This Document Contains Chapters 5 to 6 Chapter 5 Policy Makers and the Money Supply CHAPTER PREVIEW It is important to recognize that the Federal Reserve as administrator of monetary policy does not operate in isolation but rather in conjunction with other policy makers (i.e., the President, Congress, and the U.S. Treasury) in attempting to achieve national policy objectives. We will see in this chapter that these policy makers influence the operation of the financial system and the economy through their policies and actions directed towards influencing national policy objectives. We begin by reviewing our country’s national economic policy objectives. This is followed by how the federal government influences the economy. We then turn our attention to policy instruments of the U.S. Treasury and how the Treasury manages the national debt. Next, we cover how the money supply is changed and discuss factors that affect bank reserves. We conclude with a discussion of the monetary base and the money multiplier. LEARNING OBJECTIVES Discuss the objectives of national economic policy and the conflicting nature of these objectives. Identify the major policy makers and briefly describe their primary responsibilities. Identify the policy instruments of the U.S. Treasury and briefly explain how the Treasury manages its activities. Describe U.S. Treasury tax policy and debt management responsibilities. Discuss how the expansion of the money supply takes place in the U.S. banking system. Briefly summarize the factors that affect bank reserves. Explain the meaning of the monetary base and money multiplier. Explain what is meant by the velocity of money and give reasons why it is important to control the money supply. CHAPTER OUTLINE I. NATIONAL economic POLICY OBJECTIVES A. Economic Growth B. High Employment C. Price Stability D. Balance in International Transactions II. FOUR POLICY MAKER GROUPS ETHICAL BEHAVIOR IN GOVERNMENT POLICY MAKERS IN THE EUROPEAN ECONOMIC UNION III. GOVERNMENT INFLUENCE ON THE ECONOMY IV. POLICY INSTRUMENTS OF THE U.S. TREASURY A. Managing the Treasury’s Cash Balances 1. Treasury Tax and Loan Accounts 2. Treasury Receipts and Outlays B. Powers Relating to the Federal Budget and to Surpluses or Deficits 1. General Economic Effects of Fiscal Policy 2. Effects of Tax Policy 3. Effects of Deficit Financing C. Recent Financial Crisis-Related Activities V. DEBT MANAGEMENT VI. CHANGING THE MONEY SUPPLY A. Checkable Deposit Expansion B. Offsetting or Limiting Factors C. Contraction of Deposits VII. FACTORS AFFECTING BANK RESERVES Changes in the Demand for Currency B. Federal Reserve System Transactions l. Open-Market Operations 2. Depository Institution Transactions 3. Federal Reserve Float 4. Treasury Transactions VIII. THE MONETARY BASE AND THE MONEY MULTIPLIER IX. SUMMARY LECTURE NOTES I. NATIONAL economic POLICY OBJECTIVES Commentators offer a vast array of national policy objectives. It is possible, however, to narrow down the various objectives to a few broad, all-inclusive categories. They are: economic growth, high and stable levels of employment, price stability, and inter-national financial equilibrium. An interesting class discussion can be developed with respect to what these objectives include. Economic growth has afforded a dramatic increase in our standard of living and is a reflection of the nation’s productivity. Aggregate growth of a nation’s gross domestic product (GDP) could occur simply as a result of an increase in population. But, an increase in the welfare of individuals depends on a growth in productivity. Increased productivity is a function of an increasing stock of resources—capital, skilled workers—and improved tools, technology, and skills. High and stable levels of employment reduce the burden and costs of unemployment and is a stated objective of the government. Although a certain amount of unemployment is basic to a market system as plants and products become obsolete, wide swings in unemployment levels are clearly undesirable. Business cycles create unemployment from time to time, but it is in the nation’s best interests to moderate these swings as much as possible. Price stability is an important factor in accomplishing the objectives of growth and high and stable levels of employment. Inflation has been one of the most disruptive factors in our economy. It discourages savings and reduces investment in factors of production. It has been argued that inflation is necessary to provide high employment levels, but experience has proved that this is too high a price to pay. In the long run, the effects of inflation on employment levels are just the opposite. International financial equilibrium has become increasingly important as world markets have become more integrated. It is not only in the United States’ best interests but those of the rest of the world that we maintain national financial equilibrium. (Use Discussion Question 1 here.) II. FOUR POLICY MAKER GROUPS tHE FOUR GROUPS OF POLICY MAKERS IN THE U.S. ARE: (1) FEDERAL RESERVE SYSTEM, (2) THE PRESIDENT, (3) CONGRESS, AND (4) U.S. TREASURY. THE POLICY MAKERS ESTABLISH POLICIES OR DECISIONS RELATING TO: (1) MONETARY POLICY, (2) FISCAL POLICY, AND (3) DEBT MANAGEMENT. THESE POLICIES OR DECISIONS INFLUENCE THE ECONOMIC OBJECTIVES OF: (1) ECONOMIC GROWTH, (2) HIGH EMPLOYMENT, (3) PRICE STABILITY, AND (4) INTERNATIONAL BALANCE. An interesting discussion can be developed with respect to which policy makers’ functions are dynamic, defensive, or accommodative in nature. Some overlap exists, of course, but the discussion should bring out the reasons for these variations in functions. (USE FIGURE 5.1 AND DISCUSSION QUESTION 2 HERE.) III. GOVERNMENT INFLUENCE ON THE ECONOMY The federal government is charged with accomplishing those things for which the private sector of the economy is less suited. Support of the armed forces is the most obvious example. Students may want to discuss a wide range of functions that are not as clear-cut. As the government carries out its various functions and pursues its regulatory activities it exerts a profound influence on the entire economy. A government raises funds to pay for its activities in the following three ways: (1) levies taxes, (2) borrows, and (3) prints money for its own use. The option of printing money has tempted some governments in the past. To provide controls against excessive use of the print money option, Congress delegated the power to create money to the Fed. Taxation has dual influence on the economy since it reduces the purchasing power of one group while increasing the purchasing power of groups benefiting from government expenditures. The power to tax is the power to reshape the structure of the economy. The Fed’s influence on interest rates and the way in which the U.S. Treasury manages the national debt through refunding security issues also have a profound influence on the economy. IV. POLICY INSTRUMENTS OF THE U.S. TREASURY The two principal methods by which the U.S. Treasury exercises an influence on the nation’s economic affairs are the management of its cash balances and its fiscal policy. While cash balance management is an administrative function of the Treasury, fiscal policy is a function of Congress and the administration that is implemented through the operations of the Treasury. The large cash balances of the Treasury are necessary to meet expenditures that occur on an intermittent basis. Funds are allowed to build up with depository institutions as taxes are collected. When needed for payments, funds are transferred to the Federal Reserve Banks. The Treasury tries to keep balances in its accounts at the Federal Reserve Banks relatively stable. Careful forecasts are made of daily receipts and expenditures from the Treasury account so that funds from the Tax and Loan Accounts may be shifted in the right amounts at the right time. Fiscal policy has a significant effect on aggregate demand and economic activity. Not only is government spending a large component of aggregate demand, but any change in government spending has a multiplied effect on total spending. Increases in government spending increase employment and income as well as consumer spending. Changes in taxes also have a direct impact on disposable income and, in turn, consumer spending. The effect of tax policy is a function not only of the level of taxes but of their incidence. That is, taxes on high-income individuals have a different effect on the economy than taxes on low- and middle-income individuals. Changes in corporate tax rates also have an important effect on the economy. Increases in corporate taxes reduce the amount of money a corporation has for current expenditures and for investment in additional plant and equipment. Deficit financing by the government is generally assumed to stimulate the economy, but the method of financing the deficit also has a special effect. At times when credit demands are great, the sale of Treasury obligations may tend to crowd out private borrowers, creating even greater pressure on the capital markets. When credit demands are slack, the capital markets may easily absorb such Treasury financing, expanding the total credit. The U.S. Treasury played an important role in helping the U.S. survive the 2007-09 financial crisis. The Treasury was actively involved in helping financially troubled financial institutions merge with stronger institutions. The Economic Stabilization Act of 2008 provided the Treasury with funds to purchase troubled assets from financial institutions although much of the funds were actually used to invest capital in banks with little equity on their balance sheets. (Use Discussion Questions 3 and 4 here.) V. DEBT MANAGEMENT The vast array of maturities, represented by the national debt, requires almost constant attention to refunding efforts. Refinancing maturing debt issues with long-term obligations has a far different impact on the economy than refinancing with short- or intermediate-term obligations. During periods of intense inflation, the sale of long-term issues may assist orderly growth and stability by reducing the purchasing power of the public. During slack periods, the sale of short-term obligations may attract idle funds and depository reserves with little adverse effect on the economy. This may lead to credit expansion. (Use Discussion Question 5 here.) VI. CHANGING THE MONEY SUPPLY The Federal Reserve System attempts to regulate and control the supply of money and the availability of credit. Today, Federal Reserve notes are backed by gold certificates, Special Drawing Rights (SDRs), and U.S. government and agency securities (the primary source). SDRs are a form of reserve asset or “paper gold” created by the International Monetary Fund to provide worldwide monetary liquidity and to support international trade. The supply of Federal Reserve notes expands and contracts to meet changes in the demand for currency. The instructor may wish to elaborate on this statement or ask students for examples of why demand for currency might change during a year’s time. One answer is the increased demand for currency during the Christmas shopping season. Refer students to the discussion titled “An Holiday-Related Example” in the section titled “Factors Affecting Bank Reserves.” (Use Discussion Question 6 here.) The banking system (comprised of commercial banks and other depository institutions) of the U.S. can expand and contract the volume of checkable deposits to meet the needs for funds by individuals, businesses, and governments. The ability to alter the money supply and deposits is based on the use of a “fractional reserve” system (i.e., reserves equal to some portion of deposits must be held with the Federal Reserve). A primary deposit adds new reserves to the bank where deposited. A derivative deposit occurs when