Tutorial- Exchange Rates and the Foreign Exchange Market: An Asset Approach

1) What are the three factors that affect the demand for foreign currency?

expected return,
risk
liquidity.

2) Explain risk and liquidity of assets.

Risk is the variability an asset contributes to a savers' wealth. An asset's real return can be
unpredictable and savers dislike this uncertainty if the return fluctuates widely.
Liquidity refers to the ease with which an asset can be sold or exchanged for goods. Cash is
the most liquid of assets because it is always acceptable at face value as payment for goods or
other assets. Thus, savers consider an asset's liquidity and its expected return and risk in
deciding how much of it to hold.

3) Explain two types of changes in exchange rates

a. Depreciation of home country’s currency

It makes home goods cheaper for foreigners and foreign goods more expensive for
domestic residents.
b. Appreciation of home country’s currency
It makes home goods more expensive for foreigners and foreign goods cheaper for
domestic residents.

4) How will changes in the Current Exchange Rate Affect Expected Returns?
• Depreciation of a domestic country’s currency today lowers the expected
domestic currency return on foreign currency deposits.
• Appreciation of the domestic currency today raises the domestic currency
return expected of foreign currency deposits.
5) What is the Effect of changing Interest Rates on the Current Exchange Rate?
An increase in the interest rate paid on deposits of a currency causes that currency to
appreciate against foreign currencies.
A rise in dollar interest rates causes the dollar to appreciate against the euro.
A rise in euro interest rates causes the dollar to depreciate against the euro.
OR
A decrease in the interest rate paid on deposits of a currency causes that currency to
depreciate against foreign currencies.
A decrease in dollar interest rates causes the dollar to depreciate against the euro.
A decrease in euro interest rates causes the dollar to appreciate against the euro.
6) What are the Effect of changing Expectations on the Current Exchange Rate
A rise in the expected future exchange rate causes a rise in the current exchange rate.
A fall in the expected future exchange rate causes a fall in the current exchange rate.
7) Discuss (with the use of graph) the effects of a rise in the interest rate paid by euro
deposits on the exchange rate (Dollar/Euro exchange rate).

There are two effects to consider. If we make the unrealistic assumption that the expected
exchange rate will not change, then a rise in the interest rate paid by Euro deposits causes the
dollar to depreciate. However, if the expected exchange rate were to rise, then the current
exchange rate would also rise. People in the US will deposit their money in Europe because
of an appreciation of Euro, to get better returns.
8) Discuss (with the use of graph) the effects of a rise in the dollar interest rate on the
exchange rate (Dollar/Euro exchange rate).

There are two effects to consider. A rise in the interest rate offered by dollar deposits
combined with a constant expected exchange rate will cause the dollar to appreciate, due to
an increase of interest rates. The Euro will depreciate against the dollar, because no one will
want to hold the euro (due to an increase in offered by dollar deposits). Then, Europeans will
deposit their money in the US.