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ECS3703 2019 2 TL 201

International Economics (University of South Africa)

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ES3703/201/1/2019

Tutorial Letter 201/2/2019

International Finance

ECS3703

Semester 2

Department of Economics

IMPORTANT INFORMATION
This tutorial letter contains important information
about your module.

BARCODE

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Dear Student

This tutorial letter contains the following:

 Comments on Assignment 01 (second semester)

 Comments on Assignment 02 (second semester)
 The format of the November 2019 examination

1. COMMENTS ON ASSIGNMENT 01

The compulsory Assignment 01 consisted of 20 multiple-choice questions of which 10

contributed to your semester mark.

The answers to the questions are as follows:

Questio Questio
Answer Answer
n n
1 - 11 3
2 - 12 2
3 - 13 1
4 - 14 1
5 - 15 2
6 - 16 4
7 - 17 4
8 - 18 2
9 - 19 1
10 - 20 2

QUESTION 11: The correct answer is option [3].

Statement (a) is incorrect. No information is supplied to enable you to determine what

happens to the pound/euro exchange rate.
Statement (b) is correct. A shortage of pounds will (with market forces at work) result in an
increase in the “price” of pounds. In this instance more of the other currency (not mentioned
in the question) will have to be paid to get a pound which implies an appreciation of the
pound relative to that currency (and a corresponding depreciation of the other currency).
Statement (c) is incorrect. The exchange rate is kept within narrow limits in different
monetary centres
by arbitrage. The textbook p 411 says ”…the same…” but in practice it is rather “within
narrow limits”. For arbitrage to take place the exchange rate between two centres of cause
have to differ momentarily as explained on p 411.
Also see the prescribed textbook pp 408 and 409.

QUESTION 12: The correct answer is option [2].

Statement (a) is correct. See the definition and explanation of direct investment on p 6 of the
study guide.
Statement (b) is incorrect. Net gold exports are recorded in the current account and not in
the financial account. See pp 3 and 5 of the study guide.
Statement (c) is correct. See the definition and explanation of portfolio investment on p 6 of
the study guide.

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QUESTION 13: The correct answer is option [1].

Option [1] is correct according to the definition of “appreciation”. See the prescribed
textbook p 409.
The other options are thus obviously incorrect.

QUESTION 14: The correct answer is option [1].

Since none of the statements refer to a year it is not possible to determine their correctness
and thus option [1] is correct.

QUESTION 15: The correct answer is option [2].

When the interest differential in favour of the foreign country is zero, the foreign currency is
neither at a forward discount nor at a forward premium. Such a situation is referred to as
covered interest arbitrage parity and the forward rate on the foreign currency is equal to
its spot rate.
When there is indeed an interest differential in favour of the foreign country, as in this
question, then there cannot be covered interest arbitrage parity.
Only statement [2] is thus correct.
See the textbook p 427.

For those who are not that comfortable with covered interest arbitrage, let us use the
example on p 426 of the prescribed textbook. For an American investor, Germany is the
foreign country (Frankfurt is the financial centre there). The interest rate (on 3-months
treasury bills) is 6 percent per year in the USA (New York is the financial centre there) and 8
percent in the foreign country (Frankfurt in Germany). The currency with the higher interest
rate is usually at a forward discount and the euro is accordingly assumed to be at a forward
discount of 1 percent in this example.

What does this forward “discount” means? Should the spot rate be $1,00 = €10,00 and the
forward rate is $1,00 = €11,00, then the euro is at a discount. The American investor will only
receive $0,90 for €1,00 ($1,00 = €11,00 implies $0,90 = €1,00) when he brings his money
home in a year’s time (at the forward rate) while he now pays $1,00 for a euro (spot rate) to
buy the treasury bills. That is his cost of taking out forward cover.
American investors will move their money to Germany to earn the higher interest rate which
will decrease the interest rates there (in Germany). They will simultaneously take out
forward cover buying dollar forward which will depreciate the forward $/€ rate (they will
increasingly have to pay more $ for a euro) thus increasing their costs. Ordinary market
forces are at play in both instances. This process will theoretically continue until the costs
are equal to the interest rate differential (benefit) which will then stop the movement of
money from the USA to Germany for this purpose.

Note: Why would the currency with the higher interest rate be at a forward discount? It is
simply a matter of costs. For example: Interest rates in South Africa are currently higher
(almost double) than in the USA (roughly 10% versus 5%). The Standard bank (selling) spot
rate today (5 November at 11:00) is USD1,0000 = ZAR14.8153 while the 12-month forward
rate is USD1,0000 = ZAR15.5702. The “forward discount” thus implies that with the forward

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rate you have to pay more rand for the dollar than with the spot rate. Why? The banks do not
want to take the foreign exchange rate risk and should you buy dollar forward for delivery in
12 months, the bank will buy the dollars now at the spot rate and keep it for the 12 months.
Since the bank earns less interest on the dollar than they would on the rand, you have to pay
them the difference in terms of a “higher” exchange rate. (Note that a “higher exchange rate”
is not a correct term to use in Economics but in this instance it is useful)

QUESTION 16: The correct answer is option [4].

