international finance professor canzoneri exercise 1 duefaculty.georgetown.edu/canzonem/econ 244...

International Finance Professor CanzoneriExercise 1 Due:

Preliminary figures (in billions of dollars) for 2004 taken from the 2005 Economic Report of thePresident showed that: Y = 11,728.0, C = 8,231.1, EX = 1,170.2, IM = 1,779.6, G = 2,183.8 andT = 1771.7. We can use the national income identities to describe the financing of U.S. businessinvestment and the U.S. government deficit

Part A: Use the income identities to find what U.S. private business investment, I, was in 2004. Show your work.

Part B: Use the income identities to find what U.S. private savings, S, was in 2004. Show yourwork.

Part C: Both U.S. private business investment and the U.S. government deficit need to befinanced each year. What were the total financing needs of business and government in 2004?

Part D: Was private savings sufficient to finance both private business investment and thegovernment deficit? What was the shortfall? Where did U.S. firms and the U.S. governmentfind the extra financing? Can you see the shortfall in the numbers provided at the outset (Hint:think about the current account)?

International Finance Professor CanzoneriExercise 1 ANSWERS

Preliminary figures (in billions of dollars) for 2004 taken from the 2005 Economic Report of thePresident showed that: Y = 11,728.0, C = 8,231.1, EX = 1,170.2, IM = 1,779.6, G = 2,183.8 andT = 1771.7. We can use the national income identities to describe the financing of U.S. businessinvestment and the U.S. government deficit

Part A: Use the income identities to find what U.S. private business investment, I, was in 2004. Show your work.

ANSWER – Y = C + I + G + EX - IM Y

I = Y - (C + G + EX - IM) = 11,728.0 - (8,231.1 + 2,183.8 + 1,170.2 - 1,779.6) = 1,922.4

Part B: Use the income identities to find what U.S. private savings, S, was in 2004. Show yourwork.

ANSWER – Y = C + S + T Y S = Y - (C + T) = 11,728.0 - (8,231.1 + 1771.7) = 1725.2

Part C: Both private U.S. business investment and the U.S. government deficit need to befinanced each year. What were the total financing needs of business and government in 2004?

ANSWER – I + (G - T) = 1,922.4 + ( 2,183.8 - 1771.7) = 2334.5

Part D: Was private savings sufficient to finance both private business investment and thegovernment deficit? What was the shortfall? Where did U.S. firms and the U.S. governmentfind the extra financing? Can you see the shortfall in the numbers provided at the outset (Hint:think about the current account)?

ANSWER – Shortfall = [I + (G - T)] - S = 2334.5 - 1725.2 = 609.3

They had to borrow from foreigners.

As shown in class, the income identities imply that I + (G - T) = S - CA. So, the shortfall, [I + (G - T)] - S = - CA = IM - EX = 1,779.6 - 1,170.2 = 609.3. The current account deficit isU.S. borrowing from abroad.


In the exercise, you will study two “arbitrage” conditions that show how financial marketsdetermine exchange rates.I. CROSS RATE ARBITRAGE: E$/€ = E$/¥ * E¥/€

A. Find recent quotes (Financial Times or use the internet1) for the dollar rates for Euro andYen, and also find the cross rate between Euro and Yen. Suppose you sell $1 and buyEuros, then you sell the proceeds to buy Yen, and finally you sell the proceeds of thatsale to buy back dollars. Do you end up with more or less than the $1 you started outwith?

B. Economists would expect the rate of return in Part A to be quite small. Explain why?(Hint: think what would happen if there were a big return?)

1997 1998 1999 2000

US Dollar 1 1 1 1

JPN Yen 116.05 130.615 113.3 102.31

INA Rupiah 2363 5535 8005 7050

Figures for January 1st of each year

C. Use the above figures for Part C.1. Suppose you are manager of an Indonesian company that borrowed the equivalent

of US$1,000,000 in Yen from a Japanese bank at the beginning of 1997. Thatamount is immediately converted into Rupiah for operations in your Indonesianfactory. How much Rupiah do you now have for operations?

