ECO 473 Foreign Exchange Markets Answer Key Fall 2018 – Dr. D. Foster

Above are the major exchange rates copied from XE. com for 11/26/2018 Above are the major exchange rates copied from XE.com for 11/26/2018. They are - U.S. Dollar (USD), Canadian Dollar (CAD), British Pound (GBP), Euro (EUR), Australian Dollar (AUD), and the New Zealand Dollar (NZD), UAE Dirham (AED), Swiss Franc (CHF), and Japanese Yen (JPY). Be careful to read the table correctly (e.g. one U.S. dollar cost .88269 euros while it costs $1.1329 to buy one euro).

1a. Since November 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 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 CAD has depreciated by 7%, and it now takes CAD1.5012 to buy a Euro, then it must have been CAD1.403 in November of 2014. (1.5012)/(1.07) = 1.40299 D€ 1.403 1.5012 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 CAD 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: 1/1.403 = .7128 €/Can $ .7128 S$ S’$ .6661 D$ Can $ Or, you can get a slightly different value: (.66614)/(.93) = .71628

2a. Since October of 2014 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 2014 to 2018 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 ₤0.68543 per $: (.78052)/(1.03) = .7578 £/$ S$ .7578 D$ .7805 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, . . .

2a. con’t. £/$ S’$ S$ .7805 .7578 D’$ D$ $ OR, . . . We can show this as a combination of rising demand for $ and a falling supply of $ - The British want more $ to buy cheaper American goods while Americans want to offer fewer $ because British goods are now more expensive.

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/(.75778) = $1.31963 S£ 1.319 $/£ S’£ 1.281 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 November of 2018 the Australians decided to impose tariffs on goods shipped there from Japan. Consequently the yen is expected to depreciated by 6% over the next two years. Show what we expect to be happening in the foreign exchange market from 2018 to 2020 from the Japanese perspective. ¥/AUS$ S’AUS$ 3a. Japanese perspective. If the Australian tax Japanese goods, that will make them more expensive, and less will be sold, thus lowering the supply of Australian currency. We must solve for the current yen price of AUD from the table: 1/.01220 = 81.97 Since the yen is expected to depreciate by 6%, we can solve accordingly: 81.97*(1.06) = 86.88 SAUS$ 86.88 81.97 DAUS$ AUS$

3b. Repeat exercise #3a, except show this from the Australian perspective. 3b. Australian perspective. If the Australians tax Japanese goods, that will make them more expensive, and less will be purchased, thus lowering the demand for Japanese currency. Since the AUD is expected to appreciate by 6%, the new exchange rate is expected to be: 1/86.88524 = .011509 AUD [Or, .0122/1.06] .0122 .0115 D¥ ¥

ECO 473 Foreign Exchange Markets Answer Key Fall 2018 – Dr. D. Foster