The Determination of Exchange Rates & The International Monetary System

Universidad de Puerto Rico, Recinto de Rio Piedras

Escuela Graduada de Administracin de Empresas
FING 6717 International Trade and Finance
Dr. Carlos Coln de Armas

Darwin J. Morales: 802-03-4757

Asignacin #1 para entregar Agosto 17

The Determination of Exchange Rates

Work required to prepare for class:
S, Chapter 2, Questions 1-10, Problems 1-4, 6
Questions
1. Describe how these three typical transactions should affect present and future exchange
rates:
a. Seagram imports a years supply of French champagne. Payment in French francs
is due immediately.
Given the rise in demand of Francs, the French Francs should appreciate in
value immediately.
b. MCI sells a new stock issue to Alcatel, the French telecommunications company.
Payment in dollars is due immediately.
Given the rise in demand of dollars, the dollar should appreciate in value
immediately.
c. Korean Airlines buys five Boeing 747s. As part of the deal, Boeing arranges a
loan to KAL for the purchase amount from the U.S. Export-Import Bank. The
loan is to be paid back over the next seven years with a two-year grace period.
Given the rise in demand of dollars, the dollar should appreciate in value over
the next seven to nine years (2 year grace period).
2. The maintenance of moneys value is said to depend on the monetary authorities. What
might the monetary authorities do to a currency that would cause its value to drop?
The most straight forward way to cause a currencys value to drop is to increase the
amount of that currency available.
3. For each of the following six scenarios, state whether the value of the dollar will
appreciate, depreciate, or remain the same relative to the Japanese yen. Explain each
answer. Assume that exchange rates are free to vary and that other factors are held
constant.

a. The growth rate of national income is higher in the United States than in Japan.
A nation with strong economic growth will attract investment capital seeking to
acquire domestic assets which in turn would result in an appreciation of the
dollar..
b. Inflation is higher in the United States than in Japan.
A higher rate of inflation in the United States than in Japan will lead to a
depreciation of the dollar relative to the euro
c. Prices in Japan and the United States are rising at the same rate.
Remain the same.
d. Real interest rates in the United States rise relative to real rates in Japan.
If the increase in U.S. interest rates relative to Japan rates just reflects higher
U.S. inflation, the predicted result will be a weaker dollar. Only an increase in the
real U.S. interest rate relative to the real Eurozone rate will result in an
appreciating dollar.
e. The United States imposes new restrictions on the ability of foreigners to buy
American companies and real estate.
Investors prefer to hold lesser amounts of riskier assets; thus, low risk currencies
those associated with more politically and economically stable nationsare
more highly valued than high-risk currencies. Lower amounts of investment from
foreigners would result in lower demand for the dollar which would result in a
depreciating dollar.
f. U.S. wages rise relative to Japanese wages, while American productivity falls
behind Japanese productivity.
Reduced productivity with higher costs (wages) would make the U.S a less
attractive place for investment and would result in a depreciating dollar.
4. The Fed adopts an easier monetary policy. How is this likely to affect the value of the
dollar and US interest rates?
Given how easier monetary policies, would mean boosting the money supply to lower
interest rates this would result in a devalued currency.

5. Comment on the following headline from the New York Times. Germany Raises Interest
Rates, and Value of Dollar Declines (October 10, 1997).
The standard approach of staving off currency devaluation is to raise interest rates. This
makes it more attractive to hold the local currency and results in increasing capital
inflows. However, this approach has historically been problematic. For Asian central
banks, raising interest rates boosted the cost of funds to banks and made it more difficult
for borrowers to service their debts, thereby further crippling an already sick financial
sector. Higher interest rates also lowered real estate values, which served as collateral
for many of these loans, and pushed even more loans into default. Thus, Asian central
banks found their hands were tied and investors recognized that.
6. In the 1995 election for the French presidency, the Socialist candidate, Lionel Jospin,
vowed to halt all privatizations, raise taxes on business, spend heavily on job creation,
and cut the workweek without a matching pay cut. At the time Jospin made this vow, he
was running neck and neck with the conservative Prime Minister Jacques Chirac, who
espoused free-market policies.
a. How do you think the French franc responded to Jospins remarks?
I would expect the franc to depreciate based upon the halting of competition,
raising taxes on investments, incurring in costs for job creation, and cutting
productivity.
b. In the event, Chirac won the election. What was the francs likely reaction?
I would expect it to appreciate due to the reduction of risk in having
counterproductive monetary policy.
7. On November 28, 1990, Federal Reserve Chairman Alan Greenspan told the House
Banking Committee that despite possible benefits to the U.S. trade balance, a weaker
dollar also is a cause for concern. This statement departed from what appeared to be an
attitude of benign neglect by U.S. monetary officials towards the dollars depreciation.

