Chapter 2: Exchange Rates

Question 1

Main actors of forex market

Answer 1

• Commercial banks
• Corporations
• Nonbank financial institutions
• central banks

Question 2

Changes of supply and demand of foreign currency from Euro perspective:

1. Germans export more goods to US
2. Germans buy more shares of US companies
3. Germans make more holidays in Germany than US
4. US exports of goods increase
5. US investors sell Greek bonds and use this capital to buy German bonds

Answer 2

1. Supply of $ increases, demand decreases
2. Demand of $ increases, lower value of own currency
3. Demand for $ deceases, $ depreciates
4. Higher imports means higher demand for $, $ appreciates
5. No changes in exchange rate

Question 3

Do changes of supply and demand for foreign currency depend on the currency that is used?

Answer 3

• No

- Only thing that is different is who demand and who supplies certain currency

Question 4

Determinants of floating exchange rates

Answer 4

• Economic events
• Productivity changes
• Changes in demand
• Government fiscal and monetary policy
• Political and psychological factors
• Expectations

Question 5

Absolute PPP

Answer 5

Level of exchange rate is explained by ratio of international price levels, equilibrium if price levels are equal

Question 6

Relative PPP

Answer 6

Change of exchange rate determined by differences in inflation rates

Question 7

How can PPP be restored in the long run?

Answer 7

Adjustment of trade flows, demand of currency adjusts until it has levelled again

Question 8

How is the concept of real exchange rates related to the PPP theory?

Answer 8

• Real exchange rate: Ratio of price baskets between countries
• PPP theory predicts that market forces will cause exchange rate to adjust when prices of national baskets are not equal
• under absolute PPP: Real exchange rate =1

Question 9

How is monetary policy related to exchange rate fluctuations?

Answer 9

Increases in money supply -> increases in relative price levels -> reduce value of country’s currency

Question 10

Why does PPP fail in the short run?

Answer 10

Doesn’t account for:

• Transaction goods
• Nontraded goods
• Imperfect competition and legal obstacles
• Price stickiness

Question 11

How can interest parity be restored?

Answer 11

• Capital flows will move towards the country with higher expected returns
• Exchange rate needs to be adjusted until interest rate parity holds again