Question

Draw the demand and supply curves and provide brief explanations about the exchange rate and the value of the domestic currency in each case. Note: you just need to state whether the dollar has appreciated or depreciated and whether the exchange rates (R) goes up or down) (after drawing the graphs). Note: be sure to use the currency of the foreign country implied in each question!

a) Real interest rates rose in Japan relative to those in the U.S.

b) Real interest rates rose in the U.S. relative to those in Great Britain.

c) The British expect the value of the U,S, dollar to delcine.

Answer 1

Foreign exchange rate and its determination under flexible exchange rate

Foreign exchange rate is the rate at which one country’s national currency is converted into one another country’s national currency. For example if exchange rate is INR 60 =$1, it means that INR 60 is needed to buy $1 or $1 is required to by INR 60. In terms of purchasing power by paying INR 60 and Indian can buy goods worth $1 or with paying $1 an American can buy goods worth INR 60 from India.

Under the flexible exchange rate system the exchange rate is determined by the demand for and supply of foreign currency. The exchange rate is determined at the point where the demand for foreign currency is equal to the supply of foreign currency. When the demand for foreign currency is equal to the supply of foreign currency the rate is known as the equilibrium exchange rate.

Suppose the demand for dollar increase in relation to Indian rupee, while supply remaining the same moves the demand curve from DD to DD₁ resulting an increased exchange rate for dollar from OR to OR₁. While demand remaining the same an increase in the supply of dollar depreciate its value from OR to R₂.

If the demand for foreign currency (dollar) in the domestic market of India increase,(while remaining the same) the value of Indian currency in terms dollar depreciate and the value of dollar in terms of Indian rupee appreciate. It means that India has to give more rupees to buy one unit of dollar than earlier. On the other hand if the demand for dollar in the Indian market (while supply reaming the same) decrease, the value of Indian rupee in terms of dollar appreciate. In other words India has to pay fewer dollars to purchase one unit of dollar than earlier.

A country demand foreign currency when it’s citizens need to purchase foreign good, invest in foreign firms and purchase foreign bonds.

In your example, If the real interest rate in Japan rise relative to US, US investments in government’s bonds and securities increase in Japan resulting more demand for Japan’s currency. This lead to more capital flow from US to Japan. Consequently the value of Japan’s currency(Yuen) increase and that of US(dollar) depreciate.

If the real interest rate in US rise relative to Britain, more funds flow from Britain to US resulting an appreciation in the value of dollar and depreciation in the value of Pound.

If the Britain expects depreciation in the value of US dollar, speculation in the foreign exchange market leads to less demand for US dollar which further depreciates its value.

The changes in domestic interest rate largely affect the foreign exchange rate. A higher domestic interest rate gives more returns to lenders in foreign country, thus it invite more foreign capital resulting appreciation of country’s currency because its demand in the international market increase.

A lower domestic interest rate causes the domestic currency less attractive and a less demand in the foreign market. Similarly more domestic currency flows to foreign country as investing in foreign country ensure more returns. Thus the country’s national currency depreciates and that of the country’s currency appreciate which is more attractive to invest in.

The central bank of a country can control the foreign exchange through fixing domestic interest rate and adopting suitable monetary measures

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