chapter 6 (2)

Question 1

When PPP is violated the real exchange rate will

Answer 1

Deviate from unity.

Suppose for example the annual inflation rate is 5 percent in the united states and 3.5 percent in the UK and the pound appreciated against the dollar by 4.5 percent then the real exchange rate is q = 0.97

Question 1

q = 1
q > 1
q < 1

Answer 1

q = 1: competitiveness of the domestic country is unaltered

q > 1: Competitiveness of the domestic country deteriorates

q < 1: Competitiveness of the domestic country improves

Question 2

nontradables

Answer 2

commodities that never enter into international trade

e.g. haircuts, housing etc

Question 3

Fisher effects

Answer 3

Fisher effect holds that an increase in the expected inflation rate in a country will cause a proportionate increase in the interest rate in the country

Question 4

Fisher effect can be written for the U>S as follows

Answer 4

i$ = P$ + E(pi$) + P$*E(pi$) == P$ + E(pi$)

P$ = the equilibrium expected real interest rate int the united states

Question 5

The Fisher effect implies that the expected inflation rate is the difference between the nominal and real interest rates in each country, that is

Answer 5

E(pi$) = (i$ - P$)/(1+P$) == i$-P$

E(Ppound) = (ipound -Ppound)/(1 + Ppound) == ipound - Ppound

Question 6

International Fisher effect

Answer 6

Suggests that the nominal interest rate differential reflects the expected change in exchange rate. For instance if the interest rate is 5 percent per year in the united states and 7 percent per year in the UK the dollar is expected to appreciate against the british pound by about 5 percent per year

Question 7

When the international fisher effect is combined with IRP that is

Answer 7

(F-S)/S = (i$ - ipound)/(1 + ipound) we obtain

(F - S)/S = E(e)

Question 8

Forward expectation parity

Answer 8

(F-S)/S = E(e)

States that any forward premium or discount is equal to the expected change in the exchange rate. When investors are risk neutral, forward parity will hold as long as the foreign exchange market is informationally efficient

Question 9

Most forecasting techniques can be classified into three distinct approaches

Answer 9

Efficient market approach

Fundamental approach

Technical approach

Question 10

Efficient market hypothesis (EMH)

Answer 10

Suppose that foreign exchange markets are efficient. This means that the current exchange rate has already relected all relevant information, such as money supplies, inflation rates, trade balances and output growth. The exchange rate will then change only when the market receives new information. in a word, incremental changes in the exchange rate will be independent of the past history of the exchange rate. If the exchange rate indeed follows a random walk, the future exchange rate is expected to be the same as the current exchange rate, that is,

> Sl = E(St+1)

Question 11

Random walk hypothesis

Answer 11

suggests that todays exchange rate is the best predictor of tomorrows exchange rate

Question 12

The fundamental approach to exchange rate forcasting

Answer 12

Uses various models for example ethe onetary approach to exchange rate determination. Suggests that the exchange rate is determined by three independent explanatory variables

1 Relative money supplies

2 relative velocity of monies

3 relative ational outputs

Question 13

One can formulate the omnetary approach in the following empirical form

Answer 13

s = alpha + beta1(m - m) + beta2(V-v) + beta3(y*-y) + u

Where

s = naturla logarithm of the spot exchange rate

m - m* = natural logarithm of domestic/foregin money supply

v-v* = natural logarithm of domestic/foregin velocity of money

y*-y = natural logarithm of foreign/domestic output

u = random error term, with mean zero

alpha, beta = model parameters

Question 14

Generating forecasts using the fundamental approach would involve three steps

Answer 14

1) estimation of the structural model to determine the numerical values for the parameters such as alpha and beta

2) estimation of future values of the independent variables like (M - m) (v-v) and (y*-y»)

3) substituting the estimated values of the independent variables into the estiated structural model to generate the exchagne rate forecasts

If for example the forecaster would like to predict the exchange rate one year into the future, he or she has to estimate the values that the independent variable will assume in one year. These values will then be substituted in the structural model that was fitted to historical data

Question 15

Fundamental approach to exchange rate forecasting has three main difficulties

Answer 15

1) one has to forecast a set of idependent variables to forecast the exchange rates

2) The parameter values that is alpha and betas that are estimated using historical data may change over time because of changes in government policies and/or the underlying structure of the economy

3) The model itself can be wrong

Question 16

Technical approach (exchange rates

Answer 16

First analyzes the past behavior of exchange rates for the purpose of identifying patterns and then projects them into the future to generate forecasts.

The technical approach is based on the premise that history repeats itself