reserves created from a primary deposit are made available through bank loans to borrowers who leave them on deposit in order to write checks against the funds. As an aid to students’ understanding of the process of expansion and contraction of the money supply, have them rework the examples given in this section with different values (e.g., a new primary deposit of $25,000 and a reserve requirement of 12 percent). Students can also be assigned the task of developing a new version of Table 5.1 based on initial reserves of $25,000 and a 12 percent reserve requirement. (Use Table 5.1 and Discussion Questions 7 through 10 here.) VII. FACTORS AFFECTING BANK RESERVES Total reserves in the banking system consist of reserve deposits and vault cash. Reserve balances are held at the Federal Reserve Banks by commercial banks and other depository institutions. Vault cash is coin and paper currency held on the premises of depository institutions. The extent to which the process of deposit expansion or contraction takes place is governed by the level of excess reserves that a depository institution has (i.e., reserves above the level of required reserves). There are two kinds of factors which affect total reserves: those which affect the currency holdings of the banking system and those which affect deposits at the Fed. Currency flows in response to changes in the demand for it by households and firms. Reserve balances are affected by a variety of transactions involving the Fed and banks, by the Treasury, or by other factors. When the Fed, through its open market operations, purchases securities such as government bonds, it adds to bank reserves. For example, the Fed buys a government security from Bank A for $10,000, the check for which is deposited in First National Bank. As a result, 1. First National’s reserve balance at its Reserve Bank is increased by $10,000. The Reserve Bank has a new asset—a bond worth $10,000. 2. Deposits in Bank A are increased by $10,000 ($2,000 in required reserves and $8,000 in excess reserves). Just the opposite occurs when the Fed sells securities in the market. When a bank borrows from its Reserve Bank, it is borrowing reserves; so reserves are increased by the amount of the loan. Similarly, when a loan to the Reserve Bank is repaid, reserves are reduced by the amount so repaid. Changes in reserve requirements change the amount of deposit expansion that is possible with a given level of reserves. With a reserve ratio of 20 percent, excess reserves of $100 can be expanded to $100 of additional loans and deposits. If the reserve ratio is reduced to 10 percent, it is possible to expand $100 of excess reserves to $1,000 of additional loans and deposits. Additional expansion also takes place because when the reserve ratio is lowered; part of the required reserves becomes excess reserves. This process is reversed when the reserve ratio is raised. Bank reserves are also affected by the transactions of the Treasury. Treasury funds from tax collections or the sale of bonds are generally deposited in its accounts in banks, which increases bank reserves. When the Treasury has a need for funds to make payments from its accounts at the Reserve Banks, it transfers funds from banks to its accounts at the Reserve Banks. This process reduces bank reserves. Other factors also affect the level of bank reserves. Federal Reserve float is the temporary increase in bank reserves that results when checks are credits to the reserve account of the depositing bank before they are debited from the accounts of the banks on which they are drawn. Bank reserves are also affected by changes in the level of deposits of foreign central banks and governments at the Reserve Banks. (Use Figure 5.2 and Discussion Questions 11 through 13 here.) VIII. THE MONETARY BASE AND THE MONEY MULTIPLIER The monetary base consists of reserve deposits held in Reserve Banks, vault cash or currency held by banks and other depository institutions, and currency held by the nonbank public. The money multiplier at any point in time can be directly calculated by dividing the money stock by the monetary base. A useful exercise is to have students determine the money multiplier at different times by referring to selected issues of the Federal Reserve Bulletin or from the Fed’s Web site to find information on the money stock and the monetary base. (Use Discussion Questions 14 and 15 here.) The velocity of money measures the rate of circulation of the money supply expressed as the average number of times each dollar is spent on purchases of goods and services. The velocity of money is calculated as nominal GDP (expressed in current dollars) divided by the Ml definition of money stock or supply. It is useful to have students determine the velocity of money at different points in time by referring to selected issues of the Federal Reserve Bulletin or by accessing the Fed’s Web site to find information on the size of nominal GDP and the amount of the money stock. (Use Discussion Questions 16 and 17 here.) DISCUSSION QUESTIONS AND ANSWERS 1. List and describe briefly the economic policy objectives of the nation. The nation’s economic policy objectives are four-fold, as follows: a. Economic growth: This encompasses not only growth of total output but also growth on a per capita basis. b. High and stable levels of employment: It is a stated objective of the government to promote stability of employment and production at levels close to the nation’s total potential. c. Price stability: Inflation causes inequities and discourages investment. Consistently stable prices help create an environment in which the other economic objectives are achieved more easily. d. International financial equilibrium: The increasing importance of international trade and of the flow of funds in the international capital markets imposes a strong incentive for maintaining international financial equilibrium. 2. Describe the relationship between policy makers, types of policies, and policy objectives. As indicated in Figure 5.1 of the textbook, there are multiple policy makers, types of policies, and policy objectives. The sequence, of course, is for policy makers to make decisions to achieve objectives. More specifically, certain policy makers have special responsibility for certain types of decisions. For example, the Federal Reserve System has primary responsibility for monetary policy. Yet policy makers are subject to influence by other policy makers in the exercise of their duties. For example, it is well known that the President, the Congress, and the Treasury all impose considerable pressure on the Federal Reserve authorities. 3. Describe the effects of tax policy on monetary and credit conditions. Tax policy of the federal government has a direct effect on monetary and credit conditions through its influence on the volume of savings and funds available for investment. Further, tax policy, as it relates to corporate activity, has a direct relationship to the demands for funds in the capital markets and in turn the supply of funds for short-term investment in government bonds. 4. Federal government deficit financing may have a very great influence on monetary and credit conditions. Explain. Budgetary deficits result in government competition for private funds. At times when credit demands are great, private borrowers may be crowded out. At times when credit demands are slack, deficits may simply result in putting idle bank reserves to work. When deficits are so large that the private sector cannot absorb them, the Fed may create credit by purchasing government obligations, leading to the possibility of rising inflation. 5. Discuss the various objectives of debt management. Although it has been argued that the Treasury should conduct its debt management activities in such a way as to provide a dynamic influence on the economy, it has, in fact, been largely content to play as neutral a role as possible and to limit its influence to encouraging orderly growth and stability. Other objectives include holding down interest costs, maintaining stable government securities markets, and accommodating individuals’ investment needs by tailoring securities to meet them. 6. Explain how Federal Reserve notes are supported or backed in our financial system. Federal Reserve notes are backed or supported by: (a) gold certificates; (b) Special Drawing Rights (SDRs), which represent a form of reserve asset or “paper gold” created by the International Monetary Fund; (c) eligible paper (business notes and drafts); and (d) United States government and agency securities. Today, U.S. government securities represent the primary source of backing for Federal Reserve notes. Gold certificates, which reflect the stock of U.S. gold holdings, represent a much smaller secondary support or backing. 7. Why are the expansion and contraction of deposits by the banking system possible in our financial system? The expansion and contraction of deposits is possible in the United States because our banking system utilizes or operates under a “fractional reserve” system. This means that banks and other depository institutions are required to hold reserves equal to some portion or fraction of their deposits rather than on a dollar-for-dollar basis. The process of deposit expansion and contraction takes place as a result of the operations of the whole banking system, but it arises out of the independent transactions of individual banks or other depository institutions. 8. Trace the effect on its accounts of a loan made by a bank that has excess reserves available from new deposits. Assets Liabilities Reserves $10,000 Deposits $10,000 Loan of $8,000 and required reserves = 20%. Assets Liabilities Reserves $10,000 Deposits $18,000 Loans 8,000 A check for $8,000 is written against the deposit arising out of the loan. Assets Liabilities Reserves $2,000 Deposits $10,000 Loans 8,000 9. Explain how deposit expansion takes place in a banking system consisting of two banks. We describe in the Finance text the process of deposit expansion involving bank loans. It is assumed, of course, that this is a “closed” banking system; that is, loans made by one bank will come back as deposits in either of the two banks in the two-bank system. For example, a derivative deposit arising out of a loan from the first bank is transferred by check to the second bank (or possibly even the first bank) where it is received as a primary deposit, and so on. 10. Explain the potential for deposit expansion when required reserves average 10 percent and $2,000 in excess reserves are deposited in the banking system. The potential for deposit expansion would be determined by dividing the dollar amount of initial excess reserves by the reserve requirement percentage. In this example, we divide $2,000 by .10, which would result in a deposit expansion limit of $20,000. The total amount of deposits can increase 10 times the original deposit. The original new deposit ($2,000) becomes required reserves, and loans which can be made equal nine times the initial reserves that were provided. 