Week 2 Class Problems Fin403

Chapter 4

2. Inflation Effects on Exchange Rates. Assume that the U.S. inflation rate becomes high relative to Canadian inflation. Other things being equal, how should this affect the (a) U.S. demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the Canadian dollar?

ANSWER: Demand for Canadian dollars should increase, supply of Canadian dollars for sale should decrease, and the Canadian dollar’s value should increase.

3. Interest Rate Effects on Exchange Rates. Assume U.S. interest rates fall relative to British interest rates. Other things being equal, how should this affect the (a) U.S. demand for British pounds, (b) supply of pounds for sale, and (c) equilibrium value of the pound?

ANSWER: Demand for pounds should increase, supply of pounds for sale should decrease, and the pound’s value should increase.

4. Income Effects on Exchange Rates. Assume that the U.S. income level rises at a much higher rate than does the Canadian income level. Other things being equal, how should this affect the (a) U.S. demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the Canadian dollar?

ANSWER: Assuming no effect on U.S. interest rates, demand for dollars should increase, supply of dollars for sale may not be affected, and the dollar’s value should increase.

5. Trade Restriction Effects on Exchange Rates. Assume that the Japanese government relaxes its controls on imports by Japanese companies. Other things being equal, how should this affect the (a) U.S. demand for Japanese yen, (b) supply of yen for sale, and (c) equilibrium value of the yen?

ANSWER: Demand for yen should not be affected, supply of yen for sale should increase, and the value of yen should decrease.

18. Factors Affecting Exchange Rates. Mexico tends to have much higher inflation than the United States and also much higher interest rates than the United States. Inflation and interest rates are much more volatile in Mexico than in industrialized countries. The value of the Mexican peso is typically more volatile than the currencies of industrialized countries from a U.S. perspective; it has typically depreciated from one year to the next, but the degree of depreciation has varied substantially. The bid/ask spread tends to be wider for the peso than for currencies of industrialized countries.

a. Identify the most obvious economic reason for the persistent depreciation of the peso.

ANSWER: The high inflation in Mexico places continual downward pressure on the value of the peso.

b. High interest rates are commonly expected to strengthen a country’s currency because they can encourage foreign investment in securities in that country, which results in the exchange of other currencies for that currency. Yet, the peso’s value has declined against the dollar over most years even though Mexican interest rates are typically much higher than U.S. interest rates. Thus, it appears that the high Mexican interest rates do not attract substantial U.S. investment in Mexico’s