Chapter 14
Exchange Rates in the Short Run
This chapter uses the interest rate parity and Fisher equations as a foundation for building towards
an understanding of the relationship among key financial asset prices—exchange rates and interest rates.
The chapter focuses on the theory of uncovered interest rate parity as the basic model of short-run
exchange rate behavior.
The text includes plots or tables of exchange rates, stock indexes, and interest rates. All exhibits can be
updated from the sources cited. Data from the International Financial Statistics, published by the IMF,
can be used to compare and contrast economic variables of developing countries with those of the
1. According to equation (14.4), if the foreign interest rate falls, all other things constant, what
should happen to the price of foreign money in the short run?
2. According to equation (14.4), if expectations about the future exchange rate suddenly fall, all
other things constant, what should happen to E?
Chapter 14 Exchange Rates in the Short Run 63
3. If rp is positive in equation (14.9), then foreign assets are perceived as being more risky than
domestic counterparts. In that case, according to (14.9), what will happen to the exchange rate
if the risk premium suddenly rises? Does this make sense? Explain.
4. The one-year interest rate on Swiss francs is 5 percent, and the dollar interest rate is 8 percent.
a. If the current $/SF spot rate is $0.60 and uncovered interest rate parity holds in the market, what
would you expect the spot rate to be in 1 year?
(1.08/1.05)0.60 = $0.6171
b. Suppose U.S. policy changes and leads to an expected future spot rate of $0.63. What would you
expect the dollar interest rate to be now? (Assume no change in the Swiss interest rate.)
5. Assume the 3-month interest differential for Swiss francs minus British pounds is equal to −0.05. The
6-month interest differential is equal to −0.03. Is the British pound selling at a premium or a discount
relative to the Swiss franc? How is the expected rate of pound appreciation or depreciation changing
over time?
6. Suppose the term structure of interest rates is rising for the United States and falling for Japan. If this
is all you know, what can you say about the expected change in the yen/dollar exchange rate?
7. If two countries had identical term structures of interest rates, how would you expect the forward
premium or discount to change over time?
8. Suppose that the current price of one British pound (£) is $1.59 and three-month interest rates in
both the United Kingdom and the United States equal 3 percent. If uncovered interest rate parity
holds, what do you expect one pound will cost in three months?
64 Husted/Melvin • International Economics, Ninth Edition
$1.01 and the spot rate for the A$ is $1.00. Does covered interest rate parity hold in this case? If
not, what would arbitragers do?
10. Suppose that the three-month forward rate on the euro is $1.43 but you think that the spot price in
three months will be $1.39. Using only the forward market, what actions should you take and how
much profit per euro do you expect to make?