PSU
Winter 2017
Hiro Ito
ECON441/541
Homework Assignment #2
Answer Keys
Question 1:
Problem 4 in KOM’s Ch. 3 (14).
a. ($250,000 – $200,000)/$200,000 = 0.25.
b. ($275 – $255)/$255 = 0.078.
c. There are two parts of this return. One is the loss involved due to the appreciation of the dollar; the
dollar appreciation is ($1.38 – $1.50)/$1.50 = –0.08. The other part of the return is the interest paid
by the London bank on the deposit, 10 percent. (The size of the deposit is immaterial to the
calculation of the rate of return.) In terms of dollars, the realized return on the London deposit is
thus 2 percent per year.
Question 2:
Problem 8 in KOM’s Ch. 14. (Hint: Trades expect a decline in the U.S. interest rate. How does that
affect the diagram?) Make sure you draw a graph to answer this question.
Assuming that current interest rate on the dollar and the euro do not change then, the effect on the current
euro/dollar exchange rate of an expected decline on interest rate on dollars is the same as an increase in the
Expected Return of Euros. This is depicted as a shift in the downward-sloping curve in the diagram below:
$/Euro
E2
Expected Return on Euros(2)
E1
Expected Return on Euros(1)
R$1
Rates of Return
(in Dollar Terms)
1
An expected decline on the interest rate of dollars is similar to an expectation that the euro would be stronger
in the future relative to the dollar. This results to a current appreciation of the euro and a corresponding a
depreciation of the dollar from E1 to E2.
Question 3:
a. Suppose you start the Totally Cool International Shirt (TCIS) Company, a business that
imports authentic college t-shirts from foreign universities and sells them on campuses in the
United States. You need to translate the foreign prices of the shirts into dollars. Do this for
the t-shirts from the following universities by filling in the table:
University (Country)
Price of T-Shirt
Exchange Rate
Dollar Price
12.0 Euros
350.0 Rupees
8080.0 Wons
24.0 Shekels
8.0 Pounds
1.0 Euros/$
35.0 Rupees/$
800.0 Wons/$
3.0 Shekels/$
0.7 Pound/$
$12.00
$10.00
$10.10
$ 8.00
$11.43
Sorbonne (France)
Delhi University (India)
Seoul National Univ. (Korea)
Hebrew Univ. (Israel)
Oxford Univ. (U.K.)
b. Suppose that a month from now the exchange rates are given below. State whether these
new exchange rates represent an appreciation or a depreciation of each currency against the
dollar. Also, without calculating the actual dollar prices of t-shirts, state whether the dollar
price will fall or rise.
Currency
Exchange Rate
Appreciation or Depreciation?
Dollar Price Rise or Fall?
Euro
Rupee
Won
Shekel
Pound
0.9 Euro/$
Apprec.
Rise
30 R/$
Apprec.
Rise
880 W/$
Depr.
Fall
2.5 S/$
Apprec.
Rise
0.6 P/$
Apprec.
Rise
2
Question 4:
a. A temporary increase in the money supply shifts out the money supply line, lowering
interest rates and depreciating the currency.
b. An increase in the price level lowers real balances, shifting the money supply line up, raising
interest rates and appreciating the currency. If the change in the price level is temporary,
there is no effect on the interest parity line.
c. A decrease (that is, an appreciation) in the expected future exchange rate shifts the interest
parity curve in but has no effect on the money market. This causes the spot exchange rate to
appreciate.
Question 5:
Problem 1 in KOM’s Ch. 15.
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-run and long-run effects on the exchange rate, interest
rate, and price level.
A reduction in the real aggregate demand function constitutes a leftward shift of this curve depicted below
from L1 (R,Y) to L2 (R,Y):
FOREX MARKET
E3
2
E2
E4
3
E1
1
I2
I1
R
MONEY MARKET
L2(R, Y)
L1(R, Y)
M/P2
M/P1
3
The immediate effect of such movement in the aggregate real money demand is the depreciation of the
exchange rate from E1 to E2. This is when the reduction in money demand is temporary. If the reduction is
permanent, then the exchange rate depreciation will occur at E3. The impact on the exchange rate is larger
if the reduction in money demand is permanent because this also affects the expected future exchange rate.
In the long-run, the price level will increase in order to bring the money market in equilibrium. However,
output and the nominal interest rate will be the same, while the domestic currency will be depreciating in
the same amount as the decrease in money demand. The long-run level of real money balances is at M/P2
(after price level has adjusted) where long-run interest rate is equal to its initial value (before the change in
money demand). The movement of the exchange rates in response to a permanent reduction in money
demand is from point 1 with exchange rate at E1, to point 2 with exchange rate E3 and over time to a longrun position at point 3, with exchange rate E4. At point 2, the exchange rate overshot its long-run
equilibrium at E4. This exchange rate overshooting occurs because following the change in money
demand; prices do not immediately adjust to its long-run equilibrium (price rigidity). If prices are flexible
however, there would be no need for the exchange rate to overshoot and will immediately jump to its longrun level.
Question 6:
Draw a diagram comparable to Figure 15-6 and show how a contrationary monetary policy affects the
exchange rate. Assume that prices are sticky (i.e., there can be a short-term effect), and that the policy
action is credible (i.e., people’s expectations are affected by the policy).
<Graduate students>
Question 7:
Problem 14 in KOM’s Ch. 14. Draw a graph to answer the question.
Imagine everyone in the world pays a tax of τ percent on interest earnings and on any capital gains
due to exchange rate changes. How would such a tax alter the analysis of the interest rate parity
condition? How does your answer change if the tax applies to interest earnings but not to capital gains,
which are untaxed?
A tax on interest earnings and capital gains leaves the interest parity condition the same, since all its
components are multiplied by one less the tax rate to obtain after-tax returns. If capital gains are untaxed,
the expected depreciation term in the interest parity condition must be divided by 1 less the tax rate. The
component of the foreign return due to capital gains is now valued more highly than interest payments
because it is untaxed.
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