Statements [1], [2] and [3] correctly refer to properties of the absolute purchasing power
theory and thus statement [4] is the correct choice.
See the prescribed textbook p 444.

QUESTION 17: The correct answer is option [4].

Since the statements in this question refer to” depreciation” and ”appreciation” the reference
is to flexible exchange rates. Theoretically the interest (rate) differential between two
countries will always equal the expected change in the exchange rate between the
(countries’) two currencies.
The country’s currency with the relatively lower interest rate will be expected to appreciate
so as to equalise the return on the two currencies.
The interest rate can of cause also be expected to change but that is not applicable to this
question (according to the ceteris paribus rule).
Statement [1] is thus correct which of cause implies that statement [2] is also correct.
Statement [3] is also correct. Although the other currency is not mentioned it is implied that
there is another currency.
The statements in the questions could have contained a bit more information. For example,
statement [1] could have read as follows: “The interest differential in favour of the dollar
(relative to the euro) equals the expected rate of depreciation of the euro.” I am sure that
you understood it correctly that the implied currency relative to which there is an interest
(rate) differential is also the euro.
See the prescribed textbook p 459.

QUESTION 18: The correct answer is option [2].

Statement [1] is incorrect and thus statement [2] is correct. That is exactly what is explained
in fig.16.1.
Statements [3] and [4] are incorrect since the elasticity of the demand and supply curves
under consideration has no direct reference to the feasibility of an exchange rate system.
See the prescribed textbook pp 486 and 487.

QUESTION 19: The correct answer is option [1].

Statement ([1] states the Marshall-Lerner condition correctly which also implies that
statement [2] is incorrect.
Since the Marshall-Lerner is an exact formulation the wording of statements [3] and [4]
makes them incorrect.
See the prescribed textbook p 494.

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QUESTION 20: The correct answer is option [2].

This question refers to the phenomenon of (potentially incomplete) “Currency Pass-

Through”.
See the prescribed textbook p 501. As explained there the currency pass-through may be
incomplete and thus statement [2] is the only correct option.

2. COMMENTS ON ASSIGNMENT 02

Assignment 02 consisted of an essay question and it contributed to your semester mark. The
marks awarded are not an indication of how it will be in the exam. A question like this one will
rather be for 25 marks in the exam. See assignment 3 in TL101 for a better indication of how
marks will be allocated. In the exam we tried to structure the questions so that you know
exactly what is expected from you.

Many students used other sources than the prescribed which is much appreciated. You
could however have scored full marks by merely using the prescribed material. Since the
question was directly from the prescribed textbook (pp 662-664) it was expected from you to
cover at least the aspects referred to in the book although you could have added from other
sources.

Although many of the essays contained topics not relevant to the question (for example the
gold standard), nobody was penalised for that. Please remember that in the exam time is
usually a factor so rather not digress from the actual topic. You will likewise not be penalised
for irrelevant facts in the exam, but they do not earn marks of cause.

In general, the essays were excellent and I was pleasantly surprised by the effort put into the
appearance of the essays by most students. In real life the presentation of a document is
often considered to be a sign of diligence and it can count a lot in your favour.

The following are some key words around which you could have built your answer, but
marks were awarded generously for deviations too:

Operation
Reality was reluctance to change par values
Considered as sign of weakness
Until long overdue
Forced on them by destabilising speculation
Example(s)
Effects was: Robbed BW of flexibility and mechanisms. Crucial role in collapse.
Huge destabilising international capital flows
Example(s)

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Convertibility of $ into gold resumed

Other examples
Capital account restrictions permitted
Despite restrictions huge destabilising capital flows continued
Facilitated by Eurocurrency markets
Trade: Trade expansion act
Gatt
Many non-tariff barriers remained
Economic integration

Evolution
GAB: Help nations with BOP
Standby arrangements
Swap arrangements: Combat hot money flows
SDR’s: Supplement international reserves
Central Bank only
Gold pool: control gold price

3. FORMAT OF THE MAY EXAMINATION

The November 2019 examination paper is a fill-in paper. You may not remove the paper
from the examination venue.

The paper consists of two (2) sections: A and B.

SECTION A (50 marks)

Section A consists of TWO questions. ANSWER BOTH THE QUESTIONS. Each question
carries twenty five (25) marks.

SECTION B (50 marks)

Section B consists of FOUR questions. You must answer any TWO of the four questions.
Each question carries twenty five (25) marks.

The number of lines provided for answering each question should give you an indication of
how much you should write (the maximum). If the size of your handwriting deviates from the
average (you would know that), take it into account. A few pages for rough work are provided
at the end of the script. You can also use that for any overflow from an answer. Please
indicate it as such so that it is not assumed to be rough work.

Note: There will be no calculations expected from you.

Study unit 1 of the study guide is prescribed although chapter 13 of the prescribed
textbook is not.

1MR Marais
E-mail: maraimr@unisa.ac.za

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