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Below is a summary of the economic situation as of 2013.
$1 equals 0.6 pound.
U.S. interest rate is 0.02.
U.K. interest rate is 0.03.
It is expected that $1 would equal 0.8 pound next year.
U.S. price index is 1.
U.K. price index is 1.2.
A. What is the nominal exchange rate in 2013? What is the expected nominal exchange rate for next year? Which currency will appreciate?
B. What is the real exchange rate in 2013? What is the economic meaning of the real exchange rate?
C. The interest parity condition is given by 1+i =(1+i*)E/E(e) , where i is the domestic (U.S.) interest rate, i* the foreign (U.K.) interest rate, E and E(e) are the actual and expected exchange rate, respectively. Considering the interest parity condition and the information above, are we likely to observe capital inflows into or outflows from the US? Explain why. Discuss the ultimate effect on the nominal exchange rate if this situation (capital inflows or outflows) lasts for a considerable period.
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