Question

Economic activity in the United States increased at a stable speed over the first half of 2018. In this economic environment, economists worry that there might be a massive capital outflow from emerging markets in Asia to the United States.

1. The exchange rate of USD to Malaysian Ringgit decreased from 0.2579 USD/Ringgit on 28 January 2018 to 0.2459 USD/Ringgit on 1 August 2018. With the help of a demand-supply diagram, briefly explain how did the capital outflow from Malaysia to the United States lead to the depreciation of Malaysian Ringgit against USD? Please indicate the above exchange rates in your diagram.
2. Suppose that US investors sell a large amount of Ringgit denominated bonds and use the proceeds to buy the US dollar. How will this event affect the price of Ringgit denominated bonds and hence interest rate in Malaysia? Illustrate your answer with a demand-supply diagram.

Answer 1

ingly enget) supply rughtle) 0.257 0.2459 - Demand Bauget Supply boud (1) Suply baud (1) 'Demand band Pbad Obed o boude (m) bond peer . Intereel rate

a.) Capital outflow from Malaysia into the US to purchase commodities denominated in USD require the exchange of ringgits to USD. The capital outflow leads to a rise in the supply of ringgits in the foreign exchange market this shifts the supply curve to the right as shown in the first diagram above. This rightward shift causes the ringgit to depreciate against the dollar from 0.2579 dollars per ringgit to 0.2459 dollars per ringgit. This means that each ringgit can now buy fewer dollars.

b.) If investors start dumping a large amount of ringgit denominated bonds, the supply of ringgit denominated bonds in the market will rise. This will cause the supply curve to shift to the right (as shown in the second diagram above). This will cause a drop in the price of the bonds as the quantity of these bonds in the market rises. The third diagram illustrates the relationship between bond prices and interest rates. Bond prices and interest rates are negatively correlated, which means as the price of bonds falls due to the dumping of ringgit denominated bonds, the interest rates will rise in order to contract the effects of the increased money supply in the market.