SUPPOSE THERE ARE TWO COUNTRIES IN THE GLOBE-A AND B. THE OFFICIAL...

24. Suppose there are two countries in the globe-A and B. The official currencies of country A and B are called Corvette and Diablo. As of today, the exchange rate between these two currencies is formed at the level of 1 Corvette=1 Diablo. The two countries adopt the floating exchange rate regime. Consider a risk neutral investor in Country A. He is informed that the exchange rate tomorrow will be doubled with probability of 1/2 or will be halved with probability of 1/2. The official definition of exchange rate is E = the unit(s) of Diablo traded for 1 unit of Corvette. In these circumstances, it occurrs to the risk neutral investor that the expected payoff from investing in Diablo and cashing it back tomorrow will be greater than the expected payoff from investing in Corvette for the following reason: when the exchange rate is halved, the investor will receive 2 corvette for the initial investment of 1 corvette. On the other hand, when the exchange rate is doubled, the investor will receive 1/2 corvette. Summing up, 1/2*2 corvette+1/2*0.5 corvette=1.25>1. (1) Assume that in this world economy PPP holds perfectly. Then, evaluate this reasoning of the risk neutral investor. (10pts) Answer) Under the dominance of PPP, the uncertainty described above implies that the price level of country A is doubled or halved with probability of 1/2 each. So, as an investor in A, if he converts 1 corvette into 1 diablo and keeps it, he will get the nominal return as mentioned in the above. However, if we measure his gains and losses in physical goods (or in real terms), we will see that he will not gain anything. (i) 2 corvettes are obtained when the price level is doubled. So his purchasing power will be the same as before. (ii) 1/2 corvette means the price level is halved. Hence, no changes in his purchasing power. (2) Consider that there is another risk neutral investor in country B. What will he think about the future exchange rate movement (he is equally informed just like his counterpart in country A)? Will he consider it favorable or unfavorable? (10pts) Answer) Same as in (1). (3) Now disregard the assumption that PPP holds. Instead suppose there are non-tradable commodities or services across the countries. Then, how will your answer to (i) change? (10pts) (hint: try to use the interest parity condition.) Answer) Since there are non-tradable goods, the determination of the exchange rate will not follow the PPP condition and instead the interest parity condition will hold. Accordingly, the interest rate differential between the two countries will move in accordance with the exchange rate change so that it may make up for the exchange rate differential in each realization of the uncertainty. To rephrase, by changing Corvettes with Diablos the investor may get gains from exchange rate movement while losing interest rate income.