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Final

ECON332 Study Guide - Final Guide: Financial Ratio, Foreign Exchange Market, Nominal Interest Rate


Department
Economics
Course Code
ECON332
Professor
Sharif Khan
Study Guide
Final

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U n i v e r s i t y o f W a t e r l o o
ECON 332 INTERNATIONAL FINANCE
Ingrid Liu
Chapter 13 National Income Accounting and Balance of Payments, Chapter 14 Exchange
Rates and the Foreign Exchange Market: An Asset Approach, Chapter 15 Money, Interest
Rates, and Exchange Rates, Chapter 16 Price Levels and Exchange Rate in Long Run, Chapter
17 Output and Exchange Rate in Short Run, Chapter 18 Fixed Exchange Rates and Foreign
Exchange Intervention, and Chapter 19 International Monetary Systems: An Historical
Overview
Fall
16
08
Fall

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OPTIONAL ASSIGNMENT 1
According to asset approach to exchange rate determination, other things remaining constant, an increase in UK
nominal interest rate causes US dollar to appreciate against British pound.
FALSE Increase in UK nominal interest causes US dollar to depreciate against British pound
Uncovered Interest Parity (UIRP):
R$=R£+(Ee
$/£-E$/£)/ E$/£
R$
Return to dollar deposits
R£+(Ee
$/£-E$/£)/ E$/£
Expected dollar return on pound deposits
Initially, foreign exchange rate
market is in equilibrium at
point 1.
Rise in pound interest rate
increases expected dollar
return on pound deposits.
At initial exchange rate,
expected depreciation rate of
$ is same as before rise in
Expected $ return on £
deposits now exceeds that on
$ deposits
Those holding $ deposits want
to sell for £ deposits
Return on $ is lower than £
deposits at exchange rate
no holder of £ deposit willing
to sell for $ at that rate
Creates excess supply of $ in
foreign exchange market
$ holders trade by offering better price for £ $/£ rate rises to point 2 £ becomes more expensive in terms of $
At point 2, no more excess supply of $ $ holders no longer have incentive to try to sell them for pounds since both
deposits offer equal returns
Foreign exchange market at equilibrium at point 2
In rising from point 1 to 2, equalizes expected returns of both types by reducing rate at which $ is expected to
depreciate in future making £ deposits less attractive relative to $ deposits

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According to asset approach to exchange rate determination, all else equal, a rise in expected future exchange rate
causes rise in current equilibrium exchange rate in short run.
TRUE Uncovered interest parity (UIRP) condition between US and EU:
R$=R¬+(Ee
$/¬-E$/¬)/ E$/¬
Initially, foreign exchange rate market in
equilibrium at point 1.
Rise in expected future exchange rate from 1
to 2 increases expected depreciation rate of $
increases expected $ return on € deposits
Expected $ return on € exceeds that of $
deposits -> anyone holding $ want to sell for €
No wants to buy $ at that rate excess
supply of $
$ holders offer better price for € $/
exchange rate rises towards 2, and € becomes
expensive in terms of $
At point 2, $ and offer equal returns (no
more excess supply of $)
In short run, rise in expected future exchange
rate causes rise in current equilibrium
exchange rate
Explain following transactions entering Canadian balance of payment accounts.
(I) Canadian government sells military equipment to foreign government.
Export of merchandise: credit (+) entry in current account
EX. Canadian gov’t buys cars from foreign country: debit (-) entry into current account
(II) Bank of Canada sells yen to, and buys dollars from, a Swiss bank.
Decrease in Canadian official reserve assets: credit (+) entry into financial account
Bank of Canada sells dollars to, and buys deutsche marks from, the Bundesbank
Debit (-) entry in financial account
(II) Canadian bank receives interest on loans to Brazil.
Investment income receipt from abroad: credit (+) entry into current account
Canadian bank re-invests interest earnings and buys more Brazillian bonds
Debit (-) entry in financial account
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