Chapter 10 - Foreign Exchange

Chapter 10
Foreign Exchange

Chapter Overview

This chapter provides an introduction to foreign exchange rates and exchange markets,
helping students to understand how they are determined and what accounts for their
fluctuation over days, months, years, and decades.

Reading this chapter will prepare students to:

Define exchange rates and explain the causes of their movements.
Distinguish between nominal and real exchange rates and analyze the impact of
inflation rates.
Explain and apply the theory of purchasing power parity.
Assess the role of government in foreign exchange markets.

Important Points of the Chapter

Exchange rates are a key tool that makes international trade possible. Since buyers and
sellers both want to use their own currencies, which are likely to be different, there must
be an exchange of currencies. The exchange rate is the price of one currency in terms of
another. Exchange rates have implications for countries and individuals; long swings or
sudden spikes in exchange rates affect the costs of different goods in different countries.

Application of Core Principles

Principle #4: Markets. Arbitrage is the basis for the law of one price, the idea that
identical products should sell for the same price. If they did not, there would be an
opportunity for someone to profit by purchasing the item where it is cheap and reselling it
where its price is higher, but by doing that, the relative supplies would change and move
the two prices to equality.

Principle #4: Markets. The equilibrium exchange rate is determined by the supply and
demand for dollars. The values of all the major currencies of the world are determined by
market forces.

Principle #1: Time. The real interest rate is the nominal interest rate minus expected
inflation; an increase in real foreign interest rates when U.S. real rates are steady would
result in an increased demand for the foreign bonds and so an increase in the supply of
dollars on the foreign exchange market.

Principle #2: Risk. Changes in the riskiness of U.S. assets compared to foreign assets
will affect the supply of dollars and so the exchange rate.

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Principle #4: Markets. Government officials may intervene in foreign exchange markets
either to fix or to influence the value of the currency.

Teaching Tips/Student Stumbling Blocks

The discussion of the law of one price refers back to arbitrage, as discussed in
Chapter 9. You may wish to review this material to reinforce the concept.
When covering the calculation of the real exchange rate be aware that some
students may be puzzled by the example in the text, pointing out that there are
Starbucks coffee shops all over the world. Emphasize that, as used in the
example, Starbucks coffee represents espresso sold in the United States.
Have your students track the dollar against the yen and the euro by following (and
graphing) the daily movements for a week or two. Students can read the articles
that accompany the foreign exchange tables in The Wall Street Journal each day
and summarize the factors that have been important in the time period under
consideration. This is a good exercise to reinforce the idea presented in the
chapter about how exchange rates are recorded (i.e., in which currency unit) and
to illustrate how and why they fluctuate.

Features in this Chapter

Tools of the Trade: Following Exchange Rates in the News

This section explains how to read the foreign exchange table in The Wall Street Journal.
It points out that the table includes data on forward and spot rates.

Your Financial World: Investing Overseas

Investing abroad can increase diversification and so reduce risk without decreasing the
expected return. So long as the returns on stocks in other countries do not move in lock
step with the U.S. stock market, holding them will reduce the risk of your investment
portfolio. The data does indicate that the returns on other countries stock markets do
move independently of the U.S. stock market. The evidence shows that holding foreign
stocks reduces risk without sacrificing returns, despite the risk of exchange rate
fluctuations.

Applying the Concept: The Big Mac Index

The Economist magazine uses the McDonalds Big Mac to provide a humorous
illustration of purchasing power parity. Twice a year the magazine publishes a table
showing the price of the Big Mac in about fifty countries and uses it to show which
currencies are overvalued or undervalued relative to the U.S. dollar. The Big Mac index
is a clever idea, and works surprisingly well considering that it is based only on one

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commodity (that is not tradable), and whose local price depends on costs like wages,
rents and taxes.

Your Financial World: Dont Bet on Exchange Rates

Having a good sense of what will happen over the long run doesnt help much in the short
run; what the experts cant tell you is when exchange rate movements will occur.
Forward markets do provide forecasts of future exchange rates, but these rates are
typically very close to the current (spot) rates. In the short run, exchange rates are
inherently unpredictable, and betting on them is a bad idea.

