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Current Account
-Records transactions arising from trade in goods and services
-consists of:
- trade account : Payments and receipts arising from import and export of goods and services
- Capital-service account (investment income) : Payment and receipts from income on assets (e.g.
interest and dividends)
Capital Account
-Records international transactions in assets (bonds, shares, real estate)
-ie. net change in national owner ship of assets
-consists of:
- Foreign direct investment
- Portfolio investment
- Other investment
- Reserve account
Current Account: CA = NX
GDP = C + I + G + NX = C + S + T
CA = S+ (T-G) - I
VARIABLES THAT AFFECT S/D in FX MARKET
1) FX rate - increase value of dollar ( increase imports, decrease exports) -> BOP deficit
2) Income - increase in income -> Buy more, increase imports (M) -> BOP deficit but*
-> increase foreign investment -> BOP surplus
3) Interest rates - increase real interest rate -> increase in foreign investment -> BOP surplus
4) Increase in price level - decrease exports -> BOP deficit
5) Relative price change - If stuff we export increases in price relative to our imports -> BOP surplus
6) Expectations - If foreigners expect increase in the value of the dollar -> BOP surplus
FISCAL POLICY (reaction
^ G-> ^ AD for g&s -> K-multiplier -> ^ income -> ^ imports -> BOP deficit
-> ^ money demand -> ^ interest rates -> ^ capital inflows
....-> BOP surplus
Net effect: -> BOP surplus
Flexible Fx
-> ^ FX -> ^ M v X -> v AD for g&s -> weakens the fiscal policy
In a Fixed FX:

-> ^ M/S -> ^AD for g&s -> fiscal policy is stronger

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Reaction to Monetary policy:
^ M/S -> Fed buys bonds -> ^ price of bonds -> v Int. rate -> ^ AD for g&s -> k-mult -> ^ income ->
^ Imports -> BOP deficit
from v Int. rate -> v capital inflows -> BOP deficit
Net effect: -> BOP deficit
Flexible FX
-> v FX -> v M ^X -> ^ AD for g&s -> Monetary policy is stronger
In a Fixed FX:
-> v M/S -> v AD for g&s -> weakens the monetary policy but v M/S continues until original increase is offset

Sterilization policy
(under fixed fx)
BOP deficit -> deplete foreign reserves -> Major drop in FX
BOP surplus -> accumulate foreign reserves -> ??
Non interest rate, inflation parity -> based case and new case, ignore that question, quiz is moved the week
after

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CHE375S Engineering Finance and Economics

Macroeconomic Problem Set
1) The following questions are with regard to monetary policy.
a) What is the main mandate of Canadas central bank?
To keep inflation at a specified rate (in the range of 1% to 3%).

b) What mechanism does the central bank use to control monetary policy?
It buys and sells bonds (to target a specific interest rate)

c) Briefly sketch the money multiplier process.

Fed buys bonds from bond holder and the money goes into bond holders account, this
instantly increases the money supply, furthermore, because the bank only has to hold a
portion on this money in reserves (usually 10%), the bank can lend the excess to
someone else, further increasing the money supply. If this loan in then deposited in
another bank account which can again be leveraged. The process continues.
(Ultimately, the money multiplier = 1/(% reserve requirement)).
d) Under open market conditions, the actions by the central to increase money supply can
lead to an increase or decrease in the nominal interest rate. Discuss how either
condition could transpire.

If inflation is not expected, then get scenario on the left whereas if inflation is
expected then an increase in money supply only leads to perceived increase in money
growth which leads to increased inflation expectations and an increase in the nominal
rate (in this case the real rate will remain the same).

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2) The following questions are with regard to fiscal policy.

a) What mechanism does government use to control fiscal policy?
Primary mechanism is through government spending.

b) Briefly sketch the multiplier process.

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3) Assume fiscal spending is increased.

a) As discussed in class, this will lead to the Keynesian multiplier process leading to an
increase in income and money demand. Both the current and capital accounts will be
impacted. Discuss how they are impacted before accounting for foreign exchange rate
changes. What is the overall impact on the balance of payments (surplus or deficit).
After K-mult process, we will see an increase in income, therefore an increase in
imports and therefore a current account deficit.
At the same time, we will see an increase in money demand due to increase in income,
leading to an increase in interest rates, and therefore an increase in capital inflows and
a capital account surplus.
Net capital inflow surplus is stronger, leading to a BoP surplus.

b) Continuing with the scenario above, describe what happens under a flexible FX policy
and the overall effectiveness of the fiscal policy?
Under a flexible FX, a BoP surplus will lead to an appreciation of the domestic
currency, leading to an increase in imports and decrease in exports, with a resulting
decrease in aggregate demand for g&s, and ultimately a weaker fiscal policy.

c) Continuing with the scenario above (a), describe what happens under a fixed FX
policy and the overall effectiveness of the fiscal policy?
Under a fixed FX, there will be pressure for the domestic currency to appreciate and
the central bank will counter this by buying foreign bonds, thus increasing the supply
of domestic money supply, leading to an increase in the aggregate demand for g&s,
further strengthening the fiscal policy.