11. Trace the effect on bank reserves of a change in the amount of cash held by the public. A decrease in the amount of cash held by the public increases bank reserves; an increase in cash decreases bank reserves. The effects on an individual bank and its Federal Reserve Bank are summarized in the text. 12. Describe the effect on bank reserves when the Federal Reserve sells U.S. government securities to a bank. When the Federal Reserve sells U.S. government securities, the result is a decrease in bank reserves. A check is written on a bank to pay for the purchase of the securities. Deposits in the bank are decreased and deposits held by the bank at its Reserve Bank are also decreased. The transactions would be just the opposite of those presented in the text. 13. Summarize the factors that can lead to a change in bank reserves. The factors that can lead to a change in bank reserves are shown in Figure 5.2 and may be summarized as follows: a. Nonbank public (change in the nonbank public’s demand for currency to be held outside the banking system) b. Federal Reserve System (open market operations and changes in: reserve requirements, bank borrowings, float, foreign deposits held in Federal Reserve Banks, and other Federal Reserve accounts) c. United States Treasury (changes in Treasury expenditures out of accounts held at Federal Reserve Banks, and changes in Treasury cash holdings) 14. What is the difference between the monetary base and total bank reserves? Total bank reserves consist of bank and other depository institution deposits held in Federal Reserve Banks plus vault cash or currency held by banks and other depository institutions. In contrast, the monetary base consists of bank reserves (as previously defined) plus currency held by the nonbank public. Thus, the monetary base adds a basic component of the money supply to the bank reserves definition. 15. Briefly describe what is meant by the money multiplier and indicate the factors that affect its magnitude or size. The money multiplier times the monetary base produces the Ml definition of the money supply. The money multiplier represents the multiple extent to which a given monetary base can support a larger money supply or stock. The size of the money multiplier is affected by: (a) the ratio of currency held by the nonbank public to checkable deposits; (b) the ratio of bank reserves to total deposits; (c) the ratio of noncheckable deposits to checkable deposits; and (d) the ratio of government deposits to checkable deposits. 16. Define the velocity of money and explain why it is important to anticipate changes in money velocity. The velocity of money measures the rate of circulation of the money supply expressed as the average number of times each dollar is spent on purchases of goods and services and is calculated as nominal GDP divided by Ml. Changes in money velocity affect the growth rate in real economic activity and the rate of inflation. 17. Why does it seem to be important to regulate and control the supply of money? Changes in money supply have been found to lead to changes in economic activity in the past. Rapid Ml growth has sometimes been offset by a decline in the velocity of money with the result being moderate economic growth with relatively low inflation. Monetary policy making by the Federal Reserve needs to take into consideration both money supply growth targets and possible changes in velocity in order to achieve future desired effects on real GDP and inflation. EXERCISES AND ANSWERS 1. Go to the St. Louis Federal Reserve Bank’s website at http://www.stlouisfed.org, and access current economic data. a. Find M1 and the monetary base, and then estimate the money multiplier. The instructor will need to periodically update the money supply (M1) and monetary base (MB) amounts, and calculate the money multiplier (M1/MB). Determine the nominal gross domestic (formally national) product (GDP in current dollars). Estimate the velocity of money using M1 from (a) and nominal GDP. The instructor will need to periodically update the GDP (in current dollars) and the money supply (M1) amounts, and calculate the money velocity (GNP/M1). c. Indicate how the money multiplier and the velocity of money have changed between two recent years. The instructor, based on updated calculation in (a) and (b), will need to identify the extent to which changes in the money multiplier and/or the velocity of money have changed. IMPORTANT POLICY OBJECTIVES OF THE FEDERAL GOVERNMENT INCLUDE ECONOMIC GROWTH, HIGH EMPLOYMENT, PRICE STABILITY, AND A BALANCE IN INTERNATIONAL TRANSACTIONS. THE ACHIEVEMENT OF THESE OBJECTIVES IS THE RESPONSIBILITY OF MONETARY POLICY, FISCAL POLICY, AND DEBT MANAGEMENT CARRIED OUT BY THE FEDERAL RESERVE SYSTEM, THE PRESIDENT, THE CONGRESS, AND THE U.S. TREASURY. DESCRIBE THE RESPONSIBILITIES OF THE VARIOUS POLICY MAKERS IN TRYING TO ACHIEVE THE FOUR ECONOMIC POLICY OBJECTIVES. THE PRESIDENT OF THE UNITED STATES ALONG WITH HIS ADVISORS FORMULATES FISCAL POLICY. CONGRESS ENACTS LEGISLATION TO IMPLEMENT FISCAL POLICY (AFTER EXERCISING ITS AUTHORITY MODIFY THE POLICY). THE FED HAS PRIMARY RESPONSIBILITY FOR MONETARY POLICY, WHILE THE TREASURY HANDLES DEBT MANAGEMENT. 3. An economic recession has developed and the Federal Reserve Board has taken several actions to retard further declines in economic activity. The U.S. Treasury now wishes to take steps to assist the Fed in this effort. Describe the actions the Treasury might take. Although the U.S. Treasury usually leaves monetary policy to the Fed, it can lend some influence. To assist the Fed in easing monetary conditions, the Treasury would probably roll over maturing debt with short-term obligations. In so doing it would not draw funds from the public sector that might flow into capital investment by business. In addition, the Treasury could draw down its accounts at Federal Reserve Banks. This would have the effect of increasing the reserves of the banking system since Treasury disbursements would exceed the Tax and Loan Account funds coming into Federal Reserve Banks. 4. The president and members of Congress are elected by the people and are expected to behave ethically. Let’s assume that you are a recently elected member of Congress. A special-interest lobbying group is offering to contribute funds to your next election campaign in the hope that you will support legislation being proposed by others that will help the group achieve its stated objectives. What would you do? Congress people and others often are faced with such a dilemma. One the one hand funding raising is a necessary part of running for Congress. On the other hand, donors often would like something in return for their donations. It is not wrong to support legislation that you believe is fair and honest and represents consistent ethical behavior on your part. Of course, it is important to separate donor gifts from influencing your decision. If donors are also behaving ethically, they should expect that your decision whether or not to support a specific legislative proposal should be the best, ethically-based decision that you can make—any not one that is influenced by support from a special-interest lobbying group. PROBLEMS and answers 1. Assume that Banc One receives a primary deposit of $1 million. The bank must keep reserves of 20 percent against its deposits. Prepare a simple balance sheet of assets and liabilities for Banc One immediately after the deposit is received. ASSETS LIABILITIES Reserves $1 million Deposits $1 million 2. Assume that Bank A receives a primary deposit of $100,000 and that it must keep reserves of 10 percent against deposits. a. Prepare a simple balance sheet of assets and liabilities for the bank immediately after the deposit is received. ASSETS LIABILITIES Reserves $100,000 Deposits $100,000 b. Assume Bank A makes a loan in the amount that can be “safely lent.” Show what the bank’s balance sheet of assets and liabilities would look like immediately after the loan. ASSETS LIABILITIES Reserves $100,000 Deposits $190,000 Loans $90,000 c. Now assume that a check in the amount of the “derivative deposit” created in Part b was written and sent to another bank. Show what Bank A’s (the lending bank’s) balance sheet of assets and liabilities would look like after the check is written. ASSETS LIABILITIES Reserves $10,000 Deposits $100,000 Loans $90,000 Rework Problem 2 assuming Bank A has reserve requirements that are 15 percent of deposits. a. Prepare a simple balance sheet of assets and liabilities for the bank immediately after the deposit is received. ASSETS LIABILITIES Reserves $100,000 Deposits $100,000 b. Assume Bank A makes a loan in the amount that can be “safely lent.” Show what the bank’s balance sheet of assets and liabilities would look like immediately after the loan. ASSETS LIABILITIES Reserves $100,000 Deposits $185,000 Loans $85,000 c. Now assume that a check in the amount of the “derivative deposit” created in Part b was written and sent to another bank. Show what Bank A’s (the lending bank’s) balance sheet of assets and liabilities would look like after the check is written. ASSETS LIABILITIES Reserves $15,000 Deposits $100,000 Loans $85,000 Assume that there are two banks, A and Z, in the banking system. Bank A receives a primary deposit of $600,000 and it must keep reserves of 12 percent against deposits. Bank A makes a loan in the amount that can be safely lent. a. Show what Bank A’s balance sheet of assets and liabilities would look like immediately after the loan. Bank A: ASSETS LIABILITIES Reserves $600,000 Deposits $1,128,000 Loans $528,000 b. Assume that a check is drawn against the primary deposit made in Bank A and is deposited in Bank Z. Show what the balance sheet of assets and liabilities would look like for each of the two banks after the transaction has taken place. Bank A: ASSETS LIABILITIES Reserves $72,000 Deposits $600,000 Loans $528,000 Bank Z: ASSETS LIABILITIES Reserves $528,000 Deposits $528,000 c. Now assume that Bank Z makes a loan in the amount that can be safely lent against the funds deposited in its bank from the transaction described in Part b. Show what Bank Z’s balance sheet of assets and liabilities would look like after the loan. Bank Z: ASSETS LIABILITIES Reserves $528,000 Deposits $992,640 Loans $464,640 5. The SIMPLEX financial system is characterized by a required reserves ratio of 11 percent; initial excess reserves are $1 million; and there are no currency or other leakages. a. What would be the maximum amount of checkable deposits after deposit expansion and what would be the money multiplier? Maximum deposit expansion: $1,000,000/.11 = $9,090,909 Money multiplier: 1/.11 = 9.091 = 9.1 (rounded) b. How would your answer in (a) change if the reserve requirement had been 9 percent? Maximum expansion for a 9% reserve requirement: $1,000,000/.09 = $11,111,111 Money multiplier for a 9% reserve requirement: 1/.09 = 11.111 = 11.1 (rounded) Assume a financial system has a monetary base of $25 million. The required reserves ratio is 10 percent and there are no leakages in the system. a. What is the size of the money multiplier? Money multiplier: 1/.10 = 10.0 What will be the system’s money supply? Money supply: $25 million × 10.0 = $250 million Rework Problem 6 assuming the reserve ratio is 14 percent. Money multiplier for a 14% reserve requirement: 1/.14 = 7.143 = 7.1 (rounded) Money supply: $25 million × 7.1 = $177.5 million Note: This problem assumes that no currency is held by the public. 