Weighing Factors That Affect Exchange Rates

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Question 28

WEIGHING FACTORS THAT AFFECT EXCHANGE RATES

Assume that the level of capital flows between the United States and the country of Zeus is negligible (close to zero) and will continue to be negligible. There is a substantial amount of trade between the United States and the country of Zeus. The main import by the United States is basic clothing purchased by U.S retail stores from Zeus, while the main import by Zeus is special computer chips that are only made in the United States and are needed by many manufacturers in Zeus. Suddenly, the U.S. government decides to impose a 20 percent tax on the clothing imports. The Zeus government immediately retaliates by imposing a 20 percent tax on the computer chip imports. Second, the Zeus government imposes a 60 percent tax on any interest income that would be earned by Zeus investors if they buy U.S securities. Third, the Zeus central bank raises its local interest rate so that they are now higher than interest rates in the United States. Do you think the currency of Zeus (called the zee) will appreciate or depreciate against the dollar as a result of all the government actions described above? Explain.

Answer:

Factors that may affect the value of Zee:

1. US Impose 20% Tax on Clothing Import

Import from Zeus by United States will increase the price of clothing. Hence the volume of clothing exported by Zeus will decrease. This will cause the export earning of Zeus to fall. As there will be less requirement of import from Zeus the demand for Zeus will decrease and hence will the price for Zee. This will result in depreciation of Zee.

1. Zeus Imposing 20% Tax on computer chip imports

As the computer chips are essential for the manufacturers in Zeus and are only made by the United States producers the demand for the chips is inelastic in nature. Hence imposition of tax on computer chips will not decrease the import of chips from United States to that extent.

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As there is equal percentage of tax imposed by both the governments the tax on clothing will have more effects than the tax on chips. The overall effect will cause the value of Zee to depreciate.

The figure shows that the quantity demanded for Zee will decrease causing a shift of demand from Q to Q1. This will cause the price shift from P to P1.

However, the following factors will not have any effects on Zee:

1. 60 percent tax on any interest income.
2. Increase of relative interest rate in Zeus

This is because there is insignificant capital flow between these two countries and both the above effects will impact the currencies only if there is a transaction of capital between them.