Question

Assume that the United States invests heavily in government and corporate securities of Country K. In addition, residents of Country K invest heavily in the United States. Approxi-mately $10 billion worth of investment transactions occur between these two countries each year. The total dollar value of trade transactions per year is about $8 million. This information is expected to also hold in the future.

Because your firm exports goods to Country K, your job as international cash manager requires you to forecast the value of Country K's currency (the “krank”) with respect to the dollar. Explain how each of the following conditions will affect the value of the krank, holding other things equal. Then, aggregate all of these impacts to develop an overall forecast of the krank's movement against the dollar.

a. U.S. inflation has suddenly increased substantially, while Country K's inflation remains low.

b. Country K's interest rates have increased substantially, while U.S. interest rates remain low. Investors of both countries are attracted to high interest rates.

c. The U.S. income level decreased substantially, while Country K's income level has remained unchanged.

d. Country K is expected to impose a small tariff on goods imported from The U.S..

e. Combine all expected impacts to develop an overall forecast.

Answer 1

a) With inflation changes, there is an increase in the U.S. demand for the krank. Simultaneously, there is a decrease in supply of kranks available for sale. This results in an upward pressure in the krank's value.

b)With interest rate changes, there is a decrease in the U.S. demand for the krank. Simultaneously, there is an increase in supply of kranks for sale. This results in a downward pressure on the krank's value.

c) With income level changes, there is an increase in the U.S. demand for the krank resulting in upward pressure on the krank's value.

d)The tariff increase will cause a demand reduction in the United States' for Country K's goods, and will therefore reduce the demand for available kranks for sale resulting in a downward pressure on the krank's value.

e) The scenarios are related to trade lead to an upward pressure on the krank. However, trade flows are relatively minor between the U.S. and Country K. On the contrary, interest rate scenario places downward pressure on the krank and considering that interest rates affect capital flows and capital flows dominate trade flows between the U.S. and Country K, the interest rate scenario should overwhelm all other scenarios. Thus, cumulatively, the krank is expected to depreciate.