POINT/COUNTER-POINT:
How Can Persistently Weak Currencies Be Stabilized?
POINT: The currencies of some Latin American countries depreciate against the U.S. dollar on a
consistent basis. The governments of these countries need to attract more capital flows by raising interest
rates and making their currencies more attractive. They also need to insure bank deposits so that foreign
investors who invest in large bank deposits do not need to worry about default risk. In addition, they could
impose capital restrictions on local investors to prevent capital outflows.
COUNTER-POINT: Some Latin American countries have had high inflation, which encourages local firms
and consumers to purchase products from the U.S. instead. Thus, these countries could relieve the
downward pressure on their local currencies by reducing inflation. To reduce inflation, a country may have
to reduce economic growth temporarily. These countries should not raise their interest rates in order to
attract foreign investment, because they will still not attract funds if investors fear that there will be large
capital outflows upon the first threat of continued depreciation.
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support?
Offer your own opinion on this issue.
1. Percentage Depreciation. Assume the spot rate of the British pound is $1.73. The expected spot rate
one year from now is assumed to be $1.66. What percentage depreciation does this reflect?
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?
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?
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.
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Exchange Rate Determination 2
demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the
Canadian dollar?
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?
6. Effects of Real Interest Rates. What is the expected relationship between the relative real interest
rates of two countries and the exchange rate of their currencies?
7. Speculative Effects on Exchange Rates. Explain why a public forecast by a respected economist
about future interest rates could affect the value of the dollar today. Why do some forecasts by
well-respected economists have no impact on today’s value of the dollar?
8. Factors Affecting Exchange Rates. What factors affect the future movements in the value of the euro
against the dollar?
9. Interaction of Exchange Rates. Assume that there are substantial capital flows among Canada, the
U.S., and Japan. If interest rates in Canada decline to a level below the U.S. interest rate, and
inflationary expectations remain unchanged, how could this affect the value of the Canadian dollar
against the U.S. dollar? How might this decline in Canada’s interest rates possibly affect the value of
the Canadian dollar against the Japanese yen?
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Exchange Rate Determination 3
10. Trade Deficit Effects on Exchange Rates. Every month, the U.S. trade deficit figures are announced.
Foreign exchange traders often react to this announcement and even attempt to forecast the figures
before they are announced.
a. Why do you think the trade deficit announcement sometimes has such an impact on foreign
exchange trading?
b. In some periods, foreign exchange traders do not respond to a trade deficit announcement, even
when the announced deficit is very large. Offer an explanation for such a lack of response.
11. Comovements of Exchange Rates. Explain why the value of the British pound against the dollar will
not always move in tandem with the value of the euro against the dollar.
12. Factors Affecting Exchange Rates. In some periods, Brazil’s inflation rate was very high. Explain
why this places pressure on the Brazilian currency (called the Brazilian real).
13. National Income Effects. Analysts commonly attribute the appreciation of a currency to expectations
that economic conditions will strengthen. Yet, this chapter suggests that when other factors are held
constant, increased national income could increase imports and cause the local currency to weaken. In
reality, other factors are not constant. What other factor is likely to be affected by increased economic
growth and could place upward pressure on the value of the local currency?
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Exchange Rate Determination 4
14. Factors Affecting Exchange Rates. If Asian countries experience a decline in economic growth (and
experience a decline in inflation and interest rates as a result), how will their currency values (relative
to the U.S. dollar) be affected?
15. Impact of Crises. Why do you think most crises in countries (such as the Asian crisis) cause the local
currency to weaken abruptly? Is it because of trade or capital flows?
16. Economic Impact on Capital Flows. How do you think the weaker U.S. economic conditions could
affect capital flows? If capital flows are affected, how would this influence the value of the dollar
(holding other factors constant)?
Advanced Questions
17. Measuring Effects on Exchange Rates. Tarheel Co. plans to determine how changes in U.S. and
Mexican real interest rates will affect the value of the U.S. dollar. (See Appendix C for the basics of
regression analysis.)
a. Describe a regression model that could be used to achieve this purpose. Also explain the expected
sign of the regression coefficient.
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Exchange Rate Determination 5
b. If Tarheel Co. thinks that the existence of a quota in particular historical periods may have affected
exchange rates, how might this be accounted for in the regression model?
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.
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
securities. Why do you think U.S. investors do not try to capitalize on the high interest rates in
Mexico?
c. Why do you think the bid/ask spread is higher for pesos than for currencies of industrialized
countries? How does this affect a U.S. firm that does substantial business in Mexico?
19. Aggregate Effects on Exchange Rates. Assume that the United States invests heavily in government
and corporate securities of Country K. In addition, residents of Country K invest heavily in the United
States. Approximately $10 billion worth of investment transactions occur between these two countries
each year. The total dollar value of trade transactions per year is about $8 million. This information is
expected to also hold in the future.
Because your firm exports goods to Country K, your job as international cash manager requires you to
forecast the value of Country K’s currency (the “krank”) with respect to the dollar. Explain how each
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Exchange Rate Determination 6
of the following conditions will affect the value of the krank, holding other things equal. Then,
aggregate all of these impacts to develop an overall forecast of the krank’s movement against the dollar.
a. U.S. inflation has suddenly increased substantially, while Country K’s inflation remains low.
b. U.S. interest rates have increased substantially, while Country K’s interest rates remain low.
Investors of both countries are attracted to high interest rates.
c. The U.S. income level increased substantially, while Country K’s income level has remained
unchanged.
d. The U.S. is expected to impose a small tariff on goods imported from Country K.
e. Combine all expected impacts to develop an overall forecast.
20. Speculation. Blue Demon Bank expects that the Mexican peso will depreciate against the dollar from
its spot rate of $.15 to $.14 in 10 days. The following interbank lending and borrowing rates exist:
Lending Rate Borrowing Rate
U.S. dollar 8.0% 8.3%
Mexican peso 8.5% 8.7%
Assume that Blue Demon Bank has a borrowing capacity of either $10 million or 70 million peos in the
interbank market, depending on which currency it wants to borrow.
a. How could Blue Demon Bank attempt to capitalize on its expectations without using deposited
funds? Estimate the profits that could be generated from this strategy.
ANSWER: Blue Demon Bank can capitalize on its expectations about pesos (MXP) as follows:
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Exchange Rate Determination 7
ANSWER: Blue Demon Bank can capitalize on its expectations as follows:
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Exchange Rate Determination 8
21. Speculation. Diamond Bank expects that the Singapore dollar will depreciate against the dollar from
its spot rate of $.43 to $.42 in 60 days. The following interbank lending and borrowing rates exist:
Lending Rate Borrowing Rate
U.S. dollar 7.0% 7.2%
Singapore dollar 22.0% 24.0%
Diamond Bank considers borrowing 10 million Singapore dollars in the interbank market and investing
the funds in dollars for 60 days. Estimate the profits (or losses) that could be earned from this strategy.
Should Diamond Bank pursue this strategy?
ANSWER:
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