2. If you were to pay back the Japanese bank at the beginning of 1998, how muchRupiah does you company have to pay for the full principal borrowed in 1997?What about in 1999? And in 2000?

3. If you were manager of an Indonesian company that exported goods to America,how would these exchange rate movements have affected the dollar sales price ofyour goods?

2. INTEREST RATE ARBITRAGE: R$ = R€ + (Ee$/€ - E$/€)/E$/€

A. Suppose the rate of return on a Eurobond is 4.3%, and suppose the dollar is expected todepreciate by 0.5%; what is the expected dollar rate of return on the Eurobond?

B. Suppose the rate of return on a Eurobond is 4.3%, and suppose the Euro is expected toappreciate by 0.5%; what is the expected dollar rate of return on the Eurobond?

C. Use the interest rate parity equation to calculate the spot exchange rate (E$/€) when R$ = 0.045, R€ = 0.043, and Ee

$/€ = 1.094. Is the resulting E$/€ greater or less than 1.094?D. Suppose R$, R€, and Ee

$/€ are at the values specified in Part C, but suppose that the spotexchange rate (E$/€) is initially equal to 1.094. Describe the market forces that woulddrive the spot rate to the answer you found in Part C.

1 For example, you can use http://finance.yahoo.com or http://www.oanda.com/convert/classic


In the exercise, you will study two “arbitrage” conditions that show how financial marketsdetermine exchange rates.I. CROSS RATE ARBITRAGE: E$/€ = E$/¥ * E¥/€

A. Find recent quotes (Financial Times or use the internet2) for the dollar rates for Euro andYen, and also find the cross rate between Euro and Yen. Suppose you sell $1 and buyEuros, then you sell the proceeds to buy Yen, and finally you sell the proceeds of thatsale to buy back dollars. Do you end up with more or less than the $1 you started outwith?

ANSWER- On September 9, 2003: E$/€= 1.12, E ¥/$= 116.37, E¥/€= 130.15$1@ E€/$ @ E¥/€ @ E$/¥ = 1@ (1/1.12) @ 130.15 @ (1/116.37) = $0.9986 < $1

B. Economists would expect the rate of return in Part A to be quite small. Explain why?(Hint: think what would happen if there were a big return?)

ANSWER-If the loss were large, arbitragers would go the other way, making large profits. Peoplewould be buying (not selling) dollars. The dollar would appreciate, raising E€/$ and E¥/$. This would make the return converge on 0.

1997 1998 1999 2000

US Dollar 1 1 1 1

JPN Yen 116.05 130.615 113.3 102.31

INA Rupiah 2363 5535 8005 7050

Figures for January 1st of each year

C. Use the above figures for Part C.1. Suppose you are manager of an Indonesian company that borrowed the equivalent

of US$1,000,000 in Yen from a Japanese bank at the beginning of 1997. Thatamount is immediately converted into Rupiah for operations in your Indonesianfactory. How much Rupiah do you now have for operations?

ANSWER-$1,000,000 @ E ¥/$ @ ER/¥ = $1,000,000 @ 116.05 @ (2363/116.05) = 2,363,000,000R in 1997

2. If you were to pay back the Japanese bank at the beginning of 1998, how muchRupiah does you company have to pay for the full principal borrowed in 1997?What about in 1999? And in 2000?

2 For example, you can use http://finance.yahoo.com or http://www.oanda.com/convert/classic

ANSWER-$1,000,000 @ E ¥/$ = $1,000,000 @ 116.05 = 116,050,000 Yen initially borrowed1998:116,050,000 Yen @ ER/¥ = 116,050,000 @ (5535/130.615) = 4,917,787,008 R1999: 116,050,000 Yen @ (8005/113.3) = 8,199,296,117 R2000:116,050,000 Yen @ (7050/102.31) = 7,996,798,944 R

3. If you were manager of an Indonesian company that exported goods to America,how would these exchange rate movements have affected the dollar sales price ofyour goods?

