Foreign Exchange Chapter 10

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Questions and Answers

What happens to the dollar when there is an increase in demand for it?

Demand for dollars has no effect on its value.

The dollar depreciates relative to other currencies.

The dollar appreciates relative to other currencies. (correct)

The number of euros per dollar increases.

What was a significant consequence during the 2007-2009 financial crisis regarding U.S. dollars?

Banks found it easy to borrow U.S. dollars.

Non-U.S. banks struggled to acquire the dollars necessary for their loans. (correct)

The interbank market was highly liquid.

Banks faced no currency risk in their operations.

What was the impact of the extraordinary dollar swaps arranged by the U.S. central bank?

They prevented foreign investment into U.S. markets.

They successfully mitigated the threat of a currency-driven meltdown. (correct)

They eliminated all currency risks faced by banks.

They increased the supply of euros in the market.

What primarily drove the 30 percent appreciation of the dollar relative to the euro between January 1999 and October 2000?

A decrease in dollars supplied by Americans or an increase in dollars demanded by foreigners. Signup and view all the answers

What trend occurred when Americans increased their purchases of foreign goods during the period leading up to the dollar's appreciation?

The demand for dollars outweighed the supply. Signup and view all the answers

What is the main purpose of the Foreign Exchange column in the Wall Street Journal?

To provide information on foreign exchange rates. Signup and view all the answers

Which of the following best describes spot rates in foreign exchange?

Rates for immediate exchange with a two-day settlement period. Signup and view all the answers

Why might the law of one price fail in practice?

Transportation costs can be significant. Signup and view all the answers

What does the law of one price suggest about identical goods?

They should sell for the same price in all markets. Signup and view all the answers

What percentage of currency transactions involve the U.S. dollar?

85 percent Signup and view all the answers

Which statement is true regarding forward rates in foreign exchange?

They indicate future purchasing power for currencies. Signup and view all the answers

What justifies the need for diversification in an investment portfolio?

A diverse portfolio can enhance overall returns. Signup and view all the answers

What is the nominal exchange rate?

The rate at which one currency can be exchanged for another Signup and view all the answers

In foreign exchange transactions, exchanging Thai baht for Japanese Yen requires how many transactions?

Two transactions through U.S. dollars. Signup and view all the answers

What does a depreciation of a currency signify?

A decline in the value of the currency relative to another currency Signup and view all the answers

Which of the following factors can influence fluctuations in exchange rates?

Differences in inflation rates between countries Signup and view all the answers

What does purchasing power parity indicate about exchange rates over a long time period?

Nominal exchange rates can deviate from levels suggested by purchasing power parity. Signup and view all the answers

Which currency is most commonly used among European Monetary Union members?

Euro Signup and view all the answers

If a dollar purchases 0.90 euros, how is the dollar described in relation to the euro?

Undervalued. Signup and view all the answers

What is the relationship between exchange rates and international transactions?

Exchange rates determine the relative price of currencies in international trade Signup and view all the answers

What is one key aspect that establishes the demand for currency in foreign exchange markets?

The appetite for foreign investments Signup and view all the answers

Which index uses Big Mac prices to analyze currency valuation?

The Big Mac Index. Signup and view all the answers

Why is understanding nominal and real exchange rates important in foreign exchange?

They can affect the purchasing power and international competitiveness Signup and view all the answers

What primary factor influences short-run exchange rates?

Supply and demand for currencies. Signup and view all the answers

How does the supply of dollars typically behave in the market?

It slopes upward with higher prices. Signup and view all the answers

In what scenario would an increase in a country's currency supply potentially lead to depreciation?

When the country's exports decrease significantly Signup and view all the answers

What describes the demand for dollars when the dollar's value decreases?

Demand increases due to lower prices of goods. Signup and view all the answers

What is the primary limitation of purchasing power parity?

It is solely applicable to long-term analysis. Signup and view all the answers

What do deviations in nominal exchange rates indicate in the short run?

