ECO 471 NAME _______________________ Fall 2005 EXAM 2 ID _______________________ a. Write your name and ID number on top of your exam. b. You may use the back pages if necessary. Part I. Show your work. Answer alone will get no credit. 1. A £10,000 deposit in a London bank in a year when the interest rate on pounds is 7 percent and the $/£ exchange rate moves from $1.60 per pound to $1.68 per pound. Calculate the dollar rate of return on the deposit. Note: Express 7 percent as 0.07 in the following. 0.07 + (1.68-1.60)/1.60 = 0.07 + 0.05 = 0.12 12 percent 2. Suppose that the dollar return to a U.S. investor from buying a euro bond is 6% per annum. Spot and 1-year expected future exchange rates ($/€) are 1.100 and 1.078, respectively. a. The expected rate of depreciation of the dollar is _____________________. (Use a negative sign if the dollar is expected to appreciate.) b. The 1-year interest rate on the euro bond is equal to ___________________. a. (1.078-1.10)/1.10 = - 0.02 ⇒ This means the dollar is expected to appreciate by 2%. b. 0.06 = x + (-0.02) ⇒ x = 0.08 or 8 percent. 3. If the reference commodity basket costs $180 in the United States and €120 in Europe, PPP predicts a dollar/euro exchange rate of $____ per euro.2 4. Suppose that on January 1, 2001, the yen price of the dollar was 120 and purchasing power parity held at the rate. Over the year, the Japanese inflation rate was 3% and the U.S. inflation rate was 5 %. a. If PPP continued to hold for the year, what would be the yen-dollar (¥/$) exchange rate at the end of 2001? Derive your answer. b. If the actual exchange rate is $1 = ¥110 at the end of 2001, is the yen overvalued, undervalued, or at the PPP level? Explain. 5. Fill in the blanks and find the magnitudes of under or over-valuation of the Argentinean peso and the Japanese yen according to the Hamburger Standard of the Economist magazine. (No explanations necessary.) Big Mac Prices in local currency In US dollars Actual dollar exchange rate Under (-) / over (+) valuation against the dollar Purchasing power price United States $2.65 - - - - Argentina Peso 3.85 2.99 Japan ¥263 105.63 Part II. Below is a roster of transactions for the mythical economy of Freedonia in year 2004. Use the roster to complete the balance of payments chars which follows. (All transactions are in millions of Freedonia dollars.) Description Amount Credit Debit a. Sale of Freedonian cigars to Belgium $8 A E b. Payment of dividends to Italian shareholders in Fredonia Balloon Co. $9 E C c. Sale of stock in the Freedonian Balloon Company to U.S. investors $5 _E__ _E__ d. Freedonian foreign aid of medical equipment to Mongolia $1 _A__ _D__ e. Purchase of British tea sets $3 _E__ _A__ f. Sale of Freedonia’s largest hotel to Japanese investors $14 _E__ _E__ g. Purchase of IBM stock by several Freedonian investors $20 _E__ _E__ h. Sale of Freedonian harps to Switzerland $22 _A__ _E__ i. Purchase of Canadian hockey sticks $5 _E__ _A__ j. Rental of hotel rooms by German tourists in Freedonia $3 _B__ _E__ k. Purchase of British pounds by Freedonian central bank $18 _E__ _F__ 1. First, classify the credit and debit sides of each transaction by choosing one from the following list and then fill the last two columns in the above list according to the examples given for the first two transactions. A. Merchandise B. Services C. Investment income D. Unilateral transfers E. Financial account (private) F. Official reserve assets 2. Calculate the Freedonia Balance of Payments on the following accounts (millions of Freedonia dollars) using all the transactions (a through k): a. Balance on Current Account __8-9-3+22-5+3 = +$16 million_____ b. Balance on Financial Account _____+$2 million_____ c. Balance on Official Reserve Assets __-8+9+3-22+5-3+18 = -$18 million___ d. Balance of Payments ___$18 million___ 3. Suppose that at the beginning of year 2004, Freedonia had 20 (million) Freedonian dollars worth of net foreign assets. At the end of 2004, net foreign assets would be __36__ million Freedonian dollars. Part III4 Suppose there is an increase in aggregate real money demand, that is, a positive shift in the aggregate real money demand function in an economy where prices are sticky. In the following diagram of the money market and the foreign exchange market, the initial situation is market by point (1). a. Find the short-run and the long-run positions of the economy and mark them by (2) and (3) in each graph. b. Trace the short-run and long-run effects on the exchange rate (E), interest rate (R), and price level (P) in a time plot for each variable shown on the right column. [Note the increase in real money demand occurs when the real line ends and the dotted line begins.] c. In the remaining blank space below (and, if necessary, back page) (i) discuss what exchange-rate overshooting is; (ii) whether it arises in this case; and (iii) why it arises if it does or why not if not. timetime E M/P RERP(1) (1)