1. Suppose the dollar interest rate and the pound sterling interest rate are the same, 3 percent per year. What is the relation between the current equilibrium dollar/pound exchange rate and its expected future level? a. Expected dollar/pound exchange rate is higher than the current one. b. Expected dollar/pound exchange rate is equal to the current one. c. Expected dollar/pound exchange rate is lower than the current one. d. One cannot tell given the information above. Suppose the expected future exchange rate, $1.11 per pound, and the US interest rate remain constant, while Britain's interest rate rises to 7 percent per year. What is the new equilibrium dollar/pound exchange rate? e. New equilibrium exchange rate is $1.15 per pound. (Enter your response to the nearest penny. ) 2. Suppose the equilibrium exchange rate is determined by the Uncovered Interest Parity (UIP) condition. The graph on the right depicts the dollar return on a dollar asset. a. As a result of this change, the equilibrium exchange rate (dollars per euro) will rise 3. We noted that we could have developed our diagrammatic analysis of foreign exchange market equilibrium from the perspective of Europe, with the euro/dollar exchange rate E€/$=1/E$/€ on the vertical axis, a schedule vertical at R€ to indicate the euro return on euro deposits, and a downwardsloping schedule showing how the euro return on dollar deposits varies with E€/$, as shown on the graph to the right. 4. The following report appeared in the New York Times on August 7, 1989: "But now the sentiment is that the economy is heading for a 'soft landing,' with the economy slowing significantly and inflation subsiding, but without a recession. This outlook is good for the dollar for two reasons. A soft landing is not as disruptive as a recession, so the foreign investments that support the dollar are more likely to continue. Also, a soft landing would not force the Federal Reserve to push interest rates sharply lower to stimulate growth. Falling interest rates can put downward pressure on the dollar because they make investment in dollar-denominated securities less attractive to foreigners, prompting the selling of dollars. In addition, the optimism sparked by the expectation of a soft landing can even offset some of the pressure on the dollar from lower interest rates." Using the graph on the right, show how lower interest rates can put downward pressure on the dollar. 5. Suppose the dollar exchange rate of the euro and the yen are equally variable. The euro, however, tends to depreciate unexpectedly against the dollar when the return on the rest of your wealth is unexpectedly low, while the yen tends to appreciate in the same circumstances. As a U.S. resident, which currency, the euro or the yen, would you consider riskier? a. For a US resident, the EURO is more risky 6. In October 1979, the U.S. central bank (the Federal Reserve System) announced it would play a less active role in limiting fluctuations in dollar interest rates. What do you expect will be the effect of this new policy on the volatility of the dollar's exchange rates against foreign currencies? a. Dollar's exchange rates against foreign currencies are likely to become more volatile. 7. Imagine that everyone in the world pays a tax of τ percent on interest earnings and on any capital gains due to exchange rate changes. How would such a tax alter the analysis of the interest parity condition? a. The interest parity condition will be unchanged R$= R€+Ee $/€−E$/€/E$/€. Now suppose that the tax applies to interest earnings, but capital gains are untaxed. How would we have to modify the interest parity condition? b. The interest parity condition will become R$= R€+Ee$/€−E$/€/(1−τ) E$/€. 8. Suppose the one-year forward $/€ exchange rate is $1.2 per euro and the spot exchange rate is $1.9 per euro. What is the forward premium on euros (the forward discount on dollars)? a. The forward premium on euros is −36.8 percent. (Give your answer as a percentage with one decimal and do not forget a negative sign, if appropriate.) Given the above information, what is the difference between the interest rate on one-year dollar deposits and that on one-year euro deposits (assuming no political risk)? b. The difference between the dollar interest rate and the euro interest rate R$−R€= −36.8 percent. (Give your answer as a percentage with one decimal and do not forget a negative sign, if appropriate.) 