ΘΕΜΑΤΑ MANAGERIAL ECONOMICS ΓΙΑ ΑΓΓΛΙΚΑ ΠΑΝΕΠΙΣΤΗΜΙΑ

MANAGERIAL ECONOMICS

Question 1 (25%)
International mobility of labor and capital (chapter 8)

1. Explain how the inflow of capital in Greek shipyard industry will affect the wages of various groups of workers. (50%)
2. Critically discuss that an increase in international trade barriers induces migration flows while an increase in the restrictions of factor movement stimulates international trade. (50%)

Answer

1. Specific factors model, par. 8.2.3 (pages 147-148)
2. International trade and migration, par. 8.1.3 (pages 143-144)




Question 2 (25%)
Budget deficits (Chapter 10)

One of the most important and persistent problem of the Greek economy is the current account deficit.
1. Briefly discuss the problem during the last couple of years (15%)
2. Critically discuss the role of the following Greek policy tools to alleviate this problem; (a) Fiscal policy (b) Monetary policy (c) Exchange rate policy (d) trade policy. (70%)
3. Briefly discuss at least two factors (not related to the above) that could worsen the deficit. (15%)




Answer
1. Greek current account deficit was reduced to 12,5 of GDP in 2009 compared to 14,5% of GDP or 34.98 bn euros in 2008. The cut was the result of reduced imported goods and services due to the crisis.
2. (a) According to the national accounts identity
(G-T)+ (I-S)=-CA,
where G: government expenditure, T: government taxes,
I: private investment, S: private saving
-CA: current account deficit.
when the country has a current account deficit, it means that the country has domestic spending larger than its national income, and thus the country should borrow from abroad. According to the above identity, an increase in the budget deficit must be compensated either by a fall in private sector borrowings (less private investment or more private saving) or by an increase in the current account deficit. Budget deficits also affect the current account indirectly by increasing interest rates and inflation rate. (b) Monetary policy does not represent a national policy tool in the case of Greece. An expansionary monetary policy of the ECB may create higher inflation or expectations of higher inflation rate resulting in a loss of home competitiveness and thus to a budget deficit. A higher interes rate in Eurozone compared to the rest of the world, by attracting short term capital (foreign portfolio investment), may result in an exchange rate appreciation of the euro that will worsen the current account. (c) Exchange rate policy does not represent a national policy tool in the case of Greece. An overvalued euro would have negative effects on the current account. (c) Trade policy is also a European and not a national policy. Greece could not impose trade controls, including tarrifs, quotas or subsidies and non-tariff barriers, free trade zones and quantitative restrictions to induce consumers to switch to import substitutes.
3. A higher oil import bill due to the rise in petroleum prices, increased payments for the purchase of ships and higher dividend and interest payments might worsen the deficit.



Question 3 (25%)
Foreign Exchange Market & International Finance (Chapters 11&12)

Consider the following demand and supply functions for foreign exchange ($):

D$ = 100 – 40e Demand for foreign currency (e = nominal exchange rate in €/$)
S$ = 52 + 20e Supply of foreign currency (e = nominal exchange rate in €/$)

The domestic and foreign price levels are Ρ = 90 and Ρ* = 100 respectively.
(a) Calculate the real exchange rate.
(b) Thoroughly explain why the nominal exchange rate is not a reliable index of international competitivess of an economy.
(c) Suppose that in the next year domestic inflation is 3% and foreign inflation is 2% and that the Central Bank increases its demand for U.S. dollars by 12 units for each level of the nominal exchange rate. Show by how much the real exchange rate will change.
Answer

(a) The real exchange rate is defined as the price of foreign relative to domestic goods and services. It is the nominal exchange rate adjusted to the ratio of the foreign price level to the domestic price level.


where, e is the nominal exchange rate, P and P* are the domestic and foreign price level.

Therefore

We first calculate the nominal exchange rate by equating the demand for and the supply of foreign exchange ($). This will give us that

e = 0.80 euros per USD

and



(b) The nominal exchange rate is not a reliable index of the international competitiveness of an economy since it only reflects adjustments in the demand for and the supply of foreign exchange, but takes no account of the relative prices. The real exchange rate is the correct measure of international competitiveness as indeed takes into account the inflation rate and essentially the production cost in each country. The concept of real exchange rate is derived from the Purchasing Power Parity in the sense that when PPP holds then Q =1 and there is no change in the international competitiveness of an economy. When the real exchange rate increases either, because the domestic currency depreciates or the domestic price level declines relative to the foreign price level then we refer to a real depreciation of the domestic currency and therefore the domestic goods and services become relatively cheaper and more competitive in the international markets. In contrast when the real exchange rate declines either due to an appreciation of the domestic price or an increase of the domestic price level given the foreign price level then we have a real appreciation of the domestic currency and the domestic products become more expensive and the domestic economy faces a decline in its competitiveness in the international goods markets.

