Introduction to Exchange Rates

2
and the Foreign Exchange Market

1. Refer to the exchange rates given in the following table.

Today One Year Ago

June 25, 2010 June 25, 2009

Country Per $ Per £ Per € Per $

Australia 1.152 1.721 1.417 1.225

Canada 1.037 1.559 1.283 1.084
Denmark 6.036 9.045 7.443 5.238
Euro 0.811 1.215 1.000 0.703
Hong Kong 7.779 11.643 9.583 7.750
India 46.360 69.476 57.179 48.160
Japan 89.350 134.048 110.308 94.860
Mexico 12.697 18.993 15.631 13.220
Sweden 7.740 11.632 9.577 7.460
United Kingdom 0.667 1.000 0.822 0.609
United States 1.000 1.496 1.232 1.000
Source: U.S. Federal Reserve Board of Governors, H.10 release: Foreign Exchange Rates.

a. Compute the U.S. dollar–yen exchange rate, E$/¥, and the U.S. dollar–Canadian
dollar exchange rate, E$/C$, on June 25, 2010, and June 25, 2009
Answer:
June 25, 2009: E$/¥ = 1 / (94.86) = $0.0105/¥
June 25, 2010: E$/¥ = 1 / (89.35) = $0.0112/¥
June 25, 2009: E$/C$ = 1 / (1.084) = $0.9225/C$
June 25, 2010: E$/C$ = 1 / (1.037) = $0.9643/C$

b. What happened to the value of the U.S. dollar relative to the Japanese yen and
Canadian dollar between June 25, 2009 and June 25, 2010? Compute the percent-
age change in the value of the U.S. dollar relative to each currency using the U.S.
dollar–foreign currency exchange rates you computed in (a).
Answer: Between June 25, 2009 and 2010, both the Canadian dollar and the
Japanese yen appreciated relative to the U.S. dollar. The percentage appreciation
in the foreign currency relative to the U.S. dollar is:
%
E$/¥  ($0.0112 – $0.0105) / $0.0105 = 6.17%
%
E$/¥  ($0.9643 – $0.9225) / $0.9225 = 4.53%

S-5
S-6 Solutions ■ Chapter 2 Introduction to Exchange Rates & the Foreign Exchange Market

c. Using the information in the table for June 25, 2010, compute the Danish
krone–Canadian dollar exchange rate, Ekrone/C$.
Answer: Ekrone/C$ = (6.036 kr/$)/(1.037 C$/$) = 5.8206 kr/C$.
d. Visit the Web site of the Board of governors of the Federal Reserve System at
http://www.federalreserve.gov/. Click on “Economic Research and Data” and
then “Statistics: Releases and Historical Data.” Download the H.10 release For-
eign Exchange Rates (weekly data available). What has happened to the value of
the U.S. dollar relative to the Canadian dollar, Japanese yen, and Danish krone
since June 25, 2010?
Answer: Answers will vary.
e. Using the information from (d), what has happened to the value of the U.S. dol-
lar relative to the British pound and the euro? Note: the H.10 release quotes
these exchange rates as U.S. dollars per unit of foreign currency in line with long-
standing market conventions.
Answer: Answers will vary.
2. Consider the United States and the countries it trades with the most (measured in
trade volume): Canada, Mexico, China, and Japan. For simplicity, assume these are the
only four countries with which the United States trades. Trade shares and exchange
rates for these four countries are as follows:

Country (currency) Share of trade $ per FX in 2009 Dollar per FX in 2010

Canada (dollar) 36% 0.9225 0.9643

Mexico (peso) 28% 0.0756 0.0788
China (yuan) 20% 0.1464 0.1473
Japan (yen) 16% 0.0105 0.0112

a. Compute the percentage change from 2009 to 2010 in the four U.S. bilateral ex-
change rates (defined as U.S. dollars per units of foreign exchange, or FX) in the
table provided.
Answer:
%∆E$/C$ = (0.9643 – 0.9225) / 0.9225 = 4.53%
%∆E$/pesos = (0.0788 – 0.0756) / 0.0756 = 4.23%
%∆E$/yuan = (0.1473 – 0.1464) / 0.1464 = 0.61%
%∆E$/¥ = (0.0112 – 0.0105 / 0.0105 = 6.67%
b. Use the trade shares as weights to compute the percentage change in the nomi-
nal effective exchange rate for the United States between 2009 and 2010 (in U.S.
dollars per foreign currency basket).
Answer: The trade-weighted percentage change in the exchange rate is:
%∆E = 0.36(%∆E$/C$) + 0.28(%∆E$/pesos) + 0.20(%∆E$/yuan) +0.16(%∆E$/¥)
%∆E = 0.36(4.53%) + 0.28(4.23%) + 0.20(0.61%) + 0.16(6.67%) = 4.01%
c. Based on your answer to (b), what happened to the value of the U.S. dollar
against this basket between 2009 and 2010? How does this compare with the
change in the value of the U.S. dollar relative to the Mexican peso? Explain your
answer.
Answer: The dollar depreciated by 4.01% against the basket of currencies. Vis-
à-vis the peso, the dollar depreciated by 4.23%.
3. Go to the Web site for Federal Reserve Economic Data (FRED): http://research.
stlouisfed.org/fred2/. Locate the monthly exchange rate data for the following:
 Solutions ■ Chapter 2 Introduction to Exchange Rates & the Foreign Exchange Market S-7

