Exchange Rate Regimes and Trade

PS-1

Essays

Chp-2

1)Refer to the exchange rates below to answer the following questions. Table: Annual average
exchange rate measured in US dollar per foreign currency (E$/FX).

Country Currency 2013 2014

Mexico Peso 0.0692 0.0805
Switzerland Franc 1.059 1.028
Thailand Baht 0.0316 0.0328
United Kingdom Pound 1.545 1.604
Canada Can.Dollar 0.971 ?

a. For the first four currencies in the table, did the U.S. dollar appreciate or depreciate relative to
these currencies between 2013 and 2014?

The dollar depreciated relative to each of the currencies except for Switzerland, where it
appreciated.

b. Compute the Mexico/Thailand exchange rate Epeso/baht for 2013.

In 2013, Epeso/baht = E$/baht / E$/peso = 0.0316 / 0.0692 = 0.4566

c. Compute the Switzerland/United Kingdom exchange rate Efranc/pound for both 2013 and 2014.
Did the Swiss franc appreciate or depreciate in value relative to British pound during this time?

In 2013, Efranc/pound = E$/pound / E$/franc = 1.545 / 1.059 = 1.459

In 2014, Efranc/pound = E$/pound / E$/franc = 1.604 / 1.028 = 1.560 Since it takes more francs to
buy a pound in 2011, the franc depreciated relative to the pound.

d. We know that the percentage change in the US-Canadian exchange rate (E$/C$) from its level in
2013 (0.971) to 2014 is a positive 6%. Please compute the value of the exchange rate (E$/C$) in 2014.
Did the U.S. dollar appreciate or depreciate during this time relative to the Canadian dollar?

According to the question, we can set up the following equation: (E$/C$ 14 - E$/C$ 13)/ E$/C$ 13 =
0.06. Use 0.971 for E$/C$ 13 in the equation, and solve for E$/C$ 14 = 1.0293. The U.S. dollar
depreciated.
2) Consider the United States and the countries it trades with the most (measured in trade volume):
Canada, Mexico, China, and Japan. For simplicity, assume these are the only four countries with
which the United States trades. Trade shares (trade weights) and U.S. nominal exchange rates for
these four countries are as follows:

Country (currency Share of Trade $ per FX in 2015 $ per FX in 2016

Canada (dollar 36 % 0.8271 0.6892
Mexico (peso) 28 % 0.0683 0.0538
China (yuan) 20 % 0.1608 0.1522
Japan (yen) 16 % 0.0080 0.0086

a) Compute the percentage change from 2015 to 2016 in the four U.S. bilateral exchange rates
(defined as U.S. dollars per unit of foreign exchange, or FX) in the table provided.

Answer: %∆E$/C$ = (0.6892 − 0.8271)/0.8271 = −16.67%

%∆E$/pesos = (0.0538 − 0.0683)/0.0683 = −21.23%

%∆E$/yuan = (0.1522 − 0.1608)/0.1608 = −5.35%

%∆E$/¥ = (0.0086 − 0.008/0.008 = 7.50%

b) Use the trade shares as weights to compute the percentage change in the nominal effective
exchange rate for the United States between 2015 and 2016 (in U.S. dollars per foreign
currency basket).

Answer: The trade-weighted percentage change in the exchange rate is: %∆E = 0.36(%∆E$/C$) +
0.28(%∆E$/pesos) + 0.20(%∆E$/yuan) + 0.16(%∆E$/¥) %∆E = 0.36(−16.67 %) + 0.28(−21.23%) +
0.20(−5.35%) + 0.16(7.50%) = −11.82%
3) Suppose quotes for the dollar–euro exchange rate E$/€ are as follows: in New York $1.05 per euro,
and in Tokyo $1.15 per euro. Describe how investors use arbitrage to take advantage of the
difference in exchange rates. Explain how this process will affect the dollar price of the euro in New
York and Tokyo.

Answer: Investors will buy euros in New York at a price of $1.05 each because this is relatively
cheaper than the price in Tokyo. They will then sell these euros in Tokyo at a price of $1.15,
earning a $0.10 profit on each euro. With the influx of buyers in New York, the price of euros in
New York will increase. With the influx of traders selling euros in Tokyo, the price of euros in Tokyo
will decrease. This price adjustment continues until the exchange rates are equal in both markets.

4) You are a financial adviser to a U.S. corporation that expects to receive a payment of 60 million
Japanese yen in 180 days for goods exported to Japan. The current spot rate is 100 yen per U.S.
dollar (E$/¥ = 0.01000). You are concerned that the U.S. dollar is going to appreciate against the yen
over the next six months.

a. Assuming the exchange rate remains unchanged, how much does your firm expect to receive in
U.S. dollars?

Answer: The firm expects to receive $600,000 (= ¥60,000,000/100).

b. How much would your firm receive (in U.S. dollars) if the dollar appreciated to 110 yen per U.S.
dollar (E$/¥ = 0.00909)?

Answer: The firm would receive $545,454 (= ¥60,000,000/110).

c. Describe how you could use an options contract to hedge against the risk of losses associated
with the potential appreciation in the U.S. dollar.

