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Exchange Rate Fluctuations: Causes and Impacts

1. Look at the economist website at:
using the tables from the latest issue of the Economist, please answer the following questions. Please clearly state your assumptions that you need. Please clearly show, in detail, the calculations and steps you use to arrive at your answers. Please do not use any other sources for the data required to answer these questions. Based on Britain (£) and Australia ($).
a. For all practical purposes, are real interest rates about equal (real interest rate is nominal interest rate, adjusted for inflation) in these two countries?
b. Compared to last year, has the Australian dollar appreciated or depreciated against the pound and by how much? (Please provide your complete reasoning and computations). Is that what you would expect based on your answer to part a? Explain your reasoning.
c. Identify any two other pieces of information from the tables that might, in theory at least, help to explain appreciation or depreciation of the Australian dollar in general. Now determine whether the actual data from the tables are consistent with your answer to part b (about the appreciation or depreciation of the Australian dollar).

2. Consider a small country, MadhatterLand trades goods and assets with the rest of the world consisting of perfect capital markets.
a. Suppose MadHatterLand has fixed exchange rate. The governor of the Central Bank, Ms. March hare, attempts to increase aggregate domestic demand through an unsterilized, open market expansion of money supply.
i. What will happen to the overall BOP and why?
ii. What will happen to the forex holdings of the Bank and why?
b. Now suppose MadhatterLand has a fully floating exchange rate (i.e. Bank never intervenes in the forex market to affect exchange rates). Again, Ms. March Hare chooses to expand domestic demand through expansion in money supply.
i. What will happen to the overall BOP and why?
ii. What will happen to the exchange rate and why?

3. Consider a Mexican firm that knits sweaters for sale to a U.S. department store. The firm incurs total costs of 16 pesos/sweater, and sells the sweater to the department store for $5 per sweater. The exchange rate is 4 pesos/$.
a. What is the firm markup per sweater as a percentage of revenues?
b. If the peso is devalued 20%, what is the new value of the peso?
c. If the firm keeps dollar prices constant and peso costs constant, what is the markup per sweater as a percentage of revenue after the devaluation?
d. If the firm decides to keep the gross margin per sweater constant (at 20%), would sales expand or decline? Why? What would the new dollar price be after devaluation?

Solution Preview

1. The data that is being used to answer this question is based on the what is available with the economist. When it comes to exchange rates the Economist publishes the exchange rate against the USD, and not against other currencies. So one has to determine other exchange rates assuming efficient markets. As far as the interest rates go, one can consider both the 3-month and the 10-year government bond rates that the Economist provides. I use the 3-month rate, since when people say interest rates that usually means the short-term rate. The inflation rate again is an issue since the Economist provides the inflation rate for the first quarter (Jan-Mar) for Australia but for April for Britain. Assume that the inflation rate has not changed much, and we can use the first quarter rate for Australia with Britain's April rate.

The numbers from the website are as follows:

Britain: Inflation Rate (Apr) = +2.3%
Exchange Rate (Pounds per USD) = 0.61
Exchange Rate (Pounds per USD) = 0.51 (a year ago)
GDP Growth (Q1) = -4.1%
3-month Interest Rate = 1.20%

Australia: Inflation Rate (Q1) = +2.5%
Exchange Rate (AUD per USD) = 1.23
Exchange Rate (AUD per USD) = 1.04 (a year ago)
GDP Growth (Q1) = 0.4%
3-month Interest Rate = 3.20%

Changes in Commodity prices over the last month = +8.7%

a. Real Interest Rate in Britain = Nominal Rate - Inflation = 1.2 - 2.3 = -1.1%
Real Interest Rate in Australia = Nominal Rate - Inflation = 3.2 - 2.5 = +0.7%

Though the numbers are different they are not very different. The difference is just about 1.8%. For all practical purposes this is equal to zero, and the interest rates are the same for all practical purposes. ...