Q.
1 Discuss the various factors which influence the exchange rate of US Dollar?
Answer:
Exchange rates are
determined by supply and demand. For example, if there was greater demand for
American goods then there would tend to be an appreciation (increase in value)
of the dollar. If markets were worried about the future of the US economy, they
would tend to sell dollars, leading to a fall in the value of the dollar.
Note:
·
Appreciation = increase in value of
exchange rate
·
Depreciation / devaluation =
decrease in value of exchange rate.
Main Factors that Influence
Exchange Rates
1. Inflation-
If inflation in the UK is relatively
lower than elsewhere, then UK exports will become more competitive and there
will be an increase in demand for Pound Sterling to buy UK goods. Also foreign
goods will be less competitive and so UK citizens will buy less import.
Therefore countries with lower inflation rates tend to see an appreciation in the value of their currency.
Therefore countries with lower inflation rates tend to see an appreciation in the value of their currency.
2. Interest Rates
If UK interest rates rise relative
to elsewhere, it will become more attractive to deposit money in the UK. You
will get a better rate of return from saving in UK banks; therefore demand for
Sterling will rise. Higher interest rates cause an appreciation.
This is known as “hot money flows” and is an important short run factor in
determining the value of a currency.
3. Speculation
If speculators believe the sterling
will rise in the future, they will demand more now to be able to make a profit.
This increase in demand will cause the value to rise. Therefore movements in
the exchange rate do not always reflect economic fundamentals, but are often
driven by the sentiments of the financial markets. For example, if markets see
news which makes an interest rate increase more likely, the value of the pound
will probably rise in anticipation.
4. Change in Competitiveness
If British goods become more
attractive and competitive this will also cause the value of the Exchange Rate
to rise. This is important for determining the long run value of the Pound.
This is similar factor to low inflation.
In 2010 and 2011, the value of the
Japanese Yen and Swiss Franc rose because markets were worried about all the
other major economies - US and EU. Therefore, despite low interest rates and
low growth in Japan, the Yen kept appreciating.
6. Balance of Payments
A deficit on the current account
means that the value of imports (of goods and services) is greater than the
value of exports. If this is financed by a surplus on the financial / capital
account then this is OK. But a country who struggles to attract enough capital
inflows to finance a current account deficit, will see a depreciation in the
currency. (For example current account deficit in US of 7% of GDP was one
reason for depreciation of dollar in 2006-07)
7. Government Debt.
Under some circumstances, the value
of government debt can influence the exchange rate. If markets fear a
government may default on its debt, then investors will sell their bonds
causing a fall in the value of the exchange rate. For example, Iceland debt
problems in 2008, caused a rapid fall in the value of the Icelandic currency.
For example, if markets feared the
US would default on its debt, foreign investors would sell their holdings of US
bonds. This would cause a fall in the value of the dollar.
8. Government Intervention
Some governments attempt to
influence the value of their currency. For example, China has sought to keep
its currency undervalued to make Chinese exports more competitive. They can do
this by buying US dollar assets which increases the value of the US dollar to
Chinese Yuan.
Many reasons influence the
exchange rate of US dollar:
There are many factors that influence the exchange rate of US dollar.
Generally speaking, there are mainly four reasons:
1.
The health condition and the rate of return for
investment of the US economy.
2.
The balance of international payment in the US.
3.
The level of interest rates in the US compared with
those in other countries.
4.
The rate of inflation.
Meanwhile, there are also many other temporary
pounding factors
from
without, such as wars, oil price, scandals from large companies as well as
psychological factors etc, which are believed to have connections with former
four factors.
Judging
from the estimation by various parties, evident enough, many economists take the balance of international
payments as the decisive factor for the trend of the US dollar. Although this
kind of view is not unreasonable, it is partial. If considered from history,
people will find out that the balance of international payment featuring trade
deficit and current account deficit has been dominating the US economy since
1970s. But the track of the US dollar's circulation does not show a plummet
drop.
The exchange rate of US dollar used to be high for two times since the
US implemented the floating exchange rate: one occurred during Reagan's reign
while the other was in Clinton's rule. So far as Reagan's reign is concerned,
the federal budget deficit, trade deficit and current account deficit were
high, but the exchange rate of US dollar was also high. It is simply because
the high deficit triggered the high interest rate and high interest rate
consequently resulted in high exchange rate. The trade deficit is not the
result of the change of exchange rate but rather its reason.
Q.
2 Do you think dollar can depreciate sharply against other major currencies?
Discuss.
Answer:
The year of 2004 was the third consecutive
year for the depreciation of US dollar against the Euro-dollar. When entering
2005, the exchange rate of US dollar once showed a tendency of rise, however,
it was still unstable.
On 30 Dec. 2005, the rate of exchange of one Euro-dollar was
equivalent to 1.3623 US dollar, telling the lowest level of the US dollar
against Euro in history. The US dollar began to rise to one euro against USD
1.3122 in the latter 20 days of January 2005, and kept on rising to one euro against
1.2957 US dollars in the first 15 days of February. However, the US dollar
devalued sharply on Feb. 22 to one euro against 1.3260 US dollars, the lowest
point since last August. It is reported that there were many reasons
accountable for the depreciation of US dollars: one was that the price of oil
has climbed to USD 51 per barrel; the other was the diversification for
currency reserve by South Korea. People were worried that the sell of US dollar
could have chain reactions upon other major powers.
