Quiz 36: The International Monetary System: Order or Disorder

Exchange rate Exchange rate refers to the amount of domestic currency required to purchase one unit of foreign currency. For example, 0.02 dollar is required to buy one Indian rupee; in this case, the exchange rate is $0.02: Rs1. Consumption from abroad The dress materials produced in India are consumed consistently. When American demand for dress material decreases, then American demand for Indian rupee, in the foreign exchange market, also decreases. This reduces the supply of American dollar in the foreign exchange market; and thereby increases the value of American dollar. On the other hand, since Americans buy less amount of dress material the demand for Indian rupee falls; this reduces the value of Indian rupee. Hence, from an American's point of view, the exchange rate increases. Now, the same unit of American currency can buy more Indian rupee than earlier.

Exchange rate Exchange rate refers to the amount of domestic currency required for purchasing one unit of foreign currency. Diagram for exchange rate The below diagram illustrates how demand and supply of dollars in the foreign exchange market determine the exchange rate. In the above diagram, X axis measures number of dollars and Y axis measures exchange rate. S curve represents supply for dollar and D curve represents demand for dollars in the foreign exchange market. Exchange rate is in equilibrium at point e where the demand for dollar is equal to the supply of dollar. The exchange rate is E, and the level of dollar is Y. If the demand for dollar is j and the supply of dollar is K, then the excess supply of dollar causes a decrease in the value of dollar, which in turn decreases the exchange rate from to E If the demand for dollar is M and supply of dollar is L, then the excess demand causes appreciation in the dollar value, which causes an increase in the exchange rate from to E. a. If Japan opens the economy When Japan opens up its economy to more foreign countries' competition, then the exports from America to Japan would increase. It leads to an increase in the demand for American dollar in the foreign exchange market. The rise in demand for dollar appreciates its value, which in turn increases the exchange rate. b. If Tokyo stock market would fall When the investors expect that the value of the Tokyo stock market will fall, then they will shift their investment from Tokyo market to American stock market. This leads to more capital outflow from Japan to America. This in turn increases the demand for dollars in the foreign exchange market, which increases the value of dollar. This turn increases the exchange rate. c. If U.S. Federal Reserve cuts interest rate When the Federal Reserve cuts interest rate in the United States, the American investors are attracted by the higher interest rate in Japan. To invest in Japan, investors demand more Japanese Yen in the foreign exchange market. This leads to an increase of Yen value against dollar, which in turn decreases the exchange rate. d. Huge foreign aid from America An increase in United States' foreign aid to other nations increases the supply of dollar in the foreign exchange market. The increase in supply of dollar decreases the dollar value, which in turn reduces the exchange rate. e. If United States is in recession and Japan is in boom When the United States is in recession, its imports would decrease and exports would increase. Therefore, United States' demand for Japanese Yen will decrease. On the other hand, Japan's imports would increase and exports would decrease due to the boom in the economy. Therefore, they demand more dollars, which in turn increases the value of dollar and increases the exchange rate. f. If inflation in United States is higher than Japan When the United States' inflation increases more than that of Japan, it leads to an increase in United States' imports. The increase in imports increases the supply of dollars in the foreign exchange market. The increase in supply of dollar decreases the value of dollar, which in turn reduces the exchange rate.

Exchange rate Exchange rate refers to the amount of domestic currency required to purchase one unit of foreign currency. For example, if 0.02 dollar is required to buy one Indian rupee then the exchange rate is $0.02:Rs 1. Impact of appreciating the currency value When the currency value appreciates, then the exchange rate increases. This decreases the price of foreign goods in the domestic market. Impact of appreciating the dollar value and the price of German camera When the dollar value appreciates, it leads to increase in the exchange rate. Since the exchange rate increases, it results in the purchase of more euros for the same amount of dollars. This decreases the price of European goods in America. Therefore, the price of German camera in America decreases. Impact of appreciating the dollar value and the demand for German camera Since the price of German camera in America decreases, Americans buy more German cameras. This increases the demand for German camera in America. Shape of the demand curve for euro When the exchange rate increases due to appreciation of American dollar, the value of euro depreciates. Since the value of the euro decreases, demand for European goods increases; this in turn leads to increase in the value of euro in America, and vice versa. Hence, demand for euro in America slopes downward.