CHOOSE THE OPTION FROM HIGHLIGTED BELOW Suppose the variables R, R*, E, F, and E
ID: 2760425 • Letter: C
Question
CHOOSE THE OPTION FROM HIGHLIGTED BELOW
Suppose the variables R, R*, E, F, and Ee are defined,. If we let x = (Ee - E)/E and y = (F- E)/E by definition, then according to the uncovered interest parity condition,
R = R* - y
R = R* + x
R = R* / y
R = R* - x
R = R* + y
1b.
All else equal, if there is a substantial increase in imports into Sweden from Germany then
exports to Germany must immediately increase to maintain the balance of payments.
the current account for Sweden will increase due to the additional credit in that account
the Swedish crown will weaken (depreciate) against the euro.
exports to Germany must immediately decrease to maintain the balance of payments.
the Swedish crown will strengthen (appreciate) against the euro.
Explanation / Answer
According to the uncovered interest rate parity condition the interest rate differential between the two countries(R-R*) is offset by future exchange rate movements appreciation/depreciation( x = (Ee - E)/E) between the two countries such that there are no arbitrage conditions. The percent expected change in the exchange rate x should equal to the interest rate differential R-R* between the two countries. Therefore R-R*=x=>R=R*+x
1b) current account=Exports-Imports, therefore with increase in imports current account for Sweden will decrease. If there is increase in exports immediately then this shall offset the increase in imports therefore the balance of payments is maintained.
Therefore correct is:
exports to Germany must immediately increase to maintain the balance of payments.