INTERNATIONAL ECONOMICS, 7TH EDITION
Study Resources: Questions for Study & Review
Chapter 17
1. When the dollar depreciates,
a. What should happen to international capital flows in and out of the U.S., according
to interest arbitrage?
b. What should happen to the return on financial investment/equity prices in the U.S.,
according to interest arbitrage?
c. Write down an interest arbitrage equation you would expect to hold most of the
time. Be comprehensive and specific!
2. For a long time, interest rate differentials between European countries were high. Use
the concept of interest parity to explain how interest rates moved closer and closer
together as more countries joined the European Exchange Rate Mechanism,
eventually introducing perfect capital mobility.
3. Assume a country with flexible exchange rates has a financial account given by:
FA = FA¯¯¯ + TR (i = i*) where TR are transaction costs.
Show how the BP = 0 line behaves in the i/Y space as transaction costs increase.
4. You open the Wall Street Journal and see that the spot rate is $1 for 100 yen. The
interest rate in Japan on a one-year, yen-denominated deposit is 8 percent. The U.S.
annual interest rate on dollar deposits is 5 percent.
a. Provide a formula for the forward rate and calculate the forward rate.
b. The forward rate that you find in the Wall Street Journal does not coincide with your
calculations. Cite four reasons.
c. The interest on a yen-denominated deposit in London is 11 percent. Can you
explain the apparent lack of arbitrage?
5. Assume Ft+1 increases:
a. What would this say about people’s expectations about Et+1?
b. Would capital flow into or out of the country?
c. How exactly would the domestic balance of payments be affected?
d. What would happen to the domestic/foreign interest differential?
e. With flexible exchange rates between the domestic and the foreign economy, what
would you expect might happen to Et?
6. A one-year bond denominated in $ earns an interest rate of 5 percent per year. A one-
year bond denominated in £ earns 7 percent per year and the exchange rate is
$1.6714/£1. Assume that an investor can hedge on the forward market and that the
90-day forward exchange rate is $1.6602/£1.
a. Calculate the forward discount on the dollar on a yearly basis (include the sign).
b. Is the dollar at a forward discount or at a forward premium with respect to the
pound?
c. In which direction will capital flow?
d. Calculate (in dollars) his return on the $1,000 invested for 90 days (i.e. the $ return
he will receive by investing in the most profitable alternative whether $ or £).
7. Assume that the interest rate in the Netherlands is 10 percent, i.e. i* = 0.1, the nominal
exchange rate E between the U.S.$ and the euro is U.S.$1.30 /€ while the expected
exchange rate in a year Eet+1 is U.S.$1.32 /€.
a. Is the euro expected to appreciate or to depreciate with respect to the U.S. dollar?
b. Calculate the expected rate of appreciation of the euro.
c. Calculate the expected return of U.S.$1 invested in the Netherlands (do not use the
approximation).
d. Use the above results and the equation describing the uncovered interest parity
condition to determine the U.S. interest rate corresponding to interest parity.
e. Now suppose that the U.S. interest rate becomes 12 percent, in which direction will
capital flow?
8. Derive the BP=0 line when interest rates are on the horizontal axis and income is on
the vertical axis.
9. How does the BP line change when the contagion coefficient “c” changes?
10. The BP=0 line corresponds to equilibrium on the foreign exchange market. With fixed
exchange rates, it is defined in terms of the amount of intervention needed to stay on
the BP=0 line. How much intervention is needed?
11. If it becomes riskier for Americans to invest in Algeria due to political turmoil in that
country, what happens to the American BP=0 line (assume a two-country model).
INTERNATIONAL ECONOMICS, 7TH EDITION
Study Resources: Questions for Study & Review
Chapter 17: Answers
1.
a. Assuming no change in the interest rates at home and overseas, capital flows out of the
3.
5.
a. The forward rate now reflects a greater future depreciation of the domestic currency.
7.
a. The euro is expected to appreciate with respect to the dollar as more dollars
b.
e−Et
9.
The contagion coefficient “c” enters the equation for the BP=0 line as {minus
11. An increase in R* (the risk in Algeria) means that the BP=0 line shifts down. A