Question

In: Economics

1. Start with a demand and supply curve for foreign exchange: Explain what the “price”...

1. Start with a demand and supply curve for foreign exchange: Explain what the “price” means:

Explain with a graph as well as in words:

2. If there is economic growth in domestically, what happens to net exports and the domestic currency (demand or supply shift)?

3. If there is economic growth in a foreign country, what happens to net exports and the domestic currency (demand or supply shift)?

4. If domestic interest rates rise, what happens to the demand and supply curves? Does the domestic currency appreciate or depreciate?

5. What often happens to a currency when expectations are that a currency will depreciate?

Expert Solution

1. Price refers to the value of one currency in terms of foreign currency. It refers to the external purchasing power of domestic currency. It is also known as foreign exchange rate. Under the flexible exchange rate system, it is determined at a point where demand (D)and supply curve (S) intersect.

2. Economic growth refers to more Production of goods and services. If there is Economic growth in the Domestic country, exports will increases or imports will decrease.

Increase in exports will result in more inflow of foreign exchange. Supply curve will shift rightward from S to S1. Equilibrium rate of exchange will fall from R to R1. This reduction in the price of foreign exchange rate is known as appreciation of domestic currency.

Decrease in imports will result less demand for foreign currency. Demand curve will shift leftward from.D to D1. Equilibrium rate of exchange will fall from R to R1. This is known as appreciation of domestic currency.

3. If there is Economic growth in foreign country, imports of domestic country will rise or Exports from domestic nation will decline.

Increase in imports means more demand for foreign currency. Demand curve will shift rightward from D to D1. Equilibrium rate of exchange will rise from R to R1. This is known as Depreciation of domestic Currency.

Fall in exports means decrease in supply of foreign exchange. Supplycurve of foreign currency will shift leftward from S to S1. Equilibrium rate of exchange will rise from R to R1. This is known as Depreciation of domestic currency.

4. High interest rates indicate that a country’s currency is more valuable. From a foreign investor’s perspective, saving or investing in that country is more likely to yield better returns. Thus, this would increase the demand for that country’s currency. To take advantage of the high rates offered, they would move their funds there. When demand for a domestic currency goes up,it is said to strengthen or appreciate. This will result more inflow of foreign exchange. Supplycurve will shift rightward from S to S1. Equlibrium rate of exchange will fall from R to R1. This is referred as appreciation of domestic currency.

5. Depreciation refers to decrease in the value of domestic currency in terms of foreign currency. This happens when foreign exchange rate rises. When it is expected that Currency will Depreciate in future. Demand for foreign exchange at current price will increase. This will shift demand curve rightward from D to D1. Rate of exchange will rise from R to R1.

Rahul Sunny answered 1 year ago

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