a. Canada (dollar), 1980–2009

b. China (yuan), 1999–2005 and 2005–2009
c. Mexico (peso), 1993–1995 and 1995–2009
d. Thailand (baht), 1986–1997 and 1997–2009
b. Venezuela (bolivar), 2003–2009
Look at the graphs and make a judgment as to whether each currency was fixed (peg
or band), crawling (peg or band), or floating relative to the U.S. dollar during each
time frame given.
a. Canada (dollar), 1980–2009
Answer: Floating exchange rate
b. China (yuan), 1999–2005 and 2005–2009
Answer: 1999–2005: Fixed exchange rate. 2005–2009: Gradual appreciation vis-
à-vis the dollar.
c. Mexico (peso), 1993–1995 and 1995–2006
Answer: 1993–1995: crawl; 1995–2006: floating (with some evidence of a man-
aged float)
d. Thailand (baht), 1986–1997 and 1997–2006
Answer: 1986–1997: fixed exchange rate; 1997–2006: floating
e. Venezuela (bolivar), 2003–2006
Answer: Fixed exchange rate (with occasional adjustments)
4. Describe the different ways in which the government may intervene in the foreign
exchange market. Why does the government have the ability to intervene in this way
whereas private actors do not?
Answer: The government may participate in the forex market in a number of ways:
capital controls, official market (with fixed rates), and intervention. The government
has the ability to intervene in a way that private actors do not because (1) it can im-
pose regulations on the foreign exchange market, and (2) it can implement large-scale
transactions that influence exchange rates.
5. Suppose quotes for the dollar–euro exchange rate, E$/€, are as follows: in New York,
$1.50 per euro; and in Tokyo, $1.55 per euro. Describe how investors use arbitrage to
take advantage of the difference in exchange rates. Explain how this process will af-
fect the dollar price of the euro in New York and Tokyo.
Answer: Investors will buy euros in New York at a price of $1.50 each because this
is relatively cheaper than the price in Tokyo. They will then sell these euros in Tokyo
at a price of $1.55, earning a $0.05 profit on each euro. With the influx of buyers in
New York, the price of euros in New York will increase. With the influx of traders
selling euros in Toyko, the price of euros in Tokyo will decrease. This price adjustment
continues until the exchange rates are equal in both markets.
6. Consider a Dutch investor with 1,000 euros to place in a bank deposit in either the
Netherlands or Great Britain. The (one-year) interest rate on bank deposits is 2% in
Britain and 4.04% in the Netherlands. The (one-year) forward euro–pound exchange
rate is 1.575 euros per pound and the spot rate is 1.5 euros per pound. Answer the
following questions, using the exact equations for UIP and CIP as necessary.
a. What is the euro-denominated return on Dutch deposits for this investor?
Answer: The investor’s return on euro-denominated Dutch deposits is equal to
€1,040.04 ( €1,000  (1  0.0404)).
S-8 Solutions ■ Chapter 2 Introduction to Exchange Rates & the Foreign Exchange Market

b. What is the (riskless) euro-denominated return on British deposits for this in-
vestor using forward cover?
Answer: The euro-denominated return on British deposits using forward cover
is equal to €1,071 ( €1,000  (1.575 / 1.5)  (1  0.02)).
c. Is there an arbitrage opportunity here? Explain why or why not. Is this an equi-
librium in the forward exchange rate market?
Answer: Yes, there is an arbitrage opportunity. The euro-denominated return on
British deposits is higher than that on Dutch deposits. The net return on each
euro deposit in a Dutch bank is equal to 4.04% versus 7.1% ( (1.575 / 1.5) 
(1  0.02)) on a British deposit (using forward cover). This is not an equilibrium
in the forward exchange market. The actions of traders seeking to exploit the ar-
bitrage opportunity will cause the spot and forward rates to change.
d. If the spot rate is 1.5 euros per pound, and interest rates are as stated previously,
what is the equilibrium forward rate, according to CIP?
Answer: CIP implies: F€/£  E€/£ (1  i€) / (1  i£)  1.5  1.0404 / 1.02 
€1.53 per £.
e. Suppose the forward rate takes the value given by your answer to (d). Calculate
the forward premium on the British pound for the Dutch investor (where ex-
change rates are in euros per pound). Is it positive or negative? Why do investors
require this premium/discount in equilibrium?
Answer: Forward premium  (F€/£ / E€/£  1)  (1.53 / 1.50)  1  0.03 
3%. The existence of a positive forward premium would imply that investors ex-
pect the euro to depreciate relative to the British pound. Therefore, when estab-
lishing forward contracts, the forward rate is higher than the current spot rate.
f. If UIP holds, what is the expected depreciation of the euro against the pound
over one year?
Answer: According to the UIP approximation,
Ee£/€ / E£/€  i£  i€  2.04%.
Therefore, the euro is expected to depreciate by 2.04%. Using the exact UIP
condition, we first need to convert the exchange rates into pound–euro terms to
calculate the depreciation in the euro. From UIP:
Ee£/€  E£/€  (1  i£) 
(1  i€)  (1 / 1.5)  (1  0.02) / (1  0.0404)  £0.654 per €.Therefore, the
depreciation in the euro is equal to 1.95% (0.654  0.667)/0.667.
g. Based on your answer to (f ), what is the expected euro–pound exchange rate one
year ahead?
Answer: Using the exact UIP (not the approximation), we know that the fol-
lowing is true: Ee£/€  E£/€  (1  i€) / (1  i£)  1.5  1.0404 / 1.02  (€1.53
per £. Using the approximation, E£/€ decreases by 2.04% from 0.667 to 0.653. This
implies the new spot rate, E€/£  1.53.
7. You are a financial adviser to a U.S. corporation that expects to receive a payment of
40 million Japanese yen in 180 days for goods exported to Japan. The current spot
rate is 100 yen per U.S. dollar (E$/¥  0.0100). You are concerned that the U.S. dol-
lar is going to appreciate against the yen over the next six months.
a. Assuming that the exchange rate remains unchanged, how much does your firm
expect to receive in U.S. dollars?
Answer: The firm expects to receive $400,000 ( ¥40,000,000 / 100).
b. How much would your firm receive (in U.S. dollars) if the dollar appreciated to
110 yen per U.S. dollar (E$/¥  0.00909)?
Answer: The firm would receive $363,636 ( ¥40,000,000 / 110).
Exchange Rates I: The Monetary
3
Approach in the Long Run

