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FINS5516 International Corporate Finance
Term 2, 2024
Week 1 Reading Guide & Homework Questions
Chapters 1, 3: Multinational Financial Management, International Monetary Systems
Week 1 Readings (Shapiro, 11E)
Chapter 1 – Introduction: Multinational Corporations and Financial Management
1.1 The Rise of the Multinational Corporation
1.2 The Internationalization of Business and Finance
Appendix 1A: The Origins and Consequences of International Trade
Chapter 3 – The International Monetary System
3.1 Alternative Exchange Rate Systems
3.2 A Brief History of the International Monetary System - only content covered in lecture
3.3 The European Monetary System and Monetary Union - only content covered in lecture
3.4 Emerging Market Currency Crises - only content covered in lecture
Note: only content covered in lecture does not imply you can skip these parts of the book – it means
you only have to know the concepts and theories explained in the lectures.
Homework Questions
Chapter 1:
Conceptual Question 1.1, 1.2, 1.7, 1.10
Appendix 1A: Question A2
Chapter 3:
Conceptual Questions 3.1, 3.5, 3.7 Problems 3.1, 3.2
Chapter 1:
1.a. What are the various categories of multinational firms?
ANSWER. Raw materials seekers, market seekers, and cost minimizers.
b. What is the motivation for international expansion of firms within each category?
ANSWER. The raw materials seekers go abroad to exploit the raw materials that can be found there. It just
happens that nature didn't place all natural resources domestically. Market seekers go overseas to produce and
sell in foreign markets. The cost minimizers invest in lower-cost production sites overseas in order to remain
cost competitive both at home and abroad. In all cases, the firms involved recognize that the world is larger than
the home country and provides opportunities to gain additional supplies, sell more products or find lower cost
sources of production.
2.a. How does foreign competition limit the prices that domestic companies can charge and the wages and benefits
that workers can demand?
ANSWER. As domestic producers raise their prices, customers begin substituting less expensive goods and
services supplied by foreign producers. The likelihood of losing sales limits the prices that domestic firms can
charge. Foreign competition also acts to limit the wages and benefits that workers can demand. If workers
demand more money, firms have two choices. Acquiesce in these demands or fight them. Absent foreign
competition, the cost of acquiescence is relatively low, particularly if the industry is unionized. Since all firms will
face the same higher costs, they can cover these higher costs by all of them simultaneously raising their prices
without fear of being undercut or of being placed at a competitive disadvantage relative to their peers. Foreign
competition changes the picture since foreign firms' costs will be unaffected by higher domestic wages and
benefits. If domestic firms give in on wages and benefits, foreign firms will underprice them in the market and
take market share away. In this case, higher domestic costs will put domestic firms at a disadvantage vis-à-vis
their foreign competitors. Recognizing this, domestic firms facing foreign competition are more likely to fight
worker demands for higher wages and benefits.
b. What political solutions can help companies and unions avoid the limitations imposed by foreign
competition?
ANSWER. The classic political solution is protectionism. By limiting foreign competition, either through tariffs or
quotas, companies and workers limit the ability of foreign goods to restrain domestic price increases. The
government can also subsidize domestic firms in competing against foreign firms. These subsidies allow
domestic firms and unions to perpetuate uneconomic work rules, wages, and productions processes.
c. Who pays for these political solutions? Explain.
ANSWER. Consumers pay for protectionism in the form of higher prices for their goods and service, fewer choices,
and lower quality. These consumers include firms that use imports to produce their own goods and services for
sale. Taxpayers pay for subsidies in the form of higher taxes or fewer of the other services provided by
government.
7. A memorandum by Labor Secretary Robert Reich to President Clinton suggests that the government
penalize U.S. companies that invest overseas rather than at home. According to Reich, this kind of
investment hurts exports and destroys well-paying jobs. Comment on this argument.
ANSWER. The assumption underlying Secretary Reich's memo is inconsistent with the empirical evidence.
According to this evidence, U.S. companies that invest abroad tend to expand their exports from the United
States. The jump in exports stems from the fact that by investing abroad, companies are able to expand their
presence in foreign markets as well as protect foreign markets that would otherwise be lost to competitors. This
enables them to sell more product, most of which is made in the United States. In addition, the foreign plants
tend to use components and capital equipment that are mostly made in and exported from U.S. plants.
Penalizing U.S. companies that invest abroad as Secretary Reich suggests would most likely lead to the loss of
foreign markets as well as the additional exports that such markets generate. Such penalties would also reduce
the efficiency of the world economy. After all, there is usually a reason, rooted in sound economic logic, why
MNCs invest abroad.
10. In what ways do financial markets grade government economic policies?
ANSWER. Traders and their customers receive a continuing flow of news from around the world. The
announcement of a new policy leads traders to buy or sell currency, stocks or bonds based on their evaluation
of the effect of that policy on the market. A desirable policy leads them to buy more of the assets favorably
affected by the policy, while a policy that is judged to be harmful leads to sell orders of those assets that will be
hurt by the policy. The result is a continuing global referendum on a nation's economic policies, even before
they are implemented.
Politicians who pursue particular economic policies that they perceive to be beneficial to them (e.g., by
improving their re-election odds), even if these policies harm the national economy, usually don't appreciate
the grades they receive. But the market's judgments are clear-eyed and hard-nosed and will respond negatively
to unsound fiscal and monetary policies. Politicians will not admit that it was their own policies that led to higher
interest rates or lower currency values or stock prices; that would be political suicide. It is much easier to blame
greedy speculators rather than their policies for the market's response.
Appendix.