Answer: The firm could buy ¥60 million in call options on dollars, say, for example, at a rate of 105¥
per dollar. A call option gives the buyer a right to buy dollars at the price agreed upon. If the dollar
appreciates such that its price rises above 105¥, say to 110¥, the firm will exercise the option. This
ensures the firm’s yen receipts will at least be worth $571,428 (= ¥60,000,000/105).
Chp-3

5) Suppose the cost of basket is Peu = 300 euros in the Eurozone and PTurkey =800 liras in Turkey. Suppose the
home country is Turkey, and the exchange rate is 1.8 liras per euro.

a) Write the absolute purchasing power parity (PPP) equation. Check to see whether PPP holds for the lira-euro
exchange rate.

Abs PPP : ETL/EEU = PTR/ PEU Home: Turkey (TL), Foreign: Eurozone (EU)

1,8 ≠ 800/300 = 2.67 So, PPP does not hold.

b) Calculate the real exchange rate. Determine whether lira is over-valued, under-valued or neither.

E
RER = = 1.8/ 2.67 = 0.67 ˂ 1 So Lira is overvalued.
P TR / P EU

c) Write two reasons for why the tendency for PPP to hold is weak in the short-run.

Sticky Prices, Nontradables, Transportation costs, barriers to trade

5) Consider two countries: Japan and Korea. In 1996 Japan experienced relatively slow output growth (1%),
while Korea had relatively robust output growth (6%). Suppose the Bank of Japan allowed the money supply to
grow by 2% each year, while the Bank of Korea chose to maintain relatively high money growth of 12% per
year. For the following questions, use the simple monetary model (where L is constant). You will find it easiest
to treat Korea as the home country and Japan as the foreign country.

a. What is the inflation rate in Korea? In Japan?

πk = ʮk - gk = %12- %6 = % 6 for Korea

πJ = ʮJ – gJ = %2 - %1 = % 1 for Japan

b.What is the expected rate of depreciation in the Korean won relative to the Japanese yen ?

%ΔE won/yen = (πk – πJ) = %6 - %1 = % 5

Also, you can calculate it by using %ΔE won/yen = (ʮk - gk) – (ʮJ – gJ)

c. Suppose the Bank of Korea increases the money growth rate from 12% to 15%. If nothing in Japan changes,
what is the new inflation rate in Korea?

πk = ʮk - gk = %15 - %6 = %9
6) Suppose you learn that the current exchange rate for the Japanese Yen is $1 = 120 yen.

a. If you expect Japanese monetary growth to be a total of 25% larger over the next ten years than US monetary
growth, what is your best guess as to the exchange rate ten years from now? What theory underlies your
prediction? Explain why we apply this theory here over a long run period, like 10 years, rather than over a short
period, say less than a year?

In the long run, the price level equals the ratio of money supply to money demand. A 25% larger increase
in the Japanese money supply than in the US money supply implies that the Japanese price level should
increase 25% more than the US price level. Relative purchasing power parity in turn implies that the
Japanese yen should depreciate by 25% in relation to the dollar in the long run. Thus the exchange rate 10
years from now should be about $1 = 150 yen. This theory applies in the long run because it requires
prices to be flexible, and it is based on PPP, which holds best in the long run.

b. If you expect that in addition to the higher money growth rate in Japan above, you also expect the output
growth rate to be higher in Japan by 30%. Would you predict that the value of the Japanese yen will appreciate
or depreciate relative the dollar (more or fewer dollars per yen).

The higher output growth would make the value of the yen appreciate 30%, so combined with the 25%
depreciation due to the money supply growth described above, this implies an appreciation on net (of 5%),
that is, more dollars per yen

7) Consider a period when the Swiss Central Bank targeted its money growth rate to achieve policy
objectives. Suppose Switzerland has output growth of 2% and money growth of 3% each year. What
is Switzerland’s inflation rate in this case? Describe how the Swiss Central Bank could achieve an
inflation rate of 2% in the long run through the use of a nominal anchor.

Answer: From the monetary approach: πS = µ S − gS = 3% − 2% = 1%. If the Swiss Central Bank wants
to achieve an inflation target of 2%, it would need to increase its money growth rate to 4%

8) Several countries that have experienced hyperinflation adopt dollarization as a way to control
domestic inflation. For example, Ecuador has used the U.S. dollar as its domestic currency since 2000.
What does dollarization imply about the exchange rate between Ecuador and the United States?
Why might countries experiencing hyperinflation adopt dollarization? Why might they do this rather
than just fixing their exchange rate?

Answer: Dollarization implies a country is adopting dollar as its currency. Because one U.S. dollar is
one U.S. dollar (regardless of where it is used to buy goods), this means that Ecuador has a fixed
exchange rate with the United States: E$/$ = 1, so %∆Ee$/$ = 0. Since Ecuador cannot print dollars,
it no longer controls the supply of its currency—the U.S. Federal Reserve does. A country
experiencing hyperinflation may adopt a currency such as the U.S. dollar in the hopes of controlling
inflation. We can see this from the Fisher effect. If the country no longer controls and thereby
creates excess money, the money growth stops, which in turn stabilizes prices.