Chapter1: Making Economics Decisions
Section: Chapter Questions
Problem 1QTC
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Transcribed Image Text:3) Consider an open economy and use the IS/TR model together with uncovered interest parity
condition (UIP) to answer the following questions:
(a) Discuss and illustrate how globalization (NX) and interdependence of financial markets (UIP) can
affect the propagation of international shocks.
(b) Discuss and illustrate with the IS/TR and UIP graphs the effects on the domestic economy of an
increase in the interest rate by a big foreign economy, affecting the level of the international interest
rate. Assume that the domestic economy is adopting perfect capital mobility and a flexible
exchange rate regime.
(c) Why might a rise in international interest rates lead to hyperinflation in some highly-indebted
countries?
(d) A risk neutral investor in London has two investment opportunities. They can invest in one year UK
government bonds with an annual nominal interest rate of 5%. Or they can invest in one year US
government bonds with an annual nominal interest rate of 2.5%. Currently the spot exchange rate is
1.2 US dollar/UK pound (i.e., the price of one UK pound= 1.2 US dollars) and the one year expected
exchange rate is 1.12 US dollar/UK pound. Should the investor hold their money in UK or US
government bonds? (In replying to the question, use the exact and not the approximate version of
the relevant interest rate formula, and show your work).
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Step 1: Define Globalization
VIEWStep 2: Explain the globalization & interdependence of financial markets can affect the international market
VIEWStep 3: Explain the the effects on the domestic economy of an increase in the interest rate by a big foreign
VIEWStep 4: Explain the rise in international interest rates to hyperinflation in some highly-indebted country
VIEWStep 5: Explain the Investment Decision for the Risk-Neutral Investor
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