# Foreign Exchange Rate and Application of International Capital Investment

Answer all questions below with relevant graphs, equations, estimations, and explaining clearly in words. Please do not leave the questions themselves in your answers. Only Q#s and their respective answers of your own will be in the answer document.

Cover CH17 – CH20

1. Foreign Exchange Rate and Application of International Capital Investment 6 pts 1.

1. Suppose the interest parity condition holds and that the domestic interest rate is greater than the foreign interest rate. What does this imply about the current versus future expected exchange rate? Explain. 1 pt

1. Suppose the one-year nominal interest rate is 2.0% in the United States and 5.0% in Canada. Should you hold Canadian bonds or U.S. bonds? Explain 1 pt

1. Suppose the CFO of a German corporation with surplus cash flow has 1 million Euros to invest. Suppose that interest rates on 1-year CD deposits in US banks are 2%, while rates on 1year CD deposits denominated in euros in German banks are currently 4.5%. Suppose further that the CFO expects that the (euro/\$) exchange rate will increase from 1euro per \$ to 1.1 euros per \$ during the coming year. Should the CFO invest in CD’s denominated in dollars or in euros? Show your work of estimation to substantiate your response as credible! 2 pts

1. Suppose the CFO of an American corporation with surplus cash flow had \$100 million to invest last July 15 and the corporation did not believe it would need to utilize these funds to retool or expand production capacity for 1 year. Suppose further that the interest rate on 1 year CD deposits in US banks was .5%, while the rate on 1 year CD deposits in England (denominated in British Pounds) was 2% at the time. Suppose further that the exchange rate at that time was \$1.68 per British pound.

1.d.1. Suppose that now a year later the exchange rate is \$1.55 per US pound. What rate of return did the CFO earn on the investment in the British CD? (Note: a specific numeric answer is required for full credit.) 1pt

1.d.2. What must the CFO have expected about the value of the British pound in \$ today to believe that investment in British CD’s was more profitable than investment in US CD’s last July? 1pt

The following questions are based on open economy macroeconomic model. The answers must be written in your words along with graphical illustration. Without explaining in your words, the graphical illustration alone will not be credible. Also make sure you use the relevant symbols and notation on each of the lines and axis on the graph(s) to clearly indicate the working mechanism of variables. 6 Pts

1. a. ) Using the ZZ/Y and NX graphs, illustrate graphically and explain what effect a reduction in taxes will have on output, exports, imports, and net exports. Clearly label all curves and clearly label the initial and final equilibria. 2 pts

1. Using the ZZ/Y and NX graphs, illustrate graphically and explain what effect a reduction in foreign output (Y*) will have on output, exports, imports, and net exports. Clearly label all curves and clearly label the initial and final equilibria. 1 pts

1. Suppose the national output in the US is below the policy makers’ desired level of output and is experiencing a trade deficit. Assume that the policy makers’ goals are to achieve the desired level of output (i.e., full employment output) and balanced trade. Given this information, what type of exchange rate and/or fiscal policy can be used to achieve simultaneously these two goals? 2 pts

1. Using the ZZ/Y and NX graphs, illustrate graphically and explain what effect an increase in government spending will have on output, exports, imports, and net exports. Clearly label all curves and clearly label the initial and final equilibria. 1 pts

1. a. Suppose the domestic and foreign interest rates are both initially equal to 4%. Now suppose the foreign interest rate rises to 6%. Explain what effect this will have on the exchange rate. Also explain what must occur for the interest parity condition to be restored. 2 pts

1. Assume the exchange rate is allowed to fluctuate freely. Using the IS-LM-IP model, graphically illustrate and explain what effect an increase in government spending will have on the domestic economy. In your graphs, clearly label all curves and equilibria. 2 pts

1. Assume the exchange rate is allowed to fluctuate freely. Using the IS-LM-IP model, graphically illustrate and explain what effect expansionary monetary policy will have on the domestic economy. In your graphs, clearly label all curves and equilibria. 1 pts

1. Assume that policy makers are pursuing a fixed exchange rate regime. Now suppose that the foreign interest rate falls. Discuss what policy makers must do to maintain the pegged exchange rate. Also discuss what effect this will have on domestic output and net exports. 1 pts

1. Assume the exchange rate is fixed. Using the IS-LM model, graphically illustrate and explain what effect an increase in consumer confidence will have on the domestic economy. In your graphs, clearly label all curves and equilibria. 1 pts

1. a. Assume a country is in a fixed exchange rate regime such as China. Explain what factors might cause individuals to expect that a country will revalue its currency. Explain the various actions that policy makers can choose in response to this expected revaluation. 2 pts

1. Assume a country is in a fixed exchange rate regime. Now suppose that individuals expect that policy makers will devalue its currency. Explain the various actions that policy makers can choose in response to this expected devaluation. 2 pts

1. Suppose the economy is operating below the natural level of output. Discuss the arguments for and against using devaluation in such a situation. 2 pts

1. Suppose the economy is initially operating above the natural level of output. In a fixed exchange rate regime, explain how the economy will adjust to this situation. 1 pts

1. Since the Summer of 2015 markets around the world have been rattled by signs of a slowdown in growth of the Chinese economy, together with a massive sell–off in its stock market… plus a massive default by Greece on its debts to the IMF , the ECB and on its government bonds which will be averted only if it agrees to harsh budget austerity measures imposed by Germany and the rest of the European Union…In the process, the value of the \$ has risen against the Euro, the Yuan and many other currencies. Based on this scenario, answer following 3 parts of questions. 4pts

5.i. Given the current condition of the US economy, do you think US policy makers would prefer to see the \$ rise in value, decline in value or stay at its current value? Discuss the advantages and disadvantages to the US economy at this time of a stronger vs. a weaker \$. Frame your answer in terms of the current Aggregate Demand and Aggregate Supply situation of the US economy. 2pts

5.ii. How is it relevant to the events aftermath of the Brexit vote in the UK on June 23, 2016, especially in the context of trade and economy of the US with the UK in particular, and with the EU in general? 1 pt

5.iii. Draw an AS/AD diagram to illustrate your answers for both A) and B) above. Clearly label axes and the current position of AS, & AD relative to full employment RGDP….also indicate any shifts that would occur if the exchange rate of the \$ rose sharply against other major currencies 1pt

P(5.u)

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