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8) Use a figure to illustrate the ineffectiveness of monetary policy to spur on an economy under a
fixed exchange rate.
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Copyright © 2015 Pearson Education, Inc.
10) Define devaluation and use a figure to show the effect of a currency devaluation on the
economy.
Answer:
A devaluation occurs when the central bank raises the domestic currency price of foreign
currency. In the figure, the domestic currency is devalued from to . Since nothing in the DD
schedule has changed, the new equilibrium at point 2 must be reached by an expansion of the
money supply (AA curve shifts outward). Notice also that output has increased from to .
Page Ref: 509-511
Difficulty: Difficult
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11) Please use a figure to discuss whether or not a devaluation under a fixed exchange rate has
the same long-run effect as a proportional increase in the money supply under a floating rate.
Answer:
A currency devaluation shifts the AA schedule outward from equilibrium point 1 to equilibrium
point 2. The devaluation does not change long-run demand or supply conditions in the output
market. Thus, the increase in the long-run price level will exactly offset the increase in exchange
rate. Thus, a devaluation is neutral in the long run and this is the exact same scenario as for an
increase in the money supply under a floating exchange rate.
Page Ref: 509-511
Difficulty: Difficult
18.6 Managed Floating and Sterilized Intervention
1) Imperfect asset substitutability assumes
A) the returns on foreign and domestic currency bonds are identical.
B) the returns on foreign and domestic currency are unrelated.
C) the risks of holding foreign and domestic currency are identical.
D) the risks of holding foreign and domestic currency are unrelated to returns.
E) the returns on foreign and domestic currency differ and are influenced by risk.
Answer: E
Page Ref: 512-517
Difficulty: Easy
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2) The global financial crisis of 2007-2008 resulted in a(n) ________ of the Swiss franc as
foreign currency flowed ________ the country. As result, Swiss products became ________
competitive in world markets.
A) depreciation; out of; more
B) depreciation; into; more
C) appreciation; out of; less
D) depreciation; out of; less
E) appreciation; into; less
Answer: E
Page Ref: 512-517
Difficulty: Easy
3) The global financial crisis of 2007-2008 resulted in a(n) ________ of the Swiss franc. In 2011,
the Swiss central bank intervened in order to cause a(n) ________ of the franc.
A) appreciation; appreciation
B) depreciation; depreciation
C) appreciation; revaluation
D) depreciation; appreciation
E) appreciation; depreciation
Answer: E
Page Ref: 512-517
Difficulty: Easy
4) Perfect asset substitutability is the assumption that
A) the foreign exchange market is in equilibrium only when expected returns on domestic assets
are greater than returns on foreign currency bonds.
B) the foreign exchange market is in equilibrium only when expected returns on foreign currency
bonds are greater than returns on domestic assets.
C) the foreign exchange market is in equilibrium only when expected returns on all assets are
negative.
D) the foreign exchange market is in equilibrium only when expected returns on domestic assets
are equal to returns on foreign currency bonds.
E) the foreign exchange market is in equilibrium only when domestic assets are risk-free.
Answer: D
Page Ref: 512-517
Difficulty: Easy
5) Imperfect asset substitutability exists
A) when it is possible for the expected returns on two assets to be different.
B) when the expected returns on two assets are the same.
C) only when one asset is foreign and the other is domestic.
D) when there is risk in the foreign exchange market.
E) when assets are liquid.
Answer: D
Page Ref: 512-517
Difficulty: Easy
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6) The interest parity condition can be written as
A) R = R - (Ee - E)/E.
B) R = R + (Ee - E)/E.
C) R = R2 - (Ee - E)/E.
D) R = R /(Ee - E).
E) R = R + (Ee + E)/E.
Answer: B
Page Ref: 512-517
Difficulty: Easy
7) When domestic and foreign currency bonds are imperfect substitutes, the domestic interest
rate (R) can be written as
A) R = R - (Ee - E)/E + ρ.
B) R = R - (Ee - E)/E.
C) R = R + (Ee - E)/E + ρ.
D) R = R - (Ee + E)/E + ρ.
E) R = R - (Ee - E)ρ.
Answer: C
Page Ref: 512-517
Difficulty: Easy
8) In the interest rate parity condition with imperfect substitutes and a risk premium of ρ
A) an increased stock of domestic government debt will raise the difference between the
expected returns on domestic and foreign currency bonds.
B) a decreased stock of domestic government debt will raise the difference between the expected
returns on domestic and foreign currency bonds.
C) an increased stock of domestic government debt will reduce the difference between the
expected returns on domestic and foreign currency bonds.
