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You are given the following information. The current dollar-pound exchange rate is $2 per pound. A U.S basket that costs $100 would cost $120 in the United Kingdom. For the next year, the Fed is predicted to keep U.S. inflation at 2% and the Bank of England is predicted to keep U.K inflation at 3%. The speed of convergence to absolute PPP is 15% per year.

a What is the expected U.S minus U.K. inflation differential for the coming year?

b What is the current U.S real exchange rate qUS/UK with the United Kingdom?

c How much is the dollar overvalued / undervalued?

d What do you predict the U.S. real exchange rate with the United Kingdom will be in one year's time?

e What is the expected rate of real depreciation for the United States(versus the United Kingdom)?

f What is the expected rate of nominal depreciation for the United States(versus the United Kingdom)?

g What do you predict will be the dollar price of one pound a year from now?

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Joshua Stredder
Joshua StredderLv10
28 Sep 2019

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Related questions

Suppose the current dollar–pound exchange rate is $1.5 per pound. A U.S. basket that costs $100 would cost $120 in the United Kingdom. For the next year, the Federal Reserve is predicted to keep U.S. inflation at 2% and the Bank of England is predicted to keep U.K. inflation at 3%. The speed of convergence to absolute PPP is 15% per year.

1）What is the expected U.S. minus U.K. inflation differential for the coming year?
2) What is the current U.S. real exchange rate, q$/£, with the U.K.?
3) How much is the dollar overvalued/undervalued?
4) What do you predict the U.S. real exchange rate with the U.K. will be in one year’s time?
5) What is the expected rate of real depreciation for the U.S. (versus the U.K.)?
6) What is the expected rate of nominal depreciation for the U.S. (versus the U.K.)?
7) What do you predict will be the dollar price of one pound a year from now?

 

1. In which market will a company arrange to receive currency for a transaction at a future date?

Select one:

a. the forward market

b. the currency futures market

c. the arbitrage market

d. the forward spot market

2. The U.S. dollar is overvalued and the peso is undervalued in the foreign exchange market

Select one:

a. if a visitor to Mexico from the United States can buy more goods in the United States
than he can buy in Mexico when he converts dollars to pesos.

b. if a visitor to Mexico from the United States can buy the same amount of goods in
Mexico as he can buy in the United States when he converts dollars to pesos.

c. if a visitor to Mexico from the United States can buy more goods in Mexico than he can
buy in the United States when he converts pesos to dollars.

d. if a visitor to Mexico from the United States can buy more goods in Mexico than he can
buy in the United States when he converts dollars to pesos.

3. Given the following data (t is current time; t+1 is time after one period)

Et = ¥ 110 = $1

Et+1 = ¥ 95 = $1

Current Interest rate in the US = iUS= 8%

If the interest parity condition is expected to hold, interest rates in Japan (iJapan) should equal approximately:

Select one:

a. 3.38%

b. 8%

c. -5.64%

d. None of the above.

4. Suppose the Japanese interest rate is I% while the interest rate in Britain is 3%. Interest rate parity predicts that relative to the Japanese Yen,

Select one:

a. the British pound will depreciate by 4%.

b. the British pound will appreciate by 2%.

c. the British pound will depreciate by 2%.

d. the British pound will appreciate by 4%.

5. Suppose the U.S. grows more slowly than Canada. The best medium term prediction is that the

Select one:

a. U.S. interest rates will rise.

b. U.S. dollar will appreciate against the Canadian dollar.

c. U.S. dollar will depreciate against the Canadian dollar.

6. Purchasing Power Parity (PPP) implies that

Select one:

a. In the long run, a forward exchange rate can purchase an interest rate swap for the same
price as the spot rate.

b. In the medium run, a forward exchange rate can purchase an interest rate swap for the
same price as the spot rate.

c. The short run, a given amount of money can buy the same amount of goods, whether
they are purchased at home or abroad.

d. the long run, a given amount of money can buy the same amount of goods, whether
they are purchased at home or abroad.

7. The current account balance will fall if

Select one:

a. the real exchange rate depreciates and disposable income goes up

b. the real exchange rate appreciates or disposable income goes up

c. the real exchange rate depreciates or disposable income goes down

d. the real exchange rate appreciates and disposable income goes down

8. A person who paid $10 for an umbrella in the U.S. sees the exact same umbrella in a store in London, England for 6 British pounds. If the person could expect the real exchange rate to be 1 U.S. umbrella per 1 English umbrella, then the person could infer that the nominal exchange rate is

Select one:

a. 0.6 U.S. dollars per 1 English pound.

b. 1.67 U.S. dollars per 1 English pound.

c. 0.6 English pounds per I U.S. dollar.

d. 1.67 English pounds per 1 U.S. dollar.

9. A U.S. wine merchant travelling in France has found a French wine of the same quality as a U.S. wine they regularly sell. She assumes that the real exchange rate should be 1 case of U.S. wine equals one case of French wine. The French wine merchant will sell her a case of the French wine for 350 euros. She knows that a case of the equivalent U.S. wine sells for $400. The euro is selling in France for $1.20. Assuming transportation costs are zero, the U.S. wine merchant should

Select one:

a. buy the French wine and sell it in the U.S. and make a profit.

b. buy the U.S. wine and sell it in France and make a profit.

c. It doesn't matter either way; there is no profit in the deal.

d. None of the above.

10. In a fixed exchange rate system, how do countries address the problem of currency market pressures that threaten to lower or raise the value of their currency?

Select one:

a. If demand falls, then countries must increase demand by buying up the excess supply
with domestic currency.

b. If demand rises, countries must fill the excess demand for foreign currency by selling
their reserves.

c. If demand rises, then countries can adjust the value of the exchange rate to the desired
level.

d. A and B only.

2. Assume that you are able to borrow $1,000,000 from a local bank. Explain how you could make profits from arbitrage in the following situations. Explain also the amount of profits that you would make, assuming that there are no brokerage or transactions costs.

a. The current dollar-Euro exchange rate (E$/€) is equal to 1.1 in Frankfurt and 1.05 in New York.

b. The dollar-Euro exchange rate (E$/€) = 1.1, the dollar-pound exchange rate (E$/£)= 1.5, and the pound-Euro rate (E£/€ )= .8.

c. The nominal interest rate equals 3% in the U.S. and 1% in Europe, the current dollar-Euro exchange rate (E$/€) is equal to 1, the forward exchange rate (F$/€) is equal to 1.02 and your expected exchange rate one year from now (Ee$/€) equals 1.05.

3. Use the information below to answer question 3.

L M Y

U.S 0.1 2,000 10,000

U.K 0.04 500 5,000

a. Calculate the price levels in both the U.S. and the U.K. according to the quantity theory of money.

b. Calculate the nominal exchange rate (dollars per pound) assuming the quantity theory of money and absolute PPP.

c. Assume that output rises in the U.S. to 11,000. Calculate the new nominal exchange rate.

d. Assume that output in the U.S. is 10,000 but that the money supply rises to 2,200 in the U.S. and to 600 in the U.K. Calculate the new nominal exchange rate.

e. Assume values at the beginning of the problem but assumethat L in the U.K. rises to .06. Calculate the new nominal exchange rate.

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