Information sources: Lecture notes and reading materials from Week 10: Mishkin Chapter 18 and

Kent 2022

Provide answers to the following questions.

1.   A German sports car is selling for €65,000. What is the dollar price in the United States for the German car if the exchange rate is 0.80 euros per dollar?

65,000 euros × ($1/0.80 euros) = $81,250.

2.    “A country is always worse off when its currency is weak (falls in value).” Is this statement true, false, or uncertain? Explain your answer.

False. Although a weak currency has the negative effect of making it more expensive to buy      foreign goods or to travel abroad, it may help domestic industry. Domestic goods become         cheaper relative to foreign goods, and the demand for domestically produced goods increases. The resulting higher sales of domestic products may lead to higher employment, a beneficial    effect on the economy.

3.    If nominal interest rates in Australia rise but real interest rates fall, predict what will happen to the AUD dollar exchange rate.

The AUD dollar will depreciate. A rise in nominal interest rates but a decline in the real rate          implies a rise in expected inflation that produces an expected depreciation of the dollar that is   larger than the increase in the domestic interest rate. As a result, the expected return on dollar    assets falls at any exchange rate, shifting the demand curve to the left and leading to a fall in the exchange rate.

4.    Explain why as a country becomes more productive relative to other countries, its currency appreciates in the long-run.

When productivity in a country rises, it tends to rise in domestic sectors that produce traded      goods rather than nontraded goods. Higher productivity, therefore, is associated with a decline in the price of domestically produced traded goods relative to foreign traded goods. As a result, the demand for domestic traded goods rises, and the domestic currency tends to appreciate. If, however, a country’s productivity lags behind that of other countries, its traded goods become relatively more expensive, and the currency tends to depreciate. In the long run, as a country    becomes more productive relative to other countries, its currency appreciates.

5.   The Australian dollar (AUD) to U.S. dollar (USD) exchange rate is 1.49, and the British pound    (GBP) to U.S. dollar exchange rate is 0.65. If you find that the British pound to the Australian   dollar is trading at 0.5, what would be a riskless profit strategy per Australian dollar invested?

Complete the following transactions simultaneously:

i.     Exchange AUD 1.00 into £0.5 British pounds

ii.    Exchange £0.5 British pounds into USD $0.77 = 0.5/0.65

iii.   Exchange USD $0.77 into AUD 1.15 = 0.77 x 1.49 This yields a riskless $0.15 per AUD dollar invested.

6.    Following up on the question above, given the exchange rates between the AUD to the USD and between the GBP to the USD, find the exchange rate between the AUD to the GBP for   which there are no riskless profitable opportunities.

Given that AUD to USD is 1.49 (meaning you need 1.49 AUD to get 1 USD) and BGP to USD is      0.65, then these two exchange rates imply that BGP to AUD should be 0.436 for there to be no  riskless profitable exchanges. To see this consider using 1 AUD to purchase 0.6711 USD = 1 /      1.49. Next, use 0.6711 USD to purchase British pounds by 0.436 GBP = 0.6711 x 0.65. If the         exchange rate BGP to AUD is 0.436 (meaning you need 0.436 GBP to get 1 AUD), then using       0.436 GBP to purchase AUD obtains 1 AUD = 0.436 / 0.436. So in this case we start with 1 AUD  and end up with 1 AUD. In practice, of course, there is a BID/ASK spread (i.e transactions costs), so if you were to do this you would end up with a bit less than 1 AUD.

7.    Explain why changes in the expected future value of the exchange rate, Et(e)"1, shifts the current

demand for domestic assets and changes the current value of the exchange rate. Use a diagram to illustrate.

Expectations about the future value of the exchange rate play an important role in shifting the   current demand curve because the demand for domestic assets, like that for any physical or        financial asset, depends on the future resale price. Given the current exchange rate , any factor  that causes the expected future exchange rate  to rise increases the expected appreciation of     the Australian dollar. The result is a higher relative expected return on Australian dollar assets,   which increases the demand for Australian dollar assets at every exchange rate, thereby shifting the demand curve to the right as shown in the figure below. The equilibrium exchange rate rises to point 2 at the intersection of the D' and S curves. A rise in the expected future exchange rate shifts the demand curve to the right and causes an appreciation of the domestic currency.           According to the same reasoning, a fall in the expected future exchange rate  shifts the demand curve to the left and causes a depreciation of the currency.

8.   Assume the domestic price level measured in domestic currency is P = 112, the foreign price   level measured in foreign currency is P* = 29 and 1 unit of the foreign currency buys 3 units of the domestic currency. a) Calculate the real exchange rate. b) Calculate the value of the nominal exchange rate for which purchasing power parity (PPP) holds.

a)   The real exchange rate, rer, in Mishkin’s book is defined as the ratio of the domestic price level, P, to the foreign price level, P*. That is

rer =

Where E is the nominal exchange rate (as in the Mishkin’s book) expressed as the number of foreign currency needed to obtain one unit of domestic currency. With the numbers               provided, we have that E = 1/3. So

rer =  =  = 1.29

A real exchange rate above 1 indicates that it is more expensive to buy the basket of goods at home than it is abroad. In other words, a real exchange rate above 1 tells us

that the domestic currency is high relative to foreign currency.

b)   For PPP to hold the nominal exchange rate must be such that the basket of goods costs the same in both countries. In other words, when we expressed the foreign price level in             domestic currency, we must find that this is exactly the same as the domestic price level. So to find the value of the nominal exchange rate that achieves PPP we can solve for E in the    equation below

EP = P ∗

Which given the numbers provided is

E  × 112 = 29

or

E =   = 0.26

so for PPP to hold the domestic exchange rate must fall (i.e. the domestic currency must depreciate). Finally notice that when PPP holds the real exchange is equal to 1.

9.    From you reading of Kent 2022, what has characterized the recent dynamics between the US dollar, the Australian dollar and Australian inflation?

The US dollar has appreciated over 2022 consistent with the sharp increases in US interest rates relative to Australia. As of April 2023, the Federal Funds rate is currently at 5%, while the cash     rate in Australia is at 3.6%. The depreciation of currencies against the US dollar adds pressure to inflation via a rise in the prices of imports. But that’s not the end of the story, Kent 2022 makes   two other points. A) higher interest rates in the United States will help slow down the growth of US demand. The US economy accounts for about 25 per cent of the global economy, so an            easing in demand pressures in the United States will help to ease global demand. B) When most of the world’s currencies depreciate against the US dollar, households and firms in those               economies will not be as willing nor able to pay the same US dollar denominated prices for their imports. Hence, we could expect those prices to decline, or at least rise less rapidly, over time.    For emerging market economies, there is a sizeable pass-through of the depreciation of their       currencies against the US dollar to domestic inflationary pressures because these economies       have a larger share of tradable goods in their consumption baskets compared with advanced       economies. Also, inflation tends to be less well anchored in these economies. Some economies – including emerging – have experienced broad-based exchange rate depreciations. So those           economies will tend to experience more notable increases in their import prices as a result. This is in contrast to economies whose currency depreciations have been more narrowly based. The    Australian dollar is in that latter camp. While it has depreciated significantly against the US dollar – falling by 14 per cent in 2022 – in trade-weighted terms, the Australian dollar has depreciated  by only 2 per cent over the same period. So while the exchange rate can play an important role   in inflation outcomes, Kent argues that the recent depreciation of Australia’s nominal trade-         weighted exchange rate over the year to date is expected to contribute only a modest amount    to increasing the level of consumer prices over the period ahead.