ECON 7520 SEMESTER 1, 2023
Tutorial 2
Problem 1 (Net International Investment Position)
This question is about the balance of payments of a country named Outland.
The currency of Outland is the U.S. dollar. Assume that during the entire year
2023, the exchange rate of U.S. dollars to euros is 1.5 U.S. dollars per euro.
(a) Outland starts 2023 with holdings of 100 shares of the German car company
Volkswagen. These securities are denominated in euros. The rest of the world
holds 200 units of bonds denominated in U.S. dollars issued by the Outlandian
government. At the beginning of 2023, the price of each Volkswagen share
is 1 euro and the price of each unit of Outlandian bond is 2 U.S. dollars.
Compute the net international investment position (NIIP) of Outland at the
beginning of 2023.
Answer:
• Outland holds foreign assets of 150 U.S. dollars.
• The rest of the world holds Outlandian assets of 400 U.S. dollars.
• Therefore NIIP = 150− 400 = −250 U.S. dollars.
(b) During 2023, Outland exports toys for 7 U.S. dollars and imports shirts for 9
euros. The rate of return on the Volkswagen shares was 5 percent and the rate
of return on Outlandian bonds was 1 percent. Residents of Outland received
money from relatives living abroad for a total of 3 euros and the government
of Outland gave 4 U.S. dollars to a hospital in Guyana. Calculate the Out-
landian trade balance, net investment income, and net unilateral transfers in
2023. What was the current account in that year? What is the Outlandian
NIIP at the end of 2023 expressed in U.S. dollars?
Answer:
• Trade Balance = 7− 1.5 · 9 = −6.5 U.S. dollars.
• Net Investment Income = Income Balance = 0.05 · 100 · 1.5 − 0.01 ·
400 = 3.5 U.S. dollars.
• Net Unilateral Transfers = 3 · 1.5− 4 = 0.5 U.S. dollars.
• Current Account = −2.5 U.S. dollars.
• NIIP = −250− 2.5 = −252.5 U.S. dollars.
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ECON 7520 SEMESTER 1, 2023
(c) Suppose that at the end of 2023, Outland holds 110 Volkswagen shares. How
many units of Outlandian government bonds are held in the rest of the world?
Assume that during 2023, all financial transactions were performed at the
beginning-of-year prices. Also, assume that there are only two types of assets
in this world, Volkswagen shares and Outlandian government bond.
Answer: From
Financial Account = 2 · x− 1.5 · (110− 100)
= 2.5 = −(Current Account)
we infer x = 8.75. Therefore, 208.75 units of bonds are held by the rest of
the world at the end of 2023.
(d) To answer this question, start with the international asset and liability po-
sitions calculated in part (c). Suppose that at the end of 2023, the price of a
Volkswagen share falls by 20 percent and the dollar appreciates by 10 percent.
Calculate the end-of-year NIIP of Outland in U.S. dollars.
Answer: NIIP = 0.8 · (1.5 · 0.9) · 110− 2 · 208.75 = −298.7.
Problem 2 (Current Account Sustainability)
Consider a two-period economy that at the beginning of period 1 has a net
foreign asset position of −100. In period 1, the country runs a current account
deficit of 5 percent of GDP, and GDP in both periods is 120. Assume the interest
rate in periods 1 and 2 is 10 percent. [To answer the following questions, ignore
net international compensation to employees and net unilateral transfers.]
(a) Find the trade balance in period 1 (TB1), the current account balance in pe-
riod 1 (CA1), and the country’s net foreign asset position at the beginning of
period 2 (B1).
Answer:
• CA1 = −0.05 · 120 = −6.
• Substituting above values into the equation CA1 = TB1 + rB0 yields
−6 = TB1 + 0.1 · (−100)
and thus TB1 = 4.
• From CA1 = B1 −B0 we infer that B1 = −106.
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ECON 7520 SEMESTER 1, 2023
(b) Is the country living beyond its means? To answer this question find the
country’s current account balance in period 2 and the associated trade balance
in period 2. Is this value for the trade balance feasible? [Hint: Keep in mind
that the trade balance cannot exceed GDP.]
Answer:
• CA2 = B2−B1 and B2 = 0. Therefore, CA2 = 106.
• Substituting values into CA2 = TB2 + rB1 yields
106 = TB2 + 0.1 · (−106)
and thus TB2 = 116.6.
• Since GDP = 120, this value of the trade balance is feasible.
(c) Now assume that in period 1, the country instead runs a much larger current
account deficit of 10 percent of GDP. Find the country’s net foreign asset
position at the end of period 1, B1. Is the country living beyond its means? If
so, show why.
Answer:
• CA1 = −0.1 · 120 = −12.
• From CA1 = TB1 + rB0 we obtain
−12 = TB1 + 0.1 · (−100) ⇔ TB1 = −2.
• From CA1 = B1 −B0 we infer that B1 = −112.
• Since CA2 = B2 − B1 and B2 = 0, we obtain CA2 = 112.
• Substituting values into CA2 = TB2 + rB1 yields
112 = TB2 + 0.1 · (−112) ⇔ TB2 = 123.2.
• Since GDP = 120, this value of the trade balance is not feasible.