Lessons from the Crisis: Currency Risk and Rollover Risk

During the crisis of 2007-2009, banks faced currency risk and rollover risk. When
interbank markets dried up, banks found it difficult to borrow US dollars needed to fund
their dollar loans and securities. When a bank lends on a foreign currency, it typically
borrows in that currency, too. Banks face currency risk if they borrow in one currency
but loan in another. Banks also face rollover risk because loans usually have a longer
maturity than borrowings, and banks face a danger that funding liquidity in the foreign
currency will dry up. In the financial crisis of 2007-2009 the rollover risk facing
internationally active banks became acute and posed a threat to the financial system as a
whole. To limit its credit exposure, the Fed arranged a series of dollar swaps with ten
other countries.

In the News: U.S. Standoff with Beijing

In November, 2009, President Obama asked China to reconsider its economic strategy
and was rebuffed. The policy is one of using government authority to peg the value of its
currency to the dollar instead of letting the yuan fluctuate fully in response to
independent market forces. This policy helps the Chinese economy but hurts the U.S.
economy through reduced exports opportunities resulting in huge trade deficits.

In 2009, most analysts viewed the Chinese yuan as significantly undervalued, and
many firms complained that an overly cheap yuan was putting Chinese producers at
an unfair advantage. In response, other governments sought to convince China to
allow their currency to appreciate. But Chinese exporters, preferring a weak Yuan,
successfully prevailed upon Chinese policy makers to continue to keep the yuan
weak, as they had for years. As a by-product of this policy, China accumulated a
record volume of currency reservesin excess of $2 trillionand became the largest
holder of U.S. Treasury debt. It remains to be seen how long China can delay a rise
of the yuan.

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Additional Teaching Tools

Almost any days issue of The Wall Street Journal is likely to provide an article that will
flesh out the material covered in this chapter. For example, in the June 14, 2010 online
issue, several articles discuss the recent drop in the value of the euro, subsequent
increases and predictions from experts that it will continue to increase.

Virtual Tools

Visit The Economist on line for the latest version of the Big Mac index. On January 15,
2004 the magazine also introduced Lattenomics, which does a similar analysis (but,
like this text chapter, uses coffee instead of burgers). It is interesting for students to
compare the two and, in particular, to see where they differ. The magazines web site is:
http://www.economist.com/

An excellent website which provides foreign exchange data, including graphs can be
found at http://www.x-rates.com. In particular, it allows the user to switch the units of
currency for the exchange rate to illustrate the point made in the chapter (i.e., dollars in
euro versus euro in dollars, etc.). The site also has some educational sections and
forecasts.

For More Discussion

Ask students, Do exchange rates only matter if you travel? and be surprised as to how
many of them will answer, Yes. How much of what you buy is actually imported?
Give students a sense of the role of imports in their lives by having them read labels
(particularly on clothing) or find out the origins of things they purchase. Discuss the
importance of the value of the dollar in terms of what they buy.

Chapter Outline

I. Foreign Exchange Basics

A. The Nominal Exchange Rate
1. The exchange rate is the price paid in one currency to obtain an amount of
another currency.
2. Exchange rates change every day.
3. A decline in the value of one currency relative to another is called a
depreciation (of the currency whose value is falling); an increase is called an
appreciation (of the currency whose value is rising).
4. When comparing two currencies, if one currency goes up in value relative to
the other, the value of the other currency must go down.

