CHAPTER 22: EXCHANGE RATES
22.1 Determination of exchange rates
Exercises: Answers
1. According to Table 22.1, what are the current values of the Indian rupee (INR) in terms of the
US dollar (USD), the euro (EUR) and the pound sterling (GBP)?
- Indian rupee converted into the US dollar: 0.02243USD = 1 INR
- Indian rupee converted into the euro: 0.01682 EUR = 1 INR
- Indian rupee converted into the pound sterling: 0.01457 = 1 INR
2. What are the inverse values (i.e. the values of USD, euro, and GBP in terms of INR)?
- The inverse values are the inverse of exchange rate
3. Explain how you would calculate these numbers
- I just need to divide 1 by the current exchange rate of the two currencies for the inverse relationship.
- For example, 1/ 44.5798INR = 0.02243USD
4. Assuming there were no transaction fees, how much in pounds (GBP) would it cost for a
British tourist to buy a South African bottle of wine for 350 rand (ZAR)?
- The exchange rate is 11.5233 ZAR to 1GBP -> The cost is 350/11.5233 = 30.373 GBP
22.6 Exchange rate calculations and linear functions (HL only) HL Exercises:
14. Given the following linear demand and supply functions for the USD in terms of Chinese
RMB: QS = 10 + 3P; QD = 50 – 2P
a) Calculate the exchange rate for USD in terms of RMB.
b) Plot the linear supply and demand curves on a diagram, indicating the equilibrium price and quantity Answer:
a) Set Qd equal to Qs and solve for P: Qd=10+3P Qs=50-2P  10+3P=50-2P  5P=40=> P=8
So, this is the exchange rate in term of RMB for 1 USD.
b) The demand curve is Qd=10+3P The supply curve is Qs=50-2P
Plot the demand and supply curves: Demand curve: when P=0, Qd=10 P=10, Qd=40 Supply curve: when P=0, Qs=50 P=25,Qs=0
The equilibrium occurs where Qd equals Qs, which is at P = 8. At this price: - Qd=10+3*8=34 - Qs= 50-2*8=34
So, the equilibrium price is 8 RMB per USD, and the equilibrium quantity is 34 units of USD.
15. Assume that the exchange rate for British pounds and USD is 1.60 USD per GBP.
a) Calculate the value in GBP for 1 USD.
b) For the information given above, calculate how many pounds would be received in exchange for 1200 USD.
c) Calculate in USD the price of a Manchester United football jersey that costs 45 GBP.
d) Assume that large pack of US writing pens costs 10 GBP. A change in the exchange rate raises
their price to 11 GBP. Calculate the value of the new USD per GBP exchange rate Answer:
a) 1.60 USD per GBP. So, to find the value in GBP for 1 USD:
1 USD / 1.60 USD per GBP = 0.625 GBP
b) 1200 USD *(1GBP/1.60 USD ) = 750 GBP
c) Price in USD = Price in GBP/Exchange Rate = 45 GBP / 1.60 USD per GBP = 28.125 USD
d) 10 GBP at the old exchange rate = 11 GBP at the new exchange rate
Now, solve the new exchange rate:
1.60 USD per GNP (old rate) = X USD per GBP (new rate)
X = (10 GBP /11 GBP)*1.60 USD per GBP
=> X approximately 1.4545 USD per GBP when the price of US writing pens increases to 11 GBP
16. Last year, Japan could import athletic jerseys from China costing 60 RMB, which cost 720
JPY at current exchange rates. Now the same 60 RMB jersey costs 780 JPY. What is the current exchange rate? Answer:
Last year, the jersey cost 60 RMB and was equivalent to 720 JPY. This gives us a conversion rate:
1 RMB = 720 JPY / 60 RMB = 12 JPY per RMB
The current exchange rate: 1 RMB = 780 JPY / 60 RMB = 13 JPY per RMB PRACTICE QUESTIONS
1. India faces rising currenc/(Reading) Questions:
a) Define the following terms indicated in bold in the text:
i. economic growth (paragraph 1)
ii. interest rates (paragraph 6).
b) Using an appropriate diagram, explain why the Indian rupee has ‘increased 15% against the
US$ in the past year’ (paragraph 2 ).
c) Using an aggregate supply and demand diagram, explain how the rupee’s appreciation will
afect exports and overall economic performance (paragraph 3)
d) Using information from the text/data and your knowledge of economics, evaluate the extent to
which the Indian government should intervene to manage the value of the Indian rupee. Answer:
a) i. Economic growth: this term refers to the increase in a country’s production of goods and
services over time, typically measured by the rise in its Gross Domestic Product (GDP). It
signifies capacity to produce and consume, leading to improved living standards, job
opportunities, and overall prosperity.
ii. Interest rate: An interest rate is the cost or price of borrowing money, typically expressed as a
percentage. It represents the amount a lender charges a borrower for the use of their funds or the
return on investment earned by saving or investing money
b) Explain why the Indian rupee has ‘increased 15% against the US$ in the past year’
- Increased Foreign Investment: The significant increase in foreign investment into India during
2007 suggests a higher demand for Indian assets, such as stocks and bonds. This increased
demand for Indian assets can lead to an appreciation of the rupee as foreign investors need to
convert their foreign currency into rupees to make investments.
