Chapter 15: Flexible Exchange Rates
MULTIPLE CHOICE
1. In the trade-based model of exchange rate determination, the nominal exchange rate is
determined by:
a. Purchases and sales of currencies arising from imports and exports.
b. Transactions arising from the exchange of assets.
c. Transactions arising from both the current and capital/financial accounts of the
balance of payments.
d. None of the above.
2. In the assets-based model of exchange rate determination, the nominal exchange rate is
determined by:
a. Purchases and sales of currencies arising from imports and exports.
b. Transactions arising from the exchange of assets.
c. Transactions arising from both the current and capital/financial accounts of the
balance of payments.
d. All of the above.
3. In the trade-based model of exchange rate determination as developed in this book, the
demand for the home-country currency is assumed to be:
a. Perfectly inelastic.
b. Relatively inelastic.
c. Relatively elastic.
d. None of the above.
4. In the trade-based model of exchange rate determination for a flexible exchange rate
regime, how is the equilibrium exchange rate determined?
a. When the supply of a country’s currency exceeds demand.
b. When the supply of a country’s currency is less than demand.
c. When the supply of a country’s currency is equal to the amount demanded.
d. None of the above.
5. In the trade-based model of exchange rate determination for a flexible exchange rate
regime, suppose that the supply of a country’s currency exceeds demand for it. What
must happen to achieve an equilibrium exchange rate?
a. The excess supply of the currency will act to reduce demand for it.
b. As the currency depreciates, the trade deficit falls.
c. The trade deficit falls until the nominal exchange rate reaches a value where the
supply of the currency equals the demand for it.
d. All of the above.
6. In an assets-based model of exchange rate determination for a flexible exchange rate
regime, suppose that the supply of a county’s currency exceeds demand for it. Which of
the following will help to achieve an equilibrium exchange rate?
a. The rise in the value of the currency decreases the trade deficit.
b. The fall in the value of the currency increases the trade deficit.
c. The fall in the value of the currency increases foreign savings.
d. None of the above.
7. After an expansion of money supply in a country, which of the following is true?
a. The value of the currency decreases.
b. The domestic interest rate decreases.
c. The value of the foreign currency increases.
d. All of the above.
8. After a contraction in the money supply in a country, which of the following is true?
a. The value of the domestic currency decreases.
b. The domestic interest rate rises.
c. The value of the foreign currency rises.
d. None of the above.
9. Covered interest rate parity differs from uncovered interest rate parity in the following
way:
a. Instead of the forward nominal exchange rate, covered interest rate parity uses the
expected exchange rate.
b. Instead of the foreign interest rate, covered interest rate parity uses the domestic
interest rate.
c. Instead of the expected nominal exchange rate, covered interest rate parity uses the
forward exchange rate.
d. Instead of the domestic, interest rate, covered interest rate parity uses the foreign
interest rate.
TRUE/FALSE
1. If exports (E) of a country are negatively related to the value of a country’s currency and
imports (Z) are positively related to the value of this currency, then the trade deficit (Z-E)
is positively related to the value of the currency.
2. The purchasing power parity model of exchange rate determination applies to the short
run, while the trade- and assets-based models apply to the long run.
3. As the value of a country’s currency rises, its demand for imports rises.
4. As the value of a country’s currency rises, demand for its exports falls.
5. As the value of a country’s currency falls, demand for its exports falls.
6. As the value of a country’s currency falls, its demand for imports rises.
7. The assets-based model of exchange rate determination focuses on foreign savings and
the trade deficit in determining how equilibrium nominal exchange rates arise.
8. If a country’s domestic interest rate rises, the value of its currency will rise.
9. If a country’s domestic interest rate falls, the value of its currency will rise.
10. If the foreign interest rate rises, the value of the domestic country’s currency will rise.
11. If the foreign interest rate falls, the value of the domestic country’s currency will rise.
SHORT ANSWER
1. Which model of exchange rate determination (trade-based or assets-based) is favored and
why?
2. In models of exchange rate determination under flexible exchange rate regimes, what do
we call increases and decreases of the nominal exchange rate?
3. What two elements do we need to build a trade-based model of exchange rate
determination for a flexible exchange rate regime?
4. In the trade-based model of exchange rate determination for a flexible exchange rate
regime, the supply of a country’s currency is less than demand. What will happen in
order for the foreign exchange market to achieve equilibrium?
5. How should an investor in a home country allocate her portfolio between local-currency-
denominated assets and foreign-currency-denominated assets?
6. When the expected future value of a country’s nominal exchange rate increases, what
happens to the asset demand for that currency?
7. When the value of a country’s currency increases, what happens to the asset demand for
that country’s currency?
8. Suppose that, in an assets-based model of exchange rate determination under a flexible
exchange rate regime, the supply of the country’s currency exceeds demand. What must
happen in order to achieve an equilibrium value of the currency?
9. In the diagram below, please explain which value of the peso is associate with an excess
supply of the local currency and which is associated with an excess demand. What will
happen to the value of the local currency in each case?