Tutorial 05 Solutions – Determination of Exchange Rate*
BFW2341
1. 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?
($1.66 – $1.73)/$1.73 = –4.05%
Expected depreciation of 4.05% percent
2. Assume that the U.S. inflation rate becomes high relative to Canadian inflation. Other things
being equal, how should this affect the
(a) U.S. demand for Canadian dollars
(b) Supply of Canadian dollars for sale
(c) Equilibrium value of the Canadian dollar?
Demand for Canadian dollars should increase, supply of Canadian dollars for sale should
decrease, and the Canadian dollar’s value should increase.
3. Assume U.S. interest rates fall relative to British interest rates. Other things being equal,
how should this affect the
(a) U.S. demand for British pounds
(b) supply of pounds for sale
(c) equilibrium value of the pound?
Demand for pounds should increase, supply of pounds for sale should decrease, and the
pound’s value should increase.
4. What is the expected relationship between the relative real interest rates of two countries and
the exchange rate of their currencies?
The higher the real interest rate of a country relative to another country, the stronger will be
its home currency, other things equal.
5. What factors affect the future movements in the value of the euro against the dollar?
The euro’s value could change because of the balance of trade, which reflects more U.S.
demand for European goods than the European demand for U.S. goods. The capital flows
*
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between the U.S. and Europe will also affect the U.S. demand for euros and the supply of
euros for sale (to be exchanged for dollars).
6. Assume that there are substantial capital flows among Canada, the U.S., and Japan. If interest
rates in Canada decline to a level below the U.S. interest rate, and inflationary expectations
remain unchanged, how could this affect the value of the Canadian dollar against the U.S.
dollar? How might this decline in Canada’s interest rates possibly affect the value of the
Canadian dollar against the Japanese yen?
If interest rates in Canada decline, there may be an increase in capital flows from Canada to
the U.S. In addition, U.S. investors may attempt to capitalize on higher U.S. interest rates,
while U.S. investors reduce their investments in Canada’s securities. This places downward
pressure on the Canadian dollar’s value. Japanese investors that previously invested in
Canada may shift to the U.S. Thus, the reduced flow of funds from Japan would place
downward pressure on the Canadian dollar against the Japanese yen.
7. The New Zealand dollar's spot rate was equal to $.60 last month. New Zealand conducts much
international trade with the U.S. but that the financial (investment) transactions between the
two countries are negligible. Assume the following conditions have occurred in the last year.
First, interest rates in New Zealand increased but decreased in the U.S. Second, inflation in
New Zealand increased but decreased in the U.S. Third, the New Zealand central bank
intervened in the foreign exchange market by exchanging a very small amount of U.S. dollars
to purchase a very small amount of New Zealand dollars. How should the New Zealand dollar
change over the year based on the information provided here?
The key is to weigh the influence of each effect in order to derive a total effect. Two of the
factors described above place upward pressure on the value of the New Zealand dollar. The
high interest rate could increase financial flows into New Zealand but the financial flows are
negligible so this factor will not have much of an impact. The central bank intervention could
place upward pressure on the NZ $, but it is a very small amount and therefore should not
have much of an impact. The inflation effect will place downward pressure on the NZ $ and
this factor should have a large impact, because trade flows are large. Overall, the NZ $ should
depreciate over the year.
8. If Asian countries experience a decline in economic growth (and experience a decline in
inflation and interest rates as a result), how will their currency values (relative to the U.S.
dollar) be affected?
A relative decline in Asian economic growth will reduce Asian demand for U.S. products,
which places upward pressure on Asian currencies. However, given the change in interest
rates, Asian corporations with excess cash may now invest in the U.S. or other countries,
thereby increasing the demand for U.S. dollars. Thus, a decline in Asian interest rates will
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place downward pressure on the value of the Asian currencies. The overall impact depends on
the magnitude of the forces just described.
