Question

Modern managers in today's business world have many more issues and concerns
regarding managing business enterprises relative to before the advent of
globalization. In that vein, they must be careful that they fully and completely take
into account the global economy so that they develop and adopt correct and proper
strategies that add value to the firms they are managing. In other words, they must
develop and adopt strategies that will create and sustain positive economic profits
for their firms. These endeavors often involve keeping detailed track of, as well as
precise management of, foreign exchange rate movements and changes.

Consider the following situation. Suppose that a change in tastes occurs in the
United Kingdom (UK) such that residents in the UK are prompted to purchase more
goods and services from the U.S. In other words, UK consumers purchase more
imports from the U.S.

A.     What would be the effect on the U.S. dollar-Uk pound sterling (l.e. U.S. dollar
per pound sterling, or $/£) exchange rate as a result of this situation? Would
this exchange rate rise or fall? Explain carefully and illustrate with an
appropriately drawn diagram.

B.     Which currency has appreciated? Which currency has depreciated? Explain
carefully.

C.     How would this situation affect the sales of a firm that produces in the U.S.
but sells goods and services to UK residents? Explain carefully.

(Hint: What would happen to the price of U.S. goods and services in the
UK? What would happen to U.S. sales in the UK?)

Answer 1

(A) If UK consumers purchase more imports from US, demand for US dollar rises (in order to pay for higher imports) and dollar appreciates, so UK pound depreciates. The Dollar-Pound exchange rate, therefore, increases.

In following graph, exchange rate (P) and quantity of dollars (Q) are measured vertically and horizontally respectively. D0 & S0 are initial demand & supply curves for dollar, intersecting at point A with initial exchange rate P0 and quantity of dollars Q0. As demand for dollar rises, its demand curve shifts right to D1, intersecting S0 at point B with higher exchange rate P1 and higher quantity of dollars Q1.

(B) Since demand for dollar rises, its value increases and dollar appreciates. Since demand for Pound falls, its value decreases and pound depreciates.

(C) An appreciation of dollar makes the US-made goods more expensive in UK, therefore exportable goods become less competitive. As a result, US export demand will fall.