3.2 Exchange Rates
The exchange rate
The exchange rate measures the external value of sterling in terms of
how much of another currency it can buy. For example - how many
dollars or Euros you can buy with £5000.
The daily value of the currency is determined in the foreign exchange
markets (FOREX) where billions of $s of currencies are traded every
hour.
The UK is currently operating with a floating exchange rate – where
the currency’s value is purely market determined and the Bank of
England does not seek to intervene through buying and selling
currencies in order to influence the pound’s value.
In contrast, the member states of the Euro Zone have created a single
currency eliminating individual national exchange rates against each
other – although the Euro is free to float against the pound, the US
dollar ($) and other currencies.
Types of exchange rate regimes
1
Free-floating exchange rates
2
3
4
The determination of the exchange rate under a floating exchange
rate is shown in the above figure.
 The demand curve (DD) indicates the quantity of Australian
dollars that buyers (those people who hold US dollars) are
willing to purchase at each possible exchange rate.
 The supply curve (SS) shows the quantity of Australian dollars
that will be offered for sale (those people who hold Australian
dollars) at each exchange rate.
 At the equilibrium exchange rate of $A1.00 = $US0.50 the
equilibrium quantity supplied and demanded is Q1 Australian
dollars. At an exchange rate above equilibrium, such as $A1.00
= $US0.60, an excess supply of Australian dollars exists and
market forces will force the exchange rate down towards
equilibrium.
 If the exchange rate is below equilibrium, such as $A1.00 =
$US0.40, an excess demand situation exits and market forces
will put upward pressure on the value of the Australian dollar.
Difference between an appreciation and depreciation in a
currency operating in a free floating exchange rate regime
‘When a currency appreciates it means it increased in value relative
to/in terms of another currency; depreciates means it weakened or
fell in value relative to/in terms of another currency’.
Source: http://study.com/academy/lesson/currency-appreciationdepreciation-effects-of-exchange-rate-changes.html, accessed Friday
September 18 2015
5
Currency Appreciation
 In Figure 2a there has been an increase in demand (DD to
D1D1) for Australian dollars. This has led to an increase
(appreciation) in value of the Australian dollar from $US0.50 to
$US0.60 and the quantity of Australian dollars traded has also
increased from 0Q to 0Q1.
The shift in the demand curve
could have been caused by an increase in the demand for
Australian exports, such as coal, aluminum, beef or lamb.
 In Figure 2b there has been a decrease in the supply (SS to
S1S1) of Australian dollars. This has led to an increase in the
value (appreciation) of the Australian dollar from $US0.50 to
$US0.60. However the quantity of Australian dollars traded has
decreased from 0Q to 0Q1.
This decrease in the supply of
Australian dollars may have been caused by a recession,
slowing the demand for imports.
6
Currency Depreciation
 In Figure 3a there has been a decrease in demand (DD to
D1D1) for Australian dollars. This has led to a depreciation in
the value of the Australian dollar from $US0.50 to $US0.40. The
quantity of Australian dollars traded has also decreased from
0Q to 0Q1.
The decrease in the price of Australian dollars in
terms of US dollars could have been generated by a slow down
in global economic activity, so decreasing the demand for
Australian exports, or because of foreign investors lacking
confidence in the Australian economy and investing elsewhere.
 Figure 3b indicates an increase in supply of Australian dollars
with the supply curve moving from SS to S1S1. Again the value
of the Australian dollar has decreased from $US0.50 to $US0.40
while the quantity of Australian dollars traded has increased
from 0Q to 0Q1.
The depreciation may have resulted from
strong domestic economic growth increasing the demand for
imports, or from higher overseas interest rates, causing a
capital outflow from Australia.
Source:
http://hsc.csu.edu.au/economics/place/exchange_rates/Tutorial5De
terminationofEx.html, accessed Friday September 18 2015
7
The effect of the exchange rate on the macroeconomic objectives
Low and stable rate of inflation
The exchange rate affects inflation in a number of direct and indirect
ways:
1. Changes in the prices of imported goods and services – this has a
direct effect on the consumer price index. For example, an
appreciation of the exchange rate usually reduces the sterling price of
imported consumer goods and durables, raw materials and capital
goods. The effect of a changing currency on the prices of imported
products will vary by type of import and also the price elasticity of
demand, which is influenced by the extent of competition within
individual markets.
