International Economics

1. [15 POINTS] There are two countries in the world, Yego and Zed. Currently, Yego and Zed do
not permit international capital flows. Yego has $5 trillion of capital; KYEGO = 5. Zed also has
$5 trillion dollars of capital, KZED = 5. The marginal product of capital schedules are known to
be:

i MPKYEGO = 36 – SKYEGO
l MPKZED = 22 – 4KZED
The marginal products of capital are quoted as real rates of return (real interest rates).
A. Is this equal split of capital between Yego and Zed (KYEGo = 5 and KZED = 5) optimal?
Explain your position carefully. [3 POINTS]
B. Suppose Yego and Zed begin to allow free flows of capital. [12 POINTS]
Will Yego borrow or lend capital,
and how much will it borrow or
lend?
Will Zed borrow or lend capital,
and how much will it borrow or
lend?
After international capital flows,
what is the world equilibrium real
interest rate?
After international capital flows,
how much is Yego better off or
worse off?
After international capital flows,
how much is Zed better off or
worse off?
After international capital flows,
how much is the world better off or
worse ofl”?

1. [15 POINTS] There are two countries in the world, Yego and Zed. Currently, Yego and Zed do
not permit international capital flows. Yego has $5 trillion of capital; KYEGO = 5. Zed also has
$5 trillion dollars of capital, KZED = 5. The marginal product of capital schedules are known to
be:

MPKYEGO = 36 – 5KYEGo
MPKZED = 22 ~ 4KZED
The marginal products of capital are quoted as real rates of return (real interest rates).
A. Is this equal split of capital between Yego and Zed (KYEGO = 5 and KZED = 5) optimal?
Explain your position carefully. [3 POINTS]
B. Suppose Yego and Zed begin to allow free flows of capital. [12 POINTS]
Will Yego borrow or lend capital,
and how much will it borrow or
lend?
Will Zed borrow or lend capital,
and how much will it borrow or
lend?
Alier international capital flows,
what is the world equilibrium real
interest rate?
After international capital flows,
how much is Yego better off or
worse off?
After international capital flows,
how much is Zed better off or
worse off?
After international capital flows,
how much is the world better off or
worse ofi?
2. [25 POINTS] Suppose the US. and South Africa currently do not allow capital flows between
the two countries, but that they are negotiating a bilateral agreement to permit up to $2 trillion of
capital flows. This would be a capitalcontrol – the countries are not permitting free flows ofl
capital and are regulating the quantity of foreign investment. Currently, the US. has $14 trillion
of capital and South Africa has $6 trillion. The diagram below shows the MPK schedules for
IZhe US. and South Africa. The MPK schedules for the US. and South Africa are: ” 7 rijs
MPKus. = 17 – Ku_s_ 16
r“ ‘5 MPKSA = 16-Ks.A. K
4 ‘ m
15 ‘ ‘5
{Z I 2
[I H
10 ID
q 0!
g 8
I 7 , 7
6 6
fi 5″ l g
‘f 1 u
3 g . 3
2 g 2
l M? 05 l M pksfi I
012345678‘1‘15101IZ’IBI‘tIS’lénlo“(29
TRlLumos oF out-Mes
A. Answer the . uestions below. 10 POINTS
Once the agreement to permit up to $2 trillion
of capital flows is in place, which way does the
capital flow? (In other words, which country is
the borrower and which coun- is the lender?)
With the capital controls, what is the rate of
return on capital in the U.S.?
With the capital controls, what is the rate of
return on capital in South Africa?
By limitingthe capital flows to $2 trillion) is
the world-better off or worse off compared to
the alternative of unrestricted capital flows?
How much is the world better off or worse ofi‘?
By opening up the opportunity for $2 trillion of
capital flows, is the world better off or worse
off compared to the alternative of no capital
flows? How much better off or worse ofi?
NOTE: THIS QUESTION CONTINUES ON THE NEXT PAGE

