EC3359: International Macroeconomics
Spring 2025
Manolis Galenianos
Exercises for Seminar Week 3 - optional
1. Consider a Dutch investor who has €1,000 to place in a bank deposit in either the
Netherlands or the UK. The one-year interest rate on bank deposits is 1% in the
UK and 5% in the Netherlands. The one-year forward euro-pound exchange rate is
1.65 euros per pound and the spot rate is 1.5 euros per pound. Answer the following
questions using the exact (not the approximate) equations for uncovered interest parity
(UIP) and covered interest parity (CIP).
(a) What is the euro-denominated return on Dutch deposits for this investor?
(b) What is the riskless euro-denominated return on British deposits for this investor?
(c) Is there an arbitrage opportunity here? Explain why or why not. Is this an
equilibrium in the forward exchange rate market?
(d) What is the equilibrium forward rate according to CIP?
(e) If UIP holds, what is the expected depreciation of the euro against the pound
over one year?
(f) Based on your previous answer, what is the expected euro-pound exchange rate
one year ahead?
2. You are given the following information. The current euro-pound exchange rate is €1.5
per pound. A basket of goods that costs €100 in the Eurozone would cost €120 in the
UK (i.e., after the cost in pounds was turned into euros at the current exchange rate).
For the next year, the European Central Bank is predicted to keep Eurozone inflation
at 2% and the Bank of England is predicted to keep UK inflation at 3%. The speed of
convergence to absolute PPP is 15% per year.
(a) What is the expected Eurozone minus UK inflation differential for the coming
year?
(b) What is the current real exchange rate of the Eurozone with the UK, qEU/U K ?
(c) How much is the euro overvalued/undervalued with respect to the pound?
(d) What do you predict the Eurozone real exchange rate with the UK will be in one
year’s time?
(e) What is the expected rate of real depreciation for the Eurozone vs the UK?
(f) What is the expected rate of nominal depreciation for the euro vs the pound?
(g) What do you predict will the euro price of one pound in a year from now?
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