Currency Exchange and Depreciation Quiz

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Questions and Answers

What is the definition of depreciation in terms of currency value?

Depreciation is a decrease in the value of a currency relative to another currency.

How does an appreciated currency affect the amount of foreign currency that can be purchased?

An appreciated currency allows an individual to exchange it for a larger amount of foreign currency.

If the exchange rate changes from $1/€ to $1.20/€, what does this indicate about the dollar?

This indicates that the dollar has depreciated relative to the euro.

How does depreciation affect the price of imports and exports?

A depreciated currency makes imports more expensive and exports cheaper. Signup and view all the answers

Given that a Nissan costs ¥2,500,000, how much would it cost in dollars at an exchange rate of ¥0.01027?

$25,672.50 Signup and view all the answers

What does a change in exchange rate from $1/€ to $0.90/€ imply about the euro?

This implies that the euro has depreciated relative to the dollar. Signup and view all the answers

What impact does exchange rate fluctuation have on purchasing foreign goods?

It affects the cost of purchasing foreign goods depending on whether the currency is appreciated or depreciated. Signup and view all the answers

How can an increase in the value of a currency affect the domestic economy?

It can lead to decreased prices for imports and increased competition for domestic producers. Signup and view all the answers

What is the interest rate on the dollar deposit?

The interest rate on the dollar deposit is 2%. Signup and view all the answers

Calculate the expected value of €104 in dollars after one year if the exchange rate is projected to be $0.97/€1.

The expected value is $100.88. Signup and view all the answers

What is the expected rate of return on the euro deposit after one year in dollar terms?

The expected rate of return on the euro deposit is approximately 0.88%. Signup and view all the answers

How does the expected rate of return from euro deposits compare to that from dollar deposits?

The expected rate of return from euro deposits is lower than that from dollar deposits. Signup and view all the answers

What is the effective rate of return from a dollar deposit after one year?

The effective rate of return from a dollar deposit is 2%. Signup and view all the answers

What happens to the value of euro deposits when considering expected currency depreciation?

The value decreases due to the expected rate of depreciation of 3%. Signup and view all the answers

Summarize the formula for the dollar rate of return on euro deposits.

The formula is R€ = interest rate + expected rate of appreciation. Signup and view all the answers

What conclusion can be drawn about investors' preferences for dollar vs euro deposits?

Investors will prefer dollar deposits over euro deposits due to higher returns. Signup and view all the answers

How is the real rate of return calculated for a currency deposit when considering inflation?

The real rate of return is calculated by subtracting the inflation rate from the nominal rate of return. Signup and view all the answers

What assumption can be made about prices in the short run regarding currency deposits?

It can be assumed that prices do not change from day to day in the short run. Signup and view all the answers

What two factors influence the decisions of investors when choosing currency deposits?

Investors are primarily influenced by the interest rates on the deposits and expectations of currency appreciation or depreciation. Signup and view all the answers

Explain the relationship between nominal rates of return and real rates of return when the inflation rate is 0%.

When the inflation rate is 0%, nominal rates of return are equal to real rates of return. Signup and view all the answers

How do risk and liquidity factors relate to currency deposits in foreign exchange markets?

Risk and liquidity are considered to be essentially the same for currency deposits, playing a secondary role in investment decisions. Signup and view all the answers

What does liquidity of an asset refer to in the context of currency deposits?

Liquidity refers to the ease with which an asset can be used to buy goods and services. Signup and view all the answers

What is the primary concern for investors when deciding to buy or sell currency deposits?

Investors are primarily concerned about the rates of return on their currency deposits. Signup and view all the answers

Define the interest rate of a currency deposit.

The interest rate of a currency deposit is the amount of currency earned by lending a unit of the currency for one year. Signup and view all the answers

What components are used to construct the model of foreign exchange markets?

The model uses the demand for dollar denominated deposits and the demand for foreign currency denominated deposits. Signup and view all the answers

What does interest parity imply about deposits in different currencies?

Interest parity implies that deposits in all currencies offer the same expected rate of return and are equally desirable assets. Signup and view all the answers

What would happen if the expected rate of return on dollar deposits is greater than that of euro deposits?

Investors would prefer dollar deposits, increasing demand for dollars and decreasing demand for euros, leading to a depreciation of the euro. Signup and view all the answers

How does the depreciation of the domestic currency affect the expected rate of return on foreign currency deposits?

Depreciation increases the initial cost of investing in foreign currency deposits, thereby lowering their expected rate of return. Signup and view all the answers

What occurs to the expected return of foreign currency deposits when the domestic currency appreciates?

Appreciation of the domestic currency raises the expected return on deposits of foreign currency. Signup and view all the answers

What is the relationship between exchange rate changes and interest rates in the context of foreign currency deposits?

Exchange rate changes directly influence the expected rates of return on foreign currency deposits, affecting their attractiveness to investors. Signup and view all the answers

What drives the equilibrium in the foreign exchange market according to the interest parity condition?

Equilibrium is driven by the need for expected returns on deposits in different currencies to be equal. Signup and view all the answers

Explain the impact of arbitrage opportunities in the foreign exchange market.

Arbitrage opportunities would cause price discrepancies among currencies, disrupting the interest parity condition and leading to market corrections. Signup and view all the answers

How does an appreciation of the domestic currency influence the expected return on foreign currency deposits?

