1. 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 countries	Funds flow in	Funds flow out	Currency Appreciates	Currency 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
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

2. 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.

\fCost of Exchange credit Rate Price/E S S D D Q of real credit/time (RC) E/per of timeCost of Exchange credit Rate Price/E S S D D Q of real credit/time (RC) #/per of time