Currency Peg

  1. Explain how the Dirham (AED) is pegged to the US dollar and explain what the future prospects are for the Dirham.

When a currency has been pegged on another, it implies that the exchange rate shall always be relatively stable such that the expected changes are negligible. For the Dirham to be pegged on the US Dollar, it means that the former currency can be exchanged for the latter at 1 USD = Dh 3.672. The forex traders do not have to necessarily keep on checking the market rates each day because the Dirham has already been pegged.

It is known that whenever the US decides that it wants to have the interest rate to be raised, the implication is that the USD shall appreciate. Upon the appreciation of the USD, the extra cost which has been brought about by the fluctuation is settled by the UAE central bank as the guardian of the Dirham. This is done in a bid to ensure that the exchange rate stays stable and unchanged by the appreciation of the dollar. The implication is that those who are holding Dirhams shall have an advantage hence a higher purchasing power. However, the traders have to go an extra mile and exchange the USD for another currency, such as the Euro.

Assuming that the USD goes for Dh 3.972, then the UAE central bank shall be tasked with the burden of footing the excess Dh 0.3 of assets per USD. In the opposite action, if the Dirham depreciates against the USD, the UAE central bank purchases an additional amount of USD to keep the exchange rate stable.

In conclusion, the UAE central bank shall play a significant role to make sure that the future of the Dirham is predictable. The exchange rate is pegged at 1 USD = Dh 3.672, and this shall prevail with the supervision of the UAE monitory authority.

  1. How do covered and uncovered interest parity explain exchange rate behavior?

The difference between the exchange rates of two countries and the currency foreign exchange rates’ change in the same period is the same. This is the uncovered interest parity, and it requires forecasting the rate such that only the expected spot rate is used. On the other hand, the tactic of covered interest parity requires the use of forward contracts in the covering of exchange rates.

Uncovered interest rate deals with two routes of investments; the first one from the interest rate of investments on foreign money market while the other is change in the spot rate of foreign currency. This interest rate parity does generalize that the condition of the existence of the equilibrium on the foreign exchange. This means that the return of any risk-free investment such as the US treasury bill shall be equal to the profit expected to be yielded by any asset invested in foreign economies. Nonetheless, the change in the exchange spot rates of foreign currencies has to be adjusted first.

Uncovered interest rate implies that the countries that have high interest rates on the money market shall have depreciation in their currencies and thus discourages the nations from hiking interest rates. The controllers of the markets shall always try to make sure that the interest rates remain in equilibrium to avoid depreciation of the currency.

In conclusion, the expected and forward spot rates determine the reactions to the exchange rates over the covered and uncovered rates. However, there is no difference when the forward and expected rates are at the same level. Nonetheless, sometimes the empirical evidence disapproves the theoretical explanation of the covered and uncovered rates.

  1. What are the different approaches used to forecast exchange rates. Explain why it is important to MNCs that they know future exchange rate movements.

Exchange rates are forecasted using various ways. Among all the methods, none of them has proved to be better or inferior to the others. Here, two approaches are all discussed in brief as well as the reasons as to why MNCs should keep an eye on the movements of exchange rates.

  1. The use of purchasing power parity

This is the most common due to its use by many scholars. This law of one price says that a particular good should have the same price everywhere, regardless of the economic region. For instance, a khaki bag in Australia should cost the same as it would cost in the US. Nonetheless, there must be an inflation factor to be considered. Different countries have varying inflation rates, and thus prices are expected to change. Suppose the price of the khaki bag in Australia would increase by 6% and the rise in the US would be 3%. Then there must be the inflation differential which is 3%. This is an implication that the USD would have to depreciate by a margin of 3% if the price of the khaki bag would remain the same. MNCs should be the first to know about the change in exchange rates because their trading activities must be affected by any changes.

  1. Relative Economic Strength

Different countries have various rates of economic growth. This is because there are those countries that have a higher potential to grow economically than others. These nations are expected to attract a more significant number of investments. Any investor in a particular country would want to convert their money into the currency of that specific nation. The state that has a higher potential, therefore, must receive a higher demand for its currency, hence appreciating the currency.

  1. Analyze how governments can influence exchange rates.

Governments can influence exchange rates through a variety of ways that are aimed at benefiting their citizens. These ways include:

  1. manipulating interest rates

The monetary authorities of different countries make sure that they use interest rates in their favor. A government makes sure that there are higher interest rates so that lenders can get better returns to their investments. Nonetheless, the borrowers are affected negatively by this. So when the government wants to throw its weight behind borrowers, it brings down the interest rates so that they are encouraged to borrow even more. High-interest rates are associated with high exchange rates. When the government needs to decrease the exchange rates, it brings down the interest rates.

  1. use of public debt

In most countries, large projects in the public sector are financed using borrowed money. Investors less prefer these nations who have an insatiable appetite for borrowing. This is because an enormous public debt brings about a higher level of inflation in a country. in the worst scenario, the government may print money to pay off the debt, pumping a lot of currency in the local market, offsetting the exchange rate. Securities are increased by the same government so that foreigners are enticed into buying. In such a case, the exchange rate falls significantly.

iii. Political stability

When a country is peaceful, the economic performance is likely to go up. Foreign and domestic investors are likely to put their money there. The rate of exchange also goes up because such a country is being sought after by serious investors. On the other hand, when a nation turns chaotic and is full of civil unrest or terrorist attacks, investors run away. The confidence the investors have in the currency is likely to be eroded by the lack of peace. Such a currency then depreciates, and losses value, affecting exchange rate negatively.

  1. Analyze how interest rates and inflation can determine exchange

Interest rates and inflation can either have a positive or negative influence on exchange rates. The impact is determined by the intention of the application of the two factors.

Interest rates also have a positive and adverse effect on the exchange rate. When the interest rates are high, investors shy away and do not invest because of the cost of borrowing. However, the lenders enjoy such a situation because they know they would make a lot of money charging such exorbitant interest rates. Borrowers are scared of obtaining expensive loans, and therefore the industrial sector is likely to deteriorate, and this means lower levels of employment. Many people become unemployed, and production generally decrease. The economy performs dismally, and its growth becomes negative. The exchange rate deteriorates in such a situation and therefore is impacted negatively. However, when the interest rates are lower than average, investors are happy because they find plenty of money to invest in the economy. In this case, there are a lot of projects that are launched. As a result, the economy is stimulated, and a lot of things start happening in terms of developments.

Low-interest rates attract higher rates of employment, and the factors of production are put into optimal use because the resources are available. Production increases tremendously, and some of the produce is exported, earning foreign exchange. This means that the exchange rate is positively impacted, leading to a healthy nation economically.

Inflation means that there is a high amount of circulation of currency in the economy. Interest rates fall drastically. The currency depreciates, and the economy performs well. However, high levels of inflation influence the economy negatively, creating a negative impact on the exchange rate because investors are scared of such an economy.