1. Suppose Russia's in
ation rate is 10 percent over one year but the in
ation rate in Switzerland is only
5 percent.
(a) According to relative PPP, what should happen over the year to the Swiss franc's exchange rate
against the Russian ruble? Use the approximation from the lecture for your answer and compare it
to the exact solution. How large is the approximation error?
(b) Now suppose Russia's in
ation rate is 4 percent and Switzerland's in
ation rate is 2 percent. Again
calculate the exact and the approximate solution. Compared to (a), what happens to the size of
the approximation error?
2. (a) Based on what you have learned in the lecture, provide a brief explanation of how the exchange
rate disconnect puzzle can be resolved by the existence of transport costs.
(b) For simplicity, assume that Europe and the USA trade only one good, laptops, and that a laptop
costs 500 euros in the Eurozone and 675 dollars in the USA. Assuming that absolute PPP holds,
calculate the nominal euro-dollar exchange rate.
(c) Now we introduce transport costs  = 0:1 that are proportional to the price of goods (e.g. due to
an ad-valorem tari ). Calculate the range within which you would expect the nominal euro-dollar
exchange rate to
oat.
(d) Suppose transport costs are reduced to  = 0:02. Again calculate the range within which you would
expect the nominal euro-dollar exchange rate to
oat. Compare your answer to your answer from
(c).
3. Consider a small open economy. Let y1 and y2 denote exogenous GDP for two periods. In the rst
period, the representative household can use international nancial markets to save or borrow at a xed
interest rate r. At the beginning of period 1 and at the end of period 2 the household's wealth is zero.
(a) What is the representative household's intertemporal budget restriction? (Note: In each period,
the household can use it's income for consumption and save or borrow to move income between
periods.)
(b) Assume that the household maximizes the general utility function U = u(c1) + u(c2); 0 < < 1.
Derive and interpret the rst order conditions.
(c) Calculate consumption in periods 1 and 2 for the utility function U = ln(c1)+ ln(c2). Under what
conditions does consumption in period 1 equal consumption in period 2?
(d) Illustrate the maximization problem in an indi erence curve diagram. What is the highest utility
level the household would be able to reach in a closed economy?
(e) Assume y1 = y2.
 Under what conditions does the current account in the rst period show a surplus?
 Under what conditions does intertemporal trade with the rest of the world have no positive
e ect on utility compared to the closed economy?
(f) Let = 1
1+r and y1 = y2. How does the current account change in response to
 a permanent increase in income? (both y1 and y2 increase by the same amount)
 a temporary increase in income? (y1 increases while y2 stays the same)
4. Following the material from the lecture, illustrate and explain the theory of exchange rate overshooting.
Carefully explain the economic intuition behind the diagrams.