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3.2 Exchange Rates The exchange rateThe exchange rate measures the external value of sterling in terms of how much of another currency it can buy. For example - how many dollars or Euros you can buy with ?5000.The daily value of the currency is determined in the foreign exchange markets (FOREX) where billions of $s of currencies are traded every hour.The UK is currently operating with a floating exchange rate – where the currency’s value is purely market determined and the Bank of England does not seek to intervene through buying and selling currencies in order to influence the pound’s value.In contrast, the member states of the Euro Zone have created a single currency eliminating individual national exchange rates against each other – although the Euro is free to float against the pound, the US dollar ($) and other currencies.Types of exchange rate regimes Free-floating exchange rates The determination of the exchange rate under a floating exchange rate is shown in the above figure.The demand curve (DD) indicates the quantity of Australian dollars that buyers (those people who hold US dollars) are willing to purchase at each possible exchange rate.The supply curve (SS) shows the quantity of Australian dollars that will be offered for sale (those people who hold Australian dollars) at each exchange rate.At the equilibrium exchange rate of $A1.00 = $US0.50 the equilibrium quantity supplied and demanded is Q1 Australian dollars. At an exchange rate above equilibrium, such as $A1.00 = $US0.60, an excess supply of Australian dollars exists and market forces will force the exchange rate down towards equilibrium.If the exchange rate is below equilibrium, such as $A1.00 = $US0.40, an excess demand situation exits and market forces will put upward pressure on the value of the Australian dollar.Difference between an appreciation and depreciation in a currency operating in a free floating exchange rate regime ‘When a currency appreciates it means it increased in value relative to/in terms of another currency; depreciates means it weakened or fell in value relative to/in terms of another currency’.Source: , accessed Friday September 18 2015Currency AppreciationIn Figure 2a there has been an increase in demand (DD to D1D1) for Australian dollars. This has led to an increase (appreciation) in value of the Australian dollar from $US0.50 to $US0.60 and the quantity of Australian dollars traded has also increased from 0Q to 0Q1.?The shift in the demand curve could have been caused by an increase in the demand for Australian exports, such as coal, aluminum, beef or lamb.In Figure 2b there has been a decrease in the supply (SS to S1S1) of Australian dollars. This has led to an increase in the value (appreciation) of the Australian dollar from $US0.50 to $US0.60. However the quantity of Australian dollars traded has decreased from 0Q to 0Q1.?This decrease in the supply of Australian dollars may have been caused by a recession, slowing the demand for imports.Currency DepreciationIn Figure 3a there has been a decrease in demand (DD to D1D1) for Australian dollars. This has led to a depreciation in the value of the Australian dollar from $US0.50 to $US0.40. The quantity of Australian dollars traded has also decreased from 0Q to 0Q1.?The decrease in the price of Australian dollars in terms of US dollars could have been generated by a slow down in global economic activity, so decreasing the demand for Australian exports, or because of foreign investors lacking confidence in the Australian economy and investing elsewhere.Figure 3b indicates an increase in supply of Australian dollars with the supply curve moving from SS to S1S1. Again the value of the Australian dollar has decreased from $US0.50 to $US0.40 while the quantity of Australian dollars traded has increased from 0Q to 0Q1.?The depreciation may have resulted from strong domestic economic growth increasing the demand for imports, or from higher overseas interest rates, causing a capital outflow from Australia.Source: , accessed Friday September 18 2015 The effect of the exchange rate on the macroeconomic objectives Low and stable rate of inflationThe exchange rate affects inflation in a number of direct and indirect ways:1. Changes in the prices of imported goods and services – this has a direct effect on the consumer price index. For example, an appreciation of the exchange rate usually reduces the sterling price of imported consumer goods and durables, raw materials and capital goods. The effect of a changing currency on the prices of imported products will vary by type of import and also the price elasticity of demand, which is