8. The BASIC financial system has a required reserves ratio of 15 percent, initial excess reserves are $5 million, cash held by the public is $1 million and is expected to stay at that level, and there are no other leakages or adjustments in the system. What would be the money multiplier and the maximum amount of checkable deposits? Money multiplier: 1/.15 = 6.667 or 6.7 (rounded), or Money multiplier (m) = (1 + .00)/[.15(1 + .00 + .00) + .00] = 1/.15 = 6.667 = 6.7 (rounded) Maximum checkable deposits: $5 million x 6.667 = $33,335,000; or if m is rounded, $5 million x 6.7 = $33,500,000 What would be the money supply amount in this system after deposit expansion? Money supply = Checkable deposits plus cash held by the public = $33,335,000 + $1,000,000 = $34,335,000 If m is rounded, money supply = $33,500,000 + $1,000,000 = $34,500,000 Rework Problem 8, assuming that the cash held by the public drops to $500,000 with an equal amount becoming excess reserves and the required reserves ratio drops to 12 percent. Excess reserves = $5 million + $.5 million = $5.5 million Money multiplier = 1/.12 = 8.333 or 8.3 (rounded) Maximum checkable deposits: $5.5 million x 8.333 = $45,831,500 Money supply = $45,831,500 + $500,000 = $46,331,500 Using an m of 8.3 gives: ($5.5 million x 8.3) + $.5 million = $46,150,000 The COMPLEX financial system has these relationships: the ratio of reserves to total deposits is 12 percent and the ratio of noncheckable deposits to checkable deposits is 40 percent. In addition, currency held by the nonbank public amounts to 15 percent of checkable deposits. The ratio of government deposits to checkable deposits is 8 percent, and the monetary base is $300 million. a. Determine the size of the M1 money multiplier and the size of the money supply. Money multiplier (m): m = (1 + k)/[r(1 + t + g)k] = (1 + .15)/[.12(1 + .40 + .08) + .15] = 1.15/.328 = 3.506 = 3.5 (rounded) Money supply (M1) = Monetary base × Money multiplier (m) Money supply: $300 million × 3.5 = $1.05 billion b. If the ratio of currency in circulation to checkable deposits were to drop to 13 percent, what would be the impact on the money supply? Money multiplier (m): (1 + .13)/[.12(1 + .40 + .08) + .13] = 1.13/.308 = 3.669 = 3.7 (rounded) Money supply: $300 million × 3.7 = $1.11 billion The money supply increases by $.06 billion ($1.11 billion versus $1.05 billion). If the ratio of government deposits to checkable deposits increases to 10 percent while the other ratios remained the same, what would be the impact on the money supply? Money multiplier (m): (1 + .13)/[.12(1 + .40 + .08) + .13] = 1.13/.308 = 3.669 = 3.7 (rounded) Money supply: $300 million × 3.7 = $1.11 billion The money supply increases by $.06 billion ($1.11 billion versus $1.05 billion). d. What would happen to the money supply if the reserve requirement increased to 14 percent while noncheckable deposits to checkable deposits fell to 35 percent? Assume the other ratios remain as originally stated. Money multiplier (m): (1 + .15)/[.14(1 + .35 + .08) + .15] = 1.15/.350 = 3.286 = 3.3 (rounded) Money supply: $300 million × 3.3 = $990 million (or $.990 billion) The money supply decreases by $.15 billion ($1.05 billion versus $.990 billion). Challenge Problem ABBIX has a complex financial system with the following relationships. The ratio of required reserves to total deposits is 15 percent, and the ratio of noncheckable deposits to checkable deposits is 40 percent. In addition, currency held by the nonbank public amounts to 20 percent of checkable deposits. The ratio of government deposits to checkable deposits is 8 percent and the initial reserves are $900 million. a. Determine the M1 multiplier and the maximum dollar amount of checkable deposits. Money Multiplier and Deposit Expansion Money multiplier (m) = (1 + .20)/[.15(1 + .40 + .08) + .20] = 1.20/.42 = 2.857 = 2.9 (rounded) Checkable deposits = Initial reserves × m = $900 million × 2.9 = $2,610 million or $2.61 billion Determine the size of the M1 money supply. Currency = .20 × $2,610 million = $522 million Money supply (M1) = Currency + Checkable deposits = $522 million + $2,610 million = $3,132 million or $3.132 billion c. What will happen to ABBIX’s money multiplier if the reserve requirement decreases to 10 percent while the ratio of noncheckable deposits to checkable deposits falls to 30 percent? Assume the other ratios remain as originally stated. Money multiplier (m) = (1 + .20)/[.10(1 + .30 + .08) + .20] = 1.20/.338 = 3.550 = 3.5 (rounded) d. Based on the information in (c), estimate the maximum dollar amount of checkable deposits, as well as the size of the M1 money supply. Checkable deposits = Initial reserves × m = $900 million × 3.5 = $3,150 million or $3.15 billion Currency = .20 × $3,150 million = $630 million Money supply (M1) = $630 million + $3,150 million = $3,780 million or $3.78 billion e. Assume that ABBIX has a target M1 money supply of $2.8 billion. The only variable that you have direct control over is the required reserves ratio. What would the required reserves ratio have to be to reach the target M1 money supply amount? Assume the other original ratio relationships hold. Target money supply: $2.8 billion Target checkable deposits = money supply – currency = $2.8 million - $630 million = $2.17 billion Target money multiplier: $2.17 billion/$.9 billion = 2.411 or 2.4 (rounded) Money multiplier (m) = (1 + .20)/[r(1 + .40 + .08) + .20] = 1.2/x = 2.4 Let x = the denominator = 1.2/2.4 = .50 .50 = [r(1 + .40 +.08) + .20] Required reserves ratio = .50 - .20 – r(1.48) = .30/1.48 = r = .20 Check: m = (1 + .20)/[.20(1 + .40 + .08) + .20] = 1.2/.50 = 2.4 Checkable deposits = $.9 billion x 2.4 = $2.16 billion Money supply = $.63 billion + $2.16 billion = $2.79 billion or $2.8 billion (rounded) f. Now assume that currency held by the nonbank public drops to 15 percent of checkable deposits and that ABBIX’s target money supply is changed to $3.0 billion. What would the required reserves ratio have to be to reach the new target M1 money supply amount? Assume the other original ratio relationships hold. Target money supply: $2.8 billion Target checkable deposits = money supply – currency = $3.0 million - $630 million = $2.37 billion Target money multiplier: $2.37 billion/$.9 billion = 2.633 or 2.6 (rounded) Money multiplier (m) = (1 + .15)/[r(1 + .40 + .08) + .15] = 1.15/x = 2.6 Let x = the denominator = 1.15/2.6 = .44 .44 = [r(1 + .40 +.08) + .15] Required reserves ratio = .44 - .15 – r(1.48) = .29/1.48 = r = .20 Check: m = (1 + .15)/[.20(1 + .40 + .08) + .15] = 1.15/.44 = 2.6 Checkable deposits = $.9 billion x 2.6 = $2.34 billion Money supply = $.63 billion + $2.34 billion = $2.97 billion or $3.0 billion (rounded) SUGGESTED QUIZ 1. Define or discuss briefly: a. National economic policy objectives b. Total reserves c. Types of transactions that affect bank reserves d. Monetary base e. Money multiplier 2. Develop a table showing the multiplying capacity in five rounds of a new primary deposit of $1,000 with 10 percent required reserves. Solution: Multiplying Capacity of Money in Bank Transactions Amount Amount Amount for Transaction Deposited Lent Reserves 1 $1,000.00 $ 900.00 $100.00 2 900.00 810.00 90.00 3 810.00 729.00 81.00 4 729.00 656.10 72.90 5 656.10 590.49 65.61 Totals $4,095.10 $ 3,685.59 $409.51 3. Determine the size of the money multiplier when: the ratio of reserves to total deposits is 10 percent; the ratio of noncheckable deposits to checkable deposits is 30 percent; currency held by the nonbank public is 20 percent of checkable deposits; and the ratio of government deposits to checkable deposits is 10 percent. Also determine the money supply if the monetary base is $10 million. Solution: Money multiplier = (1 + .20)/[.10(1 + .30 + .10) + .20] = 1.20/.340 = 3.529 = 3.5 (rounded) Money supply = $10 million × 3.529 = $35.29 million [Or, if the rounded money multiplier is used: $10 million × 3.5 = $35 million] 4. Discuss the importance of managing the U.S. Treasury’s cash balances in maintaining stable monetary conditions. 5. Describe the techniques used by the Treasury in managing the debt to help achieve an economic climate which would encourage orderly growth and stability. Chapter 6 International Finance and Trade CHAPTER PREVIEW Today it is not possible for a developed country to operate in isolation from other countries. Financial capital flows freely from country to country depending on interest rates, inflation, and political stability. Individuals want to be able to purchase goods and services at the lowest prices for a given quality wherever in the world where the goods and services are available. This chapter begins with a discussion of international transactions from the perspective of currency exchange rate relationships between countries. We then turn our attention to the management of foreign exchange exposure by businesses. This is followed by a discussion of how international trade is financed both by exporters and importers. We also discuss how international trade is encouraged and stimulated. Our final focus is on the characteristics of and the difficulty in achieving a balance in international payments. LEARNING OBJECTIVES Explain how the international monetary system evolved and how it operates today. Describe the efforts undertaken to achieve economic unification of Europe. Describe how currency or foreign exchange markets are organized and operate. Explain how currency exchange rates are quoted. Describe the factors that affect currency exchange rates. Describe how the world banking systems facilitate financing of sales by exporters and purchases by importers. Identify recent developments in the U.S. balance of payments. CHAPTER OUTLINE I. GLOBAL OR INTERNATIONAL mONETARY SYSTEM DEVELOPMENT OF INTERNATIONAL FINANCE HOW THE INTERNATIONAL MONETARY SYSTEM EVOLVED BEFORE WORLD WAR I WORLD WAR I THROUGH WORLD WAR II: 1915-1944 BRETTON WOODS FIXED EXCHANGE RATE SYSTEM: 1945-1972 FLEXIBLE EXCHANGE RATE SYSTEM: 1973--PRESENT II. EUROPEAN UNIFICATION EUROPEAN UNION EUROPEAN MONETARY UNION THE EURO III. CURRENCY EXCHANGE MARKETS AND RATES CURRENCY EXCHANGE MARKETS EXCHANGE RATE QUOTATIONS C. Factors that Affect Currency Exchange Rates 1. Supply and Demand Relationships 2. Inflation, Interest Rates, and Other Factors D. Currency Exchange Rate Appreciation and Depreciation E. Arbitrage F. EXCHANGE RATE DEVELOPMENTS FOR THE U.S. DOLLAR IV. CONDUCTING BUSINESS INTERNATIONALLY a. MANAGING FOREIGN EXCHANGE RISK B. ETHICAL CONSIDERATIONS V. FINANCING INTERNATIONAL TRADE A. Financing by the Exporter 1. Sight and Time Drafts 2. Bank Assistance in the Collection of Drafts 3. Financing Through the Exporter’s Bank B. Financing by the Importer 1. Financing Through the Importer’s Bank 2. Importer Bank Financing—An Example C. Bankers’ Acceptances D. Other Aids to International Trade 1. The Export-Import Bank 2. Traveler’s Letter of Credit 3. Traveler’s Checks VI. BALANCE IN INTERNATIONAL TRANSACTIONS GOAL A. Nature of the Problem B. Balance-of-Payments Accounts VIi. SUMMARY LECTURE notes I. GLOBAL OR INTERNATIONAL MONETARY SYSTEM A general discussion of the nature of international trade and finance provides an interesting opening for this material. Most students show interest in the subject and usually there are some who have a career interest in international business. It is easy to develop illustrations of how various nations specialize in the activities best suited for their productive capabilities. Products such as automobiles are manufactured primarily in highly industrialized countries whereas inexpensive plastic toys are generally manufactured in labor intensive countries. Other products also should lend themselves to illustrate the discussion. It can then be emphasized that this vast interchange of the world’s products can only be accomplished with the assistance of an intricate and smoothly operating system of international finance. An international monetary system is designed to foster world trade, manage the flow of financial capital, and determine currency exchange rates. A gold standard exists when currencies of countries are convertible into gold at fixed exchange rates. The Bretton Woods system was formulated in mid-1944 and was an international monetary system in which the U.S. dollars was valued in gold and other exchange rates were pegged to the dollar. An international monetary system based on flexible exchange rates is a system in which currency exchange rates are determined by supply and demand. Today, a large number of countries allow their currencies to float against other currencies. (Use Discussion Questions 1 through 5 here.) EUROPEAN UNIFICATION Efforts to unify the countries of Europe began after World War II. While initial progress was slow there now are 27 members of the European Union (EU) with 13 of the countries joining to form the Economic and Monetary Union of the European Union or European Monetary Union (EMU). These developments have resulted in