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International Economics Ralph Sonenshine Problem Set 2 (Due September 21) 1

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International Economics Ralph Sonenshine Problem Set 2 (Due September 21) 1. A £10,000 deposit in a London bank in a year when the interest rate on pounds is 10% and the $/£ exchange rate moves from $1.50 / £1.0 to $1.38/£1.0. What is the dollar rate of return on this asset? 2. Construct a trade weighted index for the US based on total trade and exports (2 indexes of 6 years each) using the following data. Please ignore Zimbabwe. Hint, use the exports and imports data to form your weights, then construct an index for each current (1/e or foreign currency/dollar). The exchange rates are given (See the spreadsheet which does the first three for you). Then multiply the export weights times the currency amounts to get a series of export weighted exchange rates covering for 6 years. Do the same thing for total trade (exports+imports) weighted exchange rates. Canada Japan Mexico UK Germany Switzerland Korea Australia Exports 230257 59649 134167 45393 41320 14392 32455 17782 Imports 307823 152244 200516 54630 91222 14774 47636 8563 Used Market Rate AE from IMF database Partner 2004 2005 2006 2007 2008 2009 Canada 1.204 1.165 1.165 0.988 1.225 1.047 Japan 104.120 117.970 118.950 114.000 90.750 92.060 Mexico 11.265 10.778 10.881 10.866 13.538 13.059 UK 1.931 1.722 1.963 2.003 1.458 1.620 Germany 0.734 0.848 0.759 0.679 0.719 0.694 Switzerland 1.132 1.314 1.220 1.126 1.064 1.031 Korea 1,035.100 1,011.600 929.800 936.100 1,259.500 1,164.500 australia 1.284 1.363 1.264 1.134 1.443 1.115 Zimbabwe 5.940 80.770 258.920 30,000.000 130.000 not available Zimbabwe $ per US $ through Apr.'08; Millions $ per US $ May-July '08; New Zimbabwe $ per US $ thereafter Show your results then graph your two series. (See the excel sheet on Canvass) Finally, explain your results. 3. Traders in asset markets suddenly learn that the interest rate on dollars will decline in the near future. Use the diagrammatic analysis in Chapter 3 to determine the effect on the current dollar/euro exchange rate, assuming current interest rates on dollar and euro deposits do not change. 4. Answer the following questions concerning covered and uncovered interest rate differentials and parity conditions: a. Suppose the spot dollar-euro exchange rate is $1.20/€ , and the 60-day forward rate is $1.24/€. Is the euro selling at a forward discount or premium? What about the dollar? b. Now suppose the interest rates on one-year U.S. and Eurozone (EMU) bonds are rUS = 5% and rEMU = 3%. You expect that, one year from now, the dollar-euro exchange rate will be at $1.26/€. Today the rate is $1.20/€. Which should you invest in, the U.S. or EMU bond? Explain Hint use uncovered interest rate parity to get your answer. c. Suppose the interest rate is 4% in the US and 8% in the UK. If the actual exchange rate is e = $2.00/£1 (home is the US), what must the expected exchange rate ee be? 5. Suppose there is a reduction in aggregate real money demand, that is a negative shift in the aggregate real money demand function. Trace the short and long run effects on the exchange rate, interest rate, and price level.