04 Jun Question 1.(a) The markets for foreign exchange are of c
Question
1.(a) The markets for foreign exchange are of central importance to international finance. To date, we have referred two classes of foreign exchange markets:
(i) spot markets; (ii)forward markets. Distinguish carefully between the two classes.
(b) Spot markets for foreign exchange can be subject to different forms of exchange rate regimes:
(i) fixed (pegged) exchange rates
(ii) flexible (freely floating) exchange rates
(iii) “managed” floating exchange rates
Discuss the basic nature of each exchange rate regime. Which of the three comes closest to describing the regime currently in place in Canada? Explain.
2. Variations in the exchange rates in the spot markets can have a significant impact on export and import flows. If the economy of the country in question is a very open one (such as Canada), the impact on export/import flows can, in turn, have a significant impact upon the country’s economy. Over the past year, the U.S. dollar has appreciated dramatically against the Canadian dollar in the Canadian spot market for foreign exchange, reaching levels not seen since the depths of the Great Recession in February, 2009. After defining the term “appreciation”, explain on what grounds (everything else being equal) it could be argued that this appreciation of the US dollar (with respect to the Canadian dollar) could be seen as a welcome stimulus to Canada in its recovery from the Great Recession.
3. Suppose, at a particular moment in time, that the price for U.S. dollars in the Toronto inter-bank spot foreign exchange market is U.S. $1.00 = Can. $1.2200. If the price for Canadian dollars in the New York inter-bank foreign exchange market, at the same moment in time is: Can. $1.00 = U.S. $0.8197 (1/1.2200), we could say that the foreign exchange rates are “consistent”. After explaining what is meant by “consistency” in this context, describe the forces that would come into play to eliminate any “inconsistency” in the Toronto – New York US dollar-Canadian dollar exchange rates, that might arise. What, if anything, does the question of “consistency” of foreign exchange rates have to do with the Law of One Price? Explain.
4. Define what is meant by Canada’s Balance of International Payments, and then go on to distinguish clearly between Current Account transactions and Financial Account
transactions.
What precisely is the difference between Capital Inflows and Capital Outflows?
Changes in Canada’s official foreign exchange reserves (Official Monetary Movements) have been placed by us in a separate category for analytical purposes. These changes, however, really reflect Financial Account transactions.
Move forward to 2016, and suppose that, for the calendar year 2015, Statistics Canada
was to record a net decrease in Canada’s official foreign exchange reserves of Can. $20 billion. Would you say that the decrease in official foreign exchange reserves, in 2015, constituted: (i) a Capital Inflow; (ii) a Capital Outflow; or (iii) neither? Explain.
5. “The terms Balance of Payments Surplus, and Balance of Payments Deficit have no real meaning, if a country is operating under a system of fixed (pegged) exchange rates. It is only if the country is operating under a system of flexible (freely floating) exchange rates that the term takes on meaning.” Explain why you agree, or disagree, with this statement.
6. In looking back in recent history, there is reason to believe that Can.$ – US$ exchange rate (spot) was in long run equilibrium in period p – 1. The exchange during that period was, on average, equal to:
U.S. $1.00 = Can. $1.1500
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