CARLETON UNIVERSITY

Department of Economics
International Monetary Problems
Economics 3602 Winter 2015
Problem Set 1: Due February 24th 2:35pm

The Exchange Rate and Outsourcing. [3 points]

In the past few decades, firms from industrial economies have installed production plants in developing countries. This strategy allowed them to move production from expensive locations to
cheaper ones (a phenomenon called outsourcing). If the Indian Rupee depreciates against the US
dollar, what would happen to outsourcing in India by US companies? Explain.

Chinese Current Account Surplus vs U.S. Current Account Deficit. [3 points]

Recently, there has been substantial pressure on China from the U.S. government to allow the value
of the yuan (i.e. the Chinese currency) to appreciate relative to the U.S. dollar. Why might the
U.S. government want this change in the value of the yuan? How would such a change affect the
relative price of Chinese goods versus U.S. goods? How would it affect the value of U.S. liabilities
owned by Chinese residents?

Foreign Exchange Market Equilibrium. [9 points]

We say that the foreign exchange market is in equilibrium when deposits of all currencies offer the
same expected rate of return (when returns are denominated in the same currency). Formally,
i$ = ie +

e
E$/e
E$/e

E$/e

(1)

(a) Explain why in points 2 and 3 in Figure 1 the foreign exchange market is not in equilibrium.
Do not forget to use a graph to support your answer and describe how the equilibrium can be
restored. [6 points]
(b) Now suppose the foreign exchange market is in equilibrium (i.e. point 1 in Figure 1). Explain
what would happen to the US/euro nominal exchange rate if the interest rate in Europe falls.
Do not forget to use a graph to support your answer. [3 points]

ChangesinDomesticandForeignReturnsand
FXMarketEquilibrium(a)
Figure 1: Foreign Exchange Market Equilibrium

Increase in the domestic interest rate, i$

Money Market and Foreign Exchange Market. [13 points]

Use the foreign exchange market and money market diagrams to answer the following
questions. This question considers the relationship between Swedish kronor (SK) and
Danish krone (DK). Let the exchange rate be defined as Swedish kronor per Danish
krone, ESK/DK. On all graphs, label the initial equilibrium point A. Suppose that
there is an exogenous increase in the real money demand in Sweden.
a Assume this change in real money demand is temporary. Using the foreign exchange market
and money market diagrams, illustrate and explain how this change affects the money and
foreign exchange markets. Label your short-run equilibrium point B and your long-run equilibrium point C. [4 points]
b Now assume this change in real money demand is permanent. Using a new diagram, illustrate how this change affects the money and foreign exchange markets. Label your short-run
equilibrium point B and your long-run equilibrium point C. [4 points]
c Illustrate how each of the following variables changes over time in response to a permanent
increase in real money demand: nominal money supply M S , price level PS , real money supply
M S /PS , Swedish interest rate iSK , and the exchange rate ESK/DK . [5 points]

Money Supply Shocks and the Nominal Exchange Rate. [11 points]

Use the money and foreign exchange markets diagrams to answer the following questions about
the relationship between the British pound () and the U.S. dollar ($). Let the exchange rate be
defined as U.S. dollars per British pound, E$/ . We want to consider how a change in the U.S.
money supply affects interest rates and exchange rates. On all graphs, label the initial equilibrium
point A.
a Illustrate and explain how a temporary decrease in the U.S. money supply affects the money
and foreign exchange markets. Label your short-run equilibrium point B and your long-run
equilibrium point C. [3 points]
b Using your diagram from (a), state how each of the following variables changes in the short
e
run (increase/decrease/no change): U.S. interest rate, British interest rate, E$/ , E$/
, and
U.S. and British price levels. [4 points]
c Using your diagram from (a), state how each of the following variables changes in the long
run (increase/decrease/no change relative to their initial values at point A): U.S. interest rate,
e
, and U.S. and British price levels. [4 points]
British interest rate, E$/ , E$/

Fundamental Equation to the Exchange Rate (General Model). [9 points]

Using the fundamental equations from the general monetary approach, describe how each of the
following will affect the home and foreign price level, real money balances, and the exchange rate,
EH/F in the long run. Also, state whether the home currency appreciates or depreciates for each.
a A permanent increase in home money supply. [3 points]
b A permanent increase in the foreign money supply. [3 points]
c An increase in home real income. [3 points]

PPP and the LOOP. [6 points]

Suppose that two countries, Brazil and Mexico, produce bananas. Brazil uses the real, Mexico uses
the peso. In Mexico, bananas sell for 10 pesos per pound of bananas. The exchange rate is 0.5 reals
per peso, Ereals/pesos = 0.5. The peso-dollar exchange rate is Epesos/$ = 10.
a If LOOP holds, what is the price of bananas in Brazil? What is the price in the United States?
[2 points]

b Suppose the price of bananas in Brazil is 5.5 reals per pound. At the same time, the price
of bananas in the United States is $1.00 per pound. Based on this information, where does
LOOP hold? [2 points]
c How will banana traders respond to the previous situation? In which markets will traders buy
bananas? Where will they sell them? What will happen to the prices of bananas in Mexico,
Brazil, and the United States? [2 points]
8

Answer True or False. Briefly explain your answer. No credit without explanation.
Support your answer with a graph if needed. [6 points]
a From the PPP theory we can conclude that a country with higher inflation (relative to its
foreign partners) should have an appreciating currency. [3 points]
e
b If there is a decrease in the expected future level of the dollar/euro rate (i.e. E$/e
goes down)
then at unchanged interest rates, todays dollar/euro exchange rate will also go down. [3
points]