Exercise Set 6
THE INTEREST PARITY CONDITION

I. Objectives

1. To compare the returns on deposits denominated in different currencies
2. To obtain the eqbm spot exchange rate
3. To understand how the spot rate is affected by changes in interest rates and expected exchange rates

II. Data

• Input the data for the interest rates in Japan and the U.S.
• Select a value for the expected exchange rate one year hence (E^f)
• Select an amount to start with (keep it around $1000)
• Compute the eqbm spot rate. Click on Gimme Spot Rate! to confirm.

III. Questions

1. Given the following data:
   r_US = 8.5%     r_J = 3.0%     E^f = $0.0098/yen

2. Compute the equilibrium spot rate: E = ______ $/yen. Show your calculations.

3. Suppose you have $800 to invest.
   • If you invest it in dollar-denominated securities, your amount at the end of the year will $_________.

   • Suppose you convert the $800 into ____________ yen, and invest it in yen-denominated securities.

     At the end of one year, you will have an amount of _______________ yen.

     Finally, if you convert the yen into dollars using the expected future exchange rate, you will have a total of $ ______________.

   • Barring rounding errors, does the interest parity condition hold? Explain.

4. Suppose the Japanese monetary authorities raise interest rates. Ceteris paribus, this will cause [ capital inflows into / capital outflows from ] the U.S. which in turn will result in a dollar [ appreciation / depreciation ] in the spot market. The new spot exchange rate is $ ______ per yen.

5. Suppose the expected future exchange rate rises by 10%. Ceteris paribus, this will cause the spot rate to [ rise / fall ] by _____%. Noting the likely actions of investors (in what direction is capital likely to flow?), explain why the dollar depreciates in the spot market.

6. If the dollar-yen exchange rate were fixed, and capital were freely mobile, what would be the relationship between U.S. and Japanese interest rates? Explain.

7. The interest parity condition may not hold in real life. How come?

8. If the Fed raises interest rates, the likely result in the short run is [ a depreciation / an appreciation ] of the dollar. Explain. Using suitable values for interest rates and the expected exchange rate, compute the new spot rate.