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SUGGESTED SOLUTIONS

King’s College
Secondary 7A (2008-2009)
Economics
Assignment

Source: Supplementary Exercises on Balance of Payments Accounting and Adjustments and Exchange Rates
Date of submission: 05/01/2009 (Mon)

Attempt the following questions on single-lined paper.

Exercise 1
1. Assume that the central bank is obliged to buy up any excess supply of foreign currencies with its
domestic currency at that fixed rate. It is also obliged to sell from its official foreign exchange reserves to
meet any excess demand for foreign currencies at that fixed rate. Besides, the country is assumed to have
sufficiently large foreign exchange reserves to maintain the fixed rate.
Under a BOP surplus, the government will buy up the excess supply of foreign currencies with domestic
currency. Thus, the official reserve will increase.
Under a BOP deficit, the government will sell foreign currencies from its official reserves to meet the
excess demand in the market. Thus, the official reserve will fall.
2. (a) A rising trade deficit means that imports rise faster than exports. The supply of the US dollar rises
faster than the demand for it.

As shown in the above diagram, the exchange rate of the US dollar will fall from E1 to E2 when the
rise in the supply of the US dollar is greater than the increase in the demand for it. Thus, the US
dollar will depreciate in the world market, ceteris paribus.
(b) A rise in exports from Japan to the USA will increase the demand for the US dollar. Thus, the US
dollar will appreciate against the Japanese yen, ceteris paribus.
(c) The expenditure of the US tourist in the U.K. belongs to invisible imports of the U.S.A. The supply
of the US dollar rises and the US dollar will depreciate against the pound, ceteris paribus.
3. Under a flexible exchange rate system, a BOP deficit (i.e. an excess demand for foreign currency) will
raise the exchange rate, while a BOP surplus (i.e. an excess supply of foreign currency) will lower the
exchange rate.
Suppose there is a payments deficit in a country. Subsequently, the flexible exchange rate rises and the
country’s currency (domestic currency) depreciates. Hence, the price of its imports increases, the amount
of imports fall and the quantity demanded for foreign currency decreases (Qd = Pf × QM ; as Pf remains
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unchanged and QM drops, Qd drops).
On the other hand, the depreciation of domestic currency lowers the price of the country’s exports in
terms of foreign currency. Hence, the amount of exports increases. If the price elasticity of foreign
demand for the country’s exports is elastic, the quantity supplied of foreign currency increases (Qs = Pf ×
QX ; as Pf drops; QX rises and the demand for domestic exports is elastic, Qs rises).
Hence, if the Marshall-Lerner condition holds, under a BOP deficit, the domestic currency will depreciate
until the quantity demanded for foreign currency equals the quantity supplied of it. There will be no
payments disequilibrium.
The opposite case also applies.

Exercise 2
1. Depreciation means that the external value of a currency falls in the foreign exchange market.
Devaluation means the value of a currency relative to one or more other currencies is lowered by the
central bank or the monetary authority. Depreciation is caused by market forces while devaluation is
deliberately announced by the central bank or the monetary authority of a country.
2. Depreciation occurs when the external value of a currency falls in the foreign exchange market. The
effect which depreciation will have upon a country’s trade deficit depends upon the elasticity of demand
abroad for the country’s exports, and the domestic elasticity for imports. According to the
Marshall-Lerner conditions, these elasticities have to be greater than unity in order for depreciation to
improve a country’s trade deficit. In addition, it should be noted that the second law of demand dictates
time lag in any such improvement (the so-called “J-curved” effect).
3. If the demand for imports is very inelastic, the fall in the quantity of goods imported is proportionately
less than the rise in import prices (in terms of domestic currency), the import value (in terms of domestic
currency) may increase greatly after depreciation. If the demand for her imports is very inelastic, the
increase in quantity of goods exported is proportionately less than the fall in export prices (in terms of the
foreign currency; export prices remain unchanged in terms of the domestic currency), the export value
may not increase much (in terms of the domestic currency) after depreciation.
According to the Marshall-Lerner conditions, these elasticities have to be greater than unity in order for
depreciation to improve a country’s trade deficit.
4. For a surplus country under a fixed exchange rate system:
- Foreign currency   money supply   price level   exports 
- Foreign currency   money supply   demand for imports 
- Foreign currency   money supply   interest rate   net capital inflow 
5. (a) When prices of the country’s imports increase, by the law of demand, the amount of its imports QM
will fall. As Pf  and QM , the change in quantity demanded for foreign currency (Qd = Pf × QM)
depends on the price elasticity of the country’s demand for imports.
If the country’s demand for imports is elastic, Qd falls. Hence, the equilibrium exchange rate drops,
i.e. the country’s currency appreciates.
If the country’s demand for imports is unitarily elastic, Qd remains unchanged and so as the exchange
value of the country’s currency.
If the country’s demand for imports is inelastic, Qd rises. Hence, the equilibrium exchange rate rises,
i.e. the country’s currency depreciates.
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(b) When the country implements an expansionary fiscal policy, the IS curve shifts rightward. Both the
interest rate and the national income rise.
The rise in the interest rate encourages capital inflow and discourages capital outflow. Hence, the
supply of foreign currency increases while its demand decreases.
On the other hand, the rise in the national income increases the expenditure on imports. Hence, the
demand for foreign currency increases.
The overall change in the equilibrium exchange rate of the country’s currency is uncertain since it is
indeterminate whether the demand for foreign currency decreases or increases.

Exercise 3
1.

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2. - “In balance” means that the sum of debits is equal to the sum of credits.
- “In equilibrium’ means that the market quantity demanded for foreign exchange (desired debits) is
equal to the market quantity supplied of foreign exchange (desired credits).
Under the flexible exchange rate system,
- the accounting BOP is always in balance, while the market BOP is always in equilibrium. So the
latter part of the statement is incorrect.
- The accounting BOP is always in balance because the BOP account records actual transactions by the
double-entry accounting system. In each actual transaction, the realised Qd (actual debits) must
always be equal to the realised Qs (actual credits); otherwise the transaction cannot have taken place.
- The market BOP is always in equilibrium because the market exchange rate is the equilibrium
exchange rate. Hence, the market Qd is always equal to the market Qs.
Under the fixed exchange rate system,
- the accounting BOP is always in balance but the market BOP may not be in equilibrium. So, the
statement holds under the fixed exchange rate system.
- The accounting BOP is always in balance because the BOP account records actual transactions by the
double-entry accounting system.
- The market BOP may not be in equilibrium because the fixed exchange rate may not be equal to the
equilibrium exchange rate. Hence, the market Qd may not be equal to the market Qs.
3. 1) BOP equilibrium can be restored by depreciation only if the Marshall-Lerner condition holds.
2) The supply curve is upward sloping only if the foreign demand for a country’s exports is elastic. If it
is unitarily elastic, the supply curve is vertical. If it is inelastic, the supply curve is downward sloping.
3) Under a fixed exchange rate system, there exists an automatic adjustment mechanism which can
eliminate the payments imbalance automatically.

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