2. Commodity prices and the CAP: Many internationally traded
commodities are priced in dollars – so a change in the sterling-dollar
exchange rate has a direct impact on the £ price of commodities such
as oil. The operation of the Common Agricultural Policy (CAP) can
also help to absorb fluctuations in the prices of imported foodstuffs
because of the variable import tariff. If world prices rise, the import
tariff can fall to insulate the EU from the effects of higher import
costs.
3. Changes in the growth of UK exports – movements in the
exchange rate affect the competitiveness of UK export industries in
global markets. A higher exchange rate makes it harder to sell
overseas because of a rise in relative UK prices. If exports slowdown
(price elasticity of demand is important in determining the scale of
any change in demand), then exporters may choose to cut their
prices, reduce output and cut-back employment levels. A fall in
export demand will reduce real national income relative to potential
output – and thus might lead to a negative output gap. This puts
downward pressure on inflation.
4. The exchange rate and wage bargaining – some economists
believe that the exchange rate influences the power of employees to
bargain for increases in real wages. When the exchange rate is high,
there is pressure on businesses to control their costs of production in
order to remain competitive – this may lead to downward pressure
on wage inflation.
8
Low rate of unemployment/full employment
To the extent that movements in the exchange rate affect the growth
of demand, output and investment in those sectors of the economy
exposed to international trade, the rate of unemployment can also be
influenced by currency fluctuations. In broad terms:
 An exchange rate appreciation tends to cause a slower rate of
growth of real GDP (e.g. because of a fall in net exports)
 A reduction in demand and output may cause job losses as
businesses seek to control costs and rationalize their
operations. Some job losses are temporary – reflecting short term changes in export demand and import penetration. Others
are permanent if domestic industries move out of some export
markets or if imports take up a permanently higher share of
the UK market
 Some industries are more exposed than others to currency
fluctuations – e.g sectors where a high percentage of total
output is exported and where demand is highly price sensitive
(price elastic)
AD-AS analysis can be used to illustrate the effects. In the first
diagram, we see an inward shift in the AD curve due to a rise in net
imports and in the second diagram we draw the effects of a reduction
in production costs arising from cheaper raw material and
component prices.
9
Summary of advantages of strong currency
1. Cheaper imports for consumers: A high pound leads to lower
import prices – this boosts the real living standards of
consumers at least in the short run – for example an increase in
the real purchasing power of UK residents when travelling
overseas or the chance to buy cheaper computers from the
United States or Europe.
2. Lower production costs for producers: When the sterling
exchange rate is high, it is cheaper to import essential raw
materials, component parts and capital inputs such as plant
and equipment – this is good news for businesses that rely on
imported components or who are wishing to increase their
investment of new technology from overseas countries. A fall in
import prices has the effect of causing an outward shift in the
short run aggregate supply curve. And if a country can now
import more productive technology, the long-run aggregate
supply curve may shift outwards as well.
3. Lower inflation: A strong exchange rate helps to control the
rate inflation because domestic suppliers now face stiffer
international competition from cheaper imports and will look
to cut their costs accordingly. Cheaper prices of imported
foodstuffs and beverages will also have a negative effect on the
rate of consumer price inflation.
4. If inflation is lower, then interest rates will be lower than if
the exchange rate was weaker – and cheaper money will
stimulate higher consumer spending and capital spending.
Disadvantages of a strong currency
1. Increase in the trade deficit: The lower price of imports leads
to consumers increasing their demand and this can cause a
larger trade deficit. Exporters lose price competitiveness
(because they will find it more expensive to sell in foreign
markets) and face losing market share – this can damage
profits and employment in some sectors. For example the high
exchange rate had damaged employment in Britain in sectors
such as textiles and clothing, car manufacturing and semiconductor production as production has shifted away from the
UK towards countries with lower production costs
2. Slower economic growth: If exports fall, this causes a
reduction in aggregate demand and reduces the short-term
10
rate economic growth as measured by the % change in real
GDP. This affects some regions of the UK economy more than
others. In the North-East for example, manufacturing industry
accounts for over 28% of regional GDP whereas the percentage
for the UK as a whole is just 19%. So a strong exchange rate
may threaten output, employment living standards more in
some regions than others.
