Finance Homework: Exchange Rates, Inflation, and Economic Analysis

This finance assignment delves into the intricacies of the foreign exchange market, covering topics such as spot and forward exchange rates, the impact of inflation on currency values, and the Triffin dilemma. The assignment includes multiple-choice questions, true/false statements, and problem-solving scenarios related to exchange rate calculations and market dynamics. Furthermore, it explores the Nash equilibrium in the context of economic decision-making and its application in predicting market behaviors. The assignment examines the relationship between exchange rates and a country's trade balance, along with the influence of inflation on currency valuation. It also touches on the role of central banks and their monetary policies in stabilizing currency values. The document presents detailed explanations and calculations to support the answers, providing a comprehensive understanding of the concepts. Finally, the assignment concludes with a discussion on how economic factors such as inflation and interest rates affect exchange rates and international trade.

1.
Answer: B
2. a. New York Foreign Exchange located in Time Square - F
Answer: Explanation: New York Stock Exchange is not located in Times Square.
New York Stock exchange has distance of 5-6 miles from Times Square.
b. The central bank of US in 1900 is US treasury. F
Answer: Explanation: Central Bank was established in 1913, whereas, US treasury
was established way back in 1789.
c. Competition has a negative effffect on Bid/Ask spread? T
Answer: Explanation: Higher the competitions lower the Bid/Ask spread, so,
competition has negative impact on Bid/Ask spread.
3. a.
Answer:
1 Pound sterling would receive 1.2 Euros.
Explanation: Since 1 Pound Sterling = 1.2 Euros, hence for 1 Pound will receive 1.2
Euros
Answer:
b.
1 Euro would receive 0.8333 Pound sterling.
Explanation: Since 1 Euro = 1/1.2 Euros, hence for 1 Euro will receive 0.8333 Pound
sterling
Answer:
c.
First difference, that comes to mind that in spot rate (current Market rate) transaction
is that settlement or delivery of currency takes place on the second working day

from the day of contract signed, while in the case of forward currency trading it
takes place on specified future date as per the contract, because it is forward
exchange rate not current prevailing exchange rate.
In forward contract rate cannot be same as spot rate, it can be lower or higher, due to
various reasons like, time value of money, arbitrageurs, presence of speculators, risk
free interest rate, supply and demand of currency and some others factors.
Forward exchange rate as mentioned above can either be higher or lower than spot
exchange rate due to the factors already discussed above. If forward rate is above the
spot rate than currency is said to be in premium, that is, currency would be
expensive in futures, if the forward rate is less than spot rate then currency will be at
discount or cheaper in futures.
Forward exchange rate can have more than exchange rates, like, 1 month rate, 2
months rate and also 3 months rate but in spot rate there can be only one rate that
current available rate. Due to this many available rates, one has to be very careful
while transacting in forward currency market (Parikh, 2014).
d.
Answer:
For UK change in CPI (2016 to 2018) =120-100= 20
Inflation = (20/100)*100 = 20%
Inflation in UK’s Pound Sterling from 2016 to 2018 rises to = (15/150)*100 = 10%
For Euro CPI = 165-150 = 15
Inflation in Euro from 2016 to 2018 rises to = (15/150)*100 = 10%
The purchasing power of two countries should be the same for identical products.
(Law of one price). Absolute PPP is The exchange rate between two countries is a
ratio of prices.
f.
Answer:
For UK change in CPI (2016 to 2018) =120-100= 20

Inflation = (20/100)*100 = 20%
For Euro CPI = 165-150 = 15
Inflation = (15/150)*100 = 10%
As the UK’s inflation is higher, its currency depreciates (inverse relation between
price levels and currency value.) and Euro’s currency appreciates. So, increase in
inflation tends to reduce the value of currency, which in long term reduces exchange
rate of a country.
g.
Answer:
Use of open market operation by Bank of England will help decrease interest rate in
UK and stabilizes it currency, Pound Sterling, but policy of not adopting any measure
by European central Bank and keeping status quo would depreciate European union
currency euro as compared to Pound sterling.
Hence, European Union currency’s nominal exchange rate as against UK’s pound
sterling would decrease and pound sterling would appreciate as against Euro.
4.
Answer:

