2. The value of asset is driven by its scarcity.What the monetary authorities could do is to make money less scarce by issuing more of it.
This will lower its scarcity value. Even though its nominal value will always be the same,the added supply will reduce the purchasing power per
unit of money.

3. A. rise B. fall C. same D. rise E. fall F. fall

4. The value of the dollar will drop as fears of inflation rise.  Short-term U.S. interest rates will initially fall but will then rise as
investors seek to protect themselves from higher anticipated inflation.  Long-term rates will probably rise immediately because of fears of future
inflation. If the growth in the money supply stimulated the economy to grow more rapidly than it otherwise would, the value of the dollar
could rise, and so could the interest rates.

5.The increase in German interest rates made german assets more attractive to investors.In process of shifting the funds from US to
Germany,investors sold dollars to buy DM they needed to invest in German assets.Alternative explanation is that the rise in interest rates reflected a
tightening of German monetary policy,leading investors to anyicipate less German inflation in the future, which would increase the desire to
hold DM and thereby boost its value.

6.a. Policies reflect economic insanity-calculated to destroy economic incentives to invest,hire people and promote economic efficiency
which would be bad news for franc.As expected the franc fell.    b. Positive because it reduced likelyhood of jospins policies.

7. a. The dollar rose when Greenspan indicated that he was concerned about the dollar's slide and would not aggressively ease monetary
policy. Investors responded to his statement by lowering their expectations about future U.S. inflation,  making dollars a more
desirable asset.
    b. Yes, by tightening U.S. monetary policy, he can lower investor expectations about future U.S. inflation and raise real       U.S.
interest rates (at least temporarily). Both of these effects of tighter monetary policy will boost the dollar's  value.

8.a.In order to hold down the value of their currencies, Asian central banks must buy up the foreign exchange in the market.
    the result is increase foreign reserves and expanded domestic money supply,which has potential to increase inflation.
    At the same time,lower exchange rates boost asian export competitiveness but at the expense of lower living standards
    for their populations.
  b. In order to sterlize the expanded domestic money supply resulting from purchase of foriegn exchange the asian central
     bank must sell government securities to the market. The sales would drive down the price of government bonds and drive up
     domestic interest rates.Higher interest rates would attract more foreign capital which would boost domestic
     currency. Thus in long run,sterilized intervention will not affect exchange rates and export competitiveness.

9.a. As capital flows in the currency board must exchange the foreign currency for an equivalent amount of HK dollars this rise in dollars will lead
to higher inflation rate.Combined with fixed exchange rate ,the rise in the inflation  rate will result in increase in real exchange rate,making it less competitive.

10. An appreciation in the real value of the Colombian peso during1994. This real appreciation reduces the competitiveness of Columbia’s
legal exports.

                                                             Problems

1.a.The U.S dollar value of the zim dollar prior to devaluation was $0.0263. Subsequent to devaluation it was worth $0.02
  b.The U.S dollar value of the zim dollar has changed by (0.02-0.0263)/0.0263 = -24%. Thus it has devalued by 24% against USD.

2.a.Dollar value of yen in 1995 was $0.0125. By 2000 It was $0.00909
  b.Between 1995 and 2000,the yen fell by 27.27% calculated as (0.00909-0.0125)/0.0125
  c.During the same period the dollar appreciated by 37.5% calculated as (110-80)/80.
3.a.Euro appreciation is (0.9457-0.8984)/0.1984 = 5.27%
  b.Dollar depreciation is an amount  ((1/0.9457)-(1/0.8984))/(1/0.8984)  = -5.00%
4.a.Lira devlaued by (0.0012613-0.0013065)/0.0013065 = -3.46%
  b.DM appreciated against lira by [(1/0.0012613)-(1/0.0013065)]/[(1/0.0013065)] = 3.58%
  c.Prior to devaluation the DM billion was worth Lit(4billion/0.0013065).Following devaluation the DM 4 billion borrowing
    could cost Lit( 4 billion/0.0012613) to repay. Hence the Italian govt would lose Lit 4 billion X  [(1/0.0012613)-(1/0.0013065)]
    = Lit109,716,164344 or DM 138,384,998 at new exchange rate.
  d.Bundesbank would have bought Lit 24 billion/0.0013065.Following the lira devaluation these would be worth DM(24 billion/0.0013065)x
0.0012613. The result is foreign exchange loss for Bundesbank of DM 830,309,998 on this currency intervention
5.a.Under the new system P1= $0.50+ $ 0.85/2 = $ 0.925. The pesovalue of dollar is thus 1/0.925. This is equivalent to dollar appreciation of
8.1% against the peso.
b.As shown in answer to part a,P1=$0.925. This exchange rate is
equivalent to peso devaluation against dollar of 7.5%
===============================================================