Adjustments in the real exchange rate. Signup and view all the answers

What is the impact of currency appreciation on a country's exports?

Decreases the competitiveness of exports. Signup and view all the answers

What is foreign exchange intervention?

The practice of central banks buying or selling currency. Signup and view all the answers

Which country has been noted as the most frequent participant in foreign exchange markets?

Japan Signup and view all the answers

What does a 'dirty float' refer to in foreign exchange policy?

A managed exchange rate with occasional interventions. Signup and view all the answers

Why might government officials choose to intervene in foreign exchange markets?

To maintain currency stability and protect domestic businesses. Signup and view all the answers

What was Brazil's stance on foreign currency manipulation?

It only manipulates its currency if other countries do the same. Signup and view all the answers

How did loose monetary policy in developed countries affect developing countries?

It led to currency appreciation and reduced their export competitiveness. Signup and view all the answers

What is a potential consequence of currency appreciation for domestic businesses?

Increased difficulty in selling products abroad. Signup and view all the answers

What is the primary factor that determines the equilibrium exchange rate for dollars?

Market forces of supply and demand Signup and view all the answers

Which of the following factors would NOT increase the supply of dollars in the foreign exchange market?

A decrease in the demand for American goods Signup and view all the answers

What effect does an increase in the supply of dollars have on its value?

It leads to a depreciation of the dollar Signup and view all the answers

Which of the following is a reason that might lead foreigners to demand more dollars?

An expected appreciation of the dollar Signup and view all the answers

What is generally considered the best forecast of the future exchange rate?

Today’s exchange rate Signup and view all the answers

Which factor increases the demand for dollars from the perspective of foreigners?

Higher preference for American-made goods Signup and view all the answers

An expected depreciation of the dollar will have what effect on its supply?

Increase in supply Signup and view all the answers

Which of the following would likely lead to an increase in the demand for dollars?

A decrease in the riskiness of American investments Signup and view all the answers

Study Notes

Chapter Ten: Foreign Exchange

This chapter covers foreign exchange, including nominal and real exchange rates, the relationship between exchange rates, price levels, and inflation, currency supply and demand, and government intervention in foreign exchange.
Global business involves goods, services, stocks, bonds, etc., traded across the globe.
Understanding these transactions requires familiarity with exchange rates.
All cross-border transactions involve a buyer and a seller using their own currency.
The exchange rate is the price of one currency in terms of another.

Learning Objectives

Students will understand nominal and real exchange rates.
Students will understand the relationship between exchange rates, price levels, and inflation.
Students will understand currency supply and demand.
Students will understand government intervention in foreign exchange.

Introduction

This chapter discusses how foreign exchange rates are determined.
It will explain what accounts for fluctuations in exchange rates over various timeframes (days, months, years, decades).
It will cover the connection between foreign exchange rates and exchange markets.

Foreign Exchange Basics

When traveling, goods and services are usually bought using the local currency.
In Europe, the euro (€) is the common currency for most countries in the European Monetary Union.
The dollar-euro exchange rate is the price of one euro in dollars.

The Nominal Exchange Rate

Exchanging currency is like any other transaction, but in different countries.
The nominal exchange rate is the price paid in one currency for the currency of another.
Exchange rates change daily.
Figure 10.3 shows the dollar-euro exchange rate from January 1999 to January 2013.
The figure shows how many dollars are needed to buy one euro.
A decline in one currency relative to another is called depreciation.
A rise in one currency relative to another is called appreciation.
A currency's value going up means the other currency's value goes down.
The price of the British pound and Japanese yen are quoted in a similar way as the euro, using the number of dollars that can buy one pound (£) or Japanese yen (¥).

