Question

Assume that the United States invests in government and corporate securities of Country K. In addition, residents of Country K invest in the United States. Approxi­mately $10 million worth of investment transactions occur between these two countries each year. The total dollar value of trade transactions per year is about $8 billion. This information is expected to also hold in the future.

Because your firm exports goods to Country K, your job as international cash manager requires you to forecast the value of Country K’s currency (the "krank") with respect to the dollar. Explain how each of the following conditions will affect the value of the krank, holding other things equal. Then, aggregate all of these impacts to develop an overall forecast of the krank’s movement against the dollar.
a. The U.S. inflation has suddenly increased substantially, while Country K’s inflation remains low.
b. The U.S. interest rates have increased substantially, while Country K’s interest rates remain low. Investors of both countries are attracted to high interest rates.
c. The U.S. income level increased substantially, while Country K’s income level has remained unchanged.
d. The U.S. is expected to impose a small tariff on goods imported from Country K.
e. Combine all expected impacts to develop an overall forecast.

Answer 1

a. Increased U.S. demand for the krank. Decreased supply of kranks for sale. Upward pressure in the krank's value.

b. Decreased U.S. demand for the krank. Increased supply of kranks for sale. Downward pressure on the kranks value.

c. Increased U.S. demand for the krank. Upward pressure on the krank's value.

d. The tariff will cause a decrease in the United States' desire for Country K's goods, and will therefore reduce the demand for kranks for sale. Downward pressure on the krank's value.

e. Since the interest rates affect capital flows and capital flows dominate trade flows between the U.S. and Country K. the interest rate should overwhelm the other scenarios. So, krank is expected to depreciate as a result of considering the importance of the implications of all scenarios,