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Problem SET 3

International Financial Economics (Libera Università Internazionale degli Studi Sociali

Guido Carli)

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PROBLEM SET 3

Exercise 4
Use the money market and FX diagrams to answer the following questions. This question considers
the relationship between the euro and the US dollar. The exchange rate is in US dollar per euro !"#$ .
Suppose that with financial innovation in the United States real money demand in the United States
decreases.
a. Assume this change in U.S. real money demand is temporary. Using the FX/money market
diagrams, illustrate how this change affects the money and FX markets. Label your short-run
equilibrium point B and your long-run equilibrium point C.

Answer: The financial innovation triggers a shift of the money demand schedule downward from
%&' to %&( . This implies a reduction of the interest rate from) ' to ) ( . On the forex market the
reduction of the domestic interest rate ( the domestic return curve shifts down from &*' to &*( )
implies an exchange rate depreciation. When the shock washes out, the real money demand return
from %&( to %&' and teh interest rate returns to its initial level. The same happens for the spot
exchange rate. We assume that the reversal of real money demand occurs before the price level
adjusts. The long-run values are the same as the initial values because the shock is temporary.

b. Assume this change in U.S. real money demand is permanent. Using a new diagram, illustrate
how this change affects the money and FX markets. Label your short- run equilibrium point B
and your long-run equilibrium point C.

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Answer: The financial innovation triggers a shift of the money demand schedule downward from
%&' to %&( . This implies a reduction of the interest rate from) ' to ) ( . On the forex market the
reduction of the domestic interest rate ( the domestic return curve shifts down from &*' to &*( )
Since the change is permanent expected exchange rate is affected. Market expect a depreciation of
the exchange rate. Therefore, the FR schedule in the forex market also shifts upward from +*' to
+*( . In the long run, the price level will have to increase to adjust for the drop in real money demand
(assuming the central bank does not change the money supply M). This requires that the price level
increase to reduce real money supply. The drop in real money demand will have to be met one-for-
one with a drop in real money supply (generated by an increase in the price level).
In the long run nominal interest rate returns to its initial level. Real money balance is lower with
respect to its inital level. Exchange rate is higher with respect to its initial level.

c. Illustrate how each of the following variables changes over time in response to a permanent
reduction in real money demand: nominal money supply %,- , price level .,- , real money
supply %,- /.,- , U.S. interest rate ),- , and the exchange rate !"#$ .

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Exercise 5
This question considers how the FX market will respond to changes in monetary policy. For these
questions, define the exchange rate as South Korean won per Japanese yen, !/01#23 343
Use the FX and money market diagrams to answer the following questions. On all graphs, label the
initial equilibrium point A.
a. Suppose the Bank of Korea permanently increases its money supply. Illustrate the short-run
(label the equilibrium point B) and long-run effects (label the equilibrium point C) of this policy.

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SHORT RUN EQUILIBRIUM

In the short run, prices are fixed but the supply of South Korean won increases and real money
' (
supply shifts out. To restore equilibrium interest rate falls from )567 to )567 . In the FX market,
the home interest rate falls, so the domestic return curve shifts down from &*' to &*( . In
addition, the permanent change in the home money supply implies a permanent long run
8
depreciation of the won. Hence there is a permanent rise in !/01#23 which causes a permanent
increase in the foreign return and, all else equal, FR shifts up from +*' to +*( . The simultaneous
fall in DR and rise in FR cause the home currency to depreciate steeply (overshooting) from
' (
!/01#23 to !/01#23 leading to a new equilibrium at point B.
LONG RUN EQUILIBRIUM
In the long run, prices are flexible. So the home price level and the exchange rate rise both in
(
proportion with the money supply. Prices rise to .567 and both real money supply and domestic
interest rate return to their respective original levels. The money market gradually shifts back
to equilibrium at point C. In the FX market, the domestic return DR, which equals the home
interest rate, gradually shifts back to its original level from &*( to &*' 9 &*: . . The foreign
return curve FR does not move at all. The FX market equilibrium gradually shifts to point C. The
( :
exchange rate falls from !/01#23 to !/01#23 .

b. Now, suppose the Bank of Korea announces its plans to permanently increase its money supply
but doesn’t actually implement this policy. How will this affect the FX market in the short run if
investors believe the Bank of Korea’s announcement?

