ECON335 Assignment 1 (Due 5pm Thu. Mar 28, at the beginning of the class) All answers should be typed or neatly handwritten. Assignment should be no more than 5 pages. 1. Calculate the dollar rates of return on the following assets: a. A painting where the price rises from $200,000 to $250,000 in a year. b. A bottle of rare wine where the price rises from $225 to $275 between 2010 and 2011. c. A £10,000 deposit in a London bank in a year when the interest rate on pounds is 10% and the $/£ exchange rate moves from $1.50 per pound to $1.38 per pound. 2. Exchange rates can be quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency. Unless otherwise stated, we adopt the convention that is given in your textbook, that is, we define exchange rates as domestic currency per unit of foreign currency. Using the dollar and euro as a currency pair, the bilateral exchange rate is E$/€, expressed as dollars per euro. a. Suppose that the initial exchange rate is given as $1/€1, i.e., E$/€ = 1. Now, it has changed to $0.85/€1, i.e., E$/€ = 0.85. What does the fall in E$/€ mean in terms of the value of the dollar (domestic currency) and the euro (foreign currency)? b. Now, suppose instead that the initial exchange rate is $1/€1.30. Write down the value for E$/€. What is the value of E$/€ when the exchange rate changes to $1/€1? Has E$/€ increased or decreased? Has the domestic currency (dollar) appreciated or depreciated? What about the foreign currency (euro)? 3. The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return. The condition that the expected returns on deposits of any two currencies are equal when measured in the same currency is called the interest parity condition. Consider the following two currencies, the dollar ($) and the euro (€). Let R$ and R€ represent the interest rates on dollar deposits and euro deposits respectively and let E$/€ represent the current exchange rate defined in terms of dollars per euro. Further, denote the expected exchange rate by Ee$/€ a. Write down the interest rate parity condition for this currency pair using the above b. c. d. e. notations. Underline the term representing the return on dollar deposits in part (a). Graph and label this on a diagram with the vertical axis labelled “Exchange rate (E$/€)”and the horizontal axis labelled “Rates of returns (in dollar terms)”. Circle the term(s) representing the expected rate of return on euro deposits expressed in terms of dollars in part (a). Graph and label this on the same diagram in part (b). Indicate with “2” on your diagram the point where no one would be willing to hold euro deposits and label the corresponding exchange rate as E2$/€. Explain why that would be the case using the interest parity condition you have written down in (a). What happens to the demand for dollars and euros? Similarly, indicate with “3” on your diagram the point where no one would be willing to hold dollar deposits and label the corresponding exchange rate as E3$/€. Explain why that would be the case. What happens to the demand for dollars and euros? f. Label the point on your diagram where the interest parity condition is satisfied as “1” and label the exchange rate corresponding to this point as E1$/€. Explain how points “2” and “3” are on your diagram would ultimately reach point “1”, with detailed reference to how the terms in the inequality expression given in slide 14-31 of your lecture handout, would have a tendency to change. 4. You have now graphed and explained the model of exchange rate determination in 3. Comparative static analysis can now be applied to this simple model. Use the diagrammatic analysis of foreign exchange equilibrium and explain the effects of a rise in the interest rate paid on dollar deposits from R1$ to R2$. [Hint: Your answer should include an explanation of what happens to the relative attractiveness of holding deposits in the two currencies (dollars and euros) at the original exchange rate E1$/€ and how the new equilibrium exchange rate E2$/€ is achieved.] 5. Equilibrium interest rate is achieved in the money market when aggregate demand for real monetary assets equals the supply of real monetary assets. a. Write down the condition required for equilibrium in the money market using real quantities of monetary assets. b. The aggregate real money demand function is given as L(R, Y). For a given level of income, real money demand decreases as interest rate increases. Explain why L is negatively related to interest rates. How is the real income related to the aggregate real money demand? c. Briefly state the effect of an increase in the nominal money supply on the interest rate, for a given price level. 6. Explain the monetary approach to exchange rate determination using the equations that characterize this approach, stating its general prediction. What are its specific predictions about the long-run effects on the exchange rate of changes in money supplies, interest rates, and output levels?