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BE630 – International Finance
Class 1 –Exchange rates and Purchasing power parity
Part I
1.
(a) If the UK pound currently purchases 1.3 US dollars. How many UK pounds will
an American get for their US dollars?
(b) If the UK pound now purchases 1.4 US dollars (and keeping relative prices
constant), can the American buy more UK goods and services?
(c) Has the UK pound appreciated or depreciated?
(d) What is the percentage appreciation/depreciation of the UK currency?
2. Consider country A, trading against countries B and C. Assume national prices and
trade weights have not changed and that time t is the base year. Further assume that
60% of country A’s trade is with country B, and 40% with country C. Given the
information below, and calculating using a geometric mean, has country A become
more or less competitive?
Time t: S(B/A) = 1.5 S(C/A) = 2
Time t+1 S(B/A) = 2.1 S(C/A) = 1.9
3. The current spot rate quoted on the market between the UK and Switzerland is 1.6235
CHF/GBP. Further the rate between the UK and the US is 1.4002 USD/GBP.
a. What should be the CHF/USD exchange rate that would be indicative of an
absence of arbitrage?
b. If the exchange rate observed in the market was 1.2200 CHF/USD, and you
had 1 USD, what transactions would you engage in to take advantage of this
arbitrage opportunity? What would be your arbitrage profit?
c. How would your answer in b. change if the observed market rate was
1.1010 CHF/USD?
4. If the British government cut taxes significantly, raising the after-tax return on
investments in Great Britain. What would be the likely consequence of this tax cut
on the equilibrium value of the British pound?
Part II
5. The world comprises 2 countries (A and B), and within the economy of each
country there are the same 3 tradeable commodities (Goods 1, 2, and 3). The
following table lists the prices and consumption weights of these commodities at
times t and t+k. The prevailing exchange rates are also given for both periods.
The exchange rates given are the price of a unit of foreign currency, treating the
currency of country A as the domestic currency. This rate is XB.
a. Does the law of one price hold at time t?
b. Does the absolute PPP consistent exchange rate at time t match the rate quoted in
the market? What about time t+k?
c. Does relative PPP hold between time t and time t+k? What t+k exchange rate
does relative PPP imply?
Weights A B
Good 1 0.15 0.36
Good 2 0.3 0.32
Good 3 0.55 0.32
N.B. The consumption weights are assumed to be fixed, and do not change in response
to any price changes.
6. What is the difference between CPI and PPI price index data? Why might we expect
to see more favourable evidence of PPP using PPI data rather than CPI data in our
empirical analysis PPP?