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Answer: In this case, how it is possible to see in the first panel, interest rates on won-
denominated deposits don’t change because the Bank of Korea doesn’t raise the money supply.
However, because investors believe the announcement of the Korean Central Bank to increase
the money supply, they expect the won will depreciate relative to the yen. Hence there is a
8
permanent increase in !/01#23 which causes a permanent increase in the foreign return and, all
else equal, FR shifts up from +*' to +*( .This change causes an increase in the current exchange
rate in the short run. Notice the resulting change in the exchange rate is relatively small if
compared with the dramatic increase we see in [a].

c. Finally, suppose the Bank of Korea permanently increases its money supply, but this change is
not anticipated. When the Bank of Korea implements this policy, how will this affect the FX
market in the short run?

Answer: In this case, the central bank doesn’t communicate its decision to permanently increase
money supply. Thus, in the short run, what we observe is an increase of the money supply and
a decrease of the interest rate to restore the equilibrium in the money market. In the forex
market the decrease of the interest rate in the money market push down the domestic return
curve that shifts down from &*' to &*( . Anyway, the expected exchange rate is unchanged

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because the investors didn’t expect the increase in the money supply, since the central bank has
not announced this decision. As such, the FR is unchanged. The equilibrium in the forex market
is reached at point B with an exchange rate which is higher with respect to the original level.
Moreover, the resulting change in the exchange rate is even smaller if compared to point a) and
b).

d. Using your previous answers, evaluate the following statements:

• If a country wants to increase the value of its currency, it can do so (temporarily) without raising
domestic interest rates.
True. In (b) we see a depreciation of the South Korean won relative to the Japanese yen without
an interest rate change. The opposite of such a policy could achieve an appreciation of the
exchange rate without raising domestic interest rate. The Central Bank indeed can announce a
permanent decrease of the money supply without effectively decreasing the money supply. As
a result the domestic interest rate remains unchanged but since investors believe the
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announcement they expect a permanent decrease in !;<#" , which causes a permanent decrease
in the foreign return, all else equal; FR shifts down from +*' to +*( causing an appreciation of
the current exchange rate.

• The central bank can increase both the domestic price level and the value of its currency in the
long run.
False: as shown in (a). An increase in price level implies an exchange rate depreciation by PPP.

. 9 !.=
Indeed, if there is an increase in domestic price level while foreign price level remains
unchanged, exchange rate should adjust in order to restore PPP implying as a consequence that
it has to increase, that is a depreciation.

• The most effective way to decrease the value of a currency is through surprising investors.
False: as shown in (b) and (c) compared with (a). The most dramatic depreciation of the won
occurs when the increase in money supply is coupled with investors anticipating the
depreciation of the won. In general, a policy must be credible for it to have an effect in the long
run. The effects of unanticipated policies as in (b) and (c) will fade quickly as foreign investors
update their expectations after the policy change.

Exercise 6

In the late 1990s, several East Asian countries used limited flexibility or currency pegs in managing
their exchange rates relative to the U.S. dollar. This question considers how different countries
responded to the East Asian currency crisis (1997–1998). For the following questions, treat the East
Asian country as the home country and the United States as the foreign country. Also, for the
diagrams, you may assume these countries maintained a currency peg (fixed rate) relative to the U.S.
dollar. Also, for the following questions, you need consider only the short-run effects.

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a. In July 1997, investors expected that the Thai baht would depreciate. That is, they expected
that Thailand’s central bank would be unable to maintain the currency peg with the U.S.
dollar. Illustrate how this change in investors’ expectations affects the Thai money market and
the FX market, with the exchange rate defined as baht (B) per U.S. dollar, denoted !>#"
Assume the Thai central bank wants to maintain capital mobility and preserve the level of its
interest rate, and abandons the currency peg in favor of a floating exchange rate regime.