He also rejected the notion that the Fed should aggressively ease monetary policy, as
some Treasury officials had been urging. At the same time, Greenspan did not mention
foreign exchange market intervention to support the dollars value.
a. What is the likely reaction of the foreign exchange market to Greenspans
statements? Explain.
I would expect the dollar to appreciate given how the expectation of not wanting
to weaken the dollar any further would mean that he would not be aggressively
increasing supply of the currency and not mentioning foreign exchange market
intervention suggests that he would be willing to support the currencys stability.
b. Can Greenspan support the value of the U.S. dollar without intervening in the
foreign exchange market? If so, how?
He could change real interest rates to favor investment in the U.S.
8. Many Asian governments have attempted to promote their export competitiveness by
holding down the value of their currencies through foreign exchange market intervention.
a. What is the likely impact of this policy on Asian foreign exchange reserves? On
Asian inflation? On Asian export competitiveness? On Asian living standards?
Devaluing their currency would result in rising relative inflation rates and would
reduce their foreign exchange reserves. Even though this would make Asian
export more competitive it would also result in a reduction of Asian living
standards given the higher inflation.
b. Some Asian countries have attempted to sterilize their foreign exchange market
intervention by selling bonds. What are the likely consequences of sterilization on
interest rates? On exchange rates in the longer term? On export competitiveness?
The net result of sterilization should be a rise or fall in the countrys foreign
exchange reserves but no change in the domestic money supply. Because
sterilized intervention entails a substitution of foreign currency-denominated
securities for domestic currency securities, the exchange rate will be permanently
affected only if investors view domestic and foreign securities as being imperfect

substitutes. If this is the case, then the exchange rate and relative interest rates
must change to induce investors to hold the new portfolio of securities.
9. As mentioned in the chapter, Hong Kong has a currency board that fixes the exchange
rate between the U.S. and H.K. dollars.
a. What is the likely consequence of a large capital inflow for the rate of inflation in
Hong Kong? For the competitiveness of Hong Kong business? Explain.
b. Given a large capital inflow, what would happen to the value of the Hong Kong
dollar if it were allowed to freely float? What would be the effect on the
competitiveness of Hong Kong business? Explain.
c. Given a large capital inflow, will Hong Kong business be more or less
competitive under a currency board or with a freely floating currency? Explain.
10. In 1994, an influx of drug money to Colombia coincided with a sharp increase in its
export earnings from coffee and oil.
a. What was the likely impact of these factors on the value of the Colombian peso
and the competitiveness of Colombias legal exports? Explain.
b. In 1996, Colombias president, facing charges of involvement in his countrys
drug cartel, sought to boost his domestic popularity by pursuing more
expansionary monetary policies. Standing in the way was Colombias independent
central bank Banco de la Republica. In response, the president and his
supporters discussed the possibility of returning central bank control to the
executive branch. Describe the likely economic consequences of ending Banco de
la Republicas independence.

Problems
1. On August 8, 2000, Zimbabwe changed the value of the Zim dollar from Z$38/US$ to
Z$50/US$.

a. What was the original U.S. dollar value of the Zim dollar? What is the new U.S.
dollar value of the Zim dollar?
b. By what percentage has the Zim dollar devalued (revalued) relative to the U.S.
dollar?
c. By what percentage has the U.S. dollar appreciated (depreciated) relative to the
Zim dollar?
2. In 1995, one dollar bought 80. In 2000, it bought about 110.
a. What was the dollar value of the yen in 1995? What was the yens dollar value in
2000?
b. By what percentage has the yen fallen in value between 1995 and 2000?
c. By what percentage has the dollar risen in value between 1995 and 2000?
3. On February 1, the euro is worth $0.8984. By May 1, it has moved to $0.9457.
a. By what percentage has the euro appreciated or depreciated against the dollar
during this three-month period?
b. By what percentage has the dollar appreciated or depreciated against the euro
during this period?
4. In early August 2002 (the exact date is a state secret), North Korea reduced the official
value of the won from $0.465 to $0.0067. The black market value of the won at that time
was $0.005.
a. By what percentage did the won devalue?
b. Following the initial devaluation, what further percentage devaluation would be
necessary for the won to equal its black market value?