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5. Exchange rates can be quoted in units of either currency; for example, as the
number of dollars needed to buy one euro or as the number of euro needed to
buy one dollar.
6. The two prices are equivalent (one is simply the reciprocal of the other) and
there is no rule for determining which way a particular exchange rate should
be quoted.
7. In practice, most rates tend to be quoted in the way that yields a number larger
than one.
B. The Real Exchange Rate
1. The real exchange rate is the rate at which one can exchange the goods and
services from one country for the goods and services from another country.
2. The real exchange rate is the cost of a basket of goods in one country relative
to the cost of the same basket of goods in another country.
3. To compute the real exchange rate we take the dollar price of a good in the
United States divide it by the dollar price of the same good in another country
(the dollar price in the other country is found by taking the local price and
multiplying by the nominal exchange rate).
4. Whenever the real exchange rate as calculated above is greater than one (the
real exchange rate has no units), foreign products will seem cheap.
5. The real exchange rate is more important than the nominal exchange rate
because it measures the relative price of goods and services across countries,
telling us where things are cheap and where they are expensive.
6. The real exchange rate is the guiding force behind international transactions.
7. The competitiveness of U.S. exports depends on the real exchange rate; if it
appreciates, U.S. exports become less competitive and if it depreciates they
become more competitive
C. Foreign Exchange Markets
1. The daily volume of foreign exchange transactions is enormous.
2. Because of its liquidity, the U.S. dollar is one side of roughly 90 percent of the
currency transactions that occur.
3. The most important center for such transactions is London; other significant
foreign exchange trading occurs in New York, Tokyo, Singapore, Frankfurt,
and Zurich.
II. Exchange Rates in the Long Run
A. The Law of One Price
1. The law of one price is the starting point for understanding how long-run
exchange rates are determined.

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2. The law is based on arbitrage, the idea that identical products should sell for
the same price.
3. If the same good did not sell for the same price in two places there would be
an opportunity for someone to profit by purchasing the item where it is cheap
and reselling it where its price is higher, but by doing that, the relative
supplies would change and move the two prices to equality.
4. The law of one price fails almost all the time; the same commodity or service
sells for vastly different prices in different countries as a result of
transportation costs, taxes, differences in technical specifications, differences
in tastes, and that fact that some things simply cannot be traded (like haircuts).
B. Purchasing Power Parity
1. Even with its obvious flaws the law of one price is extremely useful in
explaining the behavior of exchange rates over long periods, like ten or twenty
years.
2. Extending the law from a single commodity to a basket of goods and services
results in the theory of purchasing power parity (PPP), which means that one
unit of U.S. domestic currency will buy the same basket of goods and services
anywhere in the world.
3. PPP implies that the real exchange rate is always equal to one.
4. PPP implies that when prices change in one country but not in another the
exchange rate should change as well.
5. Changes in exchange rates are therefore tied to differences in inflation from
one country to another; the currency of a country with high inflation will
depreciate.
6. Over weeks, months, and even years, nominal exchange rates can deviate
substantially from the levels implied by purchasing power parity. Such short-
term movements have other explanations
7. A current market rate that deviates from purchasing power parity results in a
currency being considered undervalued or overvalued.
III. Exchange Rates in the Short Run
A. The Supply of Dollars
1. Someone who wants to exchange dollars for another currency supplies them
to the foreign exchange markets.
2. The two reasons for such an exchange would be to purchase foreign goods
and services or to invest in foreign assets.
3. The more valuable the dollar, the cheaper foreign goods, services, and assets
are, and the higher will be the supply of dollars in the foreign exchange
market.

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B. The Demand for Dollars

1. Foreigners who want to purchase American-made goods, assets, or services
need dollars to do so and so represent the demand for dollars.
2. The cheaper the dollar the more attractive such goods, assets, or services are
and the higher the demand for dollars with which to buy them.
C. Equilibrium in the Market for Dollars
1. Equilibrium in the market for dollars occurs where the supply and demand are
equal.
2. Fluctuations in the values of currencies are the result of shifts in supply or
demand.
D. Shifts in the Supply and Demand for Dollars
1. Shifts in supply: the supply of dollars will increase (i.e., the supply curve
shifts right) the more Americans want to import goods and services from
abroad or the higher their preference for foreign stocks and bonds. These can
result from:
a. An increase in Americans preference for foreign goods.
b. An increase in the real interest rate on foreign bonds.
c. An increase in American wealth.
d. A decrease in the riskiness of foreign investments relative to U.S.
investments.
e. An expected depreciation of the dollar.
2. Demand: the demand will increase (i.e., the demand curve shifts right) if
there is an increased desire by foreigners to buy American-made goods and
services or to invest in U.S. assets. This can be the result of:
a. An increase in foreigners preference for American goods.
b. An increase in the real interest rate on U.S. bonds.
c. An increase in foreign wealth.
d. A decrease in the riskiness of U.S. investments relative to foreign
investments.
e. An expected appreciation of the dollar.
3. Explaining exchange rate movements: the supply and demand model helps to
explain short-run movements in currency values.
4. Shifts in supply and demand can both occur at the same time, and the
movement of the exchange rate will depend on which effect is stronger (i.e.,
which shift is bigger).

