International Finance Essay

2250 Words Nov 18th, 2013 9 Pages
1. What is net foreign wealth and what is its relationship to the current account? Suppose that a country starts with $10B in net foreign wealth and its exports and imports in the following three years are $2B and $4B, $1B and $5B, and $2B and $6B, respectively. What is the country's net foreign wealth after three years? Should the country's government worry about this trend? What could it do about it? Does your answer depend on the exchange rate regime? Explain.

- Net foreign wealth is defined as the difference between the foreign assets owned by home country (ex. U.S.) and home country assets (U.S. assets) owned by foreigners. The relationship of net foreign wealth and current account is that the current account balance measures the
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This means that domestic goods will become cheaper than foreign goods, which would increase exports and fix the country’s current account balance.
- This scenario will depend on the exchange rate regime. Because in the fixed exchange rate regime, when they are faced with a current account deficit, the government must intervene in the foreign exchange market by buying the domestic currency with its reserves of foreign currencies. In this regime, it is important for a government to have significant foreign exchange reserve balance. If it does not, it may be unable to buy back its domestic currency and will be forced to devalue.
2. In the floating exchange rate regime, interest rate parity is the most important determinant of the exchange rate in the short run. Why must this condition be satisfied and what happens if it is not? Does it have to be satisfied in the long run as well? Does this condition play a role in the fixed exchange rate regime? Explain.

- Interest rate parity is the “expected returns on deposits of any two currencies that are equal when measured in the same currency”. If interest parity does not hold in the floating exchange rate regime, that is, if the difference in interest rates between two countries is not equal to the expected change in exchange rates

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