Deck 17: The Foreign Exchange Market

Question 1

Predicting the Future
Answer the remaining questions by drawing the appropriate exchange market diagrams.
The president of the United States announces that he will reduce inflation with a new anti-inflation program. If the public believes him, predict what will happen to the exchange rate for the U.S. dollar.

Answer 1

Exchange rate is nothing but the value of a currency in terms of another foreign currency. In simple exchange rate is the rate at which one currency can be converted into another currency.
Anti-inflation program means raising the interest rates and this encourages foreign investors to buy U.S securities. Hence, the announcement results a fall in the U.S inflation that means U.S. dollar appreciates and the foreign currency depreciates. Due to this the expected return on the deposits made in foreign countries will also decreases.
Therefore, the demand for the U.S. deposits increases and the dollar will appreciate.

Question 2

Use a graph of the foreign exchange market for dollars to illustrate the effects described in each problem.
If a strike takes place in France, making it harder to buy French goods, what will happen to the value of the U.S. dollar?

Answer 2

Suppose a strike takes place in France and makes it harder for other countries to purchase French goods. This affects the foreign exchange market for dollars as follows: The amount of French exports decrease because access to French goods is limited. In contrast, the amount of U.S. exports is now relatively higher as countries use dollars to purchase American goods in place of French goods. This increases the demand for dollars in the foreign exchange market, shifting the demand curve rightward from D to D'. As a result, the exchange rate for the U.S. dollar increases from E t to E t ' and leads to the appreciation of the dollar.

Question 3

If the British central bank lowers interest rates to reduce unemployment, what will happen to the value of the pound in the short run and in the long run?

Answer 3

Suppose the British central bank lowers interest rates to reduce unemployment. This will increase the demand for pounds as savings decrease and consumption increases. As a result, the pound appreciates in the short-run. Its value will return to its equilibrium in the long-run because altering interest rates is not a factor that affect exchange rates in the long-run. These factors include trade barriers, productivity, relative price levels, and preferences for domestic goods as opposed to foreign goods.

Question 4

Predicting the Future
Answer the remaining questions by drawing the appropriate exchange market diagrams.
If the Indian government unexpectedly announces that it will be imposing higher tariffs on foreign goods one year from now, what will happen to the value of the Indian rupee today?

Question 5

Predicting the Future
Answer the remaining questions by drawing the appropriate exchange market diagrams.
If nominal interest rates in America rise but real interest rates fall, predict what will happen to the U.S. exchange rate.

Question 6

If American auto companies make a breakthrough in automobile technology and are able to produce a car that gets 200 miles to the gallon, what will happen to the U.S. dollar exchange rate?

Question 7

Predicting the Future
Answer the remaining questions by drawing the appropriate exchange market diagrams.
If Mexicans go on a spending spree and buy twice as much French perfume, Japanese TVs, English sweaters, Swiss watches, and Italian wine, what will happen to the value of the Mexican peso?

Question 8

When the euro appreciates, are you more likely to drink California or French wine?

Question 9

Through the summer and fall of 2008, as the global financial crisis began to take hold, international financial institutions and sovereign wealth funds significantly increased their purchases of U.S. Treasury securities as a safe haven investment. How should this have affected U.S. dollar exchange rates?

Question 10

The Federal Reserve maintains a website that lists the exchange rates between the U.S. dollar and many other currencies. Go to http://www.newyorkfed.og/markets/foreignex.html. Go to the historical data for 1999 and afterward, and find the data on the euro.
a. Calculate the difference between the LIBOR rate in the United States and the LIBOR rates in the three other countries using the data from one year ago and the most recent data available.
b. Based on the changes in interest rate differentials, do you expect the dollar to depreciate or appreciate against the other currencies?

Question 11

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In March 2009, the Federal Reserve announced a quantitative easing program designed to lower intermediate and longer-term interest rates. What effect should this have on the dollar/euro exchange rate?

Question 12

"A country is always worse off when its currency is weak (falls in value)." Is this statement true, false, or uncertain? Explain your answer.

Question 13

A German sports car is selling for 70,000 euros. What is the dollar price in the United States for the German car if the exchange rate is 0.90 euros per dollar?

Question 14

International travelers and business people frequently need to accurately convert from one currency to another. It is often easy to find the rate needed to convert the U.S. dollar into another currency. It can be more difficult to find exchange rates between two non-U.S. currencies. Go to http://www.oanda.com/convert/classic. This site lets you convert from any currency into any other currency. How many Lithuanian litas can you currently buy with one Chilean peso?

Question 15

If the Canadian dollar to U.S. dollar exchange rate is 1.28 and the British pound to U.S. dollar exchange rate is 0.62, what must the Canadian dollar to British pound exchange rate be?

Question 16

When the U.S. dollar depreciates, what happens to exports and imports in the United States?

Question 17

The New Zealand dollar to U.S. dollar exchange rate is 1.36, and the British pound to U.S. dollar exchange rate is 0.62. If you find that the British pound to New Zealand dollar were trading at 0.49, what would you do to earn a riskless profit?

Question 18

If the Japanese price level rises by 5% relative to the price level in the United States, what does the theory of purchasing power parity predict will happen to the value of the Japanese yen in terms of dollars?

Question 19

In 1999 the euro was trading at $0.90 per euro. If the euro is now trading at $1.16 per euro, what is the percentage change in the euro's value? Is this an appreciation or depreciation?

Question 20

If the demand for a country's exports falls at the same time that tariffs on imports are raised, will the country's currency tend to appreciate or depreciate in the long run?

Question 21

The Mexican peso is trading at 10 pesos per dollar. If the expected U.S. inflation rate is 2% while the expected Mexican inflation rate is 23% over the next year, what is the expected exchange rate in one year?

Question 22

When the Federal Reserve conducts an expansionary monetary policy, what happens to the money supply? How does this affect the supply of dollar assets?

Question 23

If the price level recently increased by 20% in England while falling by 5% in the United States, how much must the exchange rate change if PPP holds? Assume that the current exchange rate is 0.55 pounds per dollar.

Question 24

From 2009 to 2011, the economies of Australia and Switzerland suffered relatively mild effects from the global financial crisis. At the same time, many countries in the euro area were hit hard by high unemployment and burdened with unsustainably high government debts. How should this have affected the euro/Swiss franc and euro/Australian dollar exchange rates?

Question 25

Use a graph of the foreign exchange market for dollars to illustrate the effects described in each problem.
If expected inflation drops in Europe, so that interest rates fall there, what will happen to the exchange rate on the U.S. dollar?

Question 26

In the mid- to late 1970s, the yen appreciated relative to the dollar even though Japan's inflation rate was higher than America's. How can this be explained by an improvement in the productivity of Japanese industry relative to American industry?

Question 27

Use a graph of the foreign exchange market for dollars to illustrate the effects described in each problem.
If the European Central Bank decides to pursue a contractionary monetary policy to fight inflation, what will happen to the value of the U.S. dollar?