NATIONAL UNIVERSITY OF SINGAPORE

Department of Economics
EC3102 Macroeconomic Analysis II
Questions and answers prepared by Ho Kong Weng
Tutorial 7
Question 1
Consider two bonds, one issued in euros in Germany and the other issued in dollars in
the United States. Both government bonds are one-year bonds, paying the face value of
the bond one year from now. The exchange rate E is now 1 dollar = 0.75 euros.
The face values and prices of the two bonds are:
Face Value Price
U.S.
$10,000
$9,615.38
Germany 10,000
9,433.96
(a) Compute the nominal interest rate on each of the bonds.
Answer: The nominal return on the U.S. bond is 10,000/(9615.38) 1 = 4%. The
nominal return on the German bond is 10,000/9433.95 1 = 6%.
(b) Compute the expected exchange rate next year consistent with the uncovered interest
parity.
Answer: The uncovered interest parity relation is given by

(1 + ) = (1 + )( )
+1

1+ i
.
1 + it
Hence, expected exchange rate = 0.75(1.06)/(1.04)=0.76442 euro/$ = 0.76 euro/$. In
other words, according to the uncovered interest parity condition, we expect the dollar
to appreciate.
Ete+1 = Et

*
t

(c) If you expect the dollar to depreciate relative to the euro, which bond should you
buy?
Answer: If you expect the dollar to depreciate (opposite to the prediction of the
uncovered interest rate parity condition), purchase the German bond, as it pays a
higher interest rate and you expect a capital gain on the currency.
(d) You are a U.S. investor. You exchange dollars for euros and purchase the German
bond. One year from now, it turns out that the exchange rate, E, is actually 0.72. What is
your realized rate of return in dollars compared to the realized rate of return you would
have made had you held the U.S. bond?

Answer: The dollar depreciates by 4% (because 0.72/0.75 = 0.96) or the euro has
appreciated by 4%, so the total return on the German bond (in $) is 6% + 4% =10%.
Investing in the U.S. bond would have produced a 4% return.
Note: An answer of 0.72/0.76 = 0.96 is incorrect. It should be 0.72/0.75 = 0.96.
Although the two answers are the same in two decimal places, the former answer or
method is incorrect. The appreciation/depreciation is with respect to the original
exchange rate.
(e) Are the differences in rates of return in (d) consistent with the uncovered interest
parity condition? Why or why not?
Answer: Tell me!
Question 2
Consider three equal-sized economies (A, B, and C) producing three goods (clothes,
cars, and computers). All consumers want to consume equal amounts on all three
goods. The value of production of each good in this world of three economies
follows:
A B C
Clothes
10 0 5
Cars
5 10 0
Computers 0 5 10
(a) What is the GDP in each economy? If the total value of GDP is consumed and
borrowing from abroad is impossible, how much will consumers in each economy
spend on each of the goods?
(b) If no economy borrows from abroad, what will be the trade balance in each
economy? What will be the pattern of trade in this world (what is exported and what
is imported in each economy)?
(c) Continue from (b). Will economy A have a zero trade balance with economy B?
With economy C? Will any economy have a zero trade balance with any other
economy?
(d) U.S. has a large overall trade deficit. Its trade deficit with China is larger than with
other countries. Suppose U.S. eliminates its overall trade deficit. Does that mean its trade
balance with every one of its trading partners will become zero? Does the especially
large trade deficit with China imply that China does not allow U.S. goods to compete on
an equal basis with Chinese goods?

Question 3
Suppose the domestic currency depreciates. Equivalently, nominal exchange rate E falls.
Assume P and P* remain constant.
(a) How does the nominal depreciation affect the relative price of domestic goods?
Consequently, what is the likely effect on the demand for domestic goods? On domestic
unemployment rate?
(b) Given the foreign price level P*, what is the price of foreign goods in terms of
domestic currency? How does a nominal depreciation affect the price of foreign goods in
terms of domestic currency? How does a nominal depreciation affect the domestic
consumer price index?
(c) If the nominal wage remains constant, how does a nominal depreciation affect the
real wage?
(d) A depreciating currency puts domestic labor on sale. Do you agree with the
statement?