Question #25

Mundell-Fleming approach focuses on the role of interest rate in exchange rate determination. Mundell-Fleming model does not explicitly take into account the role of inflation. (Module 5.3, LOS 5.k) Patrick Sheehan is the head of foreign currency desk at GPN Bank NA, a large U.S. Bank holding company. Patrick is concerned about recent spike in volatility of EUR. He obtains current spot and forward quotes from his terminal (given in Exhibit 1). He also collects interest rate information (given in Exhibit 2). Exhibit 1: Current spot and forward exchange rate quotes Currency Paid Spot rates Forward rates 30-day 60-day 90-day USD/EUR 1.3110−14 +3.18/+3.38 +6.73/+7.18 +10.48/+10.78 CHF/USD 0.9273−77 −4.09/−3.79 −8.45/−7.95 −12.80/−12.05 USD/GBP 1.6242−47 −26.10/−24.6 −50.20/−47.20 −72.20/−68.2 Exhibit 2: Selected interest rates Interest Rates USD EUR CHF INR 30 day 0.21% 0.90% 1.12% 6.72% 60 day 0.22% 0.93% 1.15% 6.84% 90 day 0.25% 1.04% 1.25% 6.90% Sheehan reviews bank's current open forward contracts. One of the contracts calls for purchase of EUR 200 million at an all-in rate of USD 1.3912 and matures in 30 days. During the market turmoil of late 2008, GPN had lost a lot of money in FX carry trades. Sheehan realizes that GPN has not established any new FX carry trade positions since then and is anxious to establish new positions. One trade that he finds promising is a carry trade in Indian Rupee (INR). Sheehan notes that while the spot rate is 53.88 INR/USD, Melissa Andrews, GPN's Chief Economist expects the Rupee to trade at 54.12 INR/USD in 90 days. During his conversation with Andrews, Sheehan asks about the driving factor behind depreciation of the Rupee in the recent past. Andrews explains that there are several theories to explain exchange rate movements. Personally, she prefers to focus on the long- term implications of fiscal policy. She feels that the interest rate in India is expected to be higher than in the U.S. She also states that India is following a more expansionary fiscal policy as compared to the U.S. and that policy is expected to continue. Sheehan observes that such deficits have resulted in large external debt relative to GDP for India. Sheehan observes that over the past decade, capital controls in India have been loosened resulting in free flow of capital. Additionally, due to a relatively more restrictive monetary policy in India relative to the U.S., nominal interest rates have been substantially higher in India as compared to the U.S.