1. In 1973, the GDP deflator was 15.6 in the United Kingdom and 34.

3 in the
United States ( with 1995 = 100 ). In 2001, it was 116.1 in the United Kingdom
and 112.1 in the United States. The exchange rate was £0.4078 to the dollar in
1973 and £0.6944 to the dollar in 1998
a. Calculate the rate of inflation in the United Kingdom minus the rate of inflation
in the United States from 1973 to 2001 and compare it with the rate of
depreciation of the British pound with respect to the U.S. dollar over the same
time period
b. Did the relative purchasing-power parity (PPP) theory hold between the United
Kingdom and the United States between 1973 and 2001? Why?

a. The rate of inflation of UK from 1973 to 2001 was :

116.1−15.6 100.5
x 100= x 100=152 %
( 116.1+15.6 ) 65.85
2
The rate of inflation in the US from 1973 to 2001 was
112,1−34,3 77,8

( 112,1+ 34.3
2 )
x 100 =
73,2
x 100=106,3 %

The inflation rate of the United Kingdom minus the inflation rate of the United
States from 1973 to 2001 was :
146 %−106.3 %=39.7 %
From 1972 to 2001, the British pound depreciated with respect to the U.S
dollar from £0.4078 to the dollar in 1973 to £0.6944 to the dollar in 2001 or :
0,6944−0,4078 0,2866

( 0,6944+0,4078
2
=
)0,5511
=52 %

b. The relative PPP only hold to the extent that the rate of inflation was lower in
the US and the British pound depreciated with respect to the US dollar. But the
% depreciation of British pound with respect to the dollar was higher than that
predicted by the PPP so that the relative PPP did not hold

2. In 1973, the GDP deflator was 45.0 in Switzerland and 34.3 in the United
States ( with 1995 = 100 ) . In 2001, it was 103.2 in Switzerland and 112.1 in
the United States . The exchange rate of the Swiss franc was SF3.1648 per
dollar in 1973 and SF1.6878 in 2001. Did the relative PPP theory hold between
Switzerland and the United States between 1973 and 2001? Why ?
The rate of inflation in Switzerland from 1973 to 2001 was :
 103.2−45 58.2

( 103.2+ 45
2 )× 100=
74.1
=78.5 %

The rate of inflation in Switzerland minus the inflation rate of the United States
from 1973 to 2001 was
78.5 %−106.3 %=−27.8 %

The Swiss Franc appreciated with respect to the dollar by

3.168−1.6876

( 3.168+ 1.6876
2 )×100=60,9 %

The % appreciation of the SF to the US Dollar was much greater than the
predicted PPP => PPP didn’t hold
The PPP only hold to the extent that the rate of inflation was lower in
Switzerland and the US $ depreciated with respect to the SF
3. Suppose that the velocity of circulation of money is V=5 and the nominal GDP
of the nation is $200 billion
a. What is the quantity of money demanded by the nation?
b. By how much the quantity of money demanded rise if the nation’s nominal
GDP rises to $220 billion
c. What happens to the nation’s demanded for money if its nominal GDP
increases by 10%/year?
a. The quantity of money demand by the nation
1 1
Md=kpy ⇒ Md= × py = ×200=$ 40 billion
v 5
b. If the nation’s nominal GDP rises to $220 billion
1 1
Md=kpy ⇒ Md= × py = ×220=$ 44 billion
v 5
The quantity of demanded money rises by $4 billion
c. If nominal GDP increases by 10% each year, Md would also increase by 10%
each year 44 + ( 44 ×10 % )=48,4 billion
4. Suppose that the domestic credit created by the nation’s monetary authorities is
$8 billion and the nation’s international reserve are $2 billion, and that the
legal reserve requirement for the nation’s commercial bank is 25%
a. How much is the monetary base of the nation?
b. What is the value of the money multiplier?
c. What is the value of the total supply of money of the nation?
a. The monetary base of the nation is
D + F = 8 + 2 = $10 billion dollars
b. The valur of the money multiplier is
1 1
m= = =4
LRR 0,25
c. The value of the nation’s total money supply is
Ms=m ( D+ F ) =4 ( 8+ 2 )=40
5. Assuming fixed exchange rates, find the size of the decifit or surplus in the
balance of payments of the nation described in
a. Problems 3a and 4a
b. Problems 3b and 4b
c. Problems 3c and 4c
a. Md = Ms = $40 billion and the nation is in balance of payment equilibrium
b. Md of $44 billion exceeds Ms of $40 by $4 billion, so that there will be a BOP
surplus.
c. Md in 3c increases by 10% each year ($48.4 billion), thus exceeds the Ms in 4c
by 8.4 billion => a BOP surplus.
6. Explain how the balance-of-payments disequilibrium is corrected if monetary
authorities do not change the the dosmetic component of the nation’s monetary
base?
a. In problem 5b
b. In problem 5c
c. What happen if monetary authorities completely sterilize the BOP
disequilibrium by with a change in domestic component of the nation’s
monetary base ? How long can this go on ?
a. Md of $44 billion exceeds Ms of $40 by $4 billion, so that there will be a
BOP surplus. The excess in the stock of money demanded would be
satisfied by:
1
4 billion× =$ 800 million
5
b. Md in 3c increases by 10% each year ($48.4 billion), thus exceeds the Ms
in 4c by 8.4 billion => a BOP surplus. The excess in the stock of money
demanded would be satisfied by:
1
8,4 × =$ 1,68 billion
5
c. If money demanded is satisfied by change in domestic component of
monetary base, there will be a continuous inflow of international reserves
7. Suppose that a nation’s nominal GDP = 100, V= 4, Ms = 30. Explain why this
nation has a deficit in its balance of payments
 1
Md=100⋅ =25
4

