QUIZ #1 : [TOPIC 1] 0101 – 0102, More on Forward Rates

Q1. Suppose the euro/franc (E€/f) exchange rate is 4, and the dollar/franc exchange rate (E$/f) is
2, what is the dollar/euro rate (E$/€)?
(a) 2 (b) 4 (c) 0.5 (d) 0.25 (e) none of a – d

▣ [Q2-Q5] Choose the closest answer for each question, if necessary.

• Consider a Dutch investor with 2,000 euros to place in a bank deposit in either the Netherlands
or the UK.
• The (one-year) interest rate on bank deposits is 10% in the Netherlands, and 1% in the UK.
• The (one-year) forward euro-pound exchange rate is 1.5€/£ and the spot rate is 1.25€/£.

2. What is the euro-denominated total return on Dutch deposits for this investor?
a) 2050 b) 2100 c) 2150 d) 2200

3. If this investor uses forward cover, what is the riskless euro-denominated total return
(calculated in its exact form) on British deposits?
a) 2375 b) 2400 c) 2425 d) 2500

4. In the situation described above, ______ being violated.

(a) covered interest rate parity is (b) real interest rate parity is

(c) law of one price is (d) no arbitrage condition is e) two of a- d are

5. If the UIP condition (in its exact form) is applied to the situation above, what is the expected
depreciation of the euro (against the pound) over a one-year period?
a) 10% b) 9% c) 8% d) 7% e) 6%
Q6. [Use the approximate formula discussed in the lecture] Consider the Republic of
Hufsanistan, whose currency is ‘thaler’ and its trade partners are Austria, Britain, and Chile. Trade
shares and exchange rates for these three countries are as follows:

Country (currency) Share of Trade Thaler per FX in 2019 Thaler per FX in 2020

Albania (euro) 50% 10 9

Britain (pound) 25% 20 22

Chile (peso) 25% 5 6

Between 2019 and 2020, how did the value of Hufsanistan thaler changed against the basket of
the three currencies?
a) depreciation by 5% b) appreciation by 5%
c) depreciation by 2.5% d) appreciation by 2.5% e) none of a - d

[Q7-Q9] Consider the following situation where:

i) Both the UIP and CIP conditions hold in their APPROXIMATE forms.
ii) Domestic interest rate: iH =10%.
iii) Spot exchange rate EH/F is 100.
iv) Forward premium (with 1-year maturity) is 5%.

Q7. What is the expected rate of deprecation for domestic currency?

Q8. For the above situation to correspond to an “equilibrium”, foreign interest rate iF should
be ___.

Q9. In view of the answer to Q8 above, how can you justify the interest rate differential
between home and abroad?
 QUIZ #2: [TOPIC 2] 0201 - 0202

Q1. If a pound of coffee costs 50 pesos in Mexico City and 10 pesos = 40 rupees, then the same
pound of coffee should cost ______ rupees in New Delhi, under the law of one price.
a) 125 b) 150 c) 175 d) 200 e) 225

[Q2-Q3: Use the following information:

- the price of Big Mac Meal is $5.90 and 5900 Won in the US (= Foreign country) and
Korea (= Home country), respectively.
- the market exchange rate between USD ($) and Korean Won (₩), denoted EW/$ , is 1350.

2. Using the prices of Big Mac in the two countries, calculate the PPP exchange rate (i.e., the
‘hypothetical’ exchange rate at which the price of Big Mac Meal would be equalized between
the two countries).

3. Given the answer to Q2 above, Korean won is (under- or over- ?)_____valued by ____%.
a) under, 25% b) over, 25%
c) under, 30% d) over, 30% e) none of a- d

Q4. [Assume the “simple” money demand as discussed in the class] Suppose that money
supply growth is 2% higher in Japan than in the US, and that output growth is 2% higher in
Japan than in the US. According to the "Monetary Approach" to exchange rates, the exchange
rate (dollar/yen) will ____.
(a) rise by 4% (b) fall by 4%
(c) rise by 2% (d) rise by 2% (e) none of a) – d)

[Q5-Q6] Suppose British pound is pegged to euro. If European output growth is 10% higher
than British output:

5. the European money supply growth is ________ than British money supply growth, …
(a) 5% higher (b) 5% lower
(c) 10% higher (d) 10% lower (e) none of a) – d)
6. … and inflation in Britain is ____________ in Europe.
(a) 5% higher than (b) 5% lower than
(c) 10% higher than (d) 10% lower than (e) none of a) - d)

[Q7-Q9: Convergence to PPP rates] Suppose the following:

∙ Currently, PKOR = 1000(\), PUS = 1300($), EKOR/US = 1.

