Economics Assignment: Interest Rates and Exchange Rate Determination

This economics assignment delves into various aspects of international finance, starting with the differentiation between foreign exchange swaps and currency swaps, highlighting their economic motives and balance sheet implications. It explores the International Fisher Effect (IFE) theory, emphasizing the relationship between interest rates and exchange rate depreciation. The assignment critically examines the Purchasing Power Parity (PPP) theory, discussing reasons for its failure and differentiating between absolute and relative PPP. Practical calculations of cross rates are demonstrated, followed by an analysis of arbitrage opportunities arising from interest rate differentials between Singapore and the US. The impact of changes in foreign interest rates and expected appreciation in exchange rates on arbitrage opportunities is graphically illustrated. Furthermore, the assignment discusses the effects of changes in the rate of money growth on price levels, interest rates, and exchange rates, and it empirically tests the absolute PPP theory using data from different planets. Finally, the assignment analyzes the effects of permanent increases in government spending on exchange rates and provides a comparative analysis of price indices and spot exchange rates across the United States, Euro Area, China, and India, concluding with a critique of the absolute PPP theory's applicability.

Running head: ECONOMICS ASSIGNMENT
Economics Assignment
Name of the Student:
Name of the University:
Authors Note:

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ECONOMICS ASSIGNMENT
Contents
Part 1:...............................................................................................................................................2
Part 2:...............................................................................................................................................2
Part 3:...............................................................................................................................................3
Part 4:...............................................................................................................................................3
Part 5:...............................................................................................................................................4
Part 6:...............................................................................................................................................6
Part 7:...............................................................................................................................................7
Part 8:...............................................................................................................................................9
Part 9:...............................................................................................................................................9
Part 10:...........................................................................................................................................10
Part 11:...........................................................................................................................................11
References:....................................................................................................................................13

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Part 1:
Concurrent purchase and sale of one currency with another currency having different value dates
and identical amount can be termed as foreign exchange swap. Exchange of interest amount in
one currency for another currency on fixed dates is referred to as currency swap. Thus, foreign
exchange swap takes place with different value dates whereas in currency swap it is about
exchange of interest amount and sometimes even principal amount from one currency to another
on fixed dates. Currency swaps are considered as foreign exchange transactions and not required
to be shown in the Balance sheet of a company. Foreign exchange swap is generally for short
duration unlike currency swap which is generally long term transaction.
One economic motive of engaging into swap is to exchange cash flows between parties on the
basis of notional principal amount. Economic motives include reducing the risk of interest rate
fluctuation and risk of foreign exchange rate fluctuations on the financial position of the parties
entering into such swap.
Part 2:
The rate of interest in a country generally dictate the rate of inflation and value of money. The
higher the rate of interest in a country the higher would be the inflation rate and depreciation to
the value of money and currency. As per the International Fisher Effects (IFE) theory the
exchange rate in a country would depend to a large extent on the interest rate prevailing in the
country. High rate of interest in the country would depreciate the domestic currency at higher
rate. Thus, between two countries the country that will have higher interest rate in comparison to
the rate of interest of the other would have higher depreciation to its currency. Hence, the
exchange rate between the two currencies would be accordingly effected. The value of currency

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of the country with higher interest rate would depreciate faster to appreciate the currency of other
country. Thus, it would be wrong to claim that the country with higher interest rate compared to
others will experience appreciation in exchange rate. It is in-fact other way around positive
interest rate differential will result in depreciation in exchange rate as the currency of the country
will be depreciated faster. The present value of c currency after n year would be less in the
country with high interest rate as compared to the present value of the currency of the country
with low interest rate. The purchasing power will be significantly less of domestic currency of
the country with high interest rate thus, it will accompanies by an exchange rate depreciation.
Part 3:
There are number of reasons that might result in the failure of Purchasing Power Parity theory;
few of these are as following:
I. Tastes and behavior are different in different countries.
II. Impact of real economic events on changes in exchange rate are not considered in PPP.
III. Movements in individual prices in index are often different thus, using price index may not
be relevant in such instances (Li, Lin & Hsiao, 2015).
Part 4:
Absolute PPP assumes that the purchasing powers of two currencies will be equal due to the
equilibrium in exchange rate of two currencies. Relative PPP is the dynamic version of PPP used
to predict the movement in the exchange rate between two currencies by tracking the inflation
rates of the respective countries. In order to derive the relative PPP relation from absolute PPP
following equation can be used:

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PPP equation
Where, P = price in a country,
Q = Quantity,
S = Value of currency.
And C is the constant.
Part 5:
USD to EEK 11.6971/7076
EUR to USD 1.1339/43
GBP to USD 1.2789/93
Cross rate for:
Estonian Kroon to the Euro
1 Euro to USD (1.1339/43) 0.026369767
1 USD to EER (7076/11.6971) 0.001653067
1 Euro to EER (0.02637 x 0.001653) 0.0000435

