ECO 473 Foreign Exchange Markets Answer Key Spring 2016 – Dr. D. Foster

Foreign Exchange Rates April 12, 2016 There are two lines for each pair of currencies; the top line shows the price of one unit of the currency in the left-hand column in terms of the currency at the top of the column (e.g. one U.S. dollar cost 66.38 Indian rupees); the second line shows this the other way around (e.g. one Indian rupee costs 0.01506 U.S. dollars).

Foreign Exchange Rates Issues: Cause & Effect -- the event causes a shift and the effect is a change in the price/rate. -- the problems identified whether the currency appreciated or depreciated. -- the appreciation/depreciation did not cause the curves to shift. Illustration of changes from the other perspective is not arbitrary -- if the supply of Can$ increases, then the demand for euros increases. -- if the demand for pounds falls, then the supply of yen falls. -- if the rate, $/€, falls, then the rate, €/$, must rise. The current values reflect the change that has taken place! U.S. Dollar (USD), Euro (EUR), British Pound (GBP), Indian Rupee (INR), Australian Dollar (AUD), Canadian Dollar (CAD) and Japanese Yen (JPY)

1. Since April of 2014 there has been an increase in Canadian preference for European goods, causing to exchange rate to change by 7% to the value(s) shown above. Draw the graph of the foreign exchange market from the Canadian perspective showing what has happened between 2014 and 2016. Can $/€ S€ 1. Canadian perspective. If there is an increased preference for European goods, Canadians will have to acquire more Euros, so the demand for Euros rises. This will raise the exchange rate, depreciating the Canadian dollar. Since the Can $ has depreciated by 7%, and it now takes C$1.4532 to buy a Euro, then it must have been $1.3582 in April of 2014. (1.4532)/(1.07) = 1.3582 D€ 1.3582 1.4532 D’€ €

2. Repeat exercise #1, except show this from the European perspective. 2. European perspective. If the Canadians are demanding more Euros, then they must be supplying more dollars (in order to buy more European goods). It is the “flip view” of the market presented in #1. So, the supply of dollars increases, shifting to the right, driving down the exchange rate (from the European perspective). Since these values are the inverse of the ones used in #1, we can solve for the previous exchange rate directly: 1/1.3582 = .7363 €/Can $ .7363 S$ S’$ .6881 D$ Can $ Or, you can get a slightly different value: (.6881)/(.93) = .7399

3. Since October of 2013 Britain has experience a rate of inflation that is 3% more than that in the U.S. If the “relative purchasing power parity” holds, show how the exchange rate has changed from 2013 to 2016 from the British perspective 3. British perspective. If the inflation rate in the U.K. is 3% higher than in the U.S., the relative purchasing power parity condition states that the exchange rate ($/₤) will change by the difference in the inflation rates, or by -3% in this case. %ΔE = πUS - πUK So, while we don’t know the individual rates of inflation, we know the result. If E is falling, then the $ is appreciating. The previous exchange rate must have been ₤0.6124 per $: (.7015)/(1.03) = .6811 £/$ S$ .6811 D$ .7015 D’$ $ Why is this happening? Since the U.K. is experiencing more inflation, their goods are getting more expensive, and ours are cheaper. Consequently, they would like to buy more of our cheaper goods, for which they’ll need dollars. So, the demand for $ rises. OR, . . .

4. Repeat exercise #3, except show this from the U.S. perspective. 4. U.S. perspective. If the British are demanding more dollars (because our goods are relatively cheaper), then they must be supplying more pounds. Again – this must be true! The past exchange rate must be the inverse of the value from #3: 1/(.6811) = $1.4683 S£ 1.4683 $/£ S’£ 1.4255 D£ £ OR, . . . the demand for pounds is decreasing, because their goods are more expensive, or some combination of the two. Regardless, the exchange rate (U.S. perspective) is falling.

5. In late April of 2016 the Japanese decide to impose tariffs on goods shipped there from India. Consequently the rupee is expected to depreciated by 6% over the next two years. Show what we expect to be happening in the foreign exchange market from 2016 to 2018 from the Indian perspective. rupee/¥ S’¥ S¥ 5. Indian perspective. If the Japanese tax Indian goods, that will make them more expensive, and less will be purchased, thus lowering the demand for Indian currency. Since the Japanese are demanding less rupees, they must be supplying less yen. Since the rupee is depreciating by 6%, the previous exchange rate must have been: (.61096)*(1.06) = .647618 .6476 .61096 D¥ ¥

6. Repeat exercise #5, except show this from the Japanese perspective. ¥/rupee Srup 5. Japanese perspective. If the Japanese tax Indian goods, that will make them more expensive, and less will be purchased, thus lowering the demand for Indian currency. Since the rupee is depreciating by 6%, the yen is appreciating by 6%. We can solve for the yen price of rupees directly: 1/.647618 = 1.544 1.64 1.54 Drup D’rup Rupee

7. Suppose we create a basket of foreign currencies made up of 45 euros, 38 British pounds, 1500 Indian rupees, 25 Australian dollars, 35 Canadian dollars and 2500 Japanese yen. What is the dollar value of this market basket on April 12, 2016? In 2016, the dollar value of this basket of foreign currencies is $197.53, as shown in the table above, using the current exchange rates. 8. A year from now we have new exchange rates as follows … What is the dollar value of this market basket on April 12, 2017?

9. Has the dollar appreciated or depreciated against this basket of currencies? By how much? In 2017, the dollar value of this basket of foreign currencies is 1.583% higher than in 2016. The dollar has depreciated (it costs more $ to buy the same basket). 10. Against which specific currencies is the dollar stronger? 11. Against which specific currencies is the dollar weaker? The dollar has appreciated against the euro, pound and Canadian dollar. The dollar has depreciated against the rupee, Australian dollar, and yen.

12. Draw a graph of the foreign exchange market where the foreign exchange is this basket of currencies (from the U.S. perspective) showing what has happened for 2016 to 2017. In 2016, the value of this basket is $197.53. The price of this basket has risen by 1.58% over the year, to $200.66, so we can say that the dollar has depreciated by this much. S $/basket S’ 200.66 197.53 D D’

ECO 473 Foreign Exchange Markets Answer Key Fall 2011 – Dr. D. Foster