Middle East Technical University Spring 2015-2016
Faculty of Economics and Administrative Sciences
Department of Economics
ECON354: Introduction to International Economics II
PROBLEM SET 2
TRUE/ FALSE/UNCERTAIN
1) The demand for a foreign currency in a country is determined only by two activities; the demand
for foreign goods & services and the demand for foreign investment.
This statement is false, because there is also of demand for foreign currency that is coming
from the financial transactions as well as speculation and hedging activities.
2) Law of one price says that any given commodity tends to have the same price worldwide when
measured in the same currency and it is a concept that is related to absolute purchasing power
parity.
True
3) The equilibrium exchange rate that is determined at the foreign exchange market surely balances
current account.
This statement is false, since the financial account transactions and current account
transactions together carry the exchange rate to equilibrium, therefore the current account
balance can give surpluses or deficits. The equilibrium exchange rate does not necessarily
balance the current account.
4) If the expected future spot rate is less than the current forward rate, the speculators will purchase
foreign currency forward. It is called taking a long position in foreign exchange. If it is expected
that the future spot rate will be higher than the current forward rate, the speculator will contract
to sell the foreign exchange forward, or take a short position.
False. When the expected future spot rate is higher than the current forward rate, the
speculator will purchase foreign currency forward, i.e. take a long position. If the expected
future spot rate is less than the current forward rate, the speculator will contract to sell the
foreign exchange forward, i.e. take a short position.
5) An increase in the dollar price of other currencies tends to cause U.S goods to be cheaper than
foreign goods.
True
6) Grain shortages in countries that buy large amounts of grain from the United States would
increase the demand for American grain and increase the demand for dollars resulting in a
depreciation of the U.S dollar.
False, This will cause the U.S dollar to appreciate
PROBLEMS
1) “The equilibrium foreign exchange rate (price of domestic currency in terms of foreign
currency) is above the rate that equilibrates the demand and supply resulting from current
account transactions in a country with a current account surplus”. Do you agree? Explain.
The equilibrium foreign exchange rate and the rate that equilibrates the demand and supply
resulting from current account transactions are equal only when current account is in balance.
When equilibrium rate is above the current account transactions rate, current account gives
a surplus and it will be offset by an equivalent financial account deficit under flexible exchange
rate policy.
2) Suppose that Consumer Price index for Turkey is 200 in 2006. According to the table below,
calculate NEER, REER, RER and relative PPP for each country. Use 1999 as the base year
whenever necessary. Explain the results.
COUNTRY
ER99
ER06
X&M
CPI06
U.K.
1.4
1.8
200,000
140
France
1.1
1.2
150,000
155
Germany
1.25
1.5
750,000
125
Russia
1.2
1.35
250,000
170
1.1
1.7
500,000
135
