Introductory Macroeconomics
Dr King
1. Illustrate how each of the following affects the exchange rate and quantity of
Deutschmarks (DM), using a demand/supply diagram. Assume the exchange rate is in
terms of U.S. dollars per DM and that the exchange rate is floating.
a) Mercedes (a German-manufactured car) sales in the U.S. decrease.
b) Germans purchase fewer U.S. goods.
c) The U.S. experiences an economic boom.
d) Germany experiences an economic boom, increasing Germans’ demand for American
goods.
e) Germans decide they would rather buy more German automobiles and fewer American
automobiles.
f) Interest rates on U.S. bonds increase, while those on German bonds remains unchanged.
See next page for diagrams.
a) This reduces the demand for DM because Americans need fewer DM when they buy
fewer Mercedes.
b) This reduces the supply of DM because Germans sell back their U.S. dollars and
purchase their own currency in the foreign exchange market. This reduces the supply of
DM.
c) This increases the demand for DM, because Americans need to hold more DM to
purchase more German imports into the U.S.
d) This increases the supply of DM because Germans sell their DM to acquire U.S. dollars.
e) This reduces the supply of DM because Germans sell their U.S. dollars for German DM
to purchase more German goods.
f) The higher interest rates will cause Germans and Americans to want to hold U.S. bonds.
This means Americans will demand fewer DM and more dollars, causing the demand for
DM to fall. Germans will want fewer DM and more dollars, so they can hold more of
their assets in the form of U.S. bonds. They will sell their DM to acquire dollars,
increasing the supply of DM in the market.
1.1 How does each of the policies in a) – f) affect the value of the DM? How does each affect the
value of the U.S. dollar? Indicate whether each currency appreciates or depreciates.
a), c), f) Since e falls, the DM depreciates and the U.S. dollar appreciates. It takes
fewer dollars to buy a DM, so the value of the DM has decreased and the value of the
dollar has increased.
b), d), e) Since e rises, the DM appreciates and the U.S. dollar depreciates. It takes
more dollars to buy a DM, so the value of the DM has increased and the value of the
dollar has decreased.
Price of DM (in U.S. Dollars)
S1
e2
e1
Panel e)
Price of DM (in U.S. Dollars)
Panel a)
D1
Panel c)
S1
S2
e2
e1
Price of DM (in U.S. Dollars)
Price of DM (in U.S. Dollars)
Price of DM (in U.S. Dollars)
S1
e1
e2
Price of DM (in U.S. Dollars)
Introductory Macroeconomics
Dr King
e
e
e
e
DM
S2
S1
e2
e1
D2
D1
D1
DM
Panel b)
DM
D1
Panel f)
DM
e
S1
S2
e1
e2
D2
D1
Panel d)
DM
e
S1
S2
e1
e2
D2
D1
DM
Introductory Macroeconomics
Dr King
2. During the 1997-1998 Asian financial crisis, Indonesia, Korea, Malaysia, Korea suffered
from speculative attacks on their currencies. Before the crisis, Korea had its currency
(the won) pegged to the U.S. dollar. Except for Malaysia, these countries have since
moved to floating exchange rates, and are in the process of recovering from recessions.
The price of 100 won fell from $0.11 in May 1997 to $0.06 in December 1998.
(a) Illustrate the market for the Korean won, assuming a fixed exchange rate.
Since the currency is neither overvalued nor undervalued, that means it is equal to
the market rate.
(b) In 1997, one of Korea’s major trading partners (China) experienced an increase in interest
rates. Illustrate how this affects the market for won using your diagram from (a).
An increase in Chinese interest rates means that Korean will want sell their won to
obtain Chinese yuan (China’s currency). This increases the supply of won. Also, the
Chinese will sell their won to hold more of their own currency, reducing the demand
for won. The market exchange rate for won is below the fixed exchange rate.
e
S1
Price of won (in U.S. Dollars)
Price of won (in U.S. Dollars)
e
efixed
S1
S2
efixed
BOP Deficit
D1
Panel a)
D2
won
D1
Panel b)
(c) Suppose the Korean central bank (the Bank of Korea) decides to maintain the value of the
Korean won. How does it do so?
The Bank of Korea must buy the excess supply of won. It does so by spending its
foreign reserves. This maintains the fixed exchange rate.
(d) The Korean central bank attempted to increase the demand for won by increasing the
interest rate. From May 1997 to December 1997, the interest rate soared from 11% to
30%. Illustrate how this should affect the foreign exchange market.
To increase the interest rate, the Bank of Korea must reduce the money supply. This
should attract investors (both Korean and foreign) to invest in Korean bonds. This
should cause the demand for
won
Introductory Macroeconomics
Dr King
e
Price of won (in U.S. Dollars)
Price of won (in U.S. Dollars)
e
S2
S1
BOP Deficit
efixed
D1
Panel d)
S1
S2
BOP Deficit
efixed
D1
D2
won
Panel e)
won to increase and the supply of won to decrease.
(e) The Bank of Korea’s monetary policy was unsuccessful, and investors believed the
value of the won could no longer be defended the Bank of Korea. How will they
respond? What will happen to the supply of won?
Investors will respond by selling their won holdings. This will increase the supply of
won.
won