                        Chapter 3
1. a. Free float,Managed float,Target zone arrangement,Fixed rate system, Hybrid system.
   b. Free float : Exchange rates determined by interaction of currency supplies and demands       Managed float:Governments intervene actively in foreign exchange
market to smooth out exchange rate fluctuations in order to reduce economic uncertainity associated with free float.
      Target zone arrangement: Countries adjust their national economic policies to maintain their exchange rates within
 specific margin agreed upon,fixed  central exchange rates.
Fixed rate system:Each bank buys or sells actively its currency,in foreign exchange market whenever its exchange rate
threatens to deviate from its stated par value by more than an agreed upon percentage.
  Hybrid system: Major currencies are floating on a managed basis.Some are freely floating and other currencies are  moving in and out of pegged exchange rate relationships.
  c. Benefits of floating rate system : At the time the system was adopted proponents said it would reduce economic volatity  and facilitate free trade.It
would offset international differences in inflation  rates so that trade,wages,employment and output would not have to adjust.  High inflation countries would see currencies depreciate allowing firms to stay  competitive without having to cut wages.
competitive disadvantage.Real exchange rates would stabilize even if permitted to float upon in principle because the underlying conditions
affecting trade and relative productivity of capital would change only gradually and if countries would coordinate their monetary policies to achieve
convergence of  inflation rates then nominal rates would also stabilize. Another advantage is that it  absorbs pressures that would otherwise build up in countries that try
to peg the exchange rate while simultaneosly pursuing an independent monetary policy.  It also acts as a shock absorber to cushion real economic shocks that change
equilibrium rate.
 Costs of floating rate system: Exessive volatility is one of the costs majorly due to expectations of future government policies
 Benefits of managed float: The government can reduce the volatility associated with freely floating exchange rate.
Costs of managed float: The governments run risk of creating an exchange crises and wasting reserves by failing to
recognize the difference between temperory exchange rate disequilibrium and a permanent one.
Benefits of target zone: Forces  convergence of monetary policy to that of the country with anti-inflation policy and
leads to low inflation.
 Costs of target zone : Requires political will to direct fiscal and monetary policies.Another cost is that fundamental changes in
equilibrium exchange rate cannot getr reflected in actual exchange rate changes without currency crises.
  Benefits of fixed rate system: Currency stability and absence of currency crises.More monetary discipline than in freely
floating system and lower inflation.
Costs of fixed rate system: The exchange rate cannot cushion the effects of real economic shocks.This can result in
higher unemployment and less economic growth.
 Benefits of hybrid system: Gives countries the option to select what best meets their needs.
 Costs of hybrid system:There is no constraint on choices that governments can make.
d.Excessive movements would indicate that there are profits to be earned by betting against the market.In effect excessive currency
fluctuations would exhibit the phenomenon of overshooting.

2. This should be easy to do. The trick is will be to find a coherent statement of what the governments justification was

3. Since gold prices respond quickly to evidence of inflation, the expectation of an increase in inflation will cause a jump in gold prices.
In this way, gold serves as a burglar alarm to warn that politicians are tampering with fiat money.

4. Independent monetary and fiscal policies will lead to volatile exchange rates as market participants receive and assess new information on
these policies.
5. Skip

6. Each country within the European Monetary System had to fix its exchange rate relative to the DM.

7. A. Spain has historically pursued an easy monetary policy, with an associated high rate of inflation. High inflation, in turn, led to
continual peseta devaluation
B. Countries that seek to participate in the EMS are effectively forced to pursue a monetary policy consistent with
that of Germany, which eventually brings down their inflation rates.
C. By heightening the prospects for Spanish monetary stability, EMS membership has lowered the risks associated with holding financial assets
in Spain. The result has been to make the Spanish public more willing to save and invest.

8. The result will be higher inflation, and more currency volatility.
9. By joining EMU, Britain would lock itself into a new monetary policy.  The business cycle of the UK and Germany may not be similar.
10. Wage flexibility is an imperfect substitute for exchange rate flexibility.  If exchange rates cannot adjust to domestic imbalances then
wages need to become more flexible to avoid increase in an already high rate.Job protection schemes,minimum wages and generous unemployment
benefits make it possible for unions to negotiate wage increases that are largely independent of state of labor market.

                                                        Problems

1.a. Pound depreciated by 10.1% against the DM         (2.50-2.78)/2.78   = -10.1 %
     and by 6.8% against the dollar  (1.782-1.912)/1.912      = -6.8%

  b.The cost to Bank of england was $825 million.

