Tutorial Problem Set 3

Topic: The Balance of Payments

and The Effective Exchange
FM303: International Finance
Week 4, Sem. 1, 2019

ANSWER ALL QUESTIONS

#1. The demand for imports function is:

Qm  40  15. Pm
Calculate the quantity of imports if the foreign price of imports is 10 and the exchange rate
(domestic/foreign) is 1.20. Also calculate the demand for foreign exchange at this rate.

#2. Using the same demand function as in problem 1, calculate the quantity of foreign exchange
demanded at the following values of the exchange rate: 1.30, 1.40, 1.50, 1.60, 1.70 and 1.80.
Plot the demand for foreign exchange curve.

#3. The demand for exports function is:

Qx  40  2 Px*
Calculate the quantity of exports if the domestic price of exports is 10 and the exchange rate
(domestic/foreign) is 1.20. Also calculate the supply of foreign exchange at this rate.

#4. Using the same supply function as in problem 3, calculate the quantity of foreign exchange
supplied at the following values of the exchange rate: 1.30, 1.40, 1.50, 1.60, 1.70 and 1.80.
Plot the supply of foreign exchange curve.

#5. Use the demand and supply functions specified in problems 1 and 3 to demonstrate the
effect of inflation on the current account, starting from a situation in which Pm*  Px  10 and
S  1.20 . Plot the path of the current account over several periods of time when:
(a) The domestic and foreign inflation rates are 0 and 5%, respectively.
(b) The domestic and foreign inflation rates are 5 and 0%, respectively.

#6. You are given the following information:

Quantity of imports 200
Foreign currency price of imports 20
Exchange rate (d/f) 1.50

Calculate the foreign currency and domestic currency values of imports. What will happen if
the exchange rate falls to 1.20, assuming that the value of the elasticity of demand for imports
is -0.5? What if the elasticity is -2.5?

#7. You are given the following information:

Quantity of exports 500
Domestic currency price of exports 10

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 Exchange rate (d/f) 1.20

Calculate the foreign currency and domestic currency values of exports. What will happen if
the exchange rate falls to 0.90, assuming that the value of the elasticity of demand for exports
is -0.2? What if the elasticity is -1.8?

#8. Assume that Australia trades mostly with two countries only, the United States and the United
Kingdom, and that 70% of the trade is conducted with the United States, 25% with the United
Kingdom, and 5% with the rest of the world. The exchange rates of the Australian dollar at two
points in time, 0 and 1, are as follows:

0 1
AUD/USD 1.3541 1.7724
AUD/GBP 2.1533 2.5692

(a) Calculate the exchange rates in indirect quotation from an Australian perspective.
(b) Calculate the percentage rates of depreciation or appreciation of the Australian dollar
against the two currencies. Comment on your results.
(c) Calculate the exchange rate relatives, using 0 as a base period.
(d) Calculate an unweighted effective exchange rate index, using 0 as a base period in which
the index assumes the value of 100.
(e) Calculate the normalised trade weights.
(f) Calculate the trade-weighted effective exchange rate index. What is the rate of appreciation
or depreciation of the Australian dollar in effective terms? Compare this result with that
obtained in (b) and (d) above. Comment on your results.
(g) Recalculate the effective exchange rate as a weighted geometric average. Compare the
results with your previous ones.

#9. Using the information given in problem 8, calculate the nominal effective exchange rate,
using the bilateral exchange rates expressed in direct quotation. Compare the results with those
obtained by solving problem 8.

#10. Use the information given in problem 8, and assume that the price levels at two points in
time, 0 and 1, are as follows:

Country 0 1
Australia 100 110
United States 100 104
United Kingdom 100 105

(a) Calculate the real bilateral exchange rates.

(b) Calculate the rates of change in the real bilateral exchange rates.
(c) Calculate the real effective exchange rates of the Australian dollar, using the nominal
effective exchange rates obtained by solving problems 8 and 9.

