ECONOMICS 336
INTERNATIONAL BALANCE OF PAYMENTS
SPRING 2012
First Midterm
PART 1. (50%) Answer briefly the two questions below. Please write your answers in a blue book.
Question 1. From the latest (March 3rd) issue of The Economist:
Interest rates, %
(Ten year government bonds)
United States
Japan
Britain
Germany
Italy
(i)
1.94
0.96
2.14
1.81
5.18
Currency Units per US$
-80.9
0.63
0.75
0.75
Assuming uncovered interest parity (UIP), what is the expected rate of appreciation or
depreciation of the U.S dollar against the Japanese yen and the British pound? Explain your
answer briefly.
Answer: By UIP, the expected depreciation is equal to the inflation differential. Hence the dollar is
expected to depreciate at a rate of 1.94 – 0.96 = 0.98 percent (per year) against the yen, and to appreciate
at a rate of 1.94 – 2.14 = -0.20 percent (per year) against the pound.
(ii)
Compute the market expectation of the US$/yen and US$/pound exchange rates a year from
now.
Answer: The only thing to keep in mind is the way exchange rates are quoted. The current dollar per yen
rate is 1/80.9 = 0.0123. Using the answer in (i), a year from now it is expected to be 0.0123 times 1.0098
= 0.0125. For the dollar/pound exchange rate, the calculation is (1/0.63) times (1 – 0.002) =
(1/0.63)*0.998 = 1.584.
(iii)
What are interest rates in the U.S. and Germany telling us about the expected U.S.
dollar/Euro exchange rate?
Answer: Since the US interest rate is higher than the one in Germany, this says that the dollar is expected
to depreciate against the Euro
(iv)
Now look at interest rates in the U.S. and Italy. What do they say about the expected
dollar/Euro exchange rate?
Answer: The Italian interest rate is higher, hence this says that the dollar is expected to appreciate against
the Euro.
(v)
Are your answers to (iii) and (iv) consistent with each other? Discuss one reason for the
discrepancy. (Hint: Is UIP a good assumption here? Why or why not?)
Answer: Essentially, the “right” answer is that UIP is not a good assumption here. This is probably
because of perceptions of risk associated with Italian bonds, which would mean that UIP should not be a
reasonable assumption for US-Italy . (But other explanations of why UIP might fail may be acceptable, as
long as they make sense and do not contradict the facts. For example, it is not plausible that restrictions to
capital mobility are responsible for the breakdown, since the US and Italy are financially quite open).
Question 2. Suppose that the supply of U.S. dollars has just jumped up by 1 percent, and you observe that
the dollar has depreciated by only 0.5 percent against the British pound. Is the dollar depreciation
consistent with the theory we have studied in class? If your answer is yes, give and explain one reason
that might explain why the depreciation was smaller than the change in the money supply. If your answer
is no, describe carefully what inconsistency you see.
Answer: This is an “open ended” question. Essentially, it asks why exchange rate overshooting might not
happen. One good answer is that the change in the US money supply may be expected to be only
temporary, not permanent. In that case, overshooting would not obtain. Students should get credit for
illustrating the mechanism with, say, the appropriate graphs. (See chapter 4 of Feenstra Taylor.) Other
answers may be possible but more elaborate (e.g. that the US money supply shock was matched by a
change in the foreign money supply). Students should be given credit for answer that make sense and are
appropriately justified by the framework of Feenstra-Taylor.