EC351 - International Economics (PART II) Prof.
Jose Vasquez
Summer Term 2025 [Link]
CLASS #2
QUESTIONS
(1) Calculate the dollar rates of return on the following assets:
(a) A painting whose price rises from $200, 000 to $250, 000 in a year.
(b) A bottle of a rare Burgundy, Domaine de la Romanee-Conti 1978, whose price
rises from $255 to $275 between 2013 and 2014.
(c) A £10, 000 deposit in a London bank in a year when the interest rate on
pounds is 10 percent and the $/£ exchange rate moves from $1.50 per pound
to $1.38 per pound.
(2) What would be the real rates of return on the assets in the preceding question
if the price changes described were accompanied by a simultaneous 10 percent
increase in all dollar prices?
(3) Can you think of reasons why a government might be concerned about a large
current account deficit or surplus? Why might a government be concerned about
its official settlements balance (that is, its balance of payments)?
(4) Petroleum is sold in a world market and tends to be priced in U.S. dollars. The
Nippon Steel Chemical Group of Japan must import petroleum to use in manu-
facturing plastics and other products. How are its profits affected when the yen
depreciates against the dollar?
(5) Traders in asset markets suddenly learn that the interest rate on dollars will decline
in the near future. Use the diagrammatic analysis of this lecture to determine the
effect on the current dollar/euro exchange rate, assuming current interest rates on
dollar and euro deposits do not change.
(6) Suppose the dollar exchange rates of the euro and the yen are equally variable.
The euro, however, tends to depreciate unexpectedly against the dollar when the
return on the rest of your wealth is unexpectedly high, while the yen tends to
appreciate unexpectedly in the same circumstances. As a U.S. resident, which
currency, the euro or the yen, would you consider riskier?
(7) The lecture explained why exporters cheer when their home currency depreciates.
At the same time, domestic consumers find that they pay higher prices, so they
should be disappointed when the currency becomes weaker. Why do the exporters
usually win out, so that governments often seem to welcome depreciations while
trying to avoid appreciations?
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EC351 - International Economics (PART II) Prof. Jose Vasquez
Summer Term 2025 [Link]
(8) Suppose there is a reduction in aggregate real money demand, that is, a negative
shift in the aggregate real money demand function. Trace the short- and long-run
effects on the exchange rate, interest rate, and price level.
(9) Multinationals generally have production plants in a number of countries. Con-
sequently, they can move production from expensive locations to cheaper ones
in response to various economic developments-a phenomenon called outsourcing
when a domestically based firm moves part of its production abroad. If the dol-
lar depreciates, what would you expect to happen to outsourcing by American
companies? Explain and provide an example.
(10) What is the short-run effect on the exchange rate of an increase in domestic real
GNP, given expectations about future exchange rates?
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EC351 - International Economics (PART II) Prof. Jose Vasquez
Summer Term 2025 [Link]
QUESTIONS AND SOLUTIONS
(1) Calculate the dollar rates of return on the following assets:
(a) A painting whose price rises from $200, 000 to $250, 000 in a year.
(b) A bottle of a rare Burgundy, Domaine de la Romanee-Conti 1978, whose price
rises from $255 to $275 between 2013 and 2014.
(c) A £10, 000 deposit in a London bank in a year when the interest rate on
pounds is 10 percent and the $/£ exchange rate moves from $1.50 per pound
to $1.38 per pound.
Answer/ The euro rates of return are as follows:
(a) (250, 000 − 200, 000)/200, 000 = 0.25.
(b) (275 − 255)/255 = 0.0784.
(c) The initial value in dollars is 10, 000 × 1.50 = 15, 000 and the final value is
11, 000×1.38 = 15, 180, then the dollar rate return is (15, 180−15, 000)/15, 000 =
0.012
(2) What would be the real rates of return on the assets in the preceding question
if the price changes described were accompanied by a simultaneous 10 percent
increase in all dollar prices?