influenced by the extent of competition within individual markets.2. Commodity prices and the CAP: Many internationally traded commodities are priced in dollars – so a change in the sterling-dollar exchange rate has a direct impact on the ? price of commodities such as oil. The operation of the Common Agricultural Policy (CAP) can also help to absorb fluctuations in the prices of imported foodstuffs because of the variable import tariff. If world prices rise, the import tariff can fall to insulate the EU from the effects of higher import costs.3. Changes in the growth of UK exports – movements in the exchange rate affect the competitiveness of UK export industries in global markets. A higher exchange rate makes it harder to sell overseas because of a rise in relative UK prices. If exports slowdown (price elasticity of demand is important in determining the scale of any change in demand), then exporters may choose to cut their prices, reduce output and cut-back employment levels. A fall in export demand will reduce real national income relative to potential output – and thus might lead to a negative output gap. This puts downward pressure on inflation. 4. The exchange rate and wage bargaining – some economists believe that the exchange rate influences the power of employees to bargain for increases in real wages. When the exchange rate is high, there is pressure on businesses to control their costs of production in order to remain competitive – this may lead to downward pressure on wage inflation.Low rate of unemployment/full employment To the extent that movements in the exchange rate affect the growth of demand, output and investment in those sectors of the economy exposed to international trade, the rate of unemployment can also be influenced by currency fluctuations. In broad terms:An exchange rate appreciation tends to cause a slower rate of growth of real GDP (e.g. because of a fall in net exports)A reduction in demand and output may cause job losses as businesses seek to control costs and rationalize their operations. Some job losses are temporary – reflecting short -term changes in export demand and import penetration. Others are permanent if domestic industries move out of some export markets or if imports take up a permanently higher share of the UK marketSome industries are more exposed than others to currency fluctuations – e.g sectors where a high percentage of total output is exported and where demand is highly price sensitive (price elastic)AD-AS analysis can be used to illustrate the effects. In the first diagram, we see an inward shift in the AD curve due to a rise in net imports and in the second diagram we draw the effects of a reduction in production costs arising from cheaper raw material and component prices.Summary of advantages of strong currency Cheaper imports for consumers: A high pound leads to lower import prices – this boosts the real living standards of consumers at least in the short run – for example an increase in the real purchasing power of UK residents when travelling overseas or the chance to buy cheaper computers from the United States or Europe.Lower production costs for producers: When the sterling exchange rate is high, it is cheaper to import essential raw materials, component parts and capital inputs such as plant and equipment – this is good news for businesses that rely on imported components or who are wishing to increase their investment of new technology from overseas countries. A fall in import prices has the effect of causing an outward shift in the short run aggregate supply curve. And if a country can now import more productive technology, the long-run aggregate supply curve may shift outwards as well.Lower inflation: A strong exchange rate helps to control the rate inflation because domestic suppliers now face stiffer international competition from cheaper imports and will look to cut their costs accordingly. Cheaper prices of imported foodstuffs and beverages will also have a negative effect on the rate of consumer price inflation.If inflation is lower, then interest rates will be lower than if the exchange rate was weaker – and cheaper money will stimulate higher consumer spending and capital spending.Disadvantages of a strong currency Increase in the trade deficit: The lower price of imports leads to consumers increasing their demand and this can cause a larger trade deficit. Exporters lose price competitiveness (because they will find it more expensive to sell in foreign markets) and face losing market share – this can damage profits and employment in some sectors. For example the high exchange rate had damaged employment in Britain in sectors such as textiles and