3. If exports fall, then so will business confidence and capital
investment – because investment is partly dependent on the
strength of demand
11
Exchange rates and mathematical calculations (HL only)
Calculating the value of one currency in terms of another
currency.
You may be asked to make various calculations relating to exchange
rates and changes in exchange rates:
E.g.
1. The US dollar is currently trading against the Euro at a rate of US$1
= €0.8. What is the rate for €1 in US$?
To change an exchange rate around, we simply take the reciprocal of
the existing rate.
So, if US$1 = €0.8, then €1 = US$1.25 (1/0.8)
The table below shows the value of the Euro against five other
currencies. Fill in column 3 to express the value of one unit of each of
the currencies in Euros.
Currency
US Dollar
British Pound
Australian Dollar
Canadian Dollar
Emirati Dirham
Price of euro in Price of foreign
foreign currency
currency in euros
€1 = US$1.12
€1 = £0.74
€1 = AUS$1.59
€1 = CAD$1.48
€1 = AED4.12
12
Plotting demand and supply curves for a currency from linear
functions and identifying the equilibrium exchange rate.
You may be asked to identify the equilibrium exchange rate using
linear demand and supply functions. This is no different from finding
the equilibrium price in a demand and supply question.
Example
Country X has a currency know as the “Pesho‟. The country is
involved in international trade and the Pesho is a fully convertible
currency that is allowed to float freely on the foreign exchange
markets.
The demand and supply functions for the Pesho are given below:
QD = 3200 – 400E
QS = -400 + 400E
Where E is the exchange rate of the Pesho in terms of the US dollar
Structure to follow
Make a table to show the demand schedule and supply schedule for
the Pesho, when exchange rates are $0, $1, $2, $3, $4 and $5.
Price
$0
$1
$2
$3
$4
$5
QD = 3200 – 400E
Qs = -400 + 400E
13
Using the axes above:
ii. Draw a diagram to show the demand curve and supply curves that
represent the demand and supply schedules that you have made.
iii. Illustrate the exchange rate.
iv. Using simultaneous equations, calculate the exchange rate.
Now let us assume that the demand function for the Pesho changes
to:
QD = 3 600 – 400P
v. Explain two factors that might have caused the change in the
demand function.
14
vi. Make a new table to show the demand schedule for the new
demand function, when exchange rates are $0, $1, $2, $3, $4 and $5.
Price
$0
$1
$2
$3
$4
$5
QD = 3600 – 400E
Qs = -400 + 400E
vii. Add the demand curve that represents the new schedule to the
diagram that you drew in 2.
viii. Illustrate the new equilibrium exchange rate.
ix. Explain the likely effect that the change in the exchange rate will
have upon the demand for exports and imports in Country X.
15
Calculating the price of a good in different currencies, using
exchange rates.
You may be asked to make various calculations relating to exchange
rates and the prices of goods in different countries:
E.g.
i. If US$1 = €0.8, what would be the cost in Euros of a good that was
selling for US$75?
If a good is selling for US$75, then its cost in Euros will be 75 x €0.8 =
€60.
ii. If the exchange rate changes from US$1 = €0.8 to US$1 = €0.9,
explain what would happen to the Euro price of an Americanmanufactured dress shirt that was being exported to Europe from the
USA at a cost of US$150.
With the original exchange rate of US$1 = €0.8, the dress shirt would
cost €120 (150 x €0.8). With the new exchange rate, the value of the
Euro has depreciated. It now costs more Euros to buy the same
amount of dollars, and so the price of the dress shirt increases to
€135 (150 x €0.9).
Question 1
The table below shows the exchange rate between the Euro and five
other currencies:
Currency
US Dollar
British Pound
Australian Dollar
Canadian Dollar
Emirati Dirham
Price of euro in
foreign currency
€1 = US$1.12
€1 = £0.74
€1 = AUS$1.59
€1 = CAD$1.48
€1 = AED4.12
16
If a large beer costs €4 in Vienna, then what would be the cost in each
of the currencies above?