ANSWER-From 1997 to 1999, the dollar is appreciating relative to the Rupiah, meaning the dollarsales price is decreasing (Indonesian goods are getting cheaper for Americans). In 2000,the Rupiah appreciated against the dollar from its 1999 level, making Indonesian goodsmore “expensive” in dollars than the year before- the dollar sales price went up.

2. INTEREST RATE ARBITRAGE: R$ = R€ + (Ee$/€ - E$/€)/E$/€

A. Suppose the rate of return on a Eurobond is 4.3%, and suppose the dollar is expected todepreciate by 0.5%; what is the expected dollar rate of return on the Eurobond?

ANSWER-R€ = 4.3%$ depreciation = (Ee

$/€ - E$/€)/E$/€ = .5%R$ = 4.3 + .5 = 4.8% dollar rate of return on the Eurobond

B. Suppose the rate of return on a Eurobond is 4.3%, and suppose the Euro is expected toappreciate by 0.5%; what is the expected dollar rate of return on the Eurobond?

ANSWER-R€ = 4.3%Euro appreciation = $ depreciation = .5%R$ = 4.3 + .5 = 4.8% dollar rate of return on the Eurobond

C. Use the interest rate parity equation to calculate the spot exchange rate (E$/€) when R$

= 0.045, R€ = 0.043, and Ee$/€ = 1.094. Is the resulting E$/€ greater or less than 1.094?

ANSWER-Interest rate parity equation: R$ = R€ + (Ee

$/€ - E$/€)/E$/€

.045 = .043 + (1.094 - E$/€)/E$/€

.002 E$/€ = 1.094 - E$/€

E$/€ = 1.092 ...the resulting E$/€ is less than 1.094

D. Suppose R$, R€, and Ee$/€ are at the values specified in Part C, but suppose that the spot

exchange rate (E$/€) is initially equal to 1.094. Describe the market forces that woulddrive the spot rate to the answer you found in Part C.

ANSWER-If the spot rate starts at 1.094, the left side of the interest rate parity eqn is greater than

the right, meaning there is a greater return on dollar bonds than Eurobonds. People woulddump Euros and buy dollars, leading to an appreciation of the dollar relative to the Euro,and driving the spot rate back to that found in part C.


The financial markets diagram shows how the money market and the bonds marketsimultaneously determine equilibrium E and R. In this exercise, you will get practice using it.

I. Suppose the European Central Bank (ECB) raises its interest rate (R*) in an attempt to establish an anti-inflation reputation similar to the Bundesbank's. A. Use the financial markets diagram to show what this would do to the US interest rate (R) and

exchange rate (E) assuming the FED did not change the US money supply. Explain intuitivelywhy the exchange rate moves the direction it does? (Hint: what happens to the supplies anddemands for home and foreign bonds?) What would all of this do to the price of US importsfrom Europe?

B. Suppose the FED wanted to avoid these price level consequences in the US. Use thefinancial markets diagram to show what the FED would have to do to its money supply (M) tomaintain the original exchange rate.

C. Is there any way that the FED could simultaneously maintain its original exchange rate andits original interest rate? Justify your answer.

II. As Europe comes out of its present recession, it will import more from the US, and this will expand US output (Y). A. Use the diagram to show what this will do to the US interest rate (R) and exchange rate (E).

Explain intuitively why the interest rate and the exchange rate move in the directions they do. (Hint: again, what happens to supplies and demands?)

B. Is there any way that the FED could change its money supply so as to simultaneouslymaintain its original exchange rate and its original interest rate? Use the diagram to justifyyour answer.

International Finance Professor CanzoneriExercise 3 ANSWERSThe financial markets diagram shows how the money market and the bonds marketsimultaneously determine equilibrium E and R. In this exercise, you will get practice using it.