Answer/
Note here that the ordering of the returns of the three assets is the same whether
we calculate real or nominal returns. The real rate of return adjusts the nominal
return to account for the loss of purchasing power due to inflation.
(a) The real return on the painting would be approximately 25% − 10% = 15%.
This can also be calculated by first finding the portion of the $50, 000 nominal
increase in the price of the painting due to inflation ($20, 000), then finding the
portion due to real appreciation ($30,000), and finally finding the appropriate
real rate of return ($30, 000/$200, 000 = 0.15).
(b) Again, subtracting the inflation rate from the nominal return, we get 7.84% −
10% = −1.9%.
(c) The real return on the pound deposit would be approximately 1.2% − 10% =
−8.8%. This return could also be calculated by first finding the portion of
the $180 nominal increase in the deposit’s dollar value due to inflation, then
seeing that the nominal gain was far too small to compensate for this inflation,
resulting in a real loss of purchasing power. Finally, applying the exact real
rate of return formula gives (1 + 0.012)/(1 + 0.10) − 1 = −0.079, which gives
the exact real rate of −7.9%.
(3) Can you think of reasons why a government might be concerned about a large
current account deficit or surplus? Why might a government be concerned about
its official settlements balance (that is, its balance of payments)?
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EC351 - International Economics (PART II) Prof. Jose Vasquez
Summer Term 2025 [Link]
Answer/ A current account deficit or surplus is a situation that may be unsustainable in
the long run. There are instances in which a deficit may be warranted, for example to
borrow today to improve productive capacity in order to have a higher national income
tomorrow. But for any period of current account deficit, there must be a corresponding
period in which spending falls short of income (i.e., a current account surplus) in order to
pay the debts incurred to foreigners. In the absence of unusual investment opportunities,
the best path for an economy may be one in which consumption, relative to income, is
smoothed out over time.
The reserves of foreign currency held by a country’s central bank change with nonzero
values of its official settlements balance. Central banks use their foreign currency reserves
to influence exchange rates. A depletion of foreign reserves may limit the central bank’s
ability to influence or peg the exchange rate. For some countries (particularly developing
countries), central-bank reserves may be important as a way of allowing the economy to
maintain consumption or investment when foreign borrowing is difficult. A high level of
reserves may also perform a signaling role by convincing potential foreign lenders that the
country is creditworthy.
(4) Petroleum is sold in a world market and tends to be priced in U.S. dollars. The
Nippon Steel Chemical Group of Japan must import petroleum to use in manu-
facturing plastics and other products. How are its profits affected when the yen
depreciates against the dollar?
Answer/ When the yen depreciates versus the dollar, the costs to a Japanese firm that
imports petroleum will rise. This depresses its profits. On the other hand, that firm
will be able to register a profit for its products priced in dollar (increasing its yen price
without changing the dollar price), so there may be some offsetting effects. But, by and
large, a firm that has substantial imported input costs does not relish a depreciating home
currency.
(5) Traders in asset markets suddenly learn that the interest rate on dollars will decline
in the near future. Use the diagrammatic analysis of this lecture to determine the
effect on the current dollar/euro exchange rate, assuming current interest rates on
dollar and euro deposits do not change.
Answer/ If market traders learn that the dollar interest rate will soon fall, they also
revise upward their expectation of the dollar’s future depreciation in the foreign exchange
market. Given the current exchange rate and interest rates, there is thus a rise in the
expected dollar return on euro deposits. At the current exchange rate, the dollar return
on a European asset exceeds the dollar return on a U.S. asset. As investors shift their
money into European assets, the dollar will depreciate against the euro. This will drive
down the dollar return on European assets until interest rate parity is restored at the new
exchange rate.
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EC351 - International Economics (PART II) Prof. Jose Vasquez
Summer Term 2025 [Link]
(6) Suppose the dollar exchange rates of the euro and the yen are equally variable.
The euro, however, tends to depreciate unexpectedly against the dollar when the
return on the rest of your wealth is unexpectedly high, while the yen tends to
appreciate unexpectedly in the same circumstances. As a U.S. resident, which
currency, the euro or the yen, would you consider riskier?
