Nanyang Technological University School of Humanities and Social Sciences HE206 - INTERNATIONAL MONETARY ECONOMICS TUTORIAL 2:

Question 1 In October 1979, the US Federal Reserve announced it would pay a less active role in limiting fluctuations in dollar interest rates. With new policy put into effect, what does our analysis in Chapter 13 suggest would happen to the US dollar exchange rates against foreign currencies? Explain your answer. Question 2 STANDARD and Poor's Ratings Services stripped France of their triple-A credit ratings. S&P also downgraded Italy's credit rating by two notches to BBB+ from A, Italian news agency ANSA reported, citing government sources Herald, 14 January 2012 S&P finds Italian and French bonds to be riskier and downgrades their credit ratings. In our discussion, we assume risk to be small so we dont consider it in the model. Suppose we incorporate risk in the model by rewriting the relationship between the returns on US dollar assets and returns on euro assets as follows:
e RUS = REU + ( E$/ E$/ )/E$/ +

Where is the risk premium which is the additional return paid to holders of US assets to compensate for the higher risks of US assets relative to the euro assets. If the US assets are riskier than the euro asset, a premium is paid and risk premium is positive ( > 0) but if euro assets are riskier than US assets, then euro assets are discounted relative to the US assets so that euro bonds are discounted relative to US assets ( < 0). Hence, the expected return on euro assets (right hand side of the equation) relative to return on US assets could account for the relative riskiness of the between the euro and US assets. Given the above equation, modify Figure 14-4 to analyze what happens to the US dollareuro exchange rate after S&Ps downgrade of euro bonds (risk is discussed in Chapter 18 but the point of this exercise is to show that risk could easily be included in the asset approach to exchange rate determination).