chapter 15 theoretical questions Flashcards
explain the supply of and demand for the Canadian dollar by the U.S. market with the the effect of the following situation and its effect on the exchange rate
state in words whether the effect is long, medium, or short run,
explain your reasoning
More rapid growth in Canada than in the United States
The Canadian supply of currency to the U.S. market increases in response to the rise in Canada’s demand for American exports
–> The supply curve shifts right; the U.S. dollar appreciates; the Canadian dollar depreciates
This effect is medium run because effects of economic expansions and contraction (the business cycle) on exchange rates run for a few years (usually less than a decade)
As Canada experiences more rapid economic growth than the United States, disposable income in Canada rises, causing consumption to rise
–> Consumer confidence gradually rises as jobs become secured and plentiful.
–> Canadian expenditures on imports rise
explain the supply of and demand for the Canadian dollar by the U.S. market with the the effect of the following situation and its effect on the exchange rate
state in words whether the effect is long, medium, or short run,
explain your reasoning
A rise in U.S. interest rates.
The supply of Canadian dollars to the U.S. market increases in response to the higher interest rates
–> the supply curve shifts right
–> the U.S. dollar appreciates; the Canadian dollar depreciates
This is a short-run effect because the factors that cause interest rates to change are themselves short-run processe
explain the supply of and demand for the Canadian dollar by the U.S. market with the the effect of the following situation and its effect on the exchange rate
state in words whether the effect is long, medium, or short run,
explain your reasoning
Goods are more expensive in Canada than in the United States
The U.S. demand for Canadian dollars decreases in response to higher prices for Canadian goods
–> The demand curve shifts left causing the exchange rate to fall
–> The U.S. dollar appreciates and the Canadian dollar depreciates
This is a long-run effect in part because the prices of goods move gradually.
The higher prices of goods in Canada could also be caused by government policies such as tariffs and quotas. In general, changing government policies takes time.
achieving purchasing power parity is a long-run process
why is achieving purchasing power parity is a long-run process?
(1) shipping, insurance, and other transportation may be prohibitively expensive
(2) trade barriers such as tariffs, quotas, import license, and inspection fees may be too high
(3) a substantial number of goods may not be traded
explain the supply of and demand for the Canadian dollar by the U.S. market with the the effect of the following situation and its effect on the exchange rate
state in words whether the effect is long, medium, or short run,
explain your reasoning
A recession in the United States
The U.S. demand for Canadian dollars decreases in response to the drop in demand for imports
–> the demand curve shifts left
–> the U.S. dollar appreciates; the Canadian dollar depreciates
the effect of recessions and expansions on exchange rates can be considered medium term
explain the supply of and demand for the Canadian dollar by the U.S. market with the the effect of the following situation and its effect on the exchange rate
state in words whether the effect is long, medium, or short run,
explain your reasoning
Expectations of a future depreciation in the Canadian dollar
The demand for Canadian dollars decreases in response to its expected loss in value
–> the demand curve shifts left
–> the U.S. dollar appreciates; the Canadian dollar depreciates
Like the effects of interest rates, the effects of expectations on exchange rates are short run
–> expectations could change swiftly and could reverse course almost instantaneously
Suppose the dollar-yen exchange rate is 0.01 dollar per yen.
Since the base year, inflation has been 2 percent in Japan and 10 percent in the United States.
What is the real exchange rate?
In real terms, has the dollar appreciated or depreciated against the yen?
The real exchange rate is Rr = 0.01 · (102/110) = 0.0093 dollar per yen
The dollar has appreciated
If U.S. visitors to Mexico can buy more goods in Mexico than they can in the United States when they convert their dollars to pesos, is the dollar undervalued or overvalued? Explain
The dollar is overvalued and the peso is undervalued
The dollar buys “too many” pesos when it is converted
Hence it buys more in Mexico after its conversion to pesos
Conversely, a traveler to the United States would find that the pesos he exchanged for dollars buys him fewer goods than the same pesos spent in Mexico
In the debate on fixed versus floating exchange rates, the strongest argument for a floating rate is that it frees macroeconomic policy from taking care of the exchange rate. This is also the weakest argument.
Explain.
Fixed exchange rate systems require the monetary authority to closely monitor the exchange rate
–> In effect, the domestic money supply is a captive of the need to maintain sufficient reserves to be able to supply any excess demand for foreign exchange
__> The potential conflict in this arrangement is that the needs of the exchange rate system can be in conflict with the needs of the domestic economy.
–>This is the scenario that the United States and the United Kingdom faced during the Great Depression of the 1930s. Interest rates were raised in order to reduce the demand for foreign exchange; the rise in interest rates deepened the recession and caused unemployment to rise further.
the freeing of monetary policy from the task of maintaining an exchange rate has its own problems
–> Some economists believe that the lack of external discipline on monetary policy leads to an over reliance on inflationary policies to satisfy domestic economic needs
–> Argentina, for example, was unable to cure its constant tendency toward hyperinflation until it abandoned the ability to freely change the money supply
Suppose that U.S. interest rates are 4 percent more than rates in the EU.
Would you expect the dollar to appreciate or depreciate against the euro, and by how much?
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 percent
This interest rate arbitrage activity continues until equilibrium is restored (that is, interest rate parity is
reestablished).
Suppose that U.S. interest rates are 4 percent more than rates in the EU.
If, contrary to your expectations, the forward and spot rates are the same, which direction would you expect financial capital to flow? Why?
This suggests that the right-hand side of the interest parity equation is equal to zero, while the left-hand side of the same equation is greater than zero
If F = R as the statement suggests, then currency markets are signaling that no changes are expected in the exchange rate
Capital would flow to the United States, decreasing the demand for foreign currency and increasing the supply of foreign currency
Both of these decrease R (the spot rate)
