595 #
© 2014 Pearson Canada Inc.#- In the model of the demand and supply of dollar assets use a graph to explain how a change
in the domestic interest rate affects the equilibrium exchange rate.
Answer: In the model of the equilibrium in the foreign exchange market, when the domestic
interest rate iD rises, holding the current exchange rate Et and everything else constant, the
return on dollar assets increases relative to foreign assets, so people will want to hold more dollar
assets. The quantity of dollar assets demanded increases at every value of the exchange rate, as it
can be shown on the graph by a rightward shift of the demand curve. At the new equilibrium
point the exchange rate rises.
Diff: 2 Type: SA Page Ref: 479
Skill: Recall
Objective List: 19.4 Understand the factors that change the exchange rate
- In the model of the demand and supply of dollar assets use a graph to explain how a change
in the foreign interest rate affects the equilibrium exchange rate.
Answer: When the foreign interest rate iF rises, holding current exchange rate Et and everything
else constant, the return on foreign assets rises relative to dollar assets. Thus the relative
expected return on dollar assets falls. Now people want to hold fewer dollar assets, and the
quantity demanded decreases at every value of the exchange rate. This can be shown by a
leftward shift of the demand curve for dollar assets. The new equilibrium is reached at a point
where the value of the dollar has fallen.
Diff: 2 Type: SA Page Ref: 480
Skill: Recall
Objective List: 19.4 Understand the factors that change the exchange rate
- Why are exchange rates so volatile?
Answer: The asset market approach of exchange rate determination gives us a straightforward
explanation of volatile exchange rates. Because expected appreciation of the domestic currency
affects the expected return on foreign deposits for both the domestic and the foreign investors,
expectations on the price level, inflation, trade barriers, productivity, import demand, export
demand, and the money supply play important roles in determining the exchange rate. When
expectations about any of these variables change, our model indicates that there will be an
immediate effect on the expected return of foreign deposits and therefore on the exchange rate.
because expectations about all these variables change with just about any bit of news that
appears, it is not surprising that the exchange rate is volatile. In addition, money supply increases
produce exchange rate overshooting and this is an additional reason for the high volatility of
exchange rates.
Diff: 3 Type: SA Page Ref: 485
Skill: Recall
Objective List: 19.4 Understand the factors that change the exchange rate