The factor that McFadden is most likely referring to in Statement 4 is:

A. FX reserve levels.

B. domestic demand.

C. the level of capital flows.

Transcribed Image Text:

Connor Wagener, a student at the University of Canterbury in New Zealand, has been asked to prepare a presentation on foreign exchange rates for his international business course. Wagener has a basic understanding of exchange rates, but would like a practitioner's perspective, and he has arranged an interview with currency trader Hannah McFadden. During the interview, Wagener asks McFadden: "Could you explain what drives exchange rates? I'm curious as to why our New Zealand dollar was affected by the European debt crisis in 2011 and what other factors impact it." In response, McFadden begins with a general discussion of exchange rates. She notes that international parity conditions illustrate how exchange rates are linked to expected inflation, interest rate differences, and forward exchange rates as well as current and expected future spot rates. McFadden states: Statement 1: "Fortunately, the international parity condition most relevant for FX carry trades does not always hold." McFadden continues her discussion: "FX carry traders go long (i.e., buy) high-yield currencies and fund their positions by shorting that is, borrowing in-low-yield currencies. Unfortunately, crashes in currency values can occur, which create financial crises as traders unwind their positions. For example, in 2008, the New Zealand dollar was negatively impacted when highly leveraged carry trades were unwound. In addition to investors, con- sumers and business owners can also affect currency exchange rates through their impact on their country's balance of payments. For example, if New Zealand con- sumers purchase more goods from China than New Zealand businesses sell to China, New Zealand will run a trade account deficit with China." McFadden further explains: Statement 2: "A trade surplus will tend to cause the currency of the country in surplus to appreciate, whereas a deficit will cause currency depreciation. Exchange rate changes will result in immediate adjustments in the prices of traded goods as well as in the demand for imports and exports. These changes will immediately correct the trade imbalance." McFadden next addresses the influence of monetary and fiscal policy on exchange rates: "Countries also exert significant influence on exchange rates both through the initial mix of their fiscal and monetary policies and also by subsequent adjustments to those policies. Various models have been developed to identify how these policies affect exchange rates. The Mundell-Fleming model addresses how changes in both fiscal and monetary policies affect interest rates and ultimately exchange rates in the short term." McFadden describes monetary models by stating: Statement 3: "Monetary models of exchange rate determination focus on the effects of inflation, price level changes, and risk premium adjustments." McFadden continues her discussion: "So far, we've touched on balance of payments and monetary policy. The portfolio balance model addresses the impacts of sustained fiscal policy on exchange rates. I must take a client call, but will return shortly. In the meantime, here is some relevant literature on the models I mentioned along with a couple of questions for you to consider." Question 1: Assume an emerging market (EM) country has restrictive monetary and fiscal policies under low capital mobility conditions. Are these policies likely to lead to currency appreciation or currency depreciation, or to have no impact? Question 2: Assume a developed market (DM) country has an expansive fiscal policy under high capital mobility conditions. Why is its currency most likely to depreciate in the long run under an integrated Mundell-Fleming and portfolio balance approach? Upon her return, Wagener and McFadden review the questions. McFadden notes that capital flows can have a significant impact on exchange rates and have contributed to currency crises in both EM and DM countries. She explains that central banks, like the Reserve Bank of New Zealand, use FX market intervention as a tool to manage exchange rates. McFadden states: Statement 4: "Some studies have found that EM central banks tend to be more effective in using exchange rate invention than DM central banks, primarily because of one important factor." McFadden continues her discussion: Statement 5: "I mentioned that capital inflows could cause a currency crisis, leaving fund managers with significant losses. In the period leading up to a currency crisis, I would predict that an affected country's: Prediction 1: foreign exchange reserves will increase. Prediction 2: broad money growth in nominal and real terms will increase. Prediction 3: real exchange rate will be substantially higher than its mean level during tranquil periods." After the interview, McFadden agrees to meet the following week with Wagener to discuss more recent events affecting the New Zealand dollar.