Review Questions
The Open Economy
 Links go to  answers or hints. Although it is very tempting to do otherwise, you should make a serious attempt to answer a question before following the link. You will learn a lot about your mastery of the material by comparing your answer with mine. 
1. You are trying to imitate the famous currency speculator (and now philanthropist) George Soros, by undertaking a bet against the British pound. You borrow 10 billion pounds for one year from British banks at an annual rate of 8%. You convert this into dollars and buy US bonds earning an annual interest rate of 4%. British banks charge an interest rate equal to the rate of return on British Treasury securities plus 2 percentage points. (i) How much does the "market" expect the pound to depreciate by in a year's time? (ii) How much you need the pound to depreciate in order to make money? (ii) If the pound depreciates by 7 percent, how much money do you make? (iv) What makes you think you are smarter than the market?
2. Imagine that everyone at home pays a tax of t percent on interest earnings from foreign assets. How would this tax affect the interest parity condition?
3. Large scale wars often result in a suspension of trade, making exchange rates irrelevant. Assume that you are the finance minister of country A (whose currency is the peso) and, as a war is ending, you want to calculate the exchange rate that will prevail against country B's currency (the dollar) when international trade in goods, services, and assets resume. You have the following information: At the onset of the war, both countries had a common nominal interest rate of 10%. At then end of the war, country A's interest rate hasrisen to 20%, while country B's interest rate is unchanged at 10%. A year ago, the exchange rate was 100 pesos to the dollar. Since then, prices have risen 25% in country A and 15% in country B. You expect both countries to have inflation of 5% per year after the war.
Calculate the exchange rate you expect to prevail under the following circumstances: (i) You are undertaking this analysis in 1965 (i.e. before the interest parity condition was known about, so that your only guidance to determining what the exchange rate will be is the theory of PPP). (ii) You are undertaking this analysis in 2005 and can make use of both interest parity and PPP.
4. Using the IS-LM framework, compare the effect of a fall in consumer confidence on output when (i) the economy is closed to trade; (ii) the economy is open to trade and exchange rates are flexible, and (iii) the economy is open to trade and the central bank is following a fixed exchange rate policy.
5. "The only reason the US runs a trade deficit is because its people and its government don't have the willpower to save enough." Do you agree with this claim that savings and the trade deficit are linked? Explain.
6. The interest parity condition requires only that we adjust our interest rates to match world interest rates if we want to maintain fixed exchange rates, it does not require that we choose a particular level for the money supply.  So why can't we adjust the money supply to smooth out domestic macroeconomic shocks to output?