ECON 002 Exchange Rate Excercises solutions 2022

ECON 002 Exchange Rate Excercises solutions 2022Exercise 1: What is happening to the U.S. real exchange rate in each of the following situations? a. The U.S. nominal exchange rate is unchanged, but prices rise faster in the United States than abroad. b. The U.S. nominal exchange rate is unchanged, but prices rise faster abroad than in the United States. c. The U.S. nominal exchange rate declines, and prices are unchanged in the United States and abroad. d. The U.S. nominal exchange rate declines, and prices rise faster abroad than in the United States. ANSWER: All the parts of this question can be answered by keeping in mind the definition of the real exchange rate. The real exchange rate equals the nominal exchange rate times the domestic price level divided by the foreign price level. a. The real exchange rate rises. b. The real exchange rate declines. c. The real exchange rate declines. d. The real exchange rate declines. Exercise 2: Can purchasing-power parity be used to explain the fact that the U.S. dollar depreciated by more than 50 percent against the German mark between 1970 and 2000, but appreciated by more than 100 percent against the Italian lira during the same period? Explain your answer. ANSWER: The theory of purchasing-power parity would suggest that Italy must have experienced much more inflation than has the United States since 1970, and that Germany must have experienced much less inflation than has the United States since 1970. In fact, that is exactly what has happened. Exercise 3: Molson’s Beer is produced in Canada and sold in many countries. In the province of Ontario a six-pack of Molson’s beer sold for $8.75 Canadian in 2000. Across the border in Michigan, a six pack of the same beer was for sale for $5.19 U.S. At the time, the exchange rate was $0.67 U.S. = $1.00 Canadian. a. How much would it cost in U.S. currency to buy the beer in Ontario? b. How much would it cost in Canadian currency to buy the beer in Michigan? c. Is there an arbitrage opportunity? If so, how much profit could you expect on a six-pack? ANSWER: a. 8.75 × 0.67 = $5.86 U.S. b. 5.19/0.67 = $7.75 Canadian c. There is an arbitrage opportunity because a price differential exists. The beer is more expensive in Canada, cheaper in the United States. Profits can be made by buying a six-pack in Michigan, and selling it in Ontario. The profit per six-pack would be the difference between the price in Ontario, $5.86, and the price in Michigan, $5.19, which equals $0.67 U.S. (Or, measured in Canadian currency, a profit of $1.00 Canadian.) Exercise 4: Use the table below to compute for each country: a) The cost in dollars of a MacDonald’s Big Mac. For which country is the Big Mac most expensive? b) Calculate the cost of a US Big Mac in terms of foreign Big Macs. c) Is the US dollar “stronger” or “weaker” relative to each currency, assuming Big Macs are identical across the world? Country Cost of 1 Big Mac E (nominal exchange rate) Brazil 2.97 Real 3.57 South Korea 3,100 Won 1,304 Switzerland 5.9 Swiss Francs 1.33 USA 2.49$ 1 ANSWER: a) See the table. Formula for this part: Cost ($) of 1 Big Mac = Cost of 1 Big Mac in foreign currency/E The country for which the Big Mac is most expensive is obviously Switzerland. b) See the table. Formula is the one for the real exchange rate: P*E/Pf Country Cost of 1 Big Mac E (nominal exchange rate) Cost ($) of 1Big Mac e Real exchange rate Brazil 2.97 Real 3.57 0.83$ 3 South Korea 3,100 Won 1,304 2.38$ 1.05 Switzerland 5.9 Swiss Francs 1.33 4.43$ 0.56 USA 2.49$ 1 2.49$ 1 c) According to the Purchasing Power Parity we should observe e=1. This is not always so in our exercise. In particular the US dollar is “stronger” than the Real and the Won (e 1) while it is “weaker” than the Swiss Franc (e 1). Exercise 5: Would each of the following groups be happy or unhappy if the U.S. dollar appreciated? Explain. a. Dutch pension funds holding U.S. government bonds. b. U.S. manufacturing industries. c. Australian tourists planning a trip to the United States. d. An American firm trying to purchase property overseas. ANSWER: a. Dutch pension funds holding U.S. government bonds would be happy if the U.S. dollar appreciated. They would then get more Euros for each dollar they earned on their U.S. asset purchase. In general, if you have savings denominated in a foreign country’s currency, you are better off if that country's currency appreciates. b. U.S. manufacturing industries would be unhappy if the U.S. dollar appreciated because their prices would be higher in terms of foreign currencies, which will reduce their sales abroad. c. Australian tourists planning a trip to the United States would be unhappy if the U.S. dollar appreciated because they would get fewer U.S. dollars for each Australian dollar, so their vacation will be more expensive. d. An American firm trying to purchase property overseas would be happy if the U.S. dollar appreciated because it would get more units of the foreign currency and could thus buy more property.