Post on 29-Jan-2016
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Assignment-1
Exchange Rate DeterminationChapter 4
F405: International
Finance
Submitted to:
Syeda Mahrufa Bashar
Assistant Professor
Submitted by:
Group 02
MD. Fahmin Rahman (ZR-15)
Adiba Islam (RH-20)
Bijoya Chakraborty (RH-22)
Nafisa Afsana Taskia (RH-37)
Imtiaz Farhan Bin Habib (ZR-61)
Sec A, BBA 20th
Submitted on:
September 19, 2015
Institute of Business Administration
University of Dhaka
QUESTION 28
WEIGHING FACTORS THAT AFFECT EXCHANGE RATES
Assume that the level of capital flows between the United States and the country of Zeus
is negligible (close to zero) and will continue to be negligible. There is a substantial
amount of trade between the United States and the country of Zeus. The main import by
the United States is basic clothing purchased by U.S retail stores from Zeus, while the
main import by Zeus is special computer chips that are only made in the United States and
are needed by many manufacturers in Zeus. Suddenly, the U.S. government decides to
impose a 20 percent tax on the clothing imports. The Zeus government immediately
retaliates by imposing a 20 percent tax on the computer chip imports. Second, the
Zeus government imposes a 60 percent tax on any interest income that would be earned
by Zeus investors if they buy U.S securities. Third, the Zeus central bank raises its local
interest rate so that they are now higher than interest rates in the United States. Do you
think the currency of Zeus (called the zee) will appreciate or depreciate against the dollar
as a result of all the government actions described above? Explain.
Answer:
Factors that may affect the value of Zee:
1. US Impose 20% Tax on Clothing Import
Import from Zeus by United States will increase the price of clothing. Hence the volume of
clothing exported by Zeus will decrease. This will cause the export earning of Zeus to fall. As
there will be less requirement of import from Zeus the demand for Zeus will decrease and
hence will the price for Zee. This will result in depreciation of Zee.
2. Zeus Imposing 20% Tax on computer chip imports
As the computer chips are essential for the manufacturers in Zeus and are only made by the
United States producers the demand for the chips is inelastic in nature. Hence imposition of
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tax on computer chips will not decrease the import of chips from United States to that
extent.
As there is equal percentage of tax imposed by both the governments the tax on clothing
will have more effects than the tax on chips. The overall effect will cause the value of Zee to
depreciate.
The figure shows that the quantity demanded for Zee will decrease causing a shift of
demand from Q to Q1. This will cause the price shift from P to P1.
However, the following factors will not have any effects on Zee:
1. 60 percent tax on any interest income.
2. Increase of relative interest rate in Zeus
This is because there is insignificant capital flow between these two countries and both the
above effects will impact the currencies only if there is a transaction of capital between
them.
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BLADES INC. CASE
ASSESSMENT OF FUTURE EXCHANGE RATE MOVEMENTS
Q1. How are percentage changes in a currency’s value measured? Illustrate your answer
numerically by assuming a change in the Thai baht’s value from a value of $0.22 to $0.26.
Answer:
Percentage changes in a currency’s value= (S-St-1))/St-1
In the above equation, denotes the current spot rate, and St-1 denotes the spot rate of the previous date using which the comparison will be done. A positive percentage change represents appreciation of the currency, while a negative percentage change represents
depreciation.
According to the question, the change in Thai baht would be:
= (0.026-0.022)/0.022
=+18.18%
Therefore, Thai baht is expected to appreciate by 18.18%.
Q2. What are the basic factors that determine the value of a currency? In equilibrium,
what is the relationship between these factors?
The basic factors that determine the value of a currency are:
the supply of the currency for sale, and
the demand for the currency.
There is a positive relationship between the value of a currency and the quantity of that
currency available for sale. Thus the supply curve is upward sloping, indicating that the
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supply of a currency generally increases with the rise in currency’s value, as illustrated
below:
Conversely there is a negative relationship between the value of a currency and the quantity
available for sale, leading to a downwards sloping demand curve. This is because
corporations and individuals of home country will be encouraged to purchase more foreign
currency when it is worth less as it will take less local currency to obtain their desired level
of foreign currency.
In equilibrium, the supply and demand schedules of a given currency are combined to reach
a value where the supply of the currency equals the demand for the currency. This
equilibrium exchange rate hold true for any point in time unless external factors such as
inflation rates, interest rates, government controls etc. cause the demand and/or supply
curve to shift and establish a new equilibrium point.
