Question

Central African CFA franc (XAF) is a currency used by 14 African countries and it is pegged to the Euro (fixed E_CFA/EURO). The currency union countries are committed to protect the CFA franc, and the fixed exchange rate regime and capital mobility, under all circumstances.

Suppose that a political scandal in the area causes disturbances in the area, across multiple countries. Due to this news, investors revise their exchange rate forecasts and expect CFA franc to depreciate against the euro in the future.

1. What happens in the FX market following the change in exchange rate forecasts? Explain which schedule(s) shift and why. Assume CFA franc to be the home currency.
2. How does the equilibrium E_CFA/EURO  exchange rate change? Why?
3. What happens in the currency union money market following the change in exchange rate forecasts? Explain which schedule(s) shift and why.
4. What happens to the equilibrium interest rate? Why?

(Please show the graphs you draw, and if possible typed answers)

Answer 1

Answer (i):

From the above diagram, we can see that CFA Franc is measured along the X axis and Euro is measured along the Y axis. Here the CFA franc and the Euro curves are shown in the Foreign exchange (FX) market, where they are intersecting at point E thereby creating an equilibrium. The New CFA franc and the New Euro curves are also shown intersecting at point 2 and thereby creating another equilibrium. As a result of the expected depreciation of CFA Franc in the Foreign Exchange market, the trust of the investors in CFA Franc declines thereby leading to a decrease in investment on CFA Franc. The decrease in the investment leads to a decline in the Foreign Exchange value of CFA Franc in relation to Euros.

Answer (ii): With a decrease in the foreign exchange value of CFA Franc, the exchange value of CFA Franc declines, thereby leading to a corresponding increase in the exchange value of Euros. We can see in the above diagram that the original CFA Franc and the Euro curves intersect at point E, thereby creating the equilibrium at point E. However, with the depreciation of CFA Franc and with the subsequent appreciation of Euros, a new equilibrium E2 is established in the foreign Exchange market. This this equilibrium is a loss for CFA Franc, as it gains tremendous losses due to the depreciation of its currency.

Answer (iii): As a result of the equilibrium shift in the foreign exchange market, the demand for the home currency falls and its value depreciates. The investors in the money market fear of further loss in the exchange value of the currency, and therefore refrain from investments and if possible, they even withdraw investments. All these leads to huge shortage of money in the market. This shortage leads to a big fall in the production process in the market, thereby leading to a fall in the demand and ultimately the market falls in to a slump. This further increases the woes for the economy as the country further falls in to an economic crisis.

Answer (iv): The equilibrium interest rate increases drastically in the economy. This is because, when the value of the currency declines, the Government and other lending authorities start losing their invested money value. Therefore, in all subsequent lending’s they intend to acquire as much profit as possible to cover up some of the losses. This leads to an increase in the interest rate in the economy.