International Economics

Study Guide, Chapter 11

Market-Determined Exchange Rates

1. In March 2002 the exchange value of the Euro was $1.00 =1.14 Euros.

A. Show the exchange rate on a diagram similar to that in the text, but from the perspective of the American market for Euros. Properly label all curves and axes.

B. Using your diagram explain how the dollar-franc exchange rate would be affected by each of the following events:

• a sharp rise in Euro-Zone real interest rates
• the appearance of double-digit inflation in the Euro-Zone
• a prolonged general strike in the Euro-Zone
• a 20 percent increase in the Euro-Zone money supply
• a sharp rise in U.S. real interest rates

In each case assume that "all other things are constant."

C. What is the effect of each change in the exchange rate on the Euro-Zone's competitive position?

D. How do you explain the slope of the demand and supply curve in your diagram?

1. How and why do monetary and fiscal policies affect the exchange rate?





2. Explain the following terms: arbitrage; triangular arbitrage; speculation; spot exchange rate; forward exchange rate; future market; short position; long position; exchange rate overshooting; vehicle currency; portfolio investment; direct investment







3. Why might monetary policy lead to exchange rate overshooting? Offer examples of overshooting.

International Economics

Study Guide, Chap 11 (Continued)

FORWARD EXCHANGE MARKET

The difference in the spot rate and the forward exchange rate of a currency is the interest rate differential in the respective financial markets. So, if the interest rate in New York is 3% and in London it is 4%, the forward pound sells at a ______________ relative to the spot pound and the forward dollar sells at a _______________to the spot dollar.

Conversely, if the New York interest rate is higher than the London interest rate, the forward dollar sells at a ___________________relative to the spot dollar, and the forward pound sells at a __________________relative to the spot pound.

SPECULATION--Speculators do not take a covered position.

Speculators are taking a ______________position when they sell foreign currency forward (without owning it) expecting to buy it at a lower spot rate when the contract matures,

thus making a profit on the difference.

Speculators are taking a ______________position when they purchase foreign currency forward (without incurring an obligation to make a spot payment at the time of delivery--they buy what they do not need) expecting the spot rate to be higher when the contract matures,

thus selling at the higher rate and making a profit on the difference.