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Exchange Rate Calculations and Analysis

The document presents a problem set focused on currency exchange rates and their implications. It includes calculations for the franc-yen rate, the real exchange rate between the USD and GBP, and the expected appreciation of the dollar against the euro due to interest rate differentials. Additionally, it discusses the importance of credibility in exchange rate systems, emphasizing that successful systems must generate investor confidence regardless of whether they are fixed or flexible.

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jules.yules1909
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10 views1 page

Exchange Rate Calculations and Analysis

The document presents a problem set focused on currency exchange rates and their implications. It includes calculations for the franc-yen rate, the real exchange rate between the USD and GBP, and the expected appreciation of the dollar against the euro due to interest rate differentials. Additionally, it discusses the importance of credibility in exchange rate systems, emphasizing that successful systems must generate investor confidence regardless of whether they are fixed or flexible.

Uploaded by

jules.yules1909
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Problem Set

Question 1
Suppose the US dollar-Japanese yen exchange rate is 0.9349 dollar per yen, and the US dollar-Swiss franc rate
is 1.6723 dollars per franc. What is the franc-yen rate?
Answer:
The franc-yen rate is: (0.9349 dollar per franc) ÷ (1.6723 dollars per franc) = 0.5590 franc per Japanese
yen.
Question 2
Suppose the USD-GBP exchange rate is 1.2497 USD per GBP. Since the base year, inflation has been 5
percent in the United States and 7 percent in the United Kingdom. What is the real exchange rate? In real
terms, has the dollar appreciated or depreciated against the pound?
Answer:

The real exchange rate is 1.2497 1.2735. The USD has depreciated against the pound.

Question 3
Suppose that US (home) interest rates are 4% more than rates in the EU (foreign).
a. Would you expect the dollar to appreciate or depreciate against the euro, and by how much?
Answers:
a. Capital would flow into the United States increasing the supply of foreign exchange. Due to higher
interest rates, investment at home is more attractive than in Europe. This also reduces the demand for
foreign exchange. As a result, we expect the dollar to appreciate by 4%. This interest rate arbitrage
activity continues until equilibrium is restored (that is, interest rate parity is reestablished).

Question 4
Why do some economists claim that the most important feature of any exchange rate system is its credibility?
Answer:
Both flexible and fixed exchange rate systems have advantages and disadvantages. As a result, no system
seems to rank above any other in its ability to provide superior economic performance. Also, history has
proven that a financial crisis can take place whether a country follows a fixed or flexible exchange rate
system. Further, the source of the shocks to a financial system or economy vary from episode to episode,
as do each country’s trade partnerships and economic and political characteristics. Due to this, there
appear to be discrepancies between what might work in theory and what it has worked in practice. In
other words, it has become increasingly difficult, and even impractical, to design a “one-type-fits-all”
exchange rate policy, even if the countries considering such a policy share similar stages of economic
development.
Thus, no matter which exchange rate system is adopted, to be successful a system must generate investor
confidence and a belief that the system is sustainable. In a fixed exchange rate system, for example,
credibility is assured only if there is strong control of the money supply. Floating exchange rate systems
are also vulnerable due to the lack of monetary discipline and the temptation to finance the deficit with
additional creation of money. Thus, credibility is very important and seems to be the only useful common
guide that can serve all countries. This is especially true in this era of increased capital mobility,
international trade, and investment with numerous players. How a country establishes credibility is an
entirely different issue, which again depends on the characteristics of the individual country and the
exchange rate system it adopts.

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