Solutions for Determinants of Exchange Rates

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1. a. Describe how these three typical transactions should affect present and future exchange rates. Joseph E. Seagram & Sons imports a year's supply of French champagne. Payment in euros is due immediately.

ANSWER. The euro should appreciate relative to the dollar since demand for euros is rising. b. MCI sells a new stock issue to Alcatel, the French telecommunications company. Payment in dollars is due immediately.

ANSWER. The spot value of the dollar should increase as Alcatel demands dollars to pay for the new stock issue. The future value of the dollar should decline as dividend payments are sent to Alcatel and other Alcatel equipment and parts are imported. However, the value of the dollar in the future could increase if expanded MCI output substitutes for telecom imports. c. Korean Airlines buys five Boeing 747s. As part of the deal, Boeing arranges a loan to KAL for the purchase amount from the U.S. Export-Import Bank. The loan is to be paid back over the next seven years with a two-year grace period.

ANSWER. The spot price of the dollar should be unaffected. The future price of the dollar should increase as KAL repays the loan. 2. The maintenance of money's value is said to depend on the monetary authorities. What might the monetary authorities do to a currency that would cause its value to drop?

ANSWER. The value of any good or asset is driven by its scarcity. What the monetary authorities could do is to make money less scarce by issuing more of it. This would lower its scarcity value. Even though its nominal value will always be the same, the added supply will reduce the purchasing power per unit of money. 3. For each of the following six scenarios, say whether the value of the dollar will appreciate, depreciate, or remain the same relative to the Japanese yen. Explain each answer. Assume that exchange rates are free to vary and that other factors are held constant. The growth rate of national income is higher in the United States than in Japan.


ANSWER. The value of the dollar should rise as more rapidly rising GNP in the United States leads to a relative increase in demand for dollars. b. Inflation is higher in the U.S. than in Japan.

ANSWER. The value of the dollar should fall in line with purchasing power parity. c. Prices in Japan and the United States are rising at the same rate.

ANSWER. According to PPP, the exchange rate should remain the same. d. Real interest rates are higher in the United States than in Japan.

ANSWER. The value of the dollar should rise as the higher real rates attract capital from Japan that must first be converted into dollars.




The United States imposes new restrictions on the ability of foreigners to buy American companies and real estate.

ANSWER. The value of the dollar should fall as foreigners find it less attractive to own U.S. assets. f. U.S. wages rise relative to Japanese wages, and American productivity falls behind Japanese productivity.

ANSWER. Higher U.S. wages and declining relative productivity weaken the American economy and make it less attractive for investment purposes. Assuming that a weak economy leads to a weak currency, the dollar will fall. From a somewhat different perspective, when a nation's productivity growth lags behind that of its major trading partners, the other countries will become more depreciating currency is the market's way of restoring balance. The lagging country regains its balance, but only by accepting a lower real price for its goods. In effect, the cheaper currency is the market's way of cutting wages in the lagging country. 4. The Fed adopts an easier monetary policy. How is this likely to affect the value of the dollar and U.S. interest rates?

ANSWER. If the Fed switches to an easier monetary policy, the value of the...
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