Case study Mina Country

Mina Country is a group of fictitious islands situated in the mid-Atlantic. The

economic minister calls together his two economic staff to discuss a report prepared
by the IMF. The salient points are as follows:
Imports M$390 million, Exports M$300 million on the financial account the main
items are outward investment M$120 million, inward investment M$50 million, IMF
loan M$120 million, reduction in reserves of foreign exchange at Mina Central bank
M$60 million.
The minister observes: All this money being invested abroad is just a drain on our
economy, but if we encourage our economy that will reduce our imports and
encourage investment into our country and reduce the investment going out of the
country. The first thing we can do is to devalue the currency by a bit of quantitative
easing, printing money to fund government projects
An advisor at the meeting responds: Well, yes but elsewhere in the report it talks
about the elasticity of exports and imports a rough calculation shows that it is 0.25
for imports and 0.3 for exports and that is not enough
Minister: What are these elasticities?
Advisor: Theyre the percentage movement of quantities divided by the change in
price. So if we devalue with the result that the price of imports goes up the
implication is that the decrease in imports and increase in exports will not offset the
price increase.
Minister: What are our imports?
Advisor: Well mainly TVs, cars, computers and oil. Exports are mainly copper from
Copper Island.
Minister: What if we increase interest rates, that might reduce outward investment?
Advisor: Well, Im worried about speculators, if they start selling our currency on
the forward market we could be forced devalue. Inflation would make that position
worse. Though I hear that straddles are popular with our currency on the markets at
present, so perhaps we should keep them guessing.
You are required to:
a)
Construct a balance of payments from the information given show
clearly how it balances.
b)
Comment on the debate over quantitative easing, devaluation and
elasticities
c)
Comment on the advisors concerns about speculators.

Answer guidance notes

a) The balance of payments is as follows:
Balance of Payments
Current account M$ million
Exports
300
Imports
390
Balance on current account
(90)
Financial account
Outward investment
(120)
Inward investment
50
IMF loan
100
Reduction in reserves of foreign exchange*
60
90
Balance on the financial account
Errors
0
* Note that this is a positive figure as it amounts
to a demand for home currency by foreign
currency and is therefore the same as an export
b) Three economic/financial linked issues:
i. Whether quantitative easing will help economic development is
an open issue but obviously there is a danger of inflation and
hence the prospect of a devaluation. This would encourage
outward investment rather than discourage it.
ii. Devaluation effect on its own just makes the import bill more
expensive. Demand for copper is clearly inelastic so making it
cheaper to buy the currency will not increase demand.
Generally devaluation does not seem to be a viable option
though there does seem scope to reduce imports apart from oil
perhaps by non devaluation means
c)
If the value of the home currency falls on the forward market that will
encourage selling on the spot market investing abroad or in the other currency
and then buying back on the forward market. Home interest rates will
experience upward pressure to make investment at home rather than abroad
more attractive uncovered interest rate parity or the International Fisher
Effect being the theory this issue is developed more in part II. The straddle
earns a return if there are large positive or negative movements in the currency
therefore volatility seems to be expected by the market.