Economics 219

Solutions to Problem Set #10

1)      The real exchange rate is defined as the relative price of foreign goods in terms of domestic goods as is calculated as

Q = eP*/P

In this case, we have the dollar price of Baht is .023, the US price level is $177 and the Thai price level is 5,850.

                        Q = .023*5850/177 = .76 Thai goods per US good.

2)      The Euro exchange rate is 1.10 $/Euro while the dollar Rupee exchange rate is .02 $/Rupee.  Therefore,

                            1.10/.02 = 55 Rupees/Euro   or   .018 Euros/Rupee

3)      Uncovered interest parity implies that interest rates and exchange rates should adjust so that nobody expects to make money.  The bottom line is that any difference between foreign and domestic interest rates should be offset by currency appreciation depreciation.

a)       European bonds are paying a return (in Euros) that is one percent higher over three months than the dollar return of T-Bills.  Therefore, for European and US bonds to pay equivalent same currency returns, the Euro would need to depreciate by 1% (to 1.0296) over the next three months

b)     If the one year future price were 1.07 (a Euro appreciation, then one could make risk free profits by going short on T-Bill and using the proceeds to purchase European bonds).

4)     

a)      Savings will most likely increase in anticipation of bad times ahead.  Interest rates fall and the trade balance improves

b)     Investment increases causing interest rates to rise and the trade balance to worsen.

c)      Investment falls, causing interest rates to fall and the trade balance to improve.

d)     Investment increases causing interest rates to rise and the trade balance to worsen.

e)      Savings decreases causing interest rates to rise and the trade balance to worsen.