2.a.DM 1= FF 3.35386
  b.Upper limit = FF 3.342933 ,Lower limit = 3.27840
  c.Upper limit= FF 3.85694 and lower limit = FF 2.85078

3.a. FF 1= DF1 0.335952
  b.DF1 130,622
  c.DF1 2,121
  d.DF1 302,357

4. $400 Million to $500 Million

5.a.Between $11.1 Billion to $ 15.6 Billion
  b.The U.S gOvernment realizes this seignorage
 

.===============================================================
SUGGESTED ANSWERS TO CHAPTER 4 QUESTIONS

la. What is purchasing power parity?
ANSWER. In its absolute version, purchasing power parity states that price levels should be equal worldwide when expressed in a common currency. In other words, a unit of home
currency (HC) should have the same purchasing power around the world. The relative version of purchasing power parity, which is used more commonly now, states that the exchange
rate between the home currency and any foreign currency will adjust to reflect changes in the price levels of the two countries. For example, if inflation is 5% in the United States and 1%
in Japan, then the dollar value of the Japanese yen must rise by about 4% to equalize the dollar price of goods in the two countries.
b. What are some reasons for deviations from purchasing power parity? ANSwnt. PPP might not hold because:
• The price indices used to measure PPP may use different weights or different goods and services.
• Arbitrage may be too costly, because of tariffs and other trade barriers and high transportation costs, or too risky, because prices could change during the time that an item is in transit
between countries.
Since some goods and services used in the indices are not traded, there could be price discrepancies between countries.
• Relative price changes could lead to exchange rate changes even in the absence of an inflation differential.
• Government intervention could lead to a disequilibrium exchange rate.
c. Under what circumstances can purchasing power parity be applied?
ANSWER. The relative version of purchasing power parity holds up best in two circumstances: (a) over long periods of time among countries with a moderate initiation differential since
the general trend in the price level ratio will tend to dominate the effects of relative price changes, and (b) in the short run during periods of hyperinflation since with high inflation changes
in the general level of prices quickly swamp the effects of relative price changes.
2. One proposal to stabilize the international monetary system involves setting exchange rates at their purchasing power parity rates. Once exchange rates are correctly aligned (according
to PPP), each nation would adjust its monetary policy so as to maintain them. What problems might arise from using the PPP rate as a guide to the equilibrium exchange rate?
ANSWER. The proposal to adjust monetary policy so as to maintain purchasing power parity assumes that the PPP rate is the equilibrium rate. This assumption ignores the many
shortcomings of PPP as a theory of exchange rate determination. Deviations from PPP have prevailed throughout the history of floating rate regimes. Thus there is good reason to believe
that PPP provides a poor proxy for the equilibrium exchange rate at any point in time. If the PPP benchmark is used as a proxy for the equilibrium exchange rate when there are
equilibrium departures from PPP, this guideline will interfere with long-mn equilibration in the foreign exchange market. Here is the basic problem: Domestic and foreign goods are not
perfect substitutes, and hence issues of spatial arbitrage and the law of one price are irrelevant. Imagine that at the PPP exchange rate U.S. firms can’t find buyers for their goods, while
Japanese firms work overtime to meet the demand for their goods. Something will have to give, probably the real exchange rate. When a country opens new markets, introduces new
products, or experiences a favorable or unfavorable price shock for its traditional exports, the real exchange rate will change. Monetary policy that stabilizes a disequilibrium exchange
rate is clearly inappropriate.
3. Suppose the dollar/rupiah rate is fixed but Indonesian prices are rising faster than U.S. prices. Is the Indonesian rupiah appreciating or depreciating in real terms?
ANSWER. The rupiah’s real value is rising since it is not depreciating to compensate for higher Indonesian inflation.
4. Comment on the following statement. “It makes sense to borrow during times of high inflation because you can repay the loan in cheaper dollars.”
ANSWER. According to the Fisher effect, interest rates adjust to take into account the effects of inflation on the real cost of repaying a loan. Thus, borrowing during times of inflation is
profitable only if inflation turns out to be higher than expected at the time the loan was made. By defmition, however, it is impossible to expect to profit from the unexpected. Hence, this
statement is inconsistent with elementary notions of market efficiency.
5. Which is likely to be higher, a 150% ruble return in Russia or a 15% dollar return in the United States?
ANSWER. Since both are stated in nominal terms in different currencies, they cannot be compared directly. The cruzeiro return must be adjusted for Russian inflation and the dollar
return for U.S. inflation to get the real returns. Alternatively, the nominal Russian return should be converted into dollars to get the nominal dollar return in Russia.
6. The interest rate in England is 12%, while in Switzerland it is 5%. What are possible reasons for this interest rate differential? What is the most likely reason?
ANSWER. Although there are several possible explanations for higher interest rates, the most likely explanation is that inflation is expected to be higher in England than in Switzerland.
7. Over the period 1982-1988, Peru and Chile stand out as countries whose interest rates are not consistent with
their inflation experience. Specifically, Pen’s inflation and interest rates averaged about 125% and 8%,respectively, over this period, whereas Chile’s inflation and interest rates averaged
about 22% and 38%,respectively.
a. How would you characterize the real interest rates of Peru and Chile (e.g., close to zero, highly positive, highly negative)?
ANSWER. Highly negative for Peru and highly positive for Chile.
b. What might account for Peru’s low interest rate relative to its high inflation rate? What are the likely consequences of this low interest rate?
ANSWER. Pen’s nominal interest rate averaged around 8% during this period, even as its inflation rate approached 130% annually. This highly negative real interest rate was due to
government controls on the interest rate that could be paid on savings. As a result, Peruvian savings plummeted, a black market for capital arose, and those Peruvians who could convert
their money into dollars or other hard currencies likely to maintain their value.
c.. What might account for Chile’s high interest rate relative to its inflation rate? What are the likely consequences of this high interest rate?
ANSWER. Chile had undergone a period of rapid inflation prior to period shown in the exhibit. As a result, investors were projecting a high rate of future inflation, and this was reflected
in the interest rate (remember, the Fisher effect says nominal rates are based on expected future inflation). In addition, investors probably added an inflation risk premium to the interest
rate to compensate for inflation risk.
d. In Exhibit 4.13, Peru is shown as having a small interest differential and yet a large average exchange rate change. How would you reconcile this experience with the international Fisher
effect and with your answer to partb?