~The End~

RRK/SI/2019/FM303/W4TUT

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 Tutorial Problem Set 3
Topic: The Balance of Payments and
The Effective Exchange
FM303: International Finance
Week 4, Sem. 1, 2019
Solution Guide

1. The demand for imports function is:

Qm  40  15
. Pm
Calculate the quantity of imports if the foreign price of imports is 10 and the exchange rate
(domestic/foreign) is 1.20. Also calculate the demand for foreign exchange at this rate.

Solution
The domestic currency price of imports, Pm , is calculated by using equation (3.3) as:

Pm  SPm*  1.20  10  12
Therefore the quantity of imports is:
Qm  40  1.5  12  22

The demand for foreign exchange is Pm*Qm , which is 220.

2. Using the same demand function as in problem 1, calculate the quantity of foreign exchange
demanded at the following values of the exchange rate: 1.30, 1.40, 1.50, 1.60, 1.70 and 1.80.
Plot the demand for foreign exchange curve.

Solution
The quantity of foreign exchange demanded is equal to import expenditure. At an exchange
rate of 1.30, Pm is 13 and Qm is 20.5. Therefore, the quantity of foreign exchange demanded
is:
Pm*Qm  10  20.5  205
At the other values of the exchange rate, the quantities of foreign exchange demanded are 190,
175, 160, 145 and 130.

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The demand for FX curve

3. The demand for exports function is:

Qx  40  2 Px*
Calculate the quantity of exports if the domestic price of exports is 10 and the exchange rate
(domestic/foreign) is 1.20. Also calculate the supply of foreign exchange at this rate.

Solution
Px* is calculated from equation (3.6) as:

Px 10
Px*    8.33
S 1.20
Therefore, the quantity of exports is:
Qx  40  2  8.33  23.34
The quantity of foreign exchange supplied is:
Px*Qx  8.33  23.34  194.42

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4. Using the same supply function as in problem 3, calculate the quantity of foreign exchange
supplied at the following values of the exchange rate: 1.30, 1.40, 1.50, 1.60, 1.70 and 1.80. Plot
the supply of foreign exchange curve.

Solution
The foreign currency price of exports at the various exchange rates is 7.69, 7.14, 6.67, 6.25,
5.88 and 5.56. The corresponding quantities of exports demanded are 24.62, 25.72, 26.66,
27.50, 28.24 and 28.88. The quantities of foreign exchange supplied at these exchange rates
are 189.35, 183.67, 177.78, 171.88, 166.09 and 160.49.

As we can see, the supply curve here is downward sloping. This is because as the exchange
rate rises, the foreign currency price of exports declines while the quantity of exports rises. The
supply of foreign exchange (the product of the two) may therefore rise or fall, producing either
a positively sloped or negatively sloped supply curve. The outcome depends on the elasticity
of demand for exports.

The supply of FX curve

5. Use the demand and supply functions specified in problems 1 and 3 to demonstrate the effect
of inflation on the current account, starting from a situation in which Pm*  Px  10 and
S  1.20 . Plot the path of the current account over several periods of time when:
(a) The domestic and foreign inflation rates are 0 and 5%, respectively.

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(b) The domestic and foreign inflation rates are 5 and 0%, respectively.

Solution
(a) The calculations are shown in the following table. The results show that a higher inflation
rate in the foreign country leads to a decline in imports, and therefore an improvement in the
current account. Eventually, the deficit turns into surplus.
Pm* Px S Pm Px* Qm Qx B*
10.0 10 1.2 12.0 8.3 22.0 23.3 -25.6
10.5 10 1.2 12.6 8.3 21.1 23.3 -27.1
11.0 10 1.2 13.2 8.3 20.2 23.3 -27.8
11.6 10 1.2 13.9 8.3 19.2 23.3 -27.4
12.2 10 1.2 14.6 8.3 18.1 23.3 -25.8
12.8 10 1.2 15.3 8.3 17.0 23.3 -22.9
13.4 10 1.2 16.1 8.3 15.9 23.3 -18.3
14.1 10 1.2 16.9 8.3 14.7 23.3 -12.0
14.8 10 1.2 17.7 8.3 13.4 23.3 -3.6
15.5 10 1.2 18.6 8.3 12.1 23.3 7.1

