12 Exchange Rate, International Trade and Capital Flow

Question 1

Nominal exchange rate

Answer 1

Rate which 2 currencies can be traded for each other

Number of FOREIGN currency for 1 LOCAL currency (2.38rm for 1SGD)

-denominator is LOCAL
currency
- analyze denominator (supply of local, not foreign)

Question 2

Appreciation - exchange rate becomes higher/lower?

(opposite is depreciate)

Answer 2

Higher
$1 = 0.5pounds
now $1 = 0.6pounds

Question 3

Flexible vs fixed exchange rate

Answer 3

Flexible - varies w demand & supply, not controlled by govt

Fixed - set by govt policy

Question 4

Higher exchange rate, larger/smaller qty of dollars SUPPLIED?

Answer 4

Higher exchange rate, LARGER qty of dollars supplied

Upward sloping

US$1 can exchange for more Yen
-foreign goods are cheaper

Question 5

eg US$ local currency
Yen foreign currency

Who can demand?

Who can supply?

Answer 5

Demand - anyone who holds Yen can demand US$ (by exchanging)

Supply - anyone who holds US$

Question 6

Higher exchange rate, larger/smaller qty of dollars DEMANDED?

Answer 6

Lower

Negative slope

Higher exchange rate - 1US$ exchange for more Yen, Jap consumers need to fork out more Yen to get 1US$ - US products more ex from Jap pov - lower demand

Question 7

Supply is determined by 3 factors: (look at local pov)

(Same for demand but look at foreigner pov)

Answer 7

Higher supply:
1. Higher preference
2. Higher local real GDP - consumers richer
3. Higher interest rate

Question 8

Strong currency means can exchange for more/less of foreign currency

Answer 8

MORE

Strong currency:
- Reduce net exports - products are viewed expensive to foreigners

• Attract inflow of foreign funds for investment since strong currency

Question 9

Tighter US monetary policy lead to higher/ lower interest rate? How will it affect demand and supply?

Answer 9

Tighter policy - reduce money supply - higher interest rate - assets more attractive - demand increase, supply decrease

Local currency will appreciate

*Want to make local currency stronger: tighten money supply (dec) - raising real interest rate

Question 10

When real interest rate increase, local currency increase or dec?

Answer 10

real interest rate inc - local currency inc - demand dec since foreigners find it ex - net export dec

Question 11

Fixed exchange rate system, govt may adjust:

Answer 11

Devaluation: reduce fixed rate

Revaluation: increase fixed rate

Question 12

What is real exchange rate

Answer 12

Price of avg domestic good relative to price of avg comparable foreign good when prices expressed in common currency

price of domestic good / price of foreign good in US$

eg prices of candy:
1SGD but 1rm (cheaper in msia)
1 SGD but 3rm (same price, not much point buying in msia)

Question 13

To convert foreign price Pf to price P

Answer 13

Pf / e (nominal exchange rate)

Question 14

If relative price is >1

Answer 14

Domestic product is more ex

eg 1.09 (REAL exchange rate)
- US (domestic) computer costs 9% more ex than Jap (foreign)

Question 15

If real exchange rate is high, domestic goods are cheaper/more expensive relative to foreign goods

Answer 15

If real exchange rate is high, domestic goods are MORE EXPENSIVE relative to foreign goods

-Net exports lower because will want to buy from foreign country instead

Question 16

Purchasing Power Parity (PPP)

Answer 16

Nominal exchange rates are determined by price differential between economies

-Long run: country with signficant inflation will tend to depreciate (currency will become weaker)

Question 17

Law of one price

Answer 17

Transportation costs are small and no trade restrictions, price of internationally traded commodity must be same in all locations

Question 18

Trade balance is the same as net exports (NX)

Trade surplus: positive/ negative trade balance?

Export > or < imports?

Answer 18

Trade surplus: positive trade balance
Export > imports (sell more than buy)

Trade deficit: negative trade balance
Imports > exports

Question 19

Net capital inflow (KI)

Answer 19

Capital INflow - capital OUTflow

Diff from import/export (this is produced goods and services)

Capital is purchase of existing assets - land, buildings, deposits, shares, bonds

Question 20

NX + KI = ?
Trade balance (NX)
Net Capital Inflow (KI)

Answer 20

0

Question 21

2 roles of international capital flows

Answer 21

1. Trade imbalances
   surplus - net capital outflow
   deficit - net capital inflow
2. Efficient allocation of savings

Question 22

International capital flow graph x and y axis

Answer 22

x: net capital inflow (KI)
y: domestic real interest rate

upward sloping
KI < 0 - net capital outflow
KI > 0 - net capital inflow (higher)

Question 23

Increase in riskiness of domestic products increase/decrease capital inflow

Answer 23

Increase in riskiness of domestic products DECREASE capital inflow

More risky - foreigners less willing to buy asset - net capital inflow dec - Curve shifts left

Question 24

Y = C + I + G + NX
I = Y - C - G - NX
National savings, S = (Y-C-G)
S - NX = I

Answer 24

NX + KI =0
NX = -KI
S + KI = I