clothing, car manufacturing and semi-conductor production as production has shifted away from the UK towards countries with lower production costsSlower economic growth: If exports fall, this causes a reduction in aggregate demand and reduces the short-term rate economic growth as measured by the % change in real GDP. This affects some regions of the UK economy more than others. In the North-East for example, manufacturing industry accounts for over 28% of regional GDP whereas the percentage for the UK as a whole is just 19%. So a strong exchange rate may threaten output, employment living standards more in some regions than others.If exports fall, then so will business confidence and capital investment – because investment is partly dependent on the strength of demandExchange rates and mathematical calculations (HL only)Calculating the value of one currency in terms of another currency. You may be asked to make various calculations relating to exchange rates and changes in exchange rates: E.g. 1. The US dollar is currently trading against the Euro at a rate of US$1 = €0.8. What is the rate for €1 in US$? To change an exchange rate around, we simply take the reciprocal of the existing rate. So, if US$1 = €0.8, then €1 = US$1.25 (1/0.8)The table below shows the value of the Euro against five other currencies. Fill in column 3 to express the value of one unit of each of the currencies in Euros.Currency Price of euro in foreign currency Price of foreign currency in euros US Dollar€1 = US$1.12British Pound €1 = ?0.74Australian Dollar€1 = AUS$1.59Canadian Dollar€1 = CAD$1.48Emirati Dirham €1 = AED4.12Plotting demand and supply curves for a currency from linear functions and identifying the equilibrium exchange rate. You may be asked to identify the equilibrium exchange rate using linear demand and supply functions. This is no different from finding the equilibrium price in a demand and supply question.Example Country X has a currency know as the “Pesho?. The country is involved in international trade and the Pesho is a fully convertible currency that is allowed to float freely on the foreign exchange markets. The demand and supply functions for the Pesho are given below: QD = 3200 – 400E QS = -400 + 400E Where E is the exchange rate of the Pesho in terms of the US dollarStructure to follow Make a table to show the demand schedule and supply schedule for the Pesho, when exchange rates are $0, $1, $2, $3, $4 and $5. Price QD = 3200 – 400EQs = -400 + 400E$0$1$2$3$4$5Using the axes above: ii. Draw a diagram to show the demand curve and supply curves that represent the demand and supply schedules that you have made. iii. Illustrate the exchange rate. iv. Using simultaneous equations, calculate the exchange rate. Now let us assume that the demand function for the Pesho changes to: QD = 3 600 – 400P v. Explain two factors that might have caused the change in the demand function. vi. Make a new table to show the demand schedule for the new demand function, when exchange rates are $0, $1, $2, $3, $4 and $5. Price QD = 3600 – 400EQs = -400 + 400E$0$1$2$3$4$5vii. Add the demand curve that represents the new schedule to the diagram that you drew in 2. viii. Illustrate the new equilibrium exchange rate. ix. Explain the likely effect that the change in the exchange rate will have upon the demand for exports and imports in Country X. Calculating the price of a good in different currencies, using exchange rates.You may be asked to make various calculations relating to exchange rates and the prices of goods in different countries:E.g.i. If US$1 = €0.8, what would be the cost in Euros of a good that was selling for US$75?If a good is selling for US$75, then its cost in Euros will be 75 x €0.8 = €60.ii. If the exchange rate changes from US$1 = €0.8 to US$1 = €0.9, explain what would happen to the Euro price of an American-manufactured dress shirt that was being exported to Europe from the USA at a cost of US$150.With the original exchange rate of US$1 = €0.8, the dress shirt would cost €120 (150 x €0.8). With the new exchange rate, the value of the Euro has depreciated. It now costs more Euros to buy the same amount of dollars, and so the price of the dress shirt increases to €135 (150 x €0.9).Question 1The table below shows the exchange rate between the Euro and five other currencies:Currency Price of euro in foreign currency US Dollar€1 = US$1.12British Pound €1 = ?0.74Australian Dollar€1 = AUS$1.59Canadian Dollar€1 = CAD$1.48Emirati Dirham €1 = AED4.12If a large beer costs €4 in Vienna, then what would be the cost in each of the currencies above?Currency Price of euro in foreign currency Price of €4 beer in foreign currencies US Dollar€1 = US$1.12British