3. Given the resources available to them, countries A and B can produce the following combinations of steel
and corn.
Country A Country B
Steel (tons) Corn (bushels) Steel (tons) Corn (bushels)
36 0 54 0
30 3 45 9
24 6 36 18
18 9 27 27
12 12 18 36
6 15 9 45
0 18 0 54
a. Do you expect trade to take place between countries A and B? Why?
ANSWER. Yes. Given the data presented, we can see that if country A has 6 units of resources and it devotes X of
these units to steel production, where X is an integer, it can produce a total of 6X tons of steel and 3(6 - X)
bushels of corn Similarly, with 54 units of resources, country B of which it devotes Y units to steel production, it
can produce Y tons of steel plus (54 - Y) bushels of corn. The net effect of these production functions is that one
bushel of corn is worth 2 tons of steel in country A. In contrast, one bushel of corn is worth only one ton of steel
in country B. These relative prices indicate that country A has a comparative advantage in the production of
steel, whereas B has a comparative advantage in the production of corn.
b. Which country will export steel? Which will export corn? Explain.
ANSWER. Given these comparative advantages, A will export steel and B will export corn. The price of corn will
settle somewhere between one and two tons of steel. Suppose it settles at 1.5 tons of steel. Then, instead of
producing, say, 30 tons of steel and 3 bushels of corn, it can devote an additional resource unit to the production
of an additional 6 tons of steel. It can trade these 6 tons of steel with B for 6/1.5 = 4 bushels of corn, leaving it
one bushel of corn better off. Similarly, B can now get 6 tons of steel for the 4 bushels of corn it trades to A
instead of the 4 tons of steel it could produce on its own with the resources it took to produce the 4 bushels of
corn.
Chapter 3:
1. a. What are the five basic mechanisms for establishing exchange rates?
ANSWER. The five basic mechanisms for establishing exchange rates are free float, managed float, target-zone
arrangement, fixed-rate system, and the current hybrid system.
b. How does each work?
ANSWER. In a free float, exchange rates are determined by the interaction of currency supplies and demands.
Under a system of managed floating, governments intervene actively in the foreign exchange market to smooth
out exchange rate fluctuations in order to reduce the economic uncertainty associated with a free float. Under
a target-zone arrangement, countries adjust their national economic policies to maintain their exchange rates
within a specific margin around agreed-upon, fixed central exchange rates. Under a fixed-rate system, such as
the Bretton Woods system, governments are committed to maintaining target exchange rates. Each central bank
actively buys or sells its currency in the foreign exchange market whenever its exchange rate threatens to deviate
from its stated par value by more than an agreed-on percentage. Currently, the international monetary system
is a hybrid system, with major currencies floating on a managed basis, some currencies freely floating, and other
currencies moving in and out of various types of pegged exchange rate relationships.
c. What costs and benefits are associated with each mechanism?
ANSWER.
Benefits of a Floating Rate System. At the time floating rates were adopted in 1973, proponents said that the
new system would reduce economic volatility and facilitate free trade. In particular, floating exchange rates
would offset international differences in inflation rates so that trade, wages, employment, and output would
not have to adjust. High-inflation countries would see their currencies depreciate, allowing their firms to stay
competitive without having to cut wages or employment. At the same time, currency appreciation would not
place firms in low-inflation countries at a competitive disadvantage. Real exchange rates would stabilize, even if
permitted to float in principle, because the underlying conditions affecting trade and the relative productivity of
capital would change only gradually; and if countries would coordinate their monetary policies to achieve a
convergence of inflation rates, then nominal exchange rates would also stabilize. Another benefit is that–as
Milton Friedman points out–with a floating exchange rate, there never has been a foreign exchange crisis. The
reason is simple: The floating rate absorbs the pressures that would otherwise build up in countries that try to
peg the exchange rate while simultaneously pursuing an independent monetary policy. For example, the Asian
currency crisis did not spill over to Australia and New Zealand because the latter countries had floating exchange
rates. A floating rate system can also act as a shock absorber to cushion real economic shocks that change the
equilibrium exchange rate.
Costs of a Floating Rate System. Many economists point to excessive volatility as a major cost of a floating rate
system. The experience to date is that the dollar's ups and downs have had little to do with actual inflation and
a lot to do with expectations of future government policies and economic conditions. Put another way, real
exchange rate volatility has increased, not decreased, since floating began. This instability reflects, in part,
nonmonetary (or real) shocks to the world economy, such as changing oil prices and shifting competitiveness
among countries, but these real shocks were not obviously greater during the 1980s than they were in earlier
periods. Instead, uncertainty over future government policies has increased.
Benefits of a Managed Float. The potential benefit of a managed float is that governments can reduce the
volatility associated with a freely floating exchange rate.
Costs of a Managed Float. The costs of a managed float stem from the demonstrated inability of governments
to recognize the difference between a temporary exchange rate disequilibrium and a permanent one. By trying
to manage exchange rates when a permanent shift in the equilibrium exchange rate has occurred, governments
run the risk of creating an exchange rate crisis and wasting reserves.
Benefits of a Target Zone Arrangement. The experience with the European Monetary System is that the target
zone arrangement in effect forced convergence of monetary policy to that of the country–Germany–with the
most disciplined anti-inflation policy and led to low inflation.
Costs of a Target Zone Arrangement. Maintaining a genuinely stable target zone arrangement requires the
political will to direct fiscal and monetary policies at that goal and not at purely national ones. This turns out to
be difficult for countries to achieve. In the case of the European Monetary System, the result was periodic
currency crises. Another cost of this system is that fundamental changes in the equilibrium exchange rate cannot
get reflected in actual exchange rate changes without a currency crisis occurring.
