Please look at the attached documents and answer the following questions:

EXCHANGE-RATE PROBLEM

Derive the Lira-German mark exchange rate as a cross rate using the Lira-U.S. dollar and mark-U.S.dollar exchange rates.

Assume that the Italian Lira was at its purchasing power parity value and hence in equilibrium relativeto both the US dollar and the German mark in 1973. Compute PPP values of the Lira against both currencies for the remaining years of the sample.

The file PPP_Calculations.xls provides a detailed example of how to make these computations. Three steps are involved. The first is to rebase the CPIs to 1973 by dividing all of the yearly observations by the relevant 1973 figure and multiplying those figures by 100. The second is to divide the rebased CPI series for Italy by the relevant foreign CPI series. That gives you indices of relative price levels with a 1973 base value of 1. The third step is multiply these indices by the value of the relevant exchange rate in 1973. That gives you series of PPP values, i.e. what the actual exchange rate would be in each year if PPP held fully.

In Fall 1992, the value of the Lira?s declined precipitously against the mark and even more so thedollar. From August 1992 to the February 1993 the declines were 22% and 34% respectively. Based on your calculations in (2) were these declines moves towards or away from equilibrium? Explain.

(3) From 1999 on, the Lira has been part of the Euro bloc. It is, however, possible to compute synthetic Lira/$ and DM/$ rates using Euro/$ rates and the conversion rates for the Euro countries? currencies. I have done this. The resultant figures are shown in the table for the years 1999-2003. Comment on their relation relative to PPP over this period.