∙ The rule of thumb holds for the speed of convergence, i.e., the PPP deviations die out at a

rate of about 15% per year.

∙ The expected rates of inflation during one year to come are: πKOR = 3% and πUS = 1%.

7. The real exchange rate qKOR/US is currently _____.

8. According to the rule of thumb above, the REAL exchange rate qKOR/US is expected to

(appreciate or depreciate?)_____ by ______ %

a) depreciate, 3.5% b) appreciate, 3.5%

c) depreciate, 4.5% d) appreciate, 4.5% e) none of a- d are even close.

9. Given all information above, the NOMINAL exchange rate EKOR/US is expected to (appreciate

or depreciate?)_____ by ______ %.

a) depreciate, 1.5% b) appreciate, 1.5%

c) depreciate, 2.5% d) appreciate, 2.5% e) none of a- d are even close.

 QUIZ #3 : [TOPIC 2] 0203, [TOPIC 3] 0301a - 0302a

▣ [Q1-Q4] Use the following assumption for a LR model of ERs.

∙ PPP and UIP hold.

∙ Suppose:

- Money demand in the home country (=Korea): 𝑀 = (1/𝑖 )𝑃 𝑌

- in the foreign country (= US), price level PUS is fixed at 1 and nominal interest rate 𝑖

is fixed at 0.05.

- there are NO changes in any of the foreign variables.

- the home real income 𝑌 is fixed at 10.

- Up until period T, the home money supply (𝑀 ) has been increasing at the rate of 0.15.

- Exactly at T, the home money supply 𝑀 is 100.

- Starting from period T, the Bank of Korea begins to increase money supply faster, i.e.,

at the rate of 0.2. Refer to the figure below:

1. The home nominal interest rate 𝑖 has been ____ until period T (i.e., until right before the

policy change).

(a) 0.1 (b) 0.15 (c) 0.2 (d) none of the above

2. After time T, the (new) home interest rate 𝑖 is _______.

(a) 0.1 (b) 0.15 (c) 0.2 (d) none of the above
3. At the very moment T, the home price level PK changes from ____ to ______.

(a) 1, 1.5 (b) 1, 2 (c) 2, 2.5 (d) none of a) – c)

4. At the very moment T, the home currency instantaneously _________ by _______ relative to the

foreign currency.

(a) appreciates, 25% (b) depreciates, 25% (c) appreciates, 20% (d) depreciates, 20%

[Q5- Q6: The following Qs are about the SR approach to ER determination. Use the UIP

condition in its approximate form, if needed.] Suppose that the U.S. interest rate is 6%, the

European interest rate is 4%, and the future expected exchange rate Ee$/€ in 1 year is $1.5.

5. [Choose the closest one] If the spot rate E$/€ is $1.45, then the expected return on euro

deposits (measured in terms of the US dollar) is:

A) 7.5% B) 7%

C) 6.5% D) 6%

6. [Choose the closest one] At what level of the spot rate will the returns from investing in the

United States and Europe be equalized?

A) $1.35 B) $1.40

C) $1.45 D) $1.5

Q7. According to the UIP equation, how will the spot rate E$/€ change if the interest rate on

euro deposits falls (while all other things are held constant)?

A) the spot rate to purchase euros would rise (dollar depreciation).

B) the spot rate to purchase euros would fall (dollar appreciation).

C) the spot rate to purchase euros would be unchanged.

D) the U.S. Federal Reserve would have to raise U.S. short-term interest rates.

E) Two of A – D
[Q8-Q9: True/False] Suppose that a sudden and exogenous decrease in money demand occurs

in the home country. Other things held constant:

Q8: In the home money market, the interest rate will rise.

Q9: In the FX market, the home currency will appreciate

Q10. Given expectations EeH/F of future exchange rates, when foreign returns (FR) are greater

than domestic returns (DR), investors will ____ domestic assets, _____ domestic currency, ____

foreign currency, and _____ foreign assets.

