Part A. Choose the correct answer and justify

1.On March 31, 2021 in the foreign exchange market, one U.S. dollar was 110.00 Japanese yen (e = 110.00 /$). If the dollar depreciates by 2 percent against the yen during the 12 months following March 31, 2021, what would be the dollar-yen exchange rate on March 31, 2022?

a)120.0 /$.

b)112.2 /$.

c)112.0 /$.

d)108.0 /$.

e)107.8 /$.

2.On May 26, 2021 in the foreign exchange market, one euro was 1.23 U.S. dollar (e = 1.23$/). Exactly one year earlier on May 26, 2020 this exchange rate was e = 1.09$/. In that year,

a)the euro depreciated against the dollar by 14.0 percent.

b)the euro appreciated against the dollar by 14.0 percent.

c)the euro appreciated against the dollar by 12.8 percent.

d)the euro depreciated against the dollar by 12.8 percent.

e)the euro appreciated against the dollar by 11.4 percent.

f)the euro depreciated against the dollar by 11.4 percent.

3.In the situation described in Question 2, the price level in the U.S. economy had risen by 4.2 percent in the approximate period described in the question, while the corresponding figure for the Eurozone was 1.7 percent. Given this information, we can say that between May 26, 2020 and May 26, 2021, the real exchange rate of the euro, rounded to the whole percentage point, has appreciated against the dollar by

g)17 percent.

h)13 percent.

i)11 percent.

j)10 percent.

k)2 percent.

4.Questions' 2 and 3 settings are characterized by a change in the exchange rate from 1.09 U.S. dollars per Euro (e = 1.09$/) on May 26, 2020 to 1.23 U.S. dollars per Euro (e = 1.23$/) on May 26, 2021, as well as an increase in the price level in the U.S. economy of 4.2 percent and an increase in the price level of 1.7 percent in the Eurozone, which resulted in the overall appreciation of the real exchange rate of the Euro. You found the specific magnitude of this real exchange rate appreciation in Question 3. Given this information, we can say that compared to the US products, Eurozone products have become relatively more expensive

l)for Eurozone residents, but relatively more expensive for Americans.

m)only for people outside Eurozone and America.

n)for everyone around the world.

o)only for Eurozone residents.

p)only for Americans.

5.Peach Inc. manufactures farming equipment in the United States and exports some of its products to Canada. In the Canadian market, it competes with local firms and has to match their prices in Canadian dollars (C$). Suppose the Canadian market prices remain constant this year, but the Canadian dollar (C$) depreciates vis--vis the US$ by 3%. If Peach Inc. wants to remain as competitive in the Canadian market this year as it has been in the past price-wise, it must

q)lower the US$ price of its exports to Canada by more than 3%.

r)lower the US$ price of its exports to Canada by 3%.

s)keep the US$ price of its exports to Canada the same.

t)raise the US$ price of its exports to Canada by 3%.

u)raise the US$ price of its exports to Canada by more than 3%.

6.Suppose the euro is your home currency. If the rates of interest on euro and yen deposits are equal to each other, i = i, and the spot exchange rate is less than the expected future exchange rate, e < ee, then in the spot market for foreign exchange,

v)covered interest parity will hold.

w)uncovered interest parity will hold.

x)supply and demand will be balanced.

y)there will be excess demand for the yen.

z)there will be excess demand for the euro.

7.Assume that the interest parity condition holds and risk-free, one-year rates of interest in the US and Euro area are -0.5% and 0%, respectively. If the Fed raises the rate of interest in the US to 0.25%, the expected appreciation of the dollar vis--vis the euro during the next 12 months

aa)will rise.

bb) will decline.

cc)may rise, may decline.

dd) will remain unchanged.

8.Let ef and ee be the current one-year forward and expected exchange rates of the dollar vis--vis the yuan. Assume that the covered and uncovered interest parities both hold at all times. If the improving prospects of the US economy causes the expected exchange rate ee to go up, then

a)ef will decline by the same amount that ee rises.

b)ef will rise by more than the increase in ee.

c)ef will rise by less than the increase in ee.

d)ef will rise by the same amount as ee.

e)ef will remain unchanged.

Part 2. Short-Answer and Algebraic Questions: (The numbers in square brackets give the breakdown of the points for various parts of each question..)

