University of California Irvine Switzerland Currency Worksheet Answer questions in the files attached below. Please give full details and equations for eac

University of California Irvine Switzerland Currency Worksheet Answer questions in the files attached below. Please give full details and equations for each question. 1. Miscellaneous Short Questions [1 point each]
a. Give an example of a European country which has its own currency but which
currently pegs its currency to the euro.
b. You are a wine importer and have bought a large French wine shipment for €4
million (including delivery costs) with payment due in 90 days. You have a contract
to sell the wine shipment on to a liquor store for $5 million with payment due on the
same date. Today the spot rate is $1.05 per euro, and the 90-day forward rate is
$1.10 per euro. Can you lock in a profit by hedging with forwards? How much?
Explain. Can you potentially lose money if you don’t hedge?
c. One year ago the pound was worth $1.50. Now it is worth $1.25. Compute what the
dollar was worth at each time in pounds.
d. In the last question, has the dollar experienced an appreciation or a depreciation
against the pound over the last year?
e. Assume the world real interest rate is r* = 1.5 % per year. Your country has a long
run average inflation rate of p = 2.0 %. What will be the average nominal interest
rate (i) in your country? (Write down the equation you use.)
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f. A Big Mac costs €4.00 in the Eurozone and $4.84 in the U.S. The spot exchange rate
is $1.10 per euro. What is the PPP-implied value of the $/€ exchange rate based on a
basket of Big Macs? Is the euro undervalued or overvalued against the dollar (and
by how much)?
g. In the (flexible price) monetary model, if a country initially has a stable exchange
rate and price level, but then suddenly increases its money supply growth rate by
10 % per year, what happens to its rate of inflation and rate of depreciation?
h. Suppose the ECB keeps the euro interest rate at 1 % forever. The Fed now raises its
interest rate from 1 % to 4 % for the coming year. After this event, approximately
what is the expected rate of dollar depreciation if UIP holds over the coming year?
i.
In the last question, suppose the policies are temporary, and everyone believes the
exchange rate will revert to its long run PPP value of $1.03 per euro one year from
now. What will be the spot exchange rate ($/€) today approximately?
j.
According to the trilemma, which three macroeconomic policies are mutually
inconsistent?
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2. Uncovered Interest Parity [10 points]
Consider a Dutch investor with 100 euros to place in a bank deposit in either the
Netherlands or Great Britain. The (one-year) interest rate on bank deposits is 2% in Britain
and 4.04% in the Netherlands. The (one-year) forward euro-pound exchange rate is 1.575
euros per pound and the spot rate is 1.5 euros per pound. Answer the following questions,
using the exact equations for UIP and CIP as necessary.
a. What is the euro-denominated return on Dutch deposits for this investor? [2]
b. What is the (riskless) euro-denominated return on British deposits for this investor
using forward cover? [2]
c. Is there a riskless arbitrage opportunity here? Explain why or why not. Is this an
equilibrium in the forward exchange rate market? [2]
d. If the spot rate is 1.5 euros per pound, and interest rates are as stated, what is the
true equilibrium forward rate, according to covered interest parity (CIP)? [2]
e. If uncovered interest parity (UIP) holds, what is the expected depreciation of the
euro (against the pound) over one year? What then is the expected euro-pound
exchange rate one year ahead? [2]
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3. Monetary Model [10 points]
Assume Hungary’s money growth rate is currently 12% and output growth is 8%. Europe’s
money growth rate is 4% and its output growth is 2%. Also, assume the world real interest
rate is 2%. For the questions below, use the conditions associated with the simple
monetary model (L = constant). Treat Hungary as the home country and define the
exchange rate as Hungarian forint (Ft) per euro, EFt/€.
a. Compute the inflation rate in Hungary. [2]
b. Compute the inflation rate in Europe. [2]
c. Compute the expected rate of depreciation of the forint versus the euro. [2]
d. Suppose the Hungarian National Bank decreases the money growth rate from 12%
to 10%. If nothing in Europe changes, what is the new inflation rate in Hungary? [2]
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e. Fill in the time series diagrams (time on the horizontal axis) below to show how the
policy change in part d at time T affects the following variables: money supply MHUN,
real money balances MHUN/PHUN, price level PHUN, and exchange rate EFt/€ over time.
Clearly label the before and after growth rates for each variable on the chart. [2]
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4. Permanent Versus Temporary Policies [10 points]
This question considers how the foreign exchange (FX) market will respond to changes in
monetary policy. For these questions, the home country is Britain, and foreign is the
Eurozone. The home exchange rate is British pounds (£) per euro E£/€. Use the combined
(side-by-side) home money market and FX diagrams to answer the following questions.
Clearly label the figures: axes, equilibrium points, levels of variables. Explain briefly.
a. Suppose the Bank of England temporarily increases its money supply. Illustrate the
short run (label equilibrium point B) and long-run effects (label equilibrium point C)
of this policy. [5]
Explanation:
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b. Suppose the Bank of England permanently increases its money supply. Illustrate the
short run (label equilibrium point B) and long-run effects (label equilibrium point C)
of this policy. [5]
Explanation:
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