a major change in the international monetary system. The European Union is an organization established to promote trade and economic development among European countries. Its history can be traced back to 1957 when a treaty was agreed to that established the European Economic Community. This organization became the European Community in 1978 and the Economic Union in 1944. By 1995, there were 15 members of the European Union. Ten more members were added in 2004 and two also were added in 2007 for a total of 27 current members. The European Monetary Union is an organization of European countries that agreed to have a common overall monetary policy and the euro as their common currency. Eleven members initially agreed in 1998 to accept the euro as their new currency. The euro became an official currency on January 1, 1999. However, euro notes and coins were not introduced into circulation until January, 2002. The original eleven members were Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain. Three members of the 15-member EU existing in 1995 (Denmark, Sweden, and the United Kingdom) have not accepted the euro as their common currencies. Greece adopted the euro as its currency in 2001. Then Slovenia joined in 2007, Cyprus and Malta in 2008, and Slovakia in 2009. The current 16 members of the EMU are a sub-set of the 27 current members of the EU. The euro is the official currency of the countries in the European Monetary Union. The euro includes “gates” and “windows” for the front of the bills. Designs of “bridges” are included on the reverse of bills. (Use Discussion Questions 6, 7, and 8 here.) CURRENCY EXCHANGE MARKETS AND RATES Changes in exchange ratios are caused by supply and demand. The U.S. institutions that maintain accounts in foreign banks or have foreign branches attempt to maintain their balances in some appropriate proportion. If the claims on those foreign balances exceed the supply of funds moving into those accounts, the owners of the balances will simply raise the price to customers. This has the effect of both reducing the demand and increasing the supply. Demand decreases because foreign purchases become more expensive and are reduced proportionately. Supply increases as sellers in those foreign markets find their sales benefiting from the higher value of the dollar. The actions of a single financial institution in managing its foreign balances will not alter overall exchange rates, but in the aggregate, if demand exceeds supply or supply exceeds demand the exchange rates will change. The opportunity to take advantage of a disparity in exchange rates exists if quotations differ among the markets. Selling in one market and simultaneously buying in another market would produce a profit with no risk. This is the nature of arbitrage and where the professionals enter the picture. If they detect even small disparities, they take action that quickly eliminates the disparity. Quoted exchange rates differ depending on the form of exchange requested. A banker’s sight draft costs slightly less than a cable order since the sight draft will take days or even weeks before it is deposited and reduces the balance on which it is drawn. A cable order, on the other hand, reduces the balance immediately. A banker’s time draft, payable at a future date, will cost less than either the sight draft or cable order since the reduction in the account will not occur for some time. Student interest in international finance may be developed by having them look up the exchange rates between the dollar and various types of foreign currency in The Wall Street Journal or other financial publications. Samples of various documents used in foreign trade may be obtained from local banks. As an interesting class exercise, have the students take the position of the chief financial officer of a multinational corporation. They can then try to determine how to protect their company’s position against loss in the face of changing exchange rates. (Use Table 6.1 and 6.2, Figures 6.1 and 6.2, and Discussion Questions 9 through 12 here.) CONDUCTING BUSINESS INTERNATIONALLY FIRMS THAT HAVE FOREIGN SALES MUST BE CONCERNED WITH THE STABILITY OF THE GOVERNMENTS AND CHANGING VALUES OF CURRENCY IN THE COUNTRIES IN WHICH THEY DO BUSINESS. WHILE THE CONCEPT OF ACCEPTABLE ETHICAL BEHAVIOR DIFFERS ACROSS CULTURES AND COUNTRIES, TO OFFER “SIDE” PAYMENTS OR BRIBES TO GOVERNMENT OFFICIALS AND OFFICERS TO DO BUSINESS IN A FOREIGN COUNTRY IS MORALLY WRONG. SUCH ACTIONS ALSO MAY BE ILLEGAL UNDER THE FOREIGN CORRUPT PRACTICES ACT. Aside from the relationship of supply and demand, changes in exchange rates may stem from certain circumstances that affect the monetary systems of the various nations. Changes in political leadership, rumors of war, threats of devaluation, and many other factors have an influence on exchange rates. Because of these uncertainties, business activities involving international trade require astute business management. This is especially true of multinational businesses that have personnel responsible for dealing with these matters on a continuing basis. Risk reduction is an important strategic goal for multinational firms. In some cases, management may seize upon opportunities for speculation when conditions seem appropriate. Moving balances from one country to another is the most obvious maneuver to avoid losses that may occur as a result of anticipated changes in exchange rates. Further, a number of sophisticated financial devices such as hedging, futures contracts, and others can be used by managers of international balances. FINANCING INTERNATIONAL TRADE Financing an international transaction may fall upon either the importer or the exporter. In some situations, the credit worthiness of the parties to the transaction may affect the form of financial settlement. The text describes the various instruments that may be used by either exporter or importer. Of special interest is the use of these instruments and of certain financial institutions to limit the possibility of loss due to the failure of one of the parties to the transaction to perform according to contract terms. The special role of the financial institutions in this process should be emphasized. (Use Figures 6.3 through 6.6, and Discussion Questions 13 through 18 here.) To encourage and stimulate foreign trade, the Export-Import Bank was authorized in 1934 and became an independent agency of the government in 1945. The bank obtains its funds from the U.S. Treasury. Its principal activity is lending to foreign firms and governments to make purchases of our equipment, goods, and related services. The Export-Import Bank also aids substantially in the economic development of foreign countries. Emergency credits are provided to assist countries in maintaining the level of U.S. imports when they experience temporary balance-of-payments difficulties. The traveler’s letter of credit is issued by a domestic depository and is addressed to a list of banks abroad. The listed banks agree to purchase upon sight the drafts presented to them by persons displaying the document. This eliminates the dangers of carrying currency and assures that funds will be available when needed at the designated banks abroad. Many students will be familiar with the use of travelers’ checks in this country. They may be used to even greater advantage while traveling abroad. Since travelers’ checks may now be purchased in foreign currency denominations—for example, British pounds—they decrease a traveler’s exposure to fluctuations in exchange rates. (Use Discussion Questions 19 and 20 here.) BALANCE IN INTERNATIONAL TRANSACTIONS GOAL The nations of the world strive to achieve international financial equilibrium by maintaining a balance in their exchange of goods and services. In general, international trade benefits both countries involved in an exchange. Problems arise, however, if exports and imports are out of balance over a period of time. This is a current problem for the U.S. and will undoubtedly continue for a long period of time. Exports are sales to foreigners and represent a source of income to domestic producers. Imports divert money to foreign producers and therefore represent a loss of potential income to domestic producers. When the two are in balance there is no net effect on total income in the economy. However, an increase in exports over imports has an expansionary effect on the economy, as would an increase in investment or government spending. An excess of imports causes contraction. Since different countries use different currencies, the international financial system needs a mechanism for establishing the exchange rates among currencies, and for handling their actual exchange. During long periods in history, exchange rates were fixed by central banking authorities. Since 1973, however, a system of flexible exchange rates has existed. Under this arrangement, exchange rates are determined by supply and demand in the foreign exchange market. Fluctuations in exchange rates affect imports and exports and can thus have an effect on domestic production, incomes, and prices. International financial markets significantly influence domestic interest rates, and vice versa, so that domestic monetary policy still involves inter-national considerations. (Use Discussion Question 21 here.) The U.S. balance-of-payments accounts involves all of its international transactions including foreign investment, private and government grants, expenditures of the U.S. military forces overseas, and many other items in addition to the purchase and sale of goods and services. The single most important element of the balance of payments is the current account balance, which is the net balance of exports and imports of goods and services. A more narrow view considers only the import and export of goods and is termed the merchandise trade balance. It is clear that imports have continued to exceed exports, at an increasing rate, in recent years. The way in which this imbalance between exports and imports is brought into balance in the total picture can be understood by studying Table 6.2. Deficits or surpluses in the current account must be offset by changes in capital flows. That is, the two must be equal except for statistical discrepancies due to measurement errors. The capital account balance includes changes in foreign government and private investment in the U.S. in such forms as bank deposits, government and corporate securities, loans, and direct investment in land and buildings. Similar U.S. government and private investments or holdings in foreign countries are netted against this amount. The final adjusting factor would be a change in U.S. official reserve assets. (Use Table 6.3, and Discussion Questions 22 and 23 here.) DISCUSSION QUESTIONS AND ANSWERS 1. What is the purpose of an international monetary system? An international monetary system is designed to foster world trade, manage the flow of financial capital, and determine currency exchange rates.2. What is meant by the statement that the international monetary system has operated mostly under a “gold standard”? What are the major criticisms associated with being on a gold standard? A gold standard exists when currencies of countries are convertible into gold at fixed exchange rates. Major criticisms of being on a gold standard are: (1) as the volume of world trade increases, the supply of new gold will fail to keep pace, and (2) there is a lack of an international organization to monitor and report on whether countries are deviating from the standard when it is in their own best interests. 