Exchange Rate determination

Question 1

Explain meaning of appreciation and depreciation

Answer 1

Depreciation: decline in a currency’s value
Appreciation: increase in a currency’s value
Can be measured by percentage change in foreign currency value = (Difference in spot rates)/Earlier spot rate

Question 2

What is a measure of volatility in statistics

Answer 2

Standard deviation - quantifies the amount of dispersion in a set of data values. Value close to zero means data tends to be close to the expected value/mean

Question 3

Define exchange rate

Answer 3

The exchange rate represents the price of a currency, or the rate at which one currency can be exchanged for another.

Question 4

Explain why demand curve is downward sloping and supply is upward sloping for currency

Answer 4

Demand for a currency increases when the value of the currency decreases, leading to a downward sloping demand schedule.
Supply of a currency for sale increases when the value of the currency increases, leading to an upward sloping supply schedule.ha

Question 5

What is the equilibrium price

Answer 5

Equilibrium equates the quantity of a currency demanded with the supply of that currency for sale.

Question 6

Name factors that influence exchange rates and their equilibrium

Answer 6

Change in difference between domestic and foreign inflation/ interest rate/ income levels
Change in government controls
Change in expectations of future rates

Question 7

What happens when domestic inflation increases

Answer 7

Increase in U.S. inflation leads to increase in U.S. demand for foreign goods, an increase in U.S. demand for foreign currency, and an increase in the exchange rate for the foreign currency.

Question 8

What happens when domestic interest rates increase

Answer 8

Leads to increase in demand for U.S. deposits and a decrease in demand for foreign deposits, leading to an increase in demand for dollars and an increased exchange rate for the dollar.

Question 9

What is formula for real interest rate?

Answer 9

real interest rate = Nominal interest rate - inflation rate

Question 10

What is the effect of an increase in domestic income levels?

Answer 10

Increase in U.S. income leads to increased demand for foreign goods and increased demand for foreign currency relative to the dollar and an increase in the exchange rate for the foreign currency.

Question 11

How can government controls affect exchange rates?

Answer 11

Imposing foreign exchange barriers
Imposing foreign trade barriers
Intervening in foreign exchange markets
Affecting macro variables such as inflation, interest rates, and income levels.

Question 12

What is the impact of favourable expectations?

Answer 12

If investors expect interest rates in one country to rise, they may invest in that country leading to a rise in the demand for foreign currency and an increase in the exchange rate for foreign currency.

Question 13

What is the effect of unfavourable expectations

Answer 13

Speculators can place downward pressure on a currency when they expect it to depreciate.

Question 14

How can expectations lead to overvaluing or undervaluing a stock?

Answer 14

Speculators may overreact to signals causing currency to be temporarily overvalued or undervalued

Question 15

How does liquidity influence exchange rate fluctuations

Answer 15

If a currency’s spot market is liquid then its exchange rate will not be highly sensitive to a single large purchase or sale.

Question 16

When is there no change in the cross exchange rate?

Answer 16

If currencies A and B move in same direction, there is no change in the cross exchange rate.

Question 17

When would happen to a cross exchange rate if both currencies appreciate against the dollar?

Answer 17

When currency A appreciates against the dollar by a greater (smaller) degree than currency B, then currency A appreciates (depreciates) against B.

Question 18

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Question 19

What would happen to a cross exchange rate if one currency appreciates against the dollar and one remains unchanged?

Answer 19

When currency A appreciates (depreciates) against the dollar, while currency B is unchanged against the dollar, currency A appreciates (depreciates) against currency B by the same degree as it appreciates (depreciates) against the dollar.

Question 20

What actions would institution speculation based on expected depreciation prompt?

Answer 20

If financial institutions believe that a currency is valued higher than it should be in the foreign exchange market, they may borrow funds in that currency and convert it to their local currency now before the currency’s value declines to its proper level.

Question 21

What actions would institutional speculation based on expect appreciation prompt?

Answer 21

When financial institutions believe that a currency is valued lower than it should be in the foreign exchange market, they may invest in that currency before it appreciates.

Question 22

Define the carry trade

Answer 22

Where investors attempt to capitalise on the differential in interest rates between two countries. - Risk that exchange rates may move opposite to what investors expect.