3.1 The diagram below shows the foreign exchange (FX) market in which the Canadian dollar is traded for euros. The FX market equilibrium is currently in equilibrium at point 1 in the diagram with an equilibrium dollar/euro exchange rate of $1.54 (E¹_$/ = 1.54).

a)If the current euro interest rate (R) is higher than the Canadian interest rate (R >R_$ = 0.02) is the expected exchange rate (E^e_$/), or the value of the dollar/euro exchange rate expected to prevail in a year's time, higher or lower than 1.54?How do you know? Give an economic explanation.[Note: It is not possible to calculate the actual numerical value of E^e_$/ and thus don't try to do so.](2 marks)

b)Now suppose that two changes occur simultaneously: 1) the euro interest rate (R) increases to a new level of R² = 0.04 (4%); and 2) the expected exchange rate (E^e_$/, or the value of the dollar/euro exchange rate expected to prevail in a year's time) decreases to a new value of E^e2_$/ = 1.4938.Write out the general equation for the expected dollar rate of return on euro deposits and use it to calculate the new value of the expected dollar rate of return on euro deposits at the current exchange rate of E¹_$/ = 1.54.

(Show your method of calculation.)(3 marks)

c) In the foreign exchange market diagram above which curve will shift position and in which direction as a result of the combination of the two changes described in part b) above? (2 marks)

d) Assuming that the Canadian interest rate (R_$) does not change from the level shown in the diagram above we can predict that, as a result of the combination of the two changes described in part b) above, the equilibrium exchange rate will _______ (increase/decrease)(1 mark)

e)Explain the economics of: (i) why the equilibrium exchange rate will change in the direction you have identified in answer to part d) and (ii) why that change in the exchange rate will restore FX market equilibrium. (8 marks)

f)Assume the following values for the Canadian interest rate, the (new) euro interest rate, and the (new) expected value of the dollar/euro exchange rate:

R_$ = 0.02; R² = 0.04; E^e2_$/ = 1.4938

The value (rounded to 3 decimal places) of the dollar/euro exchange rate (E²_$/) which is now consistent with foreign exchange (FX) market equilibrium equals .

In the space below clearly show your method of calculation.