ECON 4.5: Exchange Rates

Question 1

Determinant of exchange rate: foreign demand for a country’s exports

Answer 1

Increases demand for your currency (to buy exports, they would have to exchange their foreign currency for yours)

Question 2

Determinant of exchange rate: domestic demand for foreign imports

Answer 2

Increases supply for your currency (to buy imports, you would have to exchange your currency for foreign ones)

Question 3

Determinant of exchange rate: foreign direct investment

Answer 3

Inwards (going to your country) - increases demand (exchange their currencies for yours to invest here)
Outwards (from your country) - increases supply (exchange your currency for foreign ones to invest outside)

Question 4

Determinant of exchange rate: remittances

Answer 4

Coming home - increases demand (exchanged to your currency)
Sending abroad - increases supply (exchanged for another currency, so more of your currency on for. ex.)

Question 5

Determinant of exchange rate: speculation

Answer 5

If we think it will:
Appreciate - increases demand (investors want to be a holding more valuable currency)
Depreciate - increases supply (get rid of low value currency)

Question 6

Determinant of exchange rate: relative inflation rates

Answer 6

Lower - increases demand (good PPP, relatively stronger)
Higher - increases supply (bad PPP, relatively weaker)

Question 7

Determinant of exchange rate: relative growth rates

Answer 7

Strong - increases demand (attracts financial capital)
Weak - increases supply (financial capital leaves)

Question 8

Determinant of exchange rate: relative interest rates

Answer 8

Higher - increases demand (attracts financial capital for higher rate of return on investments)
Lower - increases supply (financial capital leaves, lower rate of return)

Question 9

Determinant of exchange rate: central bank intervention

Answer 9

Revaluation (initial surplus) - govt buys country’s currency with foreign reserves - increases demand
Devaluation (initial shortage) - govt buys foreign reserves using the country’s currency - increases supply

Question 10

How can governments regulate exchange rates?

Answer 10

• Revaluation
• Devaluation
• Changing interest rates
• Imposing exchange controls
• Imposing capital controls (restricts the movement of foreign capital)

Question 11

e.g. revaluation of a currency

Answer 11

Japan’s recent intervention of monetary easing (buying Japanese currency with foreign reserves, over 6 trillion Yen) / largely due to widening gap btwn Japan (much lower) and US’ interest rate

Question 12

What is purchasing power parity?

Answer 12

PPP is a theory which states that the exchange rates between 2 currencies in when their purchasing power is the same in each of the 2 countries.