ECO 473 Foreign Exchange Markets Answer Key Spring 2017 – Dr. D. Foster

Foreign Exchange Rates 3/27/2017

Foreign Exchange Rates Above are the major exchange rates copied from XE.com on 3/27/2017. They are; U.S. Dollar (USD), Euro (EUR), British Pound (GBP), Indian Rupee (INR), Australian Dollar (AUD), Canadian Dollar (CAD), South African Rand (ZAR), New Zealand Dollar (NZD) and Japanese Yen (JPY). 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 65.357 Indian rupees); the second line shows this the other way around (e.g. one Indian rupee costs 0.0153 U.S. dollars).

1a. Since April of 2014 there has been an increase in Canadian preference for European goods, causing the 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 2018. Can $/€ S€ 1a. 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$1.446 to buy a Euro, then it must have been $1.351 in April of 2014. (1.44579)/(1.07) = 1.351 D€ 1.351 1.446 D’€ €

Or, you can get a slightly different value: 1b. Repeat exercise #1a, except show this from the European perspective. 1b. 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 #1a. 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: 1/1.351 = .74008 €/Can $ .74008 S$ S’$ .69167 D$ Can $ Or, you can get a slightly different value: (.69167)/(.93) = .7437

2a. 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 2017 from the British perspective. 2a. 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 ₤0.77592 per $: (.7992)/(1.03) = .77592 £/$ S$ .776 D$ .7992 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, . . .

2b. Repeat exercise #2a, except show this from the U.S. perspective. 2b. 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/(.77592) = $1.2888 S£ 1.288 $/£ S’£ 1.251 D£ £ OR, . . . you could motivate this outcome by noting that the demand for pounds is decreasing, because their goods are more expensive and we don’t want to buy as much. Or, some combination of these two reasons. Regardless, the exchange rate (U.S. perspective) is falling.

3a. In late March of 2017 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 2017 to 2019 from the Indian perspective. rupee/¥ S’¥ S¥ 3a. 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 will be depreciating by 6%, the new exchange rate is expected to be: (.5586)*(1.06) = .59212 .5921 .5586 D¥ ¥

3b. Repeat exercise #3a, except show this from the Japanese perspective. ¥/rupee Srup 3b. 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/.5586 = 1.7901 1.79 1.688 Drup D’rup Rupee

ECO 473 Foreign Exchange Markets Answer Key Spring 2017 – Dr. D. Foster