The time path of the current account (zero domestic inflation)

(b) The calculations are shown in the following table. The results show that a higher domestic
inflation rate leads to declining exports, and therefore to deterioration in the current account.
Pm* Px S Pm Px* Qm Qx B*
10.0 10.0 1.2 12.0 8.3 22.0 23.3 -25.6
10.0 10.5 1.2 12.0 8.8 22.0 22.5 -23.1
10.0 11.0 1.2 12.0 9.2 22.0 21.6 -21.3
10.0 11.6 1.2 12.0 9.6 22.0 20.7 -20.2
10.0 12.2 1.2 12.0 10.1 22.0 19.7 -20.0
10.0 12.8 1.2 12.0 10.6 22.0 18.7 -20.8
10.0 13.4 1.2 12.0 11.2 22.0 17.7 -22.7
10.0 14.1 1.2 12.0 11.7 22.0 16.5 -26.0
10.0 14.8 1.2 12.0 12.3 22.0 15.4 -30.7
10.0 15.5 1.2 12.0 12.9 22.0 14.1 -37.1

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The time path of the current account (zero foreign inflation)

6. You are given the following information:

Quantity of imports 200
Foreign currency price of imports 20
Exchange rate (d/f) 1.50

Calculate the foreign currency and domestic currency values of imports. What will happen if
the exchange rate falls to 1.20, assuming that the value of the elasticity of demand for imports
is -0.5? What if the elasticity is -2.5?

Solution
The foreign currency value of imports is calculated as:
20  200  4000
The domestic currency value of imports is obtained by converting the foreign currency value
at the current exchange rate:
1.50  4000  6000
At an exchange rate of 1.50, the domestic currency price of imports is 30 (1.50  20) . At an
exchange rate of 1.20, the domestic currency price of imports falls to 24 (1.20  20) . The
percentage change in the domestic currency price of imports resulting from the change in the
exchange rate is –20%. If the elasticity of demand is –0.5, the percentage change in the quantity
of imports demanded can be calculated from equation (3.8) as:
Q m  0.5  20  10%

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and so the quantity of imports rises by 10% to 220. Hence, the foreign and domestic currency
values of imports are given, respectively, by:
20  220  4400
and
1.20  4400  5280
If the elasticity of demand is –2.5, the percentage change in the quantity of imports demanded
is 50%, and so the quantity of imports rises to 300. Therefore, the foreign and domestic
currency values of imports rise to 6000 and 7200, respectively.

7. You are given the following information:

Quantity of exports 500
Domestic currency price of exports 10
Exchange rate (d/f) 1.20

Calculate the foreign currency and domestic currency values of exports. What will happen if
the exchange rate falls to 0.90, assuming that the value of the elasticity of demand for exports
is -0.2? What if the elasticity is -1.8?

Solution
The domestic currency value of exports is calculated as:
10  500  5000
The foreign currency value of exports is obtained by converting the domestic currency value
at the current exchange rate:
5000
 4167
1.2
At an exchange rate of 1.20, the foreign currency price of exports is 8.3 (10 / 1.2) . At an
exchange rate of 0.90, the foreign currency price of exports rises to 11.1 (10 / 0.9) . The
percentage change in the foreign currency price of imports resulting from the change in the
exchange rate is 33.7%. If the elasticity of demand is –0.2, the percentage change in the quantity
of exports demanded can be calculated from equation (3.9) as:
Q x  0.2  33.7  6.7%

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and so the quantity of exports falls by 6.7% to 467. Therefore the domestic and foreign currency
values of exports are given, respectively, by:
10  467  4670
and
4670
 5189
0.9
If the elasticity of demand is –1.8, the percentage change in the quantity of exports demanded
is -60.7%, and so the quantity of exports becomes 197. Therefore the domestic and foreign
currency values of exports become 1970 and 2189, respectively.

