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Advanced Applied Macroeconomics
Assignment 1
1. Exchange rate dilemmas in emerging markets
Consider the case of two countries, Mexico and the US and let us take the point of view
of Mexico. Consider the uncovered interest parity condition modified for the case of the
existence of risk premium:
RP  R$ 
EPe / $,t 1  EP / $,t
EP / $,t
 RP
a) Suppose that initially: EP / $,t  EPe / $,t 1  1 so that both the spot and expected future
exchange rate are equal to 1; domestic (Mexican) and foreign interest rates are equal to
5% so that RP = 0.05 and R$ = 0.05; and there is no risk premium on domestic assets so
that RP=0. Would the spot exchange rate change over time if nothing else changes?
b) Starting from the initial equilibrium, suppose that at time t investors change their
expectation of the future exchange rate and now believe that the currency will be
depreciated by 10% a year from now so that: EPe / $,t 1  1.10 . Suppose that the country is
in a regime of flexible exchange rates. By how much will the current spot exchange rate
change following this change in expectations? Explain why.
c) Now suppose that the country is committed to maintain the spot exchange rate fixed
to the initial parity (EP/$ = 1). Following the change in expectation about the future
exchange rate (described above in point (b)), by how much should the domestic interest
rate be changed by the domestic central bank in order to prevent a devaluation of the
domestic currency, i.e. maintain the fixed parity? Explain why.
d) Now suppose that you start again from the initial equilibrium (described in (a)
above). Suppose that investors change their view of the riskiness of the domestic assets.
They now start to believe that the domestic (Mexican) assets are more risky than the
foreign assets, maybe because of a risk of default of domestic assets. Specifically
suppose that the risk premium on domestic assets goes from zero to 7% so that now RP
= 0.07. Suppose that the country is in a regime of flexible exchange rates. By how much
will the current spot exchange rate change following this change in expectations?
Explain why.
(e) Now suppose that the country is committed to maintain the spot exchange rate fixed
to the initial parity. Following the change in the risk premium (described above in point
(d)), by how much should the domestic interest rate be changed by the domestic central
bank in order to prevent a devaluation of the domestic currency? Explain why.
2. Hungarian currency behaves wildly
Read “The flying forint” carefully, trying to identify any piece of information that could
be rationalized with the UIP.
What is the described behaviour of the forint and how is it explained?
Somewhere in the text it is said: “Indeed, many analysts think the forint is heading for a
fall”. Would you expect that? Why? (explain using the UIP)
3. Argentina’s problems before its crisis
Read “Currency dilemmas”. In this text there are two sentences that can be rationalized
using the UIP. Find them and try to explain what it is said using the UIP (a graphical
representation may be useful in the second case).
4. Go to the UIB library webpage and select “base de dades” and then select IFS. This
gives access to the International Financial Statistics of the IMF, a very useful
macroeconomic and financial data base.
The first thing you should do is to change the retrieval period. Go to the North-East part
of the page and click to “Change” next to “Retrieval period”. In the auxiliary window
select “single frequency”, “quarterly frequency”, “1st quarter of 1994” for the start
period and “2nd quarter of 2005” for the end period and, finally, click “save” and close
this window.
Now select “economic concept view” and then “interest rates”. There you will find
different interest rates. Select “treasury bill rate”1.
What we need is data on interest rates of treasury bills issued by the Bolivian
government and by the US government. For the case of Bolivia, the government issues
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Treasury bills are short term (not longer than one year) securities issued by the government.
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treasure bills nominated in bolivianos (the local currency) and nominated in foreign
currency (dollars).
So we need three data series. For each one, follow the following procedure:
Select the country (Bolivia, US) and the data concept (“treasure bill rate” for US and
Bolivia and “treasure bill rate (foreign curr.)” for Bolivia); press “View/select available
items”; in the new window, tick the small box next to the selected item; click the “+” in
the North-West part of the window; click “retrieve”; in the new window select
“Microsoft excel file”; a new window opens with possibly several excel files; yours is
the one at the top of the list.
Now gather the three data series in a single file and plot a figure for the three with the
time variable in the horizontal axis.
a) Can you make any statement from the comparison of your figure with the one about
Mexico in the slides?
b) At the beginning of 2001 the US interest rate experiences a downward trend while
the interest rate of the Bolivian assets nominated in local currency does not substantially
change. What is the explanation of this divergent behaviour according to your data?
c) If we accept that the markets do not make systematic mistakes, what do you think it
has been the behaviour of the boliviano/$ exchange rate during the whole period? Check
your intuition retrieving the data on the Bolivian exchange rate (in the “economic
concept view” select “country exchange rates”, then “national currency per $ (per avg)”,
then “RF.ZF-NC/US$, period average (187)”. For the rest, follow the same procedure as
with the interest rates. Draw and comment a time plot of this data.
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