Question 1 (40 marks)
[Use a maximum of 2 pages to answer this question (tables do not count towards
the number of pages).]
The fifile data-question1.dta (available on moodle) reports the spot exchange rate (in local currency per U.S. dollar), realised exchange rate (1 months later), one-month forward,expected exchange rate at 1 month horizon, 1-month local interest rate and 1-month U.S.
interest rate for the Euro at monthly frequency between 2000M1 and 2008M06. Use this data answer the questions below. (Note that the exchange rate expectation data is fake data)
(a) Write the Uncovered Interest Parity (UIP) condition in logs and test whether it holds.
What can you say about the estimated coeffiffifficients capturing the interest rate difffferential and the constant term? Report your econometric results, and explain your steps and answers. (Use the notation Euro per U.S. Dollar) (You do not need to report the code. Only the tables with the results.)1 (10 marks)
(b) Test the “weak” UIP condition using realised exchange rate. How does your result compare with question (a)? (10 marks)
(c) What can you say about the explanatory power of the interest rate difffferential in questions (a) and (b)? (5 marks)
(d) Test the Unbiasedness Hypothesis. Does the result change if you use realised (ex-post) exchange rates? Interpret your results. (10 marks)
(e) Test the Covered Interest Rate Parity (CIP). Does this condition hold? Explain your results. (5 marks)
Question 2 (30 marks)
A monopolist sells goods in a domestic market and exports to a foreign market. The (inverse) demand curves are identical in the two markets and are structured as follows:
P = K − βQ, (1)
P ∗ = K − βQ∗ , (2)
where variables superscripted with a * refer to the foreign market. All units are produced domestically and have a marginal cost of C. The exchange rate S is defifined in units of local currency per US dollar (LC/USD).
(a) Derive an analytical expression for the optimal price and quantity in each market and for total maximising profifits. (10 marks)
(b) Use your previous results to show how a depreciation of the local currency affffects pricing in the foreign market and quantity sold. (10 marks)
(c) Illustrate your results from (a) and (b) by considering a situation where K = 5, 500,C = 550, β = 0.5 and where S increases from 1 to 1.1. (5 marks)
(d) What are the implications of your analysis in (c) for exchange rate pass through and the law of one price in this setting? (5 marks)
Question 3 (30 marks)
[Use a maximum of 2 pages to answer this question.]
One of the approaches of the fundamental analysis of exchange rate determination argues that the exchange rate is an asset price. Employ this approach to provide an example of how news about future fundamentals can affffect the current level of the exchange rate. Support your arguments with empirical evidence.
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