International Macroeconomics - Solution to Problem Set 2

Lecturer: Dr. Riccardo TREZZI

Teaching Assistant: Andrea TUGNOLI
14th March 2023

Exercise 1
In the first case we have πEU − πRO = −0.077.
This implies that to keep the exchange rate at the PPP level, we should expect a 7.7% appreciation of the euro.
However, over 2006 we observe on the market:
Et − Et−1 0.2735 − 0.2620
(Et − Et−1 )/Et−1 = = = 0.044 (1)
Et−1 0.2620

Consequently, according to PPP the RON is overvalued and the EUR is undervalued.

In the second case we have πEU − πRO = 0.08.

This implies that to keep the exchange rate at the PPP level, we should expect a 8% depreciation of the euro to
keep it at the PPP level. But according to (1), EUR depreciates of less than 8%. Consequently, according to PPP
the RON is undervalued and the EUR is overvalued.

Exercise 2
Answers a) is not correct as the real GDP growth in one country doesn’t vary the percentage of appreciation of
one nation’s currency. The ratio of real GDP growth between two countries influences the exchange ratio of two
countries, but only in the long run through the purchasing power channel.
b) is again not necessarily true in the short-term. In the long-rung purchasing power and exchange rate variations
should be identical, but this is not certainly true in the short-term.
c) could be either true or false, depending on the effect of population growth on economics variables.
Finally, d) is the only correct answer. The percentage appreciation in one nation’s currency is equal to the percentage
of depreciation of the foreign nation’s currency.

1
Exercise 3
The formula for the Effective Exchange Rate (EER) of a country that trades with N commercial partners is:
T rade1 T rade2 T raden
EER = E1 + E2 + ... + En
TT TT TT
The effective exchange rate is a weighted average of a basket of foreign currencies, and it can be viewed as an
overall measure of the country’s external competitiveness. An increase in a nation’s EER is an indication that its
exports are becoming more expensive and its imports are becoming cheaper. It is losing its trade competitiveness.
Consequently, the correct answer is c).

Exercise 4
Part 1.

By definition absolute real exchange rate is:

P2
q1|2 = E1|2 (1)
P1
If PPP holds, then we have q1|2 = 1. Consequently, we can rewrite (1) as:
P1
E1|2 = (2)
P2
Taking the logarithm on both sides of (2), we have:
 
P1
ln E1|2 = ln = ln P1 − ln P2 (3)
P2
Now, we apply the ∆ operator on both sides of (3):

∆ ln E1|2 = ∆ ln P1 − ∆ ln P2 (4)

We can rewrite (4) as:

ln E1|2,t − ln E1|2,t−1 = ln P1,t − ln P1,t−1 − (ln P2,t − ln P2,t−1 ) (5)

and we can rearrange (5) as:      

E1|2,t P1,t P2,t
ln = ln − ln (6)
E1|2,t−1 P1,t−1 P2,t−1
Now, you can apply the "log trick" that Riccardo has shown you in class (ln(x) ≈ x − 1) to obtain:
E1|2,t − E1|2,t−1
 
E1|2,t E1|2,t ∆E1|2,t
ln = −1= = (7)
E1|2,t−1 E1|2,t−1 E1|2,t−1 E1|2,t
 
P1,t P1,t P1,t − P1,t−1 ∆P1,t
ln = −1= = = π1 (8)
P1,t−1 P1,t−1 P1,t−1 P1,t
 
P2,t P2,t P2,t − P2,t−1 ∆P2,t
ln = −1= = = π2 (9)
P2,t−1 P2,t−1 P2,t−1 P2,t
(9) is equal to the % change of E which is the rate of depreciation of the nominal exchange rate.
Consequently, we can conclude that the relative PPP formula is:
∆E1|2,t
= π1,t − π2,t (10)
E1|2,t

2
Part 2.

Defining Switzerland as Country 1 and United Kingdom as Country 2 and inserting in (10) the values given
by the exercise, we have:
∆E1|2
= −0.5% − 1.5% = −2%
E1|2
The rate of appreciation of the CHF is 2% or the rate of depreciation of the GBP is 2%.

Exercise 5
Part 1.
As seen in the previous exercise, the formula for relative PPP is:
∆E$|€,t
= π$,t − π€,t (1)
E$|€,t

From quantity theory of money we know:

Md = L · P · Y (2)
Where:
• M d is nominal demand for money.
• L is a constant.
• P is price level.
• Y is real income (or real output). Consequently P Y is nominal income (or nominal output).
Rearranging (2) we have:
Md
P = (3)
L·Y
Following the procedure used to find relative PPP, we apply to both sides of (3) the logarithm, then the ∆ operator
and finally the "log trick". We obtain:
∆P ∆M d ∆Y
= − (4)
P Md Y
This approximation holds for small changes only. L disappears from (4) because is a constant and when we apply
the ∆ operator we subtract L from L and is equal to 0. Finally, knowing that:
∆M d
• Md
= µ is the nominal growth rate of money.