1. Suppose that two countries,Vietnam and Côte d’Ivoire, produce coffee. The currency
unit used in Vietnam is the dong (VND). Côte d’Ivoire is a member of Communaute
Financiere Africaine (CFA), a currency union of West African countries that use the
CFA franc (XOF). In Vietnam, coffee sells for 5,000 dong (VND) per pound of cof-
fee. The exchange rate is 30 VND per 1 CFA franc, EVND/XOF
30.
a. If the law of one price holds, what is the price of coffee in Côte d’Ivoire, mea-
sured in CFA francs?
Answer: According to LOOP, the price of coffee should be the same in both
markets:
PCcoffee
PVcoffee/EVND/XOF
5,000/30
166.7
b. Assume the price of coffee in Côte d’Ivoire is actually 160 CFA francs per pound
of coffee. Calculate the relative price of coffee in Côte d’Ivoire versus Vietnam.
Where will coffee traders buy coffee? Where will they sell coffee? How will these
transactions affect the price of coffee in Vietnam? In Côte d’Ivoire?
Answer: The relative price of coffee in these two markets is:
coffee
q C/V
(E VND P coffee)/PVND
coffee

(30  160)/5000
0.96  1
 C
XOF

Traders will buy coffee in Côte d’Ivoire because it is cheaper there. Traders will
sell coffee in Vietnam. This will lead to an increase in the price of coffee in Côte
d’Ivoire and a decrease in the price in Vietnam.
2. Consider each of the following goods and services. For each, identify whether the law
g
of one price will hold, and state whether the relative price, qUS/FOREIGN , is greater than,
less than, or equal to 1. Explain your answer in terms of the assumptions we make
when using the law of one price.
a. Rice traded freely in the United States and Canada
g
Answer: qUS/FOREIGN
1
LOOP should hold in this case because its assumptions are met.
b. Sugar traded in the United States and Mexico; the U.S. government imposes a
quota on sugar imports into the United States
g
Answer: qUS/FOREIGN >1

S-11
S-12 Solutions ■ Chapter 3 Exchange Rates I: The Monetary Approach in the Long Run

If the U.S. government imposes a quota on sugar, this will lead to an increase in
the relative price of sugar in the United States through restricting competition.
c. The McDonald’s Big Mac sold in the United States and Japan
g
Answer: qUS/FOREIGN
1
The McDonald’s Big Mac sold in the United States may sell for a different price
compared with Japan because there are nontradable elements in the production
of the Big Mac, such as labor and rent.
d. Haircuts in the United States and the United Kingdom
g
Answer: qUS/FOREIGN
1
Because haircuts cannot be traded across the United States and the United King-
dom, consumers will not arbitrage away differences in the prices of haircuts in
these two regions.
3. Use the table that follows to answer this question.Treat the country listed as the home
country and the United States as the foreign country. Suppose the cost of the market
basket in the United States is PUS
$190. Check to see whether purchasing power
parity (PPP) holds for each of the countries listed, and determine whether we should
expect a real appreciation or real depreciation for each country (relative to the United
States) in the long run.

Country Price of Is FX currency

(currency Price of U.S. basket Real Is FX expected to
measured market in FX exchange Does PP currency have Real
in FX Per $, basket (PUS times rate hold? overvalued or appreciation or
units EFX/$ (in FX) EFX/$) qCOUNTRY/US (yes/no) undervalued? depreciation?

Brazil 2.1893 520

(real)
India 46.6672 12,000
(rupee)
Mexico 11.0131 1,800
(peso)
South Africa 6.9294 800
(rand)
Zimbabwe 101,347 4,000,000
(Z$)

Answer: See the following table. Note that the United States is treated as the foreign
country relative to each “home” country listed in the table.

