Homework # 1

Econ. 316;  Miguel D. Ramirez

1. The private demand for British pounds can be represented by the following equation:

Qd = 20 - 6e, where Qd represents the quantity demanded of pounds (in millions), and e refers to the exchange rate of the dollar against the pound. The private supply of pounds is denoted by,

Qs = 10 + 4e, where Qs is the quantity supplied of pounds (in millions).

a. Suppose the U.S. and Britain are operating under a system of flexible exchange rates. Determine the equilibrium exchange rate in the pound market. How many pounds (dollars) are being traded? Illustrate your answer via diagrams depicting the pound market.

b. Given the situation in part (a), suppose now that the Fed in the U.S. decides to intervene in the F.E.M. by selling 6 million pounds. What would be the effect of the operation in numerical terms? Explain why and illustrate your answer in the pound market.

c. Suppose that the U.S. and Britain are now operating under a system of fixed exchange rates and that the exchange rate was given at $2 per pound. What would be the U.S. Fed's gain (loss) of foreign exchange reserves, given the private supply and demand curves of part (a). (Assume that the U.S. is the country in charge of foreign exchange market intervention.)

2. Triangular arbitrage in foreign exchange markets produces consistent cross exchange rates. Suppose the exchange rate between pounds and Deutsche marks is £1 /DM5, the exchange rate between marks and dollars is $1 /DM5, and the exchange rate between pounds and dollars is $3/ £1.

a. Are these rates consistent? Why or why not?

b. If you had $100 to use in arbitraging these markets, could you make a profit (ignoring transaction costs)? If so, how and how much?

c. What would be the direction of the effect of your actions in part b on each of the three exchange rates? Why?

3. Suppose that the U.S. dollar-pound exchange rate equals $1.60, while the 1-year forward rate is $1.64 per pound. the yields on 1-year U.S. and U.K. Treasury bills are 9% and 8%, respectively. Calculate the covered interest differential, using the formula derived in class. On the basis of your results, which country would you expect to face capital outflows? Capital inflows? Illustrate your answer by making reference to the CIP line.