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F01_ps6ans - 14.02 Fall 2001 Problem Set 6 Solutions Posted I True/False 1 False Your grandmother is not accounting for the expected exchange rate

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14.02 Fall 2001 Problem Set 6 Solutions Posted October 31, 2001 I. True/False 1. False. Your grandmother is not accounting for the expected exchange rate depreciation of the Real (Brazilian currency) inherent in the higher interest rate on Brazilian bonds. (This abstracts away from default risk, transaction costs etc.) 2. False. ”Trustless” should have been a hint to see that even though this new debt promises to pay a certain amount in US\$ at maturity, the government may default and choose not to pay. Therefore to compensate holders of the debt, the country has to offer a higher interest rate over the risk-free US government bonds. (Aside: there is an entire credit-rating industry involved in assessing these risks whether for corporate ’junk bonds’ or for sovereign country bonds). 3. False. While not denying the remote possibility that the new minister’s speech may have influenced NX, but we have not modeled psychology in our IS-LM model. The realistic explanation is the J-curve, it takes time for exchange rate devaluations to feed into an improved trade balance. 4. True. The MIT class will be deserted since the return from taking a class at Harvard exceeds that of taking the MIT class, given the exchange rate is fixed at 1-to-1. The situation can be improved by ”devaluing” the exchange rate of Harvard relative to MIT to 3-to-1 (200% devaluation). Alternatively, can impose ”capital controls” to restrict students from engaging in profitable arbitrage. (This is closer to what happens in reality.) 5. False. The real exchange rate’s level is purely arbitrary. Remember that the price indices used are just that: indices. Even if you used actual prices of the consumption basket in each of the two countries, you will not be able to make a good comparison either. That is because the typical consumption bundle in Ukraine is different from that in the US (more Vodka, less Buds). So it may turn out that you will be disappointed once you move there and have to pay a big premium on your Buds.

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This note was uploaded on 11/29/2009 for the course 14 14.02 taught by Professor Geurrieri during the Fall '09 term at MIT.

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F01_ps6ans - 14.02 Fall 2001 Problem Set 6 Solutions Posted I True/False 1 False Your grandmother is not accounting for the expected exchange rate

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