Interest Rate and Exchange Rate

Question 1

What does E represent?

Answer 1

The nominal exchange rate of the domestic currency in units of the foreign currency ($1 = E euros)

Question 2

What does it mean when E increases?

Answer 2

The Euro depreciates

Question 3

what is the structure of the Foreign exchange market

Answer 3

-traders and investors buy and sell currencies in largely Inter-bank, over-the-counter transactions
-small transaction cost, high liquidity

Question 4

What is the spot rate

Answer 4

price of currency agreed upon today for immediate transaction

Question 5

What is the forward rate

Answer 5

price of currency agreed upon today for future transactions

Question 6

Why is the dollar a vehicle currency

Answer 6

Large majority of future transactions made through dollar

Question 7

What is Uncovered Interest Parity condition (UIP)

Answer 7

The link between the current exchange rate, the expected exchange rate, and the interest rate differential

Question 8

What investment strategy should a risk-neutral investor follow?

Answer 8

They should be indifferent to either holding assets in domestic currency or trading currencies.

Question 9

What is equilibrium on FOREX market

Answer 9

-r€ = r$ + (Ee –E)/E
-Ex. If E increases (€ depreciates), the return on $ assets decreases today because it is more expensive to buy $.

Question 10

What are five assumptions of valid UIP

Answer 10

-Perfect mobility of capital
-Rational expectations
-No speculative bubble
-No risk aversion
-Assets are perfectly substitutable

Question 11

What is the difference between Random Walk and UIP

Answer 11

The Random Walk is better for short-run (1-12 months) expectations, where as UIP is better for long-run expectations

Question 12

Where does UIP fail

Answer 12

-Risk premiums non-observable: varies with time
-Speculative behaviours and bubbles

Question 13

What is the covered interest parity condition (CIP)

Answer 13

-The link between E, forward rate, and interest rate differential
-A risk-adverse investor trades domestic currency for foreign currency with a higher interest rate and agrees future exchange rate today.

Question 14

How do you calculate (CIP)

Answer 14

-(1+r€) = F(1+r$)/E
-if Forward rate>Exchange rate –> investor must be compensated with a higher interest rate –> making it worth while to exchange currencies for high forward rate

Question 15

What must be true for a valid CIP

Answer 15

-Free capital movements
-Agents are profit maximizers (do not give up riskless opportunity of profit)

Question 16

What three factors affect money demand

Answer 16

-interest rate, r€
-Price level, P€
-Transactions, Y€

Question 17

What is the opportunity cost of money

Answer 17

-The interest rate, r; if r increases –> money demand decreases –> people invest
-Demand for money increases with economic activity (or GDP, Y)

Question 18

How do you find money market equilibrium

Answer 18

-MS€ = Md€ = P€ x L (r€ , Y€)
-money supply determined by central banks

Question 19

What is monetary neutrality

Answer 19

-in the long run, a change in monetary policy will have an impact on future exchange rates if prices are flexible

Question 20

What impact does money supply have on market equilibrium in the long run

Answer 20

-Money supply only impacts prices
-No real impact on interest rate (r) or output (Y)
-Thus: P€ = MS€ / L (r€ , Y€)

Question 21

What is the Quantity Theory of Money

Answer 21

-In long run increasing money supply only increases price level
-Inflation moves one for one with money growth in the long
run

Question 22

What will be the result of permanent increase in money supply

Answer 22

-Currency overshoots, causing it to decrease by more than the long-run expected value (Dornbush)
-Overshoot due to slow adjustment of goods prices and immediate adjustment of the exchange rate

Question 23

what is the result of overshooting

Answer 23

A permanent money supply leads to long-term depreciation of currency and long term increase in prices