Benefits of a Fixed Rate System. A permanently fixed exchange rate system–such as that achieved by a currency
board, dollarization, or monetary union–results in currency stability and the absence of currency crises. In a
system such as existed under Bretton Woods, where there is a commitment to a fixed exchange rate system,
but no mechanism to bind that commitment, you will have more monetary discipline than in a freely floating
system and hence lower inflation than might otherwise be the case.
Costs of a Fixed Rate System. In a permanently fixed system, the exchange rate cannot cushion the effects of
real economic shocks, such as devaluation of a major competitor’s currency. Instead, prices must adjust. Given
the lack of flexibility of many prices–because of government regulations or union restrictions–the result of these
economic shocks can be higher unemployment and less economic growth. In a system such as Bretton Woods,
the result of changes in the equilibrium exchange rate will likely be currency crises and eventual devaluation or
revaluation.
Benefits of a Hybrid System. The current system gives countries the option to select the system that best meets
their needs. However, all too often, the decision is based on political rather than economic calculations.
Costs of a Hybrid System. The costs of a hybrid system, such as the one currently in place, is that there is no
constraint on the choices that governments can make. The resulting choices can be good ones or bad ones.
d. Have exchange rate movements under the current system of managed floating been excessive? Explain.
ANSWER. Excessive movements would indicate that there are profits to be earned by betting against the market.
In effect, if currency fluctuations are excessive they would exhibit the phenomenon of overshooting (i.e.,
currency rates would overreact to economic events and then return to equilibrium). There is no evidence that
one could profit by betting that rate movements are excessive.
5. The experiences of fixed exchange-rate systems and target-zone arrangements have not been entirely
satisfactory.
a. What lessons can economists draw from the breakdown of the Bretton Woods system?
ANSWER. Adjusting monetary growth rates is the principal way to stabilize exchange rates. For example, raising
the value of the dollar relative to the yen requires tightening U.S. monetary policy relative to Japanese monetary
policy. The experience of Bretton Woods and similar experiments demonstrates that conscious and explicit
coordination of monetary policies among sovereign authorities is difficult. The problem stems from the inability
of sovereign authorities to coordinate their monetary growth rates. An agreement to stabilize the dollar at, say,
150 yen would be relatively easy if it did not entail interdependent monetary policies, robbing the Federal
Reserve, or the Bank of Japan, or both, of important degrees of monetary freedom.
Both Japan and the United States have their own targets for growth and inflation and their own independent
assessment of the macroeconomic policies required to attain those targets. Except by coincidence, independent
policies and preferences will not mesh at a stable exchange rate. Given clashing preferences, the only
alternatives to the "chaos" of floating are:
(1) One side persuades the other to change its policies;
(2) One side subordinates its policies to those of the other; or
(3) Both sides subordinate their monetary policies to an external mechanism, such as a gold standard.
Absent (3), "international monetary reform" is the search for new ways to implement (1) or (2), or some
combination. We saw that Bretton Woods collapsed because the subordination it entailed was intolerable to
the United State. That is, the United States refused to follow economic policies that would maintain the value
of gold at $35 an ounce. The basic lesson from Bretton Woods, therefore, is that stabilizing exchange rates
requires dependence and subordination, not the freedom for everybody to do their own thing. But instead of
changing policies to stay with the Bretton Woods system, the major countries simply dropped the system.
b. What lessons can economists draw from the exchange rate experiences of the European Monetary System?
ANSWER. Exchange rate stability requires that monetary policies be coordinated and geared towards maintaining
exchange rate parities. The slow progress of the European community with respect to the EMS and policy
coordination exemplifies the difficulties of achieving agreements on the many facets of economic policymaking.
Implementing target zones on a wider scale would be all the more difficult. Differences in preferences, policy
objectives, and economic structures account in part for these difficulties. More fundamentally, however,
coordination of macroeconomic policies will not necessarily benefit all participant countries equally, and those
that benefit the most may not be willing to compensate those that benefit least. In the EMS, Germany is less
inflation-prone than the other members and is reluctant to cooperate at the risk of increasing its inflation rate.
Another lesson is that in target-zone arrangements such as the EMS, a disproportionately large share of the
adjustment burden will fall on the "weak" currency countries. Countries with appreciating currencies, trade
surpluses, and increasing reserves are less prone to adjust than countries with depreciating currencies, trade
deficits, or reserve losses. The convergence of inflation rates among the EMS countries supports this view. An
equal sharing of the adjustment burden implies that inflation rates among member nations would converge to
the average rate.
Germany, however, has maintained a domestic monetary target of low or zero inflation, and often has refused
to alter domestic monetary policy because of exchange rate considerations. Because of Germany's economic
importance, the other member countries have had to adjust their domestic policies or their exchange rates to
remain competitive in international markets. As a result, inflation rates have tended to converge toward
Germany's lower rate.
7. Historically, Spain has had high inflation and has seen its peseta continuously depreciate. In 1989, though,
Spain joined the EMS and pegged the peseta to the DM. According to a Spanish banker, EMS membership
means that "the government has less capability to manage the currency but, on the other hand, the people
are more trusting of the currency for that reason."
a. What underlies the peseta's historical weakness?
ANSWER. Spain has historically pursued an easy monetary policy, with an associated high rate of inflation. High
inflation, in turn, led to continual peseta devaluation.
b. Comment on the banker's statement.
