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Financial Institutions, Instruments and Markets 8th edition Instructor's Resource Manual Christopher Viney and Peter Phillips Chapter 16 Foreign exchange: factors that influence the exchange rate Learning objective 1: Explain how factors that affect the demand for a currency, or the supply of a currency, affect the determination of an equilibrium exchange rate • An exchange rate is the price of one currency in terms of another currency • Most developed economies operate a floating exchange-rate regime whereby the price of the currency is determined by the demand for and the supply of that currency in the FX markets • Any change in the factors that impact upon the demand for and supply of a currency will result in a change in the exchange rate • A country that maintains a linked exchange rate, crawling peg or managed float exchange rate regime, whereby the local currency is tied to another currency such as the USD, or a basket of other currencies, is effectively tied into supply and demand factors that affect the currency or the basket of currencies to which it is linked or pegged Learning objective 2: Understand how the major factors that influence exchange rate movements operate, particularly relative inflation rates, relative national income growth rates, relative interest rates, exchange rate expectations, and central bank or government intervention Relative inflation rates • Of the theories advanced to explain the exchange rate, and changes in the equilibrium rate, the purchasing power parity (PPP) theory is the longest standing • Under PPP, a country with a higher inflation rate relative to another country can expect its currency to depreciate • Perhaps the most critical shortcoming of PPP is that there are variables in addition to inflation that affect the value of a currency • The Extended learning section considers PPP calculations that apply inflation differentials between two countries to determining the expected change in the exchange rate Relative national income growth rates • There is wide agreement that changes in the relative rates of growth in national incomes affect the exchange rate • There is disagreement, however, as to the nature of the effect • An increase in the relative rate of growth is likely to result in an increased demand for imports, which will result in a depreciation of the currency • On the other hand, an increase in the growth rate may also result in an increase in foreign investment inflows, which will cause the currency to appreciate • Both mechanisms are likely to operate, with the balance between the two changing from time to time Relative interest rates • The interest rate differential between two countries is also important in determining the demand for and supply of a currency in the FX market; however, the effects of a change in the interest rate differential are ambiguous • It is important to determine whether the change is due to a change in inflationary expectations or a change in the real rate of interest • If the increase in interest rates is a result of an increase in inflation expectations a currency should depreciate However, if the increase is due to a rise in the real rate of interest, then the currency should appreciate Exchange rate expectations • In addition to the economic fundamentals, exchange rate expectations are important in determining the FX value of a currency • If the markets expect the exchange rate to depreciate, this will ultimately result in FX buy or sell transactions that cause the depreciation; if an appreciation is expected, an appreciation typically will be experienced • The modelling of expectations is a particularly difficult task Theoretically, expectations should be formed on the basis of the expected values of economic fundamentals However, the FX market often reacts to new information before the impact on the longer-term economic fundamentals is fully analysed • It may be possible to adopt a specific market indicator as a proxy for exchange rate expectations For example, in Australia, the commodity price index is often used as such a proxy Central bank or government intervention • At times, the actions of governments or central banks are another variable that may be important in the FX markets • The monetary policy setting of a central bank will impact upon the demand and supply factors that affect an exchange rate Also, a central bank or government may intervene in the FX markets to influence directly the level of an exchange rate by intervening in international trade flows, intervening in foreign investment flows or conducting FX transactions in the markets • For example, in an attempt to increase the FX value of its currency, a central bank may sell foreign currency and buy the local currency; alternatively, to reduce the value of its currency, the central bank may buy foreign currency Alternatively, a government may implement policies that change tariff, quota or embargo settings relating to goods and services Learning objective 3: Explore regression analysis as a statistical technique applied to variables that impact on