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Intl Finance Assignment 5

The document discusses analyzing foreign exchange market equilibrium from the perspective of Europe rather than the US. It derives the alternative picture of equilibrium using the euro/dollar exchange rate on the vertical axis and euro return schedules. It finds that an increase in the euro interest rate or the expected dollar return would cause the euro to depreciate and the dollar to appreciate, agreeing with the earlier analysis from the US perspective.

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Aalizae Anwar Yazdani
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92 views

Intl Finance Assignment 5

The document discusses analyzing foreign exchange market equilibrium from the perspective of Europe rather than the US. It derives the alternative picture of equilibrium using the euro/dollar exchange rate on the vertical axis and euro return schedules. It finds that an increase in the euro interest rate or the expected dollar return would cause the euro to depreciate and the dollar to appreciate, agreeing with the earlier analysis from the US perspective.

Uploaded by

Aalizae Anwar Yazdani
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Aalizae Anwar Yazdani

Section A, 20U00132
International Finance
Assignment 5

Q. We noted that we could have developed our diagrammatic analysis of foreign exchange
market equilibrium from the perspective of Europe, with the euro/dollar exchange
rate E€/$(= 1/E€/$) on the vertical axis, a schedule vertical at R€ to indicate the euro return on
euro deposits, and a downward-sloping schedule showing how the euro return on dollar deposits
varies with E€/$. Derive this alternative picture of equilibrium and use it to examine the effect of
changes in interest rates and the expected future exchange rate. Do your answers agree with
those we found earlier?

We will get similar findings if we analyse the foreign exchange


market equilibrium from the perspective of Europe and from the
perspective of the US. The diagram below shows the equilibrium
in the foreign exchange market from the perspective of Europe.
At point E, there is an equilibrium of the euro/dollar exchange
rate. The return on euro deposits equals the return on dollar
deposits, showing Interest Rate Parity. An increase in the euro
interest rate from R£ to R£1 which indicates that the return on
euro deposits has increased thus exceeding the euro returns on
dollar deposits at E. This causes the exchange rate to fall at E1,
indicating the appreciation of the euro and the depreciation of
the dollar.

Similarly, if the expected dollar return increases,


individuals would now expect that dollar would
appreciate (a self fulfilling prophecy). This
appreciation would cause the Euro to depreciate
today. The diagram shows a rise in the dollar interest
rates.

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