ANSWER. Countries that seek to participate in the EMS are effectively forced to pursue a monetary policy
consistent with that of Germany, which eventually brings down their inflation rates. In effect, control of Spain's
monetary policy has been shifted from Spain's central bank, which has a weak reputation for monetary
discipline, to the much more reputable Bundesbank. Thus, Spaniards now are more trusting of their money.
c. What are the likely consequences of EMS membership on the Spanish public's willingness to save and
invest?
ANSWER. By heightening the prospects for Spanish monetary stability, EMS membership has lowered the risks
associated with holding financial assets in Spain. The result has been to make the Spanish public more willing to
save and invest.
1. During the currency crisis of September 1992, the Bank of England borrowed DM 33 billion from the
Bundesbank when a pound was worth DM 2.78 or $1.912. It sold these DM in the foreign exchange market
for pounds in a futile attempt to prevent a devaluation of the pound. It repaid these DM at the post-crisis
rate of DM 2.50:£1. By then, the dollar:pound exchange rate was $1.782:£1.
a. By what percentage had the pound sterling devalued in the interim against the Deutsche mark? Against the
dollar?
ANSWER. During this period, the pound depreciated by 10.1% against the DM
2.50 − 2.78
= - 10.1%
2.78
and by 6.8% against the dollar
1.782 − 1.912
= - 6.8%
1.912
b. What was the cost of intervention to the Bank of England in pounds? In dollars?
ANSWER. The Bank of England borrowed DM 33 billion and must repay DM 33 billion. When it borrowed these
DM, the DM was worth £0.3597, valuing the loan at £11.87 billion (DM 33 billion x 0.3597). After devaluation,
the DM was worth £0.4000. Hence, the Bank of England's cost of repaying the DM loan was £13.20 billion (DM
33 billion x 0.4), a rise of £1.33 billion. Thus, the cost to the Bank of England of this DM borrowing and
intervention was £1.33 billion.
In dollar terms, intervention cost the Bank of England $825 million. This estimate is based on the difference of
$0.025 between the DM's initial value of $0.6878 (1.912/2.78) and its ending value of $0.7128 (1/2.50) times
the DM 33 billion borrowed and spent defending the pound. Specifically, the cost calculation is $0.025 x
33,000,000,000 = $825 million.
2. Suppose the central rates within the ERM for the French franc and DM are FF 6.90403:ECU 1 and DM
2.05853:ECU 1, respectively.
a. What is the cross-exchange rate between the franc and the mark?
ANSWER. Since things equal to the same thing are equal to each other, we have FF 6.90403 = DM 2.05853. Hence,
FF1 = DM 2.05853/6.90403 = DM 0.298164. Equivalently, DM 1 = FF 6.90403/2.05853 = FF 3.35386.
b. Under the original 2.25% margin on either side of the central rate, what were the approximate upper and
lower intervention limits for France and Germany?
ANSWER. Given the answer to part a, the French franc could rise to approximately DM 0.298b164 x 1.0225 =
DM 0.304872 or fall as far as DM 0.298164 x 0.9775 = DM 0.291455. Similarly, the upper limit for the DM is FF
3.42933 and the lower limit is FF 3.27840.
c. Under the revised 15% margin on either side of the central rate, what are the current approximate upper
and lower intervention limits for France and Germany?
ANSWER. Given the answer to part a, the French franc could rise to approximately DM 0.298164 x 1.15 = DM
0.342888 or fall as far as DM 2.98164 x 0.85 = DM 0.253439. Similarly, the upper limit for the DM is FF 3.85694
and the lower limit is FF 2.85078.
3. Suppose Janghoon has to pay a cost of KRW 10 million at the end of May 2025. Currently, AUD 1 is worth
KRW 900.
a. Knowing that the rate would change to KRW800:AUD1 at the end of May 2025, how much in AUD can he
save by paying the full bill now?
10mil KRW is worth AUD 12.5k (10mil/800) if rate is 800:1, but 11.1 (10mil/900) if the rate is 900:1. He can
save 1.39k by paying the bill now.
b. What if the rate has 50% chance to be KRW800:AUD1 and 50% change to be KRW1000:AUD1, does he
profit from paying the bill early?
Paying now: AUD 11.1k; Paying later: 50%*12.5k+50%*10k=11.25k, still profitable.
c. Janghoon has no saving at the moment, and the interest rates (borrowing and lending) are at 4% in Korea
and 6% in Australia. He earns wage in AUD (has to pay back with AUD). Knowing that the rate would
change to KRW800:AUD1 at the end of May 2025, can he benefit by paying the full bill now borrowing
from a bank?
Pay later: AUD 12.5k (10mil/800)
Pay now with borrowing in Korea: borrow KRW10mil, and pay KRW 1.04 mil a year from now which is at (1:
800), AUD 13k (1.04/800)
Pay now with borrowing in Australia: borrow AUD 11.1k (10mil/900) and pay the bill, it would become
AUD 11.78k (11.1*1.06)
So, he can benefit by paying the bill now borrowing from an Australian bank.
d. Following question c, what if the rate has 50% chance to be KRW800:AUD1 and 50% change to be
KRW1000:AUD1, does he profit from paying the bill early borrowing from a bank? What if Janghoon is
extremely risk-averse? Discuss.
Pay later: 50%*12.5k+50%*10k=11.25k
Pay now with borrowing in Korea: borrow KRW10mil, and pay KRW 1.04 mil a year from now which is
11.7k (50%*(1.04/800)+50%*(1.04/1000))
Pay now with borrowing in Australia: borrow AUD 11.1k (10mil/900) and pay the bill, it would become
AUD 11.78k (11.1*1.06)
So, he can benefit by paying the bill later. However, if he is extremely risk-averse, he might prefer paying
now with borrowings from an Australian bank (no volatility).
