16.2 Demand and Supply Shifts in Foreign Exchange Markets

Equilibrium in the foreign exchange market is reached where __________.

Select the correct answer below:

the demand curve for currency intersects with its supply curve

the cost curve for currency intersects with its supply curve

the demand curve for goods and services intersects the supply curve for the currency needs to purchases them

the demand curve for foreign currency intersects with its supply curve of domestic currency

the demand curve for currency intersects with its supply curve

In the foreign exchange market, equilibrium exchange rate occurs at the intersection of the demand curve and the supply curve.

Suppose the value of the European Euro is anticipated to increase in the foreign exchange market. Demonstrate how this event will affect the supply and demand curves on the graph below by shifting them in the appropriate direction.

demand right, supply left

One reason to demand more of a currency on the foreign exchange market is the belief that the Euro's value is about to increase. If the price of the Euro is likely to increase in the future, investors are likely to supply less today and wait for the Euro to appreciate in order to benefit from the higher price in the future. 

True or false?

The shifts in supply and demand in the foreign exchange market reinforce each other in regards to either appreciating or depreciating a currency.

True

When investors expect a country’s currency to strengthen in the future, they buy the currency and cause it to appreciate immediately. The currency's appreciation can lead other investors to believe that future appreciation is likely—and thus lead to even further appreciation. Similarly, a fear that a currency might weaken quickly leads to an actual weakening of the currency, which often reinforces the belief that the currency will weaken further. Thus, beliefs about the future path of exchange rates can be self-reinforcing, at least for a time, and a large share of the trading in foreign exchange markets involves dealers trying to outguess each other on what direction exchange rates will move next.

If the rate of return on financial assets within the European Union have an average return of 5% while similar financial assets in American have a rate of return of 2%, then the demand of euros will __________ and the supply for euros will __________.

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Select the correct answer below:

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increase; increase

increase; decrease

decrease; decrease

decrease; increase

increase; decrease

The motivation for investment, whether domestic or foreign, is to earn a return. If rates of return in a country look relatively high, then that country will tend to attract funds from abroad. For example, a higher rate of return for financial assets denominated in euros makes holding euros more attractive. Thus, the demand for euros in the foreign exchange market shifts to the right, while the supply of euros shifts to the left. The new equilibrium has a stronger exchange rate than the original equilibrium.

Which of the following is not a reason why governments and businesses fear high relative inflation?

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It causes depreciation which discourages foreign investment.

The price of domestic goods increases faster relative to imported goods, making local manufacturing less competitive.

The value of the currency appreciates, making exports less competitive.

Depreciation causes imports to become more expensive in absolute terms, reducing consumer purchasing power.

The value of the currency appreciates, making exports less competitive.

Relative inflation causes depreciation, which is detrimental to foreign investors. At the same time inflation causes the price of domestic goods to rise faster than imported goods even as depreciation increases the absolute price of imports. This harms domestic producers and consumers simultaneously.

True or false?

The exchange rate that equalizes the prices of internationally traded goods across countries is the arbitrage exchange rate.

False

We call the exchange rate that equalizes the prices of internationally traded goods across countries the purchasing power parity (PPP) exchange rate. A group of economists at the International Comparison Program, run by the World Bank, have calculated the PPP exchange rate for all countries, based on detailed studies of the prices and quantities of internationally tradable goods.

Which of the following best describes the price of a currency in the foreign exchange market?

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pegged exchange rate

equilibrium exchange rate

hedging

dollarizing

equilibrium exchange rate

In a normal supply and demand graph, price is listed on the vertical axis. In the foreign exchange market, the exchange rate is listed on the vertical axis. The exchange rate is the price of a specific currency in terms of another currency. That is, it is how many units of a foreign currency it takes to purchase one unit of a domestic currency. Or, atlernatively it is how many units of a foreign currency can be bought using one unit of a domestic currency.

Suppose an influential newspaper prints an article predicting that the British pound will depreciate in value. Demonstrate how this event will affect the supply and demand curves by shifting them in the appropriate direction. 

The demand for the British pound to decrease and the supply of the British pound to increase.

If the British pound is expected to decrease in value, then investors will seek to sell more pounds today at the current relatively higher price, thus increasing the supply of pounds. At the same time, investors will demand less pounds and instead wait for the price of a pound to decrease, causing the demand for pounds to decrease. The result is a depreciation of the British pound.

An expectation that the peso will appreciate in value will __________.

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cause the peso to appreciate and increase the quantity bought and sold in the foreign exchange market

cause the peso to appreciate and decrease the quantity bought and sold in the foreign exchange market.

cause the peso to depreciate and increase the quantity bought and sold in the foreign exchange market.

cause the peso to appreciate and either increase, decrease, or not change the quantity bought and sold in the foreign exchange market.

cause the peso to appreciate and  either increase, decrease, or not change the quantity bought and sold in the foreign exchange market.

The shifts in demand and supply curves both cause the exchange rate to shift in the same direction for a currency that is expected to appreciate or depreciate. In the example of an expectation about the peso appreciating, they both make the peso exchange rate stronger. However, the shifts in demand and supply work in opposing directions on the quantity traded. In this example, the rising demand for pesos is causing the quantity to rise while the falling supply of pesos is causing quantity to fall. The result could be that quantity remains unchanged or declines or increases.

When a nation experiences higher inflation than its trading partners, both the demand and supply of the nation's currency will be affected. Which of the following will result in equilibrium?

Select the correct answer below:

The equilibrium quantity for the nation's currency will increase.

The equilibrium quantity for the nation's currency will decrease.

The equilibrium quantity for the nation's currency will not change.

The direction of change in the equilibrium quantity of the nation's currency will be indeterminate.

The direction of change in the equilibrium quantity of the nation's currency will be indeterminate.

If a currency is experiencing relatively high inflation, then its buying power is decreasing and international investors will be less eager to hold it. At the same time, the supply of the currency will increase. Although this decrease in demand and increase in supply of the currency allow us to determine the change in the exchange rate, the resulting change in equilibrium quantity is indeterminate. 

If interest rates rise in the United States as compared with Mexico, then what is the most likely outcome?

Select all that apply:

Fewer investors will demand U.S. dollars for interest-bearing assets.

More investors will be willing to supply U.S. dollars to foreign exchange markets.

More investors will demand U.S. dollars so that they can buy interest-bearing assets

Fewer investors will be willing to supply U.S. dollars to foreign exchange markets.

More investors will demand U.S. dollars so that they can buy interest-bearing assets

Fewer investors will be willing to supply U.S. dollars to foreign exchange markets.

If rates of return in a country look relatively high, then that country will tend to attract funds from abroad. Conversely, if rates of return in a country look relatively low, then funds will tend to flee to other economies. Changes in the expected rate of return will shift demand and supply for a currency. A higher interest rate or rate of return relative to other countries leads a nation’s currency to appreciate or strengthen, and a lower interest rate relative to other countries leads a nation’s currency to depreciate or weaken.

What is not true about arbitrage?

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It involves central banks building up large reserves of their country's currency to stabilize its value.

It occurs when internationally traded goods are cheaper to buy in one country than in another country.

It allows people to take advantage of price differences in markets.

It will force prices and exchange rates to align so that the price of internationally traded goods is similar in all countries.

It involves central banks building up large reserves of their country's currency to stabilize its value.

Arbitrage is the buying and selling goods or currencies across markets at a profit.