ECOS3029 Assignment 2. Marked out of 35 points.
1. The Monetary Approach to Exchange Rate (12 points in total. 2 points for each question)
At time = 0, the initial log values of the variables , , and are:
Table 1
Australia USA
2 2
2 4
3 4
What’s more, the continuous growth rate of real income and of the money supply are:
Table 2
Australia USA
.02 .01
.04 .02
Assume that households care about the opportunity cost of holding money, so that the demand for
real money balances in both the U.S.A. and Australia is now given by:
= 1 − 2 +
Where = ln (1 + i) is the log nominal interest rate. Prices are still fully flexible. For the values of
, , , and in Tables 1 and 2, calculate:
a) The nominal interest rate in Australia and the U.S.A. (in log terms) if the log world real
interest rate ln(1 + ∗) = 0.02 and real interest parity holds.
b) The equilibrium natural log price levels in Australia and the U.S.A. for = 0;
c) The equilibrium natural log price levels in Australia and the U.S.A. for = 1;
d) The log of the equilibrium exchange rate ,/ for = 0; and
e) The log of the equilibrium exchange rate ,/ for = 1.
f) The equilibrium natural log real money balances
in Australia and the U.S.A. for = 0;
2. (13 points) Now assume that commencing at time = 1, the Australian central bank
announces an immediate increase to the (continuous) growth rate of the money supply, so
that = 0.2 in Australia. Prices are fully flexible. Draw four graphs (including numerical values
on axes) covering the period = 0 through = 2 that show:
a) (2 points) The Australian log money supply, ; and
b) (3 points) Australian log real money balances and nominal interest rate; and
c) (2 points) The Australian log price level; and
d) (2 points) The log exchange rate ,/.
e) (4 points) Write an intuitive explanation for why there is a discrete jump in several of these
graphs.
3. Exchange Rate Parity Conditions (10 points in total. 2 points for each question.)
a) The current value of the spot exchange rate _ = 0.2028. If the Chinese inflation
rate for the coming year will be 3% while the Australian inflation rate will be 6%, what
value of the exchange rate _ 1 year from now would maintain Relative PPP?
b) Forward Premium. If _CAD = 1.733 and _CAD = 1.785 then calculate the forward
premium.
c) Assume that (i) one-year forward exchange rate _ = 1.523; (ii) the current spot
exchange rate _ = 1.575; and (iii) the one-year interest rate for GBP is 4.665%.
What must one-year USD interest rates be for Covered Interest Parity (CIP) to hold?
d) Assume that (i) the current spot exchange rate / = 5.0183; (ii) the one-
year interest rate for DKK is 3.8%; and (iii) the one-year interest rate for AUD is
2.5%. What must the current expected value of the future DKK/AUD spot exchange
rate (+1,/) be for Uncovered Interest Parity (UIP) to hold?
e) Assume that consumers consume only 2 items: Clothing; Food. In New Zealand,
clothing for 1 year is NZD 20,000 and food for 1 year is NZD 15,000. In Australia,
clothing for 1 year is AUD 40,000 and food for 1 year is AUD 15,000. If the spot
exchange rate is / = 1.616, what is the real exchange rate between
Australia and New Zealand (treat Australia as the domestic country)?