Aggregate effects on exchange rates. Assume that the United Kingdom invests heavily in govern- ment and corporate securities of Country K. In addition, residents of Country K invest heavily in the United Kingdom. Approximately £10 billion worth of investment transactions occur between these two countries each year. The total value of trade transac- tions per year is about £8 million. This information is expected to also hold in the future.
Because your firm exports goods to Country K, your job as international cash manager requires you to forecast the value of Country K's currency (the ‘krank') with respect to the dollar. Explain how each of the following conditions will affect the value of the krank, holding other things equal. Then, aggregate all of these impacts to develop an overall forecast of the krank's movement against the dollar.
a. UK inflation has suddenly increased substantially, while Country K's inflation remains low.
b. UK interest rates have increased substantially, while Country K's interest rates remain low. Investors of both countries are attracted to high interest rates.
c. The UK income level increased substantially, while Country K's income level has remained unchanged.
d. The United Kingdom is expected to impose a small tariff on goods imported from Country K.
e. Combine all expected impacts to develop an overall forecast.