nAnswers to Textbook Problems
1. At an exchange rate of 1.05 $ per euro, a 5 euro bratwurst costs 1.05$/euro 5 euros $5.25. Thus,
3. When the yen depreciates vs. the dollar, its costs go up. This depresses its profits. On the other hand,
4. The dollar rates of return are as follows:
a. ($250,000 $200,000)/$200,000 0.25.
5. Note here that the ordering of the returns of the three assets is the same whether we calculate real or
nominal returns.
6. The current equilibrium exchange rate must equal its expected future level since, with equality of
nominal interest rates, there can be no expected increase or decrease in the dollar/pound exchange
7. If market traders learn that the dollar interest rate will soon fall, they also revise upward their
expectation of the dollar’s future depreciation in the foreign exchange market. Given the current
8. The analysis will be parallel to that in the text. As shown in the accompanying diagrams, a
movement down the vertical axis in the new graph, however, is interpreted as a euro appreciation
This will cause the exchange rate to fall (euro appreciation, dollar depreciation) from E1 to E2.
9. a. If the Federal Reserve pushed interest rates down, with an unchanged expected
b. The “disruptive” effects of a recession make dollar holdings more risky. Risky assets must offer
some extra compensation such that people willingly hold them as opposed to other, less risky
\ 10. The euro is less risky for you. When the rest of your wealth falls, the euro tends to appreciate,
11.The chapter states that most foreign exchange transactions between banks (which accounts for the vast
majority of foreign exchange transactions) involve exchanges of foreign currencies for U.S. dollars, even
12. The interest rate parity condition tells us that interest rates and exchange rates are directly linked.
13. 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
14. The forward premium can be calculated as described in the Appendix. In this case, we find the
15. The value should have gone down as there is no more need to engage in intra-EU foreign currency
trading. This represents the predicted transaction cost savings stemming from the euro. At the same
16. If the dollar depreciated, all else being equal, we would expect outsourcing to diminish. If, as the
problem states, much of the outsourcing is an attempt to move production to locations that are