This exercise will test students' abilities to interpret data and perform calculations regarding purchasing power parity, interest rates, and exchange rates. By forming teams students will be able to work through two exercises similar to those presented in the chapters. Be sure that students are not only able to perform the required calculations, but are also able to interpret their answers. This should be accomplished through the requirement that each group explain their solutions to another group.

The class breaks up into groups of four, and each group is further divided into subgroups of two, A and B. The A subgroups must answer question A below, and the B subgroups must answer question B below. After the subgroups have found the answers, the groups of four come together and the A subgroup explains its answer to the Bs, and the B subgroup explains its answer to the As.

Question A: Suppose that today the yen/dollar exchange rate is 100 (1 US dollar buys 100 yen) and purchasing power parity holds. Over the next year there is a 5 percent inflation rate in the United States and a 2 percent inflation rate in Japan. What is the exchange rate after the year that will maintain purchasing power parity?

Solution: 102.941

Question B: Suppose a U.S. investor buys a one-year German bond for DM100,000. The German bond pays 10 percent interest over the year. If the exchange rate (dollars per mark) at the time the bond was purchased was $.60 and the exchange rate at the time the bond matures after one year is $.57, what is the dollar return from holding the German bond?

Solution: 4.5%