International Finance: Mid-Term 2 Solutions

Part I (10 marks)

  1. If ea,b = 4, what is eb,a?eb,a = ¼.
  1. If ea,b=5, what is the number of currency a needed to buy 500 units of currency b?

It would take (5a/1b)*500b = 2500a

  1. Suppose and .Calculate the rate of depreciation of currency a.

% Change in ea,b = (4-3)/3 = 1/3 = 33%

  1. What is exchange rate risk? Explain how a forward contract can remove exchange rate risk.

Exchange rate risk refers to the risk one faces when they have an obligation to buy or sell foreign currency in the future. The risk is if the exchange rate changes, the amount of domestic currency it takes to honor their obligation will change, and it could change in an unfavorable manner.

A forward contract removes the risk by setting a pre-determined exchange rate (the forward rate), an amount, and a date at which the transaction in foreign currency will occur.

  1. What is Interest Rate Parity (IRP)? Write down the equation for interest rate parity.

IRP is a condition that implies the interest rate in any two countries is the same, after taking exchange rate movements into account.

IRP equation is ra = rb + (et+1 /et)- 1

  1. What is Money Supply and Money Demand? Write down the condition for equilibrium in the money market.

Money supply is the amount of currency supplied by the government. (Nominal) Money demand is the amount of money people wish to hold.

MS = PL(Y,r)

  1. What is Purchasing Power Parity? Write down the equations for Absolute PPP and Relative PPP.

PPP is the law of one price applied to countries. It states the prices of goods in different countries will be the same, when expressed in terms of the same currency.

Absolute PPP:ea,b = Pa/Pb

Relative PPP:

  1. Explain why PPP may not by correct?

PPP may not be correct because of (i) transportation costs, (ii) government barriers to trade, (iii) existence of non-tradables, and (iv) the goods represented in different countries “baskets” are different.

  1. What is the real exchange rate? If the real exchange rate is given by qa,b write down the equation for the real exchange rate.

The real exchange rate is the rate at which one country’s goods can be exchange for goods of another country. The equation is

qa,b = ea,b(Pb/Pa)

  1. If PPP is correct, what is the real exchange rate?1.

Part II (4 marks)

  1. Let be the exchange rate of currency a for currency b at time t. According to IRP, what will be the impact on the current exchange rate from the following events:
  1. An increase in domestic interest rates. et will fall
  2. An increase in foreign interest rates.et will rise
  3. An increase in the expected future exchange rate. et will rise
  1. Let be the exchange rate of currency a for currency b. According to PPP, what will be the long-run impact of
  1. An increase in the price level of country a (Pa rises).e will rise
  2. An increase in the price level of country b (Pb rises).e will fall
  3. Money supply in country a rises (Ma rises).e will rise

Part III (6 marks)

  1. Suppose there is a one-time increase in the level of the money supply.
  1. Demonstrate graphically the time path of the following variables after the money supply increases: money supply, price level, interest rate, exchange rate.

See Figure 15-13 in the textbook.

  1. Explain why the exchange rate “overshoots” its long-run level.

The exchange rate overshoots because when the money supply increases in the short-run the price level does not adjust, so by IRP the interest rate must rise. But in the long-run the price level adjusts and the exchange rate must rise. However, the interest rate must return to its long-run value, which means it falls over time. But by IRP, if the Interest rate is falling, that means the exchange rate is falling. So for the exchange rate to fall over time, but still end up in the long-run at a higher level, it must mean the exchange rate has overshot its long-run level.

  1. Suppose there is an increase in the growth rate of the money supply.
  1. Demonstrate the effect on the time path of the following variables after an increase in the growth rate of the domestic money supply: money supply, price level, interest rate, exchange rate.

See Figure 16-1 in the textbook.

  1. Explain why the price level and exchange rate “jump up” immediately, even though the money supply does not “jump”.

When the growth rate of money increases, it causes an increase in inflation, and thus an increase in the interest rate. This causes a “jump” down in money demand, which creates a “jump” up in the price level (due to money market equilibrium). The jump up in prices causes a “jump” up in the exchange rate (due to PPP).