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IV. Government Policy and Foreign Exchange Intervention

1. Government officials can intervene in foreign exchange markets in several
ways.
2. Some countries adopt a fixed exchange rate and act to maintain it at a level of
their choosing.
3. Large industrialized countries generally allow markets to determine the
exchange rate but may intervene at times to influence the value.
4. When policymakers buy or sell currency to affect demand or supply it is
called foreign exchange intervention.
Appendix: Interest Rate Parity and Short-Run Exchange Rate Determination
1. Another way to think about the determinants of exchange rates over the short
term is to focus on them from an investors point of view.
2. If the bonds issued in different countries are perfect substitutes for each other,
then arbitrage will equalize their returns. Since investing abroad means
exchanging currencies, the result is a relationship among domestic interest
rates, foreign interest rates, and the exchange rate.
3. The interest parity condition (derived in this appendix) tells us that the U.S.
interest rate equals the rate on a foreign bond minus the dollars expected
appreciation.
4. If the interest parity condition did not hold, people would have an incentive to
shift their investments until it did.
5. Knowing current U.S. and foreign interest rates allows us to calculate what the
exchange rate should be.
6. The current value of the dollar will be higher the higher U.S. interest rates are,
the lower foreign interest rates are, and the higher the expected future value of
the dollar is.

Terms Introduced in Chapter 10

appreciation (of a currency)

Big Mac index
British pound
demand for dollars
depreciation (of a currency)
euro
law of one price
nominal exchange rate

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overvalued currency
purchasing power parity (PPP)
real exchange rate
supply of dollars
undervalued currency
yen
yuan

Lessons of Chapter 10
1. Different areas and countries of the world use different currencies in their
transactions.
a. The nominal exchange rate is the rate at which the currency of one country can be
exchanged for the currency of another.
b. A decline in the value of one currency relative to another is called depreciation.
c. An increase in the value of one currency relative to another is called appreciation.
d. When the dollar appreciates relative to the euro, the euro will have depreciated
relative to the dollar.
e. The real exchange rate is the rate at which the goods and services of one country
can be exchanged for the goods and services of another.
f. Over $1 trillion is traded every day in markets run by brokers and foreign
exchange dealers.

2. In the long run, the value of a countrys currency is tied to the price of goods and
services in that country.
a. The law of one price states that two identical goods should sell for the same price,
regardless of location.
b. The law of one price fails because of transportation costs, differences in taxation
and technical specifications, and the fact that some goods cannot be moved.
c. The theory of purchasing power parity applies the law of one price to
international transactions; it states that the real exchange rate always equals one.
d. Purchasing power parity implies that countries with higher inflation than other
countries will experience exchange rate depreciation.
e. Over decades, exchange rate changes are approximately equal to differences in
inflation, implying that purchasing power parity holds.

3. In the short run, the value of a countrys currency depends on supply and demand for
the currency in foreign exchange markets.
a. When people in the United States wish to purchase foreign goods and services or
invest in foreign assets, they must supply dollars to the foreign exchange market.
b. The more foreign currency that can be exchanged for one dollar, the greater will
be the supply of dollars. That is, the supply curve for dollars slopes upward.

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c. Foreigners who wish to purchase American-made goods and services or invest in

U.S. assets will demand dollars in the foreign exchange market.
d. The fewer units of foreign currency needed to buy one dollar, the higher the
demand for dollars. That is, the demand curve for dollars slopes downward.
e. Anything that increases the desire of Americans to buy foreign-made goods and
services or invest in foreign assets will increase the supply of dollars (shift the
supply curve for dollars to the right), causing the dollar to depreciate.
f. Anything that increases the desire of foreigners to buy American-made goods and
services or invest in U.S. assets will increase the demand for dollars (shift the
demand curve of dollars to the right), causing the dollar to appreciate.

4. Some governments buy and sell their own currency in an effort to affect the exchange
rate. Such foreign exchange interventions are usually ineffective.