D) an increased stock of domestic government debt will have no effect on the difference between
the expected returns on domestic and foreign currency bonds.
E) a decreased stock of domestic government debt will have no effect on the difference between
the expected returns on domestic and foreign currency bonds.
Answer: A
Page Ref: 512-517
Difficulty: Easy
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9) The signaling effect of foreign exchange intervention
A) never has any effect on exchange rates.
B) can alter the market's view of exchange rates independent from the stance of monetary and
fiscal policies.
C) cannot cause an immediate exchange rate change when bonds denominated in different
currencies are perfect substitutes.
D) never leads to actual changes in monetary or fiscal policy.
E) can alter the market's view of future monetary policies and cause an immediate exchange rate
change.
Answer: E
Page Ref: 512-517
Difficulty: Easy
10) Please describe in detail a self-fulfilling currency crisis.
Answer: Consider an economy in which domestic commercial banks' liabilities are mainly short-
term deposits, and in which many of the banks' loans to businesses are likely to go unpaid in the
event of a recession. If the market suspects there will be devaluation, interest rates will rise,
banks' borrowing costs go up, and a banks' assets have lower value if a recession hits. To prevent
financial collapse, the central bank will lend money to banks and no longer be able to keep the
exchange rate from rising. Thus, the emergence of devaluation expectations eventually leads to a
devaluation of currency (self-fulfilling).
Page Ref: 512-517
Difficulty: Moderate
11) Describe the effect of the 2008-2009 global financial crisis on the Swiss franc and the central
bank's efforts to respond to the resulting problems.
Answer: The 2008-2009 global financial crisis resulted in appreciation of the franc as currency
traders purchased the franc as a safe haven currency. The Swiss economy consequently suffered
as its products became less competitive with imports. The Swiss responded by committing to
currency intervention designed to control appreciation of the franc and restore the country's
competitiveness in global markets.
Page Ref: 512-517
Difficulty: Moderate
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12) Use a figure to explain how a balance of payments crisis and its hand in capital flight.
Answer:
Suppose the foreign exchange market expects the government to devalue the currency in the
future and adopt a new fixed exchange rate > . This leads to a rightward shift in the curve
that measures the expected domestic currency return on foreign currency deposits. Since the
exchange rate remains fixed at , the domestic interest rate must rise to R* + ( - )/ . The
central bank must sell foreign reserves and shrink the money supply in response. This reserve
loss accompanying a devaluation scare is labeled capital flight.
Page Ref: 512-517
Difficulty: Difficult
18.7 Reserve Currencies in the World Monetary System
1) Briefly describe two systems for fixing the exchange rates of all currencies against each other
and the time periods in which they were used.
Answer: The first is to single cut one country's currency as the reserve currency. The other
countries hold this reserve currency and fix their interest rate to it by standing ready to exchange
domestic currency for the reserve currency. The U.S. dollar was the reserve currency from 1945
to 1973. The second is the gold standard in which central banks peg the prices of their currencies
in terms of gold and hold gold as official international reserves. This was used between 1870 and
1914.
Page Ref: 518-519
Difficulty: Difficult
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2) This question concerns the mechanism of a reserve currency standard.
Two countries, X and Y, have two currencies, x and y, fixed to the reserve currency, the U.S.
dollar. Suppose the exchange rate between x and the U.S. dollar is 3x per dollar. Suppose the
exchange rate between y and the U.S. dollar is 5y per dollar. Explain (using numbers) the
mechanism if the x-y exchange rate was 0.5 x per y.
Answer: At this exchange rate, an investor can make an arbitrage profit by selling $100 to the
central bank of X (receiving 300 x), then selling your 300 x to the foreign exchange market for
300 x/(0.5 x per y) = 600 y, then buying U.S. dollars in the amount of $120 from the central bank
of Y. Thus the foreign exchange market will bid the x-y exchange rate up to 0.6 x per y.
Page Ref: 518-519
Difficulty: Difficult
3) This question concerns the mechanism of a reserve currency standard.
Two countries, X and Y, have two currencies, x and y, fixed to the reserve currency, the U.S.
dollar. Suppose the exchange rate between x and the U.S. dollar is 3x per dollar. Suppose the
exchange rate between y and the U.S. dollar is 5y per dollar. Explain (using numbers) the
mechanism if the x-y exchange rate was 0.8 x per y.
Answer: At this exchange rate, an investor can make an arbitrage profit by selling $100 to the
central bank of Y (receiving 500 y), then selling this 500 y to the foreign exchange market for
500 y/(0.8 x per y) = 400 x, then buying $133.33 U.S. dollars from the central bank of X with
this 400 x. Thus the foreign exchange market will bid the x-y exchange rate down to 0.6.