I. Suppose the European Central Bank (ECB) raises its interest rate (R*) in an attempt to establish an anti-inflation reputation similar to the Bundesbank's. A. Use the financial markets diagram to show what this would do to the US interest rate (R) and

exchange rate (E) assuming the FED did not change the US money supply. Explain intuitivelywhy the exchange rate moves the direction it does? (Hint: what happens to the supplies anddemands for home and foreign bonds?) What would all of this do to the price of US importsfrom Europe?

ANSWER – If the FED does not change M, then neither the supply nor the demand for M is affected, and R is unchanged.

R*8 6 ED for Euro-bonds 6 people move out of $ and into Euro 6 $ depreciates.

This depreciation raises the price of imports, since it now takes more $ to meet a given price quoted in Euro.

B. Suppose the FED wanted to avoid these price level consequences in the US. Use the financialmarkets diagram to show what the FED would have to do to its money supply (M) to maintain theoriginal exchange rate.

ANSWER –

The FED has to lower M enough to make R rise as much as R* did.

Then, E remains at E1.

C. Is there any way that the FED could simultaneously maintain its original exchange rate andits original interest rate? Justify your answer.

ANSWER – No. If the Fed changes M, then R must move to re-establish equilibrium in the money market. If

the FED does not change M, then E must move, for reasons given in part A.

II. As Europe comes out of its present recession, it will import more from the US, and this will expand US output (Y). A. Use the diagram to show what this will do to the US interest rate (R) and exchange rate (E).

Explain intuitively why the interest rate and the exchange rate move in the directions they do. (Hint: again, what happens to supplies and demands?)

ANSWER –

Y8 6 L()8 6 money demand curve shifts down.

ED for money 6 R8 to clear the money market.

R8 6 ED for $-bonds 6 people try to get out of Euro and into $ assets 6 $ depreciates.

B. Is there any way that the FED could change its money supply so as to simultaneously maintainits original exchange rate and its original interest rate? Use the diagram to justify your answer.

ANSWER –

Yes. FED has to increase money supply enough to accommodate the new money demand at the original R1.

If R1 is maintained, then the E1 will also be maintained.This is possible here because the interest parity curve has not shifted.


The AA-DD diagram illustrates the short run equilibrium in financial markets and in the goodsmarket. In this exercise, you will get practice using it.

I. Suppose the economy is initially at full employment, Yfe. Then, a stock market crash (such asthe one we had in 1987 or 1998) makes firms curtail some of their investment projects (since theybecome harder to finance). Use the AA-DD diagram to show how this could cause a recession.Part A: Do the AA-DD curve analysis; be sure to explain why you shift any curve.Part B: Tell the “story” of what is happening in the goods market, and how it spills over to the

financial markets.Part C: Show the path of adjustment to the new short run equilibrium. Is there any exchange rate

“overshooting”?

II. Now suppose the FED takes steps to offset the recession.Part A: Begin with an AA-DD diagram that shows where you ended up in question I; then show

what the FED would have to do to restore the original level of output, Yfe. Once again, be sureto explain why you shift any curve.

Part B: Tell the “story” of what is happening in the financial markets, and how it spills over to thegoods market; show the path of adjustment to the new short run equilibrium. Is there anyexchange rate “overshooting” in this case?

Part C: Y has been restored to Yfe, but E has not been restored to its initial level, E1. Why didn't itgo back to its initial level; that is, why was a depreciation necessary?

III. Suppose now that the FED wanted to simultaneously offset the recession and appreciate theexchange rate (for lower prices) to some E3 < E1; suppose further that it could persuade Congressto help in the effort. Part A: Begin with an AA-DD diagram that shows where you ended up in question I, and then

show how a combined monetary and fiscal policy could restore both the initial level of output,Yfe, and the exchange rate E3.

Part B: Could either monetary or fiscal policy have achieved this alone?


