Question

1. Suppose there are two countries that are otherwise the same (e.g. in regards to inflation and risk etc.) except that Country L2 is a lending country and Country B2 is a borrowing country.

(a) For Country L2, which will happen in foreign exchange markets, an increase in demand for the country’s currency or an increase in supply of the country’s currency?

(b) What happens to the strength of Country L2’s currency?

(c) What happens to the trade balance for Country L2?

2. Suppose a country wants to fix the exchange rate of its domestic currency lower than what markets alone would bring about. Which would the central bank do, buy the domestic currency or sell the domestic currency?

Answer 1

Now, under the flexible exchange rate regime the exchange rate will be determined by the forces of supply and demand. So, if there is an increase in the demand for the country’s currency, => the demand for foreign exchange will shift to the right side given the supply of foreign exchange, => the equilibrium exchange rate will increases.

a).

Now, if there is an increase in the supply of the country’s currency, => the supply of foreign exchange will shift to the right side given the demand for foreign exchange, => the equilibrium exchange rate will decreases.

b).

Now, in the 1^st case the exchange rate increases implied the value of “L2’s currency” decreases. Similarly, in the 2^nd case the exchange rate decreases implied the value of “L2’s currency” increases.

c).

Now, under the flexible exchange rate regime the exchange rate will adjust to clear the foreign exchange market, => the trade balance is always in balance situation.

2).

Now, if there is a fixed exchange rate regime, => as the demand increases, => there will be an excess demand for foreign exchange reserve, => there if an upward pressure on the exchange rate to clear the foreign exchange market. Now, to keep the exchange rate at it’s initial level central bank have to meet this excess demand by using it’s own reserve of foreign exchange, => central bank will sell foreign exchange in exchange of money, => the level of money supply increases.

Now, as the supply increases, => there will be an excess supply for foreign exchange reserve, => there if an downward pressure on the exchange rate to clear the foreign exchange market. Now, to keep the exchange rate at it’s initial level central bank have to get this excess supply of foreign exchange, => central bank will buy foreign exchange in exchange of money, => the level of money supply decreases.