Pound €1 = ?0.74Australian Dollar€1 = AUS$1.59Canadian Dollar€1 = CAD$1.48Emirati Dirham €1 = AED4.12Question 2The table below shows the exchange rate between the Euro and five other currencies at an interval of 6 months:Currency Price of euro in foreign currency (January)Price of euro in foreign currency (July)US Dollar€1 = US$1.29€1 = US$1.35British Pound €1 = ?0.81€1 = ?0.95Australian Dollar€1 = AUS$1.27€1 = AUS$1.15Canadian Dollar€1 = CAD$1.26€1 = CAD$1.10Emirati Dirham €1 = AED4.75€1 = AED4.15For each of the currencies above: i. Calculate the cost of a €25 phone card in each time period – January and July. ii. Using figures, explain whether the Euro has got weaker or stronger against the currency. Government InterventionFixed Exchange rate regime Under a fixed exchange rate system the government or one of its agencies fixes the value of a country’s currency, for example the Reserve Bank of Australia (RBA) to another currency for a specific time period.In the Figure above the official exchange rate has been fixed at a level of $A1.00 = $US0.60, which is above the market rate of $A1.00 = $US0.50. For the exchange rate to be fixed at a level higher than the market rate requires official intervention by the Reserve Bank of Australia.At this level the RBA would have to buy the excess supply of Australian dollars equivalent to Q1Q2 at a price of $US0.60. To buy the surplus of Australian dollars the government would need to sell its reserves of foreign currency.A fixed exchange rate system does not imply that the rate will stay at that same level all the time. The government may decide to change the rate because of adverse effects on the economy. For example, if the currency is overvalued exporting industries will become less internationally competitive, affecting international trade and the balance of payments and the government might take action to devalue the exchange rate.Devaluation and RevaluationA devaluation of a currency occurs under a fixed exchange rate system when there is deliberate action taken by a government to decrease its value in the FOREX market.Alternatively a revaluation occurs under a fixed exchange rate system when there is deliberate action taken by the government to increase the value of the currency in the FOREX market.Managed exchange rate regime Managed float regimes are where exchange rates fluctuate, but central banks attempt to influence the exchange rates by buying and selling currencies.Managed float regimes, otherwise known as dirty floats, are where exchange rates fluctuate from day to day and central banks attempt to influence their countries' exchange rates by buying and selling currencies. Almost all currencies are managed since central banks or governments intervene to influence the value of their currencies. So when a country claims to have a floating currency, it most likely exists as a managed float.How a Managed Float Exchange Rate WorksGenerally, the central bank will set a range, which its currency's value may freely float between. If the currency drops below the range's floor or grows beyond the range's ceiling, the central bank takes action to bring the currency's value back within range.Management by the central bank generally takes the form of buying or selling large lots of its currency in order to provide price support or resistance. For example, if a currency is valued above its range, the central bank will sell some of its currency it has in reserve. By putting more of its currency in circulation, the central bank will decrease the currency's value.Why Do Countries Choose a Managed FloatSome economists believe that in most circumstances floating exchange rates are preferable to fixed exchange rates. Floating exchange rates automatically adjust to economic circumstances and allow a country to dampen the impact of shocks and foreign business cycles. This ultimately preempts the possibility of having a balance of payments crisis. A floating exchange rate also allows the country's monetary policy to be freed up to pursue other goals, such as stabilizing the country's employment or prices.However, pure floating exchange rates pose some threats. A floating exchange rate is not as stable as a fixed exchange rate. If a currency floats, there could be rapid appreciation or depreciation of value. This could harm the country's imports and exports. If the currency's value increases too drastically, the country's exports could become too costly which would harm the country's employment rates. If the currency's value decreases too drastically, the country may not be able to afford crucial imports.This is why a managed float is so appealing. A country can obtain the benefits of a