• ∆Y
Y = g is the growth rate of real output.
We can write:
π =µ−g (5)
Finally, we plug (5) into the relative PPP formula and we obtain:
∆E$|€
= µU S − gU S − (µEU − gEU ) (6)
E$|€

We have found the relationship between rate of depreciation of nominal exchange rate, nominal money growth rates
and real output growth rates.

3
 Part 2.

Using (5) we calculate inflation for the US and for EU:

πU S = 5.5% − 2.5% = 3%

πEU = 7% − 4.5% = 2.5%

To calculate the rate of depreciation, we insert the calculated values of inflation in (6):
∆E$|€
= 3% − 2.5% = 0.5%
E$|€

The rate of depreciation of the dollar is 0.5%.

Exercise 6
Part 1.

To find Fischer Effect, we need to assume that both UIP and PPP holds. UIP equation is:
e
E$|CHF
1 + i$ = (1 + iCHF ) (1)
E$|CHF

Taking the logarithm on both sides:

e  e
E$|CHF E$|CHF
  
ln(1 + i$ ) = ln (1 + iCHF ) = ln (1 + iCHF ) + ln (2)
E$|CHF E$|CHF

Using the approximations ln (1 + x) ≈ x and ln (x) ≈ x − 1 that are true as long as x is a small number close to 0,
we can rewrite (2) as:
e
E$|CHF
i$ = iCHF + −1 (3)
E$|CHF
Rearranging (3), we have:
e e
E$|CHF − E$|CHF ∆E$|CHF
i$ − iCHF = = (4)
E$|CHF E$|CHF
The formula or relative PPP is: e
∆E$|CHF
= π$e − πCHF
e
(5)
E$|CHF
Equalizing (4) and (5), we finally obtain:

i$ − iCHF = π$e − πCHF

e
(6)

that is the Fisher Equation. Rearranging it, we obtain the Fisher Effect:
e
i$ − π$e = iCHF − πCHF (7)

Fisher Effect implies that real interest rate in the US is equal to real interest rate in Switzerland:

r∗ = r$ = rCHF

Part 2.
r∗ = 1% = i$ − π$e −→ i$ = 1$ + 1.5% = 2.5%

4
 e
iCHF − πCHF = r∗ −→ iCHF = 1% + 0% = 1%

Part 3.

In any country c, we have:

πc = ic − r∗
To control inflation in the economy, the central bank has to control interest rate. Since real world interest rate is
constant and independent of central bank actions, inflation is directly proportional to domestic interest rate.

Exercise 7
We know that:
∆EHK$|$
= πHK$ − π$
EHK$|$
∆E
Fixed exchange rate implies that percentage change in exchange rate is zero: EHK$|$
HK$|$
= 0.
Consequently, we have that πHK$ = π$ . Hong Kong imports US inflation by fixing exchange rate to the US dollar.
If inflation in the US is 2.7%, then inflation in Hong Kong is 2.7%.

Exercise 8
Defining the spot exchange rate S = £$
1.50, the forward exchange rate F = $
£ 1.52, the three-month US interest
rate i$ = 2.0%, the three-month UK interest rate i£ = 1.45%, we have.

Part 1.

1 + i$ = 1.02
F
(1 + i£ ) = 1.028 ̸= 1.02
S
Hence, Interest Rate Parity (IRP) does not hold.

Part 2.

We can make arbitrage profits by following this strategy:

• Borrow $1,500,000 ; repayment will be $1,530,000.
• Buy £1,000,000 spot using $1,500,000 borrowed.
• Invest £1,000,000 at the pound interest rate of 1.45%. At maturity the value of the investment in pounds is
£1,014,500.
• Sell £1,014,500 forward for $1,542,040.
The arbitrage profit is be $12,040.

Part 3.
Following the strategy above, these are the consequences on the market:
• The dollar interest rate will rise.

5
 • The pound interest rate will fall.
• The spot exchange rate will rise.

• The forward exchange rate will fall.

These adjustments will continue until there are profit opportunities. As more operators exploit those opportunities,
the adjustments continue and arbitrage profits reduce till IRP is restored and there are no more arbitrage profit
opportunities available.