19.3 The Determination of Exchange Rates

Question 1

Where are transactions made by the central bank included?

Answer 1

The demand and supply curves in Figure 19-1 do not include transactions in the foreign-exchange market made by the central bank in an attempt to alter the value of the exchange rate. Such transactions, if they occur at all, appear as a subset of the official financing account

Question 2

We now consider three possibilities for central-bank behaviour:

Answer 2

Question 3

What kind of exchange rate do most industrialized countries operate with?

Answer 3

Most industrialized countries today operate a mostly flexible exchange rate. It is mostly market determined but the central bank sometimes intervenes to offset significant short-run fluctuations.

Question 4

When did the EU have a fixed exchange rate?

Answer 4

The countries of the European Union (EU) had a system of fixed exchange rates (relative to one another’s currencies) between 1979 and 1999.

Question 5

When did the EU adopt a flexible exchange rate?

Answer 5

In 1999 most of the countries of the EU adopted a common currency—the euro. Within what is now called the euro zone, the countries have no exchange rates for national currencies but the single common currency has a flexible exchange rate relative to countries outside the euro zone.

Question 6

What countries have flexible exchange rates?

Answer 6

The United States, Japan, the United Kingdom, Australia, and most other major industrialized countries have flexible exchange rates with relatively small amounts of foreign-exchange intervention by their central banks.

Question 7

When did Canada alternate between a system of fixed exchange rates and flexible exchange rates?

Answer 7

Canada alternated between a system of fixed exchange rates and flexible exchange rates throughout most of the period between the Second World War and 1970.

Question 8

What is the Bretton Woods system?

Answer 8

Between the Second World War and 1970. In contrast, most other countries pegged their currencies to the U.S. dollar under what was called the Bretton Woods system.

The Bretton Woods system, established by international agreement in 1944 and operated until the early 1970s, was a fixed exchange-rate system that provided for circumstances under which exchange rates could be adjusted.

It was thus an adjustable peg system; the International Monetary Fund (IMF) has its origins in the Bretton Woods system, and one of its principal tasks was approving and monitoring exchange-rate changes.

Question 9

When is there an excess supply of foreign exchange?

Answer 9

Suppose the current exchange rate is so high (say, in Figure 19-2) that the quantity of foreign exchange supplied exceeds the quantity demanded. There is thus an excess supply of foreign exchange.

Question 10

What will an excess Supply of foreign exchange cause?

Answer 10

This excess Supply of foreign exchange, just as in our analysis in Chapter 3, will cause the price of foreign exchange—the exchange rate—to fall.

As the exchange rate falls—and the Canadian dollar appreciates—the euro price of Canadian goods rises, and this leads to a reduction in the quantity of foreign exchange supplied.

Question 11

What happens to the Canadian-dollar price of European goods as the exchange rate falls.

Answer 11

As the exchange rate falls, the Canadian-dollar price of European goods falls, and this fall leads to an increase in the quantity of foreign exchange demanded.

The excess supply of foreign exchange leads to a fall in the exchange rate, which in turn reduces the amount of excess supply.

Question 12

What is occuring when the two curves (Supply and Demand) Intersect?

Answer 12

Where the two curves intersect, quantity demanded equals quantity supplied, and the exchange rate is at its equilibrium or market-clearing value.

Question 13

Graph of excess supply and demand of foreign exchange.

Answer 13

Question 14

What does the exchange rate do in the absence of central-bank intervention?

Answer 14

In the absence of central-bank intervention, the exchange rate adjusts to clear the foreign-exchange market.

If there is no intervention by the central bank, there is a purely flexible exchange rate. It will adjust to equate the demand and supply of foreign exchange

Question 15

What is the connection between a fixed exchange rate and the central bank?

Answer 15

In the case of a fixed exchange rate, the central bank intervenes to meet the excess demands or supplies that arise at the fixed value of the exchange rate.

Question 16

How does the central bank in a fixed exchange market handle an access supply?

