Suppose that the current (simple annual) yields on 3-month U.S. (RA) and U.K. T-bills (Rb) are 16 percent and 8 percent, respectively, and that the dollar value of the pound is expected to rise 1 percent during the next three months.

(a) How might the British and American T-bill and foreign exchange markets adjust to this situation? Present and discuss an equilibrium consistent with the concept of interest rate parity (IRP) and discuss the processes by which this equilibrium might be achieved. Should you buy U.S. or U.K. bills? At what U.S. T-bill yield would you be indifferent between U.K. and U.S. Tbills given the expected changes in the exchange rate?

(b) Governments frequently buy and sell foreign exchange for the purpose of smoothing fluctuations in exchange rates. Discuss the purposes for these interventions since 1971 and describe how these actions might interfere with the efficient allocation of resources by causing forward exchange rates to be biased predictors of spot rates.

Hints:

IRP Condition: (1 + Ra) = (1 + Rb)(1 + Ee) = (1 + Rb)(1 + F/S)

where Ra = 3-month U.S. T-bill yield,

Rb = 3-month U.K. T-bill yield,

Ee = expected proportional change in the dollar value of the British pound, .

F = forward exchange rate ($/ ),

S = spot exchange rate ($/ ).