2. Describe the Bretton Woods system for setting currency exchange rates. What is meant by “special drawing rights” and how are they used to foster world trade? The Bretton Woods system was formulated in mid-1944 and was an international monetary system in which the U.S. dollars was valued in gold and other exchange rates were pegged to the dollar. Special Drawing Rights is a reserve asset, consisting of a basket of currencies, created by the International Monetary Fund to be used to make international payments involving world trade. 3. What is meant by an international monetary system based on “flexible exchange rates”? An international monetary system based on flexible exchange rates is a system in which currency exchange rates are determined by supply and demand 4. Describe the international monetary system currently in use. Today, a large number of countries allow their currencies to float against other currencies. 5. What is the European Union (EU)? How did it develop? Who are the current members of the EU? The European Union (EU) is an organization established to promote trade and economic development among European countries. Its history can be traced back to 1957 when a treaty was agreed to that established the European Economic Community. This organization became the European Community in 1978 and the Economic Union in 1944. By 1995, there were 15 members of the European Union. Ten more members were added in 2004. Two new members were added in 2007. A listing of all 27 current members is provided in the text. 6. What is the European Monetary Union (EMU)? How does it differ from the EU? Who are the current members of the EMU? The European Monetary Union is an organization of European countries that agreed to have a common overall monetary policy and the euro as their common currency. The twelve members of the EMU are a sub-set of the 27 current members of the EU. In 1995 there were 15 members of the EU. The twelve members that joined the EMU are: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy Luxembourg, Netherlands, Portugal, and Spain. The other three members of the 15-member EU existing in 1995 are Denmark, Sweden, and the United Kingdom have not accepted the euro as their common currencies. In 2004, Slovenia joined both the EU and the EMU bringing the EMU membership up to 13 members. 7. What is the euro? Identify some of its distinguishing characteristics. The euro is the official currency of the twelve countries in the European Monetary Union. The euro includes “gates” and “windows” for the front of the bills. Designs of “bridges” are included on the reverse of bills. The paper currency uses multicolored ink, 3D holographic images, and watermarks, to thwart efforts to easily counterfeit the bills. 8. What are currency or foreign exchange markets? Foreign exchange markets of the world consist of a group of telephone, cable, and electronic systems connecting the major financial centers. As such, these markets cannot be visualized in terms of a specific geographical location. In a very narrow sense, however, a local depository can be considered the relevant foreign exchange market for the individual or business in terms of day-to-day business activity. 9. Explain the role of supply and demand as it relates to the establishment of exchange rates between countries. Exchange rates reflect the forces of supply and demand. In a “free” market in which governmental controls are absent, exchange rates tend to move upward in response to an increase in net demand and vice versa. Demand exists whenever it becomes necessary for an individual or an institution of this country to make a payment to a foreigner. Supply exists when a foreigner must make a payment to this country. 10. Describe the activities and economic role of the arbitrageur in international finance. Arbitrage may be defined as the simultaneous, or nearly simultaneous, purchasing of commodities, securities, or bills of exchange in one market and selling them in another where the price is higher. In international exchange, variations in quotations between countries at any time are quickly brought into alignment through the arbitrage activities of international financiers who buy currency in the market in which the price is low and sell it in the market in which it is high. 11. What is meant by the statement that foreign exchange quotations may be given in terms of sight drafts, cable orders, and time drafts? The cable order costs more than a banker’s sight draft because it reduces the balance of the bank’s foreign deposit almost immediately. Banker’s time drafts cost less than both of these because they involve a reduction in the balance of the foreign branch or correspondent only after a specified period of time. 12. Describe the various ways by which an exporter may finance an international shipment of goods. How may commercial banks assist the exporter in the collection of drafts? Should an exporter have confidence in the foreign customer and be in a position to carry sales to these customers on open book accounts, there is no reason why the arrangement should not operate very much as it operates in domestic trade. There will, of course, be the added complication involved when payment is made in a different currency. Goods may be shipped by using a sight draft, requiring immediate payment, or a time draft, which requires acceptance on the part of the importer and payment at a specified future time. A draft is generally accompanied by an order bill of lading and papers such as insurance receipts. The bill of lading gives title to the goods, and only its holder may claim the merchandise from the transportation company. A New York exporter who is dealing with a foreign importer with whom there has been little relationship in the past may ship goods on the basis of a documentary draft that has been deposited for collection with the local bank. That bank, following the specific instructions set out regarding the manner of collection, then forwards the draft together with the accompanying documents to its correspondent bank in the foreign country involved. The correspondent bank is instructed to hold the documents until payment is made if a sight draft is used, or until acceptance is obtained if a time draft is used. Remittance is made to the exporter when collection is made on the sight draft. 13. How do importers protect themselves against improper delivery of goods when they are required to make payment as they place an order? When the importer is required to make payment with the order but wishes some protection against the failure of the exporter to make shipment in accordance with the provisions of the order, the payment may be sent to a representative bank in the country of the exporter. The bank is instructed not to release payment until certain documents are presented to the bank to confirm shipment of the goods according to the terms of the transaction. 14. Describe the process by which an importing firm may substitute the credit of its bank for its own credit in financing international transactions. The importing firm substitutes the credit of its bank for its own through the use of a commercial letter of credit. The commercial letter of credit may be described as a written statement on the part of the bank to an individual or firm guaranteeing acceptance and payment of a draft up to a specified sum if it is presented to the bank in accordance with the terms of the commercial letter of credit. Figure 6.5 provides an illustration of a commercial letter of credit. 15. How may a bank protect itself after having issued a commercial letter of credit on behalf of a customer? After having issued a commercial letter of credit, the bank, for added protection, may prefer to establish an agency arrangement between the firm and the bank whereby the bank retains title to the merchandise. A trust receipt is utilized to retain title to the goods. Under the trust receipt, as the merchandise is sold, the proceeds from the sale are turned over to the bank until the acceptance has been paid. 16. Describe the costs involved in connection with financing exports through bankers’ acceptances. Two charges are involved in an export transaction based on the bankers’ acceptance. First, the exporter typically permits her or his bank, or a correspondent bank, to hold the acceptance until it is to be presented to the importer’s bank for payment. The exporter’s bank or correspondent bank discounts the acceptance and deposits to the exporter’s account the face of the acceptance less the discount. The exporter, therefore, pays a fee to his or her bank for the privilege of receiving immediate payment from the transaction. Second, a commission charge is paid to the importer’s accepting bank. 17. Describe the ultimate sources of funds for export financing with bankers’ acceptances. How are acceptances acquired for investment by these sources? The ultimate sources of funds for export financing with bankers’ acceptances are primarily foreign central banks and both foreign and domestic commercial banks. Non-financial corporations also play a small role as a source of funds. There are relatively few firms that deal in bankers’ acceptances. These dealers arrange nearly simultaneous exchanges of purchases and sales. 18. Explain the role played by the Export-Import Bank in international trade. Do you consider this bank to be in competition with private lending institutions? The purpose of the Export-Import Bank is to aid in financing and to facilitate exports and imports between the United States and other countries. The bank serves only to supplement regular financial facilities and is not regarded as being in competition with private lending institutions. 19. Commercial letters of credit, traveler’s letters of credit, and traveler’s checks all play an important role in international finance. Distinguish among these three types of instruments. A commercial letter of credit is prepared by a bank and commits the bank to acceptance and payment of a draft or order drawn on it up to a certain amount if the terms of the letter of credit are met. In international trade, such letters of credit are usually issued for a single transaction. The traveler’s letter of credit is similar except the seller of the merchandise to be acquired is not known in advance. The traveler’s letter of credit specifies a series of foreign banks against which the letter of credit may be presented for acceptance. Again, a dollar limit is set for such letters of credit. The traveler’s check is a convenience to individual travelers, although it may serve commercial purposes as well. The traveler’s check is issued by an internationally reputable financial institution, and the accepting party need only confirm the signature of the person presenting the check. These checks are purchased at face value plus a fee and are signed once when purchased and again in the presence of the institution accepting the check. 2 0. Briefly indicate the problems facing the United States in its attempt to maintain international financial equilibrium. After World War II, the United States engaged in a massive program of international aid. This, coupled with large military expenditures, more than offset a favorable U.S. balance of trade (which existed until 1970). Competition in international markets in terms of goods and services is intense, and since 1977 the balance of trade position of the U.S. has become increasingly more negative (i.e., imports exceeding exports). The heavy reliance on imported oil has been another major factor in the ongoing unfavorable balance of trade position. 