Question

Using the supply and demand model described in Chapter 4 of the text, show on a graph (label it clearly!) and describe what should happen to the value of the Indian rupee relative to the U.S. dollar as a result of the following (each question is independent):

1. The real interest rate in the U.S. rises relative to the real interest rate in India.

2. The nominal interest rate in India rises relative to the nominal intertest rate in the U.S. The real interest rates are the same in both countries, before and after the change in the nominal rate. Should Indian speculators attempt a carry trade strategy by borrowing in the low nominal interest-rate country and investing in the higher rate country?

3. Circulating rumors suggest that the Indian government plans to impose a large tax on investment returns generated in their country and remitted to the U.S. Although analysts are uncertain about the likelihood of implementing the tax, if adopted, it will be in force for the next five years.

4. U.S. GDP is expected to grow at twice the rate of Indian GDP over the next two years.

Answer 1

Base Graph:

Fig. 1 offers an example for the exchange rate between the U.S. dollar and the Indian Rupee. The vertical axis shows the exchange rate for U.S. dollars, which in this case is measured in Indian Rupee. The horizontal axis shows the quantity of U.S. dollars being traded in the foreign exchange market each day.

The demand curve (D) for U.S. dollars intersects with the supply curve (S) of U.S. dollars at the equilibrium point (E), which is an exchange rate of 11 Indian Rupee per dollar and a total volume of $8.5 billion.

Case 1:

If rates of return in a country look relatively high, then that country will tend to attract funds from abroad. Changes in the expected rate of return will shift demand and supply for a currency.

If interest rates rise in the United States as compared with India. Thus, financial investments in the United States promise a higher return than they previously did. As a result, more investors will demand U.S. dollars so that they can buy interest-bearing assets and fewer investors will be willing to supply U.S. dollars to foreign exchange markets. Demand for the U.S. dollar will shift to the right, from D₀ to D₁, and supply will shift to the left, from S₀ to S₁, The new equilibrium (E₁), will occur at an exchange rate of twelve rupees/dollar and the same quantity of $8.5 billion. Thus, a higher interest rate or rate of return relative to other countries leads a nation’s currency to appreciate or strengthen, and a lower interest rate relative to other countries leads a nation’s currency to depreciate or weaken.

Case 2:

As the real interest rate is same in both countries, the investors will not earn with the borrowing speculation, thus will be no beneficial.

Case 3:

If the tax on the investment is increased, it will discourage the investors to invest in India, thus reducing the foreign currency inflow in the country. It will lead to reduction in the supply of US dollar in India compared to the demand, leading to increase in the value of US dollar. , appreciation of US dollar against Indian Rupee. So, at same Indian Dollar exchange rate, less US Dollar will be traded in the India.

Case 4:

As the GDP of US is expected to rise, people will be interested in investing more US, thus increasing the in Supply of Indian rupee in US and appreciating the US dollar value, due to the Shift the US dollar against Indian Rupee.