(c) The action by the Central Bank in the foreign exchange market will affect the exchange rate proportionately and therefore this will change the demand curve resulting to a higher exchange rate (depreciation of the domestic currency). In addition the price levels will change due to the annual inflation rates:

The new demand curve will be:

D$ = 112 – 40e

Therefore the new nominal exchange rate will be equal to unity. This implies that the action by the Central Bank led to a depreciation of the home currency (euro).



This shows that the increase in the nominal exchange rate (depreciation of the euro) has been carried over to the real exchange rate since it has now a value of 1.12. The real exchange rate depreciation is caused by the nominal exchange rate percentage increase which is greater thatn the differential inflation. This results to an improvement of the international competitiveness of the Eurozone relative to the US economy.





Question 4 (25%)
Foreign Exchange Market & International Finance (Chapters 11&12)

(a) Assume that in New York, London and Toronto the following exchanges rates are quoted: 1 US dollar = 0.5 sterling pounds. 1 sterling pound = 3 Canadian dollars and 1 Canadian dollar = 0.91 US dollar. Carefully explain whether there are arbitrage opportunities. In the case they exist then calculate the arbitrage profit in terms of US dollars and explain how the markets reach equilibrium.
(b) Explain the Covered Interest Rate Parity (CIP) and its differences from UIP.
(c) Given the following information:

Spot rate of US dollar and pound sterling is 1.65 (US dollar/sterling pound)
3-month UK interest rates are at 7.5% per annum (actual/365 day count basis)
3-month US interest rates are at 6% per annum (actual/365 day count basis)

Assume that there are 30 days in each month, then:

(i) Calculate the 30-day forward rate and the forward margin.
(ii) Is sterling at a forward discount or forward premium?



Answer

(a) We answer this question with the use of triangular arbitrage. This requires that we calculate the cross rates between the currencies and we compare them with the direct quotations. Specifically

Define:

S1 = exchange rate between dollar against the pound = 0.5 pounds per USD (N.Y.)

S2 = exchange rate between pound against the Canadian dollar = 3 CAD per pound (London)

S3 = exchange rate between the Canadian dollar against the US dollar = 0.91USD per CAD (Toronto)

As a first check to find out that the triangular arbitrage is profitable for an investor we calculate the product of the three exchange rates. If this is greater than one then this implies that the investor can exercise profitable arbitrage.

S1 x S2 x S3 = 1.365 > 1

Given this initial evidence we proceed as follows:

We compare the direct exchange rate S2 (3 CAD per pound) with the cross exchange rate for the two currencies that can be calculated from the N.Y. and Toronto markets.

The cross rate is S1,3 = (S3)(S1) = (0.91)(0.5) = 0.494 pounds per CAD. However, we want to have the cross rate CAD per pound so we take the inverse and we have that the cross rate S1,3 = 2.197 CAD per pound.

Therefore S2 > S1,3, 3>2.197. This means that the pound is overvalued in London and therefore there are arbitrage opportunities.

In order to evaluate the investor’s profit in USD we begin by exchanging 1 USD with 0.50 pounds in N.Y. Then, we exchange 0.5 pounds with 1.5 Canadian dollars in London and we end up in Toronto where we exchange 1.5 CAD and get 1.365 USD. Therefore, given that we started with 1 USD we make a profit of 0.365 USD.

The demand for pounds against USD will result to a reduction of the exchange rate in N.Y. The supply of pounds against CAD will result in a decline of the exchange rate in London whereas the supply of CAD against USD will result to decline in the exchange rate in Toronto. Therefore, the S2 declines and the S1,3 increases and this will continue until the two rates are equal and there is no arbitrage opportunities.


(b) The Uncovered Interest Parity (UIP) and the Covered Interest Parity (CIP) are equilibrium conditions since they each set out a specific relationship between a set of variables which must hold if investors have no incentive to switch their funds between two countries. CIP involves an investment choice between the domestic and foreign country which involves no (market) risk, since any future foreign currency receipts are fully hedged using the appropriate forward exchange rate.

In contrast UIP involves investors taking a gamble of what the spot exchange rate will be at the end of the investment horizon. It is therefore recognized as a risky investment, although with UIP we assume investors are risk neutral, so that only the expected return from the investment matters (and any risk is totally ignored by the investor in making his decisions). Therefore, the key difference is that CIP involves a riskless investment whereas UIP is a risky investment.

(c) (i) Spot and forward rates are quoted dollars per sterling pound, which we take to be “domestic per unit of foreign”. Hence we take “domestic”= USA and “foreign” = UK.





Forward margin=forward rate – spot rate = 1.6480 – 1.6500 = -0.0020 (20 points).

Also (F-S)/S = -0.12% over 30 days.

(ii) hence a US investor must get less USDs per sterling pound in the forward market, to preserve Covered Interest Parity (CIP). Hence sterling is at a forward discount (and the USD at a forward premium)