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Q3. How might the relatively high levels of inflation and interest rates in Thailand affect
the baht’s value? (Assume a constant level of U.S. inflation and interest rates)
The inflation levels and interest rates in Thailand, relative to levels of these variables in the
U.S., will both have an effect on the value of Thai baht.
Effect of high Inflation on Thai baht’s value
High Inflation is likely to reduce Thai baht's value relative to dollar. This is because a high
level of inflation tends to result in currency depreciation, as it would increase the Thai
demand for U.S. goods. Thus, there will be an increase in the Thai demand for US dollars.
Also, a relatively high level of Thai inflation would reduce the U.S. demand for Thai goods.
This will lead to an increase in the supply of baht for sale.
These market reactions are illustrated in the graph below:
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The previous equilibrium had the exchange rate at $P. The increased Thai demand for US
dollars causes the demand curve to shift the right from D to D1 and the increased supply of
baht for sale causes the supply curve to shift to the right from S to S1. The new equilibrium
is a lower exchange rate at $P1, indicating a depreciation of Thai baht relative to US dollars.
Effect of high interest rate on Thai baht’s value
High Interest rates are expected to increase Thai baht‘s value relative to dollar. A relatively
high level of interest rates in Thailand would make investments there more attractive for
U.S. investors, causing an increase in the demand for baht as there is more return on
investment in Thai bank deposits. Moreover, U.S. securities would have been less attractive
to Thai investors, causing an increase in the supply of dollars for sale. The supply of baht for
sale will decrease. However, investors might be unwilling to invest in baht-denominated
securities if they are concerned about the potential depreciation of the baht that could
result from Thailand’s inflation.
The previous equilibrium had the exchange rate at $P. The increased demand for Thai baht
causes the demand curve to shift the right from D to D1 and the decreased supply of baht
for sale causes the supply curve to shift to the left from S to S1. The new equilibrium is a
higher exchange rate at $P1, indicating an appreciation of Thai baht relative to US dollars.
Both the inflation rate and interest rate will move the value of baht in opposite directions,
but the effect can be measured by looking at the real interest rate.
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Q4. How do you think the loss of confidence in the Thai Baht, evidenced by withdrawal of
funds from Thailand, will affect the baht’s value? Would Blades be affected by the change
in value, given the primary Thai customer’s commitment?
The loss of confidence in Thailand and the withdrawn of Thai baht will increase the supply of
Thai Baht in the foreign exchange market, which will eventually cause the Thai baht to
depreciate its value with respect to the foreign currencies. The effect is illustrated in the
diagram below:
In the graph above, ‘D’ is the demand curve for the quantity of baht demanded, ‘S’ is the
initial supply curve and ‘P’ is the current equilibrium exchange rate of baht in terms of
dollar. When the investors withdraw their funds, there is a sudden increase in the supply of
baht and ‘S’ moves to ‘S1’, causing the equilibrium to switch from ‘P’ to ‘P1’. Therefore, the
value of baht depreciates in terms of US dollars.
Blades would surely be affected by the decrease in the value of baht. Since the value of baht
depreciated with respect to US dollars so now Blades can import goods from Thai suppliers
using fewer US dollars which will decline the cost of Blades imports, hence benefitting
Blades.
Q5. Assume that Thailand’s central bank wishes to prevent a withdrawal of funds from its
country in order to prevent further changes in the currency’s value. How could it
accomplish this objective using interest rates?
In order to prevent further depreciation in the bath’s value due to withdrawal of funds,
Thailand’s central bank can attempt to increase the level of interest rates in Thailand. This
would increase the demand for Thai baht by US investors as Thai securities would now seem
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more attractive due to higher rate of interests being provided on deposits with Thai banks.
This would place upward pressure on the currency’s value.
In the graph above, ‘D’ is the initial demand curve for the quantity of baht demanded, ‘S’ is
the l supply curve and ‘P’ is the current equilibrium exchange rate of baht in terms of dollar.
When interest rate is raised by the central bank, there is a sudden increase in the demand of
baht and ‘D’ moves to ‘D1’, causing the equilibrium to switch from ‘P’ to ‘P1’. Therefore, the
value of baht appreciates in terms of US dollars.
Disadvantage
However, the high interest rates could reduce local borrowing and spending and might lead
to deflation.
Assumption
The withdrawal of funds from Thailand can only be prevented by increasing interest rates,
provided that other central banks don’t make same adjustments at same time.
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