F405: International

Finance

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Assignment-1

Exchange Rate Determination

Chapter 4

Submitted to:
Syeda Mahrufa Bashar
Assistant Professor

Submitted by:
Group 02
MD. Fahmin Rahman (ZR-15)
Adiba Islam (RH-20)
Bijoya Chakraborty (RH-22)
Nafisa Afsana Taskia (RH-37)
Imtiaz Farhan Bin Habib (ZR-61)

Sec A, BBA 20th

Submitted on:
September 19, 2015

Institute of Business
Administration
University of Dhaka

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QUESTION 28
WEIGHING FACTORS THAT AFFECT
EXCHANGE RATES
Assume that the level of capital flows between the United States
and the country of Zeus is negligible (close to zero) and will
continue to be negligible. There is a substantial amount of trade
between the United States and the country of Zeus. The main
import by the United States is basic clothing purchased by U.S
retail stores from Zeus, while the main import by Zeus is special
computer chips that are only made in the United States and are
needed by many manufacturers in Zeus. Suddenly, the U.S.
government decides to impose a 20 percent tax on the clothing
imports.

The

Zeus

government

immediately

retaliates

by

imposing a 20 percent tax on the computer chip imports. Second,

the Zeus government imposes a 60 percent tax on any interest
income that would be earned by Zeus investors if they buy U.S
securities. Third, the Zeus central bank raises its local interest
rate so that they are now higher than interest rates in the United
States. Do you think the currency of Zeus (called the zee) will
appreciate or depreciate against the dollar as a result of all the
government actions described above? Explain.
Answer:
Factors that may affect the value of Zee:
1. US Impose 20% Tax on Clothing Import
Import from Zeus by United States will increase the price of clothing.
Hence the volume of clothing exported by Zeus will decrease. This will
cause the export earning of Zeus to fall. As there will be less requirement

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of import from Zeus the demand for Zeus will decrease and hence will the
price for Zee. This will result in depreciation of Zee.
2. Zeus Imposing 20% Tax on computer chip imports
As the computer chips are essential for the manufacturers in Zeus and are
only made by the United States producers the demand for the chips is
inelastic in nature. Hence imposition of tax on computer chips will not
decrease the import of chips from United States to that extent.

As there is equal percentage of tax imposed by both the governments the

tax on clothing will have more effects than the tax on chips. The overall
effect will cause the value of Zee to depreciate.
The figure shows that the quantity demanded for Zee will decrease
causing a shift of demand from Q to Q1. This will cause the price shift from
P to P1.
However, the following factors will not have any effects on Zee:
1. 60 percent tax on any interest income.
2. Increase of relative interest rate in Zeus
This is because there is insignificant capital flow between these two
countries and both the above effects will impact the currencies only if
there is a transaction of capital between them.

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BLADES INC. CASE

ASSESSMENT OF FUTURE EXCHANGE RATE
MOVEMENTS
Q1. How are percentage changes in a currencys value measured?
Illustrate your answer numerically by assuming a change in the
Thai bahts value from a value of $0.22 to $0.26.
Answer:
Percentage changes in a currencys value= (S-St-1))/St-1
In the above equation, denotes the current spot rate, and S t-1 denotes the
spot rate of the previous date using which the comparison will be done. A
positive percentage change represents appreciation of the currency, while
a negative percentage change represents depreciation.
According to the question, the change in Thai baht would be:
=

(0.026-0.022)/0.022

=+18.18%
Therefore, Thai baht is expected to appreciate by 18.18%.
Q2. What are the basic factors that determine the value of a
currency? In equilibrium, what is the relationship between these
factors?
The basic factors that determine the value of a currency are:

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the supply of the currency for sale, and

the demand for the currency.

There is a positive relationship between the value of a currency and the

quantity of that currency available for sale. Thus the supply curve is
upward sloping, indicating that the supply of a currency generally
increases with the rise in currencys value, as illustrated below:

Conversely there is a negative relationship between the value of a

currency and the quantity available for sale, leading to a downwards
sloping demand curve. This is because corporations and individuals of
home country will be encouraged to purchase more foreign currency when
it is worth less as it will take less local currency to obtain their desired
level of foreign currency.

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In equilibrium, the supply and demand schedules of a given currency are

combined to reach a value where the supply of the currency equals the
demand for the currency. This equilibrium exchange rate hold true for any
point in time unless external factors such as inflation rates, interest rates,
government controls etc. cause the demand and/or supply curve to shift
and establish a new equilibrium point.

