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.

Acountrythatmaintainsalinkedexchangerate,crawlingpegormanagedfloatexchangerate
regime,wherebythelocalcurrencyistiedtoanothercurrencysuchastheUSD,orabasketof
othercurrencies,iseffectivelytiedintosupplyanddemandfactorsthataffectthecurrencyorthe
basketofcurrenciestowhichitislinkedorpegged.

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
1. 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
1

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.
2. 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.
3. 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.
4. 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
2

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.
5. 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: Exploreregressionanalysisasastatisticaltechniqueappliedtovariables

thatimpactonanexchangerate
Regressionanalysisisastatisticaltechniquethatmaybeusedtotrytoascertaintherelationship
betweenadependentvariableandchangesinindependentvariables
Anexchangeratemaybethedependentvariable.
Majorindependentexchangeratevariablesarerelativeinflationrates,relativenationalincome
growth,relativeinterestrates,governmentorcentralbankintervention,andmarketexpectations.

Essay questions
Thefollowingsuggestedanswersincorporatethemainpointsthatshouldberecognisedbyastudent.
Aninstructorshouldadvisestudentsofthedepthofanalysisanddiscussionthatisrequiredfora
particularquestion.Forexample,anundergraduatestudentmayonlyberequiredtobrieflyintroduce
points,explainintheirownwordsandprovideanexample.Ontheotherhand,apostgraduate
studentmayberequiredtoprovidemuchgreaterdepthofanalysisanddiscussion.

1. 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.

2. 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?
(LO16.1)

AUD/EUR

Supplycurve

0.7500
0.7000

Demandcurve
Quantityofthecurrency

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.

3. 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.
5

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. (LO16.1)

AUD/USD
Price
S
1.0225
0.9820
D
15

20

25

QuantityofAUD
(billion$)

4. 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 RBAs position on the current state of affairs in the FX markets
6

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.

5. 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 Indias 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.
USD/INR
S0
49.50

S1

48.25
D1

D0

IndianRupee(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
7

6. 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 Zealands national
income relative to a stable growth rate in the USA. (LO16.2)

USD/NZD
S0
S1

D0
QuantityNZD

New Zealands 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 7 we need to consider the impact of increased investment on the
exchange rate as well.
7. Consider the following apparently contradictory statements:
(i) An increase in the rate of growth in a countrys 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 countrys national income relative to that in the rest
of the world will result in an appreciation of the currency.
8

(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 6.

Increased overseas investment:

If we continue to use the question 6 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 do 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.

USD/NZD

S0

D1
D0
QuantityNZD

(b) Is it possible to deem one or other of the forecasters to be correct? Explain your response.
(LO16.2)

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.

8. 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 Indonesias interest
rates relative to interest rates in the USA. (LO16.2)

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.
USD/IDR
S1
S0

D0

D1

QuantityIDR

However, as discussed in question 9 we need to consider the reason for the higher interest rates in
Indonesia.
9. 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. (LO16.2)
Appreciation of AUD in rising interest rate environment:

In question 8 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 8 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 8 outcome).
11

The nominal interest rate includes the real rate of interest plus an inflation expectation
component.

The scenario put forward in question 8 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 5 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 8.

10. Consider the data in the two scenarios in the table below.
Expected change in
Scenario iAUD (%) iUSD (%) value of AUD (%)
1

+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 2.

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. (LO16.2)

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. ParticipantsintheFXmarketsactivelyattempttoforecastchangesineconomicvariables
thatshouldimpactuponfutureexchangerates.Therefore,itmaybearguedthatexchange
rateexpectationsareofcriticalimportanceindeterminingtheFXvalueofacurrency.
(a) Identifyanddiscussfactorsthatmayberelevantwhenformingexchangerate
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 1 ) as purchases of the currency are deferred until
after the expected depreciation occurs.

13

AUD/USD
S0
S1

1.0200

0.9850
D1

D0

QuantityAUD

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 Australias 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)Discussthepropositionthataneconomicindicatormaybeasuitableproxyforexchange
rateexpectations.InyouranswerexaminetheuseoftheAustraliancommodity price index.
(LO 16.2)

Australiaisamajorcommodityexporter,representingover15%ofGDP.

TheReserveBankpublishesacommoditypriceindexcomprisingtwentymajorrural,base
metal,andotherresourcecommodities.

InAustraliathereisreasontoexpectthevalueoftheAUDandthecommoditypriceindextobe
positivelyrelated;therefore,asthevalueofcommoditiesincreases,allelsebeingconstant,the
valueoftheAUDshouldalsoincrease.Fallsintheindexshouldbeassociatedwithafallinthe
14

valueofthecurrency.

Researchindicatesthatusingthecommoditiesindexasaproxyindicatoronlyworkssomeofthe
timeinAustralia.

Amajorweaknessisthelaggingnatureofthecommoditypriceindex;theFXmarketsaremuch
moredynamicthanthemonthlyindex.

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)

TheRBAintervenedintheFXmarketsonatotalof10daysduring2007and2008.

Theinterventionsin2007and2008involvedsalesofforeignexchangetotalling$4billion.

ThepurposeoftheinterventionwastoaddresstheilliquiditythathademergedintheFXmarkets
andtheincreasinglywidebidaskspreadsassociatedwiththatilliquidity.

LikemostoftheRBAsinterventionsintheFXmarkets,thesetransactionswereundertakenin
the AUD/USD exchange market under the RBAs name to alert market participants of the
RBAsviewsandpresenceinthemarket.

Thiswasasmoothingoperation.

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 toattemptto forecast exchange rate movements.
(LO16.3)

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 do 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: http://www.smh.com.au/business/fair-or-not-the-australian-dollar-remains-overvalued-20130923-2ua89.html

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
1.

F Although the FX markets exhibit considerable volatility, it is possible to construct reliable

and accurate forecasts of movements in the FX markets.

2.

T If the AUD/USD exchange rate moves from AUD/USD0.945055 to AUD/USD0.9502

09, there is said to have been an appreciation of the Aussie dollar.

3.

F All other things equal, the quantity of a currency demanded will increase as its price or

value increases.
4.

F In equilibrium, the demand curve becomes exactly parallel to the supply curve and both are

upward sloping.
5.

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.
6.

T As the exchange rate of a country depreciates, the price of goods exported from that

country becomes relatively cheaper to foreign buyers.

7.

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.
8.

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.
9.

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.

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