an exchange rate • Regression analysis is a statistical technique that may be used to try to ascertain the relationship between a dependent variable and changes in independent variables • An exchange rate may be the dependent variable • Major independent exchange rate variables are relative inflation rates, relative national income growth, relative interest rates, government or central bank intervention, and market expectations Essay questions The following suggested answers incorporate the main points that should be recognised by a student An instructor should advise students of the depth of analysis and discussion that is required for a particular question For example, an undergraduate student may only be required to briefly introduce points, explain in their own words and provide an example On the other hand, a post-graduate student may be required to provide much greater depth of analysis and discussion Use the theory of demand and supply to explain how equilibrium emerges with the FX markets Is this theory consistent with the volatility that FX markets are observed to exhibit? (LO 16.1) • The quantity demanded of a currency will increase as its price (exchange rate) falls and decreases as its price rises Geometrically, this traces a negatively sloped line • The quantity supplied of a currency will decrease as its price falls and increase as its price rises Geometrically, this traces a positively sloped line • Demand and supply correspond at some point Geometrically, this is the point at which the two lines intersect or cross • At points to the left of the intersection, demand is greater than supply As such, the price of the currency will tend to increase as more supply is called forth • At points to the right of the intersection, supply is greater than demand As such the price of the currency will tend to decrease • By this logic, there is a tendency towards the point of intersection between demand and supply This point of intersection is an equilibrium point • Theoretically, divergences from the equilibrium point should be fleeting and quickly corrected • Volatility is not necessarily inconsistent with this model It could be the case that demand and supply curves oscillate a lot and new equilibria are constantly being formed However, if one views equilibrium as a calm, almost static, state the volatility exhibited by FX markets is unlikely to accord well with such a view • It should be recognised that equilibrium is not a ‘real’ phenomenon It is never observed in practice As such, there will only be a tendency towards equilibrium, which is disturbed before it can fully work itself out Draw a graph that depicts the AUD/EUR demand curve and supply curve Plot the equilibrium exchange rate at AUD/EUR0.7000 If the spot exchange rate is AUD/EUR0.7500 Euro cents, what impact will that have on the demand and supply position in the FX markets? (LO 16.1) AUD/EUR Supply curve 0.7500 0.7000 Demand curve Quantity of the currency E • Assume the Australian dollar is the local currency • At the AUD/EUR0.7500 exchange rate the price of local goods and services in the international markets increases and the demand for the AUD will fall Also, the cost of imports is cheaper therefore the supply of AUD increases as locals buy the EUR to purchase overseas goods and services • In order to sell the increased supply of AUD market participants will bid down the currency until it comes into equilibrium at AUD/EUR0.7000 Under a floating exchange rate regime, the exchange rate will always adjust so that the demand for, and the supply of, a currency in the FX market will be equal (a) Having regard to this statement, describe the mechanisms through which equilibrium is maintained in the event of a change in the demand or supply curves • Given the data in the diagram below, the equilibrium exchange rate based on the supply and demand curves is AUD/USD1.0225 • This is the exchange rate that is sustainable over time, assuming there is no change in factors influencing the supply and demand curves • Any other exchange rate is not sustainable; for example, at a rate of AUD/USD0.9820 the quantity of AUD demanded is 25 billion, but the quantity supplied is only 15 billion • There is an excess demand for the AUD • The FX dealers would not be able to meet the demands of their clients • Their clients would have to instruct their dealers to offer a higher price • The effect of the higher price is twofold; first, as the price of the AUD is bid up the quantity supplied would increase; second, some who demanded the AUD at 0.9820 would withdraw from the market as the exchange rate appreciates The combined effect is that the increase in the price reduces the excess demand • The price would continue to be bid up to a rate of 1.0225 at which point there is no pressure in the marketplace for the price to change further • This conclusion stands only while the demand and supply curves remain where they are • Factors that determine the positions of the curves change through time • With changes in these variables, and thus in the positions of the curves, the equilibrium exchange rate will change • Variables