Term 2, 2024
Week 1 Reading Guide & Homework Questions
Chapters 1, 3: Multinational Financial Management, International Monetary Systems
Week 1 Readings (Shapiro, 11E)
Chapter 1 – Introduction: Multinational Corporations and Financial Management
1.1 The Rise of the Multinational Corporation
1.2 The Internationalization of Business and Finance
Appendix 1A: The Origins and Consequences of International Trade
Chapter 3 – The International Monetary System
3.1 Alternative Exchange Rate Systems
3.2 A Brief History of the International Monetary System - only content covered in lecture
3.3 The European Monetary System and Monetary Union - only content covered in lecture
3.4 Emerging Market Currency Crises - only content covered in lecture
Note: only content covered in lecture does not imply you can skip these parts of the book – it means
you only have to know the concepts and theories explained in the lectures.
Homework Questions
Chapter 1:
Conceptual Question 1.1, 1.2, 1.7, 1.10
Appendix 1A: Question A2
Chapter 3:
Conceptual Questions 3.1, 3.5, 3.7 Problems 3.1, 3.2
Chapter 1:
1.a. What are the various categories of multinational firms?
ANSWER. Raw materials seekers, market seekers, and cost minimizers.
b. What is the motivation for international expansion of firms within each category?
ANSWER. The raw materials seekers go abroad to exploit the raw materials that can be found there. It just
happens that nature didn't place all natural resources domestically. Market seekers go overseas to produce and
sell in foreign markets. The cost minimizers invest in lower-cost production sites overseas in order to remain
cost competitive both at home and abroad. In all cases, the firms involved recognize that the world is larger than
the home country and provides opportunities to gain additional supplies, sell more products or find lower cost
sources of production.
2.a. How does foreign competition limit the prices that domestic companies can charge and the wages and benefits
that workers can demand?
ANSWER. As domestic producers raise their prices, customers begin substituting less expensive goods and
services supplied by foreign producers. The likelihood of losing sales limits the prices that domestic firms can
charge. Foreign competition also acts to limit the wages and benefits that workers can demand. If workers
demand more money, firms have two choices. Acquiesce in these demands or fight them. Absent foreign
competition, the cost of acquiescence is relatively low, particularly if the industry is unionized. Since all firms will
face the same higher costs, they can cover these higher costs by all of them simultaneously raising their prices
without fear of being undercut or of being placed at a competitive disadvantage relative to their peers. Foreign
competition changes the picture since foreign firms' costs will be unaffected by higher domestic wages and
benefits. If domestic firms give in on wages and benefits, foreign firms will underprice them in the market and
take market share away. In this case, higher domestic costs will put domestic firms at a disadvantage vis-à-vis
their foreign competitors. Recognizing this, domestic firms facing foreign competition are more likely to fight
worker demands for higher wages and benefits.
b. What political solutions can help companies and unions avoid the limitations imposed by foreign
competition?
ANSWER. The classic political solution is protectionism. By limiting foreign competition, either through tariffs or
quotas, companies and workers limit the ability of foreign goods to restrain domestic price increases. The
government can also subsidize domestic firms in competing against foreign firms. These subsidies allow
domestic firms and unions to perpetuate uneconomic work rules, wages, and productions processes.
c. Who pays for these political solutions? Explain.
ANSWER. Consumers pay for protectionism in the form of higher prices for their goods and service, fewer choices,
and lower quality. These consumers include firms that use imports to produce their own goods and services for
sale. Taxpayers pay for subsidies in the form of higher taxes or fewer of the other services provided by
government.
7. A memorandum by Labor Secretary Robert Reich to President Clinton suggests that the government
penalize U.S. companies that invest overseas rather than at home. According to Reich, this kind of
investment hurts exports and destroys well-paying jobs. Comment on this argument.
ANSWER. The assumption underlying Secretary Reich's memo is inconsistent with the empirical evidence.
According to this evidence, U.S. companies that invest abroad tend to expand their exports from the United
States. The jump in exports stems from the fact that by investing abroad, companies are able to expand their
presence in foreign markets as well as protect foreign markets that would otherwise be lost to competitors. This
enables them to sell more product, most of which is made in the United States. In addition, the foreign plants
tend to use components and capital equipment that are mostly made in and exported from U.S. plants.
Penalizing U.S. companies that invest abroad as Secretary Reich suggests would most likely lead to the loss of
foreign markets as well as the additional exports that such markets generate. Such penalties would also reduce
the efficiency of the world economy. After all, there is usually a reason, rooted in sound economic logic, why
MNCs invest abroad.
10. In what ways do financial markets grade government economic policies?
ANSWER. Traders and their customers receive a continuing flow of news from around the world. The
announcement of a new policy leads traders to buy or sell currency, stocks or bonds based on their evaluation
of the effect of that policy on the market. A desirable policy leads them to buy more of the assets favorably
affected by the policy, while a policy that is judged to be harmful leads to sell orders of those assets that will be
hurt by the policy. The result is a continuing global referendum on a nation's economic policies, even before
they are implemented.
Politicians who pursue particular economic policies that they perceive to be beneficial to them (e.g., by
improving their re-election odds), even if these policies harm the national economy, usually don't appreciate
the grades they receive. But the market's judgments are clear-eyed and hard-nosed and will respond negatively
to unsound fiscal and monetary policies. Politicians will not admit that it was their own policies that led to higher
interest rates or lower currency values or stock prices; that would be political suicide. It is much easier to blame
greedy speculators rather than their policies for the market's response.
Appendix.
3. Given the resources available to them, countries A and B can produce the following combinations of steel
and corn.
