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NATIONAL UNIVERSITY OF SINGAPOREDepartment of Economics
EC3102 Macroeconomic Analysis II
Questions and answers prepared by Ho Kong Weng
Tutorial 7
Question 1
Consider two bonds, one issued in euros in Germany and the other
issued in dollars inthe United States. Both government bonds are
one-year bonds, paying the face value ofthe bond one year from now.
The exchange rate E is now 1 dollar = 0.75 euros.
The face values and prices of the two bonds are:
Face Value PriceU.S. $10,000 $9,615.38
Germany 10,000 9,433.96
(a) Compute the nominal interest rate on each of the bonds.
Answer: The nominal return on the U.S. bond is 10,000/(9615.38)
1 = 4%. Thenominal return on the German bond is 10,000/9433.95 1 =
6%.
(b) Compute the expected exchange rate next year consistent with
the uncovered interest
parity.
Answer: The uncovered interest parity relation is given by
(1 +)=(1 +)(
+1
)
t
t
t
e
t
i
iEE
+
+=
+
1
1 *
1.
Hence, expected exchange rate = 0.75(1.06)/(1.04)=0.76442 euro/$
= 0.76 euro/$. Inother words, according to the uncovered interest
parity condition, we expect the dollarto appreciate.
(c) If you expect the dollar to depreciate relative to the euro,
which bond should youbuy?
Answer: If you expect the dollar to depreciate (opposite to the
prediction of theuncovered interest rate parity condition),
purchase the German bond, as it pays ahigher interest rate and you
expect a capital gain on the currency.
(d) You are a U.S. investor. You exchange dollars for euros and
purchase the Germanbond. One year from now, it turns out that the
exchange rate, E, is actually 0.72. What isyour realized rate of
return in dollars compared to the realized rate of return you
wouldhave made had you held the U.S. bond?
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Answer: The dollar depreciates by 4% (because 0.72/0.75 = 0.96)
or the euro hasappreciated by 4%, so the total return on the German
bond (in $) is 6% + 4% =10%.Investing in the U.S. bond would have
produced a 4% return.
Note: An answer of 0.72/0.76 = 0.96 is incorrect. It should be
0.72/0.75 = 0.96.
Although the two answers are the same in two decimal places, the
former answer ormethod is incorrect. The appreciation/depreciation
is with respect to the originalexchange rate.
(e) Are the differences in rates of return in (d) consistent
with the uncovered interestparity condition? Why or why not?
Answer: Tell me!
Question 2
Consider three equal-sized economies (A, B, and C) producing
three goods (clothes,cars, and computers). All consumers want to
consume equal amounts on all threegoods. The value of production of
each good in this world of three economiesfollows:
A B C
Clothes 10 0 5
Cars 5 10 0
Computers 0 5 10
(a) What is the GDP in each economy? If the total value of GDP
is consumed andborrowing from abroad is impossible, how much will
consumers in each economyspend on each of the goods?
(b) If no economy borrows from abroad, what will be the trade
balance in eacheconomy? What will be the pattern of trade in this
world (what is exported and whatis imported in each economy)?
(c) Continue from (b). Will economy A have a zero trade balance
with economy B?With economy C? Will any economy have a zero trade
balance with any othereconomy?
(d) U.S. has a large overall trade deficit. Its trade deficit
with China is larger than withother countries. Suppose U.S.
eliminates its overall trade deficit. Does that mean its trade
balance with every one of its trading partners will become zero?
Does the especiallylarge trade deficit with China imply that China
does not allow U.S. goods to compete onan equal basis with Chinese
goods?
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Question 3
Suppose the domestic currency depreciates. Equivalently, nominal
exchange rate E falls.Assume P and P*remain constant.
(a) How does the nominal depreciation affect the relative price
of domestic goods?Consequently, what is the likely effect on the
demand for domestic goods? On domesticunemployment rate?
(b) Given the foreign price level P*, what is the price of
foreign goods in terms ofdomestic currency? How does a nominal
depreciation affect the price of foreign goods interms of domestic
currency? How does a nominal depreciation affect the
domesticconsumer price index?
(c) If the nominal wage remains constant, how does a nominal
depreciation affect thereal wage?
(d) A depreciating currency puts domestic labor on sale. Do you
agree with thestatement?
