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Balance of Payments

A. The U.S. dollar exchange rate can be influenced by changes in the current account, the capital account and official reserve transactions. For each of the following changes in the table below indicate what account do you think it influences and why do you believe so.

b. Does the dollar appreciate or depreciate as a result of each change? why.
Practice answers should be filled out in table and with separate explanation as well.

(Consider that for each part in this problem first, identify an account that is initially and more directly impacted by the change indicated in the practice question. Choose either current account or capital account but not both and briefly state why that account is influenced by the change described in the question. Then, figure out if the change indicated in the question causes the dollar to appreciate or depreciate. Ask yourself what causes the exchange rate to change and focus on the effect of the change stated in the question on the determinate of exchange rate. )

A. Increased inflation in Japan: 1. Which account is impacted by this change? 2. Does the dollar appreciate or depreciate (which)?
B. Increases in the growth of U.S. money supply, holding prices constant: 1. Which account is impacted by this change? 2. Does the dollar appreciate or depreciate as result (which)?
C. Increased protectionism in Japan (higher tariffs or quotas on imports): 1. Which account is impacted by this? 2. Does the dollar appreciate or depreciate?
D. Fear of political instability in Europe: 1. Which account is impacted by this? 2. Does the dollar appreciate or depreciate?
E. A firm in the US develops and patents a technique to produce low cost computer chips: 1. Which account is impacted by this? 2. Does the dollar appreciate or depreciate?

Solution Preview

As I tell all my first time Econ students: I like to help undergrads understand the entire concept, rather than just provide the answers to specific problems (as an ethical issue, and because the students are better off when exam-day rolls around). So if you have any other questions or need clarification, just let me know.

OK, having said all that, let's get to work. As the problem says, the exchange rate (for the U.S. dollar or any non-pegged non-gold currency) is partially determined by the current and capital accounts, as well as "Fed" (reserve) transactions. Actually, I'm surprised the prof didn't mention the financial account... Just so you know: (capital account) + (current account) + (financial account) + (changes in official reserves) = 0 at all times.

Now it sounds like this mysterious table may have actually given you some hypothetical situations to discuss, so I'll explain how all three relationships work function with the exchange rate. This should allow you to answer any hypothetical change, both in this problem and in future assignments/tests.

** One more important "administrative" bit of information: I feel I should tell you that this answer, like most of what you are probably being taught, is based on classical economic theory. However the "punch line" is that modern econometricians (economists who do statistical research) have findings ...

Solution Summary

A deficit in the current account balance is examined.

$2.19