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9
Thus, cross rate is
EUR to EER 1/0.00004359
Estonian Kroon to sterling
1 Sterling to USD (1.2789 /93) 0.013751613
1 USD to EER (7076/11.6971) 0.001653067
Thus, cross rate is
Sterling to EER (0.013751613 x 0.001653067) 0.0000227
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Part 6:
Yes, there is an arbitrage opportunity here as the rate of interest for Singaporean dollar is
significantly less compared to the US $. Hence, by borrowing Singapore dollar (S$) at lower
interest rate a person can acquire US $ immediately. The US $ acquired from the S$ shall be
invested at the US $ interest rate of 3.12513% for 360 days. Then the US $ both principal and
interest shall be converted into Singapore dollar to repay the loan taken in Singapore dollar.
Assuming that a person has taken a loan of Singapore dollar (S$) 100.00 to take a look at the
arbitrage opportunity for the person.
Exchange arte (S$ / $) 1.3753

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Interest:
US 3.12513%
Singapore 2.06400%
Borrowing Singapore dollar 100
Add: Interest (100 x 2.0640%) 2.064
Singapore dollar to be repaid 102.064
Buy US $ (100 x 1.3753) 137.53
Add: interest (137.53 x 3.12513%) 4.297991289
US $ to be received 141.8279913
Thus, forward rate S$ / $ 1.3609
Singapore dollar to be received
(141.8279913/1.3609)
104.216321
Less: Singapore dollar to be repaid 102.064

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Net gain (Singapore dollar) 2.152321029
Thus, the person has the opportunity to gain S$2.152321029 by taking a simple loan of S$ 100.
Part 7:
Fall in foreign interest rate:
A fall in foreign interest rate shall provide an arbitrage opportunity to a person to borrow foreign
exchange to invest in domestic currency and then to convert the domestic currency to repay the
foreign exchange loan. The graph below would indicate the effects of decline in foreign interest
rate.
Fund now Fund a year later
9400
9600
9800
10000
10200
10400
10600
10800
11000
11200
Chart Title
Expected appreciation in current exchange rate:
This will also provide arbitrage opportunity for a person by acquiring foreign exchange rate and
holding the foreign exchange rate to convert the same into domestic currency in the future. The
impact would be as following:

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Fund now Fund a year later
9400
9600
9800
10000
10200
10400
10600
10800
11000
11200
Chart Title
Part 8:
(a) The price level rises with decrease in the rate of growth in money as the general purchasing
power of money will decline. Monetary neutrality drives price level.
(b) Interest rate will increase with decrease in the rate of growth in money as the demand for money
will be more in the economy. Demand and supply of capital drives the interest rate in the country.
(c) Exchange rate will depreciate with the decrease in the rate of growth in money. Inflation in the
country drives exchange rate.
Part 9:
No, it is clear from the following table that the absolute Purchasing Power Parity (PPP) theory
does not hold between these planets. The absolute purchasing power parity theory means that the
purchasing power of two currencies would be equal. However, as can be seen in the table below
that it is not that case.

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If 100 Earth credits = 1 Vulcan trail then 20 trillion units of goods (Dilithium) should have cost
5 trillion Vulcan trail as per the absolute PPP. Similarly 11 trillion units of quadrotrilicale should
have costs 1.1 trillion Vulcan as per absolute PPP theory however it has cost 2 trillion Vulcan.
Thus, it is clear from the above table that the absolute PPP theory does not hold between these
planets.
Part 10:
(a) Permanent increase in government spending will have a positive effect on the exchange rate. The
asset market curve shifts to the right as the expectation is that the exchange ratio will appreciate
in the future.

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(b) The nominal exchange rate would also appreciate subsequent to the permanent increase in
government spending. It is generally because the overall positive effects of monetary and fiscal
policy will have positive effects on the nominal exchange rate.
Part 11:
Price index in respect of United States of America, Euro Area, China and India for two years
provided in the table below:
Countries Present year Previous year
United State of America 252.83 258.94
Euro Area 104.49 104.25
China 102.50 102.50
India 140.60 140.20

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Spot index rate of United States of America, Euro Area, China and India for two years provided
in the table below:
Countries 10/06/2017 10/06/2018
US$ to INR 65.3725 67.5125
US$ to CNY 6.797 6.4038
US$ to EUR 0.8941 102.50
Note: Spot exchange rate of all currencies with US$ have been provided in the table as US$ is
widely recognized as international currency.
There are number of drawbacks in absolute PPP theory thus, more often than not the theory of
absolute PPP will not hold to the exchange rates between different countries as it has not hold
between the above countries (Bahmani-Oskooee, Chang & Lee, 2016).

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References:
Bahmani-Oskooee, M., Chang, T., & Lee, K. C. (2016). Purchasing power parity in emerging
markets: A panel stationary test with both sharp and smooth breaks. Economic
Systems, 40(3), 453-460.
Li, H., Lin, Z., & Hsiao, C. (2015). Teing purchasing power parity hypothesis: a semiparametric
varying coefficient approach. Empirical Economics, 48(1), 427-438.