2. (10 points) The following current rates have been observed:

Spot exchange rate: $1.25/SFr

Expected future spot rate in 90 days: $1.2625/SFr

Annual interest rate on 90-day U.S.-dollar-denominated bonds: 10%

Annual interest rate on 90-day SFr-denominated bonds: 6%

(1) At these initial rates, does uncovered interest parity hold (if EUD has an absolute value less than 0.005, then we assume EUD=0.)? Why?

(2) If the U.S. money supply unexpectedly increases by 10 percent, what is likely to be the effect on the spot exchange rate? In your answer assume that the asset market clears faster than the goods market (i.e. prices adjust slowly and interest rates adjust quickly). Also in your answer address short-run changes in the exchange rate as well as long-run changes.