that may affect the positions of the demand and supply curves include the relative inflation rates, relative national income growth, relative interest rates, exchange rate expectations and central bank or government intervention (b) Draw a diagram showing the appropriate demand and supply curves (LO 16.1) AUD/USD Price S 1.0225 0.9820 D 15 20 25 Quantity of AUD (billion $) The Reserve Bank of Australia sometimes intervenes in the FX markets (a) Discuss the importance of the RBA trading under its own name during these periods • When it intervenes in the FX markets, the RBA may be seeking to smooth the trading activity that is pushing the AUD much higher or lower than the RBA feels is desirable • By trading under its own name, the RBA reveals to the market that it is actively trading in a particular direction • This serves to communicate the RBA’s position on the current state of affairs in the FX markets and, especially during times of crisis, may provide a steadying or calming influence (b) What is the rationale for the RBA targeting its interventions in the AUD/USD exchange market? (LO 16.2) • The RBA targets its interventions in the FX markets to the AUD/USD exchange market because the AUD/USD market is the biggest and most visible Draw a chart and explain in words what is expected to happen to the Indian rupee demand and supply curves (USD/INR) if there is a forecast increase in India’s inflation rate while the inflation rate remains stable in the USA (LO 16.2) • Purchasing power parity contends that exchange rates will adjust to ensure prices on the same goods are equal between countries INR/USD S0 49.50 S1 48.25 D1 D0 Indian Rupee (billion) • A sustained surge in Indian inflation will increase the costs of local goods • USA demand for the Indian goods would fall • Therefore there would be a reduction in the demand for the Indian rupee • The demand curve would move from D0 to D1 • At the same time Indian would seek relatively cheaper goods from overseas • The supply of the INR would increase as importers purchased the USD • The supply curve would move from S0 to S1 • The net result would be a depreciation in the INR to and exchange rate of USD/INR48.25 Draw a chart and explain in words what is expected to happen to the New Zealand dollar demand and supply curves (USD/NZD) if there is a forecast increase in New Zealand’s national income relative to a stable growth rate in the USA (LO 16.2) NZD/USD S0 S1 D0 Quantity NZD • New Zealand’s demand for imports would increase • Increase in supply of NZD in order to purchase USD to pay for imports • The supply curve would move from S0 to S1 • With USA national income unchanged the USA demand for New Zealand goods, and thus the NZD, will remain unchanged • The demand curve is therefore unchanged • The net effect is a depreciation in the NZD However, as discussed in question we need to consider the impact of increased investment on the exchange rate as well Consider the following apparently contradictory statements: (i) ‘An increase in the rate of growth in a country’s national income relative to that in the rest of the world will result in a depreciation of that currency.’ (ii) ‘An increase in the rate of growth in a country’s national income relative to that in the rest of the world will result in an appreciation of the currency.’ (a) Outline the mechanisms through which forecasters responsible for the above comments see the change in national income affecting the FX markets • There are two factors that can affect the equilibrium exchange rate due to changes in relative income growth: o increased demand for imports o increased overseas investment • Each of these factors has an opposite impact on exchange rate movements Increased demand for imports: • will result in a depreciation of the local currency Refer to your answer in question Increased overseas investment: • If we continue to use the question example of an increase in the national income of New Zealand relative to the USA • Improved growth prospects will encourage New Zealand businesses to expand To so they will require additional funds and these may be raised through the issue of additional equity or through increased debt • Some of the equity and debt is likely to be provided by foreign investors • Foreign investors will be attracted to New Zealand debt and equity since, with higher growth in the economy, it is reasonable to expect improved profits The foreign currency that foreign investors provide will have to be converted into NZD for use in New Zealand; that is, there will be an increase in demand for the NZD in the FX market • If this impact could be taken in isolation, the higher growth rate in New Zealand would result in an appreciation of the NZD NZD/USD S0 D1 D0 Quantity NZD (b) Is it possible to deem one or other of the forecasters to be correct? Explain your response (LO 16.2) • There are conflicting influences on the value of the currency arising out of changes in relative income • One effect results in a depreciation of the currency will the other effect results in an appreciation of the currency The net outcome is not clear • The question