A) sell; sell; buy; buy B) sell; buy; sell; buy

C) buy; sell; buy; sell D) buy; buy; sell; sell E) sell; buy; buy;

[Q11-Q16] These Qs are intended for you to grasp when to apply the LR model of ERs
(from TOPIC 2) and the SR one (from TOPIC 3).

Refer to the following situation in Hufsanistan (=home country), where:

∙ Home central bank has kept money supply constant until the moment T

∙ From the moment “T” on, it starts to

increase money supply at the rate of,
say, 5% per year forever.

∙ Money demand is of the form 𝑀⬚ = L(i)PY, where i↑ → L(i) ↓

∙ All variables in the foreign country (=the US) are invariant, and so is YH.

Now you are asked to examine how (P, EH/US, i) will change during the periods “SHORTLY AFTER”.
Consider the two cases below, and answer the Qs for each case with True or False.

∙ [Case 1] The change in the policy stance and its eventual consequences for P and π are FULLY
understood by the public right away.
∙ [Case 2] The change in the policy stance is INCORRECTLY deemed as temporary, i.e., people
of Hufsanistan mistakenly think that home M supply will soon revert to the “flat” level of the old
days soon.

11. [Case 1] During the periods “SHORTLY AFTER”, P will be rising at the rate of 5%.

12. [Case 1] During the periods “SHORTLY AFTER”, E will be rising at the rate of 5%.

13. [Case 1] During the periods “SHORTLY AFTER”, the home nominal interest rate is higher than
what prevailed in the old days (when M supply was invariant).

14. [Case 2] During periods “SHORTLY AFTER”, the expected exchange rate 𝐸 / will rise.

15. [Case 2] During the periods “SHORTLY AFTER”, the home nominal interest rate will be higher
than what prevailed in the old days (when M supply was invariant).

16. [Case 2] During the periods “SHORTLY AFTER”, EH/US will be falling.

Voluntary PQs for MID1: 0302 - 0303

[PART A: Policy analysis (0302)]

Q1. Assume sticky prices and given expectations of future exchange rates. Following a temporary

decrease in the quantity of U.S. dollars (=domestic currency), what is the short-run effect on the

exchange rate E$/€ and on domestic and foreign rates of return?

A) Rates of return on domestic and foreign assets diverge as the dollar appreciates.

B) Domestic and foreign rates of return both fall as the dollar depreciates.

C) Domestic and foreign rates of return converge as the dollar depreciation lowers returns for

U.S. investors who purchase euro-based assets.

D) Rates of return on dollar assets rise causing investors to switch into U.S. assets and,

therefore, the U.S. dollar appreciates against the euro.

E) Two of A – D
Q2. Suppose that the exchange rate (EH/F) has risen a lot abruptly and then is gradually falling
back to its original level. Which of the following can cause a situation like this?

a) the expected future exchange rate (EH/Fe) has permanently risen.

b) the expected future exchange rate (EH/Fe) has temporarily fallen.
c) the home money supply has temporarily fallen.
d) the foreign money supply has temporarily risen.
e) none of a)- d)

[PART B: Taken from Feenstra & Taylor. Answers are provided in the back]

Use the FX and money market diagrams to answer the following questions. This question
considers the relationship between Swedish kronor (SK) and Danish krone (DK). Let the
exchange rate be defined as ESK/DK, measuring Swedish kronor (=HC) per Danish krone (=FC),
On all graphs, label the initial equilibrium point A. Suppose that there is an economic boom in
Sweden, leading to an increase in real income (Y) and therefore in money demand. As
discussed in the class, money demand has the form MD/P=L(i)Y.

a. Assume this change in real money demand is temporary (and people correctly understand
that). Using the FX and money market diagrams, illustrate how this change affects the money
and FX markets. Label your short-run equilibrium point B and your (new) long-run equilibrium
point C.

b. Assume this change in real money demand and income is permanent (and people correctly
understand that). Using a new set of diagrams, illustrate how this change affects the money
and FX markets. Label your short-run equilibrium point B and your new long-run equilibrium
point C.

c. Illustrate how each of the following variables changes over time in response to a permanent
increase in real money demand: nominal money supply MS, price level PS, real money supply
MS/PS, Swedish interest rate iSK, and the exchange rate ESK/DK.
[PART C: A numerical version of the previous set of Qs. Answers are provided in the back]

[Initial LR situation]
• The monetary side of the home (=Sweden) and foreign country (=Denmark) is as follows:

Money supply: MH = MF = 1000,

Real M demand: 𝑀 /𝑃 = 𝑌 , 𝑀 /𝑃 = 𝑌

• Prices are fixed int SR but fully flexible in the LR.