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B. Now suppose negotiations between the U.S. and South Africa ultimately permit
completely free capital flows, but that the U.S. decides to levy an annual tax of <3.0% on:
(1) all U.S. capital invested in South Africa; and (2) all South African capital invested in
the U.S. However, given that capital only flows one direction, one of these taxes will be
relevant and the other one will not. Answer the questions in the table below. [15
POINTS
After the agreement to permit free capital flows, and
y after the decision to levy the 3.0%, how much is the
U.S. better off or worse off compared to the initial
situation of no capital flows?
After the agreement to permit fi’ee capital flows, and
after the U.S. decision to levy the 3.0% tax, how much
is South Africa better off or worse ofi” compared to the
initial situation of no capital flows?
Suppose the U.S. decides to drop the 3.0% tax, but
South Afi‘ica picks it up. In other words, there are no
U.S. taxes on capital flows, but South Africa decides
to levy an annual tax of 3.0% on (1) all South Afiican
capital invested in the U.S.; and (2) all U.S. capital
invested in South Africa. How much is the U.S. better
off or worse off, compared to the initial situation of no
ca ital flows?
Once again, suppose the U.S. decides to drop the 3.0%
tax, but South Africa picks it up. In other words, there
are no U.S. taxes on capital flows, but South Afiica
decides to levy an annual tax of 3.0% on (1) all South
African capital invested in the U.S.; and (2) all U.S.
capital invested in South Africa. How much is South
Africa better off or worse off, compared to the initial
situation of no ca – ital flows?
Reflecting on the four questions above, do you think
i policies regarding taxes on capital flows should be a
l * subject of negotiation between the U.S. and South
1 Africa?

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3.‘ [20 POINTS] An investor is undertaking an investigation of purchasing power parity between
[-?U.S., which uses the dollar as its currency, and Erehwon, which uses the lek as its currency.
l The table below gives information for the US. and Erehwon for 2016. Prices and money
supplies are quoted in national currencies. The money demand constant represents the
proportion of nominal income that is held as money. Real income is measured in bundles of
out out, which are identical in the US. and Erehwon.
Consum tion Bundle MS Constant, k Y
A. There is missing information in the table above. What is the price of the consumption
bundle in Erehwon? What is the money supply in the U.S.‘?

B. What is the purchasing power parity exchange rate, quoted as dollars per lek? If the
actual exchange rate is $0.75/lek, is the lek overvalued or undervalued according to
purchasing power parity? 0
I. 1
1”
C. Suppose a recession in Erehwon causes real income to decline 10% to 180 bundles.

Unfortunately, the central bank in Erehwon does‘not change the money supply, and the
money‘defnand constant does not change either. Furthermore, nothing happens to the
variables in the US What is the new purchasing power parity exchange rate, again

quoted as dollars per lek? Briefly explain whether the lek should depreciate or
appreciate, and why.

4. [20 POINTS] Suppose you are given the following financial information on January 1:
Spot $/£ exchange rate (e) $1 .25/£
1-year interest rate on dollars (ius) 2.0%
1-year interest rate on pounds (iUK) 5.0%
Market’s expected spot rate in one year (eex) $1 .23/£
A. If a UK. investor is in agreement with the market’s expected fiiture spot rate, should he
make an uncovered investment in dollars or simply invest in pounds? [4 POINTS]
l r
l l x ‘ f

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B. If covered interest parity holds, what is the 1-year forward rate on January 1? [4
“w POINTS]
C. If a U.S. firm will be receiving £1 ,000,000 in one year, and wants to eliminate any
foreign exchange risk using a forward contract, what should the firm do? [4 POINT S]
D. If a U.S. firm will be receiving £1 ,000,000 in one year, and wants to eliminate any
1 foreign exchangeirisk but discovers that forward contracts are not available, what can the
firm do in the money markets? [8 POINTS]

5. [20 POINTS] Consider the spot market for the Korean won, as shown in the panel below.
won/fl
e 5

-______________________
Qolollms

A. There are proposals in the U.S. to change the corporate income tax by modifying the way
it handles taxation of revenues on exports and the deductibility of expenses related ‘to
imports: this is the “border adjustment tax.” Some analysts conclude that there would be
an‘el’fect on the won/dollar exchange rate if the border adjustment tax goes into effect.
Describe what might happen in the space below and show the effects in panel above.

B. Suppose the Bank of Korea (the central bank) pursues a fixed exchange rate regime at the
initial exchange rate, eo. What will it need to do after the U.S. implements the border
adjustment tax in ofdét’fo maintainvthis exchange rate? Describe what it needs to do in
Espace below and show the effects in the panel above.