of which influence dominates cannot be resolved at a theoretical level • What is required to attempt to resolve the issue is the use of empirical techniques, such as regression analysis, and a familiarity with what is going on in the economy and with how domestic and foreign investors are reacting to economic developments Draw a chart and explain in words what is expected to happen to the Indonesian rupiah demand and supply curves (USD/IDR) if there is a forecast increase in Indonesia’s interest rates relative to interest rates in the USA (LO 16.2) • If Indonesian interest rates rise, while those in the USA remain relatively stable, overseas residents and institutions can be expected to place some of their excess cash in interest-bearing instruments in Indonesia in order to obtain the higher rate of return This is represented by an increase in demand for IDR • At the same time, Indonesian businesses are likely to keep their surplus funds in banks and instruments in Indonesia rather than in the lower rate of return overseas 10 • With fewer IDR being placed overseas there is a reduction in the supply of IDR in the FX market • The combined effect is that the increase in interest rates has resulted in an increase in the demand for IDR, and a reduction in the supply of IDR, and consequently the IDR has appreciated IDR/USD S1 S0 D0 D1 Quantity IDR However, as discussed in question we need to consider the reason for the higher interest rates in Indonesia Each of the following statements has been put forward as an explanation of exchange rate movements ‘The increase in the value of a currency is because rates of interest in that country have risen relative to those in the rest of the world.’ ‘The decrease in the value of a currency is because rates of interest in that country have risen relative to those in the rest of the world.’ Explain and reconcile these two statements (LO 16.2) Appreciation of AUD in rising interest rate environment: • In question we recognised that an increase in relative interest rates may lead to increased investment in Indonesia by overseas investor, plus increased investment by local investors, resulting in an appreciation of the currency However, if we extend our question discussion further we are able to introduce the prospect that the higher relative interest rates may lead to a depreciation in the currency (opposite to our question outcome) 11 • The nominal interest rate includes the real rate of interest plus an inflation expectation component • The scenario put forward in question assumes the increase in interest rates was due to an increase in the real rate of interest (currency appreciated) However, if the increase in interest rates was because of an increase in the inflation expectation component then the currency may depreciate • Under PPP a sustained increase in inflation will result in a depreciation of the currency (see question answer) • Further, the higher inflation component may result in investors limiting their investment within the local economy and investing overseas in order to protect against the rising inflation This will lessen the appreciation effect discussed in question 10 Consider the data in the two scenarios in the table below Scenario iAUD (%) iUSD (%) Expected change in value of AUD (%) −  4 2 +4 (a) Under which scenario will an investor in the USA consider investing funds in the Australian money markets? Explain why this is so • The investor would only invest under scenario • In scenario 2, the US-based investor will be attracted to invest in Australia so long as he/she is confident that the expected appreciation of the AUD of 4% will occur • The 4% appreciation of the capital amount invested in Australia will more than offset the lower 2% interest rate available in Australia • The investor must be aware that forecasts of future exchange rate appreciations or depreciations contain a degree of uncertainty (b) Also, explain why the investor would not find the other scenario attractive (LO 16.2) • In scenario 1, although rates of interest are higher in Australia than they are in the USA, the investor would be reluctant to invest in Australia 12 • From the perspective of a US-based investor, if funds were placed in Australia to take advantage of the higher rate of interest, and if the expected 4% depreciation of the AUD did eventuate, then the investor would, after the depreciation, be worse off compared with the return that would be earned in the USA • The 3% per annum benefit obtained by placing funds in the Australian money market would be more than offset by the 4% depreciation of the AUD 11 Participants in the FX markets actively attempt to forecast changes in economic variables that should impact upon future exchange rates Therefore, it may be argued that exchange rate expectations are of critical importance in determining the FX value of a currency (a) Identify and discuss factors that may be relevant when forming exchange rate expectations • A large proportion of the turnover in the FX market is not accounted for by transactions associated with payments for imports and exports of goods and services