Answer 16

The central bank will purchase foreign exchange (and sell dollars) to meet the excess supply and keep the exchange rate constant.

Question 17

What does the central bank do when there is excess demand for foreign exchange?

Answer 17

The central bank will sell foreign exchange (and buy dollars) to meet the excess demand and keep the exchange rate constant.

Question 18

What happens when the exchange rate is below its equilibrium value

Answer 18

The quantity of foreign exchange demanded will exceed the quantity supplied. With foreign exchange in excess demand, its price will naturally rise, and as it does the amount of excess demand will be reduced until equilibrium is re-established.

Question 19

How is the fireign-exchange market like other competitive markets?

Answer 19

A foreign-exchange market is like other competitive markets in that the forces of demand and supply lead to an equilibrium price at which quantity demanded equals quantity supplied.

Question 20

What must the central bank do if it chooses to the the exchange rate at a particular value?

Answer 20

If the central bank chooses to fix the exchange rate at a particular value, it must transact in the foreign-exchange market to accommodate any excess demand or supply of foreign exchange that arises at that exchange rate.

Question 21

Suppose the central bank chooses to peg the exchange rate at a value like in Figure 19-2, above the market-clearing rate, .

Answer 21

In this situation, there is an excess supply of foreign exchange. In the absence of any action by the central bank, this excess supply would drive the exchange rate down to .

To prevent this downward adjustment, the central bank purchases the excess supply of foreign currency, and it does so by creating new domestic currency with which to make the purchase.

The overall result will be an increase in the central bank’s foreign-exchange reserves and an increase in the domestic money supply.

Question 22

Suppose instead that the central bank chooses to peg the exchange rate at a value like , below the market-clearing rate.

Answer 22

In this situation, there is an excess demand for foreign currency, which would normally cause the exchange rate to rise.

To prevent this depreciation, the central bank satisfies the excess demand by selling from its current foreign-exchange reserves.

When the central bank sells foreign currency, it accepts domestic currency in exchange, which is now removed from circulation in the domestic economy.

The overall result will be a depletion of the central bank’s foreign-exchange reserves and a reduction in the domestic money supply.

Question 23

What must a central bank that fixes its country’s exchange rate do the satisft the excess supply or demand at the fixed exchange rate?

Answer 23

A central bank that fixes its country’s exchange rate must either buy or sell foreign currency to satisfy the excess supply or demand that exists at the fixed exchange rate. These transactions will increase or decrease the country’s money supply.

Question 24

What was The European Exchange Rate Mechanism?

Answer 24

The European Exchange Rate Mechanism (ERM), which existed from 1979 to 1999, was also a fixed exchange-rate system for the countries in the European Union; their exchange rates were fixed to one another but floated as a block against the U.S. dollar and other currencies. As mentioned earlier, this system of separate European currencies with fixed exchange rates was replaced in 1999 when most of the countries of the EU adopted a common currency—the euro.

Question 25

We can see how the Bank’s interventions have their effect. Consider three situations:

Answer 25

Question 26

What causes exchange rates to vary?

Answer 26

The simplest answer to this question is changes in demand or supply in the foreign-exchange market.

Anything that shifts the demand curve for foreign exchange to the right or the supply curve for foreign exchange to the left leads to a rise in the exchange rate—a depreciation of the Canadian dollar.

Conversely, anything that shifts the demand curve for foreign exchange to the left or the supply curve for foreign exchange to the right leads to a fall in the exchange rate—an appreciation of the Canadian dollar.

Question 27

What will cause the Canadian dollar to depreciate?

Answer 27

An increase in the demand for foreign exchange or a decrease in the supply will cause the Canadian dollar to depreciate (the exchange rate to rise)

Question 28

What will cause the dollar to appreciate?

Answer 28

A decrease in the demand or an increase in supply will cause the dollar to appreciate (the exchange rate to fall).

Question 29

What are some important causes of the shifts in demand and supply that lead to changes in exchange rates?

