1. Consider a foreign exchange market between the Mexican peso ($) and the Japanese yen (Y):

a) Illustrate the market equilibrium. Make up a specific equilibrium exchange rate. Be sure to label the graph carefully and completely.

b) On a new graph, label a situation where the Mexicans have an undervalued currency. Are the Mexican running a balance of payments surplus or deficit? Can you say anything about the current account in this situation? Explain.

c) How would the Mexican central bank maintain this exchange rate? Be specific.

2. Suppose that you are told that the interest rates on a US government bond are lower than a comparable German bond (i.e. equal risk and maturity).

Assuming that uncovered interest parity holds (so that investors are currently indifferent between the two assets), what would this imply about the market's expectation of the future value of the dollar in the exchange market? Explain.

b) Can you draw any conclusions about the market's expectation about inflation in the US and Germany? Explain.

3.

a) Explain the relationship between the merchandising trade balance, the current account balance and the official settlements balance.

b) Suppose someone told that financial capital was immobile across international borders and that a country was running a current account deficit. What could you surmise about whether the country's central bank was intervening in the foreign exchange markets? Explain.

c) Redo part b) but assume that financial capital is perfectly mobile across borders.

4. Suppose that a country has fixed exchange rates and that is running has a balance of payments deficit. What can you surmise about whether the central bank is gaining or losing official reserves? What economic downsides exist for the domestic economy if these deficits continue? Explain.