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

rate E is dened as $/$.

(a) Denote the one-year forward exchange rate (at time t) for time t+1 by F

t+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 $0.67/$, and the forward exchange rate Ft+1

is $0.625/$. 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.?

(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).

(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).