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Question 1

Assume that you hold most of your wealth in pounds, but you are interested in diversifying your portfolio into either yen or euro-denominated assets. The pound exchange rates of the euro and the yen are equally variable; however, the yen tends to depreciate against the pound when the rest of your portfolio has high returns, while the euro tends to appreciate in the same circumstances. As a UK resident, which currency, the euro or the yen, would you consider riskier? Explain.
Do you think that pound deposits may have liquidity characteristics different from those of emerging market deposits? If so, how would the differences affect the interest differential between, say, pound and Algerian dinar deposits?
How would the dinar/pound exchange rate likely change if the liquidity characteristics of dinar deposits unexpectedly improve substantially?
Explain why many hedge funds have historically chosen to borrow money in the Japanese yen and invest it in Australian and New Zealand dollars. Provide a numerical example of how this trading strategy might be profitable. Which parity condition needs to be violated for this strategy to be profitable?

Question 2

Is an exchange rate likely to overshoot in the monetary model? Explain why or why not.
Use the monetary model to explain the likely effect on the exchange rate of an increase in domestic output.
Discuss the empirical evidence on three parity conditions. Quickly outline each of the three parity conditions chosen and discuss which are (un)likely to hold in reality; outline some of the real-world implications of deviations away from these parity conditions.

Question 3

On November 10, 2020, Weizhen Tan from CNBC reported on the US: “As rates go lower, that affects the US dollar because investors may flee dollar-denominated assets – which generate lower yields” “An increasingly bearish picture is unfolding for the US dollar … on signs that Fed money printing rather than government spending may be deployed to bolster the economy”

For each of the two quotes, explain and show graphically how the author arrived at their conclusion.
Explain how the choice of policy to stimulate the economy will impact on the current account.
The stimulus referred to above is in response to the COVID epidemic. Discuss why the AA-DD model would prescribe a fiscal stimulus as more effective than a monetary stimulus in this case.
Discuss why the US may have decided to opt for a monetary response, even though, based on the AA-DD model a fiscal stimulus would be more desirable.

Question 4

Many oil-producing countries choose to peg their currencies against the dollar. Give an explanation for this policy choice.
Following on to question (a); explain the notion of the Trilemma and how an oil-producing country with a currency pegged against the dollar can resolve this Trilemma.
Which main tools have a central bank at its disposal to defend a fixed exchange rate? Explain your answer.
Show diagrammatically what the likely economic effects are of a devaluation of the currency in the short run and long run. Explain how the adjustment works.
Discuss what is likely to happen to a fixed exchange rate if the central bank continues to grow the supply of money at a higher rate than the country to which the currency is pegged.

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