9. Europe's single currency, the euro, was introduced in January 1999, replacing the currencies of 11 European Union members, including France, Germany, Italy, and Spain (but not Britain). How do you think the value of foreign exchange trading in euro changed compared to the euro value of the pre-1999 trade in the 11 original national currencies? a. The value of foreign exchange trading in euro would be smaller 10. Multinationals generally have production plants in a number of countries. Consequently, they can move production from expensive locations to cheaper ones in response to various economic developments—a phenomenon called outsourcing when a domestically based firm moves part of its production abroad. If the dollar depreciates, what would you expect to happen to outsourcing by American companies? a. We would expect outsourcing by American companies to diminish. 11. The interest rate on U.S. three-month Treasury bills dropped to very low levels at the end of 2008 and remained there for several years. The table below contains data for four consecutive months from this period. The data are the three-month U.S. Treasury bill rate, RUS; the Korean 91-day Monetary Stabilization Bond interest rate, RSK; and the exchange rate of the U.S. dollar against the Korean won (won per dollar), EW /$. RUS RSK EW/$ Jan, 2016 0.26% 1.52% 1,203.3 Feb, 2016 0.31% 1.47% 1,216.2 Mar, 2016 0.29% 1.50% 1,181.6 Apr, 2016 0.23% 1.51% 1,145.8 Date Imagine that you borrow $100 at the Treasury bill rate to invest in Korean stabilization bonds, thus doing a carry trade that exposes you to the risk of won/dollar exchange rate fluctuations. The return to the carry trade in month t is calculated by: where RSK, t is the Korean 91-day Monetary Stabilization Bond interest rate in month t, RUS, t is the three-month U.S. Treasury bill rate in month t, EW/$, t is the exchange rate of the U.S. dollar against the Korean won (won per dollar) in month t, and EW /$, t+1 is the exchange rate in month t+1. Note that RSK, t and RUS, t need to be converted from percentage form (as given in the table) to decimal form in this calculation. a. The return on your carry trade JAN, 2016 is $2.36 b. The return on your carry trade FEB, 2016 is $-1.73 c. The return on your carry trade MAR, 2016 is $-1.87 i. Chegg Solution here 12. Does our discussion of money's usefulness as a medium of exchange and unit of account suggest reasons why some currencies become vehicle currencies for foreign exchange transactions? (The concept of a vehicle currency was discussed in Chapter 14.) a. Yes. The more currencies used in trade, the closer the trade becomes to barter, which raises transaction and calculation costs. 13. What is M1? a. A monetary aggregate that includes currency in circulation and checkable deposits. 14. Which of the Federal Reserve's measures of the monetary aggregates is composed of the most liquid assets? M1 a. Among M1 and M2, which is the largest measure? M2. 15. Which of the following is NOT a function of money? a. Capital used to produce goods and services. 16. Which of the following assets is the most liquid? a. A traveler's check. 17. The opportunity cost of money holdings is a. the alternative interest income foregone from not holding some other asset. 18. Which of the following statements is true when considering liquidity? a. The most liquid assets earn no interest. 19. How would you expect a fall in a country's population to alter its aggregate money demand function? Would it matter if the fall in population were due to a fall in the number of households or to a fall in the average size of a household? a. There would be a decrease in money demand because there would be fewer transactions. The decrease in money demand would be larger if the decrease in population was due to a fall in the number of households. 20. Figure 14-2 shows that Japan's short-term interest rates have had periods during which they are near or equal to zero. Is the fact that the yen interest rates shown never drop below zero a coincidence, or can you think of some reason why interest rates might be bounded below by zero? a. Yes. As interest rates fall, people prefer to hold more cash and fewer financial assets. Interest rates will not go below zero because the negative return on financial assets would be dominated by the zero return on cash; therefore, no one would hold financial assets. 21. Using the 3-point curve drawing tool, draw the aggregate money demand curve (nominal money balances) in the diagram to the right. Label this line 'L(R,Y)1" a. Now suppose that price level, P, rises. 