money and banking
1a. Assuming there are differences in interest rates between countries and prices are relatively sticky, exchange rates fluctuate because of the BOP inequality. Interest rate parity assumes that the asset markets have a greater effect on exchange rates than the goods market.
Interest rates change due to macroeconomic shocks, such as fiscal policy and/or monetary policy, monetary policy being a tool for economies with floating exchange rates only. For economies with a fixed exchange rate, monetary policy is only used to defend the fixed exchange rate or counteract changes of the interest rate due to fiscal policy (goods market shock). One of the disadvantages of an economy with a fixed exchange rate is that monetary policy cannot be used to stimulate the economy, whereas an economy with a floating exchange rate like the U.S. can use monetary policy to stimulate economic growth.
money and banking
When there is a macroeconomic shock, interest rates in the domestic economy change relative to foreign interest rates. For example, if there is an expansionary monetary policy, it will decrease the interest rate in the domestic economy and domestic investors will have an incentive to invest in the foreign market, which will cause a capital account deficit and cause the exchange rate to fall. The monetary expansion also increases domestic income, which will cause an increase in imports and a current account deficit as well. Because the domestic money supply increases in the foreign market due to an increase in imports and net capital outflows, it causes the domestic currency to depreciate in value due to the simple relationship between supply and demand. The fall in the exchange rate will make domestic capital more attractive for foreign investors and the domestic economy will begin to attract more foreign investment as the exchange rate falls until the BOP equals zero, resulting in interest rate parity.
money and banking
1b. The BOP factors that influence the supply for domestic currency in the foreign economies are an increase in imports and an increase in capital outflows in pursuit of higher rates of return. These factors cause a BOP deficit in the domestic economy and are mostly influenced by expansionary monetary policy that causes a reduction in the domestic interest rate.
1c. The BOP factors that influence the demand for domestic currency in the foreign economies are an increase in exports and an increase in capital inflows where foreign investors are in pursuit of higher rates of return in the domestic economy. Also, if the domestic economy is increasing exports, it means that domestic goods are relatively cheaper than foreign goods. So, foreigners will demand more domestic currency as they import more of domestic exports. If the domestic rate of returns is higher relative to foreign economies, there will be an increase in demand for the domestic currency as foreign investors will need domestic currency to purchase domestic capital.
2a. Under flexible exchange rates and relatively responsive capital flows, we can determine that any change in the capital financial account is going to be greater in magnitude than a change in the capital account and the EE curve will be relatively flat compared to the LM curve. A fiscal expansion shifts the IS curve up and to the right, causing interest rates and output (y) to increase. The increase in interest rates will cause an inflow of KA and a demand for domestic currency greater in magnitude than the CA deficit caused by rising incomes which increases imports relative to exports. This causes a BOP surplus, which causes the exchange rate to appreciate and cause the EE curve to shift up and to the left. The exchange rate will appreciate to the point where the BOP comes back to equilibrium. As the exchange rate appreciates, the rate of return on domestic capital gets smaller due to diminishing marginal returns, which will decrease the rate of capital inflows to the domestic economy and will cause the exchange rate to depreciate until the BOP is back to equilibrium.
2b. A monetary expansion will cause a down and rightward shift of the LM curve, which will cause a decrease in interest rates and a reverse effect in interest rates caused by fiscal expansion. The increase in the money supply will cause interest rates to go down and the exchange rate to depreciate as a result. Therefore, if monetary expansion is used to pay for the fiscal expansion, there is no need for the exchange rate to adjust and the market will come back to equilibrium through the two policies counteracting each other.
3a. The curve that best represents money demand is the IS curve as it represents the goods market equilibrium. The demand for goods and services directly influences the demand for money because in order to purchase goods and services one needs money. The equilibrium condition of Y = C+I+ (G-T) + (EX-IM) is that leakages equal injections, S+T+IM = I+G+EX.
3b. The interest rate acts as the opportunity cost of money because it represents the income from holding money. If the interest rate is rising, so is the opportunity cost and it will give an incentive for investors and consumers to deposit more money in banks at a low risk or invest in other very low risk investments. Since interest rates are high, the cost of acquiring capital assets and goods and services will be high as well, which will reduce the expected profits to be made off the initial investment in capital. Therefore, if interest rates fall the price of goods and services fall and the cost of acquiring capital at a low interest rate falls as well. This allows for investment in capital to have higher profits and higher expected rates of returns. When interest rates fall, so does the opportunity cost of holding money. So households have an incentive to invest in financial assets that are more risky (but have the potential for higher rates of return) than to keep the money in a savings account with a low interest rate. The lower interest rate also causes an increase in consumption because goods and services are relatively cheaper to finance due to the lower interest rate.
4b. If the foreign money supply increases relative to the U.S. domestic money supply, it will cause the spot exchange rate to rise because an increase in the foreign money supply consequently depreciates the foreign currency relative to the U.S. dollar, which will make the dollar stronger and in higher demand relative to the foreign currency in the spot market. If the foreign money supply is increasing, this suggests that the foreign economy is investing in domestic assets in pursuit of higher rates of return. This results in a higher demand for the dollar and upward pressure on the spot exchange rate. The higher spot exchange rate will have the opposite effect on the forward exchange rate and the forward exchange rate will fall. Since foreign investors will eventually want to realize the gains from their investment, they will demand more of their currency in the forward market when they sell their assets and want to convert the proceeds from their investment in dollars to their own currency. This will cause an increase in supply of the dollar and cause the exchange rate to fall. The forward market is used to hedge against that risk since foreign investors want a strong dollar when it is time to convert to their own currency because it will take more foreign currency to purchase the dollar.
5a. A monetary contraction causes an initial BOP surplus because it shifts the LM curve up and to the left and moves the LM curve up along the downward sloping IS curve. A monetary contraction decreases the money supply and causes interest rates to increase as well as income to decrease. The increase in interest rates will cause a net inflow of capital and a capital account surplus. The decrease in income will result in a decrease in imports, an increase in exports, and a current account surplus. This unambiguously results in a BOP surplus.
5b. A fiscal expansion would shift the IS curve up and to the right. With government expenditure increasing, taxes decreasing, or both, the interest rate will increase and income will increase as well. The increase in interest rates will result in net capital inflows and a capital account surplus. The increase in income will give consumers more money for imports and cause a current account deficit. Under fixed exchange rates, monetary contraction should only take place if capital flows are unresponsive, which would make the change in the current account greater in magnitude than the change in the capital account. A current account deficit results in a BOP deficit, which would have downward pressure on the exchange rate. Since the exchange rate is fixed, reducing the money supply through monetary contraction must take place to reverse the effect and relieve the downward pressure on the exchange rate.
6a. In the presence of moral hazard and adverse selection, the expected nominal rate of return demanded by investors will increase in order to compensate for the uncertainties and risks associated with moral hazard and adverse selection.
Moral hazard comes into play after a contract has been signed where the beneficiary, for example an insurance policy holder, no longer has an incentive to act morally after the contract has been signed. For example, someone with car insurance may not drive as responsibly because they are covered by an amount agreed upon in the contract. Someone without insurance, on the other hand, has the incentive to be more careful when they drive because there are no funds available to pay for damages if an accident occurs. Therefore, an insurance company (the investor in this case) must include this moral hazard risk when underwriting an insurance policy.
Adverse selection reflects an information disadvantage where the investor cannot compile all the information necessary to eliminate risk. The less information available about the risk, the higher nominal rate of return demanded by investors. More information about the risk lowers the nominal rate of return demanded by investors because the risk is reduced.