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Teaching Tip 3: The break-even condition for lenders (the equation following Figure 22-
10) implies a value of the lending rate. Solving for rL, we get
Teaching Tip 4: According to the NBER, the U.S. recession ended in June 2009. But the
unemployment rate remained well above 9% throughout 2010. Have your students visit
Teaching Tip 5: One of the best-selling books in 2010 was Gary Shteyngart’s Supersad
True Love Story. In this book, Shteyngart makes frequent references to the “northern
euro.” As far as this author knows, this was the first time that term was used. While
IN-CLASS PROBLEMS
1. Countries seeking membership into the euro area need to maintain an exchange rate
band equal to ±15% of the euro. For simplicity, assume the country sets its price
equal to the price in the Eurozone.
a. Suppose that trade costs are equal to 12%. In this case, would the country find it
difficult or relatively easy to maintain the ±15% exchange rate band? Explain.
Answer: The country would find it relatively straightforward to maintain the
b. Suppose that trade costs are equal to 20%. In this case, would the country find it
difficult or relatively easy to maintain the ±15% exchange rate band? Explain.
Answer: The country might find it difficult to keep the exchange rate within the
c. Looking at the data on total trade costs, do you believe the ±15% band is
consistent with the no-arbitrage band?
d. Based on the disaggregated data on trade costs, do you believe this band is
consistent with no-arbitrage? Which specific trade costs are likely to affect
potential euro area members? Which ones are not?
Answer: It is likely that the transport and costs at the border are lower in Europe.
2. Consider two countries, Plenus and Terra. The exchange rate is equal to 2 Plenus
pesos (PP) = 1 Terra dollar (T$). Plenus and Terra each produce two goods: tradable
computers and nontradable coaching services. Plenus workers produce 2 computers
each day; Terran workers produce 3 computers each day. Workers in both countries
can produce 1 hour of coaching services per day. Computers currently sell for
T$1,600 each. Nontraded goods account for 40% of consumption in both countries.
a. Calculate the price of computers in Plenus pesos.
b. Calculate the wages of workers in Terra and Plenus in local currency. Calculate
Plenus workers wages in T$ terms.
c. Calculate the price of coaching services in Terra and Plenus in local currency.
Calculate the price of coaching in PP terms.
d. Suppose that Plenus workers experience an increase in productivity in computer
production. Productivity in this sector increases from 2 computers each day to 3
computers each day. Calculate the wage in Plenus. Calculate the price of coaching
services.
e. Calculate the change in the real exchange rate implied by this change in
productivity.
Answer: The change in the real exchange rate is calculated as follows:
f. Suppose Plenus has a fixed exchange rate against the Terran dollar. Calculate the
change in the inflation differential in this case.
Answer: If Plenus has a fixed exchange rate with Terra, it must absorb the effects
3. Suppose you are a Swiss investor who has initial capital equal to 2,000 Swiss francs
(Swf). You are looking to borrow an additional 18,000 in Swiss francs (at the Swiss
interest rate). You plan to invest the full 20,000 in U.S. dollar‒denominated deposits.
The interest rate on Swiss deposits is equal to 3.5% and the interest rate on U.S.
deposits is equal to 5%.
a. Suppose the exchange rate remains unchanged. Calculate your return on this carry
trade.
Answer: The actual profit on this carry trade comes from the interest differential
between the Swiss franc and the U.S. dollar (here, the Swiss franc is the home
b. Is your answer inconsistent with the efficient markets hypothesis (EMH)? Explain
why or why not.
Answer: No, this answer is not inconsistent with EMH. EMH implies that
c. Suppose the Swiss franc is expected to appreciate by 1%. Calculate your return on
this carry trade.
Answer: The actual profit will decline because now when the investor converts
d. According to the EMH, what should be the average return on carry trade? For the
EMH to hold in this case, what is the implied appreciation or depreciation in the
Swiss franc relative to the U.S. dollar over the next few months?
Answer: The average return should be equal to zero according to EMH. The
e. Suppose the Swiss franc appreciates by 5%. Calculate your return. Did you lose
your initial capital investment? Explain how this relates to the concept of
leverage.
Answer: We can calculate the actual profit in the case of a 5% Swiss franc
appreciation:
4. Consider the possible explanations for why there appear to be excess returns in forex
markets. Evaluate the validity and plausibility of each based on the information given
in the chapter.
a. At high interest differentials, investors are typically more responsive, conducting
large volumes of carry trade.
Answer: This statement is true. There is evidence of nonlinearity in carry trade, that
is, investors participate in large volumes at high differentials but do not conduct
b. To execute carry trades, investors must often pay brokerage fees and other
transactions costs, allowing for the large and persistent interest differentials
observed in the data.