- Economic Growth and Potential India's reputation as a developing economy with the potential
for future economic growth is attractive to investors. The expectation of a robust economic
performance can attract more foreign investment, driving up the demand for the rupee.
- Cheap Labor and Outsourcing: India's competitive advantage in offering relatively cheap labor
for manufacturing and call centers can lead to increased foreign business operations in the
country. These businesses often require rupees to pay for local expenses, contributing to the demand for the rupee.
- Trade Balance: If India's exports exceed its imports, it can lead to an increased supply of
foreign currencies (like the US dollar) in the foreign exchange market. When there's a surplus of
foreign currency, it can put upward pressure on the value of the rupee.
- Interest Rate Differentials: Higher interest rates in India compared to the US can attract foreign
investors looking for better returns. Investing in India would require them to convert their dollars
into rupees, increasing the demand for the rupee and potentially leading to its appreciation.
c) Explain how the rupee’s appreciation will afect exports and overall economic performance 1. Effect on Exports:
- Appreciation of the rupee makes Indian goods and services more expensive for foreign buyers
when priced in their own currencies. This is because a stronger rupee means foreign buyers need
to exchange more of their currency to buy the same amount of Indian goods.
- As a result, Indian exports become less competitive in international markets. This can lead to
a decrease in the quantity of exports, as foreign buyers may turn to cheaper alternatives from other countries.
- In the aggregate supply and demand framework, this reduction in exports can be represented
as a leftward shift in the aggregate demand curve, as the decrease in exports reduces overall
demand for Indian products and services.
2. Effect on Economic Performance:
- With a decrease in exports, industries reliant on foreign markets, especially labor-intensive
manufacturing sectors, may experience reduced production and potentially cutbacks in employment.
- This can lead to an overall reduction in economic output (GDP) and slower economic growth.
In the aggregate supply and demand diagram, this can be depicted as a leftward shift in the
aggregate supply curve, indicating reduced production capacity.
- Slower economic growth can have ripple effects, including lower job creation, reduced
income levels, and potentially decreased consumer spending, which further impacts economic performance.
In summary, the appreciation of the rupee can negatively impact exports and overall economic
performance. It can lead to a decrease in exports due to reduced competitiveness in international
markets, which, in turn, can result in slower economic growth and potential challenges for labor-
intensive industries. This situation highlights the complex relationship between exchange rates,
exports, and a country's economic performance.
d) Evaluate the extent to which the Indian government should intervene to manage the value of the Indian rupee.
It appears that the Indian government is facing a dilemma regarding the value of the Indian rupee: 1. Pros of Intervention:
- Export Competitiveness : A rising currency can make Indian exports more expensive in
international markets, which could hurt India's labor-intensive manufacturing industries and overall export performance.
- Earnings Impact: As mentioned, some companies have reported significant earnings reductions
due to the rupee's appreciation, which could impact their ability to invest and create jobs.
- Inflation Control: The central bank is concerned about rising inflation, and if the rupee
continues to appreciate, it could exacerbate inflationary pressures, making intervention necessary to control inflation. 2. Cons of Intervention:
- Foreign Investment: India has attracted substantial foreign investment, and part of the reason is
the strong currency. Intervening to weaken the rupee could potentially deter foreign investors.
- Economic Growth: India has experienced high economic growth, partly due to foreign
investment and a strong currency. Weakening the rupee might hamper this growth.
- Inflation and Interest Rates: As mentioned, raising interest rates to control inflation could
further strengthen the rupee, creating a complex policy challenge.
3. Balancing Act: The government needs to strike a balance between supporting its export-
oriented industries and maintaining a favorable environment for foreign investment. Any
intervention should be well-calibrated to minimize unintended consequences.
4. Long-Term Considerations: It's essential to consider the long-term effects of currency
intervention. A short-term fix could lead to distortions in the currency market and may not
address the root causes of currency appreciation.
In conclusion, the Indian government should carefully assess the situation and consider a
combination of measures to manage the value of the Indian rupee. This may include targeted
interventions, policy adjustments, and communication with stakeholders to ensure a balanced
approach that supports both export competitiveness and economic growth while managing
inflation. Additionally, the government should address structural issues like infrastructure and
rural poverty to sustain long-term economic growth and stability.
2. The benefits of a lower dollar(Reading) Questions:
a) Define the following terms indicated in bold in the text: i. current account deficit ii. subsidy (paragraph 2).
b) Using an appropriate diagram, explain why the value of the US dollar has declined (paragraph 1).
c) Using an appropriate diagram explain why the increased value of the dollar appears to be
harming the overall economy (paragraphs 1 and 2).
d) Using information from the text and your knowledge of economics, discuss the degree to
which the US government should intervene to lower the US dollar exchange rate. Answers:
a) i. Current account deficit:
- A current account deficit is a macroeconomic indicator that measures the difference between a
country's total exports of goods and services, income received from abroad, and unilateral
transfers (such as foreign aid) and its total imports of goods and services, income paid to foreign
entities, and unilateral transfers it makes to other countries over a specific period, typically a year.
