Foreign exchange market

E

S

E₂

 

E₁ D2

D1

Q₁ Q₂ Quantity of dollars

 

Problem 3 (APT’96)

 

Year	Dollar	Yen	Franc	Mark
			4.0	1.8
			5.8	2.3

a) Given the change in the value of the dollar between year 1 and year 2, as indicated in the table above, describe the effects this will have on United States tourism overseas.

b) Using an aggregate supply and aggregate demand graph, explain the impact of the change in the value of the dollar on the price and output levels in the United States.

c) Explain what impact the change in the value of the dollar will have on the United States balance of trade.

 

Sample answer:

a) Since exchange rate between the dollar and the yen remained the same there will be no change to the tourism between the United States and Japan. However, the value of the dollar with respect to the franc and the mark has gone up between year 1 and year 2, making holidays in France and Germany less expensive in dollar terms. As a result, there will be an increase in the number of Americans going on holiday to these two countries.

b) As follows from the table, the value of the dollar has increased with respect to two of the three currencies and not changed with respect to the remaining one. This means that, in general, the dollar has appreciated. Consequently, the price of domestically produced goods has gone up in terms of foreign currencies, whereas foreign goods have become less expensive in terms of dollars and therefore more attractive to American consumers. As a result, we would expect a reduction in the United States exports and an increase in their imports. Hence, aggregate demand curve will shift in, pushing prices down and causing output to contract.

 

 

P

SAS

P₁

 

P₂ AD₁

AD₂

Y₂ Y₁ Y

c) Balance of trade is the difference between a country’s exports and its imports. In so far as the value of the United States exports has gone down, while the value of the imports has increased, there will certainly be a deterioration in the balance of trade.

 

Problem 4 (APT’97, P3)

Assume an economy is in a recession.

(a) Identify one monetary policy action and one fiscal policy action that could be used to help the economy out of the recession. Explain the effect of each policy on the price level and the equilibrium level of output.

(b) Given your answer in part (a) on the price level effect, explain the effect the policy actions you identified in part (a) would have on the economy’s imports and its exports.

(c) Given your answer in part (a) on the output effect, explain the effect the policy actions you identified in part (a) would have on the economy’s imports and its exports.

(d) Given your answers above, explain what effect the policy actions would have on the international value of the dollar.

 

Sample answer:

 

a) Since economy is in a recession, it produces below its potential level. To bring it out of the recession the government has to boost aggregate demand, which can be achieved either through expansionary monetary policy (e.g. buying out bonds in the open market) or expansionary fiscal policy (e.g. cutting personal income taxes). The monetary policy will push the interest rate down encouraging more investment, while the fiscal policy action will increase disposable income thereby boosting consumption demand. The ultimate effect of these two policies will be the same: they will increase aggregate demand causing both the equilibrium level of output and the price level to go up.

P

SAS

P₂

 

P₁ AD₂

AD₁

Y₁ Y₂ Y

 

b) The increase in prices will make domestic goods relatively more expensive and therefore less competitive thus producing a decrease in the level of the economy’s exports and an increase in its imports.

c) The increase in output we identified above will have absolutely no effect on the economy’s exports, as they depend exclusively on the income of the rest of the world and the correlation between domestic and international prices. Imports, however, are directly related to income, so that the result of the increase in output will be to increase the economy’s imports.

d) On the one hand, with increased imports, the supply of dollars in the foreign exchange market will go up. On the other hand, the fall in exports will reduce the demand for dollars. Altogether this will bring the international value of the domestic currency down, i.e. the dollar will depreciate:

E S₁

S₂

E₁

 

E₂ D₁

D₂

Quantity of dollars

 

Problem 5 (APT’98, P3)

 

In country X, labor productivity is growing at 3.2 percent per year, and the nominal wage is constant.

(i) Discuss the impact of this rate of growth in productivity on each of the following.

