Econ 457, Exam 1, February 11, 2014 Name UID All multiple choice questions are worth 4 points each. 1. Suppose 40% of Home country’s trade is with Country 1 and 60% is with Country 2. If Home’s currency appreciates 10% against Country 1’s but depreciates 40% against Country 2’s, Home’s effective exchange rate has A. depreciated by 6%. B. appreciated by 14%. C. depreciated by 20%. D. depreciated by 14% 2. A U.S. firm expects to receive payment of €1.5 million in 90 days for exports to France. At an exchange rate of $1/€, the firm will make zero profits. If the exchange rate in 90 days turns out to be $0.90/€, assuming zero transaction costs, the firm will make A. a profit of $150,000. B. a profit of $50,000. C. a loss of $150,000. D. a loss of $10,000 3. If euros can be obtained at € 0.9/$, and pounds can be obtained at £ 0.7/€, the cross rate between the pound and the dollar must be A. £ 1.52/$. B. £ 0.85/$. C. £ 1.15/$. D. £ 0.63/$. 4. For two countries (Home and Foreign), the uncovered interest parity condition implies that the Home interest rate must equal A. the Foreign interest rate. B. the Foreign interest rate plus the expected rate of depreciation of the Home currency. C. the Foreign interest rate plus the expected rate of depreciation of the Foreign currency. D. Foreign interest rate less foreign inflation rate 5. Let PUS be the price of a basket of goods in the United States, PEUR the price of the same basket in Europe, E the nominal exchange rate in terms of $ per €, and qEUR/US the real exchange rate indicating the number of U.S. baskets needed to buy 1 European basket. The U.S. will experience a real depreciation if, ceteris paribus, A. PEUR falls. B. E falls. C. PUS rises. D. None of the above 6. The Quantity Theory of Money states that the demand for money is given by Md = L x P x Y, where P is the price level, Y is real income and L is a constant. If the price level rises by 10% and real income is fixed, the demand for money will A. rise by more than 10%. B. rise by less than 10%. C. rise by 10%. D. fall by 10% 7. The demand for money is given by Md = P x Y x L(i), where P is the price level, Y is real income and i is the nominal interest rate. The demand function implies that a fall in the nominal interest rate, ceteris paribus, will cause the money demand to A. increase. B. decrease. C. remain unchanged. D. None of the above 8. Suppose expected inflation is 4% in the United Kingdom and 1% in the United States. If relative PPP holds, the market would expect the pound to A. depreciate by 3% against the dollar. B. depreciate by 8% against the dollar. C. appreciate by 3% against the dollar. D. appreciate by 5% against the dollar. 9. Suppose expected inflation is 4% in the United States and 2% in France. If interest rates in France are 4%, according to the Fisher Effect, the interest rate in the U.S. must equal A. 1%. B. 5%. C. 6%. D. 2% 10. The PPP theory fails in reality because A) the inflation data reported in different countries are based on different commodity baskets. B) transport costs and restrictions on trade. C) monopolistic or oligopolistic practices in goods markets. D) all of the above. 11. Which one of the following statements is the most accurate? A) It is hard to tell whether departures from PPP are greater in the short run than in the long run. B) Departures from PPP may often be greater in the short run than in the long run. C) Departures from PPP are similar in both the short run and long run. D) Departures from PPP are even greater in the long run than in the short run. 12. Which of the following statements is the most accurate? A) Relative PPP implies absolute PPP. B) There is no causality relation between the two. C) Absolute PPP implies relative PPP. D) Absolute PPP does not imply relative PPP. 13. Bonus question: The news report “Dollar’s rise squeezes US firms” highlights that A. US firms that sell cosmetics/jewelry to international customers are benefitting by dollar’s appreciation B. The demand for hotels in New York from international tourists is rising. C. Unlike most US firms, the aluminum giant Alcoa that mines bauxite in foreign lands and sells it in the US at dollar prices is profiting due to dollar’s rise. D. None of the above. 14. When a country's currency depreciates, A) foreigners find that its exports are more expensive, and domestic residents find that imports from abroad are more expensive. B) foreigners find that its exports are more expensive, and domestic residents find that imports from abroad are cheaper. C) foreigners find that its exports are cheaper; however, domestic residents are not affected. D) None of the above. 