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4) Assume monetary policy is used to increase money supply.

a) As discussed in class, when the central bank increases the money supply, both the
current and capital accounts are impacted. Discuss the impacts to both the current and
capital accounts before accounting for foreign exchange rate changes. What is the
overall impact on the balance of payments?
To increase the money supply, the central bank buys bonds. This results in an increase
in bond prices and therefore a decrease in the interest rate.
Domestically, the reduced interest rate will lead to higher spending i.e. increase in
demand for g&s, the Keynesian multiplier process will occur resulting in an increase
in income and increased imports, leading to a current account deficit.
A lower interest rate will lead to less foreign capital inflows, leading to a capital
account deficit.
Net, we see a BoP deficit.

b) Continuing with the scenario above (a), describe what happens under a flexible FX
policy and the overall effectiveness of the monetary policy?
Under a flexible FX, a BoP deficit will cause a depreciation of the domestic currency
leading to a decrease in imports (more expensive) and an increase in exports (less
expensive) leading to an increase in demand for g&s with a result of a strengthened
monetary policy.

c) Continuing with the scenario above (a), describe what happens under a fixed FX
policy and the overall effectiveness of the monetary policy?
Under a fixed FX, a BoP deficit will cause a depreciation of the domestic currency
which will be counteracted by buying its currency on the FX market, leading to a
decrease in the money supply, leading to a decrease in demand for g&s, weakening the
money supply but in the end, the initial increase in money supply from (a) is exactly
counteracted by trying to keep the FX rate fixed leading to a completely ineffective
monetary policy.

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5) Using the Pillips Curve, discuss how an increase in money supply can lead to inflation.

6) Utilizing the Phillips Curve, describe why fighting inflation may lead to a prolonged
period of high unemployment. What (arguably controversial) policy can the government
invoke to shorten the prolonged period of unemployment?

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Macro PS Solutions
January-27-14
5:24 PM

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Explanation: Person A goes by the average "historical", so the year before, the inflation rate was
4% and the current year it was 4.5%. Once the effects of the money growth even out, we expect
the real growth to be the same as the base case - i.e. 2%, so a 7.5% rate of money growth would
lead to an expected inflation of 5.5%.

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14) If the money supply is growing at 9 percent, the real interest rate is 3 percent, the real rate
of growth of GDP is 2 percent, and the money velocity is increasing by 1 percent per year,
what should the nominal interest be? (3 marks)

15) Suppose that firm A signs a contract to buy some hardware from a Japanese company for
600 million yen, delivery and payment to take place one year hence. The current exchange
rate is 200 yen per dollar, the U.S. interest rate is 6 percent, the Japanese interest rate is 4
percent, and there is no currency risk premium. Which of the following strategies would you
recommend that the firm adopt? (4 marks)
a) Firm A trades dollar for yen today and invest in Japanese bonds for a year; or
b) Firm A invests in U.S. bonds for a year and enters a futures contract, agreeing to buy
600 million yen in one year at an exchange rate of 195 yen per dollar.

16) On Tuesday January 28th 2014, central bank of Turkey announced its decision to increase
its short term interest rate from 4.5% to 10%. How would you expect this news to affect the
Turkish Lira (TRY)? Why? (2 marks)
It should increase the value of TRY. Rising interest rates increase the demand for
investments in Turkey and thus the demand for TRY.

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Given the following chart of USD/TRY exchange rate, using macroeconomic concepts,
justify whether or not the FX market reacted as you predicted in light of the following
news: (3 marks)
On Wednesday January 29th 2014, the U.S. Federal Reserve announced its decision to
continue stimulus package tapering and cut monthly asset purchases by $10 billion
USD.

Tapering the stimulus package decreases the amount of capital available for investments.
This resulted in sell-off of investments in developing countries such as Turkey.
Capital is flowing out of countries such as Turkey.
This reduces the value of TRY.
The hike in interest rate is only offsetting the lowering effects of capital outflow.
The result is a steady exchange rate rather than the expected rise of TRY.

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