$2.$ Consider the exchange rate between the U$.$S$.$ $ and the U$.$K$.$ $$.$ Suppose the exchange

rate E$$ is defined as $$/$$$.$

$($a$)$ Denote the one$-$year forward exchange rate $($at time t$)$ for time t$+1$ by Ft$+1.$ Suppose

the nominal interest rate in the U$.$S$.$ is $8\%,$ the nominal interest rate in the U$.$K$.$ is

$5\%,$ the current exchange rate Et$$ is $$0\mathrm{.}67/$$$,$ and the forward exchange rate Ft$+1$

is $$0\mathrm{.}625/$$$.$ Are the numbers given here consistent with the interest rate parity

equation? Clearly show all calculations. Based on this information, would you prefer

to invest in the U$.$S$.$ or in the U$.$K$.?(5$ points$)$

$($b$)$ What effect will the difference between the effective rate of return in the two countries

$($if any$)$ from part $($a$)$ have on the exchange rate $($E$).$ Clearly show all calculations,

and illustrate your answer using a well$-$labeled graph. $(10$ points$)$

$($c$)$ Consider the exchange rate determined in part $($b$).$ Suppose that the Fed $($the U$.$S$.$

central bank$)$ adopts a policy to lower the inflation rate by $2\%$ in the U$.$S$.$ Explain

the effect of such a monetary policy on the exchange rate $($E$).$ Clearly explain your

answer, and illustrate your answer using a well labeled graph. $(10$ points$)$