Deck 19: International Finance and the Foreign Exchange Market

Question 1

If the dollar depreciates relative to the Japanese yen, how will this affect the dollar price of a Japanese camera produced by Nikon, for example? How will this change influence the quantity of Nikon cameras purchased by Americans?

Answer 1

The exchange rate is the price of foreign currency in terms of home currency. The international trade between two countries allows exchange of goods and services. This exchange between two countries involves the exchange of paper money or currency. To conduct the trade one trading partner need the currency of other. The exchange rate determines how much home currency will need to purchase a basket of good that is priced as one unit of foreign currency.
The currencies are bought and sold in the foreign exchange market. The equilibrium price of foreign currency is determined through the demand and supply of home currency in the exchange market. If the price of the foreign currency relative to home currency rises, that is now it needed more of the home currency to purchase one unit of foreign currency, the home currency depreciates. On the other hand, if the price of the foreign currency relative to home currency falls, that is now it needed less of the home currency to purchase one unit of foreign currency, the home currency appreciates.
An appreciation of home currency will mean that the less money will now be needed to purchase foreign goods and services. This means that the imports become cheaper. A depreciation of home currency will mean that the more money will now be needed to purchase the same foreign goods and services. This means that the imports become expensive.
If dollar depreciates relative to Japanese Yen, the price of dollar terms of yen will decrease. This means more of the US dollar now needed to purchase one Japanese camera than before. That is price of Japanese camera in terms of dollar will increase. This means the dollar price of Japanese camera will increase if the currency depreciates.
The law of demand states that, if the price of a normal good rises, the quantity demanded of that good will fall. The rise in price of the Japanese camera will decrease the purchase. The quantity of Nikon camera purchased by American will fall.

Question 2

How will the purchases of items from foreigners compare with the sales of items to foreigners when the foreign exchange market is in equilibrium? Explain.

Answer 2

The exchange rate is the price of foreign currency in terms of home currency. The international trade between two countries allows exchange of goods and services. This exchange between two countries involves the exchange of paper money or currency. To conduct the trade one trading partner need the currency of other. The exchange rate determines how much home currency will need to purchase a basket of good that is priced as one unit of foreign currency.
The currencies are bought and sold in the foreign exchange market. The equilibrium price of foreign currency is determined through the demand and supply of home currency in the exchange market. If the price of the foreign currency relative to home currency rises, that is now it needed more of the home currency to purchase one unit of foreign currency, the home currency depreciates. On the other hand, if the price of the foreign currency relative to home currency falls, that is now it needed less of the home currency to purchase one unit of foreign currency, the home currency appreciates.
An appreciation of home currency will mean that the less money will now be needed to purchase foreign goods and services. This means that the imports become cheaper. A depreciation of home currency will mean that the more money will now be needed to purchase the same foreign goods and services. This means that the imports become expensive.
The demand for foreign exchange is derived from the purchase of foreign goods by the domestic consumer. The domestic consumer supply domestic currency in the exchange market to acquire foreign currency to purchase foreign goods, services and assets. Thus, any point on the demand curve reflects the total domestic purchase from the foreigner.
On the other hand, the supply for foreign exchange is derived from the sales of foreign goods by the domestic consumer. The foreign consumer demand domestic currency in the exchange market to acquire foreign currency to purchase domestic goods and services and assets. Thus, any point on the supply curve reflects the total domestic sales to the foreigner.
At equilibrium the demand for foreign exchange must equal to the supply of foreign exchange. This will happens all the because of flexible exchange rate. Any disequilibrium will cause a change in the exchange rate and the market will reach equilibrium. The equilibrium in the foreign exchange market also implies that total purchase of goods, services and asset from foreigner must balance with the total sales of goods and services and assets.

Question 3

Will a flexible exchange rate bring the imports of goods and services into balance with the exports of goods and services? Why or why not?

