1. This question is about how exports, imports, and interest rates affect the value of the New Zealand Dollar. Let's imagine a situation where NZ's exports increase, and our imports decrease.

a)What happens to the trade balance when this occurs? What happens to thecurrent account?

b)How does an increase in exports affect the FOREX market for NZD? Briefly explain in terms of demand or supply for/of NZD.

c)How does a decrease in imports affect the FOREX market for NZD? Briefly explain in terms of demand or supply for/of NZD.

d)Please draw out the changes you have described in b) and c) in the FOREX market, labelling all the axes, curves, and changes to price and quantity. What happens to the value of the NZD overall?

e)Now consider a different situation where NZ's interest rates decrease relative to the rest of the world. What happens to the demand and supply of NZD in the FOREX market when this occurs? Briefly explain.

f)Please draw out the changes you have described in d) in the FOREX market, labelling all the axes, curves, and changes to price and quantity. What happens to the value of the NZD overall?

2)Exchange rates and interest rates are connected through the parity conditions. Let the New Zealand interest rate be 5% per annum, the US interest rate be 10% per annum, the spot exchange rate be 0.8USD/1 NZD, and the one year forward exchange rate to be 0.85USD/1 NZD.

a)What is the return, in NZD, an NZ investor would get if they invested 1 NZD in New Zealand?

b)What is the return, in NZD, an NZ investor would get if they invested 1 NZD in the US? Hint: you'll have to exchange that NZD for USD!

c)As you should find, the values given mean the parity condition does not hold. Given the interest rates are fixed, what will happen to the value of the spot exchange rate now? Think about this in terms of demand and supply for the NZD

in the FOREX market, and you may draw out a diagram if you wish.

d) Please repeat c) for the change in value of the forward exchange rate.

3) In New Zealand, we currently have a floating exchange rate. However, this was not always the case. During most of the mid 20thcentury, NZ's exchange rate was fixed. Consider a situation where the central bank must keep the exchange rate fixed at a certain level.

a)During the outbreak of the Korean War in 1950, there was a large increase in demand for wool for stockpiles. As New Zealand exports a significant amount of wool, there was a large increase in demand for NZ exports. How does the central bank respond when demand for the NZD increased in this situation in order to maintain the fixed exchange rate? Do they buy or sell NZD? Do they buy or sell foreign currency?

b)What are two advantages and two disadvantages of a fixed exchange rate?