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Foreign Exchange Markets
1. Suppose it takes $1.05 to buy one euro. What is the nominal exchange rate for the
euro countries against the U.S. dollar? What is the nominal exchange rate for the
U.S. dollar against the euro?
ANSWER: When studying the exchange rate for the euro countries, the U.S. dollar
is treated as the foreign currency and the exchange rate is expressed as foreign cur-
2. Recall from Section 6.1 that most currency trades involve the U.S. dollar. How
would William Stanley Jevons explain this fact? (Hint: We met Jevons in Section 2.1.)
ANSWER: William Stanley Jevons coined the phrase “double coincidence of wants”
in order to explain why people use money instead of relying on barter. Recall from
Chapter 2 that the use of money allows more trades to take place. Money eliminates
3. Suppose the U.S. dollar appreciates for a period of time and then returns to its ini-
tial level. Compare a 10 percent appreciation that lasts for 2 years and a 50 percent
appreciation that lasts 6 months.
a. Which of these events hurts U.S. exporters more? Explain.
ANSWER: A dollar appreciation makes U.S. goods more expensive to people abroad.
The 2-year appreciation of 10 percent will increase the foreign currency price of the
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b. How would the answer be different if currency futures did not exist?
ANSWER: If those futures did not exist, then the 6-month appreciation of 50 percent
4. On July 15, 2002, a CNN headline reported, “Euro tops dollar.” The value of a euro
had risen from slightly below $1.00 to slightly above $1.00. Discuss the importance
of this event.
ANSWER: The increase of the value of the euro represents a euro appreciation and,
conversely, a dollar depreciation. The euro became stronger and the dollar became
5. Suppose it takes $1.05 to buy 1 euro, the U.S. price level is 120, and the European
price level is 125.
a. Calculate the real exchange rate for the U.S. against the euro.
ANSWER: When calculating the U.S. real exchange rate against the euro, the nom-
inal exchange rate eis defined as euro per dollar. The appropriate nominal exchange
b. Suppose the U.S. price level rises to 130. Calculate the real exchange rate
again and explain why it has risen or fallen.
ANSWER: The expression eP captures the price of U.S. goods in euros and P* meas-
ures the price of European goods in euros. The U.S. real exchange rate against the
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6. Section 6.2 defined the U.S. real exchange rate against the euro as the price of
American goods divided by the price of European goods. We measured both prices
in euros. Suppose we measured both prices in dollars instead of euros. Would this
change the definition of the real exchange rate? Explain.
ANSWER: Pmeasures the price of U.S. goods in dollars. The price of European
goods measured in dollars is given as (1/e)P*. Since edenotes the units of euros per
dollar, the inverse (1/e) measures the units of U.S. dollars needed to purchase one
7. For decades, one British pound has been worth more than one U.S. dollar. One
Japanese yen has been worth less than 0.01 U.S. dollar (1 cent). So a pound is more
than 100 times as valuable as a yen. Does this difference matter for the British and
Japanese economies? Explain.
ANSWER: The level of nominal exchange rates does not matter for economies. Nom-
inal exchange rates are a way to convert from one unit—for example, pounds—into
another unit—for example, dollars. Whether this conversion happens at a rate of 1:1
8. Suppose that, at a certain real exchange rate, a country’s net exports exceed its
net capital outflows. Is the equilibrium exchange rate higher or lower than this level?
Explain both in words and with a graph.
ANSWER: As in Figure 6.6, the real exchange rate ε* is the equilibrium exchange rate
9. Suppose country A sends most of its exports to country B. It gets most of its im-
ports from country C. If A’s currency appreciates against B’s currency and depreciates
against C’s, what happens to A’s imports, exports, and net exports?
ANSWER: If A’s currency appreciates against B’s currency and A sends most of its
exports to country B, then we expect country A’s exports to drop. If A’s currency de-
10. Using graphs, show how each of the following events affects a country’s net cap-
ital outflows, net exports, and equilibrium real exchange rate.
a. A rise in foreign interest rates.
ANSWER: A rise in the foreign interest rate means that capital outflows increase as
b. A fad for buying foreign goods.
ANSWER: A fad for buying foreign goods will increase imports for a given exchange
rate. This implies lower net exports for all exchange-rate levels. Graphically, this can
c. An announcement that a tax cut will occur in the future.
ANSWER: The basic principle is that changes in the future expected exchange rate
will affect the current exchange rate in the same direction. One possible scenario is
that people will expect imports to increase once the tax cut occurs. Higher domestic
demand translates into higher demand for import goods as well. So the expectation
d. Rising ethnic tensions that threaten to cause a civil war.