15. Forward and spot exchange rates A) are necessarily equal. B) do not move closely together. C) are always such that the forward exchange rate is higher. D) do move closely together, but are not necessarily equal. 16. The following is an example of Apple hedging its foreign currency risk: A) needing to pay 9,000 yen per iPhone to its suppliers in a month, Apple makes a forwardexchange deal to buy yen. B) needing to pay 9,000 yen per iPhone to its suppliers in a month, Apple makes a forward-exchange deal to sell yen. C) needing to pay 9,000 yen per iPhone to its suppliers in a month, Apple buys yen at a spot-exchange 1 month from now. D) needing to pay 9,000 yen per iPhone to its suppliers in a month, Apple sells yen at a spot-exchange 1 month from now. 17. Which major actor is at the center of the foreign exchange market? A) corporations B) central banks C) commercial banks D) non-bank financial institutions 18. If the dollar interest rate is 10 percent and the euro interest rate is 6 percent, then A) an investor should invest only in dollars. B) an investor should invest only in euros. C) an investor should be indifferent between dollars and euros. D) It is impossible to decide between the two, given the information. 19. Suppose that the one-year forward price of euros in terms of dollars is equal to $1.113 per euro. Further, assume that the spot exchange rate is $1.05 per euro, and the interest rate on dollar deposits is 10 percent and on euro it is 4 percent. Show that the Covered Interest Parity condition holds in this case. [7 points] One has to plug in the numbers to check whether Dollar interest rate = (1/spot rate)* Euro interest rate * Forward rate holds or not. It does indeed. 20. Dollar euro exchange rate is 1.35$/euro. Dollar yen exchange rate is 0.0125 $/yen. What would be the euro-yen exchange rate for no-arbitrage to hold? [6 points] 0.0125/1.35 euro/yen 21. A basket of consumption commodities in Canada cost C$100 in 1970 in Canada, whereas by 1990 the same had gone to C$392. In the US, the price of an identical basket rose from $100 to $336. In 1970 the dollar/looney exchange rate was 1, whereas by 1990 the exchange rate was 1.16 C$ per US$. What would it cost a Canadian to buy the US consumption basket in 1990? What would it cost in US $ to buy Canadian basket? (7 points) For a Canadian the cost of a 1990 US basket is 1.16*336 = 389.8 C$ For a US resident the cost of a 1990 Canadian basket is 392/1.16 = 337.9 $ 22. A big Mac costs 10 yuans in China, while it costs $4 in the US. The yuan/$ exchange rate is 7. Is yuan undervalued or overvalued relative to its value predicted by the law of one price for big Macs? By what percentage? (6 points) LOOP will require yuan/$ exchange rate to be 10/4 = 2.5 yuans. But it is 7 yuan – it is too cheap in the market – i.e., undervalued. The undervaluation is by (7-2.5)/2.5 = 4.5/2.5 = 1.8. One would say that it is undervalued by 180%. The yuan will have to depreciate by 180% to reach its value predicted by LOOP. 23. Suppose EU prices and outputs remain constant. US output is constant but the Fed announces that US money supply will now onwards grow at 10%, while previously it was kept constant. Assuming PPP holds, what is the implication for $-euro exchange rate? Assume that the money demand does not depend on the nominal interest rates. That is the real money demand is given by the quantity theory of money. (6 points) The dollar/euro exchange rate is the ratio of P_US and P_EU by PPP. Nothing happens to P_EU – it is clear. If money supply begins growing by 10%, prices begin growing by 10% too by the quantity theory equation which says that M/P = L Y. Since the RHS is constant for the LHS to be constant P_US grows by 10% too. Then the exchange rate grows by 10% too. However, there is no change at the time when the policy is announced, because the Money supply does not change at that moment. 24. Bonus Question (4 points): Please refer to the Big Mac Index data posted on the class website. Which country’s currency is most overvalued and most undervalued? Give one main reason for the Big Mac price differences across countries. Most Overvalued: Switzerland. Most undervalued: Ukraine. A Big Mac is made using both traded and non-traded (labor) goods/services. Richer countries have higher real wages and as a result a Big Mac costs more in those countries.