• Both UIP and CIP conditions hold.

• Real income has been constant at 500 both home and abroad (i.e., YH1 = YF = 500).

• The world real interest rate r* is 0.5 (This is NOT in %, so use it as it is.)

• Both the home and foreign countries have been in their respective initial LR eq’m

corresponding to the situation described above.

• Now suppose that, at the moment T, there is an economic boom in Sweden, leading to an

increase in real income from YH1 = 500 to YH2 = 1000 and therefore in its money demand.

Q0: Find the values of the relevant variables in the initial LR eq’m (A), before the increase in
Swedish real income.

[TABLE 0]

𝑃 𝑖 𝑃 𝑖 E1
A=OLD LR

Q1. Assume this change in real money demand is temporary (and people correctly understand
that). Using the FX and money market diagrams, illustrate how this change affects the money
and FX markets. Label your short-run (i.e., home price is fixed) equilibrium point B and your
long-run equilibrium point C. Also, find the values of the relevant variables at B and C.

Q2. Assume this change in real income and money demand is permanent (and people
correctly understand that). Using a new set of diagrams, illustrate how this change affects the
money and FX markets. Label your short-run equilibrium point B and your (new) long-run
equilibrium point C. Also, find the values of the relevant variables at B and C.

Q2-add. Assume this change in real income and money demand is permanent (and people
correctly understand that). Using a new set of diagrams, illustrate how this change affects the
money and FX markets at T+1, where the home price level is 𝑃 , halfway between the initial
𝑃 and the new LR level 𝑃 . Label your short-run equilibrium point B’ and find the values
of the relevant variables at B’.

Q3. Illustrate how each of the following variables changes over time in response to a
permanent increase in real money demand: nominal money supply MS, price level PS, real
money supply MS/PS, Swedish interest rate iSK, and the exchange rate ESK/DK.

[FIGURE 3]
[PART D: Additional Numerical Qs]

[Q1-Q5] Assume the following, and use the “complete SR+LR” model to examine how the
exchange rate 𝑬⬚
₩/€ moves over time.

i) prices are fixed in the SR and fully flexible in the LR.

ii) both UIP and CIP hold.

iii) real income is constant: 𝑌 =𝑌 = 10, and the world real interest rate r* is 0.1

iv) Korea (=home) and the Eurozone(=abroad) are currently in initial LR eq’m where:
𝑀 =𝑀 = 100
1 1
𝑀 = 𝑃 𝑌 , 𝑀 = 𝑃 𝑌
𝑖 𝑖
v) At period T, there is a one-time permanent increase in the home nominal money supply
(i.e., 𝑀 ↑ 𝑀 = 200)

1. What is 𝐸₩/€ in the initial LR eq’m (before the policy change)?

2. The new LR exchange rate 𝐸₩/€ after the policy change is _____.

3. Suppose people correctly understand that the increase in 𝑀⬚ is permanent. What is the
spot exchange rate 𝐸₩/€
⬚
at period T (i.e., right after the home M supply has increased but the
home price level is still fixed)?

4. Again, suppose people correctly understand that the increase in 𝑀⬚ is permanent. Further
suppose that the home price level at T+1 is halfway toward the new LR level. What is the spot
exchange rate 𝐸₩/€
⬚
at period T+1?

5. Now suppose people incorrectly think that the increase in 𝑀⬚ is temporary. What is the
spot exchange rate 𝐸₩/€
⬚
at period T (i.e., right after the home M supply has increased but the
home price level is still fixed)?
 Practice Quiz #1: ANS

[PART A]

1. D) Rates of return on dollar assets rise causing investors to switch into U.S. assets and,

therefore, the U.S. dollar appreciates against the euro.