free-floating system but still has the option to intervene and minimize the risks associated with a free floating currency. If a currency's value increases or decreases too rapidly, the central bank can intervene and minimize any harmful effects that might result from the radical fluctuation.Source: Boundless. “Managed Float.” Boundless Economics. Boundless, 21 Jul. 2015. Retrieved 18 Sep. 2015 from of overvalued and undervalued currency Purchasing Power Parity (PPP) – a method of determining the over/under valuation of a currency ‘In IB Economics we’re studying the theory of exchange rates. A floating exchange rate system should be in equilibrium when the rate enables people in different countries to buy the same basekt of goods with an equal amount of money. In other words, If I walk into McDonalds in the US and have to pay $3.00 for a Big Mac, then board a plane, land in Shanghai and walk into a McDonalds there, the price I pay in Shanghai should, given current exchange rates, be the same as what I paid in the US. In reality, a Big Mac in Shanghai costs about 56% less than one in the US. This tells economists something about the value of the Chinese RMB.If the price of a particular basket of goods for Americans is higher than the same basket of goods for Chinese given current exchange rates, than that would be a sign that the Chinese currency is undervalued. In the long run, “exchange rates should move towards levels that would equalize the prices of an identical basket of goods and services bought in either of the two countries whose exchange rates are being compared.” This concept is known as Purchasing Power Parity (PPP).One way to test the level of undervaluation of the yuan is to apply the principle of PPP. If we could compare the price of a particular basket of goods (or even ONE good that can be bought in both countries), then we can determine whether at current exchange rates the RMB is under or over-valued. Luckily, the Economist magazine has developed its own measure of PPP, and it’s chosen one product that can be purchased in nearly every country in the world, the BIG MAC!The table below shows by how much, in Big Mac PPP terms, selected currencies were over- or undervalued at the end of January… The most undervalued currency is the Chinese yuan, at 56% below its PPP rate; several other Asian currencies also appear to be 40-50% undervalued.The index is supposed to give a guide to the direction in which currencies should, in theory, head in the long run It is only a rough guide, because its price reflects non-tradable elements—such as rent and labour. For that reason, it is probably least rough when comparing countries at roughly the same stage of development. Perhaps the most telling numbers in this table are therefore those for the Japanese yen, which is 28% undervalued against the dollar, and the euro, which is 19% overvalued. Hence European finance ministers’ beef with the low level of the yen’. [ Sunday October 4th 02057400002015]Big Mac Index 2001 Country Big Mac price in local currency Big Mac price in US$Implied PPP(local price/US price)Actual exchange rate 17/04/01Under-valuation/over-valuation against the dollar %US$2.54$2.54------------AustraliaA$3.00$1.52$1 = A$1.98Britain ?1.99$2.85$1 = ?0.70CanadaC$3.33$2.14$1 = C$1.56China ?9.90$1.20$1 = ?8.28Euro area€2.57$2.27$1 = €1.14Hong Kong HK$10.70$1.37$1 = HK$7.80Japan?294$2.38$1 = ?124Russia Rouble 35.00$1.21$1 = Rouble 28.9South Korea Won 3000$2.27$1 = Won1325SwitzerlandSFr6.30$3.65$1 = SFr1.73Overvalued CurrencyAdvantagesDownward pressure on inflation i.e. imported goods will be cheaperMore imports can be boughtHigh value of currency forces domestic producers to improve their efficiency to be more competitive in the international market.DisadvantagesOvervalued currency will make exports uncompetitive in the international market, which will hurt the export industriesImports are relatively cheaper to buy due to overvalued currency. Consumers will go in for more imports, which will damage to domestic industriesUndervalued currencyAdvantagesIf currency is undervalued, the exports will be cheaper and they will grow leading to greater employment in export industriesUndervalued currency will make imports expensive for consumers, they will divert to domestic goods and thus employment in domestic industries will increase.DisadvantagesAn undervalued currency makes imports expensive which also leads to Imported inflation i.e. all the products using imported components/raw material will become expensive thus effecting the general price level.Source: , accessed Friday September 18 2015 Evaluation of fixed and floating exchange rates The case for floating exchange