Country Price of Is FX currency

(currency Price of U.S. basket Real Is FX expected to
measured market in FX exchange Does PP currency have Real
in FX Per $, basket (PUS times rate hold? overvalued or appreciation or
units EFX/$ (in FX) EFX/$) qCOUNTRY/US (yes/no) undervalued? depreciation?

Brazil 2.1893 520 415.97 0.80 No Real overvalued Real exchange rate
(real) will depreciate
India 46.6672 12,000 8,766.77 0.74 No Rupee overvalued Real exchange rate
(rupee) will depreciate
Mexico 11.0131 1,800 2,092.49 1.16 No Peso undervalued Real exchange rate
(peso) will appreciate
South Africa 6.9294 800 1,316.59 1.65 No Rand undervalued Real exchange rate
(rand) will appreciate
Zimbabwe 101,347 4,000,000 19,225,930.00 4.81 No ZW$ undervalued Real exchange rate
(Z$) will appreciate
 Solutions ■ Chapter 3 Exchange Rates I: The Monetary Approach in the Long Run S-13

In the previous table:

• PPP holds only when the real exchange rate qUS/F
1. This implies that the bas-
kets in the home country and the United States have the same price in a com-
mon currency.
• If qUS/F  1, then the basket in the United States is more expensive than the bas-
ket in the home country. This implies the U.S. dollar is overvalued and the Home
currency is undervalued. According to PPP, the Home country will experience a
real appreciation (Mexico, South Africa, and Zimbabwe).
• If qUS/F  1, then the basket in the home country is more expensive than the bas-
ket in the United States.This implies the U.S. dollar is undervalued and the Home
currency is overvalued. According to PPP, the Home country will experience a
real depreciation (Brazil and India).
4. Table 3-1 in the text shows the percentage undervaluation or overvaluation in the
Big Mac, based on exchange rates in July 2009. Suppose purchasing power parity
holds in the long run, so that these deviations would be expected to disappear. Sup-
pose the local currency prices of the Big Mac remained unchanged. Exchange rates
in January 4, 2010, were as follows (source: IMF):

Country Per U.S. $

Australia (A$) 0.90

Brazil (real) 1.74
Canada (C$) 1.04
Denmark (krone) 5.17
Eurozone (euro) 0.69
India (rupee) 46.51
Japan (yen) 93.05
Mexico (peso) 12.92
Sweden (krona) 7.14

Based on these data and Table 3-1, calculate the change in the exchange rate from
July to January, and state whether the direction of change was consistent with the
PPP-implied exchange rate using the Big Mac Index. How might you explain the
failure of the Big Mac Index to correctly predict the change in the nominal exchange
rate between July 2009 and January 2010?
S-14 Solutions ■ Chapter 3 Exchange Rates I: The Monetary Approach in the Long Run

Answer: (The complete table is included in the Excel workbook for this chap-
ter in the solutions manual.)

Exchange rate

(local currency
Big Mac prices per U.S. dollar)

Exchange Percent
Over (+) / rate actual change
under (–) Jan. 4, July 13,
Actual, valuation 2010 (local 2009–
In local In U.S. Implied July against currency Jan. 4, PPP correct
currency dollars by PPP 13th dollar, % per U.S. $) 2010 or not?

(1) (2) (3) (4) (5)

United States $ 3.57 3.57

Australia A$ 4.34 3.3643 1.2157 1.29 –5.76% 0.90 –30.23% Correct
direction, but
depreciation
was way more
than
predicted.

Brazil R$ 8.03 4.0150 2.2493 2 12.46% 1.74 –13.00% PPP predicted

depreciation,
but currency
actually
appreciated.

Canada C$ 3.89 3.3534 1.0896 1.16 –6.07% 1.04 –10.34% Correct

direction, but
appreciation
was way more
than PPP
predicted.
Denmark Kr 29.50 5.5243 8.2633 5.34 54.74% 5.17 –3.18% PPP predicted
[ic] depreciation,
but currency
actually
appreciated.

Euro area ⇔ 3.31 4.5972 0.9272 0.72 28.77% 0.69 –4.17% PPP predicted
depreciation,
but currency
actually
appreciated.

Japan ¥ 320.00 3.4557 89.6359 92.6 –3.20% 93.05 0.49% PPP predicted
appreciation,
but currency
actually
depreciated.

Mexico Peso 33.00 2.3913 9.2437 13.8 –33.02% 12.92 –6.38% Correct
direction, but
appreciation
was way less
than PPP
predicted.

