Exercises: Exchange rate determination (1)

True of false:

Supply of $ should always increase from the current account if exchange rate
rises from Rs.50 = $1 to Rs. 55 = $1.
 Free market for foreign exchange
Product market approach to exchange rate determination
And
source of instability in foreign exchange market
Exchange rate :
Influence of the goods market
e
Demand for $s:
Consider a rise in e from 40 to 50
Say the country imports 1 good m
Import price = $ Pm = $5
50
As e rises fro 40 to 50, import price
rises from Rs.200 to Rs250 40
As a result, quantity of imports should
fall
Import bill in $ falls when e rises from
40 to 50
$
The import bill (in Rupees) falls if
demand elasticity of import is high.
Supply for $s: e
Consider a rise in e from 40 to 50
Say the country exports 1 good x
Import price = Rs. Px = Rs. 400
As e rises fro 40 to 50, export price
falls from $10 to $8 50
As a result, quantity of exports should 40
rise from Q1 to Q2
Supply of $ (expressed in Rupee) rises
from 400.Q1 to 400.Q2

The export revenue (expressed in $) $

rises if demand elasticity of export is
high.
- Supply for $ rises if demand elasticity
of exports is high
 In a flexible exchange rate regime
e
e = e*
D($) S($)
Excess supply of $ at e = e* is 0

e*
In a completely flexible exchange
rate regime BOP is always 0

$
 Foreign exchange market
e
D($) equilibrium?
S($)

Should equilibrium settle at e*?

e*

$
Reading

Slides
From the Reading Matrial on Module 3 Introduction to Exchange Rates
and the Foreign Exchange Market- page 25- 33
How do we know if a currency has depreciated or appreciated against all
relevant currencies?

Through the movements of Effective exchange rate

% change in effective exchange rate
= E (effective)/ E (effective)
= (E1/E1).(T1/T) + (E2/E2).(T2/T) + . + (En/En).(Tn/T)

Where
n = number of countries this country has trade relations with
Ei = exchange rate of country i
Ti = Trade value with country i
T = Total trade value
 International payments process

US buyer imports a TV (worth $1 = 700 Won

$600) from Korea

US TV Korean Korean buyer imports a computer

importer exporter (worth $1200) from US
Bank debits
$ 600 from
Won 420,000
importers Computer
Korean US
account
importer exporter
Korean Bank debits
US Bank
Won 420,000 Bank Won 84,0000
from $1200
importers
account
Korean
US Bank
Bank $1200
 Korean Korean
US Bank US Bank
Won Bank Bank $1200 or
420,000 or Won
$600 840,000

Won 420,000

Korean US
Korean
Central Central US Bank
Bank
Won 420,000 Bank Bank $600
BOP deficit BOP surplus

Only the balance is transferred between Central Banks.

This transaction should raise the value of $ vis--vis Won.