Q3. How might the relatively high levels of inflation and interest
rates in Thailand affect the bahts value? (Assume a constant
level of U.S. inflation and interest rates)
The inflation levels and interest rates in Thailand, relative to levels of
these variables in the U.S., will both have an effect on the value of Thai
baht.
Effect of high Inflation on Thai bahts value
High Inflation is likely to reduce Thai baht's value relative to
dollar. This is because a high level of inflation tends to result in currency
depreciation, as it would increase the Thai demand for U.S. goods. Thus,
there will be an increase in the Thai demand for US dollars. Also, a
relatively high level of Thai inflation would reduce the U.S. demand for
Thai goods. This will lead to an increase in the supply of baht for sale.
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These market reactions are illustrated in the graph below:

The previous equilibrium had the exchange rate at $P. The increased Thai
demand for US dollars causes the demand curve to shift the right from D
to D1 and the increased supply of baht for sale causes the supply curve to
shift to the right from S to S1. The new equilibrium is a lower exchange
rate at $P1, indicating a depreciation of Thai baht relative to US dollars.
Effect of high interest rate on Thai bahts value
High Interest rates are expected to increase Thai bahts value
relative to dollar. A relatively high level of interest rates in Thailand
would make investments there more attractive for U.S. investors, causing
an increase in the demand for baht as there is more return on investment
in Thai bank deposits. Moreover, U.S. securities would have been less
attractive to Thai investors, causing an increase in the supply of dollars for
sale. The supply of baht for sale will decrease. However, investors might
be unwilling to invest in baht-denominated securities if they are
concerned about the potential depreciation of the baht that could result
from Thailands inflation.

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The previous equilibrium had the exchange rate at $P. The increased
demand for Thai baht causes the demand curve to shift the right from D to
D1 and the decreased supply of baht for sale causes the supply curve to
shift to the left from S to S1. The new equilibrium is a higher exchange
rate at $P1, indicating an appreciation of Thai baht relative to US dollars.
Both the inflation rate and interest rate will move the value of baht in
opposite directions, but the effect can be measured by looking at the real
interest rate.
Q4. How do you think the loss of confidence in the Thai Baht,
evidenced by withdrawal of funds from Thailand, will affect the
bahts value? Would Blades be affected by the change in value,
given the primary Thai customers commitment?
The loss of confidence in Thailand and the withdrawn of Thai baht will
increase the supply of Thai Baht in the foreign exchange market, which
will eventually cause the Thai baht to depreciate its value with respect to
the foreign currencies. The effect is illustrated in the diagram below:

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In the graph above, D is the demand curve for the quantity of baht
demanded, S is the initial supply curve and P is the current equilibrium
exchange rate of baht in terms of dollar. When the investors withdraw
their funds, there is a sudden increase in the supply of baht and S moves
to S1, causing the equilibrium to switch from P to P1. Therefore, the
value of baht depreciates in terms of US dollars.
Blades would surely be affected by the decrease in the value of baht.
Since the value of baht depreciated with respect to US dollars so now
Blades can import goods from Thai suppliers using fewer US dollars which
will decline the cost of Blades imports, hence benefitting Blades.
Q5. Assume that Thailands central bank wishes to prevent a
withdrawal of funds from its country in order to prevent further
changes in the currencys value. How could it accomplish this
objective using interest rates?
In order to prevent further depreciation in the baths value due to
withdrawal of funds, Thailands central bank can attempt to increase the
level of interest rates in Thailand. This would increase the demand for Thai
baht by US investors as Thai securities would now seem more attractive
due to higher rate of interests being provided on deposits with Thai banks.
This would place upward pressure on the currencys value.

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In the graph above, D is the initial demand curve for the quantity of baht
demanded, S is the l supply curve and P is the current equilibrium
exchange rate of baht in terms of dollar. When interest rate is raised by
the central bank, there is a sudden increase in the demand of baht and D
moves to D1, causing the equilibrium to switch from P to P1.
Therefore, the value of baht appreciates in terms of US dollars.
Disadvantage
However, the high interest rates could reduce local borrowing and
spending and might lead to deflation.
Assumption
The withdrawal of funds from Thailand can only be prevented by
increasing interest rates, provided that other central banks dont make
same adjustments at same time.

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