HW 4
International Economics, ECON 630
Due on Tuesday, August 11 @ 11:00pm PT
(Total 50 points)

1. You notice in The Wall Street Journal that the interest rate in the U.S. money markets is 7.5 percent and the interest rate in London is 9 percent. Would you expect the pound to be at premium or discount? Why? (15 points) The pound would be at discount. Because there is difference between US interest rate and UK interest rate. And UK interest rate is higher than US interest rate. This difference will be minimized by the difference between the current spot rate and the forward exchange rate.

2. Why is relative purchasing power parity (PPP) more likely to hold in a hyperinflationary period than in a more “normal” period of price behavior? (15 points) In a hyperinflationary period, money supplies is excess and price rises rapidly. Home currency will depreciate obviously due to rapid changes of price level. In normal period, the price level and exchange rate change slowly. In a hyperinflationary period these two change relatively in coincidence which means PPP more likely to hold of price behavior.

3. In the portfolio balance model, what effect, other things equal, will a foreign government’s budget deficit financed by issuing bonds have on the home country’s currency value and why? (Assume a flexible exchange rate.) (10 points) If a foreign government issues bond, the risk premium will increase. And the rate of return abroad will decrease. The demand of foreign currency will decrease and the demand of home currency will increase, which means that domestic residents would like to decline their holding of foreign assets. Moreover, for foreign investors, they need home currency to invest which also increase the demand of home currency.

4. In your view, what are the strengths of the portfolio balance or asset market approach as an explanation of exchange rate determination? What are the weaknesses of the approach? (10 points) In my opinion, the asset market approach takes the reality of the large influence of interest rates and expectations on exchange rates into consideration. It also explains the instability in exchange rates that it integrates financial markets with exchange rates.

For weaknesses, asset market approach may underplay the role of changes in real factors in the economy on exchange rates and the balance of payments. Because in developing countries assets markets are not developed and financial capital is not mobile enough. Some governments can control their exchange rates.