1. Consider a world with two countries, domestic and foreign, in both of which five units of output are produced for every unit of capital stock, broadly defined to include human capital, physical capital, technology, knowledge, etc. Suppose that the domestic (and foreign) real exchange rate is an immutable constant equal to 1.0. Suppose further that the residents of both the domestic and foreign economies choose to hold one unit of nominal money balances for every two units of nominal output, regardless of market interest rates. Finally, assume that no one in either economy requires any premium to bear risk. What will be the effect on the nominal exchange rate, the forward discount on the domestic currency and the domestic market interest rate of an unanticipated (by the private sector) one-shot increase in the domestic nominal money supply of 10 percent, brought about by the actions of the domestic government? A sudden and not previously predicted increase in the publics desired ratio of nominal money to nominal income from 0.5 to 0.6? An increase in the rate of growth of the domestic money supply, brought about by pre-announced actions of the domestic government, from 0 percent per year to 10 percent per year? How would your answers above change if it were the case that the publics desired ratio of money to income falls in both countries when the nominal interest rate increases?

1. In the above cases, does the forward discount adjust to equal the domestic/foreign interest rate differential or does the domestic/foreign interest rate differential adjust to equal the forward discount?

2. Suppose that the exchange rate between U.S. dollars and Swedish krona is $1 = 6.6565 krona. How many dollars can 10,000 krona be exchanged for?

3. You will be vacationing in Belgium and wish to take with you $500 in Belgian francs. If the exchange rate is $1 = 29.14 Belgian francs, how many francs will you need?

4. Explain covered interest parity.

5. State the law of one price.

6. How does arbitrage ensure that the law prevails?

7. What is purchasing power parity? Why does PPP not appear to hold in the real world?