Chapter 4 Questions and Applications

Lynette S. Garner

1. Percentage Depreciation. Assume the spot rate of the British pound is $1.73. The expected spot
rate one year from now is assumed to be $1.66. What percentage depreciation does this
reflect?
S-St-1/St-1 = Percent in foreign currency value so $1.66-$1.73/$1.73 = .04046 or 4.05%

2. Inflation Effects on Exchange Rates. Assume that the US inflation rate becomes high relative to
Canadian inflation. Other things being equal, how should this affect the (a) US demand for
Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the
Canadian dollar?
(a) A sudden jump in inflation in the US should cause an increase in the US demand for the
Canadian goods and also causes an increase in US demand for Canadian dollars
(b) The increased demand for the Canadian dollars would reduce the supply of Canadian dollars
for sale
(c) There would be an upward pressure on the value of the Canadian dollars

3. Interest Rate Effects on Exchange Rates. Assume US interest rates fall relative to British interest
rates. Other things being equal, how should this affect the (a) US demand for the British pound,
(b) supply of pounds for sale, and (c) equilibrium value of the pound?

(a) British investors will reduce their demand for US dollars since the British interest rates are
more attractive and there is less desire for the US bank deposits.
(b) US investors with excess cash and the supply of dollars by them will increase as they
establish more bank deposits in the British banks
(c) There would be an upward shift in the demand for US dollars and an outward shift in the
supply of dollars for sale, therefore the equilibrium exchange rate should decrease.

4. Income Effects on Exchange Rates. Assume that the US income level rises at a much higher rate
than does the Canadian income level. Other things being equal, how should this affect the (a) US
demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of
the Canadian dollar?
(a) The increase in US income should reflect an outward shift and therefore increasing the
demand for Canadian goods
(b) The supply schedule of Canadian dollars for sale should not change
(c) The equilibrium exchange rate of the Canadian dollar should rise

5. Trade Restriction Effects on Exchange Rates. Assume that the Japanese government relaxes its
controls on imports by Japanese companies. Other things being equal, how should this affect
 the (a) US demand for Japanese yen, (b) supply of yen for sale, and (c) equilibrium value of the
yen?
(a) Given that there would be relaxed controls on imports, it should cause an increase in the US
demand for Japanese yen
(b) The supply of yen would therefore decrease
(c) The equilibrium value of the yen would then increase, causing and upward pressure

6. Effects of Real Interest Rates. What is the expected relationship between the relative real
interest rates of 2 countries and the exchange rate of their currencies?

A high interest rate may attract foreign inflows (to invest in securities offering high yields),
causing an expectation of high inflation. High inflation can place downward pressure on the local
currency, so some foreign investors may be discouraged from investing in securities
denominated in that country’s currency. The REAL INTEREST RATE adjust the nominal interest
rate for inflation. This is known as the Fisher Effect.

7. Speculative Effects on Exchange Rates. Explain why a public forecast by a respected economist
about future interest rates could affect the value of the dollar today. Why do some forecasts by
well respected economists have no impact on today’s value of the dollar?

If the valued opinion (the forecast) of future high interest rates were acted upon, it could have
an immediate effect on the dollar. Investors may decide to invest their dollars in foreign
securities that are expected not to fluctuate. Consumers might decide to “purchase” now rather
than later because the dollar wouldn’t be as valuable in the future. This would cause supply and
demand levels to move. Forecasts may have a larger impact on emerging markets, however.
Some forecasts have no impact because of the daily changing value moves so quickly, there isn’t
time to respond. Banks and firms that have large purchasing/borrowing capacities would have a
greater impact. Foreign exchange rates are very volatile and a poor forecast could result in huge
losses, so investors have hopefully learned not to place as much emphasis on an “expert
forecast”.

8. Factors Affecting Exchange rates. What factors affecting the future movements in the value of
the euro against the dollar?

Either trade or financial flows will affect the exchange rates and the interaction of these two will
cause a shift in the value of the currency. All relevant factors must be considered simultaneously
to assess the likely movement of the euro or the dollar. Supply and demand are the most
determining factors. As demand for the euro rises, so does the value and the demand for the
dollar should decrease.
9. Interaction of Exchange Rates. Assume that there are substantial capital flows among Canada,
the US, and Japan. If interest rates in Canada decline to a level below the US interest rate, and
inflationary expectations remain unchanged, how could this affect the value of the Canadian
dollar against the US dollar? How might this decline in Canada’s interest rates possible affect
the value of the Canadian dollar against the Japanese yen?

If interest rates decline in Canada, then US and Japanese investors will increase their flow of
capital into Canada, thus increasing the supply of Canadian dollars. If the supply of a lower
valued Canadian dollar increases, demand will then decrease over time. The US dollar should
experience growth during this time as it invests capital in a market where it is appreciating. The
Japanese yen should be the most influenced by the interest rates because of Japan’s assumed
heavy capital flow transactions with the Canadians as well as the US.

10. Every month, the US trade deficit figures are announced. Foreign exchange traders often react
to this announcement and even attempt to forecast the figures before they are announced.

a. Why do you think the trade deficit announcement sometimes has such an impact on foreign
exchange trading?
Impact on other countries – It seems that other countries would react by continuing to push
their goods into the United States to further drive down the value of a dollar and continue to
widen the deficit, however, since most countries cannot survive without the buying power of
the US, then they most likely will not react as hastily.
Impact on the US – I don’t think announcements such as these have that great of an impact
as one might think it should. MNCs can only export what purchases are willing to buy, and
the US consumer, given such a weak dollar, demand that goods purchased are priced low, so
these imports are a must! MNCs aren’t going to react with a “knee-jerk” response because it
takes huge volumes to impact a deficit and it seems to be a losing battle.

b. In some periods, foreign exchange traders do not respond to a trade deficit announcement,
even when the announced deficit is very large. Offer an explanation for such a lack of
response.

See above, same answer – in “my” opinion. Foreign exchange traders can’t afford to respond
to every rift of movement of the deficit. An error in forecasting could cause an even worse
outcome if the interaction of trade and financial investments doesn’t take into consider ALL
the factors that can cause a shift in trade balance.