It decreases the initial cost of investing in foreign currency deposits, raising the expected rate of return. Signup and view all the answers

What happens to the dollar when the interest rate on dollar-denominated assets increases?

The dollar appreciates as higher interest rates attract more investments. Signup and view all the answers

Explain the potential impact on the dollar when interest rates on euro-denominated assets rise.

The dollar will depreciate as higher euro interest rates may attract investors away from dollar assets. Signup and view all the answers

How does the expected future appreciation of the euro affect the attractiveness of euro-denominated assets?

It increases the expected rate of return on those assets, making them more attractive to investors. Signup and view all the answers

What does the equilibrium in the foreign exchange market represent?

It represents the point where expected returns on dollar and euro deposits are equal. Signup and view all the answers

What effect does an increase in the dollar's expected future exchange rate have on euro deposits?

It causes the dollar to depreciate, as investors expect future euros to be more valuable. Signup and view all the answers

Describe the relationship between interest rates and the expected return on foreign currency deposits.

Higher interest rates increase the expected return on deposits, leading to currency appreciation. Signup and view all the answers

What is the consequence of the dollar appreciating against the euro on existing euro deposits?

It raises the expected dollar returns on those euro deposits. Signup and view all the answers

What is meant by a self-fulfilling prophecy in terms of currency appreciation?

A self-fulfilling prophecy occurs when the expectation of a currency appreciating leads to actual appreciation due to market actions based on that expectation. Signup and view all the answers

How does depreciation of a currency influence exports and imports?

Depreciation makes a currency less valuable, resulting in cheaper exports and more expensive imports. Signup and view all the answers

What key factors influence rates of return on currency deposits in the foreign exchange market?

Rates of return are influenced mainly by interest rates and expected exchange rates. Signup and view all the answers

What does interest rate parity refer to in the context of the foreign exchange market?

Interest rate parity occurs when the rates of return on deposits in domestic and foreign currencies are equal, ensuring no arbitrage opportunities. Signup and view all the answers

What impact does an increase in interest rates have on a currency's expected rate of return?

An increase in interest rates raises the expected rate of return on a currency, which typically leads to its appreciation. Signup and view all the answers

Study Notes

Exchange Rates

Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency.
Exchange rates allow the cost of goods or services to be denominated in a common currency.
An example calculation is provided using Yen and US Dollars, showing how to convert currency values.

Depreciation and Appreciation

Depreciation is a decrease in the value of a currency relative to another currency.
A currency that depreciates is less valuable and can be exchanged for a smaller amount of foreign currency.
An example is provided of the dollar depreciating relative to the euro (e.g., $1/€ → $1.20/€).
Appreciation is an increase in the value of a currency relative to another.
An appreciated currency is more expensive and can be exchanged for a larger amount of foreign currency.
An example is provided of the dollar appreciating relative to the euro (e.g., $1/€ → $0.90/€).

Participants in Foreign Exchange Markets

Commercial banks and other depository institutions conduct transactions of currency deposits for investment purposes.
Non-bank financial institutions such as mutual funds, hedge funds, and securities firms also conduct transactions.
Non-financial businesses use foreign currency to buy/sell goods.

Foreign Exchange Market Characteristics

Buying and selling in foreign exchange markets is largely dominated by commercial and investment banks.
Inter-bank transactions typically involve $1 million or more per transaction.
Central banks sometimes intervene, but these effects are generally small and temporary.

Demand for Currency Deposits

The demand for currency deposits depends on factors that influence the return on assets, such as risk and liquidity.
Rate of return is the percentage change in an asset's value over a period of time.
Real rate of return adjusts for inflation.
Risk and liquidity are secondary considerations for currency deposits in general markets.
The expected rate of return is the primary concern for investors holding currency deposits.

Model of Foreign Exchange Markets

Equilibrium in the foreign exchange market occurs when deposits of all currencies offer the same expected rate of return (Interest Parity).
Interest parity determines equivalence of deposits in different currencies.
Arbitrage in the foreign exchange market is not possible due to interest parity.

Changing Interest Rates

Increasing interest rates paid on deposits in a specific currency will increase the rate of return and lead to appreciation of the related currency.
Higher interest rates on specific deposits (e.g., for dollars) cause that currency to appreciate.
Higher interest rates in other deposits (e.g., for Euros) cause the dollar to depreciate.

Expected Currency Appreciation/Depreciation

If people predict a currency will appreciate, it will have a higher rate of return, and therefore will lead to an actual currency appreciation.
Conversely, if there is an expected depreciation of a currency, this will lead to an actual depreciation.

Summary

An exchange rate is the price of one country's currency in terms of another country's.
Depreciation of a currency decreases its value; exports become cheaper and imports more expensive.
Appreciation of a currency increases its value; exports become more expensive and imports cheaper.
Commercial and investment banks largely dominate global foreign exchange markets.
Rates of return on currency deposits are influenced by interest rates and expected exchange rates.
Equilibrium in the foreign exchange market occurs when returns are equal across currencies.

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Description

Test your understanding of currency depreciation, appreciation, and exchange rates. This quiz covers how these concepts affect international trade, prices of imports and exports, and the overall economic impact. Dive into practical calculations and theoretical implications related to currency values.