Currency Exchange Rates: Understanding Equilibrium Value

Correct Answer: The USD will depreciate against the JPY until the exchange rate reaches the equilibrium level of 1 USD = 100 JPY, assuming no other factors influence the exchange rate.

The correct answer is that the USD will depreciate against the JPY until the exchange rate reaches the equilibrium level of 1 USD = 100 JPY, assuming no other factors influence the exchange rate. If the current exchange rate is 1 USD = 110 JPY, but the equilibrium exchange rate based on economic fundamentals is 1 USD = 100 JPY, it means that the USD is overvalued relative to the JPY. In this situation, market forces will likely drive the exchange rate towards the equilibrium level. As the USD is overvalued, there will be less demand for USD in the foreign exchange market, as market participants recognize that the currency is not trading at its fair value. Simultaneously, there will be an increased supply of USD as market participants sell the overvalued currency. This decreased demand and increased supply will lead to a depreciation of the USD against the JPY until the exchange rate reaches the equilibrium level of 1 USD = 100 JPY. The other two options are incorrect because they do not reflect the market's tendency to move towards equilibrium. An appreciation of the USD would move the exchange rate further away from the equilibrium, which is unlikely. Similarly, the exchange rate remaining at 1 USD = 110 JPY is unlikely, as it does not reflect the economic fundamentals and the market's inclination to correct discrepancies between the current and equilibrium exchange rates.

Correct Answer: The current account balance equals the capital and financial account balance, resulting in no net effect on the exchange rate

The correct answer is that the current account balance equals the capital and financial account balance, resulting in no net effect on the exchange rate at equilibrium. This is because, according to the balance of payments equation, the current account balance (which includes trade in goods and services, income, and current transfers) must be offset by an equal and opposite balance in the capital and financial account (which includes financial transfers and transactions in financial assets and liabilities). At equilibrium, there is no net effect on the exchange rate as the supply and demand for the currency are balanced. The other answers are incorrect: A current account surplus does not necessarily lead to a depreciation of the currency. In fact, it often results in an appreciation due to increased demand for the currency. A current account deficit does not cause an appreciation of the currency. Instead, it typically leads to depreciation as the demand for the currency is lower relative to its supply in foreign exchange markets.

Correct Answer: The Mexican peso is expected to appreciate against the U.S. dollar, moving towards the equilibrium rate of 1 USD = 18 MXN

The correct answer is that the Mexican peso is expected to appreciate against the U.S. dollar, moving towards the equilibrium rate of 1 USD = 18 MXN. The economic fundamentals suggest that the equilibrium exchange rate should be 1 USD = 18 MXN, but the current market rate is 1 USD = 20 MXN. This implies that the Mexican peso is undervalued relative to the U.S. dollar. When a currency is undervalued, market forces will typically drive the exchange rate towards the equilibrium level. In this case, the Mexican peso will likely appreciate (increase in value) against the U.S. dollar until it reaches the equilibrium rate of 1 USD = 18 MXN. The other two options are incorrect because they suggest that the Mexican peso will either continue to depreciate or remain stable at the current level, both of which are inconsistent with the given economic fundamentals indicating an equilibrium rate of 1 USD = 18 MXN.