21. The U.S. international balance-of-payments position is measured in terms of the current account balance. Describe the current account balance and indicate its major components. Also indicate developments in the current account balance since the beginning of the 1990s. The current account balance for 2005 is shown in Table 18.2. It gives U.S. international transactions in terms of receipts and expenditures and, thus, shows the flow of income into and out of the U.S. over a year. The current account balance is comprised of: (a) the merchandise trade balance (merchandise exports minus merchandise imports); (b) the net position of various other goods and services, which include military transactions, investment income, and other service transactions; and (c) other adjustments in the form of remittances, pensions, and other transfers, plus U.S. government grants (excluding military). The balance on goods became increasingly negative as we moved from 1980 through 2005. See the presentation under the “Balance-of-Payments” heading in the chapter. 22. Discuss the meaning of the capital account balance and identify its major components. The capital account balance, except for statistical discrepancies, must exactly offset deficits or surpluses in the current account. That is, changes in investments must be recorded to offset differences between the flow of income into and out of the country. The capital account balance includes: (a) changes in foreign government and private investment in the U.S.; (b) changes in U.S. government and private investments or holdings in foreign countries; and (c) changes in U.S. official reserve assets. The capital account involves changes in terms of bank deposits, the holding of government and corporate securities, investment in plant and equipment, loans, and other liabilities involving international transfers and transactions. U.S. official reserve assets include gold, Special Drawing Rights, the reserve position in the International Monetary Fund, and foreign currency holdings. EXERCISES AND ANSWERS YOU ARE THE OWNER OF A BUSINESS THAT HAS OFFICES AND PRODUCTION FACILITIES IN SEVERAL FOREIGN COUNTRIES. YOUR PRODUCT IS SOLD IN ALL OF THESE COUNTRIES, AND YOU MAINTAIN BANK ACCOUNTS IN THE CITIES IN WHICH YOU HAVE OFFICES. AT PRESENT YOU HAVE SHORT-TERM NOTES OUTSTANDING AT MOST OF THE BANKS WITH WHICH YOU MAINTAIN DEPOSITS. THIS BORROWING IS TO SUPPORT SEASONAL PRODUCTION ACTIVITY. ONE OF THE COUNTRIES IN WHICH YOU HAVE OFFICES IS NOW STRONGLY RUMORED TO BE ON THE POINT OF A DEVALUATION, OR LOWERING, OF THEIR CURRENCY RELATIVE TO THAT OF THE REST OF THE WORLD. WHAT ACTIONS MIGHT THIS RUMOR CAUSE YOU TO TAKE? YOU COULD TRY TO HEDGE AGAINST YOUR FINANCIAL CLAIMS IN THAT COUNTRY LOSING VALUE BY MOVING SOME OF THE FUNDS IN YOUR BANK ACCOUNT TO ANOTHER COUNTRY. IN ANTICIPATION OF MOVING THE FUNDS, YOU COULD TRY TO ACCELERATE THE COLLECTION OF YOUR RECEIVABLES. YOU MIGHT ALSO SLOW DOWN YOUR PAYMENTS ON LIABILITIES WITH THE EXPECTATION OF MOVING FUNDS BACK INTO THE COUNTRY AFTER DEVALUATION, RECEIVING MORE LOCAL FUNDS IN SO DOING. OTHER DEVICES, SUCH AS DEALING IN FUTURES CONTRACTS, MAY ALSO BE AVAILABLE TO YOU. EXPLAIN THE CONCEPT OF “BALANCE” AS IT RELATES TO A NATION’S BALANCE OF PAYMENTS. IN ONE SENSE THERE IS NEVER A PRECISE COUNT THAT ESTABLISHES A BALANCE SINCE IT IS IMPOSSIBLE TO RECORD ALL TRANSACTIONS THAT ENTER INTO THE SCHEDULE. HENCE, AN ITEM REFERRED TO AS STATISTICAL DISCREPANCY SOLVES THAT PROBLEM NICELY. ASIDE FROM THE PRACTICAL MATTER OF COUNTING, HOWEVER, THE SCHEDULE MUST ALWAYS BE IN BALANCE IN A THEORETICAL SENSE. FOR EXAMPLE, WHILE WE CAN HAVE DEFICITS IN OUR CURRENT ACCOUNT BECAUSE OUR EXPORT OF GOODS AND SERVICES ARE LESS THAN OUR IMPORTS, THIS DIFFERENCE MUST BE MADE UP IN ONE OR BOTH OF THE OTHER PARTS OF THE SCHEDULE. IT CAN BE MADE UP BY A REDUCTION IN OUR GOLD RESERVES OR OTHER RESERVE ASSETS, OR WE CAN INCREASE THE AMOUNT THAT WE OWE ABROAD. 3. As an exporter of relatively expensive electronic equipment, you have a substantial investment in the merchandise that you ship. Your foreign importers are typically small- or medium-size firms without a long history of operations. Although your terms of sales require payment upon receipt of the merchandise, you are concerned about the possible problem of nonpayment and the need to reclaim merchandise that you have shipped. How might the banking system assist and protect you in this situation? As an exporter shipping merchandise to a little-known foreign customer, you can protect yourself by forwarding certain documents to a bank in the town or city of the importer. These documents provide for the foreign bank to release the merchandise at the shipping terminal only when the importer provides the funds specified in the terms of sale. The funds are then forwarded to you by the bank. Although you may consult a banking directory to find a bank in the exporter’s community to direct the transaction, it is more efficient to simply ask your banker for such information. Your banker is in a position to not only provide a list of such banks but to identify one that he or she considers the most appropriate. 4. As an importer of merchandise, you depend upon the sale of the merchandise for funds to make payment. Although customary terms of sale are 90 days for this type of merchandise, you are not well known to foreign suppliers because of your recent entry into business. Furthermore, your suppliers require almost immediate payment to meet their own expenses of operations. How might the banking systems of the exporter and importer accommodate your situation? This problem offers an excellent opportunity to describe the important role of banks in international commerce. Before placing your order for merchandise you would obtain from or through your local bank a commercial letter of credit. This letter of credit would spell out the conditions under which the bank would accept a time draft drawn on it by the exporter. Your order for merchandise along with the letter of credit would then be forwarded to the exporter. The exporter can, with confidence, ship the merchandise and submit to his or her bank the time draft to be forwarded to the bank that issued the letter of credit. The exporter’s bank “discounts” the draft, that is, deposits to the exporter’s account the amount of the sale less an interest charge for the 90 days that this draft will be outstanding, (As specified in the problem, terms of sale are customarily 90 days for this type of merchandise.) The exporter’s bank will now forward the draft to the bank that has issued the letter of credit. That bank, after satisfying itself that the merchandise has been shipped according to terms of sale, will “accept” the draft which now becomes a bankers’ acceptance. The bankers’ acceptance may then be returned to the exporter’s bank or it may be sold upon instructions from the exporter’s bank in the open market. If it is held by the exporter’s bank for the 90 days, that bank has financed the transaction. If the draft is sold in the open market, the funds are returned to the exporter’s bank and it is the third-party’s financial interest that has financed the transaction. Sales in the open market are ordinarily made in the country of the bank issuing the letter of credit since the draft will usually sell at a lower interest rate. As the importer, you simply sign a promissory note in favor of the bank that has issued the letter of credit in the amount to which that bank has committed itself, and you receive the documents necessary to claim the merchandise at the transportation terminal. Your sale of the merchandise provides the funds to meet the obligation to the bank under the terms of the promissory note. Your bank then forwards payment to the exporter’s bank when the 90-day bankers’ acceptance matures and is presented for payment. 5. As a speculator in the financial markets, you notice that for the last few minutes Swiss Francs are being quoted in New York at a price of $0.5849 and in Frankfurt at $0.5851. a. Assuming that you have access to international trading facilities, what action might you take? Purchase Swiss Francs in New York at $0.5849 and simultaneously sell Francs in Frankfurt at $0.05851 in order to “lock in” a profit of $0.0002 per Franc. Such an arbitrage activity involving one million Francs would produce a profit of $200,000. b. What would be the effect of your actions and those of other speculators on these exchange rates? The arbitrage actions in Part (a) would cause the Franc prices in New York and in Frankfurt to converge to a “same” new price. 6. You manage the cash for a large multinational industrial enterprise. As a result of credit sales on 90-day payment terms you have a large claim against a customer in Madrid. You have heard rumors of the possible devaluation of the Spanish peseta. What actions, if any, can you take to protect your firm against the consequences of a prospective devaluation? You could hedge against the devaluation of the Spanish peseta by entering into a futures contract (discussed in the Appendix to Chapter 11) for the delivery of an amount of pesetas equal to the value of the credit sales at the existing exchange rate today. 7. Assume, as the loan officer of a commercial bank, one of your customers has asked for a “commercial letter of credit” to enable his firm to import a supply of well-known French wines. This customer has a long record of commercial success yet has large outstanding debts to other creditors. In what way might you accommodate the customer and at the same time establish protection for your bank? The initial step in the process is for your customer (an importer) to substitute your bank’s credit for its own through the use of a letter of credit issued by your bank. You would not issue the letter of credit unless you are satisfied that your customer is in a satisfactory financial condition. The letter of credit is sent to an exporter who draws a draft on your bank for the price of the goods that are being sent to the importer. The draft, shipping documents, etc., are forwarded to you. Once your bank is satisfied that the terms of the letter of credit have been met, your bank accepts the draft which now becomes a bankers’ acceptance. The shipping documents are transferred to your customer who then acquires the goods that have been shipped by the exporter. For your protection, the importer is required to deposit the proceeds from the sale of the goods in its account at your bank until the amount of the bankers’ acceptance has been met. This requirement provides some protection for your bank since funds are recovered as sales are made. 8. For the entire year, the nation’s balance of trade with other nations has been in a substantial deficit position, yet, as always, the overall balance of payments will be in “balance.” Describe the various factors that accomplish this overall balance, in spite of the deficit in the balance of trade. Since the balance of payments must, by definition, always be in balance, any deficit in the balance of trade must be offset by a surplus in the capital account balance. The principal factor in the capital account is the net increase in investments in the U.S. by foreign government and private investors. 9. Assume you are the international vice president of a small U.S.