Assignment - Chapter 11
To review chapter 11, you are to answer 8 questions in this assignment and
submit the answer to the Blackboard
1. The Law of One Price (LOOP)
Theory: assuming that product quality is the same, the price of a good X must be equal in
different countries.
Example: Price of PHỞ in Vietnam is Pvn= 45,000 VND; and the price of PHỞ in the US is
Pus= 10 USD. According to the LOOP, what should be the exchange rate Evnd/usd?
Answer: the LOOP says that the price of PHỞ must be the same in 2 countries, which means
that:
Pvn = Pus*E
Or
45,000 = 10*E

Evnd/usd = 4,500  1USD = 4,500 VND
Question 1: Price of good X in the US: Pus = 5USD ; and the price of good X in Europe is
Peu = 6EUR. If the LOOP is hold, what should be the Exchange Rate Eusd/eur?
2. Purchasing Power Parity (PPP)
Theory: Assuming the same quality, PPP says that total value of goods in the CPI basket of
goods in different countries must be equal.
Example: A basket of goods and services has the following prices in two countries as follows:
Goods and
services
Rice
Hair cut
Pork meat
Gas
Price in
Vietnam
(VND)
20,000
45,000
126,000
120,000
Price in the
U.S (USD)
2
25
8
20
What should be the Exchange Rate Evnd/usd if the PPP is hold?
Answer: According the PPP, total value of the basket of goods must be equal in two countries,
which means:
(20,000+45,000+126,000+120,000) VND = (2+25+8+20) USD
 311,000 VND = 55USD  1USD = 5,655 VND
Question 2:
A basket of goods and services has the following prices in two countries as follows:
Goods and
services
Wheat
Beef
Potatoes
Petroleum
Price in
Vietnam
(VND)
18,000
89,000
28,000
22,000
Price in the
U.S (USD)
3
20
1,5
3
What should be the Exchange Rate Evnd/usd if the PPP is hold?
3. Real Exchange Rate
Theory: Given the price of the basket of goods in Europe is Peu (measured in Euro), the price of
the same basket of goods in the US is Pus (measured in USD). The Spot Exchange Rate is E:
Eusd/eur. The real exchange rate is the price ratio “q” which is the relative price between two
countries, which is expressed in the USD currency:
q = Peu*E/Pus = Price of European goods/ Price of US goods
Where:
Peu*E = the price of basket of goods in Europe which is converted into USD currency
If q increases, which is caused by E↑, there is a real depreciation of the USD because more US
goods are needed to exchange for European goods.
If q falls, which is caused by E↓, there is a real appreciation of the USD because more European
goods are needed to exchange for US goods.
If q > 1: European goods are more expensive than the US goods: the European goods are
overvalued.
If q < 1: US goods are more expensive than the European goods: the European goods are
undervalued.
Example: What happens to the real exchange rate if the USD is depreciated?
Answer: If the USD is depreciated  E↑  the real exchange rate q increases. Real
depreciation of the USD.
Question 3: Given Peu = 100; Pus= 216; Eusd/eur = 1.18. Are the US goods undervalued or
overvalued?.
4. Relationship between Exchange Rate E, Inflation Rates in different countries:
Theory:
a. Absolute relation:
Or
(between the US and Europe)
(between Vietnam and the US)
Eo = Pvn/Pus
b. Relative Relation: (between the US and Europe)
Or (between Vietnam and the US)
%∆Eo = π(vn) – π(us)
Where: %∆Eo (or ∆E$/€:/E$/€ ): percentage change in the Exchange Rate
πus : Inflation rate in the US
πE: Inflation Rate in the Europe
πvn: inflation rate in Vietnam
Example:
What happens to the USD when inflation rate in Vietnam increases?
Answer: Inflation Rate in Vietnam increases means π(vn) ↑  %∆Eo ↑  Eo↑
 The USD becomes appreciated in Vietnam.
Question 4: What happens to the USD if inflation in the European countries reduces?
5. Money supply M and the Exchange Rate:
Question 5: What is the Money Supply M1?
Theory :
Between the US and the Europe:
Where:
µus: percentage change in the Money Supply of the US
µE: percentage change in the Money Supply of the Europe
gUS: of the Economic Growth rate US
gE: of the Economic Growth rate US
Example: What happens to the EUR when the US Federal Reserves increases it Money
Supply?
Answer: The US Federal Reservces is the Central Bank of the US. When the Centrai bank
increases Money Supply, µus ↑  percentage change in Exchange Rate ∆E$/€ / E$/€ ↑  The
EURO becomes appreciated in the US.
Question 6: The US forecasts an increase in economic growth rate of the European countries
next year. What will happen to the Exchange Rate E$/€ in the Unites States?
Between Vietnam and the US:
%Eo = (%Mvn - %Mus) + (%Yus - %Yvn)
Where:
%Mvn: Money Supply in Vietnam (in VND)
%Mus: Money Supply in the US (in USD)
%Yus : Economic growth rate of US
%Yvn: Economic growth rate of Vietnam
Question 7: To recover the Economy, the US Federal Reserve Bank decided to increase the
Money Supply M1. How does it affect the Foreign Exchange Rate Evnd/usd in Vietnam?
Question 8: What factors affect the Nominal Exchange Rate in the long-run/
6. Relationship between the Exchange Rate E and the Interest Rates “i” in different
countries:
Theory:
F = Eo*(1 +ivn)/(1+ iusd)
We can conclude that:
-
Expected Foreign Exchange Rate in future (F) is affectd by the the Spot Rate (Eo), the
Interest Rate in Vietnam (ivn) and Interest Rate in the United States (iusd).
Banks forecast value of F and take it as the Forward Rate when signing forward contracts
to sell USD to importers or other ones who need to buy USD.
Example: What happens to the Exchange Rate Evnd/usd in Vietnam if the US Federal Reserves
Bank reduces the US interest rate?
Answer: The US Federal Reserve Bank reduces interest rate means iusd ↓  F ↑  The
Exchange Rate Evnd/usd is expected to increase in future.
Question 9: How does it affect the Foreign Exchange Rate Evnd/usd if the State Bank of
Vietnam decides to reduces VN interest rate?
Question 10: How does Money Supply affect the Interest Rate in the Long-run?