ANSWER. The narrow interest differential owes to the government interest rate controls mentioned in part b. The international Fisher effect refers to interest rates set in a free market. It
says nothing about controlled interest rates.
8. A number of countries (e.g., Pakistan, Hungary, and Venezuela) are shown in Exhibit 4.13 as having a small or negative interest rate differential and a large average annual depreciation
against the dollar. How would you explain these data? Can you reconcile these data with the international Fisher effect?
ANSWER. As these countries have had fairly high inflation combined with controls that held their interest rates below those that would prevail in a free market. The large average annual
depreciation can be explained by theft rapid inflation, whereas the absence of the international Fisher effect is due to the interest rate controls. As noted in the answer to question 7, part
d, the 1FF refers to interest rates set in a free market. It has nothing to say about controlled interest rates.
9. What factors might lead to persistent covered interest arbitrage opportunities among countries?
ANSWER. The principal factor would be the existence of political risk, particularly the fear that at some point the government would impose exchange controls, not allowing capital to be
removed. Another possible factor is differential tax laws which could lead to similar after-tax returns, even if before-tax returns differ.
10. In early 1989, Japanese interest rates were about 4 percentage points below U.S. rates. The wide difference between Japanese and U.S. interest rates prompted some U.S. real
estate developers to borrow in yen to finance their projects. Comment on this strategy.
ANSWER. The U.S. developers were gambling that the 400 basis point differential did not reflect market expectations of dollar depreciation, which is what the international Fisher effect
would argue for. In other words, the developers were committing the economists unpardonable sin of comparing apples (dollar interest rates) with oranges (yen rates). This policy also
makes no sense from a currency risk standpoint since the developers had dollar cash inflows (from the real estate rentals on their developments) and yen cash outflows on the mortgages,
exposing them to considerable exchange risk. A rise in the value of the yen could conceivably cost them more than the savings on the lower yen interest rates. Moreover, this rise was
quite likely since the international Fisher effect says that international differences in interest rates can be traced to expected changes in exchange rates, with low interest rate currencies
expected to appreciate against high interest rate currencies. This is indeed what happened in the case of the yen.
11. In early 1990, Japanese and German interest rates rose while U.S. rates fell. At the same time, the yen and DM fell against the U.S. dollar. What might explain the divergent trends in
interest rates?
ANSWER. According to the Fisher effect, the most likely cause for the rise in German and Japanese interest rates was higher expected inflation in those countries. At the same time, the
fall in U.S. interest rates could be attributable to a decline in expected U.S. inflation. If so, then PPP would predict that the future value of the dollar should rise relative to what was
previously expected. Since these expectations would be immediately impounded in currency values, we would expect the dollar to rise relative to the yen and DM. This scenario is
consistent with what actually happened.
12. In late December 1990, one-year German Treasury bills yielded 9.1%, whereas one-year U.S. Treasury bills yielded 6.9%. At the same time, the inflation rate during 1990 was
6.3% in the United States, double the German rate of 3.1%.
a. Are these inflation and interest rates consistent with the Fisher effect?
ANSWER. Not if one assumes that future inflation will equal past inflation. In that case, the real interest rate in Germany will be approximately 6% (9.1% - 3.1%) and in the United
States 0.6% (6.9% - 6.3%). More likely, what was happening was that the markets were anticipating a fall in U.S. inflation (because of tight money in the U.S. combined with the U.S.
recession) and a rise in German inflation (given the costs of German unification). If so, then these rates are consistent with the Fisher effect, which says that nominal interest rates are
based on expected, not past inflation.
b. ‘What might explain this difference in interest rates between the United States and Germany?
ANSWER. One possible answer was suggested in part a, namely that 1990 inflation was not considered a reasonable predictor of 1991 inflation. An alternative answer is that real
interest rates in Germany were rising to attract the added capital needed to finance the enormous investment in eastern Germany.
13. The spot rate on the euro is $0.91, and the 180-day forward rate is $0.93. What are possible reasons for the difference between the two rates?
ANSWER. The relative values of the spot and forward rates suggest that the market believes the euro will appreciate against the dollar by about $0.02 over the next 180 days. The
difference also indicates that the interest rate on dollars exceeds the interest rate on euro. These explanations are consistent with each other since a higher U.S. dollar interest rate
indicates higher expected U.S. inflation and an expected depreciation of the dollar.
14. German government bonds, or Bunds, currently are paying higher interest rates than comparable U.S. Treasury bonds. Suppose the Bundesbank eases the money supply to drive
down interest rates. How is an American investor in Bunds likely to fare?
ANSWER. The answer is impossible to determine in advance. The fall in DM interest rates will increase the price of Bunds (bond prices move inversely with interest rates), giving U.S.
investors a capital gain in DM. At the same time, however, the decline in DM interest rates and the easing of German monetary policy could lead to a weaker DM. The net effect on U.S.
investors’ dollar returns of the higher DM price of Bunds and the lower dollar value of the DM is uncertain. It depends on which of the two factors dominates.
15. In 1993 and early 1994, Turkish banks borrowed abroad at relatively low interest rates to find their lending at home. The banks earned high profits because rampant inflation in
Turkey forced up domestic interest rates. At the same time, Turkey’s central bank was intervening in the foreign exchange market to maintain the value of the Turkish lira. Comment on
the Turkish banks’ finding strategy.
ANSWER. This strategy, while profitable in the short run, exposes the Turkish banks to significant and predictable exchange risk. It will work only so long as the Turkish central bank is
able to maintain a fixed nominal exchange rate in the face of high domestic inflation. In the process of doing so, the Turkish bra’s real value will rise, putting pressure on exporters (who
will see their goods priced out of world markets) and companies competing against imports. According to purchasing power parity, higher Turkish inflation will eventually lead to lira
devaluation. If and when this happens, Turkish banks will find themselves facing a much higher lira cost of servicing their foreign debts. In fact, the Turkish lira did devalue, by 28% (in
April, 1994), forcing a number of Turkish banks to the point of bankruptcy. The squeeze on Turkish banks was exacerbated when depositors, jittery over the banks’ problems, began to
withdraw cash. The Turkish central bank was forced to step to help guarantee banks’ liquidity and calm depositors’ nerves.
 