Conceptual Problems

1. If the U.S. dollar-British pound exchange rate is $1.50 per pound, and the U.S. dollar-
euro rate is $0.90 per euro:
a. What is the pound per euro rate?
b. How could you profit if the pound per euro rate were above the rate you
calculated in part a? What if it were lower?

Answer:
pound $0.90
a. * 0.6/
$1.50 euro
b. If the pound per euro rate were above 0.6/, you could profit by
converting dollars to euros, euros to pounds, and then pounds to dollars. For
example, if the rate were 0.7/ and you started with $90, you could exchange the
$90 for 100. Then you could exchange 100 for 70, and 70 for $105, making a
profit of $15. If the pound per euro rate were below 0.6/, you could make a profit
by converting dollars to pounds, pounds to euros, and then euros to dollars.

2. If a computer game costs $30 in the United States and 26 in United Kingdom, what
is the real computer game exchange rate? Look up the current dollar-pound
exchange rate in a newspaper or an online source, and compare the two prices. What
do you conclude?

Answer: On January 8, 2007 the dollar-pound exchange rate was $1.9382 per pound.
The real CD exchange rate is $15/(13*1.9382) = 0.60. This is the ratio of the cost of
a CD in the United States to the cost of a CD in the U.K. Since the real CD exchange
rate is less than one, it implies that CDs are cheaper in the United States than in the
U.K. You can exchange one U.S. CD for 0.6 of a U.K. CD.

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3. Suppose the euro-dollar exchange rate moves from $0.90 per euro to $0.92 per euro.
At the same time, the prices of European-made goods and services rise 1 percent,
while prices of American-made goods and services rise 3 percent. What has
happened to the real exchange rate between the dollar and the euro? Assuming the
same change in the nominal exchange rate, what if inflation were 3 percent in Europe
and 1 percent in the United States?

Answer: In the first case there is no change in the real exchange rate because inflation
in the U.S. is 2% higher than in Europe and the dollar has depreciated about 2%
against the euro. In the second case the real dollar/euro exchange rate has risen by
4%.

4. The same television set costs $500 in the United States, 450 in France, 300 in
United Kingdom, and 100,000 in Japan. If the law of one price holds, what are the
euro-dollar, pound-dollar, and yen-dollar exchange rates? Why might the law of one
price fail?

Answer: If the law of one price holds, then the euro/dollar exchange rate should be
450/$500 = 0.9/$, the pound/dollar exchange rate should be 300/$500 = 0.6/$,
and the yen/dollar exchange rate should be 100,000/$500 = 200/$. The law of one
price may fail because of transportation costs, tariffs, and technical specifications.

5. *What does the theory of purchasing power parity predict in the long run regarding
the inflation rate of a country that fixes its exchange rate to the U.S. dollar?

Answer: According to the theory of purchasing power parity, changes in exchange

rates are tied to differences in inflation from one country to another. If, as in the case
of a fixed exchange rate, there are no exchange rate changes, it predicts that the
inflation rate in that country should be the same as the U.S. rate of inflation in the
long run.

6. * Why is it not a good idea to speculate on short-term exchange rate movements using
the predictions of purchasing power parity?

Answer: Purchasing power parity doesnt hold on a day-to-day basis or even on a

month-to-month or year-to-year basis. It tells us how exchange rates will move over
long periods like decades. In the short run, exchange rates can deviate substantially
from their purchasing power parity levels. In the short run, exchange rates are
determined by a host of factors affecting supply and demand for currencies and are
effectively unpredictable.

7. You need to purchase Japanese yen and have called two brokers to get quotes. The
first broker offered you a rate of 125 yen per dollar. The second broker, ignoring

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market convention, quoted a price of 0.0084 dollars per yen. To which broker should
you give your business? Why?

Answer: An exchange rate of 0.0084 dollars per yen is equivalent to 119 yen per
dollar (1/$0.0084 = 119/$), so you should get yen from the first broker.

8. During the 1990s, the U.S. Secretary of the Treasury often stated, a strong dollar is
in the interest of the United States.
a. Is this statement true? Explain your answer.
b. What can the Secretary of the Treasury actually do about the value of the dollar
relative to other currencies?