22. Using the three-point drawing Tool draw the aggregate real money demand curve in the diagram to the right. Properly label this line. a. As a result of a rise in the interest rate, the quantity of aggregate real money demanded will decrease 23. How might a zero-interest rate complicate the task of monetary policy? a. It cannot respond to an adverse shock to the economy by lowering interest rates. One option is to increase inflation by purchasing bonds to stimulate the economy. Increasing inflation with a constant zero interest rate lowers the real interest rate. 24. The figure on the right shows aggregate real money demand L(R,Y) and the initial nominal money supply. Now, suppose nominal money supply falls while the price level and all other exogenous variables remain the same. a. As the result of this change in the nominal money supply, equilibrium interest rate will rise b. Now, suppose the price level rises (this is a one-time change). Using the line drawing tool, draw the new real money supply on the same graph and label it 'MS2 (Same graph as prev question) 25. The graph on the right depicts real money supply. a. Now suppose that consumers' preferences 26. change in such a way that they choose to carry more cash. b. As a result of this change in preferences, equilibrium in the money market will be at a higher interest rate. Real money holdings will remain unchanged The velocity of money, V, is defined as the ratio of real GNP to real money holdings, V=Y/(M/P) in this chapter's notation. Use Ms/P=L(R,Y) to derive an expression for velocity. Using Ms/P=L(R,Y), velocity can be expressed as V= YL/(r,Y). a. Explain how velocity varies with changes in R and in Y. (Hint: The effect of output changes on V depends on the elasticity of aggregate money demand with respect to real output, which economists believe to be less than unity.) i. An increase in either R or Y will increase velocity. b. What is the relationship between velocity and the exchange rate? i. There is a positive relationship. Thus, an increase in velocity is associated with an appreciation of the exchange rate. 27. What is the short-run effect on the exchange rate of an increase in domestic real GNP, given expectations about future exchange rates? a. Money demand increases, the domestic interest rate increases, and the domestic currency appreciates. 28. Consider the simultaneous equilibrium in the US money market and the foreign exchange market. In this problem we will analyze the effect of a decline in the US nominal money supply on these markets. For this problem assume that prices are fixed. In the domestic money market, if there is a decline in the nominal money supply, the interest rate will rise a. The figure on the right shows the expected return on euro deposits as a function of the dollar/euro exchange rate E$/€. b. Using the line draw tool, draw a new line on the same graph representing the return on dollar deposits as nominal money supply falls, and label it 'RET-$2'. i. As the result of a decline in the nominal money supply, the dollar will appreciate 30. 29. Consider the simultaneous equilibrium in the US money market and the foreign exchange market. In this problem we will analyze the effect of a decline in the US nominal money supply on these markets. For this problem assume that prices are fixed. In the domestic money market, if there is a decline in the price level, the interest rate will fall a. Using the line draw tool, draw a new line on the same graph representing the return on dollar deposits as nominal money supply falls, and label it 'RET-$2'. i. As the result of a decline in the price level, the dollar will depreciate If a currency reform has no effects on the economy's real variables, why do governments typically institute currency reforms in connection with broader programs aimed at halting runaway inflation? (There are many instances in addition to the Turkish case mentioned in the text. Other examples include Israel's switch from the pound to the shekel, Argentina's switches from the peso to the austral and back to the peso, and Brazil's switches from the cruzeiro to the cruzado, from the cruzado to the cruzeiro, from the cruzeiro to the cruzeiro real, and from the cruzeiro real to the real, the current currency, which was introduced in 1994.) a. There may be a psychological benefit in that currency reform can have a positive effect on inflation expectations. However, for the stabilization plan to succeed, it must be backed up by concrete policies to reduce monetary growth. 31. The Federal Reserve (the Fed) and the European Central Bank (ECB) apply monetary policy by controlling interest rates: the federal funds rate, and the repo rate respectively. These two central banks apply expansionary policy by reducing the two interest rates and contractionary policy by raising the two target interest rates. Click on the graph in the window on the right and select Multiple Time Series to graph the daily federal funds rate and the repo rate for the years 1999-2005. For Y1 select the federal funds rate and for Y2 select the repo rate. Roll your cursor over the plotted lines to identify the data. Fed and the ECB is true. a. The ECB followed a very passive monetary policy for a long period (from June 2003 to December 2005). 32. Total saving = private saving+public saving =(Y-T-C)+(T-G) CA balance = GNP-C-I-G 33.