SUGGESTED SOLUTIONS TO CHAPTER 4 PROBLEMS
1. From base price levels of 100 in 1999, German and U.S. price levels in 2001 stood at 102 and 106, respectively. If the 2000 $: DM exchange rate was $0.54, what should the
exchange rate be in 2001? In fact, the exchange rate in 2001 was DM 1 = $0.56. What might account for the discrepancy? (Price levels were measured using the consumer price index.)
ANSWER. If e is the dollar value of the German mark in 200!, then according to purchasing power parity
= 106/102
or e = $05612. The discrepancy between the predicted rate of $0.5612 and the actual rate of $0.56 is insignificant and hence needs no explaining. Historically, however, discrepancies
between the PPP rate and the actual rate have frequently occurred. These discrepancies could be due to mismeasurement of the relevant price indices. Estimates based on narrower price
indices reflecting only traded goods prices would probably be closer to the mark, so to speak. Alternatively, it could be due to a switch in investors’ preferences from dollar to non-dollar
assets.
2. Two countries, the United States and England, produce only one good, wheat. Suppose the price of wheat is $3.25 in the United States and is £1.35 in England.
a. According to the law of one price, what should the $: spot exchange rate be?
ANSWER. Since the price of wheat must be the same in both nations, the exchange rate, e, is 3.25/1.35 ore $2.4074.
b. Suppose the price of wheat over the next year is expected to rise to $3.50 in the United States and to £1.60 in England. What should the one-year $ :f forward rate be?
ANSWER. In the absence of uncertainty, the forward rate, f, should be 3.50/1.60 or f $2.1875.
c. If the U.S. government imposes a tariff of $0.50 per bushel on wheat imported from England, what is the maximum possible change in the spot exchange rate that could occur?
ANSWER. If e is the exchange rate, then wheat selling in England at £1.35 will sell in the United States for l.35e + 0.5, where 0.5 is the U.S. tariff on English wheat. In order to eliminate
the possibility of arbitrage, l.35e + 0.5 must be greater than or equal to $3.25, the price of wheat in the U.S. or e> $2.0370. Thus the maximum exchange rate change that could occur is
(2.4074 - 2.0370 = 15.38%. This solution assumes that the pound and dollar prices of wheat remain the same as before the tariff.
3. If expected inflation is 100% and the real required return is 5%, what will the nominal interest rate be according to the Fisher effect?
ANSWER. According to the Fisher effect, the relationship between the nominal interest rate, r, the real interest rate a, and the expected inflation rate, i, is I + r = (1 + a)(1 + i).
Substituting in the numbers in the problem yields 1 + r = 1.05 x 2 2.1, or r 110%.
4. In early 1996, the short-term interest rate in France was 3.7%, and forecast French inflation was 1.8%. At the same time, the short-term German interest rate was 2.6% and forecast
German inflation was 1.6%.
a. Based on these figures, what were the real interest rates in France and Germany?
ANSWER. The French real interest rate was 1.037/1.018 - I = 1.87%. The corresponding real rate in Germany was 1.026/1.016-1=0.98%.
b. To what would you attribute any discrepancy in real rates between France and Germany?
ANSWER. The most likely reason for the discrepancy is the inclusion of a higher inflation risk component in the French real interest rate than in the German real rate. Other possibilities
are the effects of currency risk or transactions costs precluding this seeming arbitrage opportunity.
5. In July, the one-year interest rate is 12% on British pounds and 9% on U.S. dollars.
a. If the current exchange rate is $1.63 :£1, what is the expected future exchange rate in one year?
ANSWER. According to the international Fisher effect, the spot exchange rate expected in one year equals
1.63 x 1.09/1.12 = $1.5863.
b. Suppose a change in expectations regarding future U.S. inflation causes the expected future spot rate to decline to $l.52: £1. What should happen to the U.S. interest rate?
ANSWER. If rus the unknown U.S. interest rate, and assuming that the British interest rate stayed at 12% (because there has been no change in expectations of British inflation), then
according to the IFE, 1.52/1.63 = (1+r)or r 4.44%.
6. Suppose that in Japan the interest rate is 8% and inflation is expected to be 3%. Meanwhile, the expected inflation rate in France is 12%, and the English interest rate is 14%. To the
nearest whole number, what is the best estimate of the one-year forward exchange premium (discount) at which the pound will be selling relative to the French franc?
ANSWER. Based on the numbers, Japan’s real interest rate is about 5% (8% - 3%). From that, we can calculate France’s nominal interest rate as about 17% (12% + 5%), assuming
that arbitrage will equate real interest rates across countries and currencies. Since England’s nominal interest rate is 14%, for interest rate parity to hold, the pound should sell at around a
3% forward premium relative to the French franc.
7. Chase Econometrics has just published projected inflation rates for the United States and Germany for the next five years. U.S. inflation is expected to be 10% per year, and German
inflation is expected to be 4% per year.
a. If the current exchange rate is $0.95/, what should the exchange rates for the next five years be?
ANSWER. According to PPP, the exchange rate for the euro at the end of year t should equal 0.95(l.l0/l.04)t.Hence, projected exchange rates for the next 5 years are 1.0048, 1.0628,
1.1241, 1.1889, 1 2571.
b. Suppose that U.S. inflation over the next five years turns out to average 3.2%, German inflation averages 1.5%, and the exchange rate in five years is $0.99/_. What has happened to
the real value of the euro over this five-year period?
ANSWER. According to Equation 4.7, the real value of the euro at the end of five years is 0.9111
Hence, even though the euro has appreciated in nominal terms over this five-year period, it has fallen in real terms by 4.09% [ 0.9111- 0.95)/0.95].
8. During 1995, the Mexican peso exchange rate rose from Mex$5.33/U.S.$ to Mex$7.64/U.S.$. At the same time, U.S. inflation was approximately 3% in contrast to Mexican inflation
of about 48.7%.
a. By how much did the nominal value of the peso change during 1995?
ANSWER. During 1995, the peso fell from $0.1876 (1/5.33) to $0.1309 (1/7.64), which is equivalent to a devaluation of 30.24% ((0.1309 - 0.1 876)/0. 1876)
b. By how much did the real value of the peso change over this period?
ANSWER. Using Equation 4.7, the real value of the peso by the end of 1995 was $0.1 890
Based on this real exchange rate, the peso has appreciated during 1995 by 0.72% ((0.1890 - 0.1876)/0.1876). In other words, the real exchange rate stayed virtually constant, implying
the purchasing power parity held during the year.
9. Suppose three-year deposit rates on Eurodollars and Eurofrancs (Swiss) are 12% and 7%, respectively. If the current spot rate for the Swiss franc is $0.3985, what is the spot rate
implied by these interest rates for the franc three years from now?
ANSWER. If r and r, are the associated Eurodollar and Eurofranc nominal interest rates, Substituting in the numbers given in the problem yields e = $03985 x (1.12/1.07)3 =$0.4570.
