Consider a world with 3 countries: country 1, country 2 and country 3, which use currencies...

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Consider a world with 3 countries: country 1, country 2 and country 3, which use currencies C1, C2, C3, respectively. Suppose all countries follow a flexible exchange rate regime, which implies that the bilateral nominal exchange rates on the three currencies are priced on the market. Suppose the bilateral markets of C2 versus C1 and C3 versus C2 price currencies as follows: one unit of C2 is worth 0.5 units of C1; one unit of C3 is worth 0.25 units of C2. Assume a no-arbitrage condition holds such that the holders of C1 willing to trade it for C3 are indifferent between buying C3 directly in the bilateral market trading C1 for C3, or buy C3 indirectly by first trading C1 for C2 and then trading C2 for C3. a) Compute how many units of C3 an agent can buy for one unit of C1 and explain why your computation holds; b) consider the scenario in which C2 depreciates against C1 but it appreciates against C3. Clearly explain if C1 will certainly appreciate against C3, will certainly depreciate against C3, or if it could appreciate or depreciate against C3 depending on the size of the appreciation/depreciation of C2 versus C1 and C3. Consider a world with 3 countries: country 1, country 2 and country 3, which use currencies C1, C2, C3, respectively. Suppose all countries follow a flexible exchange rate regime, which implies that the bilateral nominal exchange rates on the three currencies are priced on the market. Suppose the bilateral markets of C2 versus C1 and C3 versus C2 price currencies as follows: one unit of C2 is worth 0.5 units of C1; one unit of C3 is worth 0.25 units of C2. Assume a no-arbitrage condition holds such that the holders of C1 willing to trade it for C3 are indifferent between buying C3 directly in the bilateral market trading C1 for C3, or buy C3 indirectly by first trading C1 for C2 and then trading C2 for C3. a) Compute how many units of C3 an agent can buy for one unit of C1 and explain why your computation holds; b) consider the scenario in which C2 depreciates against C1 but it appreciates against C3. Clearly explain if C1 will certainly appreciate against C3, will certainly depreciate against C3, or if it could appreciate or depreciate against C3 depending on the size of the appreciation/depreciation of C2 versus C1 and C3.

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a To compute how many units of C3 an agent can buy for one unit of C1 we can use the given exchange rates to find the cross rate between C1 and C3 1 u... View the full answer