Unit 5.2 Currency market and exchange rate policy

Question 1

Exchange rate of the euro (to dollar)

Answer 1

Exchange rate of the euro (to dollar): price of euro in terms of dollar. Example 1.1 $ is the euro-to-dollar exchange rate right now

E↑ (Euro Appreciates): If the exchange rate increases (e.g., from 1.1 to 1.2 USD for one euro), this is called an appreciation of the euro vis-à-vis the dollar. It means that you now need more dollars to buy the same amount of euros, indicating that the euro has become stronger relative to the dollar.
E↓ (Euro Depreciates): Conversely, if the exchange rate decreases (e.g., from 1.1 to 1.0 USD for one euro), this is called a depreciation of the euro vis-à-vis the dollar. In this case, fewer dollars are required to buy the same amount of euros, indicating that the euro has become weaker relative to the dollar.

Question 2

Demand - Exchange rate

Answer 2

Demand for euros in terms of dollars: dollar-holders (from any country, but mostly US) that want to obtain euros, buying them in exchange for dollars

Question 3

Supply - Exchange rate

Answer 3

Supply for euros in terms of dollars: euro-holders (from any country, but mostly euro area) that want to get rid of euros, selling them in exchange of dollars

Question 4

What are supply and demand of currency influenced by?

Answer 4

• Interest rate ratio
• Price level ratio
• GDP
• Expectations

Question 5

Interest rate ratio

Answer 5

𝑖€/𝑖$ → if the ratio increases, it becomes more profitable to own stock and bonds denominated in euros it happens when:
- 𝑖€ increases: both 𝑖€ and i$ increases but 𝑖€ increases more
- If i$ decreases: both i$ and 𝑖€ decreases but i$ decreases more

To obtain them, it is necessary to have euros
- Demand for euro will shift forward
- Supply of euro will shift back

The euro will appreciate vis-a-vis the dollar (and equilibrium in the capital market is restored)

Question 6

Price Levels Ratio

Answer 6

p€/p$ → if this ratio increases, a basket of products costs more in the euro area than in US. It will happen when:
- p€ increases and/or p$ decrease
- both p€ and p$ increase but p€
increases more
- both p€ and p$ decrease but p$ decreases more

To obtain exports from the US, it is necessary to have dollars:
- Demand for euro will shift back
- Supply of euro will shift forward

The euro will depreciate vis-a-vis the dollar. (And equilibrium in the goods and services markets is restored)

Question 7

GDP - Exchange

Answer 7

𝑌€ → the euro area has more GDP → more importing from US (propensity to import) → increase in supply of euro in terms of dollar → euro depreciates.

𝑌$ → the US has more GDP → more exporting (US’s propensity to import) → increase in demand of euro in terms of dollar → euro appreciates.

Question 8

Expectations - Exchange

Answer 8

Expectations that the euro will depreciate -> sales of euros and purchase of other currency (dollar) -> self-fulfilling depreciation of the euro

Expectations that the dollar will depreciate -> sales of dollar and purchase of other currency (euros) -> self-fulfilling depreciation of the dollar (appreciation of the euro)

Question 9

Fiscal expansion - Floating exchange rates when financial boarders open

Answer 9

+r -> interest from foreigners in buying our currency -> the exchange rate appreciates -> pushes down X -> IS goes down until it’s back at the beginning r and Y levels

Question 10

Fiscal expansion floating exchange rates when financial boarders are closed

Answer 10

+r has no effect on the rest of the world -> +IM -> upward pressure on foreign currency freely depreciate -> +X, - IM -> even more Y

Question 11

Fiscal expansion - Fixed exchange rates when financial boarders are open

Answer 11

+r -> interest from foreigners in buying our currency -> the central bank cannot let the currency appreciate -> central bank lowers r with monetary expansion -> even more output (+C, +I)

Question 12

Fiscal expansion - fixed exchange rates when financial boarders are closed

Answer 12

+r has no effect on the rest of the world -> +IM -> upward pressure on foreign currency -> to avoid our currency depreciating, central bank makes monetary contraction -> even higher r, Y falls back down

Question 13

Monetary expansion - Floating exchange rates when financial boarders open

Answer 13

-r -> people want to sell our currency (doesn’t yield high interest compared to others)
-> our currency depreciates -> boots X because they’re cheaper -> IS shifts forward even more Y

Question 14

Monetary expansion - Floating exchange rates when financial boarders are closed

Answer 14

-r has no effect on rest of the world -> +IM because of expansion -> upward pressure on foreign currency -> let our currency freely depreciate -> +X, -IM (IS shifts forward) -> even more Y

Question 15

Monetary expansion - Fixed exchange rate when financial boarders open

Answer 15

-r -> people want to sell our currency (doesn’t yield high interest compared to others) -> the central bank cannot let our currency depreciate -> central bank raises r with monetary expansion -> the monetary expansion effect is undone

Question 16

Monetary expansion: fixed exchange rate when financial boarders are closed

Answer 16

-r has no effect on the rest of the world -> + IM because of expansion -> upward pressure on foreign currency -> to avoid our currency depreciating, central bank makes monetary contraction -> Y falls back down