10. Assume the interest rate is 16% on pounds sterling and 7% on euros. At the same time, inflation is running at an annual rate of 3% in Germany and 9% in England.
a. If the euro is selling at a one-year forward premium of 10% against the pound, is there an arbitrage opportunity? Explain.
ANSWER. According to interest rate parity, with a euro rate of 7% and a 10% forward premium on the euro against the pound, the equilibrium pound interest rate should be
1.07 x 1.10-1 = 17.7%
Since the pound interest rate is only 16%, there is an arbitrage opportunity. It involves borrowing pounds at 16%, converting them into euros, investing them at 7%, and then selling the
proceeds forward, locking in a pound return of 17.7%.
b. What is the real interest rate in Germany? in England?
ANSWER. The real interest rate in Germany is 1.07/1.03 -l = 3.88%. The real interest rate in England is 1.16/1.09-1 = 6.42%.
c. Suppose that during the year the exchange rate changes from €1.8/£1 to €1.77/£1. What are the real costs to a German company of borrowing pounds? Contrast this cost to its real
cost of borrowing euros.
ANSWER. At the end of one year, the German company must repay £1.16 for every pound borrowed. However, since the pound has devalued against the euro by .1.67% (1.77/1.80 -
1 = -1.67%), the effective cost in euros is 1.16 x (1 - 0.0167) - 1 = 14.07%. In real terms, given the 3% rate of German inflation, the cost of the pound loan is found as 1.1385/1.03 -l =
10.74%.
As shown above, the real cost of borrowing euros equals 3.88%, which is significantly lower than the real cost of borrowing pounds. What happened is that the pound loan factored in an
expected devaluation of about 9% (16% - 7%), whereas the pound only devalued by about 2%. The difference between the expected and actual pound devaluation accounts for the
approximately 7% higher real cost of borrowing pounds.
d. What are the real costs to a British firm of borrowing øuros? Contrast this cost to its real cost of borrowing pounds.
ANSWER. During the year, the euro appreciated by 1.69% (1.80/1.77 - 1) against the pound. Hence, a euro loan at 7% will cost 8.81% in pounds (1.07 x 1.0169 - 1). In real pound
terms, given a 9% rate of inflation in England, this loan will cost the British firm -0.2% (1.0881/1.09 - 1) or essentially zero. As shown above, the real interest on borrowing pounds is
6.42%.
11. Suppose the Eurosterling rate is 15%, and the Eurodollar rate is 11.5%. What is the forward premium on the dollar? Explain.
ANSWER. According to interest rate parity, if P is the forward premium on the dollar, then (1.115)(l +P) 1.15, or P=3.14%.
12. Suppose the spot rates for the euro, pound sterling, and Swiss franc are $0.92, $1.13, and $0.38, respectively. The associated 90-day interest rates (annualized) are 8%, 16%, and
4%; the U.S. 90- day rate (annualized) is 12%. What is the 90-day forward rate on an ACU (ACU I = €1 + £1 + SFr 1) if interest parity holds?
ANSWER. The key to working this problem is to recognize that the forward rate for a sum of currencies is just the sum of the forward rates for each individual currency. Also note that
the forward rates are for 90 days.
13.  The dollar return from a three-month investment in Japan can be found by converting dollars to yen at the spot rate, investing the yen at 1.75% (7%/4), and then selling the
proceeds forward for dollars. This yields a dollar return equal to 142 x 1.0175/139 = 1.0395 or 3.95%. This return significantly exceeds the 2.25% (9%/4) return available from investing
in the United States.
b. Where would you borrow?
ANSWER. The flip side of a lower return in the United States is a lower borrowing cost. Borrow in the United States.
c. What arbitrage opportunity do these figures present?
ANSWER. Absent transaction costs that would wipe out the yield differential, it makes sense to borrow dollars in New York at 2.25% and invest them in Tokyo at 3.95%.
& Assuming no transaction costs, what would be your arbitrage profit per dollar or dollar-equivalent borrowed?
ANSWER. The profit would be a 1.7% (3.95% .2.25%) return per dollar borrowed.
14. Here are some prices in the international money markets:
Spot rate          = $0.95/€
Forward rate (one year)            = $0.97/€
Interest rate (C)            = 7% per year
Interest rate (5) 9% per year
a. Assuming no transaction costs or taxes exist, do covered arbitrage profits exist in the above situation? Describe the flows.
ANSWER. The annual dollar return on dollars invested in Germany is (1.07 x 0.97)/0.95 - 1 = 9.25%. This return exceeds the 9% return on dollars invested in the United States by
0.25% per annum. Hence arbitrage profits can be earned by borrowing dollars or selling dollar assets, buying euros in the spot market, investing the euros at 7%, and simultaneously
selling the euro interest and principal forward for one year for dollars.
b. Suppose now that transaction costs in the foreign exchange market equal 0.25% per transaction. Do unexploited covered arbitrage profit opportunities still exist?
ANSWER. In this case, the return on arbitraging dollars falls to
1.07 x 0.97/0.95 x 0.99752 - 1.09 = -0.30%
Thus, arbitraging from dollars to euros has now become unprofitable and no capital flows will occur.
Suppose no transaction costs exist. Let the capital gains tax on currency profits equal 25%, and the ordinary income tax on interest income equal 50%. In this situation, do covered
arbitrage profits exist?
How large are they? Describe the transactions required to exploit these profits.
ANSWER. In this case, the after-tax interest differential in favor of the U.S. is (0.09 x 0.50-0.07 x
+ .07 x .50) = (0.045 - 0.035)/I.035 = 0.97%, while the after-tax forward premium on the euro is 0.75x(0.97 - 0.95)/0.95 = 1.58%. Since the after-tax forward premium exceeds the
after-tax interest differential, dollars will continue to flow to Germany as before.
15. Suppose today’s exchange rate is $0.90/€. The 6-month interest rates on dollars and euros are 6% and 3%, respectively. The 6-month forward rate is $0.8978. A foreign exchange
advisory service has predicted that the euro will appreciate to $09290 within six months.
a. How would you use forward contracts to profit in the above situation?
ANSWER. By buying euros forward for six months and selling it in the spot market, you can lock in an expected profit of 80.0312 (0.9290 - 0.8978) per euro bought forward. This is a
semiannual return of 3.48% (0.0312/0.8978). Whether this profit materializes depends on the accuracy of the advisory service’s forecast.
b. How would you use money market instruments (borrowing and lending) to profit?
ANSWER. By borrowing dollars at 6% (3% semiannually), converting them to euros in the spot market, investing the euros at 3% (1.5% semiannually), selling the euro proceeds at an
expected price of $09290 C, and repaying the dollar loan, you will earn an expected semiannual return of 1.77%:
Return per dollar borrowed = (1/0.90) x 1.015 x 0.9290 - 1.03 = 1.77%
c. Which alternatives (forward contracts or money market instruments) would you prefer? Why?
ANSWER. The return per dollar in the forward market is substantially higher than the return using the money market speculation. Other things being equal, therefore, the forward market
speculation would be preferred.
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                                                                          Chapter 5

