ECON231_Assignment5_F11_Sol_Full

ECON231_Assignment5_ - ECON 231 Section 2 Introduction to International Economics Instructor Sharif F Khan Department of Economics University of

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Page 1 of 8 Pages ECON 231 – Section 2 Introduction to International Economics Instructor: Sharif F. Khan Department of Economics University of Waterloo Fall 2011 Suggested Solutions to Assignment 5 (Optional) Total Marks: 50 Part B True/ False/ Uncertain Questions [10 Marks] Explain why the following statement is True, False, or Uncertain according to economic principles. Use diagrams and / or numerical examples where appropriate. Unsupported answers will receive no marks. It is the explanation that is important. B1. [5 Marks] According to the asset approach to exchange rate determination, other things remaining constant, an increase in the U.K. nominal interest rate causes the U.S. dollar to appreciate against the British pound. [Diagrams Required] False According to the asset approach to exchange rate determination, other things remaining constant, an increase in the U.K. nominal interest rate causes the U.S. dollar to depreciate against the British pound. The uncovered interest parity (UIRP) condition between the U.S. and the U.K. two economies can be written as follows: R $ = R £ + ( E e $/£ - E $/£ )/ E $/£ The left-hand side of the UIRP condition is the return to dollar deposits and the right- hand side is the expected dollar return on pound deposits. The UIRP condition must hold if the foreign exchange market is in equilibrium, that is, at the equilibrium exchange rate, deposits of both currencies must offer the same expected rate of return. Figure 1 shows the effect of a rise in the U.K. interest rate R £ in the foreign exchange rate market. In this figure, the vertical line at R $ shows the return on dollar deposits, and the downward-sloping schedule shows the expected dollar return on pound deposits. Initially the foreign exchange rate market is in equilibrium at point 1. Given the current exchange rate E 1 $/£ , the expected future exchange rate E e $/£ and the U.S. interest rate R $ at point 1, a rise in pound interest rate increases the expected dollar return on pound deposits. As a result, the downward-sloping schedule shifts rightward. At the initial exchange rate E 1 $/£ (at point 1) , the expected depreciation rate of the dollar is the same as before the rise in R £, so the expected dollar return on pound deposits now exceeds that on dollar deposits.
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Page 2 of 8 Pages In this situation anyone holding dollar deposits wishes to sell them for the more lucrative pound deposits. But because the return on dollar deposits is lower than that on pound deposits at the exchange rate E 1 $/£ , no holder of a pound deposit is willing to sell it for dollar at that rate. This creates an excess supply of dollars in the foreign exchange market at point 1. As dollar holders try to entice pound holders to trade by offering them a better price for pounds, the dollar/pound exchange rate rises toward E 2 $/£ , that is, pounds become expensive in terms of dollars. Once the exchange rate reaches E 2 $/£ , pound and dollar deposits offer equal returns and holders of dollar deposits no longer have an
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This note was uploaded on 02/05/2012 for the course ECON 231 taught by Professor Rus during the Fall '08 term at Waterloo.

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ECON231_Assignment5_ - ECON 231 Section 2 Introduction to International Economics Instructor Sharif F Khan Department of Economics University of

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