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Exchange$ Exercise #4 Answers (
points)
Please limit your answers to the spaces provided. If necessary, write on the back of the page.
Do not attach printout or additional pages. All questions pertain to the Exchange$ module in the
SimEcon® software package.
Make sure that you have read the “Exchange$ Manual” and “SimEcon® Operation
Instructions.” These materials may be found at the Class Web site prior to beginning the
exercise. For many of the exercise’s questions, it will be necessary to refer to those instructions.
For many of the exercise’s questions, it will be necessary to refer to your text.
Open the Exchange$ module. You will arrive at the table entitled, “Initial Conditions.” Print
out this table for future reference. Click “Continue.” You will see a supply and demand graph
(in equilibrium) that represents the market for U.S. dollars. What is the equilibrium quantity of
dollars traded? $100 billion. What is the equilibrium price of one U.S. dollar in Euros? 1 euro.
Click “Disturb Market.” Select “Foreign Real GDP” and click “Continue.” If you increase the
foreign real GDP to $11 billion, what will happen to the quantity of U.S. exports to Europe? At
a given exchange rate and price level U.S. exports to Europe will increase. What will
happen to the demand for U.S. dollars? The demand for U.S. dollars will increase. Other
things being equal, what will happen to the equilibrium price of U.S. dollars in euros? The
price of U.S. dollars will increase. What will happen, other things being equal, to the quantity
of U.S. dollars traded? The quantity of U.S. dollars traded will increase. Go ahead and
increase the foreign real GDP to $11 billion and click “Continue.” Draw the resulting graph
below.
Price of $
(in €)
S
$/€2
$/€1
D2
D1
Quantity of $
0
Q1 Q2
What is the new equilibrium price (in euros) of U.S. dollars? 1.04. What is the new equilibrium
quantity of U.S. dollars? $102.40.
Now, click “New Disturbance.” Select the button entitled “Foreign Price Index” and click
“Continue.”
Course
Exchange$ Exercise #4 Answers
Page 2
If foreign prices decreased to an index of 0.92, would European consumers be more inclined or
less inclined to purchase goods and services produced in Europe? European consumers would
be more inclined to buy European goods and services. What would happen to the quantity of
U.S. exports to Europe? At a given exchange rate and price level U.S. exports to Europe
would decrease. Other things being equal, what would happen to the demand for U.S. dollars?
The demand for U.S. dollars would decrease. What would also happen to the quantity of U.S.
imports from Europe? The quantity of U.S. imports would increase. Other things being
equal, what would happen to the supply of U.S. dollars? The supply of U.S. dollars would
increase. Go ahead and enter a foreign price index of 0.92 and click “Continue.” Draw the
resulting graph below.
Price of $
(in €)
S1
S2
$/€1
$/€2
D1
D2
Quantity of $
0
Q1 =Q2
Given the graph above, what has definitely happened to the price of U.S. dollars in euros? The
price decreased. Can we say that the quantity will always increase or always decrease? It
depends on the relative shifts of the curves, it could increase or decrease.
Now, click “New Disturbance.” Select the button entitled, “Foreign Interest Rate” and click
“Continue.” If the European interest rates decreased to 6%, would U.S. investors be more or less
inclined to invest in Europe? They would be less inclined to invest in Europe. Other things
being equal, what would happen to the supply of U.S. dollars? The supply of U.S. dollars
would decrease. Would European investors be more or less inclined to invest in the United
States? European investors would be more inclined to invest in the U.S. Other things being
equal, what would happen to the demand for U.S. dollars? The demand for U.S. dollars would
increase. Enter a European interest rate of 6% and click “Continue.” Draw the graph below.
Price of $
(in €)
S2
S1
$/€2
$/€1
D2
D1
Quantity of $
0
Q1 =Q2
Course
Exchange$ Exercise #4 Answers
Page 3
Given the graph above, what has definitely happened to the price of U.S. dollars in euros? The
price has increased. Can we say that the quantity will always increase or always decrease? It
depends on the relative shifts of the curves, it could increase or decrease.
******************************************************************************
Click Menu and restart the Exchange$ module. Repeat the process you went through above of
decreasing European prices to an index of 0.92. Go through the process until you arrive at the
graph that shows a decrease in the price of U.S. dollars. What is the new equilibrium price of
U.S. dollars? 0.96 euros. This decrease in the price of U.S. dollars would be a depreciation of
the domestic currency. What would this depreciation do to the prices of products that the United
States imports from Europe? The prices of imports would increase.
