7. Exchange Rates

Question 1

FOREX (Foreign Exchange)

Answer 1

Global marketplace for trading currencies

Question 2

Who Trades in Forex Markets?

Answer 2

1. Commercial Banks (most trading volume)
2. Financial Institutions
3. Multinational Corporations
4. Central Banks

Question 3

Why Central Banks Trades in Forex Markets?

Answer 3

To manage international reserves, intervene to stabilize currencies

Question 4

What Drives Demand for Currency Deposits?

Answer 4

1. Interest Rates (Returns)
2. Risk (Safety)
3. Liquidity (Accessibility)

Question 5

Rates of return that investors expect to earn are determined by:

Answer 5

1. Interest rates that the assets will earn
2. Expectations about appreciation or depreciation

Question 6

Interest parity

Answer 6

R$ = R€ + (Ee$/€ – E$/€)/E$/€

Question 7

What could cause investors to suddenly expect a currency to appreciate or depreciate?

Answer 7

1. Expected rate of return of dollar and euro
2. Interest rate on euro deposits
3. Expected rate of appreciation of the euro
   - Expected exchange rate
   - Current exchange rate

Question 8

Interest parity

Answer 8

R$ = R€ + (Ee$/€ – E$/€)/E$/€

Question 9

Suppose R$ > R€ + (Ee$/€ – E$/€)/E$/€

Answer 9

1. Price of euros ⬇️.
2. Price of dollars ⬆️.
3. The right side increases until equality is achieved.

Question 10

How do changes in the current exchange rate affect the expected rate of return of foreign currency deposits?

Answer 10

When the dollar gets stronger, expected returns on euro deposits get higher

Question 11

Higher Interest Rates leads to

Answer 11

Currency Appreciation

Question 12

Lower Interest Rates leads to

Answer 12

Currency Depreciation

Question 13

Effect of a Rise in the Dollar Interest Rate

Answer 13

A rise in the interest rate offered by dollar deposits causes the dollar to appreciate

Question 14

Effect of a Rise in the Euro Interest Rate

Answer 14

A rise in the interest rate paid by euro deposits causes the dollar to depreciate

Question 15

What happens if traders think that the euro will increase in value in the future?

Answer 15

1. The expected rate of return on euros increases.
2. An expected appreciation of a currency leads to an actual appreciation (a self-fulfilling prophecy).

Question 16

Short vs Long run

Answer 16

1. In the short run, prices do not have sufficient time to adjust to market conditions.
2. In the long run monetary policy has no effect

Question 17

The exchange rate is said to overshoot

Answer 17

When its immediate response to a change is greater than its long-run response.
Overshooting is predicted to occur when monetary policy has an immediate effect on interest rates, but not on prices and (expected) inflation.

Question 18

Can higher inflation lead to appreciating currency?

Answer 18

Yes. Higher inflation should lead to currency depreciation but when central banks learn of inflation their response is to raise interest rates which has an immediate effect on currency rates

Question 19

Dutch Disease

Answer 19

The negative consequences that can arise from a spike in the
value of a nation’s currency.