TUTORIAL CHAPTER 18: OPENNES IN GOODS AND FINANCIAL MARKET

1. Suppose the interest parity condition holds. Also assume that the one-year interest rate in the
United States is 6% and that the one-year interest rate in Canada is 6%. What does this imply
about the current versus future expected exchange rate (for the U.S. and Canadian dollars)?
Explain.
2. Assuming that the interest parity condition holds, what type of information is contained in
interest rate differentials between domestic and foreign bonds? Explain.
3. Consider two fictional economies, one called the domestic country and the other the foreign
country. Give the transactions listed in (a) through (g), construct the balance of payments for
each country. If necessary, include a statistical discrepancy.
a. The domestic country purchased $125 in oil from the foreign country.
b. Foreign tourists spent $30 on domestic ski slopes.
c. Foreign investors were paid $20 in dividends from their holdings of domestic equities.
d. Domestic residents gave $30 to foreign charities.
e. Domestic business borrowed $75 from foreign banks.
f. Foreign investors purchased $20 of domestic government bonds.
g. Domestic investors sold $60 of their holding of foreign government bonds.
4. Consider two bonds, one issued in euro (€) in Germany, and one issued in dollars ($) in the
United States. Assume that both government securities are one year bonds paying the face value
of the bond one year from now. The exchange rate, E, stands at 1 dollar = 0.75 Euros. The face
value and prices on the two bonds are given by

Face Value Price

United Sates $10,000.00 $9,615.38
Germany €10,000.00 €9,433.96
a. Compute the nominal interest rate on each of the bonds
b. Compute the expected exchange rate next year consistent with uncovered interest parity.
c. If you expect the dollar to depreciate relative to the Euro, which bond should you buy?
d. Assume that you are a US investor. You exchange dollars for Euros and purchase the
German bond. One year from now, it turns out that exchange rate, E, is actually 0.72
(1 dollar = 0.72 Euros). What is your realized rate of return you would have made had you
held the U.S. bond?
e. Are the differences in rates of return in (d) consistent with the uncovered interest parity
condition? Why or why not?
5. The exchange rate and the labor market. Suppose the domestic currency depreciates (E fall).
Assume that P and P* remain constant.
a. How does the nominal depreciation affect the relative price of domestic goods (i.e. the real
exchange rate)? Given your answer, what effect would a nominal depreciation likely have
on (world) demand for domestic goods? On the domestic unemployment rate?
b. Given the foreign price level, P*, what is the price of foreign goods in terms of domestic
currency? How does a nominal depreciation affect the price of foreign goods in terms of
domestic currency? How does a nominal depreciation affect the domestic consumers price
index? (Hint: remember that domestic consumers buy foreign goods (imports) as well as
domestic goods.)
c. If the nominal wage remains constant, how does a nominal depreciation affect the real
wage?
d. Comment on the following statement. “A depreciating currency puts domestic labor on
sale.”