2. Suppose a basket of goods costs 210,000 Mexican pesos in Mexico, while the same basket costs $16,800in Australia. The nominal exchange rate is currently at E$/Peso = 0.10. Assume that the prices in twocountries do not change at all over time (the inflation rates in two countries are always zero). Assumethat the uncovered interest parity (UIP) holds.
(A) Calculate the real exchange rate, q$/Peso.Hint: Use the real exchange rate definition. [5 marks]
(B) Under the purchasing power parity (PPP), what will be the nominal exchange rate in the long run?Hint: Use the real exchange rate definition and apply the PPP. [5 marks]
(C) Is the Australian dollar under or overvalued against Mexican pesos at the moment?Hint: Check the definition of the under/over valuation of a currency. [5 marks]
(D) The nominal exchange rate in 1 year is expected to become Ee$/Peso = 0.097. Using the definition ofthe real exchange rate with zero inflation rates in two countries, calculate the expected realexchange rate in 1 year, qe$/Peso.Hint: Check the definition of the real exchange rate in growth rates and apply the inflation ratesgiven. [10 marks]
(E) The exchange rate in 1 year is expected to be 0.097, Ee$/Peso = 0.097 as in (D), the current 1- year interest rate in Australia is 2%, and the 1-year forward rate is F$/Peso = 0.10. If you can borrow $1million from a bank in Australia or 10 million pesos from a bank in Mexico, explain how you canmake money without any exchange rate risks. The answer should have the specific amount ofprofits in Australian dollars in 1 year.Hint: Check the UIP equation and find the interest rate in Mexico. Then, apply the way to makemoney when the CIP does not hold.