The AA-DD diagram illustrates the short run equilibrium in financial markets and in the goods

market. In this exercise, you will get practice using it.

I. Suppose the economy is initially at full employment, Yfe. Then, a stock market crash (such as

the one we had in 1987 or 1998) makes firms curtail some of their investment projects (since they

become harder to finance). Use the AA-DD diagram to show how this could cause a recession.

Part A: Do the AA-DD curve analysis; be sure to explain why you shift any curve.

Part B: Tell the “story” of what is happening in the goods market, and how it spills over to the

financial markets.

Part C: Show the path of adjustment to the new short run equilibrium. Is there any exchange rate

“overshooting”?

ANSWER –

The story: I9

D(EP*/P,Y-T,I,G)9 6 DD shifts left

initial effect is in goods mkt

yd9 6 ys follows

spills over to financial markets

Y9 6 L9 6 R9 6 E8.

move out along AA; no impact effect,

or E “overshooting”.

II. Now suppose the FED takes steps to offset the recession.

Part A: Begin with an AA-DD diagram that shows where you ended up in question I; then show

what the FED would have to do to restore the original level of output, Yfe. Once again, be sure

to explain why you shift any curve.

ANSWER –

Fed has to buy bonds to increase money

supply

Part B: Tell the “story” of what is happening in the financial markets, and how it spills over to the

goods market; show the path of adjustment to the new short run equilibrium. Is there any

exchange rate “overshooting” in this case?

ANSWER --

FED has to Ms8The Story:

initial effect in financial markets

Ms8 6 R9 6 E8 E depreciates immediately to AA2

spills over to goods market

EP*/P8 6 yd8 and ys follows

as pictured, E initially “overshoots”.

Part C: Y has been restored to Yfe, but E has not been restored to its initial level, E1. Why didn't it

go back to its initial level; that is, why was a depreciation necessary?

ANSWER:

E has to depreciate be cause (1) I9 6 E8 and (2) Ms8 6 E8; both work in the same direction on E,

for reasons already given in the two “stories”.

III. Suppose now that the FED wanted to simultaneously offset the recession and appreciate the

exchange rate (for lower prices) to some E3 < E1; suppose further that it could persuade Congress

to help in the effort.

Part A: Begin with an AA-DD diagram that shows where you ended up in question I, and then

show how a combined monetary and fiscal policy could restore both the initial level of output,

Yfe, and the exchange rate E3.

Part B: Could either monetary or fiscal policy have achieved this alone?

ANSWER --

Fiscal policy should T9 and/or G8 to

make DD cut the Yfe line at E3.

Monetary policy should Ms9 to make AA

cut the Yfe line at E3.

Neither policy could do this alone; have

to move both curves to get (E3,Yfe).

Have to combine an expansionary

fiscal policy with a contractionary

monetary policy.

International Finance Professor Canzoneri

Exercise 5 Due:

In this exercise, you will study the relationship between the substitutability of (home and

foreign) bonds and central bank independence.

Suppose the FED wants to raise R (for domestic reasons) and depreciate E (for external

reasons); that is, the FED wants to achieve the point (E2,R2) in the diagram below.

I. Suppose B and B* are imperfect substitutes. Show that an OMO can bring R to R2, and that a

sterilized intervention can then bring E to E2. In each case, explain what assets the FED swaps

with the private sector.

II. Suppose B and B* are perfect substitutes. Is there any way the FED can achieve the point

(E2,R2)? What choices of (E,R) is the FED limited to?

III. In the US, the Treasury Department (and not the FED) has the right to set exchange rate

policy. If this right is interpreted to mean that Treasury can tell the FED what E to set, then does

this right in effect abrogate the independence of the central bank? That is, can the FED still set

whatever R it wants, independent of the wishes of the Treasury?


Exercise 5 ANSWERS –

Suppose the FED wants to raise R (for domestic reasons) and depreciate E (for external

reasons); that is, the FED wants to achieve the point (E2,R2) in the diagram below.

