Question

(19.5) The New Economic Republic has a Net Foreign Asset position of $0 in 2003 but runs capital account deficits of 3% in 2004, 2005, and 2006. The capital account deficit is used to purchase overseas equity.

1.Assuming no GDP growth, no capital gains, and no change in the exchange rate, what is the IIP in 2004, 2005, and 2006?

2. Assume no GDP growth or changes in the exchange rate but that the equities pur- chased experience capital gains of 10% per annum. Recalculate your answer to (b).

3. In addition to the assumptions in (b), assume that the New Economic Republic cur- rency depreciates by 10% per annum. How does this change your answer to (b)?

Answer 1

SOLUTION:

a) With a capital account deficit of 3% GDP per year used for purchasing the overseas equity and no GDP growth, no capital gains, and no change in the exchange rate, after one year the IIP will be 3% GDP, after 2 years it is 6% GDP, and 3 years it is 9%. GDP

(b) After 1 year the IIP is 3% however this earns a capital gain of 10% ; add the new capital account deficit of 3% thus at the end of Year 2 the IIP is 6.3%. Applying the similar logic the end of Year 3 sees an IIP of 9.93% GDP.

(c) Since the foreign currency now appreciates by 10% per annum the return on overseas investment will be 20% (10% capital gain + 10% appreciation) thus the IIP position will be 3%, 6.6% and 10.92% GDP.