CHAPTER 36
(MACRO CHAPTER 21; MICRO CHAPTER 22)
Exchange Rates and Financial Links Between
Countries
FUNDAMENTAL QUESTIONS
1. How does a commodity standard fix exchange rates between countries?
2. What kinds of exchange-rate arrangements exist today?
3. How is equilibrium determined in the foreign exchange market?
OVERVIEW AND OBJECTIVES
The primary purpose of this chapter is to describe the various exchange-rate systems that have been
used throughout history and that are in use today, and how exchange rates provide a link between
prices and interest rates across countries.
After reading and reviewing this chapter, the student should be able to:
1. Discuss commodity standards and define the gold standard.
236 Chapter 36: Exchange Rates and Financial Links Between Countries
KEY TERM REVIEW
gold standard
gold exchange standard
reserve currency
International Monetary Fund (IMF)
World Bank
LECTURE OUTLINE AND TEACHING STRATEGIES
I. Past and Current Exchange-Rate Arrangements
A. The gold standard: The gold standard linked the value of a nation’s currency to the supply of
and the demand for gold.
Teaching Strategy: Understanding how a gold system works is critical for understanding
other fixed-exchange-rate systems.
B. The Bretton Woods system: In the Bretton Woods system, the dollar took the place of gold
II. Fixed or Floating Exchange Rates
Teaching Strategy: This material is often difficult for students (and instructors). Work through it
carefully.
A. Equilibrium in the foreign exchange market: The equilibrium quantity of foreign exchange
and the exchange rate are determined where the supply and demand curves for foreign
Chapter 36: Exchange Rates and Financial Links Between Countries 237
III. Prices and Exchange Rates
The price a foreign buyer must pay for goods is the result of the product price and the exchange
rate.
Teaching Strategy: Discuss exchange rates as the price of one currency in terms of another, and
ask your students to look at exchange rate equalities as the number of one country’s currency units
that are required to buy one unit of another country’s currency. Then, it is easy to see that a
IV. Interest Rates and Exchange Rates
A. The domestic currency return from foreign bonds: The domestic currency return from a
foreign bond is the foreign interest rate plus the percentage change in the exchange rate.
B. Interest rate parity: For bonds with similar risks and maturities, the interest rate differential
OPPORTUNITIES FOR DISCUSSION
1. Why did 44 countries agree to fix their currencies to the U.S. dollar under the Bretton Woods
agreement?
2. How did speculation lead to the breakdown of the Bretton Woods system?
ANSWERS TO EXERCISES
1. Because the U.S. dollar buys 1.25 times more gold than the Canadian dollar, the exchange rate
will be $1 U.S. = $1.25 Canadian.
238 Chapter 36: Exchange Rates and Financial Links Between Countries
3. The IMF was created to supervise the system of fixed exchange rates and to provide loans to
4.
5.
Chapter 36: Exchange Rates and Financial Links Between Countries 239
8. Exchange rates should change when there is a fundamental disequilibrium in the foreign exchange
9. You increased the supply of dollars to be exchanged for pesos, which would cause the dollar to
depreciate.
10. A currency appreciates (depreciates) when its price in terms of foreign currencies rises (falls). An
11. Buy a currency before it appreciates in value and then sell it for a profit after it appreciates.
12.
a. $.83
13.
a. $769,000
14.
a. $.769 × 1.10 × 1,000,000 = $845,900
15. According to purchasing power parity, if the same good is sold in more than one country, the price
16. P = EPF (P = domestic price level, E = units of domestic currency per unit of foreign currency,
PF = foreign price level). When domestic prices rise above foreign prices, the domestic currency
240 Chapter 36: Exchange Rates and Financial Links Between Countries
18. Recall the interest rate parity equation:
Domestic currency return = foreign interest rate + expected change in the exchange rate.
19. Because Italian prices rose eight times more than U.S. prices, the dollar should have appreciated
ANSWERS TO STUDY GUIDE HOMEWORK
1. Purchasing power parity (PPP).
2. Floating exchange rates.
5.
a. Demand for dollars increases, dollar appreciates
ACTIVE LEARNING EXERCISE
This exercise will prepare students for testing by requiring that they develop, through teamwork,
multiple-choice questions relative to the chapter. By developing incorrect as well as correct solutions,
students will further their understanding of a subject that appears to be quite difficult for most.
Divide the class into groups of four. Ask each group to write a multiple-choice question based on