Question

Colombia is the world's biggest producer of roses. The global demand for roses increases and at the same time Columbia's central bank increases the interest rate. In the foreign exchange market for Colombian pesos, what happens to a. The demand for pesos? b. The supply of pesos? c. The quantity of pesos demanded? d. The quantity of pesos supplied? e. The peso-U.S. dollar exchange rate?

Short answer

Increased demand for pesos, decreased supply of pesos, increased quantity demanded, decreased quantity supplied, peso appreciates against U.S. dollar.

Step-by-step solution

Understanding the Situation

Colombia is the world's biggest producer of roses and faces an increase in global demand. Simultaneously, Colombia's central bank increases the interest rate. These factors affect the foreign exchange market for Colombian pesos.

Effect on Demand for Pesos

With the increased global demand for roses, more foreign currency is needed to purchase Colombian roses, raising the demand for pesos. Additionally, higher interest rates make Colombian investments more attractive, further increasing the demand for pesos.

Effect on Supply of Pesos

Higher interest rates discourage Colombians from exchanging pesos into foreign currencies because they can get better returns domestically. Thus, the supply of pesos in the foreign exchange market decreases.

Effect on Quantity of Pesos Demanded

As the demand for pesos increases due to higher interest rates and exports of roses, the quantity of pesos demanded increases.

Effect on Quantity of Pesos Supplied

With the supply of pesos decreasing due to higher interest rates, the quantity of pesos supplied in the foreign exchange market also decreases.

Effect on Peso-U.S. Dollar Exchange Rate

Given the increased demand and reduced supply, the peso appreciates against the U.S. dollar. This means fewer pesos are needed to buy one U.S. dollar.

Key concepts

Currency Demand

In the foreign exchange market, the currency demand refers to the desire of individuals, businesses, and governments to acquire a particular country's currency.
This demand stems from several factors: the need to purchase goods and services from that country, investing in that country's assets, or speculating on currency movements.
In the context of the exercise, the increased global demand for Colombian roses means that international buyers need more Colombian pesos.
Foreign buyers will exchange their currencies for pesos to pay Colombian producers for the roses. Additionally, higher interest rates in Colombia make investments more attractive.
Investors from other countries will demand more pesos to invest in Colombian assets, further increasing currency demand.

Currency Supply

Currency supply refers to the amount of a specific currency available in the foreign exchange market. Various factors influence the supply of a currency: domestic residents traveling abroad, importing goods and services, investing in foreign assets, or speculating on currency movements.
When the central bank of Colombia raises interest rates, domestic savers and investors find it more lucrative to keep their money within the country. This means fewer pesos are converted into foreign currencies for investments abroad, restricting the supply of pesos in the foreign exchange market.
Lower supply, coupled with reduced outflow of pesos in foreign transactions, can lead to an imbalance where the amount of available pesos decreases.

Interest Rates

Interest rates are a crucial mechanism used by central banks to control monetary policy. Higher interest rates typically attract foreign investment because they offer better returns on savings and investments.
Conversely, lower interest rates may encourage borrowing and spending but can also lead to capital outflow as investors seek better returns elsewhere.
In the exercise, the Colombian central bank's decision to increase interest rates makes investments in Colombia more appealing to both local and international investors.
As a result, there is an increased demand for the Colombian peso, and fewer pesos are converted into other currencies, affecting the supply in the market as well.

Exchange Rates

Exchange rates represent the value of one currency in terms of another. These rates fluctuate based on supply and demand dynamics in the foreign exchange market.
When demand for a currency exceeds its supply, the currency typically appreciates or strengthens. This means fewer units of the currency are needed to exchange for another currency.
In the context of the story, with increased global demand for Colombian roses and higher interest rates, there's a higher demand and lower supply of pesos. This supply-demand imbalance causes the Colombian peso to appreciate against the U.S. dollar.
Consequently, fewer pesos are required to purchase one U.S. dollar, making it stronger relative to the dollar.