website title

Students Zone - Answers to End of Chapter Questions

CHAPTER 5 : FOREIGN EXCHANGE MARKETS

1. The following exchange rates were quoted for 2 August 204

£1 = US$1.8184
£1 = SF2.3264
US$1 = SK13.9546
(SF: Swiss franc; SK Swedish krona)

Calculate: (i) the sterling/krona exchange rate
(ii) the US dollar/Swiss franc exchange rate
(iii) the Swiss franc/krona exchange rate.

Answer

£1 = $1.8184 and £1 = SF 2.3265 NOTE CORRECTION - $1 = SK7.6739

So:-

i) Sterling to SK £1 = 1.8184 x 7.6739 = SK13.954

ii) S = SF £1 = SF 2.3264 = $1.8184 1.8184 = 2.3264 $1 = SF1.2794

iii) SF = SK £1 = 2.3264 = 13.954 (answer from i) 2.3264 = 13.954

SF1 = 5.998

2. What might be the effect on the exchange rate, within a flexible exchange rate system of:

income and spending within a country rising faster than that in the rest of the world?
A government choosing to tighten monetary policy by raising interest rates?
A government choosing to relax fiscal policy by permitting a growth in government spending financed by sales of government bonds?
A country experiencing a sharp and sustained increase in the growth rate of productivity compared with the rest of the world?

Answers

If income and spending in any economy were rising faster than the rest of the world, it would suggest that this will draw in imports – so there will be increased demand for foreign currency which will be bought with domestic currency. So the supply curve for domestic currency will shift to the right and the exchange rate will weaken (eg £1 = $2 will fall to £1 = $1.5)

Rising the interest rate will tend to bring in capital flows and so increase demand for the domestic currency – this will increase the rate of exchange for the domestic currency (eg £1 = $2 will rise to £1 = $2.5) – this is the case as shown in figure 5.3 in the book.

Sales of government bonds – The price of bonds and interest rates are inversely related – so increasing the supply of bonds is likely to reduce their price and increase the interest rate – as seen in ii) and increased interest rate will increase the rate of exchange. Furthermore some of these extra bonds will be bought by foreign buyers, so increase demand for the domestic currency and further increasing the rate.

iv) This depends on who gains the benefit from the higher rate of growth of productivity compared to the rest of the world. It could go in higher wages in which case this should increase income and so have the effect of i). Furthermore it is likely this greater productivity will need further imports as raw materials, components etc and again boost imports – so the currency would weaken. However it could mean that businesses see the greater productivity as a way of cutting prices and so boosting export sales. This would bring more demand for the currency and so the exchange rate would strengthen.

Q3 – sections i-iii – these should not be there – they are not part of this question! (cut and paste that got into the wrong place – apologies!)

The question should only be

3. What might be the consequences of such changes for a country which was part of a fixed exchange rate system?

In i) and iv ) where the productivity gain goes in higher wages - we see pressure for the exchange rate to change downwards. If it is fixed then the exchange rate cannot fall and the government will have to work in the market to meet the greater demand for foreign exchange by buying sterling and selling foreign exchange. If the changes in i) and iv) turn out to the long term, then it will start to run out of foreign exchange reserves and may be forced to borrow (from the European Central Bank or the IMF – but both will have conditions). Ultimately the government will have to take steps to either change the situation in i) or iv) or devalue the exchange rate.

ii ) and iii ) and iv ) where the gain goes in lower prices – here the pressure is upwards. Again if the exchange rate is fixed it cannot rise. The government will be working the in the market to sell domestic currency and buy foreign exchange. If this is long term, then the government will be seeing an increasing the domestic money supply in the process and so risking inflationary pressure. Ultimately the government will have to take steps to either change ii) or iii) or revalue the exchange rate.

4. In recent years the United States has argued strongly that China should revalue its currency upwards. One piece of evidence that has been put forward for this is that the purchasing power of the Yuan appears to be higher than that of the dollar – in other words the Yuan appears to be undervalued relative to its PPP. In the light of the discussion of PPP, in this chapter how convincing do you find this argument to be?

