MGEC61H3 Lecture Notes - Lecture 13: Foreign Exchange Spot, Interest Rate Parity, United States Dollar

2. Suppose money demand can be described as M/P = 120 - 400i, where i is the nominal interest rate. Assume that the expected future exchange rate equals 2 and that the foreign interest rate equals .05.

a. Suppose the price level equals one and the nominal money supply equals 100. Calculate the nominal interest rate.

b. Calculate the spot exchange rate according to uncovered interest rate parity

c. Suppose there is a temporary increase in the nominal money supply to 110. Assume that the price level remains at one. Calculate the new nominal interest rate.

d. Calculate the new spot exchange rate. (Hint: use the same procedure as part b). Now assume that the increase in the money supply in part c was permanent, not temporary. The foreign country interest rate has not changed.

Consider the relationship between the Japanese yen (¥) and the U.S. dollar ($). Let the exchange rate be defined as $ per ¥, E = $/¥. Apply the money market – foreign exchange market diagrams to answer the following questions. On all graphs, label the initial equilibrium point A.
1) Illustrate how a temporary decrease in Japan’s money supply affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C.
2) Refer to the diagram from (1), state how each of the following variables changes in the short-run (increase/decrease/no change): U.S. interest rate, Japanese interest rate, spot exchange rate E, expected future exchange rate F, and U.S. price level.
3) Refer to the diagram from (1), state how each of the following variables changes in the long run (increase/decrease/no change relative to their initial values at point A): U.S. interest rate, Japanese interest rate, E, F, and U.S. price level.

1. Suppose the expected real interest rate in Hong Kong is 5 percent per year while that in Singapore it is 2 percent per year. What do you expect to happen to the real HK$/SNG exchange rate over the next year?

2. Suppose the expected real interest rate in the United States is 9 percent per year while that in Europe is 3 percent per year. What do you expect to happen to the real dollar/euro exchange rate over the next year?