CHAPTER 2: THE DETERMINATION OF EXCHANGE RATES
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CHAPTER 2
THE DETERMINATION OF EXCHANGE RATES
This chapter explains what an exchange rate is and how it is determined in a freely floating exchange rate
regime, that is, in the absence of government intervention. This is done using a simple two-country
model. Because of its pervasiveness, we also examine the different forms and consequences of central
bank intervention in the foreign exchange markets. Since an exchange rate can be considered as the
relative price of two financial assets, the chapter discusses the asset market model of currencies and the
role of expectations in exchange rate determination. A separate section discusses the real changes in a
nation’s economy that cause exchange rate changes.
KEY POINTS
1. Absent government intervention, exchange rates respond to the forces of supply and demand, which
in turn depend on relative inflation rates, interest rates, and GNP growth rates.
2. Monetary policy is crucial. If the central bank expands the money supply at a faster rate than money
3. The healthier the economy is, the stronger the currency is likely to be.
5. To achieve certain economic or political objectives, governments often intervene in the currency
markets to affect the exchange rate. Although the mechanics of such intervention vary, the general
6. A critical factor that helps explain the volatility of exchange rates is that, with fiat money, there is no
anchor to a currency’s value, nothing around which beliefs can coalesce. Since people are unsure
INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.
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SUGGESTED ANSWERS TO “ASIAN CURRENCIES SINK IN 1997”
1. What were the origins of the Asian currency crisis?
ANSWER. The case suggests several causes of the Asian currency crisis. First was the loss of export
competitiveness. A number of Asian countries had tied their currencies to the dollar, so the dramatic
2. What role did expectations play in the Asian currency crisis?
ANSWER. Expectations were critical in causing the financial bubble and then popping it. Specifically, the
Asian financial bubble persisted as long as people believed the government could honor its implicit
3. How did the appreciation of the U.S. dollar and depreciation of the yuan affect the timing and
magnitude of the Asian currency crisis?
ANSWER. Sooner or later, the moral hazard associated with implicit government guarantees of reckless
4. What is moral hazard and how did it help cause the Asian currency crisis?
ANSWER. As explained above, moral hazard is the tendency to incur risks that one is protected against.
The origin of the moral hazard faced by Asian countries was the implicit or explicit government guarantees
5. Why did so many East Asian companies and banks borrow dollars, yen, and Deutsche marks
instead of their local currencies to finance their operations? What risks were they exposing
themselves to?
ANSWER. East Asian banks and companies financed themselves with dollars, yen, and Deutsche marks –
SUGGESTED ANSWERS TO “THE U.S. DOLLAR SELLS OFF”
1. How did China and Japan manage to weaken their currencies against the dollar?
2. Why did the U.S. dollar and U.S. Treasury bonds fall in response to the G7 statement?
ANSWER. The G7 endorsed “flexibility” in exchange rates, a codeword widely regarded as an
3. What is the link between currency intervention and China and Japan buying U.S. Treasury
bonds?
4. What risks do China and Japan face from their currency intervention?
SUGGESTED ANSWERS TO “A YEN FOR YUAN”
1. Why is China trying to hold down the value of the yuan? What evidence suggests that China is
indeed pursing a weak currently policy?
ANSWER. China believes that it needs to export to keep people employed and provide jobs, as state
2. What benefits does China expect to realize from a weak currency policy?
3. Other things being equal, what would a 27.5% tariff cost American consumers annually on
$200 billion in imports from China?
4. Currently, imports from China account for about 10% of total U.S. imports. A 25% appreciation
of the yuan would be the equivalent of what percent dollar depreciation? How significant would
such a depreciation likely be in terms of stemming America’s appetite for foreign goods?
5. What policy tool is China using to maintain the yuan at an artificially low level? Are there any
potential problems with using this policy tool? What might China do to counter these problems?
ANSWER. China is keeping the yuan pegged to the dollar by issuing more yuan to buy up dollars. The
6. Does an undervalued yuan impose any cost on the Chinese economy? If so, what are they?
7. Suppose the Chinese government ceased its foreign exchange market intervention and the yuan
climbed to five to the dollar. What would be the percentage gain to the dollar investor?
