Practice problems 2 - answers
1. Answer: PPP states that the exchange rate between two countries’ currencies equals
the ratio of the countries’ price levels.
A fall in a currency’s domestic purchasing power (i.e. an increase in the domestic
price level) will be associated with a proportional currency depreciation in the foreign
exchange market and vice versa.
E$/E = PUS/PE where P is the price of a reference commodity basket.
Rearrange: PUS = (E$/E) x (PE)
Thus, PPP asserts that all countries’ price levels are equal when measured in
terms of the same currency.
2. Answer: PPP theory is a monetary approach to the exchange rate. It is a long-run
theory because it does not allow for price rigidities. It assumes that prices can adjust
right away to maintain full employment as well as PPP.
Answer: All else equal, a rise in a country’s expected inflation rate will eventually cause
an equal rise in the interest rate that deposits of its currency offer. Similarly, a fall in the
expected inflation rate will eventually cause a fall in the interest rate.
Ex: If the expected U.S. inflation were to rise permanently from Π to (Π + ΔΠ),
current dollar interest rates R$ would eventually catch up to the higher inflation, rising by
a value ΔR$ = ΔΠ in accordance with the Monetary Approach that in the long run purely
monetary developments should have no effect on an economy’s relative prices since the
real rate of return on dollar assets would remain unchanged.
4. Answer: The real exchange rate between two countries is a broad summary measure of
the prices of one country’s goods and services relative to the other’s. PPP predicts that
the real exchange rate never permanently changes, which is different from nominal
exchange rates that deal with the relative price of two currencies.
5. Answer: The chain of events leading to exchange rate determination:
The spot exchange rate is equal to the real exchange rate times the ratio of U.S. to
European price levels.
Increase in U.S. money supply: The price level in the U.S. rises in proportion to the
money supply; the real exchange rate remains the same. All dollar prices will rise
(including the dollar price of the euro).
Increase in growth rate of U.S. money supply: The inflation rate, dollar interest rate,
price level in the U.S., and spot exchange rate rise in proportion to the increase in the
price level in the U.S.
Increase in world relative demand for U.S. products: E falls, and q does as well.
Increase in relative U.S. output supply: The dollar depreciates, lowering the relative
price of U.S. output. The real exchange rate rises; the effect on E is not clear since the
real exchange rate and the price level in the U.S. work in opposite directions.
a) Nigeria suffers a depreciation of its real exchange rate as the price of non-traded
goods in Nigeria falls with its fall in income.
b) There will be no effect, at least in the long run, of this purely monetary change.
In the short run, we would see a nominal and real depreciation. As prices adjust,
the real exchange rate returns to its original level.
7. A rise in the expected future rate of the real dollar/euro depreciation causes the
long-run exchange rate to depreciate. An increase in the expected rate of
depreciation of the real exchange rate increases the domestic nominal interest
rates, all else equal, as shown by the relationship between interest rate differences,
expected inflation differences and the expected change in the real exchange rate.
An increase in the domestic nominal interest rate causes excess money supply.
The money market is brought back into equilibrium through an erosion of real
balances due to an increase in the price level. By PPP, an increase in the price
level causes a depreciation of the currency.
8. Answer: The figure below shows the phenomenon of overshooting. A permanent
increase in the money supply starting from full employment equilibrium will shift the AA
curve to the right from AA1 to AA2. Now, a steadily increasing price level shifts the AA
and the DD schedules to the left until a new long-run equilibrium is reached. Note that
point 3 is above point 1, because Ee is permanently higher after a permanent increase in
the money supply. The expected exchange rate, Ee , has risen by the same percentage as
Ms. Notice that along the adjustment path between the initial short-run equilibrium (point
2) and the long-run equilibrium (point 3) the domestic currency actually appreciates
(from E2 to E3) following its initial sharp depreciation (from E1 to E2). This exchange
rate behavior is an example of overshooting, in which the exchange rate’s initial response
to some change is greater than its long-run response.
a) In this case the AA schedule is vertical and the DD schedule retains its former
b) A temporary increase in the money supply has a larger effect on the exchange rate
and on output when we assume that the exchange rate always equals its long-run level.
c) A temporary increase in the government spending has no effect on output, and a
larger effect on the exchange rate when we assume that the future exchange rate always
equal its long run level.