1.  BOP should be zero.
2.a.The nation’s goods and services become relatively more expensive in foreign currency terms, while foreign goods and services become
relatively less expensive in domestic currency terms. The result is a smaller surplus or larger deficit on the current account.
  b.It depends upon why the current account deficit rises.If it increases because of rise in economy then dollar will     increase as foreign
capital pours in.If its because of  increasing government budget deficit then dollar will decline.  If exchange rate is set at too high it might decline.
  c.A current account surplus represents excess of domestic savings over domestic investment.This could reflect lack of domestic investment
opportunities.
3. This appears as a $400 million plus on the US current account, a $400 million minus on the US capital account, and a zero impact on the
overall balance of payments for 2000.
4. A repayment of Mexico’s foreign loans is equivalent to an export of capital from Mexico. IN order for Mexico to run a capital-account
deficit, it must run a current-account surplus. Anything that reduces Mexico’s ability to export also reduces its ability to repay its debts.
5. This will cause the real to appreciate. This will reduce the Brazilian current account balance.
6. None of these factors underlie the persistent US trade deficits. Instead consider "overspending" by the U.S. and "underspending"' by its
trade partners
7. One should expect their current-account balances to swing from surplus to deficit.
8. The flip side of a trade imbalance is an offsetting flow of capital.  Of course, even without trade imbalances there will still be
international capital flows as investors seek to diversify their portfolios internationally and as companies try to take advantage of foreign investment
opportunities.
9.The US trade deficit with japan must increase.Growing US economy will import more goods and services and at same time a weak japanese economy
will reduce imports.Secondly a slump in japanese consumer spending is equivalent to rise in savings.This combination will boost japan's
current account surplus.
                                                                                    Problems

