International Monetary Economics Exercises

International Monetary Economics Exercises

 
International Monetary Economics Problem Set #2 Spring 2021 INSTRUCTIONS:



 Please submit your answers in the same order as on the problem set. Please keep your answers clear, e.g., mark the final answer or put a box around it if there are lengthy calculations. You MUST submit your answer in the PDF form. When writing explanations, aim for concise and clear answers. Problem 1. Interest Rate Parity (a) Suppose that the U.S. nominal interest rate is 1% and the comparable Russian interest rate is 4%. What is the expected behavior of the dollar/ruble exchange rate if uncovered interest parity holds? Answer quantitatively. (b) Now suppose that the US interest rate is 5% per year and the Russian rate is 1% per year, and the spot exchange rate is 0.48 dollar per ruble and the one year forward is 0.5. Does the covered interest rate parity hold? (c) Suppose that the spot rate is 0.48 dollar per ruble. The US 3, 6 and 12 month rates are respectively 2%, 4%, and 6%. For Russia these rates are 6%, 4%, and 2%. Describe the expected future path of the exchange rate assuming uncovered interest rate parity (UIP) holds. Problem 2. FX Market and Fiscal Intervention (a) Imagine that everyone in the world pays a tax of τ on interest earnings. How would the introduction of this tax alter the analysis of the interest rate parity condition? (b) How does your answer to part (a) change if the tax also applies to any capital gains1 due to exchange rate changes? (c) Now suppose that the government imposes a different tax τ̂ on interest earnings of foreign deposits. Explain what happens to the exchange rate assuming τ̂ > τ using the UIP equation. Problem 3. Sovereign Debt and Exchange Rate A recent issue of the Economist discusses the idea that a large Keynesian stimulus based on borrowing can be helpful because “thanks to low interest rates, the gains it would provide by boosting the growth rate of GDP might outstrip the cost of financing the debt taken on.” However, “if governments pushed up their debt-to-gdp ratio, markets would become unwilling to lend to them, forcing up interest rates willy-nilly.” 1 HINT : Capital gains might be due to the exchange rate fluctuation. For this question, assume the dollar is expected to depreciate, such that E e > E. 1 Let’s consider a scenario from the Japanese perspective in the context of UIP: i = i∗ + Ee − E , E (1) where i is the Japanese interest rate, i∗ is the euro interest rate, and E is the yen exchange rate against the euro. a. Assume the euro monetary policy stance remains unchanged, the Bank of Japan keeps the money supply constant, and the Japanese government implements a fiscal stimulus by additional borrowing that successfully expands output. Further, we assume that the fiscal expansion does not affect E e . What is the movement of the spot exchange rate after the fiscal expansion (appreciate, depreciate, or uncertain)? b. If the additional borrowing concerns the bond market over a potential default in Japanese sovereign debts, investors can demand a risk premium to compensate the default risk. As a result, the UIP condition becomes: Ee − E i = i∗ + + α, (2) E where α > 0 is the required risk premium. Draw a two-sided diagram to analyze the effect of the (successful) fiscal shock on the spot exchange rate given E e , what is the movement of the spot exchange rate after the shock (appreciate, depreciate, or uncertain)? Problem 4. Monetary Policy and Exchange Rate On Jan. 15, 2015, the Swiss National Bank surprised the market by announcing the end of its currency peg with the euro. In other words, the SNB announced that it would give up its commitment to supply enough Swiss francs (CHF) to meet the market demand. This question investigates the exchange rate behavior between CHF and USD by considering the policy shock as a permanent reduction in Swiss money supply. a. What are the main assumptions we made in our analysis of money supply and exchange rate in the short run? How are these assumptions different for the long-run? b. Consider Switzerland as the home country and the U.S. the foreign country. Assumptions: no change in the foreign monetary policy, the Swiss economy starts with all variables at their long-run levels, and home output remains constant as the economy adjusts to the money supply change. Use the two-sided diagram that depicts the money market equilibrium and the foreign exchange market equilibrium to show the short-run effects of the permanent reduction in Swiss money supply. Provide brief economic explanations following the graph and make sure to include and explain the concept of exchange rate overshooting. c. Using a similar diagram, show the long-run effects of this permanent reduction in money supply. What happens to the Swiss price level and interest rate? What about the exchange rate between the Swiss Franc and the US dollar? 2 ...
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