ECON102 Chapter Notes - Chapter 25: Interest Rate Parity, Purchasing Power Parity, Foreign Exchange Market

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magentaporcupine258

7 Nov 2016

School

University of Waterloo

Department

Economics

Course

ECON102

Professor

Joseph Dejuan

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ECON102 Full Course Notes

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Chapter 25 the exchange rate part 2. The exchange rate changes when it is expected to change. This change is caused by new information about the variables that in uence demand and supply in the forex market. Arbitrage is the practice of buying in one market and selling for a higher price in another market. Ex: suppose that a bank deposit earns 1% a year in tokyo and 3% in toronto. But, one year later the exchange rate is 98 yen = c, so your. Ex: suppose the exchange rate is 100 yen = c, then the 2 monies have the same value. Then, you can buy a camera in tokyo or toronto for the same price as either 10,000 yen or , but the price is the same in the 2 currencies. In this case, 100 yen = c is the ppp exchange rate.

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Problem 3

3.1. Suppose quotes for the dollar-euro exchange rate E$=e are as follows: in New York

$1.50 per euro, and in Tokyo $1.55 per euro. Describe how investors use arbitrage to take advantage of the difference in exchange rates. Explain how this process will affect the dollar price of the euro in New York and Tokyo.

3.2. What is covered interest rate parity?

3.3. What is uncovered interest rate parity?

3.4. Consider some good g that sells in the U.S. and Europe. What is the relative price of this good?

3.5. What is the law of one price, and if it holds, what should be true about the relative price of good g in (3.4)?

3.6. Consider a basket of goods in the U.S. and Europe. Given these baskets, determine the real exchange rate.

3.7. What is purchasing power parity, and if it holds, what would be true about the real exchange rate in (3.6)?

1. The "law of one price" applies to all goods, except those that:

A. Are produced only in one location.

B. Cannot be transported.

C. Are produced in a country that does not have a comparative advantage.

D. Are affected by arbitrage.

E. Are included in calculating the parity of purchasing power.

2. Which of the following would cause the U.S. demand curve for the Japanese yen to shift to the right?

A. An increase in the U.S. inflation rate compared to the rate in Japan

B. A higher real rate of interest on investments in Japan than on investments in the United States

C. The popularity of products produced in Japan increases in the United States

D. All of the above

E. None of the above

3. Which of the following might cause the U.S. dollar to depreciate against the Japanese yen?

A. Greater popularity of U.S. exports in Japan

B. An increase in the price level in Japan

C. Higher real interest rates in the United States

D. Higher incomes in the United States

E. Diminished demand for Japanese products in the United States

4. If the value of the U.S. dollar in foreign exchange markets rises:

A. U.S. exports will become relatively less expensive.

B. capital inflows into the United States will increase.

C. people in the U.S. will purchase fewer imports.

D. U.S. exports will likely decrease.

E. All of the above

bronzemammoth449

Please read the passage and answer the questions below.

During the first half of the 2000s, the Japanese yen was relatively weak against the U.S. dollar. This was a boon for Japanâs export-led economy. On January 1, 2008, it took 122 yen to buy one U.S. dollar. For the next four years, the yen strengthened relentlessly against the dollar, hitting a record high of Â¥75.31 to the dollar on October 31, 2011. The reasons for the rise of the yen were complex and had little to do with the strength of the Japanese economy because there has been very little of that in evidence. The weakness of the yen during the early to mid-2000s was due to the so-called carry trade. This financial strategy involved borrowing in Japanese yen, where interest rates were close to zero, and investing the loans in higher-yielding assets, typically U.S. Treasury bills, which carried interest rates 3 to 4 percentage points greater. Investors made profits from the interest rate differential. At its peak, financial institutions had more than a trillion dollars invested in the carry trade. Because the strategy involved selling borrowed yen to purchase dollar-denominated assets, it drove the value of the yen lower. The interest rate differential existed because the Japanese economy was weak, prices were falling, and the Bank of Japan had been lowering interest rates in an attempt to boost growth and get Japan out of a dangerous deflationary cycle. When the global financial crisis hit in 2008 and 2009, the Federal Reserve in the United States responded by injecting liquidity into battered financial markets, effectively lowering U.S. interest rates on U.S. Treasury bonds. As these fell, the interest rate differential between Japanese and U.S. assets narrowed sharply, and the carry trade became unprofitable. Financial institutions unwound their positions, selling dollar-denominated assets, and buying yen to pay back their original loans. The increased demand drove up the value of the yen. For Japanese exporters, the 40 percent increase in the value of the yen against the dollar (and the euro) between early 2008 and 2012 was a painful experience. A strong yen hurts the price competitiveness of Japanese exports and reduces the value of profits earned overseas when translated back into yen. Take Toyota as an example: In February 2012, the company stated that its profit for the year ending March 31, 2012, would be about Â¥200 billion, 51 percent lower than in the prior year. Toyota makes nearly half of the cars it sells globally at its Japanese plants, so it has been particularly hard hit by a rise in the value of the yen. In late 2012, things started to change when the pro-business Liberal Democratic Party won national elections and Shinzo Abe was appointed prime minister. Abe had campaigned on a platform that included taking actions to weaken the value of the yen to help Japanâs exporters. Even before the election, Japanâs central bank had accelerated purchases of government securities, thereby expanding the money supply, and had agreed to a higher inflation target. Under Abeâs leadership, this policy had explicit government support. One consequence of the policy was to reduce the value of the yen against other currencies. Indeed, between October 2012 and December 2013, the yen lost more than 25 percent of its value against the U.S. dollar. The yen was trading at Â¥104 to the U.S. dollar in late December 2013. While this helped Japanâs exporters, the policy was criticized by other major industrial nations as a unilateral action that came dangerously close to precipitating a currency war.

1. Who in Japan benefits from the devaluation of the yen? Who does this hurt in Japan?

2. What does this case teach you about the way foreign exchange markets work?

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ECON102 Chapter Notes - Chapter 25: Interest Rate Parity, Purchasing Power Parity, Foreign Exchange Market

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