Part -1:
1. Suppose the household in a two-period model has income of $30,000 in period 1 and $25,000 in period 2, and the interest rate is 75%.Assume the price of the goods is $1 in both periods. Suppose that the household decides to consume 26,000 in period one, and 32,000 in period 2. Now suppose that the interest rate falls to 50%, and the household decides not to borrow or lend at all. Is the household better off or worse off with the higher interest rate?
2. Describe how the budget constraint of a household in a two-period model is affected by each of the following changes. In each case, do you think the household is better off or worse off? If ambiguous, what does the answer depend on?
Part -2:
Did the dollar depreciate or appreciate against the pound, the Canadian dollar, the franc, the yen, and the mark between 1970 and 1980? Between 1980 and 1990? Between 1990 and 2000? Between 2000 and 2011?
Suppose that the exchange rate adjusts so that interest-parity holds. Suppose also that the interest rate on a one year German bond is 7% and the interest rate on a one year U.S. bond is 4%.
Interest rate parity equation: iG = iUS- %ΔXe
7%=4% - %ΔXe
%ΔXe = -3%
a. Suppose that you expect the interest rate in one year to be 1.2 dollars per euro. What is the exchange rate today?
b. Suppose the relative purchasing parity holds and that the inflation rate in Germany is expected to be 2% over the next year. What is the expected inflation rate in the United States?