Sweden Kr 39.00 4.9367 10.9244 7.9 38.28% 7.14 –9.62% PPP predicted
[ic] depreciation,
but currency
actually
appreciated.
 Solutions ■ Chapter 3 Exchange Rates I: The Monetary Approach in the Long Run S-15

We can see from the table that during this time, PPP correctly predicted the di-
rection exchange rate movements for only three of these countries. The Big Max
Index may fail to predict exchange rate movements because there are nontrad-
able inputs used in the production of Big Macs, such as labor and rent.
5. You are given the following information. The current dollar−pound exchange rate is
$2 per British pound. A U.S. basket that costs $100 would cost $120 in the United
Kingdom. For the next year, the Fed is predicted to keep U.S. inflation at 2% and the
Bank of England is predicted to keep U.K. inflation at 3%. The speed of convergence
to absolute PPP is 15% per year.
a. What is the expected U.S. minus U.K. inflation differential for the coming year?
Answer: The inflation differential is equal to 1% (
2%  3%).
b. What is the current U.S. real exchange rate, qUK/US, with the United Kingdom?
Answer: The current real exchange rate is:
qUK/US
(E$/£PUK)/PUS
$120/$100
1.2.
c. How much is the dollar overvalued/undervalued?
Answer: The British pound is undervalued by 20% and the U.S. dollar is over-
valued by 20% (
1.2  1 / 1).
d. What do you predict the U.S. real exchange rate with the United Kingdom will
be in one year’s time?
Answer: We can use the information on convergence to compute the implied
change in the U.S. real exchange rate. We know the speed of convergence to ab-
solute PPP is 15%; that is, each year the exchange rate will adjust by 15% of what
is needed to achieve the real exchange rate equal to 1 (assuming prices in each
country remain unchanged). Today, the real exchange rate is equal to 1.2, imply-
ing a 0.2 decrease is needed to satisfy absolute PPP. Over the next year, 15% of
this adjustment will occur, so the real exchange rate will decrease by 0.03. There-
fore, after one year, the U.S. real exchange rate, qUK/US, will equal 1.17.
e. What is the expected rate of real depreciation for the United States (versus the
United Kingdom)?
Answer: From (d), the real exchange rate will decrease by 0.03. Therefore, the
rate of real depreciation is equal to 2.5% (
0.03  1.20). This implies a real
appreciation in the United States relative to the United Kingdom.
f. What is the expected rate of nominal depreciation for the United States (versus
the United Kingdom)?
Answer: The expected rate of nominal depreciation can be calculated based
on the inflation differential plus the expected real depreciation from (e). In this
case, the inflation differential is 1% and the expected real appreciation is
2.5%, so the expected nominal depreciation is 3.5%. That is, we expect a
3.5% appreciation in the U.S. dollar relative to the British pound.
g. What do you predict will be the dollar price of one pound a year from now?
Answer: The current nominal exchange rate is $2 per pound and we expect a
3.5% appreciation in the dollar (from [f ]). Therefore, the expected exchange rate
in one year is equal to $1.93 (
$2  (10.035).
6. Describe how each of the following factors might explain why PPP is a better guide
for exchange rate movements in the long run versus the short run: (1) transactions
costs, (2) nontraded goods, (3) imperfect competition, and (4) price stickiness. As mar-
kets become increasingly integrated, do you suspect PPP will become a more useful
guide in the future? Why or why not?
S-16 Solutions ■ Chapter 3 Exchange Rates I: The Monetary Approach in the Long Run

Answer: Each of these factors hinders trade more in the short run than in the long
run. Specifically, each is a reason to expect that the condition of frictionless trade is
not satisfied. For this reason, PPP is more likely to hold in the long run than in the
short run.
(1) Transactions costs. Over longer periods of time, producers generally face decreas-
ing average costs (as fixed costs become variable costs in the long run). Therefore, the
average cost associated with a given transaction should decrease.
(2) Nontraded goods. Goods that are not traded among countries cannot be arbi-
traged. Since intercountry arbitrage is required for PPP, nontraded goods will prevent
exchange rates from completely adjusting to PPP. Examples of nontraded goods in-
clude many services that require a physical presence on site to complete the work.
There are many of these, ranging from plumbers to hairdressers.
(3) Imperfect competition. Imperfect competition implies that producers of differen-
tiated products have the ability to influence prices. In the short run, these firms may
either collude to prevent price adjustment, or they may engage in dramatic changes
in price (e.g., price wars) designed to capture market share. These collusion agree-
ments and price wars generally are not long-lasting.
(4) Price stickiness. In the short run, prices may be inflexible for several reasons. Firms
may face menu costs, or fear that price adjustments will adversely affect market share.
Firms also may have wage contracts that are set in nominal terms. However, in the
long run, these costs associated with changing prices dissipate, either because menu
costs decrease over time or because firms and workers renegotiate wage contracts in
the long run.
As markets become more integrated, PPP should become a better predictor of ex-
change rate movements. For PPP to hold, we have to assume frictionless trade. The
more integrated markets are, the closer they are to achieving frictionless trade.
7. Consider two countries, Japan and Korea. In 1996, Japan experienced relatively slow
output growth (1%), whereas Korea had relatively robust output growth (6%). Sup-
pose the Bank of Japan allowed the money supply to grow by 2% each year, whereas
the Bank of Korea chose to maintain relatively high money growth of 12% per year.
For the following questions, use the simple monetary model (where L is constant).
You will find it easiest to treat Korea as the home country and Japan as the foreign
country.
a. What is the inflation rate in Korea? In Japan?
Answer:
K
K  gK → K
12%  6%
6%
J
J  gJ → J
2%  1%
1%
b. What is the expected rate of depreciation in the Korean won relative to the
Japanese yen?
Answer: %
Eewon/¥
(K  J)
6%  1%
5%.You can check this by using
the following expression from the monetary model: %
Eewon/¥
( K  gK) 
( J  gJ ).
c. Suppose the Bank of Korea increases the money growth rate from 12% to 15%.
If nothing in Japan changes, what is the new inflation rate in Korea?
Answer: newK
K  gK
15%  6%
9%
Solutions ■ Chapter 3 Exchange Rates I: The Monetary Approach in the Long Run S-17

d. Using time series diagrams, illustrate how this increase in the money growth rate
affects the money supply, MK; Korea’s interest rate; prices, PK; real money supply;
and Ewon/¥ over time. (Plot each variable on the vertical axis and time on the hor-
izontal axis.)
Answer: See the following diagrams.