8. Currently the yuan is not a convertible currency, meaning Chinese individuals cannot exchange
their yuan for dollars to invest abroad. Moreover, companies operating in China must convert
all their foreign exchange earnings into yuan. What would happen to the pressure on the yuan
to revalue if China relaxed these currency controls and restraints on capital outflows?
INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.
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SUGGESTED ANSWERS TO CHAPTER 2 QUESTIONS
1. Describe how these three typical transactions should affect present and future exchange rates.
1.a. Seagram imports a year’s supply of French champagne. Payment in euros is due immediately.
1.b. MCI sells a new stock issue to Alcatel, the French telecommunications company. Payment in
dollars is due immediately.
1.c. Korean Airlines buys five Boeing 747s. As part of the deal, Boeing arranges a loan to KAL for
the purchase amount from the U.S. Export-Import Bank. The loan is to be paid back over the
next seven years with a two-year grace period.
2. The maintenance of money’s value is said to depend on the monetary authorities. What might
the monetary authorities do to a currency that would cause its value to drop?
3. For each of the following six scenarios, say whether the value of the dollar will appreciate,
depreciate, or remain the same relative to the Japanese yen. Explain each answer. Assume that
exchange rates are free to vary and that other factors are held constant.
3.a. The growth rate of national income is higher in the United States than in Japan.
3.b. Inflation is higher in the U.S. than in Japan.
3.c. Prices in Japan and the United States are rising at the same rate.
3.d. Real interest rates are higher in the United States than in Japan.
3.e. The United States imposes new restrictions on the ability of foreigners to buy American
companies and real estate.
3.f. U.S. wages rise relative to Japanese wages, and American productivity falls behind Japanese
productivity.
ANSWER. Higher U.S. wages and declining relative productivity weaken the American economy and
4. The Fed adopts an easier monetary policy. How is this likely to affect the value of the dollar and
U.S. interest rates?
ANSWER. If the Fed switches to an easier monetary policy, the value of the dollar will drop as fears of
5. Comment on the following news from the Wall Street Journal (April 3, 2007, p. C12): “The dollar
was little changed against the euro and yen, but weakened versus the currencies of Australia
and the United Kingdom as investors mulled possible further rate increases in those countries.”
ANSWER. The increase in Australia and U.K. interest rates made assets in the two countries more
6. On November 28, 1990, Federal Reserve Chairman Alan Greenspan told the House Banking
Committee that despite possible benefits to the U.S. trade balance, “a weaker dollar also is a
cause for concern.” This statement departed from what appeared to be an attitude of benign
neglect by U.S. monetary officials toward the dollar’s depreciation. He also rejected the notion
that the Fed should aggressively ease monetary policy, as some Treasury officials had been
urging. At the same time, Mr. Greenspan didn’t mention foreign exchange market intervention
to support the dollar’s value.
6.a. What was the likely reaction of the foreign exchange market to Mr. Greenspan’s statements?
Explain.
6.b. Can Mr. Greenspan support the value of the U.S. dollar without intervening in the foreign
exchange market? If so, how?
7. Many Asian governments have attempted to promote their export competitiveness by holding
down the values of their currencies through foreign exchange market intervention.
7.a. What is the likely impact of this policy on Asian foreign exchange reserves? On Asian
inflation? On Asian export competitiveness? On Asian living standards?
ANSWER. To hold down the value of their currencies, Asian central banks must buy up foreign exchange
7.b. Some Asian countries have attempted to sterilize their foreign exchange market intervention
by selling bonds. What are the likely consequences of sterilization on interest rates? On
exchange rates in the longer term? On export competitiveness?
ANSWER. To sterilize the expanded domestic money supply resulting from the purchase of foreign
8. Hong Kong has a currency board that fixes the exchange rate between the U.S. and HK dollars.
8.a. What is the likely consequence of a large capital inflow for the rate of inflation in Hong
Kong? For the competitiveness of Hong Kong business? Explain.