Answer:
a. When the dollar is strong, foreign goods are relatively cheap for consumers in
the United States. This helps keep inflation in check. A strong dollar also
attracts foreign investment. However, when the dollar is strong, U.S. goods
are more expensive for foreigners, and U.S. exports fall. So, a strong dollar
benefits some people and hurts others. What is more beneficial is a stable
dollar, so that there is not much exchange rate risk.
b. Without the cooperation of the Federal Reserve, the Secretary of the Treasury
cant do anything about the value of the dollar. He or she can buy and sell
foreign currencies, but this is not usually effective in changing the value of the
dollar because it does not influence the interest rate. And it is the interest rate
that influences investors demand and supply for dollars.

9. Your investment advisor calls to suggest that you invest in Mexican bonds with a
yield of 8.5 percent, 3 percent above U.S. Treasury rates. Should you do it? What
factors should you consider in making your decision?

Answer: In deciding whether or not to invest in Mexican bonds, you should consider
the riskiness of the bonds, as well as the potential for changes in the exchange rate.

Analytical Problems

10. If the price (measured in a common currency) of a particular basket of goods is 10%
higher in the U.K. than it is in the United States, which countrys currency is
undervalued, according to the theory of purchasing power parity?

Answer: According to the theory of purchasing power parity, the real exchange rate
should equal 1. If we look at the ratio of the cost of the basket of goods in the United
States to the cost in the U.K., that ratio (which is the real exchange rate taking the
United States to be the home country), is less than one. The U.S. dollar is therefore
undervalued. If the dollar were to strengthen, the dollar price of the U.K. basket of
goods would fall, bringing the real exchange rate back towards 1.

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11. *You hear an interview with a well-known economist who states that she expects the
U.S. dollar to strengthen against the British pound over the next five to ten years.
This economist is known for her support of the theory of purchasing power parity.
Using an equation to summarize the relationship predicted by purchasing power
parity between exchange-rate movements and the inflation rates in the two countries,
explain whether you expect inflation in the United States to be higher or lower on
average compared with that in the U.K. over the period in question.

Answer: The economists comments were about exchange rate movements in the long
run and purchasing power parity tells us that, in the long run, changes in exchange
rates are related to inflation rate differentials across countries. (Take a look at Figure
10.4). We can represent this idea by the equation
Change in exchange rate (dollars per pound) = Inflation (U.S.) Inflation (U.K.)
If the dollar is expected to strengthen, this means it takes fewer dollars to purchase a
pound, so the change in the exchange rate is negative. Therefore, inflation in the
United States is expected to be lower than in the U.K.

12. Using the model of demand and supply for U.S. dollars, what would you expect to
happen to the U.S. dollar exchange rate if, in light of a worsening geopolitical
situation, Americans viewed foreign bonds as more risky than before? (You should
quote the exchange rate as number of units of foreign currency per U.S. dollar.)

Answer: If Americans view foreign bonds as more risky than before, they will reduce
their demand for these bonds. There will be a fall in the supply of dollars Americans
use to purchase foreign assets, shifting the supply curve to the left. The exchange
rate, quoted as the number of units of foreign currency per U.S. dollar, will rise,
reflecting an appreciation of the U.S. dollar.

S1
S0
Foreign Currency per dollar

E1

E0

D0

Quantity of dollars traded

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13. In recent times, the Chinese central bank has been buying U.S. dollars in the market
in an effort to keep its own currency, the yuan, weak. Use the model of demand and
supply for dollars to show what the immediate effect would be on the yuan/dollar
exchange rate of a decision by China to allow its currency to float freely.

Answer: If the Chinese central bank stopped purchasing U.S. dollars in the market,
there would be a shift to the left in the demand curve for dollars, leading to a fall in
the number of yuans per dollar in equilibrium. In other words, the yuan would
appreciate against the U.S. dollar.

S0
Foreign Currency per dollar

E0
E1

D0
D1
Quantity of dollars traded

14. Consider again the situation described in question 13 where China decided to allow
the yuan to float. What would you expect to happen to
i) U.S. exports to China
ii) U.S. imports from China
ii) the U.S. trade deficit with China
Explain your answers.