10. a) By interest parity logic, raising the interest rate should bring money back into
country causing the exchange rate to appreciate, or at least counterbalance the attack.
b) The act of raising the interest rate may make some investors feel the cost of policies
necessary to maintain a fixed exchange rate are too high and that the government will be
unable to maintain them. These costs could be due to high government debt that becomes
more expensive when rates go up, or due to high unemployment which may get worse
due to monetary tightening. These costs may lead some domestic constituencies to call
for a devaluation, further raising investors’ concerns.
c) Yes. Even if the fixed rate was originally sensible, if the costs of defending the attack
weakens the government to the point that it no longer looks able to maintain the current
exchange rate, then investors who originally thought the rate was sensible may now feel
that a change in the exchange rate is necessary. For example, the costs of high interest
payments during the time of the attack may take the government more likely to raise the
money supply growth rate and thus make more investors inclined to attack the currency
even if they would not have done so before the initial attack.
11. A contraction of the German money supply shifts the interest parity curve out. British
monetary authorities would be forced to contract their money supply in response to
maintain the fixed Pound/DM exchange rate.
12. For example, we may find the following (only the direction of change, not the actual
amounts, can be inferred from the question). The Fed decreases its holdings of dollar
assets and increases its euro holdings thus increasing the public’s supply of dollar assets
and decreasing its holdings of euro assets.
Balance Sheet of the ECB Balance Sheet of the ECB
Before intervention After intervention
Assets Liabilities Assets Liabilities
Domestic 2000 bill. 2800 bill. Domestic 2300 bill. 2800 bill.
Foreign 800 bill. Foreign 500 bill.
•Sterilized foreign exchange intervention – policy by which central banks carry out
equal foreign and domestic asset transactions in opposite directions to nullify the impact
of foreign exchange operations on domestic money supply.
•Example: Bank of Pecunia sells $100 in foreign assets, receives $100 check from
PecuniaCorp. Central foreign assets and liabilities decline simultaneously by $100; fall in
•To negate effect on money supply, central bank buys $100 of domestic assets. This
increases its domestic assets and its liabilities by $100, offsetting the money supply effect
of sale of foreign assets.
14. Answer: Under floating, by purchasing domestic assets the central bank causes an
initial excess supply of domestic money that simultaneously pushed the domestic interest
rate downward and weakens the currency. However, under fixed exchange rate the
central bank will resist any tendency of the currency to depreciate by selling foreign
assets for domestic money and so removing the initial excess supply of money its policy
move has caused.
Answer: 1. Allow the government to fight domestic unemployment despite the
lack of effective monetary policy.
2. Improve the current account.
3. Increase foreign reserves held by the central bank.
16. Answer: The fixed exchange rate DD – AA model requires the assumption that
E = E0 . This shows that the economy’s short-run equilibrium is at point 1 when the
central bank fixes the exchange rate at the level C. Output equals Y1 at point 1 and the
money supply is at the level where a domestic interest rate equal to the foreign rate (R*)
clears the domestic market.
To Increase Output: Hoping to increase output to Y2, the central bank increases the
money supply through the purchase of domestic assets and shifting AA1 to AA2. Because
the exchange rate is fixed, the central bank must maintain E0, it has to sell foreign assets
for domestic currency, thereby decreasing the money supply immediately and returning
AA2 back to AA1. Output is unchanged as the initial equilibrium is maintained.
17. Answer: An expansionary fiscal policy shifts the DD curve to the right. Under
flexible exchange rate, point 2 in the figure is the equilibrium, e decreases (appreciates)
and Y goes up. The picture is more complicated under fixed exchange rate, however,
since E cannot change. Output is going up as a result of the fiscal expansion, and thus the
demand for domestic money increases. To prevent the increased money demand from
increase domestic interest rate above R*, and with the appreciation of the currency, the
central bank must buy foreign assets with domestic money and thereby increase the
money supply. The AA shifts to the right until E is restored to the initial fixed exchange
rate, E0, at point 3 in the figure. So under fixed exchanger rate, Y will increase by more
than under a flexible exchange rate regime. Unlike monetary policy, fiscal policy can be
used to affect output under a fixed exchange rate. A central bank is forced to expand the
money supply through foreign exchange purchases.