Bank of Korea increases Bank of Korea reduces the money

money growth rate growth rate to less than 7%

MK MK

2 7%
1 1

Time Time

PK PK

2 1
1 1

Time Time

MK / PK MK / PK

g g

Time Time

Ewon/Y Ewon/Y

Note that E actually falls

here because the won
appreciates
K2 J

K2 J 0
K1 J K1 J

T Time T Time
S-18 Solutions ■ Chapter 3 Exchange Rates I: The Monetary Approach in the Long Run

e. Suppose the Bank of Korea wants to maintain an exchange rate peg with the
Japanese yen. What money growth rate would the Bank of Korea have to choose
to keep the value of the won fixed relative to the yen?
Answer: To keep the exchange rate constant, the Bank of Korea must lower its
money growth rate. We can figure out exactly which money growth rate will
keep the exchange rate fixed by using the fundamental equation for the simple
monetary model (used above in [b]):
%
Eewon/¥
( K  gK)  ( J  gJ )
The objective is to set %
Eewon/¥
0:
( K*  gK)
( J  gJ )
Plug in the values given in the question and solve for K*:
( K*  6%)
(2%
.  1%)
K*
7%
Therefore, if the Bank of Korea sets its money growth rate to 7%, its exchange
rate with Japan will remain unchanged.
f. Suppose the Bank of Korea sought to implement policy that would cause the
Korean won to appreciate relative to the Japanese yen. What ranges of the money
growth rate (assuming positive values) would allow the Bank of Korea to achieve
this objective?
Answer: Using the same reasoning as previously, the objective is for the won to
appreciate: %
Eewon/¥  0
This can be achieved if the Bank of Korea allows the money supply to grow by
less than 7% each year. The diagrams on the following page show how this would
affect the variables in the model over time.
8. This question uses the general monetary model, in which L is no longer assumed
constant and money demand is inversely related to the nominal interest rate. Con-
sider the same scenario described in the beginning of the previous question. In addi-
tion, the bank deposits in Japan pay 3% interest; i¥
3%.
a. Compute the interest rate paid on Korean deposits.
Answer:
Fisher effect: (iwon  i¥)
(K  J)
Solve for iwon
(6%  1%)  3%
8%
b. Using the definition of the real interest rate (nominal interest rate adjusted for
inflation), show that the real interest rate in Korea is equal to the real interest rate
in Japan. (Note that the inflation rates you calculated in the previous question
will apply here.)
Answer:
r¥
i¥  J
2%  1%
1%
rwon
iwon  K
8%  6%
2%
c. Suppose the Bank of Korea increases the money growth rate from 12% to 15%
and the inflation rate rises proportionately (one for one) with this increase. If the
nominal interest rate in Japan remains unchanged, what happens to the interest
rate paid on Korean deposits?
Answer: We know that the inflation rate in Korea will increase to 9%. We also
know that the real interest rate will remain unchanged. Therefore:
iwon
rwon  K
1%  9%
10%.
Solutions ■ Chapter 3 Exchange Rates I: The Monetary Approach in the Long Run S-19

d. Using time series diagrams, illustrate how this increase in the money growth rate
affects the money supply, MK; Korea’s interest rate; prices, PK; real money supply;
and Ewon/¥ over time. (Plot each variable on the vertical axis and time on the hor-
izontal axis.)
Answer: See the following diagrams.

Bank of Korea increases

money growth rate

MK

Time

PK iwon

Time Time

MK / PK Ewon/Y

T Time T Time

9. Both advanced economies and developing countries have experienced a decrease in

inflation since the 1980s (see Table 3-2 in the text). This question considers how the
choice of policy regime has influenced this global disinflation. Use the monetary
model to answer this question.
a. The Swiss Central Bank currently targets its money growth rate to achieve pol-
icy objectives. Suppose Switzerland has output growth of 3% and money growth
of 8% each year. What is Switzerland’s inflation rate in this case? Describe how
the Swiss Central Bank could achieve an inflation rate of 2% in the long run
through the use of a nominal anchor.
Answer: From the monetary approach: S
S  gS
8%  3%
5%. If the
Swiss Central Bank wants to achieve an inflation target of 2%, it would need to re-
duce its money growth rate to 5%: *S
S  gS
2%  3%
5%.
 4 15

Exchange Rates II: The Asset Approach

in the Short Run

1. Use the money market and FX diagrams to answer the following questions about the
relationship between the British pound (£) and the U.S. dollar ($). The exchange rate
is in U.S. dollars per British pound, E$/£. We want to consider how a change in the
U.S. money supply affects interest rates and exchange rates. On all graphs, label the
initial equilibrium point A.
a. Illustrate how a temporary decrease in the U.S. money supply affects the money
and FX markets. Label your short-run equilibrium point B and your long-run
equilibrium point C.
Answer: See the diagram below.

