1) Consider the United States and the countries it trades with the most (measured in trade volume): Canada, Mexico, China, and Japan. For simplicity, assume these are the only four countries with which the United States trades. Trade shares and exchange rates for these four countries are as follows:
|
Country (currency)
|
Share of trade
|
$ per FX in 2009
|
Dollar per FX in 2010
|
|
Canada (dollar)
|
36%
|
0.9225
|
0.9643
|
|
Mexico (peso)
|
28%
|
0.0756
|
0.0788
|
|
China (yuan)
|
20%
|
0.1464
|
0.1473
|
|
Japan (yen)
|
16%
|
0.0105
|
0.0112
|
a. Compute the percentage change from 2009 to 2010 in the four U.S. bilateral ex- change rates (defined as U.S. dollars per units of foreign exchange, or FX) in the table provided.
b.Use the trade shares as weights to compute the percentage change in the nominal effective exchange rate for the United States between 2009 and 2010 (in U.S. dollars per foreign currency basket).
c. Based on your answer to (b), what happened to the value of the U.S. dollar against this basket between 2009 and 2010? How does this compare with the change in the value of the U.S. dollar relative to the Mexican peso? Explain your answer.
2)Consider a Dutch investor with 1,000 euros to place in a bank deposit in either the Netherlands or Great Britain. The (one-year) interest rate on bank deposits is 2% in Britain and 4.04% in the Netherlands. The (one-year) forward euro–pound exchange rate is 1.575 euros per pound and the spot rate is 1.5 euros per pound. Answer the following questions, using the exact equations for UIP and CIP as necessary.
a. What is the euro-denominated return on Dutch deposits for this investor?
b. What is the (riskless) euro-denominated return on British deposits for this investor using forward cover?
c. Is there an arbitrage opportunity here? Explain why or why not. Is this equilibrium in the forward exchange rate market?
d. If the spot rate is 1.5 euros per pound, and interest rates are as stated previously, what is the equilibrium forward rate, according to CIP?
e. Suppose the forward rate takes the value given by your answer to (d). Calculate the forward premium on the British pound for the Dutch investor (where exchange rates are in euros per pound). Is it positive or negative? Why do investors require this premium/discount in equilibrium?
f. If UIP holds, what is the expected depreciation of the euro against the pound over one year?
g. Based on your answer to ( f ), what is the expected euro–pound exchange rate one year ahead?
3) Consider two countries, Japan and Korea. In 1996, Japan experienced relatively slow output growth (1%), whereas Korea had relatively robust output growth (6%). Sup- pose the Bank of Japan allowed the money supply to grow by 2% each year, whereas the Bank of Korea chose to maintain relatively high money growth of 12% per year. For the following questions, use the simple monetary model (where L is constant). You will find it easiest to treat Korea as the home country and Japan as the foreign country.
a. What is the inflation rate in Korea? In Japan?
b. What is the expected rate of depreciation in the Korean won relative to the Japanese yen?
c. Suppose the Bank of Korea increases the money growth rate from 12% to 15%. If nothing in Japan changes, what is the new inflation rate in Korea?
d. Using time series diagrams, illustrate how this increase in the money growth rate affects the money supply, MK; Korea’s interest rate; prices, PK; real money supply; and Ewon/¥ over time. (Plot each variable on the vertical axis and time on the horizontal axis.)
e. Suppose the Bank of Korea wants to maintain an exchange rate peg with the Japanese yen. What money growth rate would the Bank of Korea have to choose to keep the value of the won fixed relative to the yen?
f. Suppose the Bank of Korea sought to implement policy that would cause the Korean won to appreciate relative to the Japanese yen. What ranges of the money growth rate (assuming positive values) would allow the Bank of Korea to achieve this objective?
4) This question uses the general monetary model, in which L is no longer assumed constant and money demand is inversely related to the nominal interest rate. Consider the same scenario described in the beginning of the previous question. In addition, the bank deposits in Japan pay 3% interest; ??¥=3%.
a. Compute the interest rate paid on Korean deposits.
b. Using the definition of the real interest rate (nominal interest rate adjusted for inflation), show that the real interest rate in Korea is equal to the real interest rate in Japan. (Note that the inflation rates you calculated in the previous question will apply here.)
c. Suppose the Bank of Korea increases the money growth rate from 12% to 15% and the inflation rate rises proportionately (one for one) with this increase. If the nominal interest rate in Japan remains unchanged, what happens to the interest rate paid on Korean deposits?
d. Using time series diagrams, illustrate how this increase in the money growth rate affects the money supply, MK; Korea’s interest rate; prices, PK; real money supply; and Ewon/¥ over time. (Plot each variable on the vertical axis and time on the horizontal axis.)
5) Use the money market and foreign exchange (FX) diagrams to answer the following questions. This question considers the relationship between the euro (€) and the U.S. dollar ($). The exchange rate is in U.S. dollars per euro, E$/€. Suppose that with financial innovation in the United States, real money demand in the United States de- creases. On all graphs, label the initial equilibrium point A.
a. Assume this change in U.S. real money demand is temporary. Using the FX and money market diagrams, illustrate how this change affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C.
b. Assume this change in U.S. real money demand is permanent. Using a new diagram, illustrate how this change affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C.
c. Illustrate how each of the following variables changes over time in response to a permanent reduction in real money demand: nominal money supply MUS, price level PUS, real money supply MUS/PUS, U.S. interest rate i$, and the exchange rate E$/€.