Currency
US Dollar
British Pound
Australian Dollar
Canadian Dollar
Emirati Dirham
Price of euro in Price of €4 beer in
foreign currency
foreign currencies
€1 = US$1.12
€1 = £0.74
€1 = AUS$1.59
€1 = CAD$1.48
€1 = AED4.12
Question 2
The table below shows the exchange rate between the Euro and five
other currencies at an interval of 6 months:
Currency
US Dollar
British Pound
Australian Dollar
Canadian Dollar
Emirati Dirham
Price of euro in
foreign
currency
(January)
€1 = US$1.29
€1 = £0.81
€1 = AUS$1.27
€1 = CAD$1.26
€1 = AED4.75
Price of euro in
foreign
currency
(July)
€1 = US$1.35
€1 = £0.95
€1 = AUS$1.15
€1 = CAD$1.10
€1 = AED4.15
For each of the currencies above:
i. Calculate the cost of a €25 phone card in each time period – January
and July.
ii. Using figures, explain whether the Euro has got weaker or stronger
against the currency.
17
Government Intervention
Fixed Exchange rate regime
Under a fixed exchange rate system the government or one of its
agencies fixes the value of a country’s currency, for example the
Reserve Bank of Australia (RBA) to another currency for a specific
time period.
In the Figure above the official exchange rate has been fixed at a level
of $A1.00 = $US0.60, which is above the market rate of $A1.00 =
$US0.50. For the exchange rate to be fixed at a level higher than the
market rate requires official intervention by the Reserve Bank of
Australia.
At this level the RBA would have to buy the excess supply of
Australian dollars equivalent to Q1Q2 at a price of $US0.60. To buy
the surplus of Australian dollars the government would need to sell
its reserves of foreign currency.
18
A fixed exchange rate system does not imply that the rate will stay at
that same level all the time. The government may decide to change
the rate because of adverse effects on the economy. For example, if
the currency is overvalued exporting industries will become less
internationally competitive, affecting international trade and the
balance of payments and the government might take action to
devalue the exchange rate.
Devaluation and Revaluation
A devaluation of a currency occurs under a fixed exchange rate
system when there is deliberate action taken by a government to
decrease its value in the FOREX market.
Alternatively a revaluation occurs under a fixed exchange rate
system when there is deliberate action taken by the government to
increase the value of the currency in the FOREX market.
Managed exchange rate regime
Managed float regimes are where exchange rates fluctuate, but
central banks attempt to influence the exchange rates by buying and
selling currencies.
Managed float regimes, otherwise known as dirty floats, are where
exchange rates fluctuate from day to day and central banks attempt
to influence their countries' exchange rates by buying and selling
currencies. Almost all currencies are managed since central banks or
governments intervene to influence the value of their currencies. So
when a country claims to have a floating currency, it most likely
exists as a managed float.
How a Managed Float Exchange Rate Works
Generally, the central bank will set a range, which its currency's value
may freely float between. If the currency drops below the range's
floor or grows beyond the range's ceiling, the central bank takes
action to bring the currency's value back within range.
Management by the central bank generally takes the form of buying
or selling large lots of its currency in order to provide price support
or resistance. For example, if a currency is valued above its range, the
19
central bank will sell some of its currency it has in reserve. By putting
more of its currency in circulation, the central bank will decrease the
currency's value.
Why Do Countries Choose a Managed Float
Some economists believe that in most circumstances floating
exchange rates are preferable to fixed exchange rates. Floating
exchange rates automatically adjust to economic circumstances and
allow a country to dampen the impact of shocks and foreign business
cycles. This ultimately preempts the possibility of having a balance of
payments crisis. A floating exchange rate also allows the country's
monetary policy to be freed up to pursue other goals, such as
stabilizing the country's employment or prices.
However, pure floating exchange rates pose some threats. A floating
exchange rate is not as stable as a fixed exchange rate. If a currency
floats, there could be rapid appreciation or depreciation of value.
This could harm the country's imports and exports. If the currency's
value increases too drastically, the country's exports could become
too costly which would harm the country's employment rates. If the
currency's value decreases too drastically, the country may not be
able to afford crucial imports.
This is why a managed float is so appealing. A country can obtain the
benefits of a free-floating system but still has the option to intervene
and minimize the risks associated with a free floating currency. If a
currency's value increases or decreases too rapidly, the central bank
can intervene and minimize any harmful effects that might result
from the radical fluctuation.
Source: Boundless. “Managed Float.” Boundless Economics.
