Week 10&11

Question 1

What is an exchange rate?

Answer 1

Exchange rate is the relative price of two currencies

Question 2

What are two types exchange rate quotes?

Answer 2

-European quotes
-American quotes

Question 3

What are European quotes?

Answer 3

• European quotes: units of a currency per $1
• INR (Indian Rupees) 54.84/$

Question 4

What are American quotes?

Answer 4

• American quotes: units of $ per 1 foreign currency
• $ 0.018/INR (Indian Rupees)

Question 5

What are direct quotes in terms of foreign exchange quotations?

Answer 5

• Direct quotes: The number of domestic currency per 1 unit of
  foreign currency. (domestic currency/ foreign currency)

Question 6

What are indirect quotes in terms of foreign exchange quotations?

Answer 6

• Indirect quotes: The number of foreign currency per 1 unit of
  domestic currency. (foreign currency/domestic currency).

Question 7

What are bid quotes?

Answer 7

exchange rate at which the dealer is willing to buy a currency

Question 8

What are ask quotes?

Answer 8

exchange rate at which the dealer is willing to sell a currency

Question 9

What are cross-rates?

Answer 9

• Cross rates: the exchange rate between two currencies
  calculated using a third currency.
• Alternatively, we can say cross rates are exchange rates
  between 2 currencies that do not involve the currency of the
  country in which they are quoted

Question 10

What are vehicle currency?

Answer 10

Vehicle currency is a currency which is actively traded in many
international financial transactions.

Question 11

Equation for direct quotes (Domestic / Foreign)?

Answer 11

change in = Spot exchange rate(1) - Spot exchange rate (0) / Spot exchange rate (0)

Question 12

Equation for indirect quotes (Foreign / Domestic )?

Answer 12

change in = Spot exchange rate(0) - Spot exchange rate (1) / Spot exchange rate (1)

Question 13

What is appreciation of a currency?

Answer 13

Appreciation of a currency refers to an increase in the value of one currency relative to another in the foreign exchange market. When a currency appreciates, it means that it can buy more of another currency than it could before.

Question 14

What is depreciation of a currency?

Answer 14

Depreciation of a currency refers to the decline in the value of a currency relative to other currencies in the foreign exchange market. When a currency depreciates, it means that it takes more of that currency to buy the same amount of another currency.

Question 15

Why Are Exchange Rates Important?

Answer 15

• Exchange rates are important because they affect the relative
  price of domestic and foreign goods.
• Say, the dollar price of French goods to an American is
  determined by the interaction of two factors: the price of
  French goods in euros and the euro–dollar exchange rate.
• If euro appreciates against US dollar, and if the price of French
  goods stay the same in France, the price of French goods
  exported to US will increase
• At the same time, the price of American goods exported to
  France will decrease

Question 16

How Is Foreign Exchange Traded?

Answer 16

• the foreign exchange market is organized as an
  over-the-counter market in which several hundred dealers
  (mostly banks) stand ready to buy and sell deposits
  denominated in foreign currencies. Trades involve transactions
  in excess of $1 million.
• Because these dealers are in constant telephone and computer contact, the market is very competitive; in effect, it functions no differently from a centralized market.
• Typical consumers buy foreign currencies from retail dealers,
  such as a commercial bank.

Question 17

What is the law of one price?

Answer 17

-If two countries produce an identical good, and transportation costs and trade barriers are very low, the price of the good should be the same throughout the world, regardless of which country produces it.

Question 18

What is the purchasing power parity theory?

Answer 18

Exchange rates between two currencies will adjust to reflect
changes in price levels. In other words, if one country’s price level rises relative to another’s, its currency should depreciate (the other country’s currency should appreciate)

Question 19

Why PPP Cannot Fully Explain Exchange Rates?

Answer 19

• PPP does not work in the short run
• PPP is based on the assumptions that
• all goods are identical in both countries
• transportation costs and trade barriers are very low
• Not all goods are identical in both countries
• Many goods and services are not traded (e.g., haircuts, land,
  etc.), but their prices are included in measuring the country’s price level

Question 20

Equation for expected future exchange rate?

Answer 20

• s0: current spot exchange rate (indirect quotes foreign/domestic)
• E: expectation
• πd : domestic inflation rate
• πf : foreign inflation rate

= E(spot exchange rate(1))/ Spot exchange rate (0) = 1 +πf / 1 + πd

Question 21

Equation for the change in the value of the domestic currency?

