Share
Explore BrainMass

# What Determines the Value of the Exchange Rate?

1. What determines the value of the exchange rate?
2. Suppose that there are 10 million workers in Canada and South Korea and each worker in Canada and South Korea can produce 4 cars per year. A Canadian worker can produce 10 tonnes of grain a year, whereas a South Korean worker can produce 5 tonnes of grain a year. The following table shows the production of grain and cars for the two countries, Canada and South Korea.

1 Worker Cars Grain
South Korea 4 5

(a) For this situation, construct a table outlining the opportunity costs of producing grain and cars in Canada and South Korean.
(b) Graph the production possibilities frontier of the Canadian and South Korean economies.
(c) For Canada, what is the opportunity cost of a car? For Canada, what is the opportunity cost of grain? For South Korea, what is the opportunity cost of a car? For South Korea, what is the opportunity cost of grain?
(d) Which country has an absolute advantage in producing cars? Which country has an absolute advantage in producing grain?
(e) Which country has a comparative advantage in producing cars? Which country has a comparative advantage in producing grain?
3. The international transactions for the country Kyleland for a given year are reported in the table below. (8 Marks)

Transaction Amount (billions of dollars)
Exports of goods & services 100
Imports of goods & services 130
Transfers to the rest of the world 20
Loans to the rest of the world 60
Loans from the rest of the world ?
Increases in official reserves 10
Net interest payments 0

a. What is the amount of loans from the rest of the world?
b. What is the current account balance?
c. What is the capital account balance?
d. What is the official settlements balance?
4. Explain how each of the following will affect the relative values of the dollar and the euro:
a. Income growth higher in Canada than in Europe.
b. Inflation higher in Europe than in Canada.
c. A real interest rate higher in Canada than in Europe.
hide problem.

#### Solution Preview

See the attached file.

1. What determines the value of the exchange rate?

The value of exchange rate is determined by the demand and supply in the foreign exchange market. When the exchange rate is too low, there would be shortage of dollars and hence exchange rate will increase to bring the market to equilibrium. When the exchange rate is too high, there would be surplus of dollars and hence exchange rate will decrease to bring the market to equilibrium.

Exchange rate also depends upon the domestic and foreign interest rates. The exchange rate increases with an increase in the domestic interest rate and decreases with an increase in the foreign interest rate.

An expectation about future exchange rates also leads to an increase in the current exchange rate.

2. Suppose that there are 10 million workers in Canada and South Korea and each worker in Canada and South Korea can produce 4 cars per year. A Canadian worker can produce 10 tonnes of grain a year, whereas a South Korean worker can produce 5 tonnes of grain a year. The following table shows the production of grain and cars for the two countries, Canada and South Korea.

1 Worker Cars Grain