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homework%202 - Simon Fraser University Problem Set 2 for...

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Simon Fraser University Problem Set 2 for International Finance ECON 345 Due: At the end of my Office hour, Tuesday, June 16, 3 PM. Feel free to hand in earlier in your tutorial (if it is earlier) Instructor: Michael Siemer, [email protected] Question 1 to 2: true, false, uncertain. Explain. No credit without explanation. Question 3 to 9: explanation and/or calculations/graph required. 1. (5 Points) Relative PPP is a weaker assumption than absolute PPP. Answer: True. Absolute PPP says that it always has to hold that P = EP * , i.e. real exchange rate is equal to one. Relative PPP says that the real exchange rate does not have to be equal to one but it has to be constant. That is, the above equation does not have to hold but it has to hold that x × P = EP * where x is a positive constant. 2. (5 points) The Fisher effect says that the nominal interest rate (R) will fall (rise) as the inflation rate ( π ) rises (falls), assuming that the real interest rate (r) stays constant. Answer: True. One equation we get from fisher is that r e = R - π e . 3. (5 points) What is the Marshall-Lerner Condition? Explain it’s significance. Answer: The Marshall- Lerner condition says that a real devaluation of a countrys currency will raise net exports Xn if η + η * > 1, where η = price elasticity of export demand and η * = price elasticity of import demand If the Marshall-Lerner condition is not satisfied, a devaluation will not improve the trade balance. 4. (5 points) Draw and explain a J-Curve. Answer: The J curve shows the effect of a real depreciation on the current account over time. Imme- diately after the depreciation, physical quantities of imports and exports do not have time to adjust to the change in the real exchange rate, so the value of exports falls and the value of imports rises and the current account worsens (declines). Over time, more and more adjustment in the quantity of exports and imports takes place and within the medium term the current account begins to increase, and eventually turns positive (exceeds its initial level). 5. (10 points) The Bank of Sweden has pegged the Swedish krona (SEK) at 4 SEK per deutschemark (DM), Germany’s currency before it adopted the euro). You note that Sweden’s foreign exchange reserves are very low and its trade deficit is high. You conclude that the krona is likely to fall to 5 1

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SEK/DM within 10 days. The interest rate in Germany is 5%. What Swedish interest rate would persuade you to leave your money in krona, or to invest in krona assets if you currently have your money in deutschemarks? There are 250 business days in a year. Assume that the krona will devalue in exactly 10 days. Explain your answer carefully. Don’t just write down your calculations. Answer: The interest parity condition says R s = R dm + ( E e E ) /E where R s = interest income in SEK = Annual R x 10/250 R dm = interest income in DM = .05 x 10 days/250 days per year = .002 ( E e E ) /E = (54) / 4 = . 25 Solve for R = (.002 + .25) x 250/10 = 6.3 = 630% Alternative approach. If you keep DM1000 in a German bank, then convert to SEK after the devalua-
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