Penuria is a small, impoverished country whose main trading partner is the United States. Its currency is called the chump. (Its citizens have nothing more than chump change in their pockets.) The economic information for 2001 is:

GDP: 5 billion chumps
Exports: 400 million chumps
Imports: 500 million chumps
Current account balance: -200 million chumps
Capital account balance: 200 million chumps
External debt (beginning of 2001): 500 million dollars
Interest rate on the debt: 10%
Exchange rate: 2 chumps = 1 dollar
Foreign exchange holdings: 200 million dollars

To make things simple, let's assume that the external debt is recalculated at the beginning of each year and then remains constant until the beginning of the following year.

1. What is the initial trade balance?
- 100M chumps

2. What is the initial balance in non-trade items (investment income and transfers) on the current account? What in particular causes this to happen? (Hint: look at the determinants of the two non-trade items on the current account.)
The initial balance is - 100M. This is due to debt service of 10% on an external debt of 1B chumps ($500M)

3. At the initial exchange rate, approximately how many months of imports can Penuria finance with its holdings of foreign exchange?
It can finance 4/5 of a year, or between 9 and 10 months.  ($200M = 400M chumps)

4. Assume that the trade balance remains the same for the following 12 months (2002), and that all current account deficits are financed by capital account surpluses.

(a) What is the new external debt at the beginning of 2002?
1.2B chumps or $600M

(b) What will be the interest payment on that debt?
120M chumps

(c) How will this change the current account deficit during 2002?
It will increase it by an extra 20M chumps

(d) If the capital account doesn't change, what will happen to Penuria's foreign exchange holdings?
They will decline by 20M to 380M.

Now suppose the US signs a trade deal with another small, impoverished country, Nadaland. Because of this, annual exports from Penuria to the US fall to 300 million chumps.

5. If exports and all other current account items (except interest payments) remain unchanged, what will be the current account balance at the end of 2002?
- 320M chumps

6. If the entire change in the current account balance is financed from the capital account:

(a) How much additional capital inflow must there be?
320M chumps

(b) How will this effect the following year's interest payments?
They will go up by 32M chumps

7. If the entire change in the current account balance is financed from foreign exchange, what will be the change in foreign exchange holdings?
They will be reduced by 320M  to 80M chumps.

8. Suppose at the end of 2001 that the chump falls in value by 50%; i.e. it now exchanges at four to the dollar.

(a) If the same physical quantities of goods are exported and imported by Penuria in 2002, what will be its trade balance measured in chumps?
Exports remain at 400M. Imports rise to 1B; so the trade balance becomes -600M.

(b) Do you expect the physical quantities of exports to remain the same? Explain.
No. Exported goods become half as expensive in the US (if no one raises prices); so US consumers should buy more. Imported goods are twice as expensive; so Penurians should buy less.

(c) By how much must the physical amount of exports increase in order to restore the same value of exports, measured in chumps?
They can remain the same, provided the goods sell for $100M in the US.

(d) By how much must the physical amount of imports decrease in order to restore the same value of imports? What factors could potentially lead Penurian consumers to reduce the physical quantity of their imports in this manner?
They must decline by 50%. This might occur because of steep price increases on US-made goods. It might also occur because of a large decline in the income of Penurians due to austerity.

(e) How many chumps will Penuria pay during 2002 in interest on its debt?
Without the change in exchange rates the debt would be $600M or 1.2B chumps (see 4a above). With the new exchange rate, $600M becomes 2.4B chumps. At 10% interest, Penuria must pay 240M chumps to service the debt in 2002. (This could begin to add up....)