Question

1. A beer in the United States sells for $4. The same beer can sell for €3 in France. The current nominal exchange rate is $1.08/€. Calculate the real exchange rate of the French beer per US beer (use two decimal points). Based on your response, is beer relatively more expensive in the US or in France? Show your work and explain.

b. Use the market for foreign exchange to analyze the effect of the following events. In your graph, make sure to identify the effect of each of these events on the US dollar (i.e. does the dollar get weaker/stronger?) Explain in 1-2 sentences what each of your graphs is showing. Important: Treat each event separately (i.e. draw a separate graph for each event). i. American companies discover a new technology that allows them to become much more productive. ii. The Central Bank of Canada decides to raise their interest rates.

Answer 1

a) The real exchange rate of French Beer per US beer = Nominal Exchange rate ($/€) * Price of beer in France/Price of beer in US = 1.08*3/4 = 0.81.

b) I) American companies discover a new technology that allows them to become much more productive – This factor will make the US dollar more “Stronger” relative to other currencies because

· A more productive American economy would have economies of scope and generate higher economic performance – for instance more output at lower costs.

· A higher economic performance would lead to higher investor confidence in the country and lead to heightened demand for US dollars. (as more investor money would flow into the economy)

· This high demand for US dollar will lead to appreciation of the US dollar or make it stronger. It is shown in the graph below.

Increased demand, appreciates the US dollar or E(€/$) increases.

II) The central bank of Canada decides to raise their interest rates – this factor will make the US                            dollar relatively “Weaker” than the Canadian Dollar. This is because: -

· Increasing interest rates in Canada, would attract higher foreign capital from abroad as the investors would get a higher return on investment.

· This would instigate high demand for Canadian dollars and cause the Canadian dollar to appreciate with respect to the US dollar.

· From the US perspective, thus, the US dollar would depreciate or become weaker as shown in the graph below - E $/C$ increases in value

· Graph depicts the demand and supply of Canadian dollars, price in us dollars.