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Econ 5610: International Economics

Problem Set 6

I. Exchange Rates and the Foreign Exchange Market

1. Suppose the dollar interest rate and the pound sterling interest rate are the same, 5
percent per year. Suppose the expected future $/£ exchange rate, $1.52 per pound,
remains constant as Britain’s interest rate rises to 10 percent per year. If the U.S.
interest rate also remains constant, what is the new equilibrium $/£ exchange rate?

2. How many British pounds would it cost to buy a pair of American designer jeans costing
$45 if the exchange rate is 1.50 dollars per British pound?

3. What is the exchange rate between the dollar and the British pound if a pair of American
jeans costs 50 dollars in New York and 100 Pounds in London?

4. What is the expected dollar rate of return on euro deposits if today’s exchange rate is
$1.10 per euro, next year’s expected exchange rate is $1.165 per euro, the dollar interest
rate is 10%, and the euro interest rate is 5%?

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5. Explain why the interest parity condition must hold if the foreign exchange market is
in equilibrium.

6. Draw a graph to show the effects of a rise in the dollar interest rate on the exchange
rate (You can assume that the expected exchange rate stays the same).

7. Draw a graph to show the effects of a rise in the interest rate paid by euro deposits on the
exchange rate. Assume that this also causes the expected exchange rate to rise. What
happens to the relative value of the dollar (does the dollar appreciates or depreciates)?

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II. Money, Interest Rates, and Exchange Rates

1. Using a figure describing both the U.S. money market and the foreign exchange market,
analyze the effects of an increase in the U.S. money supply on the dollar/euro exchange
rate.

2. Using figures for both the short run and the long run, show the effects of a permanent
increase in the U.S. money supply. Try to line up your figures to the short and long run
equilibria side by side. Assume that the U.S. real national income is constant.