Assignment 2 International financial market and korean economy Solution

Next, the real exchange rate is defined as follows.. Suppose the Bank of Japan allowed the money supply to grow by 2% each year, whereas the Bank of Korea chose to maintain relatively hi

Answers to Problem Set 2

(Due on October 13th, 2015)

1 Suppose that a Cadillac costs E 45,000 in Germany and that the current USD/EUR exchange rate is 0.7624 Calculate the dollar price of the Cadillac

45,000 × 0.7624 = $34,308

2 Consider the following exchange rates:

EUR/USD = 1.2500 ($/Euro)

USD/CAD = 1.1000 (CAD/$)

EUR/CAD = 1.3550 (CAD/Euro)

How could you use this information to make money in the currency markets?

EUR USD ×

USD CAD = 1.25 × 1.10 = 1.375 > 1.3550 = EUR/CAD



EUR USD ×

USD CAD ×

CAD 𝐸𝐸𝑈𝑈𝑈𝑈 =

1.375 1.3550 > 1 The above calculations tell that we can get arbitrage profits by converting 1Euro as follows

EuroCADUSDEUR

Hence, the FX markets are not in equilibrium now

3 Suppose that you took a short position on 12,500,000 Japanese Yen future (remember, a short position involves selling Yen) at a price of 104.5 Yen/$ If the spot rate on the contract's expiration date was 103.45 Yen/$, calculate your profit/loss from the futures contract

This is the case in which Yen is appreciated contrary to your anticipation Compared with the current exchange rate, you should sell yen at a cheaper price So, you will suffer loss amounting to

USD 1,214.095 = 12,500,000 × (103.45 −1 104.5)1

4 Suppose that the annualized inflation in the US is 3% while annual inflation in Europe is 1% If the current exchange rate is $1.40 per Euro, what would you expect the exchange rate to be in one year? If the exchange rate one year from now turns out to be $1.50 per Euro, what has happened to the real exchange rate?

From the UIP,

iUS= 𝑖𝑖𝐸𝐸𝐸𝐸𝑅𝑅+

𝐸𝐸 $

𝐸𝐸𝐸𝐸𝐸𝐸

𝑒𝑒 −𝐸𝐸$/𝐸𝐸𝐸𝐸𝐸𝐸

𝐸𝐸$/𝐸𝐸𝐸𝐸𝐸𝐸 0.03 = 0.01 +𝐸𝐸𝑒𝑒1.4−1.4 𝐸𝐸𝑒𝑒 = 1.428

Next, the real exchange rate is defined as follows

𝜀𝜀 =𝐸𝐸$/𝐸𝐸𝐸𝐸𝑅𝑅𝑃𝑃× 𝑃𝑃𝐸𝐸𝐸𝐸𝑅𝑅

𝐸𝐸𝑈𝑈

Rearranging the above, 𝐸𝐸$/𝐸𝐸𝐸𝐸𝑅𝑅 = 𝜀𝜀𝑃𝑃𝐸𝐸𝑈𝑈

𝑃𝑃 𝐸𝐸𝐸𝐸𝐸𝐸 So, assuming there is no change in the price levels of the two countries, the appreciation (depreciation) of the Euro (USD) exceeding the

expectation (1.50>1.40) is in line with real appreciation (real depreciation) of the Euro(USD)

relatively slow output growth (1%), whereas Korea had relatively robust output growth (6%) Suppose the Bank of Japan allowed the money supply to grow by 2% each year, whereas the Bank of Korea chose to maintain relatively high money growth of 12% per year For the following questions, use the simple monetary model (where L is constant) It will be easier to treat Korea as the home country and Japan as the foreign country.

πKor= 𝜇𝜇𝐾𝐾𝐾𝐾𝐾𝐾− 𝑔𝑔𝐾𝐾𝐾𝐾𝐾𝐾 = 12% − 6% = 6%

πJap= 𝜇𝜇𝐽𝐽𝐽𝐽𝐽𝐽− 𝑔𝑔𝐽𝐽𝐽𝐽𝐽𝐽= 2% − 1% = 1%

B What is the expected rate of depreciation in the Korean won relative to the

Japanese yen?