Country A Country B
Steel (tons) Corn (bushels) Steel (tons) Corn (bushels)
36 0 54 0
30 3 45 9
24 6 36 18
18 9 27 27
12 12 18 36
6 15 9 45
0 18 0 54
a. Do you expect trade to take place between countries A and B? Why?
ANSWER. Yes. Given the data presented, we can see that if country A has 6 units of resources and it devotes X of
these units to steel production, where X is an integer, it can produce a total of 6X tons of steel and 3(6 - X)
bushels of corn Similarly, with 54 units of resources, country B of which it devotes Y units to steel production, it
can produce Y tons of steel plus (54 - Y) bushels of corn. The net effect of these production functions is that one
bushel of corn is worth 2 tons of steel in country A. In contrast, one bushel of corn is worth only one ton of steel
in country B. These relative prices indicate that country A has a comparative advantage in the production of
steel, whereas B has a comparative advantage in the production of corn.
b. Which country will export steel? Which will export corn? Explain.
ANSWER. Given these comparative advantages, A will export steel and B will export corn. The price of corn will
settle somewhere between one and two tons of steel. Suppose it settles at 1.5 tons of steel. Then, instead of
producing, say, 30 tons of steel and 3 bushels of corn, it can devote an additional resource unit to the production
of an additional 6 tons of steel. It can trade these 6 tons of steel with B for 6/1.5 = 4 bushels of corn, leaving it
one bushel of corn better off. Similarly, B can now get 6 tons of steel for the 4 bushels of corn it trades to A
instead of the 4 tons of steel it could produce on its own with the resources it took to produce the 4 bushels of
corn.
Chapter 3:
1. a. What are the five basic mechanisms for establishing exchange rates?
ANSWER. The five basic mechanisms for establishing exchange rates are free float, managed float, target-zone
arrangement, fixed-rate system, and the current hybrid system.
b. How does each work?
ANSWER. In a free float, exchange rates are determined by the interaction of currency supplies and demands.
Under a system of managed floating, governments intervene actively in the foreign exchange market to smooth
out exchange rate fluctuations in order to reduce the economic uncertainty associated with a free float. Under
a target-zone arrangement, countries adjust their national economic policies to maintain their exchange rates
within a specific margin around agreed-upon, fixed central exchange rates. Under a fixed-rate system, such as
the Bretton Woods system, governments are committed to maintaining target exchange rates. Each central bank
actively buys or sells its currency in the foreign exchange market whenever its exchange rate threatens to deviate
from its stated par value by more than an agreed-on percentage. Currently, the international monetary system
is a hybrid system, with major currencies floating on a managed basis, some currencies freely floating, and other
currencies moving in and out of various types of pegged exchange rate relationships.
c. What costs and benefits are associated with each mechanism?
ANSWER.
Benefits of a Floating Rate System. At the time floating rates were adopted in 1973, proponents said that the
new system would reduce economic volatility and facilitate free trade. In particular, floating exchange rates
would offset international differences in inflation rates so that trade, wages, employment, and output would
not have to adjust. High-inflation countries would see their currencies depreciate, allowing their firms to stay
competitive without having to cut wages or employment. At the same time, currency appreciation would not
place firms in low-inflation countries at a competitive disadvantage. Real exchange rates would stabilize, even if
permitted to float in principle, because the underlying conditions affecting trade and the relative productivity of
capital would change only gradually; and if countries would coordinate their monetary policies to achieve a
convergence of inflation rates, then nominal exchange rates would also stabilize. Another benefit is that–as
Milton Friedman points out–with a floating exchange rate, there never has been a foreign exchange crisis. The
reason is simple: The floating rate absorbs the pressures that would otherwise build up in countries that try to
peg the exchange rate while simultaneously pursuing an independent monetary policy. For example, the Asian
currency crisis did not spill over to Australia and New Zealand because the latter countries had floating exchange
rates. A floating rate system can also act as a shock absorber to cushion real economic shocks that change the
equilibrium exchange rate.
Costs of a Floating Rate System. Many economists point to excessive volatility as a major cost of a floating rate
system. The experience to date is that the dollar's ups and downs have had little to do with actual inflation and
a lot to do with expectations of future government policies and economic conditions. Put another way, real
exchange rate volatility has increased, not decreased, since floating began. This instability reflects, in part,
nonmonetary (or real) shocks to the world economy, such as changing oil prices and shifting competitiveness
among countries, but these real shocks were not obviously greater during the 1980s than they were in earlier
periods. Instead, uncertainty over future government policies has increased.
Benefits of a Managed Float. The potential benefit of a managed float is that governments can reduce the
volatility associated with a freely floating exchange rate.
Costs of a Managed Float. The costs of a managed float stem from the demonstrated inability of governments
to recognize the difference between a temporary exchange rate disequilibrium and a permanent one. By trying
to manage exchange rates when a permanent shift in the equilibrium exchange rate has occurred, governments
run the risk of creating an exchange rate crisis and wasting reserves.
Benefits of a Target Zone Arrangement. The experience with the European Monetary System is that the target
zone arrangement in effect forced convergence of monetary policy to that of the country–Germany–with the
most disciplined anti-inflation policy and led to low inflation.
Costs of a Target Zone Arrangement. Maintaining a genuinely stable target zone arrangement requires the
political will to direct fiscal and monetary policies at that goal and not at purely national ones. This turns out to
be difficult for countries to achieve. In the case of the European Monetary System, the result was periodic
currency crises. Another cost of this system is that fundamental changes in the equilibrium exchange rate cannot
get reflected in actual exchange rate changes without a currency crisis occurring.
