Question

t (8 points) lustrate graphically and explain verbally in the context of the foreign exchange market the euro rS dellars how an increase in German interest rates would most likely influence the exchange rate (ie. 4.(8 points) Illustrate graphically and explain verbally in the context of the foreign exchange market fo US dollars how an increase in the price level of Mexico would most likely influence the exchange rate (i.e. the peso price of dollar)

Answer 1

Solution

3.How would the increase in the Germany interest rates influence the exchange rate i.e., the euro price of US Dollar

When the German interest rates are increased there will be increased inflow of investments into Germany from other countries across the world due to which the demand for German currency (Euro) increases in the world foreign exchange market.So,the Euro appreciates in relation to dollar.So,the Euro price of US Dollar will decrease.

From the above figure,you can infer that as the demand for quantity of dollars decreases from Q1 to Qe (same as saying that there is increase in demand for Euro) , the Price of Dollars in Euro decreases from P1 to Pe (this is same as saying that the Euro appreciates / the dollar is depreciating).

Dy 个 PRJEE 个h re Price ot Dollars Euros DOLLAR

4.How the increase in the price level of Mexico would influence the exchange rate (i.e., peso price of dollar)

Inflation is defined as the rise in the average price level of all goods and services in an economy.So,by saying that there is increase in the price level of Mexico it means there is inflation in Mexico.This means the more money is now needed than before to buy the same set of goods by the Mexicans i.e., there is reduction in the value of Mexican currency (Peso).So,the Mexican Peso depreciates.

So,the Peso price of dollar will increases (meaning more peso are now required to buy the same amount of dollar as before )

Gv oF 44%

In the above figure,since it is given that there is increase in  price level in Mexico which means there is inflation resulting in the depreciation of Mexican currency.So,now the price of dollar in terms of Pesos increases (from P1 to P2) which clearly leads to the increase in availability of more Pesos.