Problem 1

1. A can of soda costs $0.75 in the United States and 12 pesos in Mexico.
a. What would the peso-dollar exchange rate be if purchasing-power parity holds?
b. If a monetary expansion caused all prices in Mexico to double, so that soda rose to 24 pesos, what would happen to the peso-dollar exchange rate (provide a numerical answer to this question)?

2. Would each of the following groups be happy or unhappy if the US dollar appreciated? Explain.
a. Dutch pension funds holding US government bonds
b. US manufacturing industries
c. Australian tourists planning a trip to the United States
d. An American firm trying to purchase property overseas

3. Did the US dollar appreciate or depreciate in general versus the Sri Lankian rupee between 1980 and 2010? What does this imply about the inflation rate in the US and Sri Lanka during this time? Was Sri Lankian inflation higher or lower than US inflation in the data? (16 points)
Please note: you will need to find data on the inflation rate in Sri Lanka in order to complete this exercise. The most convenient source of this data is the World Bank's World Development Indicators. The US inflation rate and the exchange rate between the dollar and Sri Lankian rupees are available through FRED.

Problem 2

4. The rise in the US trade deficit in the 1980s was due largely to the rise in the US budget deficit. On the other hand, the popular press sometimes claims that the increased trade deficit resulted from a decline in the quality of US products relative to foreign products.

a. Assume that US products did decline in relative quality during the 1980s. How did this affect net exports (assume a fixed exchange rate)?

b. Draw a three-panel diagram to show the effect of this shift in net exports on the US real exchange rate and trade balance.

c. Is the claim in the popular press consistent with the model in this chapter? Does a decline in US products have any effect on our standard of living? (Hint: when we sell our goods to foreigners, what do we receive in return?

5. Suppose that real interest rates increase across Europe. Explain how this development will affect US net capital outflow. Then explain how it will affect US net exports.

6. One of the predictions of our extended loanable funds model is that the real interest rate of a country should rise sharply during a financial crisis that induces capital flight. For each of the following capital flight events, describe the behavior of the real interest rate during the period of capital flight. Is the behavior of the real interest rate consistent with our model's predictions?

Please note: you will need to find data on the real interest rate in order to complete this exercise. The most convenient source of this data is the World Bank's World Development Indicators.

a. Mexico in 1994
b. Russia in 1998
c. Argentina in 2001-2002