Question

Assuming market-determined exchange rates, use supply and demand schedules for pounds to analyze the effect on the exchange rate (dollars per pound) between the U.S. dollar and the U.K. pound under each of the following circumstances: a. Voter polls suggest that the U.K.'s conservative government will be replaced by radicals who pledge to nationalize all foreign-owned assets. b. Both the U.K. and U.S. economies slide into recession, but the U.K. recession is less severe than the U.S. recession. c. The Federal Reserve adopts a tight monetary policy that dramatically increases U.S. interest rates. d. Britain's oil production in the North Sea decreases, and exports to the United States fall. e. The United States unilaterally reduces tariffs on U.K. products. f. Britain encounters severe inflation, while price stability exists in the United States. g. Fears of terrorism reduce U.S. tourism in the United Kingdom. h. The British government invites U.S. firms to invest in British oil fields. i. The rate of productivity growth in Britain decreases sharply. j. An economic boom occurs in the United Kingdom that induces the U.K. consumers to purchase more U.S.-made autos, trucks, and computers. k. Ten percent inflation occurs in both the United Kingdom and the United States.

Short answer

Effect on exchange rate primarily depends on how the demand and supply of currencies is affected in different situations.

Step-by-step solution

Voter polls suggest radical government change

Such an announcement usually creates uncertainty leading to decrease in demand for the UK pound as investors would want to avoid risk. This shift in demand decreases, will lead to a depreciation of the UK pound.

Both economies slide into recession

Recessions usually make the currency of the affected country less attractive. However, if the recession in UK is less severe than in US, the British pound might appreciate relative to the US dollar.

Tight US monetary policy

Adoption of tight monetary policy will likely result in higher US interest rates. This will attract more investors to hold US dollars increasing its demand, hence, the US dollar would appreciate against the UK pound.

Decrease in Britain's oil production

A decrease in Britain's oil exports to the US reduces the demand for UK pounds, causing the UK pound to depreciate.

US reduces tariffs on UK products

This encourages more imports from the UK hence increasing demand for UK pounds. The UK pound would thus appreciate.

Inflation in Britain

Inflation reduces the currency's purchasing power; therefore the UK pound would depreciate against the US dollar.

Reduction in US tourism in UK

Fears of terrorism would reduce US demand for UK pounds, hence leading to its depreciation.

US investment in British oil fields

US firms would need UK pounds to invest, which will increase its demand, hence, the UK pound would appreciate.

Decrease in productivity growth in Britain

This would most likely reduce foreign investment hence reducing demand for UK pounds, leading to a depreciation of the UK pound.

Economic boom in the UK

During a boom, consumers purchase more imported goods. Increased imports from the US would drive up the demand for US dollars. Hence, the US dollar would appreciate against the pound.

Ten percent inflation in both countries

Since both countries are experiencing the same rate of inflation, there is likely to be no significant change in the exchange rate.

Key concepts

Market-Determined Exchange Rates

Market-determined exchange rates refer to the value of a currency being set by the open market based on supply and demand. Under this system, no government sets a fixed price or uses a central bank to intervene consistently to adjust the currency value. Instead, the exchange rate fluctuates naturally.
In such a market, changes in political dynamics, economic conditions, and investor perceptions can rapidly influence exchange rates. For example, political uncertainty, as seen when voter polls suggest a government may shift towards a less investor-friendly regime, can decrease demand for a currency like the UK pound. This decreased demand typically leads to currency depreciation when compared with a more stable currency.
Understanding market-determined exchange rates enables investors, tourists, and businesses to make informed decisions when engaging in international transactions involving different currencies.

Supply and Demand Schedules

Supply and demand schedules are tools used to visually represent how different factors affect the quantity of currency that is bought and sold in the foreign exchange market. These schedules help in understanding the relative strength of a currency.

• Supply Schedule: Represents the quantity of a currency available for sale by its holders.
• Demand Schedule: Indicates the quantity of a currency investors want to buy.

When a country's economy is less impacted by recession compared to others, as noted with the UK during a concurrent recession with the US, the demand for that country's currency might increase, potentially leading to appreciation. Conversely, if a country experiences high inflation, demand can drop, leading to depreciation.

Currency Depreciation

Currency depreciation occurs when the value of a currency decreases relative to another currency. Several factors can drive this phenomenon, including economic downturns, political instability, and decreases in foreign investment.
For instance, when the Federal Reserve in the US increases interest rates, it attracts more foreign capital, boosting demand for US dollars. This usually results in the depreciation of other currencies such as the UK pound since investors may find the dollar more appealing. Similarly, domestic issues such as reduced productivity growth or inflation also contribute to the depreciation of a currency as they lower its purchasing power.
Depreciation affects international trade, as it can make exports more competitive while increasing the cost of imports.

Foreign Investment

Foreign investment plays a significant role in determining a country's currency value. When a country attracts more foreign investment, the demand for its currency increases, which can cause an appreciation of the currency.
For example, if the British government encourages US firms to invest in the UK's oil fields, this decision brings about increased demand for UK pounds as investors exchange their dollars for pounds to make investments. This influx boosts the value of the pound relative to the dollar.

• Types of Foreign Investment:
  • Direct Investment: Establishing operations or acquiring tangible assets in another country.
  • Portfolio Investment: Purchasing equity or debt in foreign markets.

Foreign investments often herald technological advances, large capital inflows, and improved economic growth, ultimately affecting the supply-demand balance of currencies in the global exchange market.