Answer/ The euro is less risky for you. When the rest of your wealth falls, the euro tends
to appreciate, cushioning your losses by giving you a relatively high payoff in terms of
dollars. Losses on your euro assets, on the other hand, tend to occur when they are least
painful, that is, when the rest of your wealth is unexpectedly high. Holding the euro,
therefore, reduces the variability of your total wealth.
(7) The lecture explained why exporters cheer when their home currency depreciates.
At the same time, domestic consumers find that they pay higher prices, so they
should be disappointed when the currency becomes weaker. Why do the exporters
usually win out, so that governments often seem to welcome depreciations while
trying to avoid appreciations?
Answer/ As per the question, a currency depreciation benefits exporters and hurts con-
sumers by raising the cost of living. Exporters tend to have more influence with the
government for two reasons. First, there are fewer exporters than there are consumers,
so the gains from a currency depreciation are much more heavily concentrated than the
losses. As a result, each individual exporter will put forth more effort in lobbying the gov-
ernment than each individual consumer. Second, exporters are much easier to organize
and coordinate than are a disparate mass of consumers. There are effective enforcement
mechanisms in place to ensure that all exporters contribute to get a government to de-
preciate the currency, thus reducing the risk of free riding. Consumers will have a much
harder time coordinating their lobbying efforts because there is no effective way to ensure
that every consumer contributes toward such an effort. The risk of free riding is much
higher among consumers.
(8) Suppose there is a reduction in aggregate real money demand, that is, a negative
shift in the aggregate real money demand function. Trace the short- and long-run
effects on the exchange rate, interest rate, and price level.
Answer/ A reduction in the home money demand causes interest rates in the home country
to fall from Rh,1 to Rh,2 . With no change in expectations, there will be a depreciation of
the home currency from E1 to E2 as investors shift their savings into higher-interest-paying
foreign assets.
In the long run, increased spending on home products (through lower interest rates and
a depreciated currency) will cause prices in the home country to rise. This will shift the
real money supply inward to a point where home interest rates return to their original
level Rh,1 and the exchange rate falls back to E1 .
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EC351 - International Economics (PART II) Prof. Jose Vasquez
Summer Term 2025 [Link]
(9) Multinationals generally have production plants in a number of countries. Con-
sequently, they can move production from expensive locations to cheaper ones
in response to various economic developments-a phenomenon called outsourcing
when a domestically based firm moves part of its production abroad. If the dol-
lar depreciates, what would you expect to happen to outsourcing by American
companies? Explain and provide an example.
Answer/ If the dollar depreciated, all else being equal, we would expect outsourcing to
diminish. If, as the problem states, much of the outsourcing is an attempt to move pro-
duction to locations that are relatively cheaper, then the United States becomes relatively
cheap when the dollar depreciates. Although it may not be as cheap a destination as some
other locations, at the margin, labor costs in the United States will have become relatively
cheaper, making some firms choose to retain production at home. For example, we could
say that the labor costs of producing a computer in Malaysia is $220 and the extra trans-
port cost is $50, but the U.S. costs were $300; then we would expect the firm to outsource.
On the other hand, if the dollar depreciated 20% against the Malaysian ringitt, the labor
costs in Malaysia would now be $264 (that is, 20% higher in dollar terms, but unchanged
in local currency). This, plus the transport costs, makes production in Malaysia more
expensive than in the United States, making outsourcing a less attractive option.
(10) What is the short-run effect on the exchange rate of an increase in domestic real
GNP, given expectations about future exchange rates?
Answer/ An increase in domestic real GNP will cause domestic real money demand to
rise. This will cause domestic real interest rates to rise from Rh,1 to Rh,2 (see graph below).
With no change in expectations, there will be an appreciation of the home currency from
E1 to E2 as investors channel their savings into domestic assets.
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EC351 - International Economics (PART II) Prof. Jose Vasquez
Summer Term 2025 [Link]
Figure 0.1.