# Problem Set 2 Essay

International Finance

Shrikhande

Fall 2006

SUGGESTED SOLUTIONS TO CHAPTER 4 PROBLEMS

1. From base price levels of 100 in 1987, West German and U.S. price levels in 1988 stood at 102 and 106, respectively. If the 1987 $/DM exchange rate was $0.54, what should the exchange rate be in 1988? In fact, the exchange rate in 1988 was DM 1 = $0.56. What might account for the discrepancy? (Price levels were measured using the consumer price index.)

Answer. If e1981 is the dollar value of the German mark in 1988, then according to purchasing power parity e1988/.54 = 106/102 or e1988 = $.5612. The discrepancy between the predicted rate of $.5612 and the actual rate of $.56 is insignificant and hence needs no explaining.

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a. If the current exchange rate is $1.63:,1, what is the expected future exchange rate in one year?

Answer. According to the international Fisher effect, the spot exchange rate expected in one year equals 1.63 x 1.09/1.12 = $1.5863.

b.Suppose a change in expectations regarding future U.S. inflation causes the expected future spot rate to decline to $1.52:£1. What should happen to the U.S. interest rate?

Answer. If rus is the unknown U.S. interest rate, and assuming that the British interest rate stayed at 12% (because there has been no change in expectations of British inflation), then according to the IFE, 1.52/1.63 = (1+rus)/1.12 or rus = 4.44%.

5. If expected inflation is 100% and the real required return is 5%, what will the nominal interest rate be according to the Fisher effect?

Answer. According to the Fisher effect, the relationship between the nominal interest rate, r, the real interest rate a, and the expected inflation rate, i, is 1 + r = (1 + a)(1 + i). Substituting in the numbers in the problem yields 1 + r = 1.05 x 2 = 2.1, or r = 110%.

6. Suppose that in Japan the interest rate is 8% and inflation is expected to be 3%. Meanwhile, the expected inflation rate in France is 12%, and the English interest rate is 14%. To the nearest whole number, what is the best estimate of the one-year forward exchange premium (discount) at which the pound will be