Answer

In the light of the discussion in the chapter the argument is not very convincing. China seems potentially to be an example of the Balassa-Samuelson effect. To the extent that the exchange rate for the Yuan is governed by flows of traded goods, where Chinese productivity is relatively low, the value for the Yuan will be correspondingly low. However, because non-traded goods are relatively cheap in China, since wages are low but productivity in the non-traded sector is high, the Yuan has a large purchasing power and will seem to be undervalued.

However, we cannot simply say that China is a pure example of the Balassa-Samuelson effect because it is also the case that China has a (largely) fixed exchange rate and it may be the case that the Chinese authorities are keeping the value of the currency lower than the value which would arise if the currency were allowed to float freely (especially given the large Chinese trade surplus with the USA). So although the Balassa-Samuelson effect tells us that for developing countries we cannot simply assume that because currencies have a high purchasing power domestically they are undervalued, we cannot assume that their exchange rates are necessarily at the `right’ level either.

5. Dornbusch bases his overshooting model on the view that goods market prices adjust more slowly than asset market prices. Why do you think that he believed this? Do you think this is a realistic assumption?

Answer

There are two main reasons for supposing that asset market prices adjust more quickly than goods market prices:

Goods markets tend to be governed by medium or long term contractual arrangements while in asset markets contracts are often made for very short time periods and `rolled over’ if necessary
The costs of advertising and informing customers about price changes in good markets (so-called `menu costs’) are much greater than for asset markets (where electronic price dissemination systems are more prevalent). This is a disincentive to changing goods market prices unless changes in the economic environment can be known to be long-lasting. The immediate reaction to such changes will be to build up or run down stocks of goods rather than to change prices.

The assumption does seem quite a realistic one but in order for the model to be convincing it is still necessary to test whether markets really do operate in this way. `New classical’ macroeconomists have often argued that insufficient theoretical reasons have been put forward for assuming price `stickiness’ in goods markets. They claim that if price variability will increase economic welfare then new contractual arrangements and ways of organising markets are likely to emerge in order to allow such variability to obtain. Empirically, however, the volatility of asset prices does seem to be larger than that of goods prices.

6. How convincing do you think the explanations put forward in the text are for the failure of UIP to hold in practice? Can you think of any alternative explanations?

Answer

There is no strict `right or wrong’ answer to this question but the following considerations are ones which might be taken into account.

The explanation based on risk may well be becoming less convincing as opportunities for hedging against risk by using derivatives contracts become more prevalent. To the extent that such hedging can insure against the risk of holding particular currencies investors and traders are likely only to be concerned with returns.

The explanation based on expectations has some plausibility but for sophisticated foreign exchange traders it does seem reasonable to argue that expectations will on average be correct. Surely someone would not last very long in the competitive environment of international finance if they were systematically to under-predict or over-predict exchange rate values?

The explanation based on noise trading is one that has been used in stock markets to explain the divergence of prices from `fundamental’ values. It again has an intuitive plausibility but it does depend on a convincing explanation of why such speculative traders are not driven out of the market over time as they make losses on their rash trades.

Other explanations such as tax differences, exchange controls which hinder capital movements and so on do not seem any more convincing given the amount of financial deregulation we have seen over the last two decades. However, it may be the case that part of the reason for the failure of UIP to hold is the extent to which governments and central banks have deliberately influenced the value of national currencies to suit their own policy objectives. This may have lessened the impact of interest rate differentials in influencing currency sales and purchases.

7. You are the financial manager of a company which operates internationally, receiving funds and making payments in a variety of currencies. Your deputy has just completed an MBA and she tells you that the Meese-Rogoff results mean the company should simply abandon the attempt to explain exchange rate behaviour and adopt the random walk view that the best estimate of the exchange rate tomorrow is simply that it will stay the same as it is today. What would be the implications for such a company of adopting this view? Do you think it would be sensible for you as a financial manager to follow your deputy’s advice?