(i) The price level

(ii) Real wage rate

(ii) Now, the rate of growth of labor productivity in country X falls to 2.0 percent per year, while the rate of growth of labor productivity in other countries remains constant and higher that in Country X. Discuss the consequences of Country X’s decline in relative productivity on each of the following.

(a) Exports of Country X

(b) The international value of Country X’s currency

(c) Employment in Country X in the short run

Sample answer:

 

a) (i) The fact that labor productivity is growing means that firms can produce a greater output using the same amount of inputs. Thus at each given price level firms will expand their production which corresponds to a rightward shift in the aggregate supply curve and, as the graph below illustrates, will result in lower prices.

 

P AS₁

AS₂

P₁

P₂

AD

Y

(ii) With the nominal wage rate fixed and prices falling the real wage rate which is the ratio of the two (w^r=w/p) will certainly increase, indicating that workers are now able to buy more goods with the money they are paid.

b) (i) Since productivity of labor in Country X is growing slower than in other countries, it takes increasingly more labor to produce goods in Country X compared to the rest of the world. This, in turn, implies that goods manufactured in Country X are becoming relatively more expensive and therefore less competitive than those produced abroad. Consequently, the demand for domestic goods by foreigners will decline leading to a fall in the country’s exports. Conversely, the demand for foreign goods by the residents of Country X will grow causing imports to rise.

(ii) With decreased exports the demand for Country X’s currency, which is used to pay for the exported goods, will go down. Coupled with an increase in imports and a corresponding rise in the supply of the domestic currency, this will result in the depreciation of Country X’s currency, unless, of course, the Central Bank is committed to a fixed exchange rate.

(iii) Even though the negative effect on the trade balance of the slow-down in productivity growth will be partially offset by decreased value of the domestic currency, the total impact on the aggregate demand will be negative and the AD curve will shift to the left. However, since productivity of workers is still rising, the AS curve will shift to the right, so that the ultimate effect on output and employment is indeterminate: they may either increase or decrease, depending on which of the effects predominates (see the following graph):

P AS₁

A AS₂

 

 

B point B may lie either to the left or to the

AD₁ right of A, depending on which curve

AD₂ shifts further.

Y

 

Problem 6 (APT'2000, P2)

Assume that the United States and France are the only two countries in the world and that exchange rates between the two countries are flexible.

 

Price of a dollar

in terms of franks

 

Supply

 

Demand

Quantity of dollars

 

(i) Assume that there is an increase in the United States demand for French goods. Explain how this increase in demand will affect each of the following.

(i) The supply of dollars

(ii) The international value of the dollar

 

(ii) Assume that there is an increase in real interest rates in the United States, but not in France. Explain how this increase in interest rates will affect each of the following.

(a) The international value of the dollar in the foreign exchange market

(b) The quantity of dollars supplied in the foreign exchange market

 

Sample answer:

 

(b) i) With increased demand for French goods, Americans will need more francs to pay for the imports. To get these francs, however, Americans will have to sell their dollars. As a result, the supply of dollars goes up:

 

$/franc S₁

S₂

E₁

E₂

D

Quantity of dollars

 

ii) As the above graph shows, the increase in the demand for French goods will produce a depreciation of the domestic currency (the international value of the dollar decreases).

(c) i) With no restrictions on the capital movements, higher interest rates in the United States will attract capital from abroad. However, foreigners, wanting to invest their money in this country, will have to transfer francs into dollars, so that the demand for dollars will increase causing appreciation of the United States currency:

$/francs

S

E₂

E₁

D₂

D₁

Q₁ Q₂ Quantity of dollars

 

ii) As one can see from the above diagram, the increase in real interest rates in the United States will increase the quantity of dollars supplied (from Q₁ to Q₂).

 

Problem 7 (APT’2001, P2)

 

A movement toward a unified monetary policy within the European Union has led to an increase in real interest rates in member countries, but not in the United States. Explain how this increase in real interest rates will affect each of the following.

 

a. Purchases of United States financial assets by foreigners

b. The international value of the United States dollar

c. United States exports

d. United States imports