final_fall2007_q2_sol - Question 2 0.1<= percent...

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Unformatted text preview: Question 2 0.1 <= percent undervalued in base year 0.90909091 <= base year real exchange rate 7 <= number of years 2000 2007 Inflation (U.S.-China) CPI I d Numbers Index N b Nominal E h N i l Exchange Real Exchange R lE h U.S. China Rates (CNY/USD) Rates (CNY/USD) Undervaluation 300 200 9.2 0.909090909 0.1 340 190 8 0.876336898 0.141113654 1.804126126 -2.534209324 -0.730083198 Part a 14.11% <= CNY is undervalued by this amount What it means for CNY to be undervalued in real terms is that goods are What relatively cheap in China. The reason that CNY has devalued in real terms is that U.S. inflation has been far higher than Chinese inflation (actually, as was the case in reality, China had *deflation*), and th appreciation of CNY th i lit Chi h d *d fl ti *) d the i ti f - ie, it went from 9.2 to 8.0 -- did not even come close to compensating for this. Part b 7.01069519 7.5 1 0.48930481 <= nominal CNY/USD which implies PPP <= 5-year forward rate <= USD notional (million) <= USD future profit, per USD notional, if you RECEIVE CNY and DELIVER USD The forward trade is to sign a contract to deliver USD million and receive CNY. If the nominal exchange rate adjusts so that PPP holds, CNY will appreciate to the amount shown holds, CNY appreciate above and the trade will make a profit. The amount of profit will be (F_t - S_{t+1}) = 0.4893 for each dollar of notional in the forward contract. ...
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