The Swiss franc has a floating exchange rate with the U.S. dollar. Today, the interest rate on one-year Swiss bonds denominated in Swiss francs is 6 percent, and the interest rate on one-year U.S. bonds denominated in U.S. dollars is 6 percent. If uncovered interest parity holds between Swiss francs and U.S. dollars, what is the spot exchange rate that investors are expecting in one year? Now, the U.S. money supply unexpectedly increases by 10 percent. What is likely to be the effect on the spot exchange rate? In your answer assume that the asset market clears faster than the goods market (i.e. prices adjust slowly and interest rates adjust quickly). Also, in your answer address short-run changes in the exchange rate as well as long-run changes.

Question

What will be an ideal response?

Answer 1

POSSIBLE RESPONSE: The interest rate differential is zero.  So, for uncovered interest parity, investors must be expecting no change in the exchange rate over the next year.  The exchange rate expected in one year is the same as the exchange rate today. 

POSSIBLE RESPONSE: When the U.S. money increases by 10 percent unexpectedly, the dollar will quickly depreciate beyond its long-run equilibrium value in the short run, so it will depreciate by more than 10 percent. This will happen as the interest rate in the U.S. adjusts itself more quickly than the price level. With a decrease in U.S. interest rates, capital outflow will take place. Beyond this initial short run, U.S. product prices will rise slowly, the exchange rate value will decrease, and the dollar will slowly appreciate back toward its new long-run equilibrium value, which is 10 percent lower than it would have been without the U.S. money supply increase.