The Real Exchange Rate

When visiting another country, you need to know how much you can buy with the local currency.
The real exchange rate is the rate at which goods and services from one country can be exchanged for goods and services from another.
It's the cost of a basket of goods in one country compared to the cost of the same basket in another.
There's a simple relationship between the real and nominal exchange rates.
A real exchange rate calculation uses the price of a domestic good (e.g., espresso in the U.S.) compared to the price of the same good in a foreign country (e.g., Italy) in terms of their respective currencies.
The ratio (in dollars) of a domestic product to a foreign product provides a real exchange rate for the countries.
Foreign goods are cheap compared to domestic goods when the real exchange rate is greater than 1.
The competitiveness of U.S. exports depends on the real exchange rate.
An appreciation of the real exchange rate makes exports more expensive to foreigners, reducing their competitiveness.
Conversely, a depreciation of the real exchange rate makes exports seem cheaper, improving competitiveness.

Tools of the Trade

The Wall Street Journal has a Foreign Exchange column with recent exchange rates between the U.S. dollar and various foreign currencies.
Spot rates are current exchange rates.
Forward rates are rates for future exchange.

Purchasing Power Parity (PPP)

The law of one price applies to identical goods in different locations.
PPP is an extension of this; a currency unit buys the same basket of goods globally.
The exchange rate should change when prices change in one country but not another.
According to the theory of purchasing power parity in the U.S.:
- dollar price of basket = dollar price of basket of goods in U.K.
- (Dollar price of basket of goods in U.S.)/(Dollar price of basket of goods in U.K.) = 1.
On a given day, PPP might not hold true for specific items, but it is useful to understand exchange rate movements over the long term.
If one country has high inflation, its currency will likely depreciate.

Figure 10.4

This figure shows data for 62 countries from the International Monetary Fund spanning 1980-2010.
The 45-degree line represents that on this line exchange rate movements equal inflation differences.

Foreign Exchange Markets

The U.S. dollar is highly liquid and used in roughly 85% of currency transactions.
Most foreign exchange transactions may need steps, such as converting to USD to buy other currencies.
A large amount of foreign exchange trades take place in the UK.

Exchange Rates in the Short Run

Short-term exchange rates are explained with supply and demand analysis.
Nominal currency movements represent changes in the real exchange rate.
A small change in exchange rate per day or week roughly corresponds to a similar real-exchange rate change.

The Supply of Dollars

The supply of dollars slopes upward.
The higher the dollar price, the greater the supply in the foreign exchange market, reflecting foreign demand for American goods/services.

The Demand for Dollars

Foreigners demanding American goods/services need dollars, so supply slopes downward.
The cheaper the dollar, the more attractive U.S. investments are for foreigners.

Equilibrium in the Market for Dollars

Equilibrium exchange rates balance dollar supply and demand.
Exchange rates shift due to market forces.
Fluctuations in the currency value stem from supply or demand shifts.
Figure 10.5 graphically illustrates the dollar-euro market with supply and demand curves.

Shifts in the Supply of and Demand for Dollars

Factors affecting the supply of dollars include American preference for foreign goods, shifts in real interest rates on foreign bonds, changes in American wealth, shifting riskiness in foreign investments, and expectations of dollar depreciation.
Factors affecting demand include foreign preference for American goods, shifts in the real interest rates on U.S. bonds, changes in foreign wealth, shifting riskiness in U.S. investments, and expectations of future dollar appreciation.
These shifts cause changes on equilibrium in the markets.

Government Policy and Foreign Exchange Intervention

Currency appreciation hurts domestic businesses, impacting export prices.
Some countries maintain a fixed exchange rate.
Policymakers can buy or sell currency to influence market demand or supply, which is known as foreign exchange intervention.

In the News

Country examples illustrate how exchange rate policies and interventions have changed throughout the period analyzed.

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Description

Explore the fundamentals of foreign exchange in this comprehensive quiz. Understand the concepts of nominal and real exchange rates, the impact of price levels and inflation on exchange rates, and the dynamics of currency supply and demand. Additionally, learn about government intervention in the foreign exchange market.