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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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