Answer 21

• s0: current spot exchange rate (indirect quotes foreign/domestic)
• E: expectation
• πd : domestic inflation rate
• πf : foreign inflation rate

= E(spot exchange rate(1) - E(spot exchange rate(0) / Spot exchange rate (0) = πf - πd / 1 + πd

Question 22

Factors affecting exchange rates in the long run?

Answer 22

• relative price levels
• tariffs and quotas
• preferences for domestic versus foreign goods
• productivity

Question 23

What is the basic principle of r factors affect the exchange rate?

Answer 23

• If a factor increases demand for domestic goods relative to foreign goods, the exchange rate ↑
• Because domestic goods will continue to sell well even when the value of the domestic currency is higher

Question 24

What happens to relative price levels in the long run?

Answer 24

In the long run, a rise in a country’s price level (relative to the foreign price level) causes its currency to depreciate, and a fall in
the country’s relative price level causes its currency to appreciate.

Question 25

What happens to trade barriers in the long run?

Answer 25

- Barriers to free trade such as tariffs (taxes on imported goods) and quotas (restrictions on the quantity of foreign goods that can be imported) can affect the exchange rate. - Increasing trade barriers causes a country’s currency to appreciate in the long run.

Question 26

What happens to Preferences for Domestic Versus Foreign Goods in the long run?

Answer 26

Increased demand for a country’s exports causes its currency to appreciate in the long run; conversely, increased demand for imports causes the domestic currency to depreciate

Question 27

What happens to Productivity in the long run?

Answer 27

- When productivity in a country rises, it tends to rise in domestic sectors that produce traded goods rather than nontraded goods. - Higher productivity → a decline in the price of domestically produced traded goods relative to foreign traded goods → the demand for traded domestic goods rises, and the domestic currency tends to appreciate - In the long run, as a country becomes more productive relative to other countries, its currency appreciates

Question 28

What is Exchange Rates in the Short Run?

Answer 28

- In the short run, an exchange rate is the price of domestic assets (bank deposits, bonds, equities, etc., denominated in the domestic currency) in terms of foreign assets (similar assets denominated in the foreign currency). - Because the exchange rate is the price of one asset in terms of another, the natural way to investigate the short run determination of exchange rates is to use an asset market approach that relies heavily on the theory of portfolio choice - the long-run determinants of the exchange rate we have just outlined also play an important part in the short-run asset market approach

Question 29

What is the Supply curve for domestic assets?

Answer 29

- Dollar assets supplied is primarily the quantity of bank deposits, bonds, and equities in the United States. This is fairly fixed in the short-run. - The quantity supplied at any exchange rate does not change, so the supply curve is vertical

Question 30

What is the Demand curve for domestic assets?

Answer 30

- The demand curve traces out the quantity demanded at each current exchange rate by holding everything else constant, particularly the expected future value of the exchange rate. - The greater the expected rise (appreciation) of the dollar, the higher the relative expected return on dollar (domestic) assets - The theory of portfolio choice then tells us that because dollar assets are now more desirable to hold, the quantity of dollar assets demanded will rise - That is why the demand curve is downward sloping.

Question 31

What happens to increase in the demand interest rate?

Answer 31

An increase in the domestic interest rate iD shifts the demand curve for domestic assets to the right and causes the domestic currency to appreciate

Question 32

What happens to decrease in the demand interest rate?

Answer 32

A decrease in the domestic interest rate iD shifts the demand curve for domestic assets to the left and causes the domestic currency to depreciate

Question 33

What happens to increase in the foreign interest rate?

Answer 33

an increase in the foreign interest rate iF shifts the demand curve for domestic assets to the left and causes the domestic currency to depreciate;

Question 34

What happens to decrease in the foreign interest rate?

Answer 34

a fall in the foreign interest rate iF shifts the demand curve to the right and causes the domestic currency to appreciate

Question 35

What happens to increase in the Expected Future Exchange Rate?

Answer 35

A rise in the expected future exchange rate shifts the demand curve to the right and causes an appreciation of the domestic currency;

Question 36

What happens to decrease in the Expected Future Exchange Rate?

Answer 36

a fall in the expected future exchange rate shifts the demand curve to the left and causes a depreciation of the currency.