Question

Consider two countries in a fictional world economy: Rivia, where the currency is the Gulden, and Cintra, where the currency is the Ducat.

a) Graph the foreign exchange market for the Rivian Gulden, label the supply and demand curves, and identify the equilibrium by the point A. We’ll leave numbers out of this question, so label the equilibrium exchange rate e1* and the equilibrium quantity of Gulden as Q1*.

b) If there is a large increase in world demand for Rivian metal-craft products, show what will happen in the foreign exchange market for the Rivian Gulden (e.g. do any curves shift?). Identify any new equilibrium with point B.

c) Continuing from part b, suppose that concerns of a potential conflict between Rivia and a neighbouring country (Lyria) lower the expected future exchange rate for the Gulden. Add to your graph from parts a & b above to show what happens in the foreign exchange market for the Rivian Gulden (any curve shifts? explain.), identify any new equilibrium with point C, and label the equilibrium exchange rate e2*.

d) How does the equilibrium exchange rate in part c compare with the equilibrium exchange rate in part a? (e.g. higher, lower, same, ambiguous).

Answer 1

a.)

The foreign exchange curves can be drawn from th point of view of one country with respect to its exchange rate with the other country. In this case, let us consider the exchange rate of the Gulden (G) with respect to the Ducat (D). In the graph, we will plot on the y-axis the exchange rate quotation from Rivia's point of view, that is - the number of units of Ducat that is required per unit of Gulden. Hence, moving above on the y-axis would mean an appreciation of the Gulden, as more and more Ducat will be required per unit of the Gulden. On the x-axis, we plot the quantity of Gulden transacted in the economy. The demand curve is a downward sloping curve, which is obvious from the fact that the larger the number of Ducat units required for one unit of the Gulden, the lesser will be the demand for Gulden, which means the higher we move on the y-axis, the lower will be the quantity demanded of Gulden. The supply curve is an upward sloping curve. This is because the more is the number of Ducat available for one unit of Gulden, the more will people give out Gulden in exchange to get Ducat. Hence, the more we move up on the y-axis, the more is the supply of Gulden.

The diagram shows the demand curve D and the Supply curve S, intersecting at the point where the quantity of Gulden demanded is equal to the quantity of Gulden supplied, at point A, which establishes the exchange rate between Gulden and Ducat as e1 and the quantity traded at Q1.

b.)

If there is a large increase in world demand for Rivian metal-craft products, there will be a large increase in the export of the same from Rivia. Hence, the other countries who import from Rivia will want to pay for their imports. This will increase the demand for the Rivian currency Gulden, and shift the demand curve to the right, to D1. This will increase the exchange rate, that is cause appreciation of the currency and it will also increase the quantity of the currency traded. This is because the more people demand Rivian product, the more Ducats will they be willing to get Gulden units in exchange, so that they can pay for the Rivian product. Hence, we can see that the new equilibrium is B.

c.)

If the future expected exchange rate is lower, then the people will not want to hold their Gulden reserves. They will want to convert it to Ducat at the present period when they can still get more value for their Gulden units. Hence, the supply of Gulden in the market will increase as everyone would want to sell their Gulden units. This shifts the supply curve to the right, to S1, which then causes a depreciation of the Gulden. This is because now there are excess units of Gulden in the market, and people will be willing to accept lesser Ducat in order to get rid of their Gulden holdings. This will create a new equilibrium at C with a lower exchange rate of e2.

d.)

The equilibrium in part C is lower than the equiibrium exchange rate in part a. This also proves that if there is an expectation of lower exchange rates in the future, then the market acts in such a way that the lower exchange rate is actually achieved.