Benefits of a Fixed Rate System. A permanently fixed exchange rate system–such as that achieved by a currency
board, dollarization, or monetary union–results in currency stability and the absence of currency crises. In a
system such as existed under Bretton Woods, where there is a commitment to a fixed exchange rate system,
but no mechanism to bind that commitment, you will have more monetary discipline than in a freely floating
system and hence lower inflation than might otherwise be the case.
Costs of a Fixed Rate System. In a permanently fixed system, the exchange rate cannot cushion the effects of
real economic shocks, such as devaluation of a major competitor’s currency. Instead, prices must adjust. Given
the lack of flexibility of many prices–because of government regulations or union restrictions–the result of these
economic shocks can be higher unemployment and less economic growth. In a system such as Bretton Woods,
the result of changes in the equilibrium exchange rate will likely be currency crises and eventual devaluation or
revaluation.
Benefits of a Hybrid System. The current system gives countries the option to select the system that best meets
their needs. However, all too often, the decision is based on political rather than economic calculations.
Costs of a Hybrid System. The costs of a hybrid system, such as the one currently in place, is that there is no
constraint on the choices that governments can make. The resulting choices can be good ones or bad ones.
d. Have exchange rate movements under the current system of managed floating been excessive? Explain.
ANSWER. Excessive movements would indicate that there are profits to be earned by betting against the market.
In effect, if currency fluctuations are excessive they would exhibit the phenomenon of overshooting (i.e.,
currency rates would overreact to economic events and then return to equilibrium). There is no evidence that
one could profit by betting that rate movements are excessive.
5. The experiences of fixed exchange-rate systems and target-zone arrangements have not been entirely
satisfactory.
a. What lessons can economists draw from the breakdown of the Bretton Woods system?
ANSWER. Adjusting monetary growth rates is the principal way to stabilize exchange rates. For example, raising
the value of the dollar relative to the yen requires tightening U.S. monetary policy relative to Japanese monetary
policy. The experience of Bretton Woods and similar experiments demonstrates that conscious and explicit
coordination of monetary policies among sovereign authorities is difficult. The problem stems from the inability
of sovereign authorities to coordinate their monetary growth rates. An agreement to stabilize the dollar at, say,
150 yen would be relatively easy if it did not entail interdependent monetary policies, robbing the Federal
Reserve, or the Bank of Japan, or both, of important degrees of monetary freedom.
Both Japan and the United States have their own targets for growth and inflation and their own independent
assessment of the macroeconomic policies required to attain those targets. Except by coincidence, independent
policies and preferences will not mesh at a stable exchange rate. Given clashing preferences, the only
alternatives to the "chaos" of floating are:
(1) One side persuades the other to change its policies;
(2) One side subordinates its policies to those of the other; or
(3) Both sides subordinate their monetary policies to an external mechanism, such as a gold standard.
Absent (3), "international monetary reform" is the search for new ways to implement (1) or (2), or some
combination. We saw that Bretton Woods collapsed because the subordination it entailed was intolerable to
the United State. That is, the United States refused to follow economic policies that would maintain the value
of gold at $35 an ounce. The basic lesson from Bretton Woods, therefore, is that stabilizing exchange rates
requires dependence and subordination, not the freedom for everybody to do their own thing. But instead of
changing policies to stay with the Bretton Woods system, the major countries simply dropped the system.
b. What lessons can economists draw from the exchange rate experiences of the European Monetary System?
ANSWER. Exchange rate stability requires that monetary policies be coordinated and geared towards maintaining
exchange rate parities. The slow progress of the European community with respect to the EMS and policy
coordination exemplifies the difficulties of achieving agreements on the many facets of economic policymaking.
Implementing target zones on a wider scale would be all the more difficult. Differences in preferences, policy
objectives, and economic structures account in part for these difficulties. More fundamentally, however,
coordination of macroeconomic policies will not necessarily benefit all participant countries equally, and those
that benefit the most may not be willing to compensate those that benefit least. In the EMS, Germany is less
inflation-prone than the other members and is reluctant to cooperate at the risk of increasing its inflation rate.
Another lesson is that in target-zone arrangements such as the EMS, a disproportionately large share of the
adjustment burden will fall on the "weak" currency countries. Countries with appreciating currencies, trade
surpluses, and increasing reserves are less prone to adjust than countries with depreciating currencies, trade
deficits, or reserve losses. The convergence of inflation rates among the EMS countries supports this view. An
equal sharing of the adjustment burden implies that inflation rates among member nations would converge to
the average rate.
Germany, however, has maintained a domestic monetary target of low or zero inflation, and often has refused
to alter domestic monetary policy because of exchange rate considerations. Because of Germany's economic
importance, the other member countries have had to adjust their domestic policies or their exchange rates to
remain competitive in international markets. As a result, inflation rates have tended to converge toward
Germany's lower rate.
7. Historically, Spain has had high inflation and has seen its peseta continuously depreciate. In 1989, though,
Spain joined the EMS and pegged the peseta to the DM. According to a Spanish banker, EMS membership
means that "the government has less capability to manage the currency but, on the other hand, the people
are more trusting of the currency for that reason."
a. What underlies the peseta's historical weakness?
ANSWER. Spain has historically pursued an easy monetary policy, with an associated high rate of inflation. High
inflation, in turn, led to continual peseta devaluation.
b. Comment on the banker's statement.
