Macroeconomics Homework: Production Possibilities, Trade, and Parity

This macroeconomics assignment analyzes key concepts including production possibilities, international trade, current account deficits, and covered interest rate parity. The assignment begins with an analysis of a production possibility curve, demonstrating how international trade can lead to ...Read More

Running head: MACROECONOMICS
Macroeconomics
Name of the Student:
Name of the University:
Author’s Note:

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Table of Contents
Answer to question 1:.................................................................................................................2
Answer to question 2:.................................................................................................................2
Answer to question 3:.................................................................................................................3
References and bibliography:.....................................................................................................5

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Answer to question 1:
Figure: Production Possibility Curve and Changing Scenario.
In the above graph, in the horizontal axis the quantity of wheat production is
measured and in the vertical axis the quantity of steel production has been measured. When
the country was operating at point A, there was a production of 20 units of steel and 20 units
of wheat by employing all the resources of the country. Therefore, the marginal rate of
technical substation was 1. It implies, to produce one unit of additional steel, one unit of
wheat have to be sacrificed. When the international trade opens, the combination moves to
Point B, producing 30 units of steel and the 10 units of wheat. Therefore, to produce
additional 10 units of steel, the country has to sacrifice production of 10 units of wheat. The
price for the steel in the international market is two units of wheat. As additional one unit of
steel can be produced by sacrificing one unit of wheat only, and the additional steel can be
sold in the international market at a price of two unit of wheat, additional 10 units of steel
which have been produced can be sold for 20 units of wheat. Hence ultimately the country
will have an additional 10 units of wheat in balance. Therefore, the total output of the country
is 20 units of steel and 30 units of wheat which can be obtained by employing the same
Wheat
Steel
20
0 20
A
B
30
10
Production
Possibility Curve

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amount of resources. Hence, it can be concluded that by the opening of the trade, the country
can reach to a better position as compared to the previous one (Agénor and Montiel 2015).
Answer to question 2:
Current account of a country includes the net proceeds from all the import and export
transactions. It also includes some transfer incomes and foreign aids and investment incomes.
Hence, the current account deficit is the negative balance of import and export transactions.
When there is a higher outflow than the inflows, there would be a negative balance in the
current account of balance of payment. The negative balance in the current account or the
deficit in the current account denotes the requirement of funds to fulfil the internal demands
of goods and services.
Deficit in the current account of balance of payment can be financed by borrowing
from the foreigners or by borrowing foreign currencies. As a result the risk of ownership
flight increases. It implies, as much the foreign currencies are borrowed to finance the current
account deficit, the ownership of the domestic assets goes to the foreigners. Some countries
use the negative current account balance purposefully, to make an easy borrowing of foreign
currency and to attract foreign investment in the business. As an example, the UK have been
maintaining a current account deficit since a very long time and after the Brexit vote in June
2016, the current account deficit of the UK decreased significantly, which was caused by
overseas earnings in terms of foreign currency was higher comparatively (Tang 2014).
Imports, exports and transfer incomes which are included in the current account balance are
mainly the end result of the trade or are considered to be made for consumption. Imports
which are included in the current account transactions are considered to be made for
consumptions and exports are also treated like the same. Each three components of the
balance of payment, i.e. the current account balance, financial account balance and the cpital

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account balance has an importance in the total balance of payment and has a greater influence
in the growth of an economy. Hence, financing the deficit of the current account from the
balance of financial account and capital account will cause and erosion of capital and
consumption and shrinkage of finances. Therefore it is important to finance the temporary
deficit in current account balance through borrowings from the foreigners.
Answer to question 3:
Covered interest rate parity theory makes the spot exchange rate and forward
exchange rate of two currencies equal based on the interest rate on each of the currencies.
Therefore, if the covered interest rate parity conditions holds, there would be no interest
differential for the given period and the forward exchange rate can be computed using the
following equation.
Ff /d =Sf /d × 1+if
1+id
Where,Ff/d = Forward rate
Sf/d = Spot rate
if = Interest rate of foreign currency
id = Interest rate on the domestic currency
In the given case study,
Sf/d = Spot rate = £0.50
if = Interest rate of foreign currency = 4%
id = Interest rate on the domestic currency = 5%

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Therefore applying the above equation, the forward rate should have been as follows.
F f
d
=£ 0.50 × 1+ 4 %
1+ 5 % =£ 0.4952
Therefore, the covered interest differential = £ 0.4952−£ 0.4700=£ 0.0252
The covered interest rate parity is a condition when the investors can only make a
strategy to hedge against future estimated fluctuations in the foreign exchange but the
arbitrage is not possible. If the covered interest rate parity condition holds, then there would
have been no opportunity for the interest rate arbitrage. As it can be observed from the above
calculation that, the covered interest parity condition does not hold, and there is an interest
differential of £0.0252, it can be concluded that the Domestic currency, pound will have a
capital inflows and the foreign currency, USD will have a capital outflow (Du, Tepper and
Verdelhan 2018). In such a situation, if an investor goes for a forward contract to sell the
Pound in three months then there would be a profit. It implies the accumulated amount of
investment from today till the three months would result into more accumulation of Pound
than the three months forward rate.

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References and bibliography:
Agénor, P.R. and Montiel, P.J., 2015. Development macroeconomics. Princeton university
press.
Du, W., Tepper, A. and Verdelhan, A., 2018. Deviations from covered interest rate
parity. The Journal of Finance, 73(3), pp.915-957.
Tang, T.C., 2014. Fiscal deficit, trade deficit, and financial account deficit: Triple deficits
hypothesis with the US experience.
Uribe, M. and Schmitt-Grohé, S., 2017. Open economy macroeconomics. Princeton
University Press.