6. At the time Argentina launched its new exchange rate scheme, the euro was trading at
$0.85. Exporters and importers would be able to convert between dollars and pesos at an
exchange rate that was an average of the dollar and the euro exchange rates, that is, P1 =
$0.50 +0.50.
a. How many pesos would an exporter receive for one dollar under the new system?
b. How many dollars would an importer receive for one peso under the new system?

The International Monetary System

Work required to prepare for class:
S, Chapter 3, Questions 1-10, Problems 1-3
Questions
1. Answer a - d
a. What are the five basic mechanisms for establishing exchange rates?
b. How does each work?
c. What costs and benefits are associated with each mechanism?
d. Have exchange rate movements under the current system of managed floating
been excessive? Explain.
2. Find a recent example of a nations foreign exchange market intervention and note what
the governments justification was. Does this justification make economic sense?
3. Gold has been called the ultimate burglar alarm. Explain what this expression means.
4. Suppose nations attempt to pursue independent monetary and fiscal policies. How will
exchange rates behave?
5. The experiences of fixed exchange rate systems and targetzone arrangements have not
been entirely satisfactory.
a. What lessons can economists draw from the breakdown of the Bretton Woods
system?
b. What lessons can economists draw from the exchange rate experiences of the
European Monetary System?
6. How did the European Monetary System limit the economic ability of each member
nation to set its interest rate to be different from Germanys?
7. Historically, Spain has had high inflation and has seen its peseta continuously depreciate.
In 1989, however, Spain joined the EMS and pegged the peseta to the DM. According to
a Spanish banker, EMS membership means that the government has less capability to
manage the currency but, on the other hand, the people are more trusting of the currency
for that reason.
a. What underlies the pesetas historical weakness?

b. Comment on the bankers statement.

c. What are the likely consequences of EMS membership on the Spanish publics
willingness to save and invest?
8. In discussing the European Monetary Union, a recent government report stressed a need
to make the central bank accountable to the democratic process. What are the likely
consequences for price stability and exchange rate stability in the EMS if the ECB
becomes accountable to the democratic process?
9. Comment on the following statement: With monetary union, the era of protection for
European firms and workers has come to an end.
10. Comment on the following statement: The French view European Monetary Union as a
way to break the Bundesbanks dominance in setting monetary policy in Europe.

Problems
1. During the currency crisis of September 1992, the Bank of England borrowed DM 33
billion from the Bundesbank when a pound was worth DM 2.78, or $1.912. It sold these
DM in the foreign exchange market for pounds in a futile attempt to prevent a
devaluation of the pound. It repaid these DM at the postcrisis rate of DM 2.50:1. By
then, the dollar:pound exchange rate was $1.782:1.
a. By what percentage had the pound sterling devalued in the interim against the
Deutsche mark? Against the dollar?
b. What was the cost of intervention to the Bank of England in pounds? In dollars?
2. Suppose the central rates within the ERM for the French franc and DM are FF 6.90403:
ECU 1 and DM 2.05853:ECU 1, respectively.
a. What is the cross-exchange rate between the franc and the mark?
b. Under the former 2.25% margin on either side of the central rate, what were the
approximate upper and lower intervention limits for France and Germany?
c. Under the new 15% margin on either side of the central rate, what are the current
approximate upper and lower intervention limits for France and Germany?

3. A Dutch company exporting to France had FF 3 million due in 90 days. Suppose that the
spot exchange rate was FF 1 = DFl 0.3291.
a. Under the exchange rate mechanism, and assuming central rates of FF
6.45863/ECU and DFL 2.16979/ECU, what was the central cross-exchange rate
between the two currencies?
b. Based on the answer to Part a, what was the most the Dutch company could lose
on its French franc receivable, assuming that France and the Netherlands stuck to
the ERM with a 15% band on either side of their central cross rate?
c. Redo Part b, assuming the band was narrowed to 2.25%.
d. Redo Part b, assuming you know nothing about the spot cross-exchange rate?