange is E1, directly to Point 2, in which the rate of exchange is E3 and finally, as the level of prices declines over time, to the fresh long run level at Point 3, with E4 as the rate of exchange. Figure (b) 3. The velocity of money, V, is defined as the ratio of real GNP to real money holdings. Then, in chapter 15 (4) notation V=Y/(M/P). Use equation 4 in chapter 15 (4) to derive an expression for velocity and explain how velocity varies with changes in R and Y. (Hint: the effect of output changes on V depends on the elasticity of aggregate money depend with respect to output, which economists believe to be less than one). What is the relationship between velocity and the exchange rate? From Ms=P = L(R; Y ), the velocity of cash is V = Y=(M=P). Therefore, if there is equilibrium or stability in the cash marketplace such that the money demand is equivalent the money supply, then V = Y=L(R; Y ). As R increases, L(R, Y) decreases and thus the velocity increases. As Y rises, L(R, Y) increases by a smaller extent (because the aggregate money demand elasticity with regard to the actual output is not more than one) and Y/L(R, Y), the fraction, increases. Thus, the velocity increases with either a rise in the rate of interest or a rise in revenue (Gandolfo, Giancarlo, 29). Since a rise in the rates of interest as well as a rise in revenue cause the rate of exchange to appreciate, a rise in the velocity is linked to an appreciation or increase of the rate of exchange. 4. Explain (graphically) why an increase in the money supply generates an overshoot of the exchange rate in the short run in the “Asset Approach” to the balance of payments. Explain The figure thoroughly. Figure (c) If a rise in the cash supply raises actual output in the short-run, then the drop in the rate of interest will be decreased by an outward change of the cash demand curve produced by the temporarily greater transactions demand for cash. In Figure (c), the rise in the cash supply line from (M1 /P) – (M2 /P) is coupled by a change in the schedule of money demand from L1 – L2. The rate of interest drops from its original value of R1 – R1, instead of the lower point R3, due to the rise in output/yield and the resultant outward change in the schedule of money demand. Since the rate of interest does not drop as much when yield increases, the rate of exchange devalues by less: from its original value of E1 – E2, instead of E3, in the figure. In both cases the exchange rate is seen appreciating back to E4, in the long-run. The difference in overshoot is much less when there is a temporary rise in Y. The point that the rise in Y is impermanent implies that we still shift to a very similar IP curve, as the LR prices would still move the same extent when Y goes back to normal, plus we still have similar size M rise in both instances. A permanent rise in Y would entail a smaller anticipated price rise and a smaller change in the IP curve/arc. Undershooting happens if the new short run rate of exchange is originally below its new long run level. This occurs only when the rate of interest increases if the cash supply increases, i.e., if GDP increases so much that R fails to fall, but rises. This is improbable since the reason you tend to think that a rise in M might boost output is due to the effect of reducing the rates of interest, so you generally do not think that the response of Y can be very great as to raise R. 5. Graphically show the effect of a decrease in the growth rate of the money supply on the exchange rate under the assumptions of the “Monetary Approach” to the balance of payments. A permanent change in the real cash demand function would shift the long run equilibrium nominal rate of exchange, though not the long run equilibrium rate of exchange. Because the real rate of exchange does not alter, we can utilize the equation of monetary approach, E  (M/M*)  {L(R*,Y*)/L(R,Y)}. An enduring rise in cash demand at any nominal rate of interest results in a proportional increase of the long run nominal rate of exchange(Gandolfo, Giancarlo, 33). Instinctively, the price levels for any nominal balances level has to be reduced in the long-run for the equilibrium of money market. The reverse is true for a permanent reduction in cash demand. The real rate of exchange, however, relies on productivity terms and relative prices, which are not influenced by the general changes of price level. 6. At the end of WWII, the Treaty of Versailles imposed an indemnity on Germany, a large annual payment from it to the victorious allies. In the 1920s, economist John Maynard Keynes and Bertil Ohlin had a spirited debt in the Economic Journal over the possibility that the transfer payment would impose a secondary burden on Germany by worsening its terms of trade. Use the theory developed in this chapter to discuss the mechanism through which a permanent transfer from Poland to the Czech Republic would affect the real zloty/koruna exchange rate in the long run The mechanism would operate through expense effects with an enduring shift from Poland to Czech Republic escalating the Czech currency (zloty) in actual terms against the Polish currency (koruna) if (as is suitable to presume) the Czechs used a greater portion of their revenue on Czech commodities relative to Polish commodities than the Poles did. 7. Continuing with the preceding problem, discuss how the transfer would affect the long-run nominal exchange rate between the two currencies. As mentioned in the response to the preceding question, the zloty escalates against koruna in actual terms with the shift from Poland to Czech Republic when the Czechs use a greater portion of their revenue on Czech commodities relative to the Polish commodities that the Poles did. The actual appreciation would result in a nominal increase as well. 8. Can you suggest an event that would cause a country’s nominal interest rate to raise and its currency to appreciate simultaneously, in a world with perfectly flexible prices? Supposing there is a short term drop in the actual rate of exchange in a country, that is, the rate of exchange increases today and then would fall back to its initial level in future. The anticipated drop of the real rate of exchange, by real interest uniformity, causes the real rate of interest to rise (Gandolfo, Giancarlo, 37). When there is no alteration in the anticipated rate of inflation then the nominal rate of interest increases with the increase in the real rate of exchange. This event might cause the nominal rate of exchange to rise if the impact of the present increase of the real rate of exchange dominates the impact of the anticipated drop of the real rate of exchange. Register in the United States’ Real and Financial Flows Matrix the following situation. The European Central Bank decides to increase the real money supply while European governments decide to expand their expenditures and the private sector in Europe maintains their level of expenditure. Assume that international transactions are made in Euros but Americans if they have any Euro they exchange it for dollars at the Fed. Euros are less risky. If the remainder of one’s wealth drops, the euro tends to increase, cushioning one’s losses through giving them a rather high pay-off in dollars. On the other hand, losses on euro assets tend to happen when they are less painful, i.e., when the remainder of one’s wealth is unpredictably high. Therefore, holding the euro decreases the variability of one’s total wealth. The most overseas-exchange between banks entail foreign currencies’ exchange for the United States dollars, even if the final transaction entails the sale of a single non-dollar currency for other non-dollar currencies. The key role of the U.S. dollar causes it to be a vehicle in global transactions. The basis the dollar acts as a vehicle exchange is the fact that it is the most fluid of currencies as it is simple to find individuals wishing to foreign exchanges for dollars. The dollar’s greater liquidity as contrasted to, say, the peso (Mexican currency), means that individuals are more wanting to get a hold of the dollar than the Mexican peso and, therefore, deposits of dollar may offers lower rates of interest, for any anticipated depreciation rate against the third currency. Work Cited Gandolfo, Giancarlo. International Economics: 1. Berlin u.a: Springer, 1994. Print. Read More