and capital market transactions • FX transactions conducted by speculators and traders represent a significant proportion of international FX market transactions • It may be argued that once market participants’ expectations are formed, their trading activities become self-fulfilling • If speculators expect a depreciation of a currency then, all else being constant, a depreciation will often occur; for example, the anticipation of a depreciation say the AUD would provide a strong incentive to move funds off-shore • This would result in an increase in the supply of AUD on the FX market as holders of the AUD seek to buy foreign currencies before the value of the AUD falls (S 1) Simultaneously there would be a reduced demand for the AUD (D ) as purchases of the currency are deferred until after the expected depreciation occurs 13 AUD/USD S0 S1 1.0200 0.9850 D1 D0 Quantity AUD • Since it is argued that changes in relative inflation, relative income and relative rates of interest each affect the equilibrium exchange rate, it is reasonable to hypothesise that expectations about the future developments in each of these variables should influence exchange rate expectations • It is quite probable that expectations will dominate the other variables in influencing the value of the currency; for example, if Australia’s rate of inflation is higher than that in the USA, then a PPP-type of forecast would have the AUD depreciate • However, if market participants expect that the government will put in place policies aimed at reducing inflation, the AUD may well remain stable in value, or appreciate; that is, the current value of the currency may be reflecting expectations about the future levels of the relevant variables (b) Discuss the proposition that an economic indicator may be a suitable proxy for exchange rate expectations In your answer examine the use of the Australian commodity price index (LO 16.2) • Australia is a major commodity exporter, representing over 15% of GDP • The Reserve Bank publishes a commodity price index comprising twenty major rural, base metal, and other resource commodities • In Australia there is reason to expect the value of the AUD and the commodity price index to be positively related; therefore, as the value of commodities increases, all else being constant, the value of the AUD should also increase Falls in the index should be associated with a fall in the value of the currency 14 • Research indicates that using the commodities index as a proxy indicator only works some of the time in Australia • A major weakness is the lagging nature of the commodity price index; the FX markets are much more dynamic than the monthly index 12 During the global financial crisis, the Reserve Bank actively intervened in the FX markets Outline the purpose of this intervention and explain how the intervention was carried out (LO 16.2) • The RBA intervened in the FX markets on a total of 10 days during 2007 and 2008 • The interventions in 2007 and 2008 involved sales of foreign exchange totalling $4 billion • The purpose of the intervention was to address the illiquidity that had emerged in the FX markets and the increasingly wide bid-ask spreads associated with that illiquidity • Like most of the RBA’s interventions in the FX markets, these transactions were undertaken in the AUD/USD exchange market under the RBA’s name to alert market participants of the RBA’s views and presence in the market • This was a smoothing operation 13 A market-determined exchange rate is affected by changes in relative inflation, relative national income growth rates, relative interest rate differentials, government or central bank intervention, and market expectations Regression analysis is a statistical technique used in the analysis of exchange rate movements Having regard to these variables, explain how FX market participants use regression analysis to attempt to forecast exchange rate movements (LO 16.3) • Regression analysis is frequently used to assess how movements in a range of variables might affect another variable • The regression model, using the identified variables, may be specified as: % change in AUD/USD in period t = a0 + a1(IUS - IA)t + a2(YUS - YA)t + a3(iUS - iA)t + a4(GA)t+ a5(GUS)t + Ut • Where a0 equals the intercept term or constant, a1 to a4 equals the regression coefficients that measure the responsiveness of the exchange rate to the variable inflation (I), national income growth (Y), interest rates (i), central bank and government intervention (G), and U equals the 15 regression error term The model assumes an efficient market; therefore the exchange rate expectation variable should be zero • Once the data for all variables are compiled, and the regression program is run, estimates of each of the regression coefficients will be provided • The output needs to be analysed and interpreted Section 16.4 of the text provides some analysis of regression coefficients • statistical tests can be carried out to ascertain the statistical significance of the results (this is beyond the scope of material covered in this text) Extended learning questions 14 Briefly