Purchasing Power Parity and Balance of Payments
1. Define the nominal exchange rate of Mexico with respect to the US.
2. One dollar currently buys 3 pounds on the foreign exchange market. In a week’s time it is expected to buy 5 pounds. Is the dollar expected to appreciate or depreciate with respect to the pound? Answer the same question assuming that the dollar is expected to buy 1 pound in a week’s time.
3. The price of a loaf of bread is $1 in the United States, whereas it is 2 pounds in England. The prevailing exchange rate between the dollar and the pound is $1 for 4 pounds. Is this a sustainable exchange rate? If not, describe the changes that will bring the exchange rate to equilibrium.
4. Answer question 6 with the assumption that the exchange rate is $1 for 1 pound.
5. Provide a brief explanation of the purchasing power parity theory of exchange rates. Also state it utilizing the concept of the real exchange rate of a country.
6. Distinguish between the current/trade account and the capital/financial account in a nation’s BOP. Explain the following terms – trade deficit, trade surplus, capital account deficit, capital account surplus.
7. Assume a nation’s BOP has a trade and a capital account. When can this nation’s BOP be said to be in equilibrium?
8. Assume a nation runs a current account deficit and a capital account surplus that is smaller than this deficit. What steps is the central bank of the country taking to make this scenario possible?
9. Assume a nation runs a current account surplus and a capital account deficit that is smaller than this surplus. What steps is the central bank of the country taking to make this scenario possible?
10. Utilizing the concept of the trade deficit, derive the supply curve of pesos in the peso-dollar market. Draw and label a graph depicting this curve.
11. State the interest parity condition. Provide a brief explanation of the reasoning behind it.
12. Utilize the concepts of the current account surplus and the interest parity condition to derive the demand curve for pesos in the peso-dollar market. Draw and label a graph depicting this curve.
13. Assume the prevailing floating exchange rate is above the rate that ensures equilibrium in the peso-dollar market. Explain the process via which the rate will fall to equilibrium.
14. Assume the prevailing floating nominal exchange rate is below the rate that ensures equilibrium in the peso-dollar market. Explain the process via which the rate will rise to equilibrium.
15. Assume the prevailing exchange rate in a fixed exchange rate regime is fixed above equilibrium (undervalued). Explain the steps the central bank of the country is taking to make this a possible scenario.
16. Assume the prevailing exchange rate in a fixed exchange rate regime is fixed below equilibrium (overvalued). Explain the steps the central bank of the country is taking to make this a possible scenario.
……………….Answer Preview………….
The nominal exchange rate between Mexico and the US is an important statistical variable used to harmonize international economic relations.
The exchange rate has been a key element to determine economic stability among different countries however, overvaluation of the peso in regard to the dollar and its value brings about an imbalance in accounting process.
Initial economic valuation deters that overvaluation………………..
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