Can someone please explain the Saving Investment Imbalance approach for Forecasting Exchange Rates in laymens’ language?
Suppose a cash manager has an investment horizon of one-year. She has the choice of investing in either commercial paper with a maturity of six-months or commercial paper with a maturity of one-year. If she pursues the former, she will roll over her investment in six months to another six-month instrument. The current rates are 5% annually on the six-month commercial paper and 5.5% for the one-year maturity commercial paper. If in six months, the yield for six-month commercial paper is 5.2% annually, should she invest in the two six-month instruments or the one-year commercial paper? Also assume that she can utilize this strategy in either Country A or Country B. If Country A has a savings deficit and Country B has a savings surplus, which country should she invest in if she is using a savings-investment imbalances approach to forecast currency values?
A) Six-month in Country A. B) One-year in Country B. C) One-year in Country A.
given the 6 month rate = 5% and the 1 year rate is 5.5%
and the 6 month rate in 6 months is 5.2%
say she invests in 6 month paper, rolls over after 6 months
she gets 1.025 * 1.026 = 1.0516 5.2% which is less than what she would get if she invested in 1 year paper. (5.5%)
now Country B has a surplus - which would allow for currency appreciation and the like - so I would think 1 year in Country B.
Qbank question? I thought C) is the answer.
Answer is C.
Yield on one-year is noticeably higher than rolled over six-month CP, so you go with one-year.
If Country A has a savings deficit, then savings-investment balance approach to FX rates implies that Country A’s currency will appreciate. Invest in Country A.
One question for your guys; when calculating the CP rollover yield, do you do (1+(.05/2))*(1+(.052/2)) or do you do (1.05)^1/2 * (1.052)*1/2?
I also think it should be country B with saving surplus so ans B
only in the short term will country a’s currency appreciate…when the CA deficit has widened sufficiently, currency a will depreciate no?
The savings/investment imbalance assumes the CA stays constant. If country A has a savings deficit then foreign investment (both within the CA) must make up the difference. A higher demand of Country A’s currency from foreign investors would cause the currency to increase. I would say choice C as well.
B is the official answer.
Is it from qbank? Q#?
What is the official reasoning?
Borrowed from earlier post’s of Mill View & cpk
Y=C+I+(X-M) ……….Excluding G for simplicity sake here. where Y= income C= consumption I=investment X=exports M=imports i.e. (X-M) is the external imbalance
So if the difference between income and consumption (Y-C) is savings (S) then: Y-C=I+(X-M) or S=I+(X-M) thus S-I=(X-M) In other words, the savings investment imbalance is the cause of any open economy’s external (current account) imblance.
it is explained by formula too
(S-G) - (I-T) > 0 would mean Savings and Investment have a positive imbalance
This is equal to (X-M) -> Exports > Imports then.
So the two would need to be matched. And Exports > Imports causes demand for the currency - hence appreciation.
So country having CAS will experience appreciation.
I agree that debt inflows provide financing for CAD but if CAD widens to uncontrollable level, it impacts country external debt position & financial stability hence currency depreciation
EMH may apply.
So would it be correct to say:
1.Private sector and/or public sector deficit->expansionary economy.
2.Since CA=private secot+public sector->CA must be in deficit to balance.
3.In the Short run : CA deficit comes from [a] Imports>Exports and if this is not enough, then [b] Currency must appreciate which is concurrent with capital inflows to the buoyant domestic economy.
4.When CA deficit widens substantially over time-> international community may regard domestic country as
- net debtor
- relying on foreign flows to support domestic investments (as opposed to using own economic strength to support these investments)
This makes economy unattractive, global economies withdraw funds from domestic economy ->domestic currency depreciates…
does this make sense?