ANSWER: This scenario will likely cause a drop in confidence, which prompts a cap-
11. Suppose a country’s central bank wants to keep the real exchange rate constant.
What should it do to the real interest rate if foreign economies enter recessions? Ex-
plain your answer with a graph.
ANSWER: If foreign economies enter recessions, then exports to these economies
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12. Events in South Africa between 2000 and 2010 included the following:
a. At the start of the decade, a corruption scandal hurt the government’s reputa-
tion, and the AIDS epidemic intensified.
b. From 2002 to 2005, the government budget deficit and the inflation rate both
fell.
c. In 2007–2008, a shortage of electricity forced some of South Africa’s mines to
shut down.
d. In 2009, the world prices of metals mined in South Africa rose rapidly.
According to the theories in this chapter, how should each of these events have af-
fected South Africa’s exchange rate? Are these predictions confirmed by the data in
Figure 6.1? Explain.
ANSWER: The data in Figure 6.1 refers to the nominal exchange rate of dollars per
rand e. The theory developed in the textbook focuses on the determination of the real
exchange rate ε. Equation 6.5 rearranges the expression of the real exchange rate ε
and yields the following expression for the nominal exchange rate e= ε(P*/P). This
equation implies that real and nominal exchange rates move in the same direction as
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13. Suppose the U.S. real exchange rate against the British pound rises by 6 percent
from one year to the next. U.S. inflation is 2 percent and British inflation is 3 percent.
What is the change in the nominal exchange rate?
ANSWER: The U.S. real exchange rate against the British pound is ε= eP/P*, where
e is defined as pounds per dollar, Pis the price level in the United States, and P* is
the price level in the United Kingdom. Rewriting this definition in terms of percentage
changes,
14. We discussed three techniques for speculating on exchange rates: economic
analysis, monitoring of order flows, and technical analysis. Assume a key part of the
efficient markets hypothesis (EMH): It is impossible to predict exchange-rate move-
ments based on any publicly available information. Under this assumption, could any
of the three techniques succeed? Explain.
ANSWER: Economic analysis relies on using changes in economic variables such as
interest rates in order to predict changes in exchange rates. Since economic vari-
According to the EMH, the monitoring of order flows may be successful in forecast-
Technical analysis relies on publicly available past patterns of exchange rates and the
identification of support and resistance levels. Based on the EMH, technical analysis
In summary, the two forecasting methods that rely on public information should not
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ONLINE AND DATA QUESTIONS
www.worthpublishers.com/ball2
15. Compute the changes in the U.S. trade-weighted real exchange rate from 2008
to 2009 and from 2009 to 2010. Use data on exchange rates, price levels, and trade
shares from the text Web site. What economic forces might explain the changes in
the exchange rate?
ANSWER: The real trade-weighted exchange rate is calculated by multiplying the
percent of U.S. trade with a particular country by the real exchange rate between the
United States and this country and then by adding these components for all countries.
The formula for the real trade-weighted exchange rate is εT:
To be complete, the formula needs to include all countries that trade with the United
States. For this problem, calculate εTonly for the countries included in the data set
16. For 43 countries, Figure 6.5 plots the difference between a country’s inflation rate
and the U.S. inflation rate, and the percentage change in the U.S. exchange rate
against the country’s currency. The inflation rates and exchange-rate changes are
averages over 1980–2009. Redo the figure using inflation rates and exchange rate
changes in a single year, 2010. (Data are available at the text Web site.) How does
the figure change when it is based on a single year rather than 30 years? What ex-
plains the differences?
ANSWER: The data in Figure 6.5 describes a strong positive relationship between the
difference in inflation rates and the change in the U.S. nominal exchange rate against
that country. When a country has high inflation compared to the United States, the
nominal exchange rate efor that country will increase. More units of the foreign cur-
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17. Using data from the text Web site, compute the real exchange rate for the Russ-
ian ruble against the U.S. dollar from 1992 to 2009.
ANSWER: When studying the Russian ruble, we treat Russia as the home country
and the United States as the foreign country. The nominal exchange rate eis defined
as foreign currency units per unit of domestic currency. Here this means we define e
in units of dollar per ruble. Pis the CPI for Russia and P* is the CPI for the United
a. Do a bit of Internet research on Russia and try to explain the movements in the
real exchange rate.
ANSWER: In 1998 Russia underwent a currency crisis during which the ruble was de-
valued; also the government defaulted on domestic debt and stopped making pay-
b. Do movements in Russia’s real exchange rate explain most of the movements
in its nominal exchange rate? Explain.
ANSWER: No, the movement of the real exchange rate does not explain most of the
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