Italy Ex Rate (Lira/$) 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 623 594 582.5 607.92 649.43 683.55 875 871.55 829.75 804 930.5 1200 1370 1659.5 1935.88 1678.5 1358.13 1169.25 1305.77 1270.5 1130.15 1151.06 1470.86 1703.97 1629.74 1584.72 1530.57 1759.19 1653.1 1817.72 2105.92 2164.4 2060.83 1717.33 Ex Rate DM/$ 3.6600 3.4908 3.1886 2.6726 2.5878 2.4603 2.5180 2.3222 2.0086 1.8329 1.8177 2.2600 2.4266 2.5533 2.8459 2.9440 2.1715 1.7974 1.7562 1.8800 1.6157 1.6595 1.5617 1.6533 1.6228 1.4331 1.5048 1.7341 1.7597 1.8361 2.1272 2.1863 2.0816 1.7347 Money Interest Rates Supply M2 3-mo 3-yr 49.47 7.38 58.97 5.76 69.87 5.18 83.68 6.93 94.61 14.57 118.13 10.64 142.63 15.68 173.56 14.03 214.95 11.49 258.48 11.86 290.05 17.17 321.54 19.6 378.50 20.16 429.84 18.44 479.85 17.27 530.74 15.25 575.96 13.41 618.61 11.51 654.29 11.29 711.48 12.69 759.41 12.38 807.84 12.18 814.20 13.97 841.32 10.2 847.42 8.51 834.15 10.46 863.29 8.82 930.99 6.88 975.34 4.99 2.95 4.39 4.26 3.32 2.33 CPI 10-yr 7.73 7 6.59 6.92 9.61 10.04 12.66 14.71 13.05 13.02 15.25 19.36 20.22 18.3 15.6 13.71 11.47 10.58 10.54 11.61 11.87 13.37 13.67 11.21 10.57 11.98 8.93 6.47 4.55 4.04 5.29 4.64 4.48 3.36 9.01 8.34 7.47 7.42 9.87 11.54 13.08 14.62 13.7 14.05 16.11 20.58 20.9 18.02 14.95 13 10.52 9.65 10.16 10.72 11.51 13.18 13.27 11.31 10.56 12.21 9.4 6.86 4.9 4.73 5.58 5.19 5.03 4.25 14 14.7 15.6 17.2 20.5 24 28 33.2 37.2 42.7 51.8 61.9 72.1 82.7 91.6 100 105.9 110.9 116.5 123.8 131.7 140 147.2 153.5 159.7 168.1 174.7 178.3 181.8 184.8 189.5 194.8 199.6 204.9 Overall GDP BOP Nominal (Lira bil.) 148.81 67.18 658.35 72.99 -489.7 79.81 -49.78 96.74 -789.56 122.19 -2011.59 138.63 1731.67 174.87 5493.09 214.40 3424.72 253.54 2473.72 309.84 682.68 387.67 -1088.98 464.03 10731056 543.78 8923.38 633.41 4497.64 725.68 10722934 813.86 3499.71 900.44 7089.52 984.66 10955.86 1092.84 15583.9 1196.81 13925.64 1320.83 -8334.08 1440.65 13203332 1517.60 -4934.32 1563.27 2540.01 1653.40 4566.82 1787.28 18371.44 1902.28 22395.25 1987.16 18605133 2077.37 -14634.61 2145.38 6837.9 2258.75 -1272.45 2359.41 6531 2440.53 1914.58 2518.94 GDP Real 947.5317 964.2008 992.6617 1058.425 1107.797 1083.894 1154.257 1187.812 1231.973 1301.849 1347.949 1354.041 1360.47 1377.278 1415.133 1457.225 1494.01 1538.772 1599.356 1645.326 1677.884 1701.287 1714.221 1699.022 1736.582 1787.28 1806.877 1843.377 1876.746 1907.683 1965.498 2000.178 2007.345 2012.415 GDP Deflator (1995=100) 7.09 7.57 8.04 9.14 11.03 12.79 15.15 18.05 20.58 23.80 28.76 34.27 39.97 45.99 51.28 55.85 60.27 63.99 68.33 72.74 78.72 84.68 88.53 92.01 95.21 100.00 105.28 107.80 110.69 112.46 114.92 117.96 121.58 125.17 US CPI 36.1 37.6 38.9 41.3 45.8 50 52.9 56.3 60.6 67.5 76.6 84.5 89.7 92.6 96.6 100 101.9 105.7 109.9 115.2 121.4 126.6 130.4 134.3 137.8 141.7 145.8 149.2 151.5 154.9 160.1 164.6 167.2 171 US US US Germany Germany Germany treasury interest rates CPI Call moneyGovt bond yield 3-mo 3-yr 10-yr rate 10-yr 6.44 7.29 7.35 50.4 8.65 8.3 4.34 5.66 6.16 53.0 6.16 8 4.07 5.72 6.21 55.9 4.3 7.9 7.03 6.95 6.84 59.9 10.18 9.3 7.87 7.82 7.56 64.0 8.87 10.4 5.82 7.49 7.99 67.8 4.4 8.5 4.99 6.77 7.61 70.7 3.89 7.8 5.27 6.69 7.42 73.4 4.14 6.2 7.22 8.29 8.41 75.3 3.36 5.8 10.04 9.71 9.44 78.4 5.87 7.4 11.62 11.55 11.46 82.7 9.06 8.5 14.08 14.44 13.91 87.9 11.26 10.38 10.73 12.92 13 92.5 8.67 8.95 8.62 10.45 11.11 95.6 5.36 7.89 9.39 11.89 12.44 97.9 5.55 7.78 7.49 9.64 10.62 100.0 5.19 6.87 5.97 7.06 7.68 99.9 4.57 5.92 5.83 7.67 8.38 100.1 3.72 5.84 6.67 8.26 8.85 101.4 4.01 6.1 8.12 8.56 8.5 104.2 6.59 7.09 7.51 8.25 8.55 107.0 7.92 8.88 5.41 6.81 7.86 110.7 8.84 8.63 3.46 5.31 7.01 115.2 9.42 7.96 3.02 4.44 5.87 119.9 7.49 6.28 4.27 6.26 7.08 123.2 5.35 6.67 5.51 6.26 6.58 125.3 4.5 6.5 5.02 5.99 6.44 127.1 3.27 5.63 5.07 6.1 6.35 129.5 3.18 5.08 4.82 5.14 5.26 130.7 3.41 4.39 4.66 5.49 5.64 131.5 2.73 4.26 5.84 6.22 6.03 134 4.11 5.24 3.45 4.08 5.02 137.4 4.37 4.7 1.61 3.1 4.61 139.2 3.28 4.61 1.01 2.11 4.02 140.6 2.32 3.81 Deriving PPP Estimates We want to compare the actual exchange rate with the rate that is consistent with PPP over time. We observe the actual rate -- it's the market rate - but we have to estimate the PPP rate. This will involve several steps. These are illustrated for US vs. UK in the spreadsheet. First, we need to have an estimate of the PPP rate in a particular time period. I assume here that in 2003 equilibrium prevailed so that the PPP rate was equal to the actual market rate of $1.63 per pound. I will then project the PPP rate backward and forward using the CPIs for the two countries as measurers of prices. These are given in columns C and D. Since the CPI data are indices with the same arbitrary base year of 2000, we cannot use them directly. We first have to transform them so that the have the same base period as our assumed equilibrium between the PPP rate and the market rate of 2003. I do this in columns E and F. I divide the original data for each period in columns C and D by the respective values of the CPI in 2003 (106.83 and 106.50 for the US and UK, respectively). I then multiply these figure by 100 so the data have the same dimension as the original CPI data. I now divide column E by Column F. The result is an index of the relative price levels of the US vs. the UK. These figures are shown in column G. To get an estimate of USD vs. GBP PPP rates, I multiply these figures by the assumed equilibrium exchange rate of $1.63 per pound for 2003. These figures are shown in column H. Period 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Exch. Rate US CPI UK CPI US CPI UK CPI Relative CPI PPP USD/GBP 2000=100 2000=100 2003=100 2003=100 2003=1 USD/GBP 1.78 75.88 74.08 71.03 69.56 1.02 1.67 1.77 79.09 78.42 74.03 73.63 1.01 1.64 1.77 81.48 81.35 76.28 76.38 1.00 1.63 1.50 83.89 82.62 78.53 77.58 1.01 1.65 1.53 86.08 84.66 80.58 79.50 1.01 1.66 1.58 88.49 87.55 82.84 82.21 1.01 1.65 1.56 91.09 89.70 85.26 84.22 1.01 1.65 1.64 93.22 92.51 87.26 86.86 1.00 1.64 1.66 94.66 95.67 88.61 89.83 0.99 1.61 1.62 96.73 97.16 90.55 91.23 0.99 1.62 1.52 100.00 100.00 93.61 93.90 1.00 1.63 1.44 102.83 101.82 96.25 95.61 1.01 1.65 1.50 104.46 103.49 97.78 97.17 1.01 1.64 1.63 106.83 106.50 100.00 100.00 1.00 1.63 1.83 109.69 109.66 102.68 102.96 1.00 1.63 1.82 113.41 112.76 106.16 105.88 1.00 1.64 1.84 117.07 116.36 109.59 109.26 1.00 1.64 2.00 120.41 121.34 112.71 113.93 0.99 1.62 1.85 125.03 126.18 117.04 118.48 0.99 1.61 1.64 124.51 125.36 116.55 117.71 0.99 1.62