 Md falls short of Ms = 30. This would bring about an outflow of

international reserves or deficit in the nation’s balance of payment
8. Under the law of one price, the price of an internationally traded commodity in
one nation in a two-nation world is equal to the exchange rate times the price
of the same commodity in the other nation. Assuming that such a law holds,
explain why, if the first nation would otherwise face no inflation at home, it
will not be able to maintain in the long run both constant price and a constant
exchange rate in the face of inflation in the other nation.
The law of one price is the foundation of purchasing power parity, the
currency exchange rates are the same, in such we have R = P/P* => P = RxP*
If the second nation face an inflation which means the P* rises, with an
unchanged exchange rate, P would have to rise (1st nation meets inflation) so
that it would keep a constant (equal to 2nd nation) price and exchange rate
9. Suppose that the interest rate is i= 10% in New York and i* = 6% in Frankfurt,
the spot rate is SR= $1/€1 today and is expected to be $1.01/€1 in three months.
a. Indicate why the condition for uncovered interest parity (UIP) is satisfied.
b. Explain what would happen if there was a change in expectations so that the
spot rate in three months became $1.02/€1 and the interest rate differential
remains unchanged
a. (Chapter 14)
Uncovered interest rate parity (UIP) theory states that the difference in interest
rates between two countries will equal the relative change in currency foreign
exchange rates over the same period.
In this case, the Euro in Frankfurt (i*= 6%) will trade at a forward premium
($1.01/€1) in 3 months in relation to the dollar in the US (i = 10%).
Conversely, the US dollar will trade at a forward discount against the Euro.
i-i*= 10% - 6% = 4 % in annual basis, EA (expected percentage of
appreciation) = 1.1- 1 = 1% in 3 months or 4% in annual basis
b. If the EA increases from 4% to 8% at annual basis, this would make the
return on investing in Frankfurt 14% (6% in the interest rate and 8% in the
EA of euro in an annual basis ad compared to 10% return in the US. This
would lead to an immediate capital outflow from the US to Frankfurt and
actual appreciation of 4% per year to UIP
10.
a. What is the difference between the expected change in the exchange rate and the
forward discount or forward premium on the foreign currency?
b. When would the expected change in the exchange rate equal the forward discount or
forward premium in the foreign currency?
An expected exchange rate increase means that if investors had expected the pound to
appreciate, they now expect it to appreciate even more. Likewise, if investors had
expected the dollar to depreciate, they now expect it to depreciate more
FP/FD: A forward premium/discount is a situation in which the forward or expected
future price for a currency is greater or lower than the spot price,
b. Example: When s.o had expected the pound to appreciate 2% (from R = 1 to R =
1.02), in 3 months later, pound appreciated to R = 1.02 and he would gain a forward
premium = (1.02-1)/1x100 = 2%
11. Suppose that individuals and firms in a nation are holding the desired proportion of
their wealth in foreign bonds to begin with. Suppose that there is then once-and-for-all
decrease in the exchange rate (i.e. the domestic currency appreciates and foreign currency
depreciates). What is the adjustment that the simple portfolio balance model present in
Section 15.4A postulates?
If the exchange rate decreases, individuals and firms can buy more domestic money to
carry out business transaction and domestic bond to make it yield by selling the foreign
bonds when foreign currency depreciation
12. Discuss the portfolio adjustment for an increase in expected domestic inflation
under flexible exchange rates using the extended portfolio balance model in Section
15.4B.
When there is an increase in expected domestic inflation, home country residents would
demand less on the (domestic) foreign bond and demand more on the foreign currency.
This would lead to a rise in foreign exchange rate

13. . Using the extended asset market or portfolio balance model presented in Section
15.4B examine the portfolio adjustment resulting from an increase in the supply of the
foreign bond because of the foreign government budget deficit.
When the foreign government budget deficit, the real income would decrease, price
would increase. People demand for domestic and foreign bond increase increase, demand
for domestic currency decrease. This would lead to appreciation of domestic currency
appreciation and decline in exchange rate
14. . Explain the exchange rate dynamics of the dollar resulting from an unanticipated
increase in the money supply by the EMU central bank.
The increase in the money supply by EMU would lead to a decline in euro interest rate
and the gradual price in the long run. This time, the investor would buy more foreign
bond and the demand for foreign currency would rise, the exchange rate would increase
and the euro would immediately depreciate in the long run. A future depreciation of $ and
appreciation of euro would satisfy the UIP