Role of Exchange Rates

Question 1

What is the direct exchange rate?

Answer 1

Domestic price of one unit of FC

$1.10= 1 Euro

Question 2

What is the indirect exchange rate:

Answer 2

Foreign currency of one unit of domestic currency

$1 = .909 Euro

Question 3

How are exchange rates determined?

Answer 3

Free-floating currency- Exchange rate is determined by market forces of supply and demand for a currency

Pegged or movable currency- Exchange rate is fixed by the government, with frequent revisions

Most countries have a free-floating currency

Demand and supply determine the exchange rates

Question 4

What are currency demand factors?

Answer 4

• Political and economic environment- strong economy increases the demand for the currency
• Relative interest rates- higher rates relative increases investment which increases demand
• Relative inflationary rates- lower rates retain purchasing power which increases demand
• Level of public debt- higher level of debt increases risk of inflation which deters investment and decreases currency demand
• Current account balance- higher deficit (excess imports over exports and investment outflows over investment inflows) increases demand for foreign currency relative to domestic currency

Other factors: (consumer preferences, relative incomes, currency speculation- attempts to make profit on trading in currencies)

Question 5

What are currency supply factors?

Answer 5

Supply of currency is determined by the country’s Central Bank

US Federal Reserve Bank determine currency supply through monetary policy

Question 6

What are examples of the US Fed Affecting Exchange Rate:

Answer 6

Supply side: Buying dollars in open market using foreign currency reserves to reduce supply of dollars; Selling dollars would increase supply of dollars

Demand Side: Increase or decrease interest rates to increase or decrease demand for domestic investments , which decreases demand for dollars

Question 7

What are the consequences for exchange rate changes?

Answer 7

• Currency appreciation: The value of currency increases (becomes stronger). Less domestic currency to buy foreign currency or goods sold in that currency
• Currency deprecation. The value of currency decreases (becomes weaker) it takes more domestic currency to buy foreign currency or goods sold in that currency

Question 8

What are the consequences of currency appreciation?

Answer 8

• Foreign goods become cheaper for domestic buyers
• Encourages increased domestic efficiencies- in order to compete
• Puts downward pressure on domestic inflation- by keeping prices low
• Makes it difficult for domestic produces to compete in domestic and foreign markets

Question 9

What are the consequences of currency depreciation?

Answer 9

• Domestic goods become cheaper (increase exports)
• Increased exports increase employment
• Import goods become more expensive
• Drive up cost of foreign inputs (raw materials, components, as well as consumer goods)