a. The following table reports the nominal exchange rate of the US dollar against two other American currencies (Canadian dollar and Mexican pesos) on 31/12/2021. It also presents the inflation rates’ forecasts for the next 1-year period (estimated by the OECD), as well as the 1- year government bond yield (in %) for both countries.

You are a US citizen and you want to invest $300,000 to a 1-year government bond. Which country is the best to invest money in?

b. Mr. Garamond, the owner of a small publishing house in Bologna, plans to invest 2.5 million euros for one year, and he thinks to buy either a US bond with interest rate 0.38% or an Italian bond with interest rate −0.49%. Note also that today’s euro nominal exchange rate per $ equals 0.876. 

i. If Mr. Garamond expects annual appreciation of the euro by 3.5%, what will be his choice? Comment on your answer.

ii. Which expectations’ scheme regarding the exchange rate will make Mr. Garamond indifferent between the two alternatives?

c. Since 1986, The Economist has developed the ‘Big Mac Index’, as an example of the law of one price. This index serves as a comparison (but not perfect) point as to whether currencies are overvalued or undervalued. On January 31, 2022, a Big Mac costs $5.81 in the USA and 4,600 won in South Korea. Is the won overvalued or undervalued?

USA Canadian dollar (CAD) Mexican peso (MXN) Exchange rate 1.27 20.46 Inflation rates' forecasts (%) 4.78 3.25 4.43 1-year government bond yield (%) 0.38 0.76 6.92