Answer 29

A Rise in the World Price of Canadian Exports

A Rise in the Foreign Price of Canadian Imports

Changes in Overall Price Levels

Movements of Financial Capital

Question 30

Suppose there is an increase in the world price of a major Canadian export, such as wheat, oil, copper, or nickel. What happens?

Answer 30

The higher world price means that the world’s consumers are offering more foreign currency per unit of these Canadian exports.

The increase in the supply of foreign exchange occurs even if the volume of Canadian exports is unchanged; if Canadian exports increase in response to the higher world price, the supply of foreign exchange increases further.

The increase in the supply of foreign exchange shifts the supply curve to the right and causes a reduction in the exchange rate—an appreciation of the Canadian dollar.

Question 31

Suppose the euro price of European automobiles increases because of European supply disruptions. Suppose also that demand by Canadian consumers is very responsive to changes in the price for European cars because they can easily switch to Canadian-made substitutes.

What happens?

Answer 31

Consequently, they spend fewer euros for European automobiles than they did before and hence demand less foreign exchange.

The demand curve for foreign exchange shifts to the left, and the Canadian dollar appreciates. If instead the demand for foreign cars was relatively insensitive to the price, the rise in foreign prices would lead to an increase in the demand for foreign exchange (at least initially) and thus to a depreciation of the Canadian dollar.

Question 32

How do exchange rates often respond to changes in the prices of major exports or imports?

Answer 32

Exchange rates often respond to changes in the prices of major exports and imports.

A rise in the world price of Canadian exports causes the Canadian dollar to appreciate.

A rise in foreign prices of Canadian imports can cause the Canadian dollar to appreciate or depreciate, depending on the price responsiveness of the demand for those imports.

Question 33

What are the different ways that changes in the overall price levels between two countries can occur?

Answer 33

Equal Inflation in Both Countries
Inflation in Only One Country
Inflation at Unequal Rates

Question 34

What happens to the equilibrium exchange rat when there is Equal Inflation in Both Countries

Answer 34

Suppose inflation is running at 2 percent in both Canada and Europe. In this case, the euro prices of European goods and the dollar prices of Canadian goods are both rising by 2 percent per year. In this special case, the relative prices of imported goods and domestically produced goods will be unchanged and so demands will not be shifting between countries. As a result, the equilibrium exchange rate remains unchanged.

Question 35

What will happen to the supply curve if there is inflation in Canada while the price level remains stable in Europe?

Answer 35

The dollar price of Canadian goods will rise, and they will become more expensive in Europe.

This increase in price will cause the quantity of Canadian exports, and therefore the amount of foreign exchange supplied by European importers, to decrease.

The supply curve for foreign exchange shifts to the left.

Question 36

What happens to the demand curve for foreign exchange if there is inflation in Canada while the price level remains stable in Europe?

Answer 36

At the same time, the Canadian-dollar price of European goods in Canada will not change, while the price of Canadian goods sold in Canada will increase because of the inflation.

European goods have become relatively cheaper than Canadian goods, and thus more European goods will be bought in Canada.

At any exchange rate, the amount of foreign exchange demanded to purchase imports will rise.

The demand curve for foreign exchange shifts to the right.

Question 37

What happens to the equilibrium exchange rate if there is inflation in Canada, and no inflation in Europe.

Answer 37

If there is inflation in Canada, and no inflation in Europe, the supply curve for foreign exchange shifts to the left and the demand curve for foreign exchange shifts to the right. As a result, the equilibrium exchange rate must rise—there is a depreciation of the Canadian dollar relative to the euro.

Question 38

Other things being equal, what happens to Canadian currency when it has a higher/lower inflation than other countries?

Answer 38

Other things being equal, if Canada has higher inflation than other countries, the Canadian dollar will be depreciating relative to other currencies. If Canada has lower inflation than other countries, the Canadian dollar will be appreciating.

Question 39

How can flows of financial capital exert strong influences on exchange rates.

Answer 39

An increased desire by Canadians to purchase European assets (a capital outflow from Canada) will shift the demand curve for foreign exchange to the right, and the dollar will depreciate.

