Answers to Exercises

1. a. $.83
b. $.0007
c. $.5
d. $.16
e. $.66

2. a. $769,000
b. $792,750
c. $6,020
d. $1,035,000
e. $454,987

3. a. $.769 x 1.10 x 1,000,000 = $845,900

b. $1.5855 x .9 x 500,000 = $713,475

c. $.0602 x 1.10 x 100,000 = $6,622

d. $.0069 x .8 x 150,000,000 = $828,000

e. $.5515 x 2.00 x 825,000 = $909,975

4. According to purchasing power parity, if the same good is sold in more than one country, the price of the good will be the same in all of the countries. Purchasing power parity does not hold perfectly in the real world because goods, information costs, transportation costs, and tariffs are not identical.

5. P = EP^F (P = domestic price level E = units of domestic currency per unit of foreign currency P^F = foreign price level). When domestic prices rise above foreign prices, the domestic currency depreciates (the units of domestic currency required per unit of foreign currency increase), thereby effectively equalizing domestic and foreign prices.

6. Domestic interest rate = foreign interest rate + expected change in the exchange rate. For bonds with the same risk and maturity but denoted in different currencies, arbitrage in financial markets should equalize interest rates adjusted for expected exchange rate changes.

7. a. When an expansionary fiscal policy is financed by borrowing, domestic interest rates increase relative to foreign rates. The higher domestic interest rates lead to an appreciation of the domestic currency relative to the long-run equilibrium exchange rate. Because it is expected that the domestic currency will depreciate in the future, the higher domestic interest rates are offset by the expected depreciation of the exchange rate.
b. When the expansionary fiscal policy is financed through money creation, the expected rate of inflation increases, thereby leading to higher nominal interest rates. Interest rate parity holds because higher expected inflation corresponds to an expected depreciation in the exchange rate.

8. Recall the interest rate parity equation:

Domestic currency return = foreign interest rate + expected change in the exchange rate Rearranging the equation shows the expected change in the exchange rate as a function of the difference between the domestic and foreign interest rate:

Expected change in the exchange rate = domestic currency return - foreign interest rate Using the data given in the question:
Expected change in the exchange rate = 8% - 5% = 3% If interest rate parity holds, the German mark is expected to appreciate by 3%.

9. Because the U.S. inflation rate was five percentage points greater than the Japanese inflation rate, we expect the dollar to depreciate by 5 percent to 95 yen to the dollar. That the exchange rate is instead $1 = 110 means that the dollar is overvalued according to PPP.

10. Because Italian prices rose 8 times more than U.S. prices, the dollar should have appreciated 8 times relative to the lira. Hence, in 1987 the purchasing power parity value of the dollar was $1 = 4,960 lire.

11. With no restrictions on transactions, people will buy more computers where the price is lower and resell them where the price is higher until the prices adjust to differ only by the cost of the activity (like shipping costs).

12. U.S. consumers of German produced goods will be made worse off while those who produce or whose living depends on goods exported to Germany will be made better off.

13. C$6.25

14. FF4 = DM1

15. $4,400

Answers to Study Guide Homework

1. Purchasing power parity (PPP)

2. Goods are not identical in different countries, information is costly, shipping costs affect prices, tariffs and other restrictions affect prices

3. French franc will depreciate 7% per year against the dollar.

4. Happy. The Mercedes would have cost you $65,000 at the old exchange rate; now it only costs you $60,000.

5. a. $63.60 (40 x 1.59 $ per )
b. Arbitrage. $728. The 20 sweaters will sell for $2,000 but will cost only $1,272.
c. 180 = $286.20, so you still have $441.80 in potential profit.
d. $1.80

Answers to Internet Exercise

The purpose of this exercise is to expose students to the OECD, an association of industrial countries. The OECD web site will provide students with background information on the organization and its member countries. Be sure to stress the goals of the organization along with the diversity of its members. You may also wish to compare and contrast the OECD with the IMF and the World Bank.

The OECD was founded in 1961.

Countries of Europe and North America were original members, including Austria, Canada, Greece, Ireland, Sweden, United Kingdom, France, Italy, Luxembourg, the Netherlands, Portugal, Switzerland, United States, Belgium, Denmark, Germany, Iceland, Norway, Spain, and Turkey.

Poland and Hungary joined in 1996. Korea is currently awaiting ratification as a member.

The goals of the OECD are to attain the highest sustainable rate of growth while maintaining financial stability, to promote free trade, and to support development in non-OECD countries.

The OECD is located in Paris.