Questions for Week 11 Flashcards
(21 cards)
What is the nominal exchange rate?
The nominal exchange rate is the rate at which one currency can be exchanged for another, usually quoted as foreign currency per unit of domestic currency or vice versa.
Define the real exchange rate (RER) and its importance.
The RER measures the price of domestic goods relative to foreign goods, adjusted by the nominal exchange rate, impacting international competitiveness.
What is the formula for the real exchange rate?
Real Exchange Rate RER = e * P_f / P, where: e = nominal exchange rate, P = domestic price level, P_f = foreign price level.
Why do Australian households and firms supply dollars in the forex market?
They supply dollars to purchase foreign goods, services, and investments, thereby creating demand for foreign currencies.
Why do foreigners demand Australian dollars in the forex market?
Foreigners demand Australian dollars to buy Australian goods, services, and financial assets, creating demand for the AUD.
What is Purchasing Power Parity (PPP)?
PPP suggests that identical goods should cost the same across countries when prices are converted to a common currency, based on the Law of One Price.
What are limitations of PPP in explaining exchange rates?
PPP may not hold due to transport costs, tariffs, non-traded goods, and market imperfections, making it a long-run but not short-run predictor.
How does easing monetary policy (lower interest rates) affect the exchange rate?
Lower interest rates make domestic assets less attractive, reducing demand for the domestic currency and causing depreciation, which can boost exports.
How does a change in the exchange rate influence the effect of monetary policy on output?
A depreciated currency makes exports cheaper, amplifying monetary policy’s impact on output and employment by increasing demand for exports.
What is a speculative attack on an overvalued currency?
A speculative attack occurs when investors sell an overvalued currency en masse, anticipating a devaluation, which often forces the central bank to intervene or adjust the rate.
Why do speculative attacks frequently lead to devaluation?
Central banks may lack sufficient reserves to support an overvalued currency, leading them to devalue the currency when demand for it falls significantly.
How does increased risk in Australian investments affect the AUD?
If Australian investments are seen as riskier, demand for the AUD falls, leading to depreciation as investors seek safer assets.
How does increased spending on imports affect the AUD?
Higher import spending increases the supply of AUD in the forex market, leading to depreciation.
Calculate the real exchange rate if a British car costs £20,000, an Australian car costs $26,000, and the nominal rate is $1.50/£.
The British car costs 20,000 * 1.5 = $30,000, making the RER = 26,000 / 30,000 = 0.87, showing the Australian car is cheaper.
How would a nominal depreciation of the AUD affect the real exchange rate if Australian goods are less expensive?
A depreciation of the AUD would lower the RER, making Australian goods relatively cheaper and more competitive internationally.
How does a fixed exchange rate system impact monetary policy?
In a fixed exchange rate system, the central bank cannot fully use monetary policy independently, as it must adjust interest rates to maintain the pegged rate.
Explain overvaluation and undervaluation in fixed exchange rate systems.
Overvaluation occurs when the currency is priced above its market value, causing central banks to buy excess currency. Undervaluation occurs when the currency is priced below market value, leading to reserves growth as the bank sells currency to stabilize demand.
Given supply S=25,000+12,000e and demand D=30,000−8,000e, find the fundamental exchange rate (e).
Set D=S: 30,000−8,000e=25,000+12,000e. Solving for e, e=0.25 dollars per shekel.
Is the shekel overvalued or undervalued if the fixed rate is 0.30 dollars per shekel?
The shekel is overvalued because the fixed rate (0.30) is higher than the market-determined rate (0.25), requiring central bank intervention.
What makes foreign investor concerns about devaluation a self-fulfilling prophecy?
If investors expect devaluation, they sell the currency, increasing supply in the forex market. This added pressure forces the central bank to devalue, fulfilling the initial expectation.
Why would foreign investors worry about a devaluation if the fixed rate is 0.30 and the expected rate is 0.25?
Investors risk capital loss as the currency devaluation would decrease the value of their holdings in foreign terms.
