Chapter 10
Foreign Exchange
Conceptual and Analytical Problems
1. If the U.S. dollar-British pound exchange rate is $1.50 per pound, and the U.S.
dollar-euro rate is $0.90 per euro: (LO1)
b. How could you profit if the pound-per-euro rate were above the rate you
calculated in part a? What if it were lower?
Answer:
 euro
pound 90.0$
50.1$
b. If the pound per euro rate were above £0.6/€, you could profit by converting
dollars to euros, euros to pounds, and then pounds to dollars. For example, if the
If the pound per euro rate were below £0.6/€, you could make a profit by
converting dollars to pounds, pounds to euros, and then euros to dollars.
2. If a computer game costs $30 in the United States and £26 in United Kingdom, what
do you conclude? (LO1)
Answer: As of November 23, 2016, the dollar-pound exchange rate was $1.2432 per
pound. The real computer game exchange rate is $30/(£26 × 1.2432) = 0.93. This is
computer game for 0.93 of a U.K. computer game.
3. Suppose the euro-dollar exchange rate moves from $0.90 per euro to $0.92 per euro.
At the same time, the prices of European-made goods and services rise 1 percent,
and 1 percent in the United States? (LO2)
Answer: In the first case there is (approximately) no change in the real exchange rate
exchange rate is:
Dollar price of U . S . goods
Euro price of European goods∗( $
€)
So, we would have 100 / (100 × 0.90) = 1.11 as the real exchange rate at the initial
exchange rate. If prices in the U.S. rise by 3 percent and those in Europe by 2 percent
rate has risen by 4 percent.
4. The same television set costs $500 in the United States, €450 in France, £300 in the
euro-dollar, pound-dollar, and yen-dollar exchange rates? Why might the law of one
price fail? (LO1)
Answer: If the law of one price holds, then the euro/dollar exchange rate should be
5. *What does the theory of purchasing power parity predict in the long run regarding
the inflation rate of a country that fixes its exchange rate to the U.S. dollar? (LO2)
Answer: According to the theory of purchasing power parity, changes in exchange
inflation rate in that country should be the same as the U.S. rate of inflation in the
long run.
6. *Can purchasing power parity help predict short-term movements in exchange rates?
(LO2)
Answer: Purchasing power parity doesn’t hold on a day-to-day basis – or even on a
determined by a host of factors affecting supply and demand for currencies and are
effectively unpredictable.
7. You need to purchase Japanese yen and have called two brokers to get quotes. The
you give your business? Why? (LO1)
Answer: An exchange rate of 0.0084 dollars per yen is equivalent to 119 yen per
8. During the 1990s, the U.S. Secretary of the Treasury often stated, “a strong dollar is
in the interest of the United States.” (LO4)
a. Is this statement true? Explain your answer.
b. What can the Secretary of the Treasury actually do about the value of the dollar
relative to other currencies?
Answer:
a. When the dollar is strong, foreign goods are relatively cheap for consumers in the
United States. This helps keep inflation in check. A strong dollar also attracts
not much exchange rate risk.
b. Without the cooperation of the Federal Reserve, the Secretary of the Treasury
influences investors’ demand for and supply of dollars.
9. The following table gives selective data on nominal exchange rates, price levels, and
dollar (A$) as its currency. Fill in the blanks in the table. (LO1)
Nominal
Exchange Rate
(A$ per unit of
other currency)
Price Level in
Country A
Price Level in
Other Country
Real
Exchange
Rate
Country
D
$0.55 per unit
of currency D 114.5 0.80
Answer:
Nominal Exchange
Rate (A$ per unit of
other currency)
Price Level
in Country
A
Price Level in
Other Country
Real
Exchange
Rate
Country
$1.25 per unit of
D
= 260.23 0.80
10. If the price (measured in a common currency) of a particular basket of goods is 10
percent higher in the U.K. than it is in the United States, which country’s currency is
undervalued, according to the theory of purchasing power parity? (LO2)
Answer: According to the theory of purchasing power parity, the real exchange rate
goods would fall, bringing the real exchange rate back towards 1.
11. *You hear an interview with a well-known economist who states that she expects the
U.S. dollar to strengthen against the British pound over the next five to ten years.
average compared with that in the U.K. over the period in question. (LO2)
Answer: The economist’s comments were about exchange rate movements in the long
We can represent this idea by the equation:
If the dollar is expected to strengthen, this means it takes fewer dollars to purchase a
pound, so the change in the exchange rate is negative. Therefore, inflation in the
United States is expected to be lower than in the U.K.
12. Using the model of demand and supply for U.S. dollars, what would you expect to
Answer: If Americans view foreign bonds as more risky than before, they will reduce
reflecting an appreciation of the U.S. dollar.
Quantity of dollars traded
E0
S0
D0
S1
E1
would be on the Chinese yuan- U.S. dollar exchange rate of a decision by China to
allow its currency to float freely. (LO3)
Answer: Suppose initially that the Chinese central bank had maintained the exchange
rate at E0 in the diagram below. If the Chinese central bank then stopped purchasing
depreciate.
14. Consider again the situation described in Problem 13 where China decided to allow
its currency (the renminbi) to float. What would you expect to happen to
Explain your answers. (LO4)
Answer: If the yuan is undervalued and is allowed to float freely, market forces will
cause the yuan to appreciate. Thus,
a. U.S. exports to China should increase. The appreciation of the yuan would make
b. U.S. imports from China should fall. The appreciation of the yuan would make
c. The trade deficit measures the excess of imports from China over exports to
15. Suppose that, driven by waves of national pride, consumers across the world
can you say about the impact on the equilibrium dollar exchange rate? (LO3)
Answer:
A fall in foreign demand for U.S. goods would shift the demand curve for dollars to
the left while the fall in U.S. demand for foreign goods would shift the supply curve
depreciation of the dollar.
Quantity of dollars traded
E
0
S
0
D
0
E
1
D
1
S
1
16. Suppose an Italian bank has short-term borrowings of 400 million euro and 100
million U.S. dollars and made long term loans of 300 million euro and 250 million
side of the bank’s balance sheet.
b. List the risks that this bank faces.
c. If the euro-dollar exchange rate moved to $1.60 per euro, would the bank
Answer:
a. In addition to other assets and liabilities, the items appear on the balance sheet as:
b. In addition to the usual default risk, the bank faces both currency risk and
rollover risk arising from the currency and maturity mismatches between its
assets and liabilities. The gap between the bank’s lending and borrowing in
the bank cannot rollover its dollar borrowings, it would have to sell dollar loans or
borrow euro.
c. The bank has more dollar-denominated assets than dollar-denominated liabilities,
so when the dollar weakens (the euro strengthens), the bank loses. At the initial
re-computing the net value at the new exchange rate.