I. Suppose B and B* are imperfect substitutes. Show that an OMO can bring R to R2, and that a

sterilized intervention can then bring E to E2. In each case, explain what assets the FED swaps

with the private sector.

ANSWER --

1. Contractionary OMO: FED sells B (in exchange for M) to bring Ms to M2 shown above.

Note: The OMO will raise B/B*, increase ρ(B/B*) and shift interest parity condition up.

If the curve has not shifted

far enough to achieve (E2,R2), then a sterilized intervention

is needed to shift it further.

If the curve has already shifted too far up, then a sterilized intervention has to shift it

back down some.

In what follows, I will assume that the OMO has not shifted it far enough.

2. Sterilized Intervention:

FEI: FED buys B* (raising B/B*) in exchange for M.

Offsetting OMO: FED sells B (raising B/B* even more) in exchange for M.

Net effect: no change in M (that is, it stays at M2), but B/B*, and ρ(B/B*), rise enough to

achieve (E2,R2).

II. Suppose B and B* are perfect substitutes. Is there any way the FED can achieve the point

(E2,R2)? What choices of (E,R) is the FED limited to?

ANSWER --

No. If bonds are perfect substitutes, FED's operations can not shift interest parity curve. In

effect, it is limited to shifting the equilibrium along this curve.

III. In the US, the Treasury Department (and not the FED) has the right to set exchange rate

policy. If this right is interpreted to mean that Treasury can tell the FED what E to set, then does

this right in effect abrogate the independence of the central bank? That is, can the FED still set

whatever R it wants, independent of the wishes of the Treasury?

ANSWER --

The answer depends on whether or not bonds are imperfect substitutes.

If bonds are imperfect substitutes, then the FED retains independence over interest rate policy.

The FED can use OMO's to achieve its own R-target, and then use sterilized interventions to

achieve the Treasury's E-target.

If bonds are imperfect substitutes, then the FED does lose its independence; the Treasury's E

target determines the R that the FED must set.


Exercise 6 Due:

In this exercise, you will practice finding Nash solutions, and we will develop further Barro &

Gordon's Inflation Credibility Model and Obstfeld's 2nd Generation Speculative Attacks Model.

I. Finding Nash Solutions –

Part A: Define a “Nash Solution” to a non-cooperative game. (Hint: What must each player

be doing in the Nash solution.)

Part B: Consider the two games below. Start with Game 1, where the Nash solutions have

already been circled. Go from box to box explaining why each is, or is not, a Nash

solution. Then, do the same for Game 2, and circle the Nash solution(s?).

II. Recall Able and Bernanke's box matrix example of Barro-Gordon's Inflation Credibility Model:

Part A: Suppose the CB just announced that it would play Ml, and that there was no need for the

wage setters to expect Ph. Would this announcement be believed? Why or why not?

Part B: Suppose we change the point assignments as follows:

W Setters CB

N* 1 0 Now, the CB is not as concerned about achieving high levels of N:

Nh 0 1 Nh gets 1 point instead of 2, Nl gets -1 instead of -2.

Nl 0 -1 Otherwise, the point assignments are the same.

Ph 0 0 Recalculate the CB's payoffs in the four boxes, and find the

Pl 0 1 new Nash solution(s?). (Hint: there may be more than one.)

Part C: If there are multiple solutions, how might the CB bring about the best one?

III. Recall Obstfeld's box matrix example of a “2nd Generation” Speculative Attack Model:

Part A: When foreign reserves were FR = 20, “fundamentals” were so strong that an attack

was impossible. In this model, what is the minimum number of reserves that would be

required to rule out the possibility of multiple equilibria, and thus, self-fulfilling attacks?

Part B: When foreign reserves were FR = 6, “fundamentals” were so weak that an attack was

inevitable. What is the minimum number of reserves that would at least keep the attack from

being inevitable?

