ECN606 - Assignment 1

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ECN 606
Oct 18, 2023
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Assignment 1 ECN 606 - International Monetary Economics Winter 2022 Due Date: February 14 th at 9:00 am Note: You must submit a copy of your assignment in Pdf or Docx format no later than the due date and time on D2L Brightspace . Note that 9:01 am is late with a penalty of 10 assignment points. 1. Two countries recently experienced exchange rate crises, but their response was markedly different. First, Russia experienced a dramatic decrease in the value of the Russian ruble relative to the U.S. dollar in 1998. The Russian government responded by suspending payments on foreign debt. Similarly, South Korea experienced a decrease in the value of the won in 1997. In contrast, South Korea did not default on its debt. Why might these two countries have behaved differently in response to their respective crises? What are the benefits of default? What are the drawbacks? [6 Points] Answer: In 1998, the value of the Russian ruble fell precipitously in relation to the US dollar, prompting Russia to postpone further payments on foreign debt due to the start of the crisis, resulting in a threat to sovereign default. Russia is a prominent short-term capital borrower with a long history of sovereign default. Following the financial crisis, Russia's economy began to revive thanks to a cash influx as international oil prices rose from 1999 to 2000, and Russia had a big trade surplus. Because of the depreciation of currency, which resulted in an increase in the price of imported goods, domestic industries profited. Russia's exports were significantly based on commodity sales, so it is susceptible to price changes. Because people were startled that a worldwide power could default, Russia's default caused concerns throughout global markets. Capital management as a result of this collapsed. However, currency depreciation can aid exporters by making it more affordable for international countries to buy their goods and services, reducing the current account deficit. South Korea, on the other hand, had several bankrupt enterprises, which resulted in loans that didn't follow through for institutions that relied largely on short-term international borrowers. They defaulted on their existing debt, causing banks to become bankrupt. As a result, foreign creditors and investors began to withdraw their investments in Korea's stocks market and reduce their loans overall. The Bank of Korea chose to remain anonymous to preserve the worth of the won, resulting in a significant reduction in the country's foreign reserves. North Korea needed a lot of money to start developing its economy again, but it defaulted on a lot of its recently reformed foreign debt as well as owing billions of dollars, making it impossible to pay back their loans. One of the downsides of debt default is that it has a major effect on bond holders and large investors with significant investments. Additionally, it could also have an impact on a country's credit rating.
2. In June 2006, a Korean investor is considering investing in bank deposits in Korea and Japan. The annual interest rate on Korean deposits is 6.25%, versus 3.75% on deposits in Japan. Suppose that the forward rate in June 2006 is equal to won/¥ 8.2 F . In June 2006, the expected exchange rate is 8.25 won/¥. For the remainder of this question, please use the linear approximations for uncovered and covered interest rate parity. The spot exchange rate in June 2006 is won/¥ 8. E [ 6 Points each x 4 = 24 Points] a. Does covered interest parity hold in this example? If so, how do you know? Calculate the expected return in Japanese deposits (denominated in Korean won) in this case. Answer: b. Does uncovered interest parity hold in this example? If so, how do you know? If not, what is the implied risk premium? Which deposits pay a higher expected return? Calculate the return on Japanese deposits (denominated in Korean won) in this case. Answer: c. Suppose the exchange rate in June 2007 is equal to 8.528 won per yen. Calculate the Korean investor's actual return, assuming that he invests in Japanese deposits in June 2006. How do these answers compare with those from (b)? Answer: d. Consider two Korean investors: one uses speculation and the other uses hedging. Based on your previous answers, which one earned a higher return (or smaller loss) on Japanese assets between June 2006 and 2007? Explain briefly why. Answer: 3. This question considers long-run policies in Mexico relative to Canada. Assume that Mexico's money growth rate is currently 4%, and its inflation rate is 2%. Canada's money growth rate is 6%, with a 3.25% inflation rate. The world real interest rate is 0.75%. For the following questions, use the conditions associated with the general monetary model. Treat Mexico as the home country and define the exchange rate as Mexican pesos per Canadian dollar, peso/C$ E . [ 5 Points each x 6 = 30 Points] a. Calculate the growth rate of real income in each country. b. Calculate the nominal interest rate in each country. c. Calculate the expected rate of depreciation in the Mexican peso relative to the Canadian dollar. Is the peso appreciating or depreciating against the Canadian dollar? d. Suppose that Mexico's central bank wants to maintain a fixed exchange rate
against the Canadian dollar. Assuming that nothing in Canada changes, what must the central bank do to achieve this long-run objective? What will the money growth rate for Mexico's money supply make this possible? e. Calculate Mexico's new inflation rate and nominal interest rate after implementing this policy. f. Now, suppose that Canada's inflation rate increases from 3.5% to 5%. What will happen to its inflation rate if Mexico wants to maintain the fixed exchange rate?
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