2. E)

A): E rises, but never falls back to its original level. Actually, it goes all the way up to the new

higher Ee.

[PART B]
a.

b. If permanent, the exogenous increase in MD leads to a lower price level in the (new) LR.
Therefore, FR1 ↓ FR2 since Ee ↓ in anticipation of PSKe ↓.
At B, PSK is still fixed at the existing level. As PSK ↓over time, real MS increases and i2SK falls to
the LR level(=r*, whatever it is).

c.

See the following diagrams. The shock occurs at time T. The transition from the short run to
the new long run occurs between T and T +k.

[PART C]

Q0.
 [TABLE 0]

𝑃 𝑖 𝑃 𝑖 E1
A=OLD LR
1 0.5 1 0.5 1

Q1.

[TABLE 1]

𝑃 𝑖 𝑃 𝑖 E2
B=NEW SR
1 1 1 0.5 2/3

[FIGURE 1]

Q2.

• In the new LR following the permanent in YSK from 500 to 1000:

- the price level in Sweden will remain at 𝑃 (whatever it is), so the actual and expected
infla. rates in the NEW LR are 0. This in turn means that the nominal int. rate in the NEW LR is
r*.

- Therefore, 𝑃 determined in the M market by:

1000/𝑃 = (1/0.5)1000 → 𝑃 = 0.5.

- Acc. to PPP, the new ER in the NEW LR will be E3 = 𝑃 /PDK = 0.5.

• In the M Market, the new SR eq’m int. rate is determined by

1000/1 = (1/iSK)1000 → 𝑖 =1.

• In anticipation of 𝑃 = 0.5 , people lower their expected future ER from 1 to 0.5.

Therefore, FR1 shifts down to FR2: r* + 1/(2E) -1 = 0.5 + 1/(2E) -1

• In the FX market, UIP determines E2 as 1/3.

[TABLE 2]

𝑃 𝑖 𝑃 𝑖 E2
B=NEW SR
1 1 1 0.5 1/3

𝑃 𝑖 𝑃 𝑖 E3
C=NEW LR
0.5 0.5 1 0.5 0.5

[FIGURE 2]

Q2-add.

At T+1, the Swedish price level is 𝑃 = 0.75, halfway from 1(=OLD LR) to 0.5(=NEW LR). Use
this in the M market eq’m condition to find 𝑖 , which in turn will be used in UIP to find ET+1.

[TABLE 2-add]

B’ = 𝑃 𝑖 𝑃 𝑖 ET+1

SR at T+1 0.75 0.75 1 0.5 2/5 or 0.4

 [Figure 2-add]

Q3. DIY

[PART D]

1. In the initial LR situation, 𝑖 = 𝑖 = 𝑟 ∗ = 0.1.

From the money market eq’m condition, 𝑃 = 𝑃 = 1. Therefore, 𝐸₩/€ = 𝑃 /𝑃 = 1.

2. After the increase 𝑀 ↑ 𝑀 (doubling up), home price level will evetually increase to 𝑃 =2.
Therefore, 𝐸₩/€ = 𝑃 /𝑃 = 2.

3. As 𝐸₩/€ increases to 2, the foreign return curve is: 𝐹𝑅 = 𝑟 ∗ + 2 /𝐸 – 1.

In the SR money market eq’m, 𝑖 = 0.05.
UIP condition: 0.05 = 0.1 + 2 /𝐸 − 1 → 𝐸₩/€ = 2.1053

4. As 𝐸₩/€ increases to 2, the foreign return curve is: 𝐹𝑅 = 𝑟 ∗ + 2 /𝐸 – 1.

In the SR money market eq’m, 𝑖 = 0.075.
UIP condition: 0.075 = 0.1 + 2 /𝐸 − 1 → 𝐸₩/€ = 2.0512.
After overshooting above E₩/€LR= 2, therefore, E₩/€ converges to E₩/€LR over time.
5. As 𝐸₩/€ remains at 1, the foreign return curve is: 𝐹𝑅 = 𝑟 ∗ + 1 /𝐸 – 1.
In the SR money market eq’m, 𝑖 = 0.05.
UIP condition: 0.05 = 0.1 + 1 /𝐸 − 1 → 𝐸₩/€ = 1.0526