According to the PPP, E𝐾𝐾𝐾𝐾/𝑌𝑌𝑒𝑒𝑌𝑌 = 𝑃𝑃𝐾𝐾𝐾𝐾𝐾𝐾

𝑃𝑃 𝐽𝐽𝐽𝐽𝐽𝐽 Hence,

∆E 𝐾𝐾𝐾𝐾 𝑌𝑌𝑒𝑒𝑌𝑌

E 𝐾𝐾𝐾𝐾 𝑌𝑌𝑒𝑒𝑌𝑌

≈πKor− πJap= 6% − 1% = 5%

Hence, 5% depreciation of Korean Won is expected

in Japan changes, what is the new inflation rate in Korea? Using time series diagrams, illustrate how this increase in the money growth rate affects the money supply, Korea’s interest rate, prices, real money supply, and the exchange rate over time (Plot each variable on the vertical axis and time on the horizontal axis.)

πKor= 𝜇𝜇𝐾𝐾𝐾𝐾𝐾𝐾− 𝑔𝑔𝐾𝐾𝐾𝐾𝐾𝐾 = 15% − 6% = 9%

For diagrams, see Appendix A

What money growth rate would the Bank of Korea have to choose to keep the value

of the won fixed relative to the yen?

To keep the exchange rate constant, the Bank of Korea must lower its money growth rate We can figure out exactly which money growth rate will keep the exchange rate fixed by using the fundamental equation for the simple monetary model

πKor− πJap= (𝜇𝜇𝐾𝐾𝐾𝐾𝐾𝐾− 𝑔𝑔𝐾𝐾𝐾𝐾𝐾𝐾) − �𝜇𝜇𝐽𝐽𝐽𝐽𝐽𝐽− 𝑔𝑔𝐽𝐽𝐽𝐽𝐽𝐽� = (𝜇𝜇𝐾𝐾𝐾𝐾𝐾𝐾− 6%) − 1% = 0

𝜇𝜇𝐾𝐾𝐾𝐾𝐾𝐾 = 7%

Therefore, if the Bank of Korea sets its money growth rate to 7%, its exchange rate with Japan will remain unchanged

Korean won to appreciate relative to the Japanese yen What ranges of the money growth rate (assuming positive values) would allow the Bank of Korea to achieve this objective.

Using the same reasoning as previously, the objective is for the won to appreciate:

∆E 𝐾𝐾𝐾𝐾 𝑌𝑌𝑒𝑒𝑌𝑌

E𝐾𝐾𝐾𝐾

𝑌𝑌𝑒𝑒𝑌𝑌

< 0 This can be achieved if the Bank of Korea allows the money supply to grow by less than 7%

each year

longer assumed constant and money demand is inversely related to the nominal interest rate Consider the same scenario described in the beginning of the previous question In addition, the bank deposits in Japan pay 3% interest.

Fisher effect: iKor− iJap = πKor− πJapiKor− 3% = 6% − 1% iKor= 8%

inflation), show that the real interest rate in Korea is equal to the real interest rate in Japan (Note that the inflation rates you calculated in the previous question will apply here.)

𝑟𝑟𝐾𝐾𝐾𝐾𝐾𝐾 = iKor− πKor = 8% − 6% = 2%, 𝑟𝑟𝐽𝐽𝐽𝐽𝐽𝐽= iJap− πJap = 2% − 1% = 1%

the inflation rate rises proportionately (one for one) with this increase If the nominal interest rate in Japan remains unchanged, what happens to the interest rate paid

on Korean deposits?

We know that the inflation rate in Korea will increase to 9% We also know that the real interest rate will remain unchanged Therefore: iKor= 𝑟𝑟𝐾𝐾𝐾𝐾𝐾𝐾 + πKor = 1% + (6% + 3%) = 10%

affects the money supply, Korea’s interest rate; prices, real money supply; and the exchange rate over time (Plot each variable on the vertical axis and time on

See the Appendix for diagrams

<Appendix>

Diagrams for Q5-C

Diagrams for Q6-D