FINE 673 Problem Set 6 Revised on 8-20 1. Airbus prices its aircraft in US dollars but sells to airlines worldwide. British Airways has purchased an Airbus aircraft for $126 million. What is the price of this aircraft in euros? Show the computation with the currencies appropriately canceling (hint: see Figure 15-2). There are many websites that show exchange rates, but here is one: https://www.oanda.com/currency/converter/ 2. Just as with the price of a good, the price, or exchange rate, of a currency is determined by supply and demand. However, rather than using a traditional supply and demand analysis as shown in Marthinsen, currency traders often consider whether funds will flow into or out of a country as a result of a particular economic circumstance. Marthinsen also employs this concept of investment flows in several analyses. Investors seek the highest worldwide return for their investments, so a change in economic circumstances can cause investments flows of trillions of dollars. If foreigners wish to make domestic purchases or investments, foreign currency must first be exchanged for the domestic currency. Thus, investment funds flowing into a country increase the demand for the domestic currency and it appreciates. Funds flowing out reverse this process leading to depreciation of the domestic currency. In the table, place an X to indicate whether each economic condition will cause investment funds to flow in or out of the country and whether the domestic currency will appreciate or depreciate. Domestic circumstance relative to other Funds Funds Currency Currency countries flow in flow out Appreciates Depreciates Taxes increase Inflation increases rapidly Expected stock market returns are high Economy enters severe recession (consider only import effect) Real GDP rises Import effect Expected asset returns Expected economic risk Rioting erupts in protest government policies Activate Windows A large deposit of rare earth minerals is Go to Settings to activate Windows.A large deposit of rare earth minerals is discovered Central bank raises interest rates Asset prices are expected to appreciate Rapidly growing manufacturing sector imports more foreign raw materials World prices fall for the country's major export commodity Central bank purchase the domestic currency 3. Figures 1 and 2 show US-Argentine exchange rate and the Argentine inflation rate. What is the apparent relationship between inflation and the exchange rate? Does the domestic currency appreciate or depreciate with increasing inflation? In one or two sentences, explain the relationship. 70.00 67128% 600.00% 60.00 500.00% 50.00 400 00% -300.00% 30.00 200.00 20.00 100.00% 1000 000% 2016 2017 2018 2019 2020 Figure 1: Exchange rate Argentine peso to 1 US dollar Activate Windows30 20 10 2016 2017 2018 2019 2020 Figure 2: Argentine Inflation rate in annual percentage 4. The Argentine peso has been steadily depreciating against the US dollar, but the government wishes to stop the depreciation. Please answer each question concisely in one or two sentences. a. What must the Banco Central De La Republica Argentina do to stabilize the exchange rate? b. Is there a limit to the central bank's ability to stop the depreciation of the peso by intervention in the foreign exchange markets? 5. Suppose Saudi Arabia wishes to peg the Saudi riyal (SAR) to the US dollar at $0.25/SAR. Because of foreign funds flowing into SA, the SAR appreciates. a. How can the Saudi Arabian Monetary Authority (Saudi's central bank) keep the SAR from appreciating and maintain the pegged exchange rate? b. Is the Saudi central bank limited by its foreign exchange holdings in maintaining the peg? 6. The European Central Bank has increased the money supply through massive open market purchases of financial securities. a. In the graphs, show the shift in the supply and/or demand curves in the Credit Market and in the Foreign Exchange Market. Use inserted arrows to show the shift in the curves and changes to the X and Y-axis variables. Activate WindowsCost of Exchange credit Rate Price/E S S D D Q of real credit/time (RC) E/per of time b. Does the euro appreciate or depreciate relative to other currencies? c. Will this new exchange rate make Eurozone exports more or less expensive for foreign buyers? d. Recall that GDP = C + 1 + G + NE. If all other factors are unchanged (ceteris paribus), explain the predicted effect on Eurozone GDP? 7. The Bank of Japan purchases Japanese yen in the foreign exchange market. a. In the graphs, show the shift in the supply and/or demand curves in Japan's Credit Market and in the Exchange Market for the yen. Use inserted arrows to show the shift in the curves and changes to the X and Y-axis variables.Cost of Exchange credit Rate Price/E S S D D Q of real credit/time (RC) E/per of time b. Does the yen appreciate or depreciate? c. What is the effect on Japanese exports and RGDP? d. How will the real interest rate affect C and I? Activate Windows