Suppose instead that the domestic economy that we are talking about is Mexico instead of the
United States. If the prices of imports from Europe changed in the direction indicated, how
would that affect the standard of living for the average impoverished Mexican citizen? (Note
that Mexico imports a large quantity of foodstuffs.) This would dramatically lower the
standard of living. What would happen to the political stability of Mexico if the average citizen
could not afford basic foodstuffs? The government would become less stable. Would a
government such as that of Mexico have a vested interest in keeping the domestic currency from
depreciating? Yes
Given this situation of a depreciation of the domestic currency, suppose that the Mexican
government decided to regulate the price of its currency to keep it from depreciating. Suppose
that the government instituted a minimum price of 1.00 euro. Would this be a price ceiling or a
price floor? This would be a price floor. At the minimum price of 1.00 euro, which would be
greater, the quantity supplied of the domestic currency or the quantity demanded? The quantity
supplied would be greater. In order to maintain the minimum price of 1.00 euro, would the
Mexican government have to buy or sell Mexican pesos? The Mexican government would
have to buy pesos. What would the Mexican government have to give in return for the pesos?
The Mexican government would have to give foreign exchange, such as Euros, in return for
the pesos. If this process repeated itself year after year after year, would the treasury of the
Mexican government tend to increase or decrease in foreign exchange reserves? The reserves
would become depleted.
Click “Regulate Market.” Select the button entitled, “Impose Rate Above Equilibrium” and
click “Continue.” Enter a price of 1.00 and click “Continue.” What is the private supply with
the regulation? 101.13. What is the private demand with the regulation? 96.78. With the
regulation, how much does the chart indicate in terms of government sales of the currency or
government purchases? The chart indicates government purchases of 4.35. What would tend
to happen to the stock of reserves? It would be depleted. Given the scenario discussed in the
last four paragraphs, what are the political reasons for imposing a fixed exchange rate, especially
in a developing nation? A fixed exchange rate promotes economic and political stability, at
least for a while. How long could the government maintain this situation? The government
began with €73 in reserves, it now has €68.65, so it has used up €4.35. If it continues to lose
reserves at this rate they will last (68.35/4.35) = 15.7 years.
Course
Exchange$ Exercise #4 Answers
Page 4
What are the economic problems of imposing a minimum fixed exchange rate? If it is above the
equilibrium it cannot be sustained indefinitely. It also reduces the nation’s exports and
increases imports, hurting industries, jobs, and real GDP.
******************************************************************************
Click Menu and restart the Exchange$ module. When you see “Initial Conditions” click
“Continue.” You will see the graph of the currency market in equilibrium. Click “Disturb the
Market” and select the button entitled “Domestic Political Stability Index.” Click “Continue.”
Note that in the previous section we discussed how a depreciation of the domestic currency can
cause political instability, especially in a developing nation such as Mexico. Suppose that we are
dealing with such a situation. If the domestic political stability index decreased to 0.70, would
domestic investors be more or less inclined to invest abroad? They would be more inclined to
invest abroad. Would this cause an increase or a decrease in the supply of the domestic
currency? This would cause an increase in the supply of the domestic currency. Other
things being equal, what would happen to the price of the domestic currency? The price would
go down. Enter a domestic political stability index of 0.70 and click “Continue.” Draw the
resulting graph below.
Price of $
(in €)
S1
S2
$/€1
$/€2
D
Quantity of $
0
Q1 Q2
To repeat a point discussed earlier, does a fall in the price of the domestic currency represent an
appreciation or depreciation of the domestic currency? It implies depreciation. Suppose that
the domestic currency started to depreciate because of, for example, a decrease in foreign prices.
If this depreciation caused political instability, would the instability tend to cause to the price of
the currency to appreciate or further devalue? Political instability would cause further
depreciation. Would political instability tend to make the situation better or worse? It would
tend to make the situation worse.
Suppose that because of political instability in such a developing nation, the military took control
of the government and imposed martial law. Let’s assume that this increases stability despite the
fact that most people have fewer rights and are still impoverished but property rights for the well
off are better protected. Would domestic investors be more or less inclined to invest abroad?
They would be less inclined to invest abroad. What would happen to the supply of the
domestic currency, other things being equal? The supply would decrease. What would
happen to the price of the domestic currency? It would increase. Would this be a depreciation
or an appreciation of the currency? It would be an appreciation. What would happen to the
price of imports? Such prices would decline.
Course
Exchange$ Exercise #4 Answers
Page 5
If many basic necessities such as food were imported, what would happen to the standard of
living for the average person, other things being equal? The standard of living would tend to
get better.