MS 2 MS1
i$ ER

B B
DR2
i 2$ i $2

A C A =C
i $1 i 1$ DR1

MD 1 FR1

M2US M 1US E2 E1 E $/£

P 1US P 1US

S-23
S-24 Solutions ■ Chapter 4(15) Exchange Rates II: The Asset Approach in the Short Run

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, British interest
rate, E$/£, Ee$/£, and the U.S. price level.
Answer: The U.S. interest rate increases, the British interest rate does not
change, E$/£ decreases, Ee$/£ does not change, and the U.S. price level does not
change.
c. Using your diagram from (a), 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, British interest rate, E$/£, Ee$/£, and U.S. price level.
Answer: All of the variables return to their initial values in the long run. This is
because the shock is temporary, implying the central bank will increase the
money supply from M2 to M1 in the long run.
2. Use the money market and FX diagrams from (a) to answer the following questions.
This question considers the relationship between the Indian rupees (Rs) and the U.S.
dollar ($). The exchange rate is in rupees per dollar, ERs/$. On all graphs, label the ini-
tial equilibrium point A.
a. Illustrate how a permanent increase in India’s money supply affects the money and
FX markets. Label your short-run equilibrium point B and your long-run equi-
librium point C.
Answer: See the following diagram.Thick arrows indicate temporary movement
while thinner ones indicate the movements in the long run. In the short run,
prices are fixed. Therefore the real money supply changes from MS1 to MS2, thus
temporarily lowering the domestic interest rate. In the long run, as prices rise,
the real money supply and interest rate return to their original level. In the for-
eign exchange market, FR shifts to the right and stays there permanently because
of an expected depreciation of rupees.

MS1 MS2
iRs ER

A C A C
1
i Rs i 1Rs DR1

B B
2
i Rs i 2Rs DR2

FR2
MD1 FR1

M 2IN M 1IN M 2IN E1 E3 E 2 E Rs/$

2
P IN P 1IN P 1IN
 Solutions ■ Chapter 4(15) Exchange Rates II: The Asset Approach in the Short Run S-25

b. By plotting them on a chart with time on the horizontal axis, illustrate how each
of the following variables changes over time (for India): nominal money supply
MIN, price level PIN, real money supply MIN/PIN, India’s interest rate iRs, and the
exchange rate ERs/$.
Answer: See the following diagrams.
MIN i Rs

PIN ERs/$

T T n

1
MIN /PIN1 MIN2 /PIN2

c. Using your previous analysis, state how each of the following variables changes
e
in the short run (increase/decrease/no change): India’s interest rate iRs, ERs/$ ERs/$ ,
and India’s price level PIN.
Answer: India’s interest rate decreases, the U.S. interest rate remains unchanged,
e
ERs/$ increases, ERs/$ increases, and India’s price level remains unchanged.
d. Using your previous analysis, state how each of the following variables changes
in the long run (increase/decrease/no change relative to their initial values at
e
point A): India’s interest rate iRs, ERs/$ ERs/$ , India’s price level PIN.
Answer: India’s interest rate remains unchanged, the U.S. interest rate remains
e
unchanged, ERs/$ increases, ERs/$ increases (remains unchanged in transition from
short to long run), India’s price level increases.
e. Explain how overshooting applies to this situation.
Answer: The short-run exchange rate overshoots its long-run value, EE as in the
text Figure 4-13 (15-13).We can see this in the impulse response diagrams shown
previously. The overshooting is caused by the investors’ adjustment of exchange
rate expectations coupled with lower domestic interest rates. Since the rupees in-
terest rate falls, investors must be compensated by a rupee appreciation for UIP
with U.S. interest rate to hold. For a rupee appreciation to be possible, it must
depreciate more in the short run than its longer-run value.
S-26 Solutions ■ Chapter 4(15) Exchange Rates II: The Asset Approach in the Short Run

3. Is overshooting (in theory and in practice) consistent with purchasing power parity?
Consider the reasons for the usefulness of PPP in the short run versus the long run
and the assumption we’ve used in the asset approach (in the short run versus the long
run). How does overshooting help to resolve the empirical behavior of exchange rates
in the short run versus the long run?
Answer: Yes, overshooting is consistent with PPP. Investors forecast the expected ex-
change rate based on the theory of PPP. When there is some change in the market, the
investors know the exchange rate will change to equate relative prices in the long run.
This is why we observe overshooting in the short run—the investors incorporate this
information into their short-run forecasts. Exchange rates are volatile in the short run.
The theory’s implication that there is exchange rate overshooting (in response to per-
manent shocks) is one explanation for short-run volatility in exchange rates.
4. Use the money market and foreign exchange (FX) diagrams to answer the following
questions. This question considers the relationship between the euro (€) and the U.S.
dollar ($). The exchange rate is in U.S. dollars per euro, E$/€. Suppose that with fi-
nancial innovation in the United States, real money demand in the United States de-
creases. On all graphs, label the initial equilibrium point A.
a. Assume this change in U.S. real money demand is temporary. Using the FX and
money market diagrams, illustrate how this change affects the money and FX
markets. Label your short-run equilibrium point B and your long-run equilib-
rium point C.
Answer: See the following diagram. The long-run values are the same as the ini-
tial values because the shock is temporary. Also because the shock is temporary,
we assume that the reversal of real money demand occurs before the price level
adjusts—that is, MD returns from MD2 to MD1 before the price level changes.
MS1
i$ ER