rates 1. Reduced need for currency reserves: There is no exchange rate target so there is little requirement for the central bank (e.g. the Bank of England) to hold large scale reserves of gold and foreign currency to use in possible official intervention in the markets2. Useful instrument of macroeconomic adjustment: A floating rate can act as a useful tool of macroeconomic adjustment – for example a depreciation should provide a boost to net export demand and therefore stimulate growth. This assumes that the gains from a lower exchange rate are not dissolved in higher wage claims or export prices. The countries inside the Euro Zone for example might be hoping for a more competitive exchange rate as a means of creating an injection of demand into their slow-growing economies.3. Partial automatic correction for a trade deficit: Floating exchange rates offer a degree of adjustment when the balance of payments is in fundamental disequilibrium – i.e. a large trade deficit puts downward pressure on the exchange rate which should help the export sector and control demand for imports because they become relatively expensive. 4. Reduced risk of currency speculation: The absence of an explicit exchange rate target reduces the risk of currency speculation. Often, currency market speculators target an exchange rate target that they believe to be fundamentally over or undervalued.5. Freedom (autonomy) for domestic monetary policy: The absence of an exchange rate target allows short term interest rates to be set to meet domestic macroeconomic objectives such as stabilizing growth or controlling inflation. The Bank of England has enjoyed the autonomy that a floating exchange rate gives since it was made independent in May 1997.6. Floating exchange rates are not always volatile exchange rates - although the sterling exchange rate has been floating, the volatility has not been that great. Businesses have learnt to cope with modest fluctuations – helped by having a flexible labour market.The case for fixed exchange rates 1. Trade and Investment: Currency stability can help to promote trade and investment because of lower currency risk 2. Some flexibility permitted: Some adjustment to the fixed currency parity is possible if the economic case becomes unstoppable (i.e. the occasional devaluation or revaluation of the currency if agreement can be reached with other countries). That said, countries with fixed exchange rates are often reluctant to make parity adjustments – these decisions are often see as politically damaging.3. Reductions in the costs of currency hedging: Because we can never predict what will happen to the market value of a currency, many businesses hedge against this volatility by buying the currency they need in the forward currency markets. With fixed exchange rates, businesses have to spend less on currency hedging if they know that the currency will hold its value in the foreign exchange markets (hedging involves risk)4. Disciplines on domestic producers: A stable (fixed) currency acts as a discipline on producers to keep their costs and prices down and may lead to greater pressure for exporters to raise labour productivity and focus more resources on research and innovation. In the long run, with a fixed exchange rate, one country’s inflation must fall into line with another (and thus put substantial competitive pressures on prices and real wages)5. Reinforcing gains in comparative advantage: If one country has a fixed exchange rate with another, then differences in relative unit labour costs will quite easily be reflected in changes in the rate of growth of exports and imports. Consider the example of China and the United States. Most estimates indicate that the Chinese currency is undervalued against the dollar. This makes Chinese products cheaper than they would otherwise be and has led to a surge in import penetration from China into the US economy. This has led to numerous calls from US manufacturers for the Chinese to be persuaded to switch to a floating exchange rate or to adjust their currency by appreciating against the dollar. China recently announced that they would allow more market forces to determine the value of the Yuan. Questions 1: A bicycle manufactured in the United States costs $200. Using today’s current exchange rates, what would the bicycle cost in each of the following countries? Use the website site x-(a) Argentina(b) Brazil(c) Canada2: You are a US importer who buys goods from many different countries. How many US dollars do you need to settle each of the following invoices? Use the website site x-(a) AUS$1,000,000 for wool blankets(b) ?500,000 for dishes(c) 100,000 Indian rupees for baskets(d) ?150,000,000 for stereo equipment(e) €825,000 for German wine3: What is the dollar value of the invoices in Q2 if the US dollar:(a) depreciates 10% against the Australian Dollar(b) appreciates 10% against the British Pound(c) depreciates 10% against the Indian rupee(d) appreciates 20% against the Japanese Yen(e) depreciates 100% against the Euro4: The US dollar price of a Swedish Krona changes from $0.1572 to $0.1730.