Institute of Chartered Financial Analysts of India (ICFAI) University 2006 Certification Finance International and Trade – II - Question Paper

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Caselet 2

8. There are many factors that influence the exchange rate of US dollar. Generally speaking, there are mainly 4 reasons: first, the health condition and the rate of return for investment of the US economy, secondly, the balance of international payment in the US, thirdly, the level of interest rates in the US compared with those in other countries, and fourthly, the rate of inflation. Meanwhile, there are also many other temporary pounding factors from without, such as wars, oil price, scandals from large companies as well as psychological factors etc, which are believed to have connections with former 4 factors.

Judging from the estimation by different parties, evident enough, many economists take the balance of international payments as the decisive factor for the pattern of the US dollar. Although this type of view is not unreasonable, it is partial. If considered from history, people will obtain out that the balance of international payment featuring trade deficit and current account deficit has been dominating the US economy since 1970s. But the track of the US dollar's circulation does not show a plummet drop.

The exchange rate of US dollar used to be high for 2 times since the US implemented the floating exchange rate: 1 occurred during Reagan's reign while the other was in Clinton's rule. So far as Reagan's reign is concerned, the federal budget deficit, trade deficit and current account deficit were high, but the exchange rate of US dollar was also high. It is simply because the high deficit triggered the high interest rate and high interest rate consequently resulted in high exchange rate. The trade deficit is not the outcome of the change of exchange rate but rather its cause. What was worth mentioning is that the surplus was realized during Clinton's rule. But the condition of international payment hadn't been much improved due to the low private saving rate and the exchange rate of US dollar still strong. The major cause is because of the strong growth of the US economy, low returning rate and high interest rate.

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9. Generally speaking, the sharp drop of the US dollar exchange rate is impossible unless all the US dollar holders worldwide sell US dollars in large amount simultaneously, just like depositors draw money from banks during the bank credit crisis. First, the US economy still boasts the highest growth rate and strongest competitiveness among major developed countries, and other countries are still confident about the US economy; secondly, the US dollar, serving a role of a currency for international reserve, has become the natural defense for the sharp devaluation of US dollar; thirdly, since foreigners hold a huge amount of US dollars, they will suffer severe losses if they sell dollars in large amount and will not easily obtain a suitable substitution. Furthermore, the safety and circulation of euro, Japanese yen and gold are no better than the US dollar.

Earning:   Approval pending.