1. Suppose that the exchange rate of the euro with respect to the US dollar is given by the following function: Ec/8=1+0

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1 Suppose That The Exchange Rate Of The Euro With Respect To The Us Dollar Is Given By The Following Function Ec 8 1 0 1 (209.18 KiB) Viewed 11 times

1. Suppose that the exchange rate of the euro with respect to the US dollar is given by the following function: Ec/8=1+0.1 (100 (US — E)) ² where US denotes the interest rate in the US and the one in the Eurozone. (a) (10 points) Suppose that the interest rate in the US is 3% and the one in the Eurozone is 2%. What is the exchange rate of the euro relative to the US dollar? Is the euro more or less expensive than the dollar? why? (b) (10 points) Suppose that the Federal Reserve increases the US interest rate from 3% to 5.16%. The Eurozone maintains its interest rate constant. What is the new exchange rate of the euro relative to the US dollar? Explain your result. (c) (20 points) Suppose a firm located in the US imports inputs from the Eurozone to produce a good that is entirely sold in the US. The price of the final good is $100, so total revenues are given by $1000, where Q is the quantity produced. The total cost of the firm, denominated in euros, is given by 50², and the marginal cost (also denominated in euros) is 100. Using this information determine the profits and quantity produced by the firm when the exchange rate of the euro with respect to the dollar is (1) the one in part (a), (2) the one in part (b). Is the firm producing more when the US interest rate increases? Is the new scenario beneficial for the firm? Explain your result. (d) Bonus question (5 points):¹ Suppose that there is uncertainty in terms of what the Federal Reserve (Fed) will do. Agents perceive that the probability that the Fed will not raise the US interest rate (this is, we are in the scenario of question (a)) is 70%, while the probability of observing a raise is 30% (this is, we are in the scenario of question (b)). 'You do not need to answer this question to obtain full credit in this problem set. 1 Suppose the firm has the possibility of signing a forward contract to buy/sell Euros at a forward rate E/3 = 1.37, but this contract has a cost . What is the maximum value of that the firm is willing to pay? Provide an explanation for your results.