Assume that the current dollar-Euro exchange rate (E_{$/€}) is equal to 2. The interest rate in the U.S. is equal to .04 and the interest rate in Europe is equal to .06. The forward exchange rate (F_{$/€}) is equal to 1.95.

You expect the exchange rate in one year’s time (E

^{e}_{$/€}) to be 1.94.a. What is the rate of return for a U.S. citizen investing dollars in Europe, using the forward exchange rate to exchange Euros into dollars a year from now?

b. What is the expected rate of return for a U.S. citizen investing dollars in Europe, using the spot exchange rate to exchange Euros into dollars a year from now?

c. What should be the value of the forward exchange rate in order for covered interest parity hold?

d. Does uncovered interest parity hold? Explain.

2. Use the information below to answer question 2.

L M Y

U.S. .1 2,000 10,000

U.K. .04 500 5,000

a. Calculate the price levels in both the U.S. and the U.K. according to the quantity theory of money.

b. Calculate the nominal exchange rate (dollars per pound) assuming the quantity theory of money and absolute PPP.

c. Assume that output rises in the U.S. to 11,000. Calculate the new nominal exchange rate.