- A current account deficit occurs when a country's imports (the value of goods, services, and
payments to foreign entities) exceed its exports (the value of goods, services, and payments
received from foreign entities). ii. Subsidy:
- A subsidy is a financial assistance or support provided by the government or other organizations
to specific industries, businesses, individuals, or activities. Subsidies are typically intended to
promote certain objectives, such as fostering economic growth, supporting particular sectors, or
helping individuals in need. These financial incentives can take various forms, including direct
cash payments, tax breaks, reduced interest rates on loans, or price support for products. The goal
of subsidies is to make certain goods or services more affordable or profitable, stimulate
economic development, or address societal needs.
b) Using an appropriate diagram, explain why the value of the US dollar has declined (paragraph 1).
- The value of the U.S. dollar can decline due to several economic factors. One of the key factors
that can lead to a decline in the value of the dollar is changes in supply and demand in the foreign exchange market: 
Increased Supply: If the U.S. Federal Reserve pursues a policy of low-interest rates and
expansionary monetary policy (printing more money), this increases the supply of USD
in the market. This shift in supply to the right, as shown in the diagram, puts downward pressure on the exchange rate. 
Decreased Demand: Factors like reduced foreign investment in the U.S. or a trade deficit
(where the U.S. imports more than it exports) can lead to decreased demand for USD.
This shift in demand to the left, as shown in the diagram, also puts downward pressure on the exchange rate.
- The combination of increased supply and decreased demand for the U.S. dollar can lead to a
depreciation of its value in the foreign exchange market.
c) Using an appropriate diagram explain why the increased value of the dollar appears to be harming the overall economy
- Supply and Demand for U.S. Exports and Imports: 
Export Demand (ED): This represents the demand for U.S. exports from foreign
countries. It slopes downward because as the price (in foreign currency) of U.S. goods
rises (due to a strong USD), foreign buyers purchase fewer U.S. goods. 
Import Demand (ID): This represents the demand for foreign imports in the U.S. It slopes
upward because as the price (in USD) of foreign goods falls (due to a strong USD), U.S.
consumers and businesses buy more foreign goods. 
Initial Equilibrium (E1): At this point, the quantity of U.S. exports (Q1) and the quantity
of U.S. imports (Q2) are in balance. However, if the USD strengthens (overvaluation), it
can lead to a shift in this equilibrium. - Effects of a Stronger USD: 
Shift in Export Demand (ED1): A stronger USD leads to a higher price for U.S. exports in
foreign currencies, causing foreign buyers to reduce their demand for U.S. goods (shift to
the left along the export demand curve). 
Shift in Import Demand (ID1): A stronger USD makes foreign goods cheaper in the U.S.,
increasing the demand for imports (shift to the right along the import demand curve). - Resulting Impact: 
Trade Imbalance: The shift in export and import demand creates a trade imbalance where
the U.S. exports fewer goods (Q3) but imports more goods (Q4). This imbalance can lead
to a trade deficit, which can harm the domestic manufacturing sector as it loses market share. 
Lost Jobs: As a result of reduced demand for U.S. exports, the manufacturing sector may lose jobs 
Profit Reduction: With fewer exports and potentially lower prices for their products in
foreign markets, U.S. manufacturing companies may experience reduced profits. 
Lower Domestic Investment: A decline in U.S. manufacturing profits can lead to lower
investment in the domestic manufacturing sector
In summary, the overvaluation of the U.S. dollar can harm the overall economy by negatively
impacting the manufacturing sector, causing job losses, reducing profits, and discouraging
domestic investment in manufacturing. This occurs due to the adverse effects of a strong dollar
on the trade balance and the competitiveness of U.S. goods in international markets. d) - Pros of Intervention: 
Stimulating Exports: A weaker U.S. dollar can make American exports more competitive
in international markets, potentially boosting exports. This can help the struggling
manufacturing sector and create jobs. 
Addressing Trade Imbalance: The U.S. has been running a significant current account
deficit, which means it's importing more than it's exporting. Intervention to lower the
dollar could help reduce this imbalance. 
Supporting Domestic Manufacturing: By providing relief to the manufacturing sector,
the government can help retain jobs, increase profits, and encourage investment in domestic manufacturing. - Cons of Intervention: 
Market Distortion: Currency intervention can distort foreign exchange markets and may
not always lead to the desired outcomes. Exchange rates are influenced by a complex
interplay of factors, and trying to control them can have unintended consequences. 
Foreign Investor Confidence: Aggressive intervention might deter foreign investors who
have been attracted to the strong U.S. dollar. This could impact capital flows into the country. 
Inflation Risk: A weaker dollar could lead to higher import prices, potentially
contributing to inflationary pressures. The government would need to balance this risk. 
Long-Term Structural Issues: While a weaker dollar can provide short-term relief, it may
not address the underlying structural issues that have led to the trade imbalance and
manufacturing challenges, such as productivity and investment.