Boundless, 21 Jul. 2015. Retrieved 18 Sep. 2015 from
https://www.boundless.com/economics/textbooks/boundlesseconomics-textbook/open-economy-macroeconomics-32/exchangerates-130/managed-float-520-12616/
20
Consequences of overvalued and undervalued currency
Purchasing Power Parity (PPP) – a method of determining the
over/under valuation of a currency
‘In IB Economics we’re studying the theory of exchange rates. A
floating exchange rate system should be in equilibrium when the rate
enables people in different countries to buy the same basekt of goods
with an equal amount of money. In other words, If I walk into
McDonalds in the US and have to pay $3.00 for a Big Mac, then board
a plane, land in Shanghai and walk into a McDonalds there, the price I
pay in Shanghai should, given current exchange rates, be the same as
what I paid in the US. In reality, a Big Mac in Shanghai costs about
56% less than one in the US. This tells economists something about
the value of the Chinese RMB.
If the price of a particular basket of goods for Americans is higher
than the same basket of goods for Chinese given current exchange
rates, than that would be a sign that the Chinese currency is
undervalued. In the long run, “exchange rates should move towards
levels that would equalize the prices of an identical basket of goods
and services bought in either of the two countries whose exchange
rates are being compared.” This concept is known as Purchasing
Power Parity (PPP).
One way to test the level of undervaluation of the yuan is to apply the
principle of PPP. If we could compare the price of a particular basket
of goods (or even ONE good that can be bought in both countries),
then we can determine whether at current exchange rates the RMB is
under or over-valued. Luckily, the Economist magazine has
developed its own measure of PPP, and it’s chosen one product that
can be purchased in nearly every country in the world, the BIG MAC!
The table below shows by how much, in Big Mac PPP terms, selected
currencies were over- or undervalued at the end of January… The
most undervalued currency is the Chinese yuan, at 56% below its
PPP rate; several other Asian currencies also appear to be 40-50%
undervalued.
The index is supposed to give a guide to the direction in which
currencies should, in theory, head in the long run It is only a rough
guide, because its price reflects non-tradable elements—such as rent
21
and labour. For that reason, it is probably least rough when
comparing countries at roughly the same stage of development.
Perhaps the most telling numbers in this table are therefore those for
the Japanese yen, which is 28% undervalued against the dollar, and
the euro, which is 19% overvalued. Hence European finance
ministers’
beef
with
the
low
level
of
the
yen’.
[http://welkerswikinomics.com/blog/2007/11/06/burgernomicsand-the-purchasing-power-parity/accessed Sunday October 4th
2015]
22
Big Mac Index 2001
Country
Big Mac
price in
local
currency
US
Australia
$2.54
A$3.00
Big
Mac
price
in
US$
$2.54
$1.52
Britain
Canada
£1.99
C$3.33
$2.85
$2.14
China
Euro area
Hong Kong
¥9.90
$1.20
€2.57
$2.27
HK$10.70 $1.37
Japan
Russia
¥294
Rouble
35.00
South
Won
Korea
3000
Switzerland SFr6.30
$2.38
$1.21
$2.27
$3.65
Implied
PPP
(local
price/US
price)
---
Actual
exchange
rate
17/04/01
---$1
=
A$1.98
$1 = £0.70
$1
=
C$1.56
$1 = ¥8.28
$1 = €1.14
$1
=
HK$7.80
$1 = ¥124
$1
=
Rouble
28.9
$1
=
Won1325
$1
=
SFr1.73
Undervaluation/overvaluation
against
the
dollar %
-----
23
Overvalued Currency
Advantages
1. Downward pressure on inflation i.e. imported goods will be
cheaper
2. More imports can be bought
3. High value of currency forces domestic producers to improve
their efficiency to be more competitive in the international
market.
Disadvantages
1. Overvalued currency will make exports uncompetitive in the
international market, which will hurt the export industries
2. Imports are relatively cheaper to buy due to overvalued
currency. Consumers will go in for more imports, which will
damage to domestic industries
Undervalued currency
Advantages
1. If currency is undervalued, the exports will be cheaper and
they will grow leading to greater employment in export
industries
2. Undervalued currency will make imports expensive for
consumers, they will divert to domestic goods and thus
employment in domestic industries will increase.
Disadvantages
1. An undervalued currency makes imports expensive which also
leads to Imported inflation i.e. all the products using
imported components/raw material will become expensive
thus effecting the general price level.