outline the basic contention of the purchasing power parity theory of exchange rate determination • PPP theory contends that exchange rates, in a floating exchange rate regime, will adjust to ensure prices on the same goods and services are equal between countries • The PPP theory has been used to determine whether or not various currencies are appropriately valued in FX markets; for example, under PPP if the price of a product in the UK increases by 3%, but the price remains unchanged in New Zealand, the NZD should appreciate by 3% If the NZD did not appreciate by that amount it is undervalued, and market participants would expect it to appreciate • While PPP sounds rational, in practice PPP, as a theory of exchange rate determination, provides reasonable results only in the long run • PPP does not appear to be very useful in explaining movements in exchange rates where the periods under consideration are as short as a few months or even a few years 15 While the PPP theory has stood the test of time, it must be recognised that it has some identifiable inadequacies List and explain the inadequacies of the PPP theory within the context of exchange rate determination • The mechanism through which PPP is expected to work is through adjustments in the demand for goods, services and commodities between countries with different rates of inflation • Using an example of the United Kingdom and New Zealand where inflation is higher in the UK • Under PPP it is assumed that UK residents can find substitutes for UK goods in NZ, where inflation is lower, and that NZ buyers will switch their demand away from UK goods to the cheaper NZ substitutes 16 • However, such substitutes may not exist Even if they exist, buyers of goods may be reluctant to change their demand to new, unknown and untried suppliers They may prefer to pay the higher price and stay with suppliers with whom they have had a long-standing business relationship With such relationships there are often associated benefits such as good terms for payment, known reliability of quality and supply, and preferential after-sales service PPP also ignores the time factor, distance, and information availability UK residents may not be fully informed of substitute goods, services or assets available in NZ There is also a delivery factor, which, in the NZ case, is quite significant It will take additional time and cost to ship goods overseas, and services provided in one country may not be readily provided in another country FINANCIAL NEWS CASE STUDY Purchasing power parity or PPP is a core component of the economic theory of exchange rates As our discussion and examples have shown throughout this chapter, the idea is very simple The prices of the same goods in different countries should be the same after taking factors like transport costs into account If purchasing power parity holds, for example, I should be able to purchase the same basket of goods in Australia with Australian dollars as I can if I convert my Australian dollars into US dollars and purchase that basket of goods in America If, by converting my Australian dollars into US dollars, I can obtain the same basket of goods cheaper than I can in Australia, then the Australian dollar might be perceived to be overvalued and vice versa Because PPP provides an easy-to-understand indication of the relative value of exchange rates, different examples emerge in the press from time to time In fact, The Economist magazine has been running its ‘Big Mac Index’ for many years In Australia, recent debate has been focused on the strength of the Australian dollar, which has placed the manufacturing and agricultural industries under pressure The big question is whether the Australian dollar is overvalued According to PPP theory, we should be able to get some idea by comparing the prices of some popular consumer items in different parts of the world As in the example above, if I can purchase the good more cheaply by converting my Australian dollars into, say, US dollars or Euros and purchasing the item in America or Germany, this would be an indication that the Australian dollar is relatively overvalued This debate and the relevance of PPP is reflected in 17 the following observation regarding the price of the iPad: Australia is one of the cheapest places in the world to buy a new iPad, a survey suggests, raising questions about whether the Australian dollar is overvalued An analysis by Commonwealth Securities, which looked at the prices of a 16-gigabyte iPad across 46 countries, found that Australia was the fourth-cheapest place to buy the device, behind Malaysia, Hong Kong and Japan The survey compares the price of the iPad according to purchasing power parity (PPP) PPP looks at the prices of a particular good in different countries according to the local currency A similar survey by The Economist magazine, the Big Mac Index, recently concluded that the Australian dollar was near fair value in July 2013 when it was around US90¢ But economists say the dollar has some way to fall to reach fair value SOURCE: Extract from Kwek, G ‘Fair or Not, the Australian Dollar Remains