Week 10 Deck

Question 1

What is the calculation of nominal exchange rates?

Answer 1

1. Define e as the number of units of home currency per unit of foreign currency

e = no units of home currency / one unit of foreign currency

Question 2

Why is the exchange rate important to us?

Answer 2

○ Exchange rates allow us to denominate the cost or price of a good or service in a common currency
○ Exchange rates represent a cost to firms
○ Exchange rate changes create a risk to those firms that hold assets in currencies other than sterling
- Banks and shadow banks
○ Exchange rates affect the price of exports

Question 3

Define a ‘spot rate’

Answer 3

exchange rates for currency exchanges ‘on the spot’ or when trading is executed in the presents

Question 4

Define ‘forward rates’

Answer 4

exchange rates for currency exchanges that will occur at a future (forward) date

Question 5

What is the equation for real exchange rate (Q)

Answer 5

Q = Price of foreign goods expressed in home currency / Price of home goods

Pe/P
where:
P = foreign price
P = home price

A rise in Q is a real depreciation of the home currency

Question 6

Explain the real exchange in terms of costs

Answer 6

RULC = ULC*e / ULC

Where:

ULC is the unit labour cost
RULC is the relative labour cost

Question 7

Explain the Uncovered Interest Parity (UIP) condition and draw the equation

Answer 7

The UIP condition dictates the interaction between the nominal exchange rate and the interest rate, and it can be represented as:

DIAGRAM

Where:

t = time period
I = home/domestic nominal interest rate
i* = foreign nominal interest rate
e = nominal exchange rate of home country
eE = expected nominal exchange rate of home country

Question 8

Why is the UIP condition important? (2)

Answer 8

• The link between monetary policy and the foreign exchange market
• Implies 2 stabilisation channels in an open economy

Question 9

What does the UIP condition imply? (2)

Answer 9

1. That deposits in all currencies are equally desirable assets
2. That arbitrage in the foreign exchange market is not possible

Question 10

What are the key assumptions of international financial markets? (4)

Answer 10

1. Perfect international capital mobility
2. Home country is a small open economy
3. Home households can hold two assets
   i) money: only home money
   ii) bonds
   
   • Home bonds BH: whose return is the nominal interest rate
   • Foreign Bonds BF: whose return is the foreign nominal interest rate
4. Perfect asset substitutability (PAS) between BH and BF

PAS: usually an innocuous assumption when analyzing advanced economies

Question 11

What are the other assumptions of international financial markets

Answer 11

Under PAS, BH and BF are perfect substitutes thus only two things influence the choice between them:

1. i and i*
2. view about change in e

Other assumptions of international financial markets:

• Forward looking central bank (monetary policy) and participants in the foreign exchange markets
• The exchange rate is a variable that jumps in response to arbitrage opportunities

Question 12

Draw the UIP condition for a increase in the nominal interest rate by 2.5% such that i>i* for one period

Answer 12

SEE NOTES FOR WORKED EXAMPLE