The Triffin dilemma is the conflict of economic interests that arises between short-
term domestic and long-term international objectives for countries whose currencies
serve as global reserve currencies. Triffin dilemma was discovery of a Belgian-
American economist Robert Triffin in the 1960s. Triffin pointed out that the country
whose currency, being the global reserve currency, foreign nations wish to hold, must
be willing to supply the world with an extra supply of its currency to fulfill world
demand for these foreign exchange reserves, thus leading to a trade deficit (Canavan,
2015).
5.
Answer:
Probability of getting 2 US quarters will 3/5
Probability of maximum number of coin in pocket could be 5.
(a)
Answer:
When exchange rate of a country increases relative to others (currency devaluates) the
export of the country whose currency devaluates will be cheaper for others. Therefore,
export is expected to increase and imports will decrease. Similarly when exchange
rate decreases relative to others exports are discouraged and imports will be
encouraged. Therefore, exchange rates play significant roles in determining country's'
trade balance.
Countries which have very low inflation rate, generally have stable exchange rate, this
was also highlighted in a paper on money-inflation relationship written by Aizenman
and elaborated it in detail (Aizenman et al. 2010). So in the absence of exchange rate
stability and inflation rate also not in control would have very devastating impact on
an economy, its impact will be felt across all sectors of an economy.
As we all know, that demand and supply curve indicate supply for dollars and demand
of dollars. As depicted in following graph initial equilibrium exchange rate is as €0.89
per dollar:

(b) If the economy is in good state, is there any pure strategy equilibrium (Nash
Equilibrium) exist? If Yes, indicate the pure strategy equilibrium, in terms of, what
strategy Hubu play (defend or not defend)? What strategy global investor play (attack
or refrain)? If there is no pure strategy Nash Equilibrium, explain why? (5 points)
Answer:
One of the most important tools at the disposal is the Nash equilibrium; it was
propounded by John Nash, a Nobel prize awardees in 1994 for its discovery. In this
discovery by John Nash in Nash equilibrium, it basically tell that, every person in a
group makes the best decision for herself, based on what she thinks the others will do.
And no-one can do better by changing strategy: every member of the group is doing
as well as they possibly can. In the case of the prisoners' dilemma, keeping quiet is
never a good idea, whatever the other thug chooses. Since one suspect might have
already revealed the secret, snitching avoids a lifetime in jail for the other. And if the
other does keep quiet, then confessing sets him free. Nash equilibrium applied to the
real world, it was used by economic analyst to predict future pricing of competing
firms and response by their competitors. Two large companies setting pricing
strategies to compete against each other will probably press customers harder than
they could if they each faced thousands of competitors. (K., 2016)

(c)
Answer:
Nash equilibrium helps economic analyst in identifying that how decision/s can be
good for individual but terrible for an entire groups. This tragedy of the commons
explains why we overfish the seas, and why we emit too much carbon into the
atmosphere. Some restraint required to be shown to make everyone better off,
otherwise impatience can be spoiler for everyone. But given what everyone else is
doing, fishing or high fuel consumption makes individual sense. Besides, general
feeling of pessimism or despondency about an economy’s helps policymakers come
up with solutions to complicated problems. The Nash equilibrium helped many
economist raised billions for the public purse. (K., 2016)

References:
Parikh, V. (2014). Difference between Spot and Forward Rate. Retrieved 17 August 2019, from
https://www.letslearnfinance.com/difference-between-spot-and-forward-rate.html
Canavan, G. (2015). The Triffin Dilemma. Retrieved 17 August 2019, from
https://dailyreckoning.com/the-triffin-dilemma/
K., S. (2016). What is the Nash equilibrium and why does it matter?. Retrieved 17 August 2019, from
https://www.economist.com/the-economist-explains/2016/09/06/what-is-the-nash-
equilibrium-and-why-does-it-matter
Aizenman, J., Chinn, M., & Ito, H. (2010). Surfing the Waves of Globalization: Asia and Financial
Globalization in the Context of the Trilemma. Retrieved 17 August 2019, from
http://web.pdx.edu/~ito/Aizenman_Chinn_Ito_hi_Oct7_2009.pdf