Question

1. Suppose you are asked to advise a risk-avert individual who is to invest $50 million for six month either in the U.S. or in U.K. Given the following information, where would you advise her/him to invest? Annual rate of interest in the US, iu.s. = 4%; annual rate of interet in UK, iu.k. = 5%; Spot exchange rate =1.8 dollars per pound; and six month forward exchange rate = 1.6 dollars per pound.

Let the following equations represent a model of an economy.

                        1. Y = C + I + G + X - M

                        2. C = 100 + 0.8Y

                        3. I = 200

                        4. G = 250

                        5. X = 100

                        6. M = 50 + 0.05Y

            a. How much is equilibrium income and open economy multiplier?

            b. Is the balance of payments in surplus or deficit?

            c. By how much do we need to change G in order to have a balance of payments         

                 equilibrium?

            d. What will be the impact on Y and the trade balance if exports increase by 10 (say

                due to an increase in foreign demand) and Fed cuts the discount rate which results

                in an increase in investment by 10 and an increase in autonomous consumption by

               10.

Answer 1

We assume that the Investor is a US citizen wanting to invest Dollars.

Amount	USA market	UK market
50,000,000
Exchange rate ( spot = $ 1.8 : 1 P)	$ 50,000,000	27,800,000 Pounds
Interest rate	4 % (per annum)	6 % ( per annum)
Returns (after 6 months)	50 mil + (0.02 *50) = $ 51,000,000	27.8 + (0.03*27.8) =28,634,000 P
Exchange rate ( 6 months ffwd) $1.6 = 1 P
Return on investment	$1, 000,000	834,000 Pounds
Which investment to choose?	1, 000,000	$1,334,400

The answer is obvious. He should invest in the UK at ^% per annum for 6 months ( assuming that the exchange rate holds true at the end of 6 month period.)