Source: http://www.dineshbakshi.com/ib-economics/internationaleconomics/157-revision-notes/2088-consequences-of-overvaluedand-undervalued-currencies, accessed Friday September 18 2015
24
Evaluation of fixed and floating exchange rates
The case for floating exchange rates
1. Reduced need for currency reserves: There is no exchange rate
target so there is little requirement for the central bank (e.g. the Bank
of England) to hold large scale reserves of gold and foreign currency
to use in possible official intervention in the markets
2. Useful instrument of macroeconomic adjustment: A floating rate
can act as a useful tool of macroeconomic adjustment – for example a
depreciation should provide a boost to net export demand and
therefore stimulate growth. This assumes that the gains from a lower
exchange rate are not dissolved in higher wage claims or export
prices. The countries inside the Euro Zone for example might be
hoping for a more competitive exchange rate as a means of creating
an injection of demand into their slow-growing economies.
3. Partial automatic correction for a trade deficit: Floating
exchange rates offer a degree of adjustment when the balance of
payments is in fundamental disequilibrium – i.e. a large trade deficit
puts downward pressure on the exchange rate which should help the
export sector and control demand for imports because they become
relatively expensive.
4. Reduced risk of currency speculation: The absence of an explicit
exchange rate target reduces the risk of currency speculation. Often,
currency market speculators target an exchange rate target that they
believe to be fundamentally over or undervalued.
5. Freedom (autonomy) for domestic monetary policy: The absence
of an exchange rate target allows short term interest rates to be set
to meet domestic macroeconomic objectives such as stabilizing
growth or controlling inflation. The Bank of England has enjoyed the
autonomy that a floating exchange rate gives since it was made
independent in May 1997.
6. Floating exchange rates are not always volatile exchange rates
- although the sterling exchange rate has been floating, the volatility
has not been that great. Businesses have learnt to cope with modest
fluctuations – helped by having a flexible labour market.
25
The case for fixed exchange rates
1. Trade and Investment: Currency stability can help to promote
trade and investment because of lower currency risk
2. Some flexibility permitted: Some adjustment to the fixed currency
parity is possible if the economic case becomes unstoppable (i.e. the
occasional devaluation or revaluation of the currency if agreement
can be reached with other countries). That said, countries with fixed
exchange rates are often reluctant to make parity adjustments –
these decisions are often see as politically damaging.
3. Reductions in the costs of currency hedging: Because we can
never predict what will happen to the market value of a currency,
many businesses hedge against this volatility by buying the currency
they need in the forward currency markets. With fixed exchange
rates, businesses have to spend less on currency hedging if they
know that the currency will hold its value in the foreign exchange
markets (hedging involves risk)
4. Disciplines on domestic producers: A stable (fixed) currency acts
as a discipline on producers to keep their costs and prices down and
may lead to greater pressure for exporters to raise labour
productivity and focus more resources on research and innovation.
In the long run, with a fixed exchange rate, one country’s inflation
must fall into line with another (and thus put substantial competitive
pressures on prices and real wages)
5. Reinforcing gains in comparative advantage: If one country has
a fixed exchange rate with another, then differences in relative unit
labour costs will quite easily be reflected in changes in the rate of
growth of exports and imports. Consider the example of China and
the United States. Most estimates indicate that the Chinese currency
is undervalued against the dollar. This makes Chinese products
cheaper than they would otherwise be and has led to a surge in
import penetration from China into the US economy. This has led to
numerous calls from US manufacturers for the Chinese to be
persuaded to switch to a floating exchange rate or to adjust their
currency by appreciating against the dollar. China recently
announced that they would allow more market forces to determine
the value of the Yuan.
26
Questions
1: A bicycle manufactured in the United States costs $200. Using
today’s current exchange rates, what would the bicycle cost in each of
the following countries? Use the website site www.x-rates.com
(a) Argentina
(b) Brazil
(c) Canada
2: You are a US importer who buys goods from many different
countries. How many US dollars do you need to settle each of the
following invoices? Use the website site www.x-rates.com
(a) AUS$1,000,000 for wool blankets
(b) £500,000 for dishes
(c) 100,000 Indian rupees for baskets
(d) ¥150,000,000 for stereo equipment
(e) €825,000 for German wine
3: What is the dollar value of the invoices in Q2 if the US dollar:
(a) depreciates 10% against the Australian Dollar
(b) appreciates 10% against the British Pound
(c) depreciates 10% against the Indian rupee
(d) appreciates 20% against the Japanese Yen
(e) depreciates 100% against the Euro
4: The US dollar price of a Swedish Krona changes from $0.1572 to
$0.1730.
