Question

1) A) Explain the six major factors of driving exchange rate value

between two currencies;

b) Using these six factors, explain how each factor should have

impacted the USD value?

3) A country’s real rate of return is 1.5% and expected inflation is 2%.

Under fisher effect, what’s the nominal interest rate?

Answer 1

ANSWER 1) A)

Six factors driving the exchange rate are:

1. Inflation: Changes in market inflation cause changes in currency exchange rates. The prices of goods and services increase at a slower rate where inflation is low.
2. Interest Rate: Changes in interest rate affect currency value and dollar exchange rate. Forex rates, interest rates, and inflation are all correlated.
3. Current account Deficits: A country’s current account reflects the balance of trade and earnings on foreign investment. It consists of the total number of transactions including its exports, imports, debt, etc. A deficit in the current account due to spending more of its currency on importing products than it is earning through the sale of exports causes depreciation. Balance of payments fluctuates exchange rate of its domestic currency.
4. Public Debt: Government debt is public debt or national debt owned by the central government. A country with government debt is less likely to acquire foreign capital, leading to inflation. Foreign investors will sell their bonds in the open market if the market predicts government debt within a certain country. As a result, a decrease in the value of its exchange rate will follow.
5. Terms of Trade: Related to current accounts and balance of payments, the terms of trade is the ratio of export prices to import prices. A country's terms of trade improve if the prices of its exports rise at a greater rate than its imports prices. This results in higher revenue, which causes a higher demand for the country's currency and an increase in its currency's value. This results in an appreciation of the exchange rate.
6. Political Stability and Economic Performance: A country's political state and economic performance can affect its currency strength. A country with less risk for political turmoil is more attractive to foreign investors, as a result, drawing investment away from other countries with more political and economic stability. Increase in foreign capital, in turn, leads to an appreciation in the value of its domestic currency. A country with sound financial and trade policy does not give any room for uncertainty in the value of its currency. But, a country prone to political confusions may see a depreciation in exchange rates.

ANSWER 1) B)

Impact of factors on USD value:

1. Inflation: USD appreciates when it has a lower inflation rate than the other country has.
2. Interest Rate: Higher the Interest Rate, higher will be the Exchange rate.
3. Current Deficit: Surplus in Current account causes appreciation in USD value. Current deficit causes depreciation in USD value.
4. Public Debt: Public debt leads to inflation and higher inflation means lower exchange rate.
5. Terms of Trade: Improvement in Terms of trade results in higher revenue and an increase in its currency( USD) value.
6. Political Stability and Economic Performance: Political and Economic performance leading to Increase in foreign capital, leads to an appreciation in the value of its domestic currency(USD). A country with sound financial and trade policy does not give any room for uncertainty in value of its currency. But, a country prone to political confusions may see a depreciation in exchange rates.

ANSWER 3)

Under Fisher Effect,

Nominal Interest Rate = Real Interest Rate + Expected Inflation Rate

= 1.5% + 2%

= 3.5%