2 - Determination of Exchange Rates

Question 1

Exchange rate

E.g. $1.5:Euro

Answer 1

The price of one country’s currency in terms of another

-1 Euro will buy $1.5

Question 2

Spot vs Forward rate

Answer 2

Spot: price at which currencies are traded for immediate delivery
Forward: price at which foreign exchange is quoted for delivery at a future date

Question 3

Two forces determine the price of a foreign currency in terms of a domestic currency

Answer 3

1. Demand for a foreign currency

2. Supply of a foreign currency

Question 4

Demand for a foreign currency: e.g. Euro

Answer 4

• Derived from the demand for foreign country’s goods, services, and financial assets
• E.g. when Americans demand German goods, they pay in euros, so they need to exchange dollars for euros
• At higher exchange rates, Americans demand less euros and vice versa

Question 5

Supply of a foreign currency: E.g. Euro

Answer 5

• Derived from the foreign country’s demand for local goods, services and financial assets
• E.g. when German consumers demand US goods, they must convert euros to dollars, which increases the supply of euros in the USA
• At higher exchange rates, Germans supply more euros and vice versa

Question 6

Bid vs ask rate

Answer 6

Bid rate: rate dealers are willing to buy foreign currency

Ask rate: rate dealers are willing to sell foreign currency

Question 7

Formula for calculating appreciation/depreciation of foreign currency (euro) against domestic currency (dollar)

Answer 7

= (e1 - e0) / e0
where e0 = old dollar value of euro
and e1 = new

Question 8

Factor that affect the equilibrium exchange rate (i.e. cause a SHIFT in the curve)

Answer 8

• Relative inflation rates
• Relative interest rates
• Relative economic growth rates
• Political and economic risk

Question 9

The role of expectations

Answer 9

Currency values are forward looking, and therefore depend on current events and currency supply and demand, as well as FORECASTS about future exchange rate movements

Question 10

Economic factors (3) that affect a currency’s value

Answer 10

1. Usefulness of domestic currency as a store of value (depends on rate of inflation)
2. Usefulness of domestic currency as a store of liquidity (depends on volume of transactions in that currency)
3. Demand for assets denominated in that currency

Question 11

Advantages of a STRONG domestic currency

Answer 11

• Cheaper imported goods and services
• Lower import prices = lower production cost = lower inflation
• Low cost of foreign investment
• Strong currency attracts foreign capital which keeps the interest rate low

Question 12

Disadvantages of a STRONG domestic currency

Answer 12

• Exports become less competitive
• Domestic firms face strong competition from low price foreign imports
• Job loss
• Reduces foreign investment at home

Question 13

Why do governments intervene in foreign exchange markets?

Answer 13

They can prefer overvalued or undervalued or correctly value currency depending on their economic goals:

1. Growth
2. Employment
3. Stable prices

Question 14

Mechanisms of government intervention

Answer 14

-Purchases and sales of foreign currencies by the central bank
E.g. If the FED wants to raise the value of the dollar against the euro, it will buy dollars with euros
If the ECB wants to reduce the value of euro, it will sell euros in the FX market

Question 15

Sterilised vs unsterilised intervention: US example

Answer 15

• If the FED wants to raise the value of the dollar against the euro, it will buy dollars with euros - example of unsterilised intervention
• A problem with this strategy is that is will reduce money supply, putting downward pressure on price
• To neutralise/sterilise this, the FED may purchase T-bills (open market operations) from the banks, increasing the money supply

Question 16

Long term effects of sterilisation:
What is the impact of holding down the value of a currency through foreign exchange market intervention:
-on foreign exchange reserves?
-on inflation?
-on export competitiveness?
-on living standards?

Answer 16

• Must buy up foreign currencies in the market
• The result is increased foreign reserves and an expanded domestic MS, which has the potential to increase inflation
• At the same time, the lower exchange rates boost export competitiveness, but at the expense of a lower living standard (foreign goods and services more expensive)

Question 17

Effect of sterilisation: some Asian countries attempt to sterilise their FX market intervention by selling bonds.
What are the likely consequences of sterilisation on interest rates? on exchange rates in the long term? on export competitiveness?

Answer 17

• Sales of gov securities to the market would drive down the price of gov bonds and drive up domestic interest rates
• Higher interest rates, in turn, would attract more foreign capital, which would boost the value of domestic currency
• Thus, in the long run, sterilised intervention will not affect exchange rates and export competitiveness