Answer

The implications for the company of adopting this view are that they would no longer try to predict exchange rates actively, while still, presumably, using derivatives (futures, forwards, options) to hedge against the risk that rates might fall or rise. Whether this is a sensible course of action to adopt or not depends very much on one’s view of the impact of the Meese-Rogoff results for attempts to predict rates. We cannot simply rely on hedging to eliminate exchange rate risk since we need some kind of prediction of future rate changes to determine the terms of the hedge. By adopting the random walk hypothesis we are not ceasing to make any prediction – we are simply saying that a rate rise is as likely as a rate fall. If the means to predict rate changes more precisely than this do exist then we could use them to improve the terms of our hedge and gain a financial reward. However, we would have to set the potential gains from that kind of active exchange rate prediction against any potential costs involved in employing forecasters and other staff. It might well be that, even if in theory using a specific model of the exchange rate would improve our ability to predict costs and revenues, in practice the costs involved in doing this would outweigh the benefits.

8. What current developments in the European Union might encourage or discourage movement towards the euro-zone countries becoming an optimal currency area? Do you think such a development is likely in the short or medium term?

Answer

According to the theory of OCAs four main kinds of development might increase the likelihood of the euro-zone becoming such an area:

Labour and capital mobility within the euro-zone might increase. The evidence in the chapter indicates that capital mobility within the zone is increasing but labour mobility also depends on cultural, social and linguistic factors and so is harder to predict.
Countries participating in the zone may adopt more open and diversified trade structures. Trade is already very open within the zone, but the question of diversification is more complex. The impact of the euro might go in one of two opposite directions. On the one hand it might encourage foreign investment within the zone leading to a greater amount of intra-industry trade and more diversified industrial structures within each participating country. This would make an OCA more likely. On the other hand it might lead to greater concentration of industry in particular favourable regional centres. This might well make industrial structures in each country less diversified and make an OCA less likely.
More similar policy preferences among participating countries . The hope of those promoting EMU was that the experience of having a common currency would bring policy preferences across Europe together and make an OCA more likely. This may well happen. On the other hand it could also be argued that the similarity of preferences evident in the 1990s was the result of a temporary unity around the specific project of implementing the Maastricht Treaty and that, now this has been done, old policy differences may re-emerge. Conflicts over the stability and growth pact among euro-zone members do give some credibility to this view.
Increased fiscal transfers between countries . Fiscal transfers within the euro-zone are small and actually seem to be getting less insofar as more of the EU budget is going to the `accession countries’ who joined in 2004 and are not (so far) euro-zone members. So to this extent the euro-zone may be moving away from becoming an OCA

9. What are the arguments for and against the euro becoming an international currency which could rival the dollar from the point of view of (a) the euro-zone countries and (b) the international financial system as a whole? Would such a development be one that European businesses should welcome?

Answer

From the point of view of the euro-zone countries the main arguments are (i) lower transactions costs in international dealings and (ii) seigniorage. However, neither of these seem convincing. The costs involved in holding dollars are surely not a major problem for European businesses operating globally – especially as many are now producing in North America as well as Europe. Seigniorage revenues are also not that high. So the main advantages probably relate to political power and prestige and the general position of Europe in world affairs.

The dangers of instability in world money arrangements if firms and businesses hold large amounts of currency in both dollars and euros (currency substitution) are potentially quite significant and might be a reason why the international financial system as a whole might be concerned about the rise of the euro. However, set against this, the availability of a second international currency would reduce risk to the system from possible irresponsible behaviour from the USA. For example, given the current size of the US trade deficit, the possible impact of a sharp devaluation of the dollar, to correct balance of payments imbalances, could be rather severe. The availability of the euro as an alternative might mitigate some of these problems.

Ultimately the issue of the relative weighting of the costs and benefits of the emergence of the euro as a potential competitor to the dollar is closely linked to the question of whether a `unipolar’ world order, centred on the USA, or a `multipolar’ world order is the most attractive way of organising international economic and political arrangements.

Other End of Chapter Questions >>

website title

Site Links

Lecturers Zone

Students Zone

Other