a) Define the nominal exchange rate of a country. Define the real exchange rate of a country. Explain how a higher domestic inflation rate relative to foreign inflation rate affects the real exchange rate relative to the nominal exchange rate.
b) If the domestic country’s real exchange rate (currency) appreciates, how would you expect this to affect the domestic country’s trade balance in the short-run and in the long-run? Explain your answer carefully.
c) Suppose the uncovered interest parity condition holds, and that the domestic interest rate is higher than the foreign interest rate. What does this imply about expectations of the future versus the current exchange rate value of the domestic country? Explain your answer carefully.
d) Assume that the one-year interest rate in the United States is 5% and that the one- year interest rate in Canada is 3%. According to uncovered interest rate parity, what should happen to the value of the dollar in the future qualitatively and quantitatively?
e) Explain why a simple comparison of the interest rates on domestic and foreign bonds might provide misleading information about which bonds yield the highest expected returns.