Deck 14: Exchange Rates and Their Determination: A Basic Model

Question 1

Describe what the terms appreciation and depreciation mean.

Answer 1

An increase in the value of a currency is referred to as appreciation. Analogously, a decline in the value of the currency is referred to as depreciation.

Question 2

What is the difference between direct and indirect quotes of the exchange rate? Give an example of each.

Answer 2

Exchange rates can be quoted as either domestic currency per unit of foreign currency (a direct quote) or units of foreign currency per unit of domestic currency (an indirect quote). The exchange rate between the dollar and the Japanese yen is usually reported as yen per dollar- indirect quote. The direct quote is one yen is worth approximately one U.S. penny. So the exchange rate of 110 yen to the dollar is somewhat easier to think about than .0090909 dollars per yen.

Question 3

Why does the demand for foreign exchange slope downwards and to the right? What factors would cause this curve to shift?

Answer 3

The demand for foreign exchange results from domestic residents demanding foreign goods and services and the exchange rate is simply the price of foreign exchange. As the exchange rate falls, the dollar appreciates and imports become less expensive. As imports become less expensive, the quantity demanded increases. If any other factor that influences the demand for the good in question changes, then the entire demand curve shifts. As with most goods and services, changes in the demand for foreign exchange are related to a country's income level and relative price levels. The two most important factors that shift the U.S. demand for foreign exchange are changes in U.S. income and prices in the U.S. relative to prices in foreign countries.

Question 4

Why does the supply of foreign exchange slope upwards? What factors would cause this curve to shift?

Question 5

Explain how changes in domestic income affect the exchange rate.

Question 6

How do changes in foreign income affect the exchange rate?

Question 7

Suppose that inflation in the U.S. is 2 percent and 5 percent in the U.K. Show what would happen to the dollar/pound exchange rate?

Question 8

If domestic income is increasing rapidly and domestic prices are rising faster than foreign prices, what will happen to the exchange rate?

Question 9

The equilibrium exchange rate tends to change frequently, why does this occur?

Question 10

Suppose that you had to forecast the exchange rate for a country for the next year. What factors would you have to consider?

Question 11

Explain how exchange rate volatility tends to lower the amount of international trade.