(a) Has the dollar depreciated or appreciated against the Krona?(b) Has the Krona appreciated or depreciated against the dollar. 5: If the interest rate on one-year government bonds is 5% in Germany and 8% in the United States, what do you think is expected to happen to the dollar value of the Euro?6: Suppose a US investor buys a one-year German bond (bund) with a face value of €10,000 that has a 10% annual interest rate. How many dollars will a US investor receive at maturity if the exchange rate is $1 = €0.817: Suppose that yesterday; the US dollar was trading on the foreign exchange Market at 100 yen per dollar. Today, the US dollar is trading at 105 yen per dollar.(a) Which of the two currencies has appreciated and which depreciated today?(b) List the events that could have caused today’s change in the value of the US dollar on the foreign exchange market.(c) Did the events that you listed in part (b) change the demand for US dollars, the supply of US dollars or both demand and supply of US dollars?(d) If the Federal Reserve (Central bank) tried to stabilise the value of the US Dollar at 100 yen per dollar, what action would it have taken?(e) In part (d), what effect would the Fed’s actions have had on the US official reserves?8: Suppose that yesterday the Canadian dollar was trading on the foreign exchange market at $0.75 US per C$1. Today, the Canadian dollar is trading at $0.70 per C$1(a) Which of the two currencies has appreciated and which depreciated today?(b) List the events that could have caused today’s change in the value of the Canadian dollar on the foreign exchange market.(c) Did the events that you listed in part (b) change the demand for Canadian dollars, the supply of Canadian dollars or both demand and supply of Canadian dollars?(d) If the Bank of Canada (Central bank) tried to stabilise the value of the Canadian Dollar at 100 at $0.75, what action would it have taken?(e) In part (d), what effect would the Bank of Canada’s actions have had on the Canadian official reserves?9: The US dollar appreciates, State, with reasons, which of the following events could have caused these changes to occur:(a) The Fed intervened in the foreign exchange market and sold dollars(b) People began to expect the dollar to appreciate(c) The US interest rate differential narrowed(d) The US current account went into deficit. 10: If the US dollar depreciates against the Euro, what will be the economic consequences for US residents?11: Using a FOREX diagram, illustrate the effect of a change in tastes prompting German residents to buy more goods from the United States. If the exchange rate is floating, what will happen to the foreign-exchange-market equilibrium?12: Suppose that on January 1st the Yen price of the dollar is 120. Over the year, the Japanese inflation rate is 5% and the US inflation rate is 10%. If the exchange rate is $1=?130 at the end of the year, relative to PPP, does the Yen appear to be overvalued, undervalued, or at the PPP level? 13: Under a gold standard, if the price of an ounce of gold is 400 US$ and 500 C$, what is the exchange rate between US and Canadian dollars?14: If Mexico uses a fixed exchange rate relative to the US dollar, how can Mexico fix the value of the peso relative to the dollar when the demand for and supply of dollars and pesos change continually? Illustrate your explanation with a graph.15: If the price of a pound of salmon is $5 in Seattle, Washington, and the exchange rate between US and Canadian dollars is $0.80 = C$1.00, then what would the Canadian dollar price of salmon have to be in Vancouver, British Columbia in order for PPP to hold?16: Illustrate and explain the meaning and likely effects of an overvalued exchange rate.17: Other things being equal, what kind of exchange-rate system would you expect each of the following countries to adopt?(a) A small country that conducts all of its trade with the United States.(b) A country whose policies have led to a 300% annual rate of inflation.(c) A country that wants to offer exporters cheap access to the imported inputs they need but to discourage other domestic residents from importing goods. (d) A large country like the United States or Japan. ................
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