Overvalued’, Sydney Morning Herald, 24 September 2013 Available at: DISCUSSION POINTS • This news article contends that the AUD is overvalued because the price of a new iPad is relatively low in Australia Explain how this conclusion can be supported by appealing to the theory of purchasing power parity Comparing the cost of the iPad in different countries amounts to comparing the relative cost of a basket of goods that contains a single item (iPad) The logic remains the same If the basket of goods can be purchased more cheaply in Australia than in another country there is an indication that the Australian dollar is relatively overvalued • Identify some potential strengths and weaknesses of the analysis presented in the news article For example, is an iPad an international consumer item? Is it expensive to transport? Is it likely to be indicative of the relative prices of a broader ‘basket of goods’? In some respects an iPad is a reasonable choice of product to use in this type of ‘analysis’ It is an international product that can be transported easily, etc However, when a single 18 product is chosen, there are doubts about its representativeness It depends, for example, on how much of a commitment out of consumers’ disposable income an iPad purchase represents in different countries It depends, for example, on nuances of pricing policy If the Australian consumers view different tablet devices as more or less perfect substitutes, the price of the iPad may be lower due to competition that does not exist elsewhere The difficulties appear to stem from choosing a single item for the ‘basket of goods’ rather than any particular features of the iPad True/False questions F Although the FX markets exhibit considerable volatility, it is possible to construct reliable and accurate forecasts of movements in the FX markets T If the AUD/USD exchange rate moves from AUD/USD0.9450–55 to AUD/USD0.9502– 09, there is said to have been an appreciation of the Aussie dollar F All other things equal, the quantity of a currency demanded will increase as its price or value increases F In equilibrium, the demand curve becomes exactly parallel to the supply curve and both are upward sloping T The supply of a currency into the FX markets should increase if holders of the local currency purchase foreign currency in order to fund investment and consumption overseas T As the exchange rate of a country depreciates, the price of goods exported from that country becomes relatively cheaper to foreign buyers F Where there is excess supply of a currency in the FX markets, dealers will bid up the price in order to create a demand for the currency and therefore maintain the exchange rate equilibrium T With the USD/AUD currency pair, a reduction in the demand for the USD is equivalent to a reduction in the supply of the AUD in the FX markets, and would result in the supply curve moving upwards to the left T A surge in inflation in the USA relative to that in another country could be expected to result in increased demand by US residents for goods from that lower inflation country, and the FX demand curve would move upwards to the right 10 T A change in the inflation differential between two countries will theoretically be offset by a corresponding change in the equilibrium exchange rate 19 11 T The purchasing power parity theory contends that an equilibrium exchange rate will prevail, such that the price of a specific asset in one country will cost the equivalent amount in another country 12 F Research into PPP tends to support the view that the theory is more reliable in the short term, and therefore is a less appropriate measure of exchange rate determination over the longer term 13 F The exchange rate will always change to reflect variations in inflation differentials between countries, because in a modern global economy goods and services are perfect substitutes 14 T A significant relationship between changes in the relative growth rates in national incomes and the exchange rate operates through changes in the demand for imports and exports 15 F There is conclusive evidence that an increase in national output growth and income will result in an immediate and sustained appreciation of the exchange rate 16 F There is no relationship between interest rates and the exchange rate, because interest rates reflect the current yield on financial assets whereas exchange rates are the relative prices of different currencies 17 T All else being constant, it is to be expected that a currency will appreciate if there is an increase in real interest rates relative to those in other countries 18 F A central bank is said to be smoothing the FX markets when it carries out transactions to purchase foreign currency to pay for goods purchased by the government 19 F Central banks of countries that operate a floating exchange rate regime no longer intervene in the FX markets to influence the direction or speed of movements in the exchange rate 20 F Regression analysis is used to calculate accurately future changes in an exchange rate over a range of forward periods 20
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