(a) Has the dollar depreciated or appreciated against the Krona?
(b) Has the Krona appreciated or depreciated against the dollar.
5: If the interest rate on one-year government bonds is 5% in
Germany and 8% in the United States, what do you think is expected
to happen to the dollar value of the Euro?
27
6: Suppose a US investor buys a one-year German bond (bund) with a
face value of €10,000 that has a 10% annual interest rate. How many
dollars will a US investor receive at maturity if the exchange rate is
$1 = €0.81
7: Suppose that yesterday; the US dollar was trading on the foreign
exchange Market at 100 yen per dollar. Today, the US dollar is
trading at 105 yen per dollar.
(a) Which of the two currencies has appreciated and which
depreciated today?
(b) List the events that could have caused today’s change in the value
of the US dollar on the foreign exchange market.
(c) Did the events that you listed in part (b) change the demand for
US dollars, the supply of US dollars or both demand and supply of US
dollars?
(d) If the Federal Reserve (Central bank) tried to stabilise the value
of the US Dollar at 100 yen per dollar, what action would it have
taken?
(e) In part (d), what effect would the Fed’s actions have had on the US
official reserves?
8: Suppose that yesterday the Canadian dollar was trading on the
foreign exchange market at $0.75 US per C$1. Today, the Canadian
dollar is trading at $0.70 per C$1
(a) Which of the two currencies has appreciated and which
depreciated today?
(b) List the events that could have caused today’s change in the value
of the Canadian dollar on the foreign exchange market.
(c) Did the events that you listed in part (b) change the demand for
Canadian dollars, the supply of Canadian dollars or both demand and
supply of Canadian dollars?
(d) If the Bank of Canada (Central bank) tried to stabilise the value of
the Canadian Dollar at 100 at $0.75, what action would it have taken?
(e) In part (d), what effect would the Bank of Canada’s actions have
had on the Canadian official reserves?
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9: The US dollar appreciates, State, with reasons, which of the
following events could have caused these changes to occur:
(a) The Fed intervened in the foreign exchange market and sold
dollars
(b) People began to expect the dollar to appreciate
(c) The US interest rate differential narrowed
(d) The US current account went into deficit.
10: If the US dollar depreciates against the Euro, what will be the
economic consequences for US residents?
11: Using a FOREX diagram, illustrate the effect of a change in tastes
prompting German residents to buy more goods from the United
States. If the exchange rate is floating, what will happen to the
foreign-exchange-market equilibrium?
12: Suppose that on January 1st the Yen price of the dollar is 120.
Over the year, the Japanese inflation rate is 5% and the US inflation
rate is 10%. If the exchange rate is $1=¥130 at the end of the year,
relative to PPP, does the Yen appear to be overvalued, undervalued,
or at the PPP level?
13: Under a gold standard, if the price of an ounce of gold is 400 US$
and 500 C$, what is the exchange rate between US and Canadian
dollars?
14: If Mexico uses a fixed exchange rate relative to the US dollar, how
can Mexico fix the value of the peso relative to the dollar when the
demand for and supply of dollars and pesos change continually?
Illustrate your explanation with a graph.
15: If the price of a pound of salmon is $5 in Seattle, Washington, and
the exchange rate between US and Canadian dollars is $0.80 =
C$1.00, then what would the Canadian dollar price of salmon have to
be in Vancouver, British Columbia in order for PPP to hold?
16: Illustrate and explain the meaning and likely effects of an
overvalued exchange rate.
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17: Other things being equal, what kind of exchange-rate system
would you expect each of the following countries to adopt?
(a) A small country that conducts all of its trade with the United
States.
(b) A country whose policies have led to a 300% annual rate of
inflation.
(c) A country that wants to offer exporters cheap access to the
imported inputs they need but to discourage other domestic
residents from importing goods.
(d) A large country like the United States or Japan.
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