Different predictions could be heard on the issue of the future trend
of the US dollar. According to the experts with Merrill Lynch, one of the
world's leading financial management and advisory companies, the year of 2005
is the fourth consecutive year to see the weakening of the US dollars. The
overvalued US dollar and the tight policy pursued by the US Federal Reserve are
the due cause for the sluggish US dollar while other experts believed that the
undercurrent that manipulated the depreciation of US dollar was quite likely
being reversed. It's impossible to see the US dollar to drop furthermore. If
the global economic growth slows down, the US dollar is hopefully to
appreciate.
Q.
3 How falling dollar is affecting the Asian countries? How they can combat the
situation?
Answer:
A weak U.S. dollar
is the result of devaluation of American currency with regards to its
purchasing power when held against foreign currencies. Supply and demand
determine the currency value within the global market and it is the positive or
negative shifts in supply and demand that unveil the strength of the U.S.
dollar when compared to foreign currencies.
The weak dollar is important because it affects not only the American economy but the international economies as well. The economy of the United States is the largest in the world and the most open, which is why most foreign countries flock to invest in it.
Today, value of currency in the
United States is considered weak. This means that in relation to our global
economic counterparts, the value of the U.S. dollar has fallen and is worth
less and offers less purchasing power than the other major currencies. The weak
dollar acts as a dual-edged mechanism presenting both monetary advantages and
disadvantages. The advantage of a weak U.S. dollar is that it contributes
greatly to the domestic economy. It is "…easier to sell goods in foreign
markets…" ("Strong Dollar, Weak Dollar,") is less competitive,
American tourism increases and foreign investments peak.
The disadvantages are that foreign
imported goods become expensive, American cost of living is propelled,
international travel for Americans becomes expensive and foreign investment in
the American market stagnates
Asian
economies are also feeling affects of the decreasing U.S. dollar. Countries in
Asia are the largest holders of U.S. debt. Japan has U.S. treasury holdings of
$720 billion and China is currently holding $174 billion. Profits seen from
selling their goods in the U.S. have been invested into treasury bonds. As the
value of the dollar has continued to decline, so has the value of their
investments. In an attempt not to influence a worldwide recession, analysts
believe that countries in Asia have little choice but to maintain their current
holdings in the U.S. treasury bonds they have. It is feared that if these
countries were to cash out of their investments and take their losses, they
would in turn cripple their own economies.
A
falling dollar will affect the price of foreign products. When the U.S. dollar
looses value relative to foreign currencies, foreign products become more
expensive for the U.S. buyer. As seen in 2002, the dollar had fallen by 32
percent against the Euro. This devaluation of the U.S. dollar caused the prices
of European goods to increase nearly three times over the past several years
(Francis). Because foreign goods become more expensive within the U.S. market,
many Americans will turn to the more affordable American-made goods and
services.
The decline in
value of the U.S. dollar has subsequently hurt the foreign job market and
economies of many European and Asian countries. Many foreign leaders have
pressed President Bush to decrease the U.S. trade deficit; this would promote a
stronger dollar and help to stimulate their economies. Although, the weak U.S.
dollar has helped to pull the U.S. economy out of recession and increase the
production of goods and services, boosting the demand for jobs, the call for a
strong dollar continues to be echoed.
Currency
fluctuations can also affect foreign investment in American companies and
products. When the U.S. dollar is strong against foreign currencies it
encourages U.S. companies to pursue overseas investments yielding higher
returns or to expand businesses to foreign countries due to lower costs. In
contrast, when the U.S. dollar is weak foreign companies are attracted to the
U.S. market. They are motivated to move production facilities to the U.S.
because the operating cost are more desirable. The Los Angeles entertainment
industry, for example, has seen a remarkable increase in foreign business
wanting to film within the U.S. because of more affordable on-the-ground costs,
stuntmen and production costs.
Similarly, Toyota
has built seven manufacturing facilities within the United States hiring more
than 100,000 people. In this case, the weak dollar has helped the American
economy by providing jobs and having a positive effect on the American
unemployment rate.
The down side of a
weak U.S. dollar is that imports of critical goods increase. Steel is a much
needed commodity for US auto makers. When the U.S. dollar weakens steel costs
increase and this cost increase is then passed to the consumer through an
increase in automobile prices.
Ultimately, the
weak dollar indicates a need for attention for both present day problems and
for future concerns of the economy as a whole.
Pressure to revalue Chinese
Yuan and Other currencies.
Falling
in dollar is also pressure to revalue Chinese Yuan other Currencies.
· China
and other Asian countries such as Thailand have a fixed exchange rate against
the dollar. Thus at the moment they are benefiting from a competitive exchange
rate increasing exports and creating more jobs.
· However
arguably the Chinese economy would benefit from a moderate appreciation. This
is because growth is very fast and it is approaching full capacity and
therefore could cause an increase in inflationary pressures. An increase in the
value of the currency would help reduce this.
