Suppose the dollar interest rate and the pound sterling

INTERNATIONAL FINANCE Hw2

ECON 171 International Finance Problem Set #2 Due: August 10th, 2020 (11:59 pm) Instructions: Please provide complete answers to the following questions. You must submit your solutions by 11:59 pm Monday on August 10th. Note that it is plagiarism if your answers look remarkably similar to someone else’s and you do not indicate the group work. A group-work is strongly encouraged to do this problem set, but you will have to submit your own solutions. Write your answers as CLEARLY as possible. Illegible answers may lose points. Lastly, make sure to accompany appropriate reasoning or calculation as part of your solutions if it is required to understand your conclusion. I. Interest Parity Condition Revisited Suppose the dollar interest rate and the pound sterling interest rate are the same, 5 percent per year. What is the relation between the current equilibrium $/₤ exchange rate and its expected future level? Suppose the expected future $/₤ exchange rate, $1.52/₤, remains constant as Britain’s interest rate rises to 10 percent per year. If the U.S. interest rate also remains constant, what is the new equilibrium $/₤ exchange rate?

II. Understanding Nominal Interest Rates

Consider the following chart of dollar and yen interest rates:

ECON 171 2

From the mid 1990’s up to mid 2000’s, Japan’s short-term interest rates clearly have had periods during which they were near or equal to zero. Is the fact that the yen interest rates shown never drop below zero a coincidence, or can you think of some reason why nominal interest rates might be prevented by market forces from going below zero?

III. Link between Money Market and Foreign Exchange Market 1. Suppose there is a permanent decrease in the U.S. money supply. Trace the short-run and long- run effects on the current and expected exchange rate, interest rate, and price level. Draw the two- sided diagram to help explain your answer. Also draw the time paths of each of these variables. (We assume the economy starts with all variables at their long-run levels and that output remains constant as the economy adjusts to the changes in money supply, i.e. real output Y is given.) Include in your answer a brief description of how exchange rate overshooting or undershooting may appear in this case. 2. Suppose the Federal Reserve wants to fix the U.S. exchange rate with the yen at $0.008 per yen. If the equilibrium market exchange rate were significantly lower at $0.007 per yen, what would the Fed need to do to maintain the fixed rate of $0.008 per yen? What would be the effect of these actions on the money supply in the U.S.? Explain. 3. Upon reading in the newspaper that the dollar exchange rate with the euro has depreciated 12% in the last month, after a 15% appreciation in the previous month, one of your friends tells you, “I don’t understand a thing about these currency fluctuations. Surely the market must be irrational. Nothing justifies such large movements up and down.” What is your response?

IV. Purchasing Power Parity 1. Big Mac Index Case Study Here are data for a few countries:

Country Price of a Big Mac PPP-implied Exchange Rate Actual Exchange Rate

Indonesia 15,900 rupiah rupiah/$ 9,015 rupiah/$ Hungary 600 forints forints/$ 180 forints/$ Czech Republic 52.9 korunas korunas/$ 21.1 korunas/$ Brazil 6.90 real real/$ 1.91 real/$ Canada 3.88 C$ C$/$ 1.05 C$/$

(a) For each country, compute the predicted exchange rate of the local currency per U.S. dollar.

ECON 171 3

Note that the U.S. price of a Big Mac was $3.41. (b) According to purchasing-power parity, what is the predicted exchange rate between the Hungarian forint and the Canadian dollar? What is the actual exchange rate? (c) Provide all possible reasons why there exists some discrepancy between the predicted exchange rate based on PPP and the actual exchange rate. (References: Pakko & Pollard (2003) and Rogoff (1996); Both are available on Blackboard.)

2. Suppose that in December 2005, the euro exchange rate with the RON (the Romanian currency) is 0.2620 €/RON. Over the year 2006, the Romanian inflation rate is 9.7%, and the Euro area inflation rate is 2%. If the exchange rate at the end of the year 2006 is 0.2735 €/RON, does the RON appear to be overvalued, undervalued, or at the PPP level? Explain. What if instead Romanian inflation were 2% and the Euro area inflation rate were 10% over the year? Explain why your answer changes.

V. The Long-run Impact of Import Tariff

A country imposes a tariff on imports from abroad. How does this action change the long-run real exchange rate between the home and foreign currencies? How is the long-run nominal exchange rate affected? Will this import restriction necessarily improve the home country’s trade balance in the long-run? Explain carefully.