Page Ref: 518-519
Difficulty: Difficult
4) Explain how a country whose currency is the reserve currency can use monetary policy for
macroeconomic stabilization. In particular, explain the result if that country doubled its domestic
money supply.
Answer: The immediate result of the doubling of the money supply in the reserve currency's
country will be able to increase the exchange rate between the reserve currency and all other
currencies. However, all other countries must fix their exchange rate to the reserve currency, so
they will purchase the reserve currency and hold it as official international reserves (thus
increase their own money supply) until the exchange rate has returned to normal. Thus, the
reserve country has the power to affect its own economy and all other countries must adjust in
response.
Page Ref: 518-519
Difficulty: Moderate
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18.8 The Gold Standard
1) From 1837 and up until the Civil War, the United States adhered to a
A) gold standard.
B) silver standard.
C) bimetallic standard.
D) bronze standard.
E) copper standard.
Answer: C
Page Ref: 520-526
Difficulty: Easy
2) From the Civil War up to 1914, the United States adhered to a
A) gold standard.
B) silver standard.
C) bimetallic standard.
D) bronze standard.
E) copper standard.
Answer: A
Page Ref: 520-526
Difficulty: Easy
3) Assuming perfect asset substitutability, can sterilized intervention by the central bank be
effective? Please discuss.
Answer: No, a sterilized foreign exchange intervention by the central bank leaves the domestic
money supply unchanged. Under floating exchange rates, a change in the interest rate is needed
to affect the exchange rate, but the interest rate won't change if the money supply does not.
Under a fixed exchange rate, an expansive policy needs to be offset by an increase in the
domestic money supply. To avoid inflation, the central bank sterilizes this increase in the money
supply by selling domestic assets. However, with a fixed exchange rate, this means buying
foreign assets. If foreign assets are perfect substitutes for domestic assets, this sterilization is not
effective.
Page Ref: 520-526
Difficulty: Moderate
4) Does the signalling effect of foreign exchange intervention support or refute the claim that
assets cannot be perfect substitutes if sterilized intervention is going to have any effect? Please
explain.
Answer: The signalling effect refutes the claim. Even with the assumption of perfect asset
substitutability, if the market is unsure of the future direction of policy, then sterilized
intervention can fix a market's expectations about the exchange rate in the future. From post
discussion, a change in the expected exchange rate will lead to a change in the exchange rate
today.
Page Ref: 520-526
Difficulty: Moderate
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5) Briefly discuss the main advantage of the bimetallic standard over the gold standard.
Answer: The advantage of bimetallism was that it might reduce the price level instability
resulting from the use of gold alone. Were gold to become scarce and expensive, cheaper and
relatively abundant silver would become the predominant form of money, thereby mitigating the
deflation that a pure gold standard would imply.
Page Ref: 520-526
Difficulty: Moderate
6) List the drawbacks of the gold standard.
Answer:
1. Undesirable constraints on the use of monetary policy to fight unemployment.
2. A stable overall price level is achieved only if the relative price of gold and all other goods
and services is stable.
3. A central bank cannot increase holdings of international reserves as its economy grows unless
new gold is discovered.
4. Unfair advantage to gold-producing nations.
Page Ref: 520-526
Difficulty: Moderate
7) Describe the mechanism which would take place if the Bank of England decides to increase its
money supply by purchasing domestic assets under the gold standard.
Answer: The increase in Britain's money supply would push interest rates down and make
foreign currency assets more attractive than domestic ones. Holders of pound deposits will
attempt to sell them for foreign deposits. To accomplish this, they sell pound deposits to the
Bank of England for gold and then use this gold to purchase foreign deposits. England loses
foreign reserves since it is selling gold and foreign countries are gaining reserves. Equilibrium is
re-established after Britain's money supply has fallen enough to force the British interest rate up
until it is equally as attractive as the interest rate on foreign currency.
Page Ref: 520-526
Difficulty: Difficult
8) Please briefly describe what is meant by a gold exchange standard.
Answer: Under a gold exchange standard, central banks' reserves consist of gold and currencies
whose price in terms of gold are fixed, and each central bank fixes its exchange rate to a
currency with a fixed gold price. The post-WWII currency system was supposed to be a gold
exchange standard with the U.S. responsible for fixing the price of gold at $35 per ounce.
