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    Macro Problem Set 6 Solutions

    Uploaded by

    Genna Ng
    The document discusses solutions to macroeconomics problems involving currency exchange rates and arbitrage opportunities. It also discusses how central banks can maintain pegged exchange rates and the implications of interest rate changes. The key points are: 1) Currency traders can profit from temporary differences in exchange rates between locations by exploiting arbitrage opportunities. 2) As more traders exploit arbitrage opportunities, exchange rates will converge to eliminate the potential for profit. 3) A central bank defending a pegged exchange rate may need to raise interest rates to prevent capital outflows as other countries raise rates. 4) Maintaining a peg can force a central bank to pursue contractionary monetary policy that worsens an economic downturn.

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    © All Rights Reserved
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    Macro Problem Set 6 Solutions

    Uploaded by

    Genna Ng
    28 views4 pages
    The document discusses solutions to macroeconomics problems involving currency exchange rates and arbitrage opportunities. It also discusses how central banks can maintain pegged exchange rates and the implications of interest rate changes. The key points are: 1) Currency traders can profit from temporary differences in exchange rates between locations by exploiting arbitrage opportunities. 2) As more traders exploit arbitrage opportunities, exchange rates will converge to eliminate the potential for profit. 3) A central bank defending a pegged exchange rate may need to raise interest rates to prevent capital outflows as other countries raise rates. 4) Maintaining a peg can force a central bank to pursue contractionary monetary policy that worsens an economic downturn.

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    Macro Problem Set 6 solutions

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    The document discusses solutions to macroeconomics problems involving currency exchange rates and arbitrage opportunities. It also discusses how central banks can maintain pegged exchange rates and the implications of interest rate changes. The key points are: 1) Currency traders can profit from temporary differences in exchange rates between locations by exploiting arbitrage opportunities. 2) As more traders exploit arbitrage opportunities, exchange rates will converge to eliminate the potential for profit. 3) A central bank defending a pegged exchange rate may need to raise interest rates to prevent capital outflows as other countries raise rates. 4) Maintaining a peg can force a central bank to pursue contractionary monetary policy that worsens an economic downturn.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    28 views4 pages

    Macro Problem Set 6 Solutions

    Uploaded by

    Genna Ng
    The document discusses solutions to macroeconomics problems involving currency exchange rates and arbitrage opportunities. It also discusses how central banks can maintain pegged exchange rates and the implications of interest rate changes. The key points are: 1) Currency traders can profit from temporary differences in exchange rates between locations by exploiting arbitrage opportunities. 2) As more traders exploit arbitrage opportunities, exchange rates will converge to eliminate the potential for profit. 3) A central bank defending a pegged exchange rate may need to raise interest rates to prevent capital outflows as other countries raise rates. 4) Maintaining a peg can force a central bank to pursue contractionary monetary policy that worsens an economic downturn.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 4

    EC1101E 1 2022 April

    Macro Problem Set 6 solutions


    Q1
    A. The pound price of the dollar is lower in London than in New York. Thus, the arbitrage
    strategy involves selling pounds to buy dollars in London and selling dollars to buy
    pounds in New York. A trader holding 100 pounds will exchange it for 100 x (1/0.64) =
    156.25 dollars in London, and then sell the dollars for 156.25 x 0.8 = 125 pounds in New
    York, making a tidy profit of 125 – 100 = 25 pounds. To fully exploit the arbitrage
    opportunity, the currency trader might even choose to use leverage, i.e., borrow 100
    million pounds to do the same trade, get back 125 pounds, pay off the loan and interest
    and keep the remaining profit.

    B. Since the arbitrage involves selling pounds in London and buying pounds in New York,
    as more people try to exploit the arbitrage opportunity, the supply curve for pounds in
    London shifts rightward, and the demand curve for pounds in New York shifts
    rightwards. The pound will thus depreciate in London while it appreciates in New York.
    The two exchange rates will converge to a number in between 0.64 and 0.8 pounds per
    dollar. In practice, the presence of arbitrage and the ability to make trades near
    instantaneously worldwide means that geographical differences in the exchange rate are
    eliminated.

    Q2
    A. A trader with 90 riyals will convert this to 90/4 = 22.5 dollars. She then converts the
    dollars into 22.5 × 0.8 = 18 pounds. Finally, she exchanges the pounds for 18 × 6 = 108
    riyals. This series of exchanges gives her a tidy profit of 108 – 90 = 18 riyals.

