Question

1. For each of the following events draw a diagram of the foreign exchange market for dollars in equilibrium, and show the effect on the demand curve and/or the supply curve of dollars as a result of each of the events. Does the dollar rise or fall in value?

      i) Interest rates in the United States rise.

     ii) Speculators become convinced that the future value of the Japanese yen will be higher relative to the dollar than it is today.

2) What would happen to the value of the dollar if prices in the United States increased more rapidly relative to prices in other countries?

3) Suppose interest rates in the U.S. are 3% while interest rates on comparable bonds in Japan are 1%. By how much is the exchange rate between the yen and dollar expected to change according to the interest-rate parity condition?

4) Suppose the Federal Reserve reduces interest rates while interest rates in Europe do not change. Make use of a graph of the foreign exchange market to show how this will affect the value of the dollar.

5) Briefly explain how a U.S. company that exports to Europe can hedge against exchange rate risk

Answer 1

Question 1

The exchange rate for a country determined by Demand & supply of foreign currency, that is, where demand & supply of foreign currency intersect will determine given country exchange rate

I) In case interest rate in US rises, more people willing to invest in US. Thus, there will be inflow of funds in US, which implies Demand for US dollar rises implies foreign exchange rate against US dollar will rise, implies depreciation of foreign currency respect to US dollar. Or in other words in order to invest in dollars foreign investors will sell their currency, and demand dollars in exchange of it. Thus, supply of foreign currency will rise implies that the US dollar exchange rate fall, implies US dollar appreciated (shown in diagram below)

II) The investor expected that Japanese yen future value will be higher than the US dollar, this will lead to increase in demand of Japenese yen, increase demand of yen lead to increase in exchange rate of US dollar with respect to Japenese yen, implies the depreciation of US dollar with respect to Japenese yen (shown in diagram below)