Description
Analysis of Factors Affecting the Equilibrium Exchange Rates of the $/£
Assumptions:
a. US and UK goods are perfect substitutes
b. Initial equilibrium exchange rate is $1.50/£
c. If exchange rates increases, assumes it goes to $1.75/£ d. If exchange rates decreases, assumes it falls $1.30/£
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Analysis of Factors Affecting the Equilibrium Exchange Rates of the $/£
Assumptions:
a. US and UK goods are perfect substitutes
b. Initial equilibrium exchange rate is $1.50/£
c. If exchange rates increases, assumes it goes to $1.75/£
d. If exchange rates decreases, assumes it falls $1.30/£
a. US Inflation increases relative to UK inflation
Arrows
Why? Explain
Demand What happens to the demand
Decrease
analysis of US goods by USA citizens?
This is due to the inflation
of the US which will
increase the price level
that will decrease the
demand
Supply
analysis
What happens to the demand
of UK goods by USA
citizens?
Increase
How does this affect the
demand of the pound by USA
citizens?
Increase
What happens to the demand
of US goods by the British?
Decrease
Lower inflation in UK
compare to US will make
the UK goods cheaper for
US citizens thereby
increasing the demand of
UK goods by the US
citizens
Lower inflation in UK
compare to US will make
the UK goods cheaper for
US citizens thereby
increasing the demand of
UK goods by the US
citizens. Increasing
demand of UK goods by
the US citizens will in
return increase the
demand for pound by
USA citizens
Increasing price level of
US goods will make it
costlier for British that
will reduce the demand
for US goods
How does this affect the
demand of USD by the
British?
Decrease Increasing price level of
US goods will make it
costlier for British that
will reduce the demand
for US goods by the
British. This will in
return reduce the
demand for USD by
British
How does this affect the
supply of the pound?
Decrease
Lower inflation in UK
compare to US will make
the UK goods cheaper for
US citizens and the
demand of UK goods by
the US citizens will
increased. Increasing
demand of UK goods by
the US citizens will
increased the demand for
Pound by USA citizens
and decrease supply of
the Pound.
How does this affect the equilibrium
exchange rate? Illustrate using a graph.
Clearly label the graph. Use dotted lines
to show the shifts. Give the values for e0
and e1
e0 = GBP/USD =1.50
e1 = GBP/USD =1.75
Did the British pound appreciate or
depreciate?
Answer: British pound will appreciate
____________________________
Did the UD dollar appreciate or
depreciate?
Formula:
Calculations:
(1.75-1.50 = 0.25) 0.25
Formula:
Calculations:
Answer Dollar will depreciate
(1.50 - 1.75 = - 0.25) 0.25
____________________________
Conclusion?
Foreign exchange market is equilibrium at point A of the graph where
GBP/USD = 1.50. Now increasing demand for GBP shift demand curve from D
to D1 appreciating GBP to point E1 that is 1.75.
b. US interest rates increases relative to UK interest rates
Consider investors have the choice of investing funds in the USA or UK
Arrows
Why? Explain
Demand What happens to the
Decrease High interest rates will offer
analysis demand of the British
investors of US a higher
pound by US citizens?
return thus the dollar price
of pounds will increase in
return decreasing the
quantity of pounds leading
t...