In contrast, a desire by foreigners to increase their holdings of Canadian assets will shift the supply curve for foreign currency to the right and cause the Canadian dollar to appreciate.

Question 40

What is an important motive for short-term capital flows? What is carry trade?

Answer 40

An important motive for short-term capital flows is a change in interest rates.

International traders hold transaction balances just as do domestic traders. These balances are often lent out on a short-term basis rather than being left idle.

Naturally, the holders of these balances will tend to lend them, other things being equal, in markets in which interest rates are highest. This is often referred to as the carry trade.

Question 41

What happens if one country’s short-term interest rate rises above the rates in other countries?

Answer 41

If one country’s short-term interest rate rises above the rates in other countries (say, because that country undertakes a contractionary monetary policy), there will tend to be a large inflow of short-term capital into that country in an effort to take advantage of the high interest rate. This inflow of financial capital will increase the demand for the domestic currency and cause it to appreciate.

Question 42

What will happen to financial capital if a monetary expansion reduces short-term interest rates in one ocuntry?

Answer 42

if a monetary expansion reduces short-term interest rates in one country, there will tend to be a shift of financial capital away from that country, and its currency will tend to depreciate.

We saw this basic relationship between interest rates, capital flows, and the exchange rate in Chapter 12 when we discussed the monetary transmission mechanism in an open economy.

Question 43

What is the effect of contractionary and expansionary monetary policy on interest rates, capital and the Canadian dollar?

Answer 43

Changes in monetary policy lead to changes in interest rates and thus to international flows of financial capital.

A contractionary monetary policy in Canada will lead to a rise in Canadian interest rates, a capital inflow, and an appreciation of the Canadian dollar.

An expansionary monetary policy in Canada will lead to a reduction in Canadian interest rates, a capital outflow, and a depreciation of the Canadian dollar.

Question 44

What is the connection between short-term capiral movements and future value?

Answer 44

A second motive for short-term capital movements is speculation about the future value of a country’s exchange rate. If foreigners expect the Canadian dollar to appreciate in the near future, they will be induced to buy Canadian stocks or bonds now; if they expect the Canadian dollar to depreciate in the near future, they will be reluctant to buy such Canadian securities and may sell the Canadian assets they are currently holding.

Question 45

What are long-term capital movements largely influenced by?

Answer 45

Long-term capital movements are largely influenced by long-term expectations regarding the business environment in a country.

Changes in tax and regulatory policy are often the causes of significant swings in long-term investment.

Question 46

An economy can undergo structural changes that alter the equilibrium exchange rate. What is structural change?

Answer 46

Structural change is an all-purpose term for a change in cost structures, the invention of new products, changes in preferences between products, or anything else that affects the pattern of comparative advantage.

Question 47

As a general rule, what do country’s with a slower pace of innovation then others tend to experience?

Answer 47

As a general rule, a country with a slower pace of innovation than other countries tends to experience a depreciation of its currency.

Question 48

How can the discovery of valuable mineral resources effect currency?

Answer 48

If firms in one country make such a discovery and begin selling these resources to the rest of the world, the foreign purchasers must supply their foreign currency in order to purchase the currency of the exporting country.

The result is an appreciation of the currency of the exporting country.

Question 49

In general, what will lead to changes in exchanges rates?

Answer 49

Anything that leads to changes in the pattern of trade, such as changes in costs or changes in demand, will generally lead to changes in exchange rates.

Question 50

If there is a fall in foreign GDP, and foreign demand for Canadian goods decreaces, there will be a (blank) in supply of foreign currency. The Canadian dollar will (blank)
.

Answer 50

decrease, depreciate

Question 51

f. A decrease in Canadian prices relative to foreign prices will cause
a (blank) in the demand for foreign​ exchange, and (blank) in the supply of foreign exchange. The exchange rate will
(blank) and the Canadian dollar will therefore (blank)

Answer 51

decrease, increase, fall, appreaciate

Question 52

Answer 52