1. (a) Suppose that the current exchange rate between the U.S. dollar ($) and the pound sterling () is Se/$=0.75 (i.e. $1 = 0.75). The basket of goods and services consumed by a typical household cost 200 in the UK and $300 in the U.S. A one-year U.S. Treasury bill yields an annual rate of retum of 3%, while a comparable UK Treasury bill yields 5%. The Federal Reserve is expected to keep the U.S. inflation rate at 2% over the coming year, while the Bank of England is expected to keep the UK inflation rate at 3% over the same period. (i) Is the pound overvalued or undervalued relative to the dollar by the standard of absolute purchasing power parity? (5) (ii) If relative purchasing power parity holds, what will be the value of Se/ a year from now? (5) (iii) If there is perfect capital mobility between the UK and the U.S. and the transaction costs of trading financial assets are negligible, what must be the value of the one-year forward exchange rate F/s? (5) (iv) If uncovered interest parity holds, what is the expected value of the spot exchange rate Ses a year from now? (3) (v) If the spot exchange rate Se/s tums out to be higher than the expected value you calculated in part (iv), should the discrepancy be interpreted as proof that uncovered interest parity does not hold? (5) 1. (a) Suppose that the current exchange rate between the U.S. dollar ($) and the pound sterling () is Se/$=0.75 (i.e. $1 = 0.75). The basket of goods and services consumed by a typical household cost 200 in the UK and $300 in the U.S. A one-year U.S. Treasury bill yields an annual rate of retum of 3%, while a comparable UK Treasury bill yields 5%. The Federal Reserve is expected to keep the U.S. inflation rate at 2% over the coming year, while the Bank of England is expected to keep the UK inflation rate at 3% over the same period. (i) Is the pound overvalued or undervalued relative to the dollar by the standard of absolute purchasing power parity? (5) (ii) If relative purchasing power parity holds, what will be the value of Se/ a year from now? (5) (iii) If there is perfect capital mobility between the UK and the U.S. and the transaction costs of trading financial assets are negligible, what must be the value of the one-year forward exchange rate F/s? (5) (iv) If uncovered interest parity holds, what is the expected value of the spot exchange rate Ses a year from now? (3) (v) If the spot exchange rate Se/s tums out to be higher than the expected value you calculated in part (iv), should the discrepancy be interpreted as proof that uncovered interest parity does not hold
