Inflation, interest rate and exchange rate targeting — MCQs

David Okafor, an international economist at Meridian Capital, is reviewing currency exposures and trade developments for a global macro portfolio. The portfolio holds euro-denominated equities, Japanese government bonds, and Lydoran sovereign debt. Okafor must ensure that all exchange-rate calculations use the firm's convention that a quotation written A/B indicates units of currency A per one unit of currency B. Current spot quotations are provided in Exhibit 1. The portfolio's reporting currency is USD, but the investment committee also monitors the yen value of its euro exposure. Okafor explains that a valid cross-rate calculation must arrange quotations so the intermediate currency cancels. He cautions that simply dividing two quoted numbers without tracking their currency units can produce a reciprocal or otherwise invalid rate. Transaction costs, bid–ask spreads, and settlement differences may be ignored for the analysis. Okafor next assesses the developments in Exhibit 2. Before the tariff, Lydora imported machinery at the world price. Domestic manufacturers supplied some machinery, while domestic businesses purchased a larger quantity and imported the difference. Lydora is too small to influence the world price. The new tariff increases domestic production and government revenue but reduces domestic consumption and import volume. There are no offsetting production subsidies or tariff rebates. Okafor also considers how an alternative policy tool, such as an import quota calibrated to the same import quantity, would compare with the tariff in terms of who ultimately captures the value created by the trade restriction. Lydoran government bonds are freely accessible to foreign investors. The announced purchases are large relative to normal market turnover, and investors will fund them by exchanging foreign currencies for Lydoran currency in the spot market. The central bank does not target a particular exchange rate, impose capital controls, or purchase foreign currency to offset the inflow. Okafor distinguishes this immediate portfolio-flow effect from any slower adjustment in exports and imports. Finally, Okafor develops a long-run equilibrium view. Lydora's productivity growth is expected to exceed that of its trading partners primarily in the tradable manufacturing sector. Labour is mobile between Lydora's tradable and non-tradable sectors, causing productivity-driven wage gains to spread across both sectors. Productivity growth in Lydora's non-tradable sector is not expected to increase comparably. Okafor assumes nominal exchange rates and domestic prices can eventually adjust, so his conclusion concerns the long-run real exchange rate rather than a temporary nominal misalignment.

Meridian Capital manages global fixed-income and currency portfolios. Its currency strategist, Javier Soto, reviews the spot rates, interest rates, and price indexes in Exhibit 1. All interest rates are effective annual rates, and forward contracts mature in exactly one year. Transaction costs, taxes, and credit risk are assumed to be zero. The USD/EUR quote states the number of US dollars per euro; therefore, EUR is the base currency and USD is the price currency. Soto first checks whether the observed one-year forward rate is consistent with covered interest parity. A trader can borrow either currency at its stated risk-free rate, convert at the spot rate, invest in the other currency, and use a forward contract to eliminate exchange-rate risk. Meridian requires any parity calculation to use the full interest-rate ratio rather than an approximation. A UK portfolio manager also needs the JPY price of one GBP. Soto is instructed to calculate the cross-rate directly from the JPY/USD and USD/GBP quotes in Exhibit 1. The quoted currencies and units must cancel algebraically; bid–ask spreads are ignored. For valuation analysis, Meridian defines the real exchange rate as q = S × P_EUR/P_US, where S is the nominal USD/EUR rate. Soto compares the current real exchange rate with the equilibrium estimate in Exhibit 1. The equilibrium estimate is based on sustainable productivity, terms-of-trade, and net foreign asset positions rather than short-term capital flows. The committee asks for the nominal rate that would be consistent with the estimated equilibrium real rate at the current price indexes. Meridian separately studies Eastland, an export-oriented economy whose currency has recently depreciated by 12% on a trade-weighted basis. Export and import quantities are fixed by contracts for the next two quarters, but firms can adjust suppliers and customers thereafter. Meridian estimates that, after adjustment, the absolute values of the long-run export and import demand elasticities sum to 1.4. Import prices are invoiced primarily in foreign currencies. No new tariffs, quotas, or capital controls are expected. Finally, Soto notes that an unexpected increase in a country's real interest rate relative to foreign rates can attract portfolio capital, other things equal. Under a floating exchange rate, such inflows generally increase demand for the domestic currency, although longer-run exchange-rate valuation also depends on inflation, productivity, trade, and external-balance fundamentals.

An economist seeking an indicator that most likely turns before aggregate economic activity should select:

An investment firm is evaluating the economic outlook for Norland, Sudoria, and Bellaria. Norland and Sudoria can produce wheat and textiles using labor with constant opportunity costs. The productivity data in Exhibit 1 show that Norland can produce more of either good per worker-day. The countries are considering a trade agreement under which each would specialize partly according to comparative advantage rather than absolute productivity. Sudoria currently imports steel at a world price of USD 500 per tonne. Its government is considering either a tariff or an import quota designed to produce the same domestic steel price and import quantity. Under the tariff, the government would collect the tariff payments. Under the quota, import licenses would be auctioned competitively to the highest bidders, with the auction proceeds retained by the government. The analyst notes that either policy would raise domestic steel prices, increase domestic production, reduce domestic consumption, and create efficiency losses relative to free trade. Bellaria is a small open economy that has historically received substantial foreign direct investment. A territorial dispute has recently escalated, and negotiations between the affected states have been suspended. Investors now assign a higher probability to capital controls, trade interruptions, and damage to transport infrastructure. Bellaria's sovereign and corporate risk premiums have increased, several multinational firms have delayed new factories, and domestic businesses have reduced capital-expenditure plans. No physical capital has yet been destroyed, but the lower investment rate is expected to persist for several years. The firm also evaluates Bellaria's sources of economic growth using a standard growth-accounting framework. The framework treats output growth as the sum of labor growth weighted by labor's income share, capital growth weighted by capital's income share, and growth in total factor productivity. Exhibit 1 provides all required growth rates and factor shares. The factor shares sum to 100%, and no additional adjustment for human capital is required. One analyst argues that Norland should export both wheat and textiles because it has absolute advantage in both goods. A second analyst argues that the geopolitical dispute affects only short-term market volatility and cannot influence potential growth unless existing factories are destroyed. The portfolio team must assess both claims using opportunity-cost analysis and the effects of persistent uncertainty on capital accumulation.

An analyst observes broad declines in real income, employment, industrial production, and wholesale-retail sales. The economy is most likely in a:

A government threatens targeted trade restrictions to induce another state to alter its security policy. An analyst should most likely classify this geopolitical instrument as:

A domestic pension fund purchases a newly issued foreign corporate bond using domestic currency. The transaction is most likely recorded as: