Question

Exercise 4

Analyze the Demand and Supply of the selected Foreign Exchange Market.

Consider the exchange rate €/$ in the short-run. Answer the questions below and provide an example for each case:

1. How can an increase of the expected inflation rate affect the equilibrium exchange rate (equilibrium point)?  (7 points)

2. How can a decrease in the domestic productivity, due to a pandemic disease, affect the exchange rate? (6 points)

3. Suppose that USA concluded a new international agreement with the EU. This agreement decreased the trade barriers between USA and EU substantially. Explain the consequences of this situation on the demanded quantity of US dollar assets. (6 points)

4. How can the relative return on the US Dollar assets be affected by an increase of 1.1 points of the interest rate available in Europe? (6 points)

Answer 1

1. The rate of inflation in a country can have a major impact on the value of the country's currency and the rates of foriegn exchange it has with the currencies of other nations. However, inflation is just one factor among that combine to influence a country's exchange rate.

How inflation affect the exchange rate

1. Creates uncertanity and lower investment

2. High inflation often leads to lower growth and less stability

3. Reduces international competitiveness

4. To reduce inflation can lead to recession

5. Fall in value of saving

6 If wages don't keep up - lower real wages

7. Inflation damage economy.

How inflation affect the exchange rate with example.

A higher rate in the UK compared to other countries will tend to reduce the value of the pound sterling becouse :

• High inflation in the UK means that UK goods increase in price quicker than European goods. Therefore UK goods become less competitive. Demand for UK exports will fall, and therefore there will be less demand for Pound Sterling.
• Also, UK consumers will find it more attractive to buy European imports. Therefore they will supply pounds to be able to buy Euros and Euro imports. This increase in the supply of pounds decreases the value of Pound Sterling.

Increase in supply of Pound sterling and fall in demand leads to lower value of the Pound against the Euro.Therefore, in the long run, changes in relative inflation rates should lead to a change in the exchange rates.

For example :- In the post-war period, the UK experience a higher inflation rate than Germany. This caused the Pound Sterling to depreciate against the German Mark. It was a reflection that German industry was becoming more competitive than UK industry.

Impact of inflation

• The rise in UK inflation in 2008 was also due to higher oil prices.
• The effect on inflation was limited because in 2009 the UK was in recession, which reduced inflation.
• The impact also depends on the elasticity of demand and whether firms will pass on the exchange rate costs onto consumers. For example, firms may reduce profit margins rather than increase the price of imports.

2. Domestic productivity and exchange rate

Over the past month (end of February / beginning of March 2020), the scale of sharp decreases in the valuation of securities shares on the stock exchanges and a fall in the price for a barrel of oil acquires the characteristics of a stock crash. In addition, there is a significant decline in the production of many product ranges made in China, etc. The Swiss franc is rising against some of the other economically more popular currencies. Revenues and profits in the tourism sector are falling strongly in many countries. Can this situation be interpreted in terms of signals suggesting the possibility of another global economic crisis in 2020?

How decrease in domestic productivity affect exchange rate

1. Flat currency value

2. Economic growth will significantly slow down globally

3. It increase the chance of trade war between so- called major economies

4 It reduce personal consumption capacity/ purchasing power

5. Reduce business investment, especially foriegn investment

6. It reduce Government spending

7. Slow down exports or badely affect exporting of low income countries

3.) Following are the important consequences

1. Massive job losses

As trade barriers are decreased or eliminated, certain goods may be cheaper to obtain overseas than to make domestically.

2. Predatory pricing

If trade takes place with no barriers at all, even an efficient company may be burned by an overseas rival with a predatory pricing strategy.

3. Increased Vuinerability

From a strategic perspective, free trade can leave a country vulnerable if it causes the demise of critical industries.

4. New Industries Can't Develop

Developing industries often benefit from domestic strategies that influence production, such as protective tariffs or tax breaks

5. It make tax traubles/ Reduced Tax Revenue

6. Theft of Intellectual Property

7. Job outsourcing.

4) RELATIVE RETURN

Relative return refers to the return achieved by an asset over a specific time period contrasted to a benchmark. The relative return is computed as the difference between the absolute return reached by the asset and the return reached by the benchmark

1. Tightening financial conditions due to stock market falls and the strong dollar,

2.A rising dollar exchange rate can mean that global trade shrinks, with negative implications for global growth.

3. Dollar's exchange rate rises banks can become reluctant to lend for trade finance because of the cost of funding in dollars.

4. Trade deficit

5. It reduce purchasing power and spending capacity of both government and individuals

6. Slow down GDP of the country

7. Reduce lending money and rises depositing money by bank.

Thank you......