7 and 8 6. If the price level recently increased by 20% in England while falling

Question

7 and 8

6. If the price level recently increased by 20% in England while falling 5% in the United States, how much must the exchange rate change if PPP holds? Assume that the current exchange rate(FL.SLpCMP} is 1.8. (a) 1.62 (b) 1.85 (c) 2.03 (d) 2.27 ECO 362 Summer 2018 7. Does the behaviar af the $- exchange rate support ar contradict the theory of Uncovered Interest Parity? Answer with reference to Figure Dollar and euro 8% interest rates Fed funds (% per year) 6 ECB refinancing 1 rate, Exchange rate (S/E) 1.30 US, exchange rate 1.10 .00 0.90 0.80 a a a Jan an s Figure 1: The &-CExchange Rate, 1990-2004 a) Supports UIP (b) Contradicts UIP (c) Both supparts and contradicts UIP (d) More information is needecd 8. The Japanese central bank announces a new program of quantitative easing', which involves increasing the growth rate of the Japanese money supply by an additional 5% per year, indel- initely. Assume prior to the announcement that both the Japanese and US money supplies had nat been growing, and goods prices were stable (there was neither inflation or deflation in the US or Japan). What is the likely long-run effect of this new Japanese policy on Japanese nominal interest rates, and the exchange rate between the Yand $? a) Raise Japanese nominal interest rates by 5% and appreciate b) Raise Japanese nominal interest rates by 5% and depreciate (c) Lower Japanese nominal interest rates by 5% and appreciate (d) Lower Japanese nominal interest rates by 5% and depreciate against $. against $ against $ against $ 9. Suppose the Bank of Japan allowed the money supply to growth by 2% each year, while the Bank of Korea chose to maintain relatively high money growth of 12% per year. In addition, the bank deposits in Japan pay 3% interest, i -396. Compute the interest rate paid on Korean deposits.

Explanation / Answer

Ans. 7: The uncovered interest parity condition states that nominal interest rate differential between two countries should be equal to the expected depreciation of the exchange rate.

If we look at Jan,1999, the nominal interest rate differential between dollar-euro is approximately 1.7 or 1.8 . Now at the corresponding year, the depreciation rate is somewhere less than and close to 1.20.

Now if we look at the point, where the nominal interest rates are intersecting at each other, the interest rate differential is zero and if we look at the exchange rate, the depreciation rate is close to 0.85 , not zero.

Hence, the figure does not support UIP.

The option (b) is right.

Ans. 8: If Japanese governnment increases 5% money supply every year, then the nominal interest rate will fall in the long run and due to a fall in the nominal interest rate, the capital outflows from the country as they would be getting lower returns. Also, due to money growth, the aggregate demand increases and so the demand for imports also rises. Hence, in the long run, the japanese nominal interest rate will fall and the japanese currency will depreciate agains US currency.

The option (d) is correct.

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