    B. As more people exploit this three-way arbitrage opportunity, the riyal will depreciate
    against the dollar and appreciate against the pound, with the dollar also depreciating
    against the pound. The three exchange rates will adjust until these trades are no longer
    profitable. This example highlights how arbitrage ties together the various bilateral
    exchanges rates.
    EC1101E 2 2022 April

    Q3
    Suppose the Central Bank of Argentina pegs its peso to the US dollar at 30 pesos per dollar.
    Initially, the interest rate in both countries is 2 percent per year. The US Federal Reserve then
    raises its interest rate to 5 percent per year.

    A. Argentinian assets are now less attractive to US residents, so the demand curve for pesos
    shift left. US assets are now more attractive to Argentina residents, so the supply curve
    for pesos shift right. At 30 pesos per dollar, there will be an excess supply for pesos. The
    peso will have to depreciate to reach the new equilibrium.

    B. To keep the exchange rate at 30 pesos per dollar, the Central Bank of Argentina must
    absorb the excess supply of pesos by buying pesos with dollars. Consequently, it will
    deplete its foreign exchange reserves. It cannot do this indefinitely because it has a finite
    holding of foreign exchange reserves.

    Q4
    If Argentina is in a slump, then the appropriate monetary policy for counter-cyclical
    purposes is to do expansionary monetary policy i.e., reduce Argentina’s interest rate.
    However, reducing the interest rate will make Argentinian assets less attractive, which then
    leads to an even larger excess supply of pesos. The Central Bank of Argentina will deplete its
    foreign exchange reserves at an even faster rate.

    To keep the peg, the Central Bank of Argentina will eventually need to raise Argentina’s
    interest rate to match the US interest rate. It must therefore run a contractionary monetary
    policy, instead of an expansionary monetary policy. This will push the economy into a
    deeper slump!

    Alternatively, the Central Bank of Argentina could impose capital controls, meaning that it
    will restrict the inflow and outflow of funds, and allowing only exchanges of peso with USD
    at the pegged rate. This will drive currency trades into the black market, and make
    Argentina a pariah for foreign investors, who will stop lending USD to local businesses and
    the Argentinian government. This, too, will push the economy into a deeper slump.

    Enrichment: While the question discusses a hypothetical situation, real-life Argentina has in
    recent years been dealing with heavy depreciation pressure, forcing its central bank to first
    apply high interest rates, seek IMF loans, and eventually imposing capital controls. A short
    EC1101E 3 2022 April

    Wall Street Journal article reprinted in the Australian Business Review1 describes the capital
    controls:

    “In a decree released on Sunday, the government said the central bank would limit
    dollar sales, requiring companies and banks authorisation to purchase hard currency.
    The country's exporters would be required to repatriate all hard currency from sales
    abroad.

    Individuals seeking to buy dollars will have a limit of $US10,000 per month. Bank
    transfers abroad by individuals will also face a monthly limit of $US10,000.

    Dollar purchases by non-residents will be restricted to $US1000 a month, and they


    won't be allowed to make bank transfers abroad.”

    Q5
    The diagram below depicts the dollar-pound market with the quantity of dollars and the
    EC1101E 1 November 2019
    pound-price per dollar. The initial equilibrium is A (Q0, E0).

    If UK residents reduce their purchases of US assets by $1 billion, the demand curve for
    dollars shifts left (D$0 to D$1) by $1 billion (Q0 – Q0’ = $1 billion). Thus, there is a $1 billion

    1SANTIAGO PEREZ, RYAN DUBE. (September 3, 2019 Tuesday). Argentina imposes capital controls
    as cash reserves drain away. The Australian. https://advance-lexis-
    com.libproxy1.nus.edu.sg/api/document?collection=news&id=urn:contentItem:5WYH-J0V1-JD3N-
    52W0-00000-00&context=1516831 (requires NUS library login).
    EC1101E 4 2022 April

    excess supply of dollars. This leads the dollar to depreciate, i.e., the equilibrium pound-price
    per dollar will fall. The new equilibrium is B (Q1, E1).

    The process of reaching point B involves

    • Movement along the demand curve D$1 from C to B. This is the increase in UK
    residents’ purchase of US goods (i.e., US exports to the UK) in response to the
    dollar’s depreciation. Thus, US exports to the UK rise (green arrow).
    • Movement along the supply curve S$ from A to B. This is the reduction in US
    residents’ purchase of UK goods (i.e., US imports from the UK) in response to the
    dollar’s depreciation. Thus, US imports to the UK fall (blue arrow).

    Together, the US trade balance against the UK improves by $1 billion.

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