-based manufacturing corporation. You are trying to expand your business in several developing countries. You are also aware that some business practices are considered to be “acceptable” in these countries but not necessarily in the United States. How would your react to the following situations? a. You met yesterday with a government official from one of the countries you would like to make sales in. He said that he could speed up the process for acquiring the necessary licenses for conducting business in his country if you would pay him for his time and effort. What would you do? We know that the concept of what is “acceptable” ethical behavior differs across cultures and countries. In some countries it seems to be acceptable practice for government officials and others to request “side” payments and even bribes as a means for foreign companies being able to do business in these countries. Such actions are morally wrong. Furthermore, with this said, the Foreign Corrupt Practices Act prohibits U.S. firms from bribing foreign officials. Violators of this Act are subject to fines, prison time, and lost reputation. Business-related bribes are both illegal and unethical. b. You are trying to make a major sale of your firm’s products to the government of a foreign country. You have identified the key decision maker. You are considering offering the official a monetary payment if she would recommend buying your firm’s products. What would you do? See the comments for Part A above. c. Your firm has a local office in a developing country where you are trying to increase business opportunities. Representatives from a local crime syndicate have approached you and have offered to provide “local security” in exchange for a monthly payment to them. What would you do? Extortion payments are morally wrong. Furthermore, paying organized criminals is not different from paying corrupt government officials. See the comments for Part A above. PROBLEMS and answers Exchange rate relationships between the U.S. dollar and the euro have been quite volatile. When the euro began trading at the beginning of 1999, it was valued at 1.18 U.S. dollars. By late-2000, a euro was worth only $.82. However, by mid-2008, a value of a euro reached $1.55. Calculate the percentage changes in the value of a euro from its initial value to its late-2000 value and to its high mid-2008 value. Beg.-1999 to late-2000 percentage change = (.82 – 1.18)/1.18 = -.36/1.18 = -.3051 or -30.51% Beg.-1999 to mid-2008 percentage change = (1.55 – 1.18)/1.18 = .37/1.18 = .3136 or 31.36% Late-2000 to mid-2008 percentage change = (1.55 - .82)/.82 = .73/.82 = .8902 or 89.02% In mid-March 2007, the U.S. dollar equivalent of a euro was $1.3310. In mid-July 2009, the U.S. dollar equivalent of a euro was $1.4116. Using the indirect quotation method, determine the currency per U.S. dollar for each of these dates. Mid-March 2007: Indirect Quotation = 1/$1.3310 = .7513 euros Mid-July 2009: Indirect Quotation = 1/$1.4116 = .7084 euros In mid-March 2007, the U.S. dollar equivalent of a euro was $1.3310. In mid-July 2009, the U.S. dollar equivalent of a euro was $1.4116. Determine the percentage change of the euro between these two dates. Percentage change = (1.4116 – 1.3310)/1.3310 = .0806/1.3310 = .0606 or 6.06% Three years ago the U.S. dollar equivalent of a foreign currency was $1.2167. Today, the U.S. dollar equivalent of a foreign currency is $1.3310. Using the indirect quotation method, determine the currency per U.S. dollar for each of these dates. Three years ago: Indirect Quotation = 1/$1.2167 = .8219 foreign currency Today: Indirect Quotation = 1/$1.3310 = .7513 foreign currency Three years ago the U.S. dollar equivalent of a foreign currency was $1.2167. Today, the U.S. dollar equivalent of a foreign currency is $1.3310. Determine the percentage change of the euro between these two dates. Percentage change = (1.3310 – 1.2167)/1.267 = .1143/1.2167 = .0939 or 9.39% The foreign currency has appreciated by 9.4% relative to the U.S. dollar. If the U.S dollar value of a British Pound is $1.95 and a euro is $1.55, calculate the implied value of a euro in terms of a British Pound. Implied value of a euro = 1.55/1.95 = .7949 British pounds 7. Assume a U.S. dollar is worth 10.38 Mexican Pesos and .64 euros. Calculate the implied value of a Mexican Peso in terms of a euro. Implied value of a Mexican Peso = .64/10.38 = .0617 euros 8. Assume that five years a euro was trading at a direct method quotation of $.8767. Also assume that recently the indirect method quotation was .8219 euros per U.S. dollar. a. Calculate euro “currency per U.S. dollar” five years ago. 1/$.8767 = 1.1406 euros b. Calculate the “U.S. dollar equivalent” of a euro this year. 1/.8219 = $1.2167 c. Determine the percentage change (appreciation or depreciation) of the U.S. dollar value of one euro between five years ago and this year. % Euro Change = ($1.2167 - $.8767)/$.8767 = $.3400/$.8767 = 38.78% d. Determine the percentage change (appreciation or depreciation) of the U.S. dollar value of the euro currency per U.S. dollar between five years ago and this year. (1.1406 - .8219)/.8219 = .3187/.8219 = 38.78% 9. Assume that last year the Australian dollar was trading at $.5527, the Mexican peso at $.1102, and the United Kingdom (British) pound was worth $1.4233. By this year the U.S. dollar value of an Australian dollar was $.7056, the Mexican peso at $.0867, and the British pound was $1.8203. Calculate the percentage appreciation or depreciation of each of these three currencies between last year and this year. Australian dollar: ($.7056 - $.5527)/$.5527 = $.1529/$.5527 = 27.7% Mexican peso: ($.0867 - $.1102)/$.1102 = -$.0235/$.1102 = -21.3% British pound: ($1.8203 - $1.4233)/$1.4233 = $.3970/$1.4233 = 27.9% 10. Assume that the Danish krone (DK) has a current dollar ($US) value of $0.18. a. Determine the number of DK that can be purchased with one $US. $1.00/$0.18 = 5.556 Danish krone (DK) per one $US b. Calculate the percentage change (appreciation or depreciation) in the Danish krone if it falls to $0.16. ($0.16 – $0.18)/$0.18 = –$0.02/$0.18 = –11.1% c. Calculate the percentage change (appreciation or depreciation) in the U.S. dollar if the DK falls to $0.16. [($1.00/$0.16) – ($1.00/$0.18)]/($1.00/$0.18) = (6.250 – 5.556)/5.556 = .694/5.556 = 12.5% Note: The percentage increase in the U.S. dollar is not the same as the percentage decrease in the DK because the “bases” from which the calculations are made are not the same. 11. Assume the U.S. dollar ($US) value of the Australian dollar is $0.73 while the U.S. dollar value of the Hong Kong dollar is $0.13. a. Determine the number of Australian dollars that can be purchased with one $US. $1.00/$0.73 = 1.370 Australian dollars per one $US b. Determine the number of Hong Kong dollars that can be purchased with one $US. $1.00/$0.13 = 7.692 Hong Kong dollars per one $US c. In $US terms, determine how many Hong Kong dollars can be purchased with one Australian dollar. $0.73/$0.13 = 5.615 Hong Kong dollars per one Australian dollar 12. Assume one U.S. dollar ($US) can currently purchase 1.316 Swiss francs. However, it has been predicted that one $US soon will be exchangeable for 1.450 Swiss francs. a. Calculate the percentage change in the $US if the exchange rate change occurs. (1.450 – 1.316)/1.316 = .134/1.316 = 10.2% b. Determine the dollar value of one Swiss franc at both of the above exchange rates. 1/1.316 = $0.76 1/1.450 = $0.69 c. Calculate the percentage change in the dollar value of one Swiss franc based on the above exchange rates. ($0.69 – $0.76)/$0.76 = –$0.07/$0.76 = –9.2% 13. Assume inflation is expected to be 3 percent in the United States next year compared with 6 percent in Australia. If the U.S. dollar value of an Australian dollar is currently $0.500, what is the expected exchange rate one-year from now based on purchasing power parity? FR1¬ = $0.500[(1.03)/(1.06)] = $0.500(.9717) = $0.486 14. ASSUME INFLATION IS EXPECTED TO BE 8 PERCENT IN NEW ZEALAND NEXT YEAR COMPARED WITH 4 PERCENT IN FRANCE. IF THE NEW ZEALAND DOLLAR VALUE OF A EURO $0.400, WHAT IS THE EXPECTED EXCHANGE RATE ONE-YEAR FROM NOW BASED ON PURCHASING POWER PARITY? FR1¬ = $0.400[(1.08)/(1.04)] = $0.400(1.0385) = $0.415 15. ASSUME THE INTEREST RATE ON A ONE-YEAR U.S. GOVERNMENT DEBT SECURITY IS CURRENTLY 9.5 PERCENT COMPARED WITH A 7.5 PERCENT ON A FOREIGN COUNTRY’S COMPARABLE MATURITY DEBT SECURITY. IF THE U.S. DOLLAR VALUE OF THE FOREIGN COUNTRY’S CURRENCY IS $1.50, WHAT IS THE EXPECTED EXCHANGE RATE ONE YEAR FROM NOW BASED ON INTEREST RATE PARITY? FR1¬ = $1.50[(1.095/1.075)] = $1.50(1.0186) = $1.528 16. ASSUME THE INTEREST RATE IN AUSTRALIA ON ONE-YEAR GOVERNMENT DEBT SECURITIES IS 10 PERCENT AND THE INTEREST RATE ON JAPANESE ONE-YEAR DEBT IS 5 PERCENT. ASSUME THE CURRENT AUSTRALIAN DOLLAR VALUE OF THE JAPANESE YEN IS $0.0200. USING INTEREST RATE PARITY, ESTIMATE THE EXPECTED VALUE OF THE JAPANESE YEN IN TERMS OF AUSTRALIAN DOLLARS ONE-YEAR FROM NOW. FR1¬ = $0.0200[(1.10)/(1.05)] = $0.0200(1.0476) = $0.0210 17. Challenge Problem Following are currency exchange “crossrates” between pairs of major currencies. Currency crossrates include both direct and indirect methods for expressing relative exchange rates. U.S. U.K. Swiss Japanese European Dollar Pound Franc Yen Euro European Monetary Union 1.1406 ? 0.6783 0.0087 --- Japan 130.66 185.98 77.705 --- 114.60 Switzerland 1.6817 2.3936 --- 0.0129 ? United Kingdom ? --- 0.4178 ? 0.6162 United States --- 1.4231 ? 0.0077 0.8767 Fill in the missing exchange rates in the crossrates table. European Union with UKPound = 1/(United Kingdom with Euro) = 1/0.6162 = 1.6228 Switzerland with Euro = 1/(European Union with Sfranc) = 1/0.6783 = 1.4743 United Kingdom with U.S.$ = 1/(United States with UKPound) = 1/1.4231 = .7027 United Kingdom with Yen = 1/(Japan with UKPound) = 1/185.98 = 0.0054 United States with Sfranc = 1/(Switzerland with U.S.$) = 1/1.6817 = .5946 b. If the inflation rate is expected to be 3 percent in the European Union and 4 percent in the United States next year, estimate the forward rate of one euro in U.S. dollars one year from now. FR1 = SR0[(1 + US inflation rate)/(1 + EU inflation rate)] = $.8767(1.04/1.03) = $.8767(1.010) = $.8855 c. If the one-year government interest rate is 6 percent in Japan and 4 percent in the United Kingdom, estimate the amount of Yen that will be needed to purchase one British pound one year from now. Indirect Method: FR1 = SR0[(1 + Japan inflation rate)/(1 + UK inflation rate) = (185.98 Yen)(1.06/1.04) = (185.98 Yen)(1.019) = 189.51 Yen d. Based solely on purchasing power parity, calculate the expected one-year inflation rate in the U.S. if the Swiss inflation rate is expected to be 3.5 percent next year, and the one-year forward rate of a Swiss franc is $.6100. SR0 US$ value of a Sfranc is 1/1.6817 = $.5946 $.6100 = $.5946(x/1.035) x = ($.6100)/($.5946/1.035) = $.6100/$.5745 = 1.062 The expected one-year inflation rate in U.S. would be: 1.062 – 1.0 = .062 or 6.2 % Check: FR¬1 = $.5946(1.062/1.035) = $.5946(1.026) = $.61006 e. Assume the U.S. dollar is expected to depreciate by 15 percent relative to the euro at the end of one-year from now and the interest rate on one-year European union government securities is 5.5 percent. What would be the current U.S. one-year government security interest rate based solely on the use of interest rate parity to forecast forward currency exchange rates. Current Euro value in U.S.$: $.8767 U.S.$ value after depreciation: -0.15 = (x - $.8767)/$.8767 = x = (1 – 0.15)$.8767 = $.7452 Check: Percent Dollar Change: -15.00% = ($.7452 - $.8767)/$.8767 = -.1315/$.8767 = -15.00% $.7452 = $.8767(1.055/x) x = ($.7452)/(1.055/$.8767) = $.7452/1.2034 = .900 The expected one-year U.S. interest rate would be: .900 – 1.00 = -.100 = -10.0% Check: FR1 = $.8767(.900/1.055) = $.8767(.850) = $.7452 Of course it is not reasonable to have a negative one-year interest rate. Thus, interest rate parity can not explain the expected 15% depreciation in the U.S. dollar. SUGGESTED QUIZ 1. Define or discuss briefly: a. Arbitrage in international exchange b. Clean draft c. Commercial letter of credit d. Trust receipt e. The Export-Import Bank f. Balance of trade 2. Briefly describe the European Union (EU) and indicate the founding members. Explain how purchasing power parity (PPP) and interest rate parity (IRP) are used to forecast future or forward currency exchange rates between two countries. 4. List the major components involved in U.S. international transactions as contained in the current account and capital account balances. Solution Manual for Introduction to Finance: Markets, Investments, and Financial Management Ronald W. Melicher, Edgar A. Norton 9780470561072, 9781119560579, 9781119398288
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