Answer: If the yuan is undervalued and is allowed to float freely, market forces
will cause the yuan to appreciate.
i) U.S. exports to China should increase. The appreciation of the yuan would
make US exports more competitive in China, as the amount of yuan that would
have to be given up for any given dollar price of a good would fall.
ii) U.S. imports from China should fall. The appreciation of the yuan would

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make imports from China more expensive in the U.S., as more dollars would have
to be given up to purchase the yuan needed for the imports.
iii) The trade deficit measures the excess of imports from China over exports to
China from the U.S. With exports rising and imports falling, the trade deficit
should narrow.

15. Impressed with the magnificent scenery from Vancouver during the coverage of the
Winter Olympics, French and German tourists flock to the west coast of Canada. Use
the model of demand and supply for Canadian dollars to illustrate and explain the
impact this would have on the euro-Canadian dollar exchange rate in the short run.

Answer: The increase in foreign preferences for Canadian tourist goods and services
would shift the demand curve for Canadian dollars to the right, leading to an
appreciation of the Canadian currency.

S0
Foreign Currency per dollar

E1
E0

D1

D0

Quantity of dollars traded

16. Suppose consumers across the world (including in the United States), driven by a
wave of national pride, decided to buy home-produced products where possible. How
would demand and supply for dollars be affected? What can you say about the
impact on the equilibrium dollar exchange rate?

Answer: A fall in foreign demand for U.S. goods would shift the demand curve for
dollars to the left while the fall in U.S. demand for foreign goods would shift the
supply curve for dollars to the left. The overall impact on the dollar exchange rate
depends on which shift dominates. As the economy of the world outside the U.S. is
larger than the U.S. economy, you might expect the demand shift to dominate, leading
to a depreciation of the dollar.

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S1
Fore ign Curre nc y pe r do llar S0

E0
E1

D0
D1
Quantity of dollars traded

17. Suppose an Italian bank has short-term borrowings of 400 million euro and 100
million U.S. dollars and made long term loans of 300 million euro and 250 million
U.S. dollars. The euro-dollar exchange rate is initially $1.50 per euro.
i) Draw up a simple balance sheet for this bank.
ii) List the risks that this bank faces.
iii) If the Euro-dollar exchange rate moved to $1.60 per euro, would the bank gain or
lose? Provide calculations to support your answer.

Answer:
i)

ii) In addition to the usual default risk, the bank faces both currency risk and rollover
risk arising from the currency and maturity mismatches between its assets and

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Chapter 10 - Foreign Exchange

liabilities. The gap between the banks lending and borrowing in foreign currency
- its currency mismatch - is $150 million. The maturity mismatch arises because
its long-term lending is financed by short-term borrowing, giving rise to risk
associated with its ability to rollover this short-term borrowing as it matures. This
rollover risk adds to the currency risk as, in the event the bank cannot rollover its
dollar borrowings, it would have to sell dollar loans or borrow euro.
iii) The bank has more dollar-denominated assets than dollar-denominated liabilities,
so when the dollar weakens (the euro strengthens), the bank loses. At the initial
exchange rate of $1.50 per euro, the currency gap is 100 million euro. If the euro
appreciates to $1.60 per euro, the bank loses 6.25 million euro.

18. *Suppose government officials in a small open economy decided they wanted their
currency to weaken in order to boost exports. What kind of foreign exchange market
intervention would they have to make to cause their currency to depreciate? What
would happen to domestic interest rates in that country if its central bank doesnt take
any action to offset the impact on interest rates of the foreign exchange intervention?

Answer: The government officials would have to sell domestic currency in exchange
for foreign currency in order for their domestic currency to weaken. This increases
the supply of domestic currency, pushing down domestic interest rates.

19. Suppose the interest rate on a one-year U.S. bond were 10% and the interest rate on
an equivalent Canadian bond were 8%. If the interest-rate parity condition holds, is
the U.S. dollar expected to appreciate or depreciate relative to the Canadian dollar
over the next year? Explain your choice.

Answer: You would expect the U.S. dollar to depreciate. If the interest parity
condition holds, the return on the two bonds should be equal. The holder of the
Canadian bond must gain on the exchange rate to compensate for the lower interest
rate to equate the two returns.

* indicates more difficult problems

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