Problem Set # 5

International Finance Miguel D. Ramirez

1. In class we discussed the origins, structure, and functions of the Eurocurrency market. Identify and explain three major economic and/or political reasons for the rapid growth of the Eurocurrency market during the 1960-98 period. Relate your answer to the spread between lending and deposit rates in both the U.S. banking system and the Eurocurrency market.

2. Create an example of money being transferred by a U.S. firm from a U.S. bank to a Eurobank in the Eurodollar market. Suppose the U.S. bank has a correspondent relationship with the U.S. bank. Your example should include at least one interbank transaction before dollars are borrowed by a German firm. How is the gross size of the Eurodollar market affected by your example? What about the net size? Has the number of dollars in the U.S. nonbank public changed and why? Suppose the Eurobank does not have a correspondent relationship with the U.S. bank. How would this affect the total number of dollars in the U.S. banking system? How about its composition?

3. In class I derived the Eurocurrency multiplier and traced some of its implications for monetary policy. Briefly identify and explain the key parameters of the multiplier and explain what would happen when their values change. In addition, briefly explain what would lead to a change in the magnitude of these parameters.

Now, suppose that the reserve requirement ratio was .03 and the fraction of every dollar deposited in the Eurocurrency market was .30. What is the value of the multiplier? What would happen to the world supply of dollars (and interest rates) if the U.S. Fed reduced the money supply by $200 billion? Briefly explain your reasoning.