ANSWER. Countries that seek to participate in the EMS are effectively forced to pursue a monetary policy
consistent with that of Germany, which eventually brings down their inflation rates. In effect, control of Spain's
monetary policy has been shifted from Spain's central bank, which has a weak reputation for monetary
discipline, to the much more reputable Bundesbank. Thus, Spaniards now are more trusting of their money.
c. What are the likely consequences of EMS membership on the Spanish public's willingness to save and
invest?
ANSWER. By heightening the prospects for Spanish monetary stability, EMS membership has lowered the risks
associated with holding financial assets in Spain. The result has been to make the Spanish public more willing to
save and invest.
1. During the currency crisis of September 1992, the Bank of England borrowed DM 33 billion from the
Bundesbank when a pound was worth DM 2.78 or $1.912. It sold these DM in the foreign exchange market
for pounds in a futile attempt to prevent a devaluation of the pound. It repaid these DM at the post-crisis
rate of DM 2.50:£1. By then, the dollar:pound exchange rate was $1.782:£1.
a. By what percentage had the pound sterling devalued in the interim against the Deutsche mark? Against the
dollar?
ANSWER. During this period, the pound depreciated by 10.1% against the DM
2.50 − 2.78
= - 10.1%
2.78
and by 6.8% against the dollar
1.782 − 1.912
= - 6.8%
1.912
b. What was the cost of intervention to the Bank of England in pounds? In dollars?
ANSWER. The Bank of England borrowed DM 33 billion and must repay DM 33 billion. When it borrowed these
DM, the DM was worth £0.3597, valuing the loan at £11.87 billion (DM 33 billion x 0.3597). After devaluation,
the DM was worth £0.4000. Hence, the Bank of England's cost of repaying the DM loan was £13.20 billion (DM
33 billion x 0.4), a rise of £1.33 billion. Thus, the cost to the Bank of England of this DM borrowing and
intervention was £1.33 billion.
In dollar terms, intervention cost the Bank of England $825 million. This estimate is based on the difference of
$0.025 between the DM's initial value of $0.6878 (1.912/2.78) and its ending value of $0.7128 (1/2.50) times
the DM 33 billion borrowed and spent defending the pound. Specifically, the cost calculation is $0.025 x
33,000,000,000 = $825 million.
2. Suppose the central rates within the ERM for the French franc and DM are FF 6.90403:ECU 1 and DM
2.05853:ECU 1, respectively.
a. What is the cross-exchange rate between the franc and the mark?
ANSWER. Since things equal to the same thing are equal to each other, we have FF 6.90403 = DM 2.05853. Hence,
FF1 = DM 2.05853/6.90403 = DM 0.298164. Equivalently, DM 1 = FF 6.90403/2.05853 = FF 3.35386.
b. Under the original 2.25% margin on either side of the central rate, what were the approximate upper and
lower intervention limits for France and Germany?
ANSWER. Given the answer to part a, the French franc could rise to approximately DM 0.298b164 x 1.0225 =
DM 0.304872 or fall as far as DM 0.298164 x 0.9775 = DM 0.291455. Similarly, the upper limit for the DM is FF
3.42933 and the lower limit is FF 3.27840.
c. Under the revised 15% margin on either side of the central rate, what are the current approximate upper
and lower intervention limits for France and Germany?
ANSWER. Given the answer to part a, the French franc could rise to approximately DM 0.298164 x 1.15 = DM
0.342888 or fall as far as DM 2.98164 x 0.85 = DM 0.253439. Similarly, the upper limit for the DM is FF 3.85694
and the lower limit is FF 2.85078.
3. Suppose Janghoon has to pay a cost of KRW 10 million at the end of May 2025. Currently, AUD 1 is worth
KRW 900.
a. Knowing that the rate would change to KRW800:AUD1 at the end of May 2025, how much in AUD can he
save by paying the full bill now?
10mil KRW is worth AUD 12.5k (10mil/800) if rate is 800:1, but 11.1 (10mil/900) if the rate is 900:1. He can
save 1.39k by paying the bill now.
b. What if the rate has 50% chance to be KRW800:AUD1 and 50% change to be KRW1000:AUD1, does he
profit from paying the bill early?
Paying now: AUD 11.1k; Paying later: 50%*12.5k+50%*10k=11.25k, still profitable.
c. Janghoon has no saving at the moment, and the interest rates (borrowing and lending) are at 4% in Korea
and 6% in Australia. He earns wage in AUD (has to pay back with AUD). Knowing that the rate would
change to KRW800:AUD1 at the end of May 2025, can he benefit by paying the full bill now borrowing
from a bank?
Pay later: AUD 12.5k (10mil/800)
Pay now with borrowing in Korea: borrow KRW10mil, and pay KRW 1.04 mil a year from now which is at (1:
800), AUD 13k (1.04/800)
Pay now with borrowing in Australia: borrow AUD 11.1k (10mil/900) and pay the bill, it would become
AUD 11.78k (11.1*1.06)
So, he can benefit by paying the bill now borrowing from an Australian bank.
d. Following question c, what if the rate has 50% chance to be KRW800:AUD1 and 50% change to be
KRW1000:AUD1, does he profit from paying the bill early borrowing from a bank? What if Janghoon is
extremely risk-averse? Discuss.
Pay later: 50%*12.5k+50%*10k=11.25k
Pay now with borrowing in Korea: borrow KRW10mil, and pay KRW 1.04 mil a year from now which is
11.7k (50%*(1.04/800)+50%*(1.04/1000))
Pay now with borrowing in Australia: borrow AUD 11.1k (10mil/900) and pay the bill, it would become
AUD 11.78k (11.1*1.06)
So, he can benefit by paying the bill later. However, if he is extremely risk-averse, he might prefer paying
now with borrowings from an Australian bank (no volatility).