Answer 3

The exchange rate is the price of foreign currency in terms of home currency. The international trade between two countries allows exchange of goods and services. This exchange between two countries involves the exchange of paper money or currency. To conduct the trade one trading partner need the currency of other. The exchange rate determines how much home currency will need to purchase a basket of good that is priced as one unit of foreign currency.
The currencies are bought and sold in the foreign exchange market. The equilibrium price of foreign currency is determined through the demand and supply of home currency in the exchange market. If the price of the foreign currency relative to home currency rises, that is now it needed more of the home currency to purchase one unit of foreign currency, the home currency depreciates. On the other hand, if the price of the foreign currency relative to home currency falls, that is now it needed less of the home currency to purchase one unit of foreign currency, the home currency appreciates.
An appreciation of home currency will mean that the less money will now be needed to purchase foreign goods and services. This means that the imports become cheaper. A depreciation of home currency will mean that the more money will now be needed to purchase the same foreign goods and services. This means that the imports become expensive.
The demand for foreign exchange is derived from the purchase of foreign goods by the domestic consumer. The domestic consumer supply domestic currency in the exchange market to acquire foreign currency to purchase foreign goods, services and assets. Thus, any point on the demand curve reflects the total domestic purchase from the foreigner.
On the other hand, the supply for foreign exchange is derived from the sales of foreign goods by the domestic consumer. The foreign consumer demand domestic currency in the exchange market to acquire foreign currency to purchase domestic goods and services and assets. Thus, any point on the supply curve reflects the total domestic sales to the foreigner.
At equilibrium the demand for foreign exchange must equal to the supply of foreign exchange. This will happens all the because of flexible exchange rate. Any disequilibrium will cause a change in the exchange rate and the market will reach equilibrium. The equilibrium in the foreign exchange market also implies that total purchase of goods, services and asset from foreigner must balance with the total sales of goods and services and assets.
Although, the equilibrium in exchange market implies that total purchase of goods, services and asset from foreigner must balance with the total sales of goods and services and assets, it does not implies the same for export and import of goods and services. This is because, the import and export of goods and services does not include the change of ownership and foreign direct investment. These items also create supply and demand for exchanges along with imports and export. Therefore, although flexible exchange rate ensures balance purchase by domestic consumers to foreigners and sales to foreigner by domestic consumers, it does not imply a balance between export of goods and services with import of goods and services.

Question 4

*The accompanying chart indicates an actual newspaper quotation of the exchange rate of various currencies. On February 2, did the dollar appreciate or depreciate against the British pound? How did it fare against the Canadian dollar?

Question 5

*Suppose the exchange rate between the United States and Mexico freely fluctuates in the open market. Indicate whether each of the following would cause the dollar to appreciate or depreciate relative to the peso.
a. an increase in the quantity of drilling equipment purchased in the United States by Pemex, the Mexican oil company, as a result of a Mexican oil discovery
b. an increase in the U.S. purchase of crude oil from Mexico as a result of the development of Mexican oil fields
c. higher real interest rates in Mexico, inducing U.S. citizens to move some of their financial investments from U.S. to Mexican banks
d. lower real interest rates in the United States, inducing Mexican investors to borrow dollars and then exchange them for pesos
e. inflation in the United States and stable prices in Mexico
f. an increase in the inflation rate from 2 percent to 10 percent in both the United States and Mexico
g. an economic boom in Mexico, inducing Mexicans to buy more U.S.-made automobiles, trucks, electric appliances, and manufacturing equipment
h. attractive investment opportunities in Mexico, inducing U.S. investors to buy stock in Mexican firms

Question 6

Explain why the current-account balance and capital-account balance must sum to zero under a pure flexible rate system.

Question 7

Rapidly growing strong economies often experience trade deficits, whereas economies with sluggish growth often have trade surpluses. Can you explain this puzzle?

Question 8

*In recent years, a substantial share of the domestic capital formation in the United States has been financed by foreign investors. Is this dependence on foreign capital dangerous? What would happen if the inflow of foreign capital came to a halt?

Question 9

*Suppose that the United States were running a currentaccount deficit. How would each of the following changes influence the size of the current-account deficit?
a. a recession in the United States
b. a decline in the attractiveness of investment opportunities in the United States
c. an improvement in investment opportunities abroad

Question 10

If taxes imposed on personal and corporate income increased substantially in the United States and the monetary policy of the United States was less stable and more inflationary than other countries, how would these policies affect the trade deficit? Why?

Question 11

If foreigners have confidence in the U.S. economy and therefore move to expand their investments in the United States, how will the U.S. current-account balance be affected? How will the exchange-rate value of the dollar be affected?

Question 12

Is a trade surplus indicative of a strong, healthy economy? Why or why not?

Question 13

*"Changes in exchange rates will automatically direct a country to a current-account balance under a flexible exchange rate system." Is this statement true or false?

Question 14

*Several members of Congress have been highly critical of Japan and China because U.S. imports from these countries have persistently been substantially greater than our exports to them.
a. Under a flexible exchange rate system, is there any reason to expect that the imports from a given country will tend to equal the exports to that country?
b. Can you think of any reason why the United States might persistently run a trade deficit with these countries?

Question 15

*In recent years, the central banks of both Japan and China have purchased large amounts of U.S. Treasury bonds. These purchases increase the exchange rate value of the dollar relative to the Japanese yen and Chinese yuan. Are these purchases harmful to the U.S. economy? Why or why not?