Part C: Who do you think is to blame for exchange rate crises in Obstfeld's model ? The

government? Speculators?


Exercise 6 Due: ANSWERS

In this exercise, you will practice finding Nash solutions, and we will develop further Barro &

Gordon's Inflation Credibility Model and Obstfeld's 2nd Generation Speculative Attacks Model.

I. Finding Nash Solutions –

Part A: Define a “Nash Solution” to a non-cooperative game. (Hint: What must each player

be doing in the solution.)

ANSWER --

We have a Nash Solution when each player is doing the best he/she can do, given the actions

of the other players in the game.

Part B: Consider the two games below. Start with Game 1, where the Nash solutions have

already been circled. Go from box to box explaining why each is, or is not, a Nash

solution. Then, do the same for Game 2, and circle the Nash solution(s?).

ANSWER --

ANSWER –

Game 1: Game 2:

NW box: both would deviate. NW box: neither would deviate.

SW box: neither would deviate. SW box: Row would deviate.

SE box: both would deviate. SE box: both would deviate.

NE box: neither would deviate. NE box: Column would deviate.

II. Recall Able and Bernanke's box matrix example of Barro-Gordon's Inflation Credibility Model:

Part A: Suppose the CB just announced that it would play Ml, and that there was no need for the

wage setters to expect Ph. Would this announcement be believed? Why or why not?

ANSWER --

It would not be believed. Wage setters know that if they play Wl (ie the SE box), the CB will

be tempted to play Mh, resulting in the NE box. The announcement is not credible.

Part B: Suppose we change the point assignments as follows:

W Setters CB

N* 1 0 Now, the CB is not as concerned about achieving high levels of N:

Nh 0 1 Nh gets 1 point instead of 2, Nl gets -1 instead of -2.

Nl 0 -1 Otherwise, the point assignments are the same.

Ph 0 0 Recalculate the CB's payoffs in the four boxes, and find the

Pl 0 1 new Nash solution(s?). (Hint: there may be more than one.)

ANSWER – Here, there are two Nash solutions.

Since the CB's incentive to create a surprise

inflation is not as strong not, the good

equilibrium (the SE box) is a possible

outcome.

Part C: If there are multiple solutions, how might the CB bring about the best one?

ANSWER --

Here, the CB could simply announce that it would play Ml. There is no reason for the wage

setters not to believe the announcement. There is no credibility problem, since SE is a Nash

solution.

III. Recall Obstfeld's box matrix example of a “2nd Generation” Speculative Attack Model:

Part A: When foreign reserves were FR = 20, “fundamentals” were so strong that an attack was

impossible. In this model, what is the minimum number of reserves that would be required to

rule out the possibility of multiple equilibria, and thus, self-fulfilling attacks?

ANSWER –

The combined holdings of the two traders is 6 + 6 = 12. If the central bank holds 13, then even

if both traders attack, they can not deplete the reserves and force a devaluation. So, 13 is the

minimum level of reserves required to rule out any possibility of an attack.

Part B: When foreign reserves were FR = 6, “fundamentals” were so weak that an attack was

inevitable. What is the minimum number of reserves that would at least keep the attack from

being inevitable?

ANSWER –

Each trader holds 6. If the central bank holds 7, then no one trader alone can deplete the

reserves. So, 7 is the minimum level of reserves required to keep the attack from being

inevitable.

Part C: Who do you think is to blame for exchange rate crises in Obstfeld's model ? The

government? Speculators?

ANSWER –

There is no one answer to this. Governments can make themselves invulnerable to attack by

keeping fundamentals very strong. On the other hand, this may (or may not) be a costly thing

to do. Governments have to at least keep fundamentals in the intermediate range, so that an

attack is not inevitable. And if fundamentals are in that intermediate range, there is no good

reason for an attack, other than the greed of speculators.

international finance professor canzoneri exercise 1 duefaculty.georgetown.edu/canzonem/econ 244...

Documents