CHAPTER 29
EXCHANGE RATES AND MACROECONOMIC POLICY
EVEN NUMBER ANSWERS, SOLUTIONS, AND EXERCISES
ANSWERS TO ONLINE REVIEW QUESTIONS
2. Foreigners supply foreign currency (say, in the market where their currency is exchanged
for U.S. dollars) because they want to buy U.S. goods and services or U.S. assets. In
general economists believe that the supply curve for foreign currency is upward sloping.
As the price of foreign currency increases, U.S. goods and services become cheaper.
Foreigners buy more U.S. goods and services, and supply more foreign currency to get
the dollars with which to buy the goods. The following shift the supply of foreign
currency schedule to the right: an increase in foreign GDP, an increase in the relative
interest rate in the United States, a change in tastes that makes U.S. goods more desirable
to foreigners, a relative decrease in prices in the United States, and an expectation that the
foreign currency will depreciate. The following shift the supply of foreign currency curve
to the left: a decrease in foreign GDP, a decrease in the relative interest rate in the United
States, a change in tastes that makes U.S. goods less desirable to foreigners, a relative
increase in prices in the United States, and an expectation that the foreign currency will
appreciate.
4. In the very short run, exchange rates move mainly due to changes in interest rates and
expectations of future exchanges rates since these forces drive hot money. In the short
run, business cycles account for most of the change in exchange rates. Countries with
higher relative GDPs demand more foreign currency, causing their own currencies to
depreciate.
6. Purchasing power parity says that the exchange rate between two countries should adjust
until the average price of goods is approximately the same in the two countries. Exchange
rates might deviate from purchasing power parity because of high transportation costs,
barriers to trade, and the inherent difficulty in trading some goods.
8. A managed float is when the central bank intervenes in the foreign currency market to
prevent an appreciation or depreciation of its currency. Governments use a managed float
to help their export-oriented industries, to keep costs down for firms that import inputs, or
to decrease the risks of international trade that arise from exchange rate changes.
10. During the 1980s interest rates rose due to the rising budget deficit, a burst of investment
spending, and a drop in the private saving rate. All of these contributed to a higher U.S.
interest rate, and a capital inflow, as foreigners purchased more U.S. assets than
Americans purchased of foreign assets. The dollar appreciated making American goods
more expensive to foreigners, and foreign goods cheaper to Americans, and a trade
deficit resulted. The trade deficit persisted in the 1990s because of the continuing budget
deficit, strong investment spending, and relatively low private savings.
PROBLEM SET
2. a. Setting the quantity of pounds demanded equal to the quantity supplied, we have
10 – 2e = 4 + 3e  6 = 5e  e = 6/5, or 1.2 dollars per pound.
b. After the U.S. government intervenes, the demand for pounds equation becomes
12 – 2e. Resolving for equilibrium, the exchange rate climbs to 1.6 dollars per pound,
a depreciation of the dollar. The U.S. government might intervene in this way if it
wanted to help its export-oriented industries.
4.
Dollars
per
Peso
S1
pesos
pesos
S2
e1
D1
e2
D2
pesos
pesos
Quantity
of pesos
a. As the U.S. interest rate rises, causing a and I to fall, U.S. GDP decreases. The
interest rate increase also makes U.S. assets more attractive to Americans and to
Mexicans. This, combined with the fall in U.S. GDP, causes the demand curve for
Mexican pesos to shift leftward and the supply curve for pesos to shift rightward. The
U.S. dollar appreciates.
b. The U.S. dollar appreciation causes net exports to fall, further shrinking equilibrium
GDP in the U.S.
c. If the Mexican central bank raised its interest rates just as much as the United States,
then the dollar would not appreciate as much. (It might still appreciate somewhat,
depending on the relative decline in U.S. and Mexican GDP, and the impact of these
declines on U.S. net exports). While U.S. output would still fall, it would not fall as
much as in the initial analysis.
6.
a.
b. A fixed rate of 1.41 dinars per dollar is the equivalent of $0.71 per dinar. Since this is
higher than the market equilibrium price of $0.50 per dinar, Jordan’s central bank must
buy dinars to keep the dinar from depreciating.
c. Jordan would eventually run out of foreign reserves, and so could not buy dinars
forever.
d.
An expected fall in the dinar causes the supply curve for dinars to shift rightward from S 1
to S2and the demand curve to shift leftward D1 to D2.
e. The end result is that Jordan’s central bank must buy even more dinars to maintain the
fixed rate.
8.
Since Country B has the higher inflation rate, its relative price level is rising. As its
basket of goods becomes relatively more expensive, only a depreciation of its currency
10.
can restore purchasing power parity. Traders would buy Country A’s currency in order to
buy its goods for resale in Country B. Country A’s currency will appreciate relative to
Country B’s (alternately stated: Country B’s currency will depreciate relative to Country
A’s).
Since the trade deficit at point B equals 2,000 billion yen, and since the exchange rate is
$0.01 per yen, the trade deficit measured in dollars is 2,000 billion x $0.01 = $20 billion.
MORE CHALLENGING
12. More spending by the U.S. government causes U.S. interest rates to rise. This makes U.S.
assets more attractive, increasing the supply and decreasing the demand for foreign
currency. The dollar appreciates, causing net exports to fall, thus reducing real GDP. This
makes fiscal policy less effective in changing equilibrium GDP than it would be if the
effects on exchange rates were excluded.