8. Assume that Australia trades mostly with two countries only, the United States and the United
Kingdom, and that 70% of the trade is conducted with the United States, 25% with the United
Kingdom, and 5% with the rest of the world. The exchange rates of the Australian dollar at two
points in time, 0 and 1, are as follows:

0 1
AUD/USD 1.3541 1.7724
AUD/GBP 2.1533 2.5692

(a) Calculate the exchange rates in indirect quotation from an Australian perspective.
(b) Calculate the percentage rates of depreciation or appreciation of the Australian dollar
against the two currencies. Comment on your results.
(c) Calculate the exchange rate relatives, using 0 as a base period.
(d) Calculate an unweighted effective exchange rate index, using 0 as a base period in which
the index assumes the value of 100.
(e) Calculate the normalised trade weights.
(f) Calculate the trade-weighted effective exchange rate index. What is the rate of appreciation
or depreciation of the Australian dollar in effective terms? Compare this result with that
obtained in (b) and (d) above. Comment on your results.
(g) Recalculate the effective exchange rate as a weighted geometric average. Compare the
results with your previous ones.

Solution
(a) The exchange rates in direct quotation from an Australian perspective are as follows:

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 Exchange rate 0 1
USD/AUD 0.7385 0.5642
GBP/AUD 0.4644 0.3892

(b) The percentage changes are –23.6% and –16.2%. The Australian dollar depreciated more
proportionately against the USD.

(c) The exchange rate relatives using a base value of 100 are 76.4 and 83.8, respectively.

(d) The unweighted effective exchange rate is:

0.5×(76.4+83.8) = 80.1

(e) The normalised trade weights for the US and the UK are:

0.7
 0.74
0.7  0.25

0.25
 0.26
0.7  0.25

(f) The trade weighted index is:

0.74×76.4+0.26×83.8= 78.3
Compared with the base period, the Australian dollar depreciated by 21.7% in effective terms.

(g) As a geometric weighted average, the effective exchange rate is calculated as:

(76.4) 0.74 (83.8) 0.26  78.3

9. Using the information given in problem 8, calculate the nominal effective exchange rate,
using the bilateral exchange rates expressed in direct quotation. Compare the results with those
obtained by solving problem 8.

Solution
In this case we use the original exchange rate, as in problem 8. The exchange rate relatives are

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130.9 and 119.3, respectively. The unweighed effective exchange rate is 125.1. The trade-
weighted effective rates calculated as arithmetic and geometric means are 127.8 and 127.7,
respectively.

10. Use the information given in problem 8, and assume that the price levels at two points in
time, 0 and 1, are as follows:

Country 0 1
Australia 100 110
United States 100 104
United Kingdom 100 105

(a) Calculate the real bilateral exchange rates.

(b) Calculate the rates of change in the real bilateral exchange rates.
(c) Calculate the real effective exchange rates of the Australian dollar, using the nominal
effective exchange rates obtained by solving problems 8 and 9.

Solution
The real bilateral exchange rates are calculated by adjusting the nominal exchange rates for
prices. The following table shows the real bilateral rates expressed both as direct and indirect
quotations, as well as their percentage changes:
Exchange rate 0 1 % change
AUD/USD 1.3541 1.6757 23.8
AUD/GBP 2.1553 2.4524 13.9
USD/AUD 0.7385 0.5968 -19.2
GBP/AUD 0.4644 0.4078 -12.2

The relatives of the real exchange rates are 123.8, 113.9, 80.8 and 87.8. The real effective
exchange rates are calculated by applying the weights to these relatives.

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