The International Financial Envirnonment

Jennifer Jones

Strayer University

The International Financial Environment

FIN535002VA016-1116-001 International Finance

Professor Matthew Ademola

1. Explain how the international trade flows should initially adjust in response to the changes in inflation (holding exchange rates constant). Explain how the international capital flows should adjust in response to the changes in interest rates (holding exchange rates constant).

Moderately elevated prices in the U.S. can lead to an boost in demand for relatively cheaper U.K. products. Thus, the demand for the British Pound (GBP) increases. Likewise, the relatively lower prices in the U.K. lead to a decrease in the supply of GBP as British consumers buy additional local products and fewer exports from the U.S. At the original exchange rate, we have the U.S. importing more than it exports, which is by definition a Trade Deficit. Further, the resultant “excess demand” for the GBP will cause the exchange rate to rise, such that the dollar depreciates.

Moderately elevated interest rates in the U.S. lead to an raise in demand for U.S. interest bearing securities (Bonds) and a decrease in demand for U.K. bonds. As a result, U.S. investors demand less GBP since they want fewer U.K. bonds. Likewise, British investors supply more GBP to buy more U.S. bonds. At the original exchange rate, this leads to the case of “excess supply” which will cause the exchange rate to fall to, such that the dollar appreciates.

2. Using the information provided, will Mesa expect the pound to appreciate or depreciate in the future? Explain.

According to the information provided, the interest rate effect should be much stronger than the inflation effect since the exchange rate is stated to be more sensitive to capital flows than it is to trade flows. We should expect the dollar to appreciate due to the inflow of capital into the USA to purchase USA bonds.

3. Mesa believes international capital flows shift in...