9. Every month, the U.S. 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?
The trade deficit announcement may provide a reasonable forecast of future trade
deficits and therefore has implications about supply and demand conditions in the
foreign exchange market. For example, if the trade deficit was larger than anticipated,
and is expected to continue, this implies that the U.S. demand for foreign currencies
may be larger than initially anticipated. Thus, the dollar would be expected to weaken.
Some speculators may take a position in foreign currencies immediately and could
cause an immediate decline in the dollar.
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.
If the market correctly anticipated the trade deficit figure, then any news contained in
the announcement has already been accounted for in the market. The market should
only respond to an announcement about the trade deficit if the announcement contains
new information.
10. The following questions are related to the ongoing debate between the U.S. and China
regarding whether the Chinese yuan's value should be revalued upward.
a. Would the U.S. balance of trade deficit in China be eliminated if the yuan was revalued
upward by 20%? Or by 40%? Or by 80%?
This is an open-ended question without a perfect answer. Students need to be aware
that a small increase in the value of the yuan is not going to make Chinese products
more expensive than U.S. products especially in labor-intensive industries, given that
Chinese wages are lower than U.S. wages in these industries.
b. If the yuan was revalued to the extent that it substantially reduced the U.S. demand for
Chinese products, would this shift the U.S. demand toward the U.S. or toward other
countries where wage rates are relatively low? In other words, would the correction of
the U.S. balance of trade deficit have a major impact on U.S. productivity and jobs?
To the extent that there are decent substitute products in other low wage countries, it
seems likely that U.S. consumers would just shift their demand toward the products in
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these countries. If so, a correction in the U.S. balance of trade deficit with China would
shift jobs to other low-wage countries rather than to the U.S.
11. Answer the following questions that are related to balance of payment.
a. Explain why a stronger dollar could enlarge the U.S. balance of trade deficit. Explain
why a weaker dollar could affect the U.S. balance of trade deficit.
A stronger dollar makes U.S. exports more expensive to importers and may reduce
imports. It makes U.S. imports cheap and may increase U.S. imports. A weaker home
currency increases the prices of imports purchased by the home country and reduces
the prices paid by foreign businesses for the home country’s exports. This should cause
a decrease in the home country’s demand for imports and an increase in the foreign
demand for the home country’s exports, and therefore increase the current account.
However, this relationship can be distorted by other factors such as the lack of product
substitutes and government interventions in the forex market.
b. It is sometimes suggested that a floating exchange rate will adjust to reduce or eliminate
any current account deficit. Explain why this adjustment would occur and why does
the exchange rate not always adjust to a current account deficit?
A current account deficit reflects a net sale of the home currency in exchange for other
currencies. This places downward pressure on that home currency’s value. If the
currency weakens, it will reduce the home demand for foreign goods (since goods will
now be more expensive), and will increase the home export volume (since exports will
appear cheaper to foreign countries).
In some cases, the home currency will remain strong even though a current account
deficit exists, since other factors (such as international capital flows) can offset the
forces placed on the currency by the current account.
c. When South Korea’s export growth stalled, some South Korean firms suggested that
South Korea’s primary export problem was the weakness in the Japanese yen. How
would you interpret this statement?
One of South Korea’s primary competitors in exporting is Japan, which produces and
exports many of the same types of products to the same countries. When the Japanese
yen is weak, some importers switch to Japanese products in place of South Korean
products. For this reason, it is often suggested that South Korea’s primary export
problem is weakness in the Japanese yen.
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12. Explain how the asset market approach can be used to forecast future spot exchange rates. How
does the asset market approach differ from the BOP approach to forecasting?
The asset market approach assumes that whether foreigners are willing to hold claims in
monetary form depends on an extensive set of investment considerations or drivers. These
drivers include the following:
• Relative real interest rates
• Prospects for economic growth and profitability
• Capital market
• A country’s economic and social
• Political safety
• The credibility of corporate governance
• Contagion
• Speculation
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