Answer: This statement is false. Although investors do face small brokerage fees
c. The risks associated with forex transactions are relatively low compared with the
expected return on carry trades.
Answer: This statement is false. The Sharpe ratios for an average of major
d. The existence of the equity premium puzzle is consistent with the existence of
excess returns in forex markets.
Answer: This statement is true. The equity premium puzzle refers to the premium
5. Use the savings and investment two-country model to analyze each of the following
scenarios. You should illustrate savings and investment for Home, Foreign, and the
world. Assume the countries begin with a current account balance. State how each of
the following variables change: the world interest rate and investment and savings in
Home, Foreign, and the world. State whether the Home and Foreign countries have a
current account deficit or surplus.
a. The Home government increases its budget deficit.
Answer: See the following diagram. Home savings declines because of the
b. A climate change leads to a decrease in productivity in Foreign, reducing
investment demand.
Answer: See the following diagram. Foreign investment decreases, so world
current account surplus; Home current account deficit.
c. Both Home and Foreign simultaneously reduce taxes on private saving.
Answer: See the next diagram. Here, we assumed the change in taxes affects
Home and Foreign by the same magnitude, increasing savings in both countries
6. Compare and contrast the experience of oil-exporting countries with that of emerging
Asian markets in terms of their investment and savings behavior. In what ways are
they different? Based on the evidence, do you believe they are acting optimally?
Explain why or why not.
Answer: Oil exporters: Rising official settlements balance is a result of temporary oil
revenues accruing to government-owned entities. State agencies manage these
savings, largely investing in safe assets such as U.S. Treasury debt. Emerging Asian
7. Consider two countries, Opes and Paupria. These countries produce identical goods.
Suppose that Paupria borrows some amount (W1) of funds from Opes at the world
interest rate, rw. The funds will be repaid in the subsequent period.
a. What happens to spending in Opes and Paupria? Explain briefly.
Answer: Income and spending in Paurpia increase because it has borrowed,
b. What happens to the demand for goods produced in Opes? The demand for goods
produced in Paupria?
Answer: The demand for goods produced in both countries is unchanged. While
c. What happens to the trade balance in Opes and Paupria in the first period? What
happens to the trade balance between period 1 and period 2?
Answer: In the first period, Paupria runs a trade deficit, equal to rwW1. Opes runs
d. Given your previous answers, what happens to the real exchange rate? Illustrate
the relationship between the trade balance and the real exchange rate for Opes.
Plot the trade balance and real exchange rate in the first and second period.
Answer: The real exchange rate is unchanged because there is no change in
e. Now assume that consumers in each country prefer to spend a higher fraction of
their income on home goods. If Paupria receives funds from Opes, what happens
to spending on Paupria’s goods? Spending on Opes’ goods? Explain why your
answer differs from (a).
Answer: Spending on Paupria’s goods will increase because Paupria’s residents
f. Given your answer to (e), what happens to the demand for goods produced in
Opes and Paupria? What does this imply about the relative prices of goods in each
country?
Answer: The demand for goods produced in Paupria increases (increase in home
g. Under the scenario described in (e), what happens to the trade balance in Opes
and Paupria in the first period? Illustrate the relationship between the trade
balance and the real exchange rate for Opes. Plot the trade balance and real
exchange rate in the first and second period.
Answer: Opes’ trade balance decreases between period 1 and period 2, as Paupria
8. Using the repayment versus default diagrams (similar to Figure 22-8), illustrate how
each of the following scenarios would affect the probability of default. Clearly label
the repayment threshold, consumption with repayment, and consumption after
nonrepayment and default. Indicate any shifts in these values on your diagrams.
a. An increase in the amount borrowed
b. A decrease in the volatility of output
c. An increase in the lending rate
d. An increase in the cost of default
Answer: The repayment probability decreases.
9. Assume a country currently has a 20% probability of default. The risk-free rate is 4%.
a. Calculate this country’s lending rate.
Answer: The lending rate charged can be determined from the break-even
condition for the lender:
b. Illustrate the country’s situation on the repayment probability and loan market
diagrams. You should stack your diagrams vertically to ensure they are consistent.
Answer: See the accompanying diagram. The probability of repayment is 80%
and the lending rate is equal to 30% > risk free rate = 4%.
c. Suppose this country experiences a decrease in the volatility of output, resulting
from improvements in the implementation of monetary policy. The probability of
default decreases to 12% after this change. Calculate the new lending rate.
Answer: Suppose this country experiences a decrease in the volatility of output,
resulting from improvements in the implementation of monetary policy. The
d. Using the diagrams from (b), illustrate how this change affects the repayment
probability, lending rate, and amount borrowed.
Answer: See the previous diagram. The repayment probability increases to 88%