9.A British money financier is managing 10 million and wants to invest it in safe bonds either in France or United Kingdom for one year. The one-year interest rate on such assets is 0.55% in Britain and 0.1% in France. The one-year forward euro-pound exchange rate is 1.135 / (euros per pound). Assume that the covered interest parity condition (CIP) always holds and to ensure consistency, treat the UK as home country. [18 points total for Question 9]

(a)What is the current euro-pound spot exchange rate? Explain and show your work.[6]

Answer:

(b)Suppose the financier believes that the uncovered interest parity (IP) condition also holds and the foreign exchange market participants are acting based on correct expectations about future spot euro-pound exchange rate in the sense that their expectations predict the future rate without bias. Given these assumptions, what is the one-year expected spot euro-pound exchange rate prevailing in the market? Explain and show your work. [6]

Answer:

(c)Now suppose that the financier believes that while the uncovered interest parity (IP) condition also holds, the foreign exchange market participants have incorrect expectations about future spot euro-pound exchange rate. She believes that she has a better understanding of the economy and expects the future spot rate to be 1.1 /, on average. Assume that she is risk neutral in the foreign exchange market. Where should she invest the 10 million? Explain and show your work. [6]

Answer:

10.In the coming year, as the COVID-19 pandemic eases and the Federal government increases its expenditure, the economic recovery in the US is likely to speed up and inflation may start to take off. Assume that this prospect gives rise to expectations in currency markets that a year from now (early 2022) the Fed will raise the US interest rate and keep it at an elevated level for some years. The following set of questions is about impact of this prospect on the exchange rate and interest rate policies of emerging markets. In answering these questions, assume that the interest parity condition always holds and that the interest rates observed in emerging markets include risk premia. That is, treating the emerging economy as home country and the US as the foreign country, if the nominal domestic and foreign interest rates inclusive of risk premia are ir and ir*, risk free interest rates can be expressed as:

i = ir- and i* = ir* - *,

where and * are the risk premia on domestic and foreign bonds, respectively. Since the risk premium for the US assets is practically negligible, assume that * = 0 and, therefore, i* = ir*. Then, the IP condition can be written as (1 + ir - )ee = (1+ i*)e. Assume that this condition always holds. [26 points total for Question 10]

(a)Consider an emerging market economy, E, where policymakers need to assess the consequences of a rise in US interest rates next year. For now, suppose that the risk premium and interest rate policies in country E are given (i.e., can be treated as constant as the US interest rate changes). How would the expected rise in the US interest rate affect ee (which is the expected exchange rate of country E's currency vis--vis the US dollar next year, 2022)? Why? How would this prospect affect the spot exchange rate of country E's currency, e, now? Why? Please remember to explain your answers using concepts covered in this module of the course. [8 points]

Answer:

(b)Let's now consider a situation where because of the COVID-19 pandemic the businesses in country E have borrowed heavily in both dollars and domestic currency, while their revenues are stagnant and entirely in local currency. In this situation, a depreciation of the domestic currency or an increase in the domestic interest rate next year could make it difficult for the indebted businesses to pay back their loans and many of them may go bankrupt. Suppose the prospect of such a debt crisis raises the risk premium in E this year. Assume as in part (a), that the central bank plans to keep the domestic interest rate constant this year and beyond. How would this prospect affect the spot exchange rate of country E's currency? Why? Please remember to explain your answers using concepts covered in this module of the course. [6 points]

Answer:

(c)Now consider the situation in part (b), but assume the central bank of country E wants to prevent any change in the spot exchange rate of its currency vis--vis the US dollar this year. It plans to return to its past policies next year and let the currency move in whichever way determine by the market at that time. In this situation, what action should Country E's central bank take in regard to the interest rate, ir, this year? Please remember to explain your answers using concepts covered in this module of the course. [6 points]

Answer:

(d)Given the situation described in part (c), could the prospect of interest rate increase in the US and the response of emerging economy's central bank cause a debt crisis in country E this year? Please remember to explain your answers using concepts covered in this module of the course. [6 points]

Answer:

11.This question is based on the article, "How America's blockbuster stimulus affects the dollar," published by The Economist on March 13, 2021. The article discusses the drivers of the past and potential future trends in the value of the dollar in terms of other currencies. Note that the article mentions changes in "risk appetite" as a driver of exchange rates. By "risk appetite" the article means willingness to hold riskier currencies as opposed to the U.S. dollar, which is considered the safest currency. So, when risk appetite declines, people prefer to hold more dollars and demand higher premia for holding risky currencies. [26 points total for Question 11]

(a)According to the article, how did risk appetite change in March 2020 and how did it affect the dollar's value in terms of other currencies? [6]

Answer:

(b)According to the article, how did the actions of the Fed help with the situation described in (a)? How did the risk appetite change in the rest of 2020 and how did it affect the dollar's value in terms of other currencies? [6]

Answer:

(c)The article claims that "the greenback's bounce-back this year is more about interest-rate differentials." Based on the evidence and arguments presented in the article, does the appreciation of the dollar between mid-December 2020 and mid-March 2021 seem to be due to changes in short-term interest rate differentials that already took place or expected changes to interest rate differentials in the future? [6]

Answer:

(d)At the time of its publication in mid-March, the article predicted that the dollar seemed "likely to rise a bit further in the near term." That prediction has not proven quite correct (see https://fred.stlouisfed.org/series/DTWEXBGS, which shows that the dollar has weakened between mid-March and mid-May 2021). However, it points out that "later in the year, though, there is a case for a mildly weaker dollar, which better matches the recent trend in the value of the dollar vis--vis other currencies. What is the article's reasoning for this prediction? [8]