A C A C
i $1 i $1 DR1

B B
i $2 i $2 DR

MD1 FR1
MD 2
1 /P1
MUS E1 E2
US E $/€

b. Assume this change in U.S. real money demand is permanent. Using a new dia-
gram, illustrate how this change affects the money and FX markets. Label your
short-run equilibrium point B and your long-run equilibrium point C.
Answer: See the following diagram. In the long run, the price level will have to
increase to adjust for the drop in real money demand (assuming the central bank
does not change the money supply, M). That is, the nominal interest rate returns
to its initial value in the long run. This requires that the price level increase to
reduce real money supply. The drop in real money demand will have to be met
one-for-one with a drop in real money supply (generated by an increase in the
price level). In this case, the expected exchange rate changes because the shock
is permanent. Therefore, FR schedule in the forex market also shifts upward.
 Solutions ■ Chapter 4(15) Exchange Rates II: The Asset Approach in the Short Run S-27

MS 3 MS1
i$ ER

A A C
i $1 i $1 DR1
C

B B
i$2 i $2 DR2

FR2
MD1
FR1
MD 2
1 / P2
MUS US
1 / P1
MUS US E1 E3 E 2 E $/€

c. Illustrate how each of the following variables changes over time in response to a
permanent reduction in real money demand: nominal money supply MUS, price
level PUS, real money supply MUS/PUS, U.S. interest rate i$, and the exchange rate
E$/€.
Answer: See the following diagrams.

M US i$

P US E $/

T T n

1 1 2 2
MUS/PUS MUS/PUS
S-32 Solutions ■ Chapter 4(15) Exchange Rates II: The Asset Approach in the Short Run

8. During the Great Depression, the United States remained on the international gold
standard longer than other countries. This effectively meant that the United States was
committed to maintaining a fixed exchange rate at the onset of the Great Depression.
The U.S. dollar was pegged to the value of gold along with other major currencies,
including the British pound, the French franc, and so on. Many researchers have
blamed the severity of the Great Depression on the Federal Reserve and its failure to
react to economic conditions in 1929 and 1930. Discuss how the policy trilemma ap-
plies to this situation.
Answer: The United States was committed to the fixed exchange rate with gold;
consequently, policy makers had to sacrifice either monetary policy autonomy or cap-
ital mobility, just as the trilemma suggests. Based on the information given in the
question, we can assume that the policy did not respond to the U.S. business cycle
(policy makers did not exercise monetary policy autonomy). Thus, if we assume in-
ternational capital mobility, the United States could not react to the business cycle
with a monetary expansion until it abandoned the gold standard.
9. On June 20, 2007, John Authers, investment editor of the Financial Times, wrote the
following in his column “The Short View”:
The Bank of England published minutes showing that only the narrowest pos-
sible margin, 5–4, voted down [an interest] rate hike last month. Nobody fore-
saw this. . . . The news took sterling back above $1.99, and to a 15-year high
against the yen.
Can you explain the logic of this statement? Interest rates in the United Kingdom
had remained unchanged in the weeks since the vote and were still unchanged after
the minutes were released. What news was contained in the minutes that caused
traders to react? Use the asset approach.
Answer: The news item indicates that investors did not expect the decision to leave
interest rates unchanged would be divisive. They thought that any increases in inter-
est rates would happen further in the future. Higher interest rates would lead to an
appreciation in the pound sterling. When the minutes showed that interest rate in-
creases were more likely than previously thought, investors came to expect an appre-
ciation sooner rather than later. This caused an appreciation in the current spot ex-
change rate.
10. We can use the asset approach to both make predictions about how the market will
react to current events and understand how important these events are to investors.
Consider the behavior of the Union/Confederate exchange rate during the Civil
War. How would each of the following events affect the exchange rate, defined as
Confederate dollars per Union dollar, EC$/$?
a. The Confederacy increases the money supply by 2,900% between July and De-
cember of 1861.
Answer: The Confederate money supply increases, the exchange rate increases,
and the Confederate dollar depreciates.
b. The Union Army suffers a defeat in Battle of Chickamauga in September 1863.
Answer: Appreciation in the Confederate dollar is expected because a military
victory means a stable economy and monetary policy, implying decreased uncer-
tainty and risk, the exchange rate decreases, and the Confederate dollar appreci-
ates.
c. The Confederate Army suffers a major defeat with Sherman’s March in the au-
tumn of 1864.
Answer: Just the opposite of (b) above: depreciation in the Confederate dollar is
expected because of military defeat increases economic and monetary uncertainty
and risk; the exchange rate increases, and the Confederate dollar depreciates.