Question

Consider the exchange rate between South Korea and Tunisia. For each example, decide whether the scenario would tend to cause an appreciation, a depreciation, or have no effect on the South Korean won relative to the Tunisian dinar.

The Economist magazine publishes an article indicating that analysts expect the value of the Tunisian dinar to rise relative to the South Korean won.

The central bank in South Korea raises interest rates on government bonds.

According to a World Bank report, the inflation rate in South Korea is going to be 5% next year, while the inflation rate in Tunisia is going be 10.5%.

The price of a specific basket of goods in South Korea is roughly 1.7 times higher than an identical basket of goods in Tunisia, even after adjusting for the exchange rate.

Answer Bank

Appreciate, Depreciate, and No effect

Answer 1

Case1 :

Since the value of the Tunisian dinar is expected to rise relative to the South Korean won, the South Korean won is likely to depreciate against the Tunisian dinar.

Case 2:

No effect on the South Korean won relative to the Tunisian dinar.

Banks may raise interest rates for fighting inflationary tendencies in the economy. Inflation erodes the purchasing power of money and the higher interest rate is said to compensate for the loss in the real value of money.

Case 3:

The Purchasing Power Theory (PPP) indicates that in countries that experience higher inflation rates, currency values decline more compared to the currencies of countries with lower inflation rates. In our case, the inflation rate in Tunisia is estimated to be 10.5% and the same is estimated to be 5% in South Korea. Since the inflation rate is lower in South Korea, the South Korean won will appreciate against the Tunisian dinar.

Case 4:

As the price of a basket of goods in South Korea is 1.7 times higher than an identical basket of goods in Tunisia, the purchasing power of the South Korean won is said to have increased relative to the Tunisian dinar. As such, the South Korean won has appreciated against the Tunisian dinar.