Chapter 13
The Foreign Exchange Market
◼ Multiple Choice Questions
1. American firms became less competitive compared to foreign firms during the 1980s because
(a) the quality and productivity of American workers declined.
(b) foreign firms were younger than American firms and as a result had more modern facilities that
made use of the latest technology.
(c) the U.S. dollar became worth more in terms of foreign currencies.
(d) the U.S. dollar became worth less in terms of foreign currencies.
2. A spot transaction in the foreign exchange market involves the
(a) exchange of exports and imports at a specified future date.
(b) exchange of bank deposits at a specified future date.
(c) immediate (within two days) exchange of exports and imports.
(d) immediate (within two days) exchange of bank deposits.
3. When the value of the British pound changes from $1.50 to $1.25, then the pound has _________
and the dollar has _________.
(a) appreciated; appreciated
(b) depreciated; appreciated
(c) appreciated; depreciated
(d) depreciated; depreciated
4. When the value of the dollar changes from £0.5 to £0.75, then the pound has _________ and the
dollar has _________.
(a) appreciated; appreciated
(b) depreciated; appreciated
(c) appreciated; depreciated
(d) depreciated; depreciated
156 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
5. When the exchange rate changes from 1.0 euros to the dollar to 1.2 euros to the dollar, then the euro
has _________ and the dollar has _________.
(a) appreciated; appreciated
(b) depreciated; appreciated
(c) appreciated; depreciated
(d) depreciated; depreciated
6. When the exchange rate changes from 1.0 euros to the dollar to 0.8 euros to the dollar, then the euro
has _________ and the dollar has _________.
(a) appreciated; appreciated
(b) depreciated; appreciated
(c) appreciated; depreciated
(d) depreciated; depreciated
7. If the dollar _________ from 1.2 euros per dollar to 0.8 euros per dollar, the euro _________ from
0.83 dollars to 1.25 dollars per euro.
(a) appreciates; appreciates
(b) appreciates; depreciates
(c) depreciates; depreciates
(d) depreciates; appreciates
8. If the dollar appreciates from 0.8 euros per dollar to 1.2 euros per dollar, the euro depreciates from
_________ dollars to _________ dollars per euro.
(a) 1.25; 0.83
(b) 0.83; 1.25
(c) 0.67; 1.50
(d) 1.50; 0.67
9. If the dollar depreciates relative to the Swiss franc,
(a) Swiss chocolate will become more expensive in the United States.
(b) American computers will become less expensive in Switzerland.
(c) Swiss chocolate will become cheaper in the United States.
(d) both (a) and (b) of the above.
10. If the dollar appreciates relative to the Swiss franc,
(a) Swiss chocolate will become more expensive in the United States.
(b) American computers will become less expensive in Switzerland.
(c) Swiss chocolate will become cheaper in the United States.
(d) both (a) and (b) of the above.
Chapter 13 The Foreign Exchange Market 157
11. When the exchange rate for the euro changes from $1.00 to $1.20 then, holding everything else
constant, the euro has
(a) appreciated and German cars sold in the United States become more expensive.
(b) appreciated and German cars sold in the United States become less expensive.
(c) depreciated and American wheat sold in Germany becomes more expensive.
(d) depreciated and American wheat sold in Germany becomes less expensive.
12. When the exchange rate for the euro changes from $1.20 to $1.00, then, holding everything else
constant, the euro has
(a) appreciated and German cars sold in the United States become more expensive.
(b) appreciated and German cars sold in the United States become less expensive.
(c) depreciated and American wheat sold in Germany becomes more expensive.
(d) depreciated and American wheat sold in Germany becomes less expensive.
13. The starting point for understanding how exchange rates are determined is a simple idea called
_________, which states that if two countries produce an identical good, the price of the good
should be the same throughout the world no matter which country produces it.
(a) Gresham’s law
(b) the law of one price
(c) purchasing power parity
(d) arbitrage
14. The theory of purchasing power parity is a theory of how exchange rate are determined in
(a) the long run.
(b) the short run.
(c) both (a) and (b).
(d) none of the above.
15. The _________ states that exchange rates between any two currencies will adjust to reflect changes
in the price levels of the two countries.
(a) theory of purchasing power parity
(b) law of one price
(c) theory of money neutrality
(d) quantity theory of money
16. The theory of purchasing power parity states that exchange rates between any two currencies will
adjust to reflect changes in
(a) the trade balances of the two countries.
(b) the current account balances of the two countries.
(c) fiscal policies of the two countries.
(d) the price levels of the two countries.
158 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
17. In the long run, a rise in a country’s price level (relative to the foreign price level) causes its
currency to _________, while a rise in the country’s relative productivity causes its currency to
_________
(a) appreciate; appreciate.
(b) appreciate; depreciate.
(c) depreciate; appreciate.
(d) depreciate; depreciate.
18. If the 2005 inflation rate in Britain is 6 percent, and the inflation rate in the U.S. is 4 percent, then
the theory of purchasing power parity predicts that, during 2005, the value of the British pound in
terms of U.S. dollars will
(a) rise by 10 percent.
(b) rise by 2 percent.
(c) fall by 10 percent.
(d) fall by 2 percent.
(e) do none of the above.
19. The theory of purchasing power parity cannot fully explain exchange rate movements because
(a) not all goods are identical in different countries.
(b) monetary policy differs across countries.
(c) some goods are not traded between countries.
(d) both (a) and (c) of the above.
(e) both (b) and (c) of the above.
20. The theory of purchasing power parity cannot fully explain exchange rate movements because
(a) all goods are identical even if produced in different countries.
(b) monetary policy differs across countries.
(c) some goods are not traded between countries.
(d) fiscal policy differs across countries.
21. Increased demand for a country’s _________ causes its currency to appreciate in the long run, while
increased demand for _________ causes its currency to depreciate.
(a) imports; imports
(b) imports; exports
(c) exports; imports
(d) exports; exports
Chapter 13 The Foreign Exchange Market 159
22. If the demand for _________ goods decreases relative to _________ goods, the domestic currency
will depreciate.
(a) foreign; domestic
