ECON 406 - ASSIGNMENT 1 International Finance

HOMEWORK ASSIGNMENT # 1

1. [5 points] Select a country other than the U.S. Find data on the value of its currency relative to the U.S. dollar on Monday, October 3 and Tuesday, October 4, 2016. You could look in a newspaper, such as the Wall Street Journal, or go on line, for example to the following IMF site:

www.imf.org/external/np/fin/data/param_rms_mth.aspx

From Monday to Tuesday, did the U.S. dollar appreciate or depreciate relative to this other currency? Please write down the relevant exchange rates on both days, to support your answer.

2. [8 points total]Suppose that you were given the following information about the exchange rates between British pounds (£), U.S. dollars ($) and Euro (€):

$2.41 = £1.00 in New York; €1.02 = $1.00 in London; €1.70 = £1.00 in Geneva;

a. (3 points) If you begin by holding $1.00, how could you make a profit?

b. (2 points) What is the arbitrage profit per U.S. dollar initially traded?

c. (3 points) Briefly explain how arbitrage would tend to eliminate the profit opportunity. In what direction would you expect each of these bilateral exchange rates to move?

3. [5 points] Suppose interest rates in the United States are 5.5%, while they are 3% in the EMU (European Monetary Union). Currently the dollar–euro exchange rate is at $2.50 per euro. If UIP holds, what do you expect the exchange rate to be in the future? Round your answer to three decimals.

4. [15 points total, 5 points each] Consider the asset approach to exchange rates (our theory to determine short run exchange rates) for two countries, China and Thailand. The current spot exchange rate is 4 Thai baht per Chinese yuan, Ebaht/yuan = 4. Analyze the following situations. For each situation, explain the changes in each of the following from the perspective of a Thai investor:

(i) expected rate of return on Thai deposits, (ii) expected rate of return on Chinese deposits, and (iii) the spot exchange rate.

a. The expected future exchange rate increases, Eebaht/yuan> 4 and interest rates in both countries remain unchanged.

b. The interest rate on Chinese and Thai deposits increases by the same amount and the expected exchange rate remains unchanged.

c. The interest rate on Chinese deposits decreases, Thai interest rates remain unchanged, and the expected exchange rate is unchanged.

5. [10 points total, 5 points each] Use the FX and money market diagrams to answer the following questions. This question considers the relationship between the Japanese yen (¥) and U. S. dollar ($). Let the exchange rate be defined as $ per ¥, E$/¥. On all graphs, label the initial equilibrium point A. U.S. is the home country.

a. Illustrate how a temporary decrease in Japan’s money supply affects the money and FX markets in the short run. Be sure to label the axes, the initial equilibrium and the final equilibrium.

b. Using your diagram from (a), state how each of the following variables changes in the short run (increase/decrease/no change): U. S. interest rate, Japanese interest rate, E$/¥, Ee$/¥, Japan price level and U. S. price level.

6. [7 points] Let US be the home country and Euro Area be the foreign country. Suppose there is a temporary economic boom in the U.S., leading to an increase in the real money demand in the U.S.

Use the FX market and the money market diagrams to illustrate this change and how this change affects the money and FX markets in the short run. Be sure to label the axes, the initial equilibrium and the final equilibrium. Explain any shifts in schedules and the behavior of E$/€, Ee$/€, i$, PEA andPUS.

7. [20 points total]In 1992, several European countries had their individual currencies pegged to the ECU (a pre-cursor to the euro) in anticipation of forming a common currency area. In practice, this meant that countries were pegged to the German deutschmark (DM). This question considers how different countries responded to the European Exchange Rate Mechanism (ERM) Crisis. For the following questions, you need only consider short-run effects. Also, treat Germany as the foreign country.

a. [7 points] Following the economic consequences of German reunification in 1990, the Bundesbank (Germany’s central bank) raised its interest rate. On September 14, 1992, Great Britain decided to float the British pound (£) against the DM. Using the FX and money market and treating Britain as the home country, illustrate the effects of Germany increasing its interest rate.

b. [8 points] After Britain abandoned the ERM (e. g. , allowed its currency to float against the DM), investors grew concerned that France would no longer be able to maintain its currency peg. The Banque de France (France’s central bank) wanted to keep its currency (French franc, FF) pegged to the DM. Using the FX and money market and treating France as the home country, illustrate the effects of Germany increasing its interest rate, assuming the currency peg is maintained.

c. [5 points] Denmark had a similar experience to that of Britain and France. Suppose Denmark’s prime minister approaches you about how to respond. He doesn’t want to give up monetary policy autonomy, but wants to maintain the exchange rate peg. Is this possible? Explain why or why not.