ECO – The markets for foreign exchange are of central

1.(a) The markets for foreign exchange are of central importance to international finance. To date, we have referred two classes of foreign exchange markets:(i) spot markets; (ii)forward markets. Distinguish carefully between the two classes.(b) Spot markets for foreign exchange can be subject to different forms of exchange rate regimes:(i) fixed (pegged) exchange rates(ii) flexible (freely floating) exchange rates(iii) “managed” floating exchange ratesDiscuss the basic nature of each exchange rate regime. Which of the three comes closest to describing the regime currently in place in Canada? Explain.2. Variations in the exchange rates in the spot markets can have a significant impact on export and import flows. If the economy of the country in question is a very open one (such as Canada), the impact on export/import flows can, in turn, have a significant impact upon the country’s economy. Over the past year, the U.S. dollar has appreciated dramatically against the Canadian dollar in the Canadian spot market for foreign exchange, reaching levels not seen since the depths of the Great Recession in February, 2009. After defining the term “appreciation”, explain on what grounds (everything else being equal) it could be argued that this appreciation of the US dollar (with respect to the Canadian dollar) could be seen as a welcome stimulus to Canada in its recovery from the Great Recession.3. Suppose, at a particular moment in time, that the price for U.S. dollars in the Toronto inter-bank spot foreign exchange market is U.S. $1.00 = Can. $1.2200. If the price for Canadian dollars in the New York inter-bank foreign exchange market, at the same moment in time is: Can. $1.00 = U.S. $0.8197 (1/1.2200), we could say that the foreign exchange rates are “consistent”. After explaining what is meant by “consistency” in this context, describe the forces that would come into play to eliminate any “inconsistency” in the Toronto – New York US dollar-Canadian dollar exchange rates, that might arise. What, if anything, does the question of “consistency” of foreign exchange rates have to do with the Law of One Price? Explain.4. Define what is meant by Canada’s Balance of International Payments, and then go on to distinguish clearly between Current Account transactions and Financial Accounttransactions.What precisely is the difference between Capital Inflows and Capital Outflows?Changes in Canada’s official foreign exchange reserves (Official Monetary Movements) have been placed by us in a separate category for analytical purposes. These changes, however, really reflect Financial Account transactions.Move forward to 2016, and suppose that, for the calendar year 2015, Statistics Canadawas to record a net decrease in Canada’s official foreign exchange reserves of Can. $20 billion. Would you say that the decrease in official foreign exchange reserves, in 2015, constituted: (i) a Capital Inflow; (ii) a Capital Outflow; or (iii) neither? Explain.5. “The terms Balance of Payments Surplus, and Balance of Payments Deficit have no real meaning, if a country is operating under a system of fixed (pegged) exchange rates. It is only if the country is operating under a system of flexible (freely floating) exchange rates that the term takes on meaning.” Explain why you agree, or disagree, with this statement.6. In looking back in recent history, there is reason to believe that Can.$ – US$ exchange rate (spot) was in long run equilibrium in period p – 1. The exchange during that period was, on average, equal to:U.S. $1.00 = Can. $1.1500(Can. $1.00 = U.S. $0.8696)From p – 1 to p, we observe the following changes in the US and Canadian price indexes, Pus and Pc:Period Pus Pcp – 1 100 100p 105 120What, according to the Relative version of the Purchasing Power Parity (PPP) Theory,should we expect the long run equilibrium exchange rate to be in period p? Why?7. Question 6 pertains to the Relative version of the Purchasing Power Parity Theory. There is also an Absolute version of the PPP Theory. Discuss the nature of the Absolute version of the PPP Theory, and explain how it differs from the Relative version. With the Absolute version of the PPP Theory in mind, what would it mean, if one were to argue that the Can. $ is undervalued in relation to the U.S. $? If one could argue that the Can. $ is undervalued in relation to the U.S. $, would it follow that the U.S. $, in turn, is undervalued in relation to the Can. $? Why?8. There is clear evidence that the true long run equilibrium exchange rate (spot) maydeviate from that predicted PPP Theory (Absolute or Relative version) for an extended period of time. This fact has given rise to the concept of the Real Exchange Rate. After explaining the concept of the Real Exchange Rate, discuss one possible reason (there are several) why the long run equilibrium exchange rate might deviate from that predicted by the PPP Theory.9. Consider now the determination of the short run equilibrium Canada – US exchange rate, in the spot market.Let the relevant short term period be one year, (i.e. p+1 = one year from now), and let the relevant financial instruments, Canadian and US, be one year term deposits.Suppose that you were given the following information:(a) The current interest rate on Canadian one year term deposits is: 3.00%(b) The current interest rate on US one year term deposits is: 2.00%(c) Market participants, on both sides of the border, are convinced that, one year fromnow (p + 1), the Canada – US spot rate will be:U.S. $1.00 = Can. $1.2800(Can. $1.00 = US $0.7812)What, according to the Interest Parity Theory studied by you, will be the short runequilibrium spot rate in the present, i.e. period p? (use the simplified version of theInterest Parity Equation).What possible explanation can you give for the theory’s prediction? Discuss.10. Suppose that we commence with short term interest rates in Canada and the US being equal, and suppose that both countries are enjoying a rate of inflation of 0%. Then suppose that, in period p, short term interest rates rise in Canada, while remaining unchanged in the US. There is no change in the inflation rates in the two countries. The expected Can. $ – US $ spot rate in period p + 1 remains unchanged. Would the US $, according to the Interest Parity Theory, depreciate or appreciate against the Can. $ in period p? Would the theory lead you to believe that the US $ (against the Can. $) would depreciate, or appreciate, between period p and p + 1? Why?11. The PPP Theory and the Interest Parity Theory appear, on the surface, to be radically different. After all, one is a long run theory based on Current Account flows, while the other is a short run theory based on Financial Account flows. There is, nonetheless, a key linkage between the PPP Theory and the Interest Parity Theory. Explain the nature of the linkage.