1.a.Net unilateral transfer abroad which is deficit on the services accounts.
  b. Show up as merchandise export.
  c. Show up as export of U.S services.
  d.Show up as export of US Services
  e.Show up as import of capital.

2.a.                                            Credit                    Debit
  US Exports                     $80,000,000
  Private liabilities                                                $80,000,000
  b.
  US Exports                      $1,000,000
  Unilateral transfer                                                $1,000,000
  c.
  Private foreign assets                                       $500,000,000
  Private liabilities            $500,000,000
  d.
  US import of services                                         $5,000,000
  Private liabilities                 $5,000,000
  e.
  Private foreign assets                                   $1,000,000,000
  Foreign official assets  $1,000,000,000
  f.
  US imports                                                        $2,000,000
  Private liabilities                 $2,000,000
  g.
  US import of services                                      $10,000,000
  Private foreign assets       $10,000,000

3. A. Japanese official reserves increased by 31 billion, which is a deficit in the official reserves account.
B. National income exceeds spending by the equivalent of 98 billion.
C. Same as part b                   D. 98 billion
E. private sector savings investment balance must equal 76 billion.

4. Exports Imports
a. merchandise: $300 in goods and services b. $225 in goods
c. 15 payments of dividends
d. 30 in tourist services
Balance on current account: +30

Capital Outflows Capital Inflows
a. $300 increase in foreign deposits
b. $225 decrease in foreign demand deposits
e. 60 increase in US holdings of foreign stocks
c. 15 increase in foreign-owned US deposits
g. 8 decrease in foreign-owned US demand deposits
d. 30 increase in foreign-owned travelers
checks drawn on US banks
e. 60 decrease in foreign demand deposits
Balance on capital account: -$38

Reserve Flows Reserve Outflows
f. $45 in gold sales f. $45 increase in foreign demand deposits
g. 8 decrease in foreign demand deposits

Balance of official reserves: +8

5. a.Minimally attributable to change in U.S private savings investment balance.
   c.U.S spent $721 Billion more than it earned.