Answer: If investors expect that the Thai baht will depreciate then expected exchange rate will
increase. This implies an upward shift of the FR curve from +*' to +*( .

b. Indonesia faced the same constraints as Thailand—investors feared Indonesia would be forced
to abandon its currency peg. Illustrate how this change in investors’ expectations affects the
Indonesian money market and FX market, with the exchange rate defined as rupiahs (Rp) per
U.S. dollar, denoted !;?#" . Assume that the Indonesian central bank wants to maintain capital
mobility and the currency peg.

Answer: As before if investor expect that the rupiah then expected exchange rate will increase. This
implies an upward shift of the FR curve from +*' to +*( . If Indonesia wants to maintain the currency
peg against the dollar and maintain international capital mobility, it will have to give up monetary
policy autonomy. In this case, Indonesia has to decrease its money supply. Domestic interest rate will

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increase to keep investors from dumping their rupiah-denominated deposits for U.S. dollars and
moving their investments out of Indonesia (this would then cause a depreciation in the rupiah).

c. Malaysia had a similar experience, except that it used capital controls to maintain its currency
peg and preserve the level of its interest rate. Illustrate how this change in investors’
expectations affects the Malaysian money market and FX market, with the exchange rate
defined as ringgit (RM) per U.S. dollar, denoted !;@#" . You need show only the short-run
effects of this change in investors’ expectations.

Answer: As before if investor expect that the rupiah then expected exchange rate will increase. This
implies an upward shift of the FR curve from +*' to +*( . In the absence of capital controls, the
Malaysian interest rate would have to rise to preserve the currency peg. However, by preventing
investors from taking advantage of arbitrage, Malaysia creates a disequilibrium. The investors require
( '
);@ to keep their deposits in Malaysia, but they receive only );@ . Because of the capital controls
imposed by Malaysia, investors cannot withdraw their ringgit-denominated deposits (selling ringgit in
exchange for dollars in the FX market). In effect, the foreign market equilibrium diagram shown below
does not work/exist. This allows Malaysia to maintain monetary policy autonomy and a fixed
exchange rate at the same time.

d. Compare and contrast the three approaches just outlined. As a policy maker, which would you
favor? Explain.

Answer: There is no “correct” answer to this question. The cases above highlight the trilemma
because each country can choose a different option depending on its domestic or international
priorities. Each country needs to compare the benefits of having any two of (a) fixed exchange rates,
(b) monetary autonomy, and (c) international capital mobility against the cost of not having the third
one.

Work It Out

2. Use the money market and FX diagrams to answer the following questions about the relationship
between the British pound (£) and the U.S. dollar ($). The exchange rate is in U.S. dollars per
British pound E$/£ . We want to consider how a change in the U.S. money supply affects interest

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rates and exchange rates. On all graphs, label the initial equilibrium point A.

a. Illustrate how a temporary increase in the U.S. money supply affects the money and FX
markets. Label your short-run equilibrium point B and your long-run equilibrium point C.
Answer: See the following diagram.

b. Using your diagram from (a), state how each of the following variables changes in the short run
(increase/decrease/no change): U.S. interest rate, British interest rate, the exchange rate E$/£ ,
the expected exchange rate E e $/£ , and the U.S. price level PUS.
Answer: The U.S. interest rate decreases, the British interest rate does not change, E$/£
increases, E e $/£ does not change, and the U.S. price level does not change.

c. Using your diagram from (a), state how each of the following variables changes in the long run
(increase/decrease/no change relative to their initial values at point A): U.S. interest rate, British
interest rate, the exchange rate E$/£ , the expected exchange rate E e $/£ , and U.S. price level PUS.
Answer: All of the variables return to their initial values in the long run. This is because the
shock is temporary, implying the central bank will increase the money supply from M 2 to M 1
in the long run.

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