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# ECO5POE S1 2013

Chapter 23: Exchange Rate and the Balance of Payments
Use the following data to work Problems 4 to 6. In June 2010, the exchange rate was 75 yen per Australian dollar. By June 2011, the exchange rate had changed to 86 yen per Australian dollar. Question 4 Explain the exports effect of this change in the exchange rate. The rise in the Australian exchange rate raises the price in Japan of Australia-produced goods. The lower price in Japan for these goods, the larger the quantity demanded. The volume of Australian exports to Japan decreases and to finance this trade the quantity of Australian dollars demanded in the foreign exchange market decreases. Question 5 Explain the imports effect of this change in the exchange rate. The rise in the Australian exchange rate lowers the price in Australia of Japanese-produced goods. The lower price in Australia for these goods, the larger the quantity demanded. The volume of Australian imports from Japan increases and consequently the quantity of Australian dollar supplied in the foreign exchange market increases. Question 6 Explain the expected profit effect of this change in the exchange rate. For a given future expected exchange rate, the rise in the Australian exchange rate reduces the expected profit from buying Australian dollars today. The decrease in the expected profit reduces the quantity of Australian dollars demanded in the foreign exchange market.

ECO5POE S1 2013

Question 13 The price level in the Eurozone (the foreign country) is 112.4, the price level in the United States (the home country) is 109.1, and the nominal exchange rate is 80 euro cents per U.S. dollar. What is the real exchange rate expressed as Eurozone real GDP per unit of U.S. real GDP? The real exchange rate equals (E P)/P* in which E is the nominal exchange rate, P is the U.S. price level, and P* is the Eurozone price level. RER = (0.8 109.1)/112.4 = 0.78 Eurozone real GDP per unit of U.S. real GDP Question 16 The Australian price level (the home country) is 106.3, the Japanese price level (the foreign country) is 95.4, and the real exchange rate is 103.6 Japanese real GDP per unit of Australian real GDP. What is the nominal exchange rate? The real exchange rate equals (E P)/P* in which E is the nominal exchange rate, P is the Australian price level, and P* is the Japanese price level. Rearranging this formula gives E = (RER P*)/P. Using the rearranged formula, the nominal exchange rate equals (103.6 95.4)/106.3 = 93.0 yen per Australian dollar.

ECO5POE S1 2013

Question 18 The table gives some information about the U.S. international transactions in a year.

Billions of Item Imports of goods and services Foreign investment in the United States Exports of goods and services U.S. investment abroad Net interest income Net transfers Statistical discrepancy 1,853 300 121 123 66 U.S. dollars 2,561 955

a. Calculate the current account balance. The current account balance equals exports of goods and services (\$1,853 billion) minus imports of goods and services (\$2,561 billion) plus net interest income (\$121 billion) plus net transfers (\$123 billion). So the current account balance is \$710 billion. b. Calculate the capital and financial account balance. The capital and financial account balance equals foreign investment in the United States (\$955 billion) minus U.S. investment abroad (\$300 billion) plus the statistical discrepancy (\$66 billion). So the capital and financial account balance is \$721 billion. c. Did U.S. official reserves increase or decrease? The official settlements account balance equals current account balance (\$710 billion) capital and financial account balance (\$721 billion). So the official settlements account balance is \$11 billion. Because the official settlements account is negative, U.S. official reserves are increasing. d. Was the United States a net borrower or a net lender in this year? Explain 3

ECO5POE S1 2013

your answer. The United States was a net borrower because foreign investment in the United States exceeded U.S. investment abroad. Question 39 After you have studied Reading Between the Lines on pp. 538-39, answer the following questions. a. Why has the Australian dollar appreciated against the U.S. dollar and other major currencies in recent years? The main reason is because of strong economic growth in developing countries, in particular China. Rapid economic growth has increased their demand for Australian exports, especially the mineral commodities in which Australia has a vast reserve. Since Australia is a commodity exporter, an increase in the demand for commodity export raises the demand for Australian dollar. As a result the Australian dollar appreciates or becomes more expensive. b. Why is a sharp rise in the Australian dollar a problem for the tourist industry, wine-makers and general manufacturing? When the Australian dollar appreciates, the export prices of Australian goods and services (including those produced by the industries in the question) become more expensive. As a result foreign buyers reduce their demand for Australian exports. c. Is the strong Australian dollar a cause or a symptom of the problems faced by the tourist industry, wine-makers and general manufacturing? It is a symptom in the sense that Australian dollar appreciates because of increase in export demand for commodities coming from Asia (and mainly China) in pushing up the demand for Australian dollar for the export payment. Non-commodity industries in Australia are, e.g., tourist, wine-making, and manufacturing industries, bearing the effect of higher export prices of their goods and services because of the higher Australian dollar. d. What would you expect the effect of a strong Australian dollar to be on the economies of China and the United States? 4

ECO5POE S1 2013

In terms of bilateral exchange rates, a stronger Australian dollar means a weaker Chinese yuan and a weaker U.S. dollar. This would lower the export prices of their goods and services, however, it becomes more expensive for them to import goods from foreign countries. e. What actions could the Reserve Bank take to stop the Australian dollar from appreciating and what side-effects would they have? In a flexible exchange rate system, which is the system that Australia currently operates (since December 1983), the RBA can lower the Australian interest rate. This has the effect of decreasing the demand for Australian dollar (shift in demand) and increasing the supply of Australian dollar (shift in supply) and as a result the exchange rate falls. In principle, side-effects can arise if the interest rate adjustment for changing the exchange rate is not consistent with the setting required for the current macroeconomic conditions. For example, if inflation is high in Australia the RBA would like to keep the interest rate high. So lowering the interest rate to decrease the value of the exchange rate may push up inflation further higher. f. Do you think the Reserve Bank should take the actions you describe in part (e)? Why? Students should freely express their opinions about this possible central bank measure. The potential side-effect discussed in (e) is in fact not an issue for the Australian economy at the time of writing (April 2013). The RBA has lowered the interest rate (or the cash rate to be precise) for a total of 175 basis points (or 1.75% ) since late 2011, mainly because of the global recession and a slowdown in the Australian economy (mostly in the non-commodity industries but more recently a cooling in the commodity industry as the commodity prices fall from their historical peaks). This has had some effect in lowering Australian dollar value. However, the RBA has stated that it does monitor the movements of the Australian dollar and so far has not intervened through interest rate adjustment.