Page Ref: 520-526
Difficulty: Moderate
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9) Use a figure to show the effect of a sterilized central bank purchase of foreign assets under the
imperfect asset substitutability assumption.
Answer:
The interest parity condition is given by
R = R* + ( - E)/E +
Suppose that the domestic assets of the central bank fall from to through a sterilized
purchase of foreign assets. Then the risk-adjusted return increases and the exchange rate
increases.
Page Ref: 520-526
Difficulty: Difficult
10) Assume that initially, the risk premium, ρ = 0 and that the domestic and foreign interest rates
are given by R = .06, R* = .05. Suppose that the risk premium depends linearly on the difference
between domestic government debt, B, and domestic assets of the central bank, A, i.e.,
ρ =
Find the new domestic interest rate if a sterilized purchase of foreign assets adjusts A s.t.
(a) B - A = -.01/
(b) B - A = .01/
(c) B - A = .03/
Answer: (a) R = .05 + .01 + (-.01) = .05
(b) R = .05 + .01 + (.01) = .07
(c) R = .05 + .01 + (.03) = .09
Page Ref: 520-526
Difficulty: Moderate
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Copyright © 2015 Pearson Education, Inc.
11) Assume that initially, the risk premium, ρ = 0 and that the domestic and foreign interest rates
are given by R = .06, R* = .05. Suppose that the risk premium depends linearly on the difference
between domestic government debt, B, and domestic assets of the central bank, A, i.e.,
ρ =
How much will the central bank have to reduce domestic assets A s.t. the domestic interest rate
will increase by (a) 1% (b) 4%?
Answer: (a) ρ = .01 =
ΔA = - (B - )
(b) ρ = .04 =
ΔA = - (B - )
Page Ref: 520-526
Difficulty: Moderate
12) Under the gold standard, if the dollar price of gold is pegged at $35 per ounce and the euro
price of gold is pegged at 12 euro per ounce, what is the dollar/euro exchange rate?
Answer: The dollar/euro exchange rate must be constant and equal to
($35 per ounce) / (12 euro per ounce) = $2.92 per euro.
Page Ref: 520-526
Difficulty: Moderate
13) Under the gold standard, if the dollar price of gold is pegged at $35 per ounce and the
dollar/euro exchange rate is set at $2.40 per euro, what must the euro price of gold be pegged at?
Answer: The euro price of gold is constant and equal to
($35 per ounce) / ($2.40 per euro) = 14.58 euro per ounce.
Page Ref: 520-526
Difficulty: Moderate
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14) From the figure below, please provide an explanation for the large decline in the growth rate
of international reserves held by developing countries in the 2008-2009 period.
Answer: The growth of global capital markets has increased the potential variability of financial
flaws across borders, and especially across the borders of developing countries. The sharp
decline in developing country reserve growth was due to an international debt crisis from 2007-
2009.
Page Ref: 520-526
Difficulty: Difficult
18.9 Appendix 1 to Chapter 18: Equilibrium in the Foreign Exchange Market
with Imperfect Asset Substitutability
1) If assets are imperfect substitutes, then an increase in the amount of domestic currency bonds
held by the public will ________ the risk premium and ________ the amount of domestic
currency bonds held by the central bank.
A) increase; leave unchanged
B) increase; decrease
C) increase; increase
D) decrease; decrease
E) leave unchanged; decrease
Answer: A
Page Ref: 532-534
Difficulty: Moderate
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Copyright © 2015 Pearson Education, Inc.
2) If assets are imperfect substitutes, then a decrease in the amount of domestic currency bonds
held by the public will ________ the risk premium and ________ the amount of domestic
currency bonds held by the central bank.
A) decrease; leave unchanged
B) increase; decrease
C) increase; increase
D) decrease; decrease
E) leave unchanged; decrease
Answer: A
Page Ref: 532-534
Difficulty: Moderate
18.10 Appendix 2 to Chapter 18: The Timing of Balance of Payments Crises
1) Balance of payments crises under fixed exchange rates occur because of
A) government policies that are inconsistent with fixed exchange rates.
B) punitive currency wars.
C) global inflation and trade imbalances due to war.
D) excessive exports and imports that overload the global system.
E) monotonic expansion in global currency volume.
Answer: A
Page Ref: 535-537
Difficulty: Easy
2) A balance of payments crises under fixed exchange rates occurs when
A) a country runs out of foreign reserves.
B) a country is in a liquidity trap.
C) exports and imports expand beyond some point.
D) marginal returns on foreign exchange investments approach zero.
E) forward currency markets undergo high volatility.
Answer: A
Page Ref: 535-537
Difficulty: Easy
