Just as with the price of a good, the price, or exchange rate, of a currency is
ID: 1168113 • Letter: J
Question
Just as with the price of a good, the price, or exchange rate, of a currency is determined by supply and demand. However, rather than using a traditional supply and demand analysis as shown in Marthinsen, currency traders often consider whether foreign funds will flow into or out of a country as a result of a particular economic circumstance. If foreigners wish to make domestic purchases or investments, foreign currency must first be exchanged for the domestic currency. Thus, foreign funds flowing into a country increase the demand for the domestic currency and it appreciates. Funds flowing out reverse this process leading to depreciation of the domestic currency. In the table, place an X to indicate whether each economic condition will cause foreign funds to flow in or out of the country and whether the domestic currency will appreciate or depreciate.
Domestic circumstance
Funds
flow in
Funds
flow out
Currency
appreciates
Currency
depreciates
Real interest rates are higher than in other countries
Risk of civil war
Business taxes are raised above world average
X
Expected stock market returns are better than elsewhere
Inflation increases
A large deposit of rare earth minerals is discovered
Rapidly growing manufacturing sector imports more foreign raw materials
Domestic circumstance
Funds
flow in
Funds
flow out
Currency
appreciates
Currency
depreciates
Real interest rates are higher than in other countries
Risk of civil war
Business taxes are raised above world average
X
Expected stock market returns are better than elsewhere
Inflation increases
A large deposit of rare earth minerals is discovered
Rapidly growing manufacturing sector imports more foreign raw materials
Explanation / Answer
Domestic circumstance
Funds
flow in
Funds
flow out
Currency
appreciates
Currency
depreciates
Real interest rates are higher than in other countries
X
X
Risk of civil war
X
X
Business taxes are raised above world average
X
X
Expected stock market returns are better than elsewhere
X
X
Inflation increases
X
X
A large deposit of rare earth minerals is discovered
X
X
Rapidly growing manufacturing sector imports more foreign raw materials
X
X
Circumstance 1: Fund flow comes in to get the benefit of higher interest rates that causes currency to appreciate.
Circumstance 2: Risk of civil war will cause people to buy forex and funds will go it. It will cause the currency to depreciate.
Circumstance 3: High tax rate causes business to make investment outside and funds flows out. It also makes currency to depreciate.
Circumstance 4: Better stock market return brings in foreign investors to the country. It causes funds to come in that appreciates the currency.
Circumstance 5: High inflation reduces the purchasing power of the money it makes funds to flow out and currency depreciates also.
Circumstance 6: Such discoveries boost the economy and funds come in to capitalize on the newer opportunities. It also appreciates the currency.
Circumstance 7: Import of raw material causes funds to go out and make currency to depreciate.
Domestic circumstance
Funds
flow in
Funds
flow out
Currency
appreciates
Currency
depreciates
Real interest rates are higher than in other countries
X
X
Risk of civil war
X
X
Business taxes are raised above world average
X
X
Expected stock market returns are better than elsewhere
X
X
Inflation increases
X
X
A large deposit of rare earth minerals is discovered
X
X
Rapidly growing manufacturing sector imports more foreign raw materials
X
X
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