Question 1:

i) Each of the following statements has been put forward as an explanation of determinants of exchange rate:

a) ‘the increase in the value of a currency is because rates of interest in that country have risen relative to those in the rest of the world'

b) ‘ the decrease in the value of a currency is because rates of interest in that country have risen relative to those in the rest of the world'

Explain and reconcile these two statements, using diagrammatic and numerical example where appropriate.

ii) Read the following case study carefully and answer the questions.

The Australian dollar hugged a tight range yesterday as global investors reconsidered their bearish stance on the US dollar after a display of some stability in offshore equity markets. The AUD closed local trading US 56.29 cents, down slightly from Friday's close of US 56.35 cents.

The Australian dollar will remain hostage to global events and will also take its cue from a batch of economic data to be released in the US this week. ANZ Investment Bank's senior foreign exchange dealer, Paul McNee, said: ‘The marker will have one eye on the US economy, which is showing signs of strength, and the other eye on the Dow, which is showing some signs of stability. But the tensions in Iraq have tightened a notch and that is not good for a global commodity currency like the Australian dollar. Overall, traders are expecting the local currency to trade between US 55.5 cents and US 57.5 cents up until the end of the year, so there will be a lot of activity to protect those levels.'

In light trading yesterday, the US dollar continued to make modest gains against the yen and the euro. Speculation about another fiscal package in Japan, the paralysing amount of bad-loan provisions in the Japanese banking sector and a 2 per cent slide in the Nikkei resulted in the US dollar edging higher. The euro was lower on the day, fuelled by speculation that the European Central Bank will cut official interest rates on December 5. At the close of the local trading session, the euro was USD 1.0103.

A research report issued by JP Morgan yesterday highlighted the wide interest rate differential between Australia and the US and predicted this gap would drive the local dollar to US 63 cents by the end of 2003. This gap now stands at 350 basis points.

Source: Baker, P.,Australian Financial Review, 19 November 2002

Question 2:

a) What are the important issues identified in the above article that are having an impact on uncertainty in the global foreign exchange markets?

b) Is it correct, as suggested by a senior foreign exchange dealer, that the foreign exchange has its eyes firmly fixed on the data coming out of the US markets? Why is it so?

c) Why might the JP Morgan report consider the large Australian-US interest rate differential as an indicator that the AUD will appreciate?