ECO 473Foreign Exchange Markets

Answer Key

Spring 2009 – Dr. D. Foster

Foreign Exchange RatesIn the mid-afternoon on 2/23/09

Foreign Exchange Rates•Issues:

•Cause & Effect-- the event causes a shift and the effect is a change in the price/rate.-- the problems identified whether the currency appreciated or depreciated.-- the appreciation/depreciation did not cause the curves to shift.

•Illustration of changes from the other perspective is not arbitrary-- if the supply of $ increases, then the demand for euros increases.-- if the demand for pounds falls, then the supply of yen falls.-- if the rate, $/€, falls, then the rate, €/$, must rise.

•The current values reflect the change that has taken place!The current values reflect the change that has taken place!

1. Since March, 2008, there has been an increase in Canadian preference for 1. Since March, 2008, there has been an increase in Canadian preference for European goods, and the $ (Can) has (appreciated/depreciated) by 7%. Show European goods, and the $ (Can) has (appreciated/depreciated) by 7%. Show what happened from the Canadian perspective.what happened from the Canadian perspective.

1.595

S€

D€

1.49

Can $/€

€

1. 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$1.5947 to buy a Euro, then it must have been C$1.49 in March.

(1.502847)/(1.07) = 1.49

D’€

2. Repeat exercise #1, except show this from the European perspective.

D$

.671

S$

€/Can $

.6271

Can $

2. 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 #1. 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:

1/1.49 = .67097

S’$

Or, you can get a slightly different value:(.6271)/(.93) = .6743

3. Since July, of 2007, Britain has experienced a rate of inflation that is 3% 3. Since July, of 2007, Britain has experienced a rate of inflation that is 3% more than that in the U.S. If the “relative purchasing power parity” holds more than that in the U.S. If the “relative purchasing power parity” holds

between these two currencies, show how this event has manifested itself from between these two currencies, show how this event has manifested itself from the perspective of the U.K.the perspective of the U.K.

D’$

S$£/$

.6881

.668

D$

$

3. 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 (U.S. perspective) exchange rate ($/₤) will change by the difference in the inflation rates, or by -3% in this case.

%ΔE = πUS - πUK So, if E is falling, then 1/E must be rising by 3%.

The previous exchange rate must have been ₤0.668 per $:

(.6881)/(1.03) = .668

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, . . . OR, . . .

4. Repeat exercise #3, except show this from the U.S. perspective.

£

$/£

1.453

S’£

S£

1.497

4. 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/(.668) = $1.497

D£

OR, . . . OR, . . . the demand for pounds is decreasing, because their goods are more expensive, or some combination of the two. Regardless, the exchange rate (U.S. perspective) is falling.

5. In late December, of 2006, the Japanese decided to raise taxes on imports 5. In late December, of 2006, the Japanese decided to raise taxes on imports from Switzerland. Consequently, the Swiss franc has depreciated (relative to from Switzerland. Consequently, the Swiss franc has depreciated (relative to the yen) by 6%. Show what is happening, from the perspective of the Swiss.the yen) by 6%. Show what is happening, from the perspective of the Swiss.

S’¥

.0123

francs/¥

D¥

¥

5. Swiss perspective. If the Japanese tax Swiss goods, that will make them more expensive, and less will be purchased, thus lowering the demand for Swiss currency. Since the Japanese are demanding less francs, they must be supplying less yen.

Since the franc is depreciating by 6%, the previous exchange rate must have been:

(.0123)/(1.06) = .0116

S¥

.0116

6a. Suppose we create a basket of foreign currencies made up of 1000 6a. Suppose we create a basket of foreign currencies made up of 1000 yen, 8 euros, 6.5 Canadian dollars, 3 British pounds, 3 Australian dollars yen, 8 euros, 6.5 Canadian dollars, 3 British pounds, 3 Australian dollars

and 2 Swiss francs. What is the dollar value of this market basket on and 2 Swiss francs. What is the dollar value of this market basket on February. 23, 2009?February. 23, 2009?

In 2009, the dollar value of this basket of foreign currencies is $33.92, as shown in the table above.

For example, 1000 yen, at .0105 dollars per yen, are worth $10.50.Note, you could do this as (1000)/(94.83), which is $10.545.

E* = 1/E* = weight w*E w/(1/E)yen 0.011 94.830 1000 10.50 $10.55euro 1.276 0.784 8 10.21 $10.21

Can. $ 0.800 1.250 6.5 5.20 $5.20£ 1.453 0.688 3 4.36 $4.36

Aus. $ 0.646 1.549 3 1.94 $1.94Swiss f 0.858 1.165 2 1.72 $1.72

$33.92 $33.97

Feb. 23, 2009 $ value

6b. If, on Feb. 23, 2010, one U.S. dollar can be traded for the following:6b. If, on Feb. 23, 2010, one U.S. dollar can be traded for the following:

What will be the value of this market basket on Feb. 23, 2010, and how will the value of the dollar have changed over the intervening year?

6b. In 2010, the value of this basket is $36.67. The price of this basket has risen by 8.1% over the year, so we can say that the dollar has depreciateddepreciated by this much.

S’

D’

$/basket

36.67

33.92

D

S

¥en Euro Can $ U.K. ₤ AU $ Swiss franc 122 .75 .85 .53 1.08 1.16

1/E* = weight w/(1/E)yen 122 1000 $8.20euro 0.75 8 $10.67

Can. $ 0.85 6.5 $7.65£ 0.53 3 $5.66

Aus. $ 1.08 3 $2.78Swiss f 1.16 2 $1.72

$36.67

Feb. 23, 2010 $ value

ECO 473Foreign Exchange Markets

Answer Key

Spring 2009 – Dr. D. Foster