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sol4 - DEPARTMENT OF ECONOMICS UNIVERSITY OF CALIFORNIA...

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Unformatted text preview: DEPARTMENT OF ECONOMICS UNIVERSITY OF CALIFORNIA, BERKELEY FALL 2007 ECON 182 Suggested Solutions to Problem Set 4 Problem 1: Relative Purchasing Power Parity a. Consider the data for Japan and the US in the following table: Exchange Rates Exchange Rates Inflation rate 09/24/07 09/25/06 over the year (CPI) Japan 114.92 116.43 US-- 2% Check if the relative PPP holds between the two countries. The relative PPP equation is E Japan, t E Japan, t 1 E Japan, t 1 D Japan ; t US ; t : Check: E Japan, t E Japan, t 1 E Japan, t 1 D 114 : 92 116 : 43 116 : 43 D 1 : 3 % Japan ; t US ; t D 2 % : (1) PPP doesn’t hold exactly. (2) The error (.7%) is not very large and probably not statistically significant. b. Consider the data for Zimbabwe and the US in the following table: Exchange Rates Inflation rate Latest interest rate 09/17/07 01/01/07 year-to-date (3-month Treasury Bill, annual yield) Zimbabwe 30,628 258 6593% 66.33% US-- 2% 3.64% Check if the relative PPP holds between the two countries. Suppose UIP and relative PPP holds and the expected US inflation rate till the end of 2007 is 0.6%, calculate the expected inflation rate of Zimbabwe dollar till the end of 2007. Check: E Z, t E Z, t 1 E Z, t 1 D 30628 258 258 D 117 : 71 Z ; t US ; t D 65 : 91 The numbers cannot be matched perfectly, but it seems that relative PPP roughly holds. The directions of exchange rate change and inflation difference are consistent and the numbers are both very large. The relative PPP condition combined with UIP is i Z, t i US, t D e Z e US : LAST MODIFIED 9:15PM, 10/03/2007 1 DEPARTMENT OF ECONOMICS UNIVERSITY OF CALIFORNIA, BERKELEY FALL 2007 ECON 182 e Z D e US C i Z, t i US, t D : 6 % C 66 : 33 % 3 : 64 % 4 D : 6 % C 62 : 69 % 4 D 16 : 3 % ; which is much lower than what we would expect. Problem 2: Fixed Exchange Rate and Purchasing Power Parity Prior to World War One, most industrial countries were on the gold standard, which meant that their exchange rates were effectively fixed vis-a-vis each other. During the war, many countries temporarily left the gold standard and let their exchange rates float freely, and hence their exchange rates were determined on the foreign exchange market as modeled in class. After the war, many of these same countries rejoined the gold standard. For concreteness, let’s consider the case of the United Kingdom.the gold standard....
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sol4 - DEPARTMENT OF ECONOMICS UNIVERSITY OF CALIFORNIA...

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