Reading 17: The Exchange Rate and the Balance of Payments-LOS 2011, class, currency, investment, searching

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Session 4: Economics for Valuation
Reading 17: The Exchange Rate and the Balance of Payments

LOS c: Discuss how the supply and demand for a currency changes the exchange rate.

 

 

David Kirk, CFA, is an analyst on the global equities desk for a large investment banking company in New York. Kirk is searching for investment opportunities in companies that operate in relatively economically undeveloped countries. He is currently researching possible investments in businesses located in Wayland, a small emerging country located in Eastern Europe. Wayland has significant coal deposits within its borders, and is a leading producer in the region. Kirk’s interest in the country stems from the fact that Wayland has recently emerged an as independent nation after centuries of rule by a larger country. Wayland is in the early stages of government formation, although many of its elected leaders are experienced, having served under the previous government.

Kirk is not a risk-averse investor, but realizes that opportunities in Wayland may have some unique features. For example, the government of Wayland is considering putting some type of trade restrictions in place to protect the country’s leading industry, the production of coal. Government officials want to ensure that the industry, which is quasi-governmental, is shielded from lower cost importers from surrounding countries. At the same time, the government wants to encourage growth and development in other industries so that in the future, the country’s economy is not dependent upon one industry. Kirk wants to explore the short- and long-term implications of any trade restrictions the government may enact.

Also, Kirk plans on performing a thorough analysis of the government of Wayland’s anticipated approach toward monetary policy. With an expected increase in international trade, the country’s central bank must more carefully manage the country’s balance of payments accounts. The current exchange rate for W$, the national currency of Wayland, is W$125/

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Which one of the following factors will most likely cause a country’s domestic currency to appreciate on the foreign exchange market? An increase in:

A) the real rate of interest in others countries.

B) its exports relative to its imports.

C) its domestic rate of inflation.

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If a country’s exports are increasing at a faster rate than its imports it means that its exports are being purchased by foreigners at a faster rate than imports from abroad are being purchased by domestic consumers. In order for foreigners to buy a country’s exports they must first buy the exporting country’s currency causing it to appreciate. An increase in the domestic rate of inflation and real interest rates in other countries will each lead to depreciation of a country’s domestic currency on the foreign exchange market.

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Phil Howell, a foreign exchange trader, makes the following two statements about foreign exchange rates:

Statement 1: A decrease in the expected future exchange value of a currency will increase supply and decrease demand for that currency.

Statement 2: Interest rate parity (IRP) is the idea that exchange rates will adjust to reflect the difference in inflation rates between different countries.

With respect to these statements:

A) only one is correct.

B) both are correct.

C) both are incorrect.

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Statement 1 is correct. A decrease in the expected future exchange rate has opposite effects on the supply and demand for a currency, decreasing demand for the currency and increasing its supply on the foreign exchange market. Statement 2 is incorrect. The idea that exchange rates will adjust to reflect the difference in inflation rates between different countries is purchasing power parity (PPP).

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If a German electronics manufacturer builds an electronics plant in Mexico, this action will create which of the following with regard to the demand and supply of the euro and the peso in the foreign exchange market? This action creates a:

A) demand for both pesos and euros in the foreign exchange market.

B) demand for pesos and a supply of euros in the foreign exchange market.

C) supply of pesos and demand for euros in the foreign exchange market.

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Building an electronics plant in Mexico will require the German electronics manufacturer to pay for expenses (construction fees, salaries, administrative expenses, etc.) associated with the project in pesos. Therefore, the manufacturer will need to convert euros to pesos thereby increasing the supply of euros in the foreign exchange market and increasing the demand for pesos.

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Which of the following would increase the supply of dollars in foreign exchange markets? The:

A) purchase of Korean televisions by an American distributor.

B) sale of a U.S. company to a Dutch investor.

C) sale of U.S. made automobiles to Vietnamese consumers.

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If an American distributor is purchasing Korean televisions, then the distributor will need to sell dollars and purchase won. This action will supply dollars to the foreign exchange market. The sale of U.S. automobiles to Vietnamese consumers would increase the demand for dollars as Vietnamese consumers sell dongs and buy dollars. The sale of a U.S. company to a Dutch investor would also increase the demand for the dollar in the foreign exchange market and increase the supply of euros as the Dutch investor sells euros and buys dollars.

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A country’s real interest rate has declined relative to its major trading partners. What will most likely be the effects on the demand for the country’s currency and on aggregate demand, respectively?

A) Both will decrease.

B) Both will increase.

C) Only one will increase.

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A decrease in a country’s domestic interest rates relative to those of other countries will cause demand for its currency to decrease because investments denominated in that currency become relatively less attractive. The resulting decrease in the value of its currency will lead to greater demand for its exports and less imports, so net exports, and therefore aggregate demand, will increase.

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The Japanese government has decided that it wants to maintain a constant exchange rate with the U.S. dollar at a time when supply and demand conditions in the foreign exchange market are causing the Japanese yen to appreciate. Which of the following actions would most likely achieve their objective?

A) A shift to a more expansionary monetary policy.

B) Reduce taxes and create a budget deficit in order to increase domestic interest rates.

C) A shift to a more restrictive monetary policy.

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If the Japanese government wants to maintain a constant exchange rate between yen and the U.S. dollar, then it would most likely shift to a more expansionary monetary policy, decrease its tariffs, or eliminate its quotas. A more expansionary monetary policy will decrease real yen interest rates, reducing investment by foreigners in Japan (decrease yen demand), and increasing investment abroad by Japanese investors (increases yen supplied).