8.b. Given a large capital inflow, what would happen to the value of the HK dollar if it were
allowed to float freely? What would be the effect on the competitiveness of Hong Kong
business? Explain.
8.c. Given a large capital inflow, will Hong Kong business be more or less competitive under a
currency board or with a freely floating currency? Explain.
ANSWER. In both instances, the HK dollar will rise in real terms. However, the ways in which the real
exchange rate change occurs will differ. With a currency board, the real exchange rate change will be
9. In 1994, an influx of drug money to Colombia coincided with a sharp increase in its export
earnings from coffee and oil.
9.a. What was the likely impact of these factors on the real value of the Colombian peso and the
competitiveness of Colombia’s legal exports? Explain.
9.b. In 1996, Colombia’s president, facing charges of involvement in his country’s drug cartel,
sought to boost his domestic popularity by pursing more expansionist monetary policies.
Standing in the way was Colombia’s independent central bank – Banco de la Republica. In
response, the president and his supporters discussed the possibility of returning central bank
control to the executive branch. Describe the likely economic consequences of ending Banco
de al Republica’s independence.
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ADDITIONAL CHAPTER 2 QUESTIONS AND ANSWERS
1. Suppose prices start rising in the U.S. relative to prices in Japan. What would we expect to see
happen to the dollar:yen exchange rate? Explain.
2. If a foreigner purchases a U.S. government security, what happens to the supply of and demand
for dollars?
3. In 1987, the British government cut taxes significantly, raising the after-tax return on
investments in Great Britain. What would be the likely consequence of this tax cut on the
equilibrium value of the British pound?
4. Some economists have argued that a lower government deficit could cause the dollar to drop by
reducing high real interest rates in the U.S. What does the asset view of exchange rates predict
will happen if the U.S. lowers its budget deficit? What is the evidence from countries such as
Mexico and Brazil?
ANSWER. The impact of a reduction in the budget deficit on the value of the dollar depends on how that
5. What is there about fiat money that makes its exchange rate especially volatile?
6. Comment on the following headlines in The Wall Street Journal:
6.a. “Sterling Drops Sharply Despite Good Health of British Economy: Oil Price Slump Is
Blamed” (January 17, 1985)
ANSWER. The value of the pound is very sensitive to the price of oil because England has large North Sea
6.b. “Dollar Surges as Coup in Soviet Union Revives Unit’s Appeal as a Safe Haven” (August 20,
1991)
ANSWER. With the reduction in world tension occasioned by the decline in Communism’s appeal in the
6.c. “Dollar Plummets on Soviet Coup Failure” (August 22, 1991)
6.d. “Dollar Falls Across the Board as Fed Cuts Discount Rate to 6.5% From 7%” (December 19,
1990)
ANSWER. There are two possible reasons for the fall in the dollar. One possibility is that the Fed’s cut in
6.e. “Canadian Dollar Likely to Fall Further On Recession and Constitutional Crisis” (September
28, 1992)
ANSWER. A Canadian recession combined with the perceived political risk associated with Canada’s
6.f. “Dollar Soars on U.S. and Iraqi Tension, Hints of Possible Lower German Rates” (Dec. 12,
1992)
ANSWER. The combination of the desire to hold more dollars because of political fears brought about by
6.g. “Inflation, Slow Growth Seen Spurring Latin America to Devaluate Currencies” (January 22,
1990)
7. Suppose a new Russian government makes threatening moves against Western Europe. How is
this threat likely to affect the dollar’s value? Why?
ANSWER. As investors in Western Europe become more nervous about their prospects, they will try to
8. On May 11, 1995, the House Budget Committee approved a plan to slash federal spending
through 2002 and thereby end the persistent U.S. budget deficits. How do you think the dollar
responded to this news?
9. Comment on the following statement: “One of the puzzling aspects of central bank intervention
is how those who manage our economic affairs think they know what is the ‘right’ price for a
dollar in terms of francs, pounds, yen, or Deutsche marks. And if they do know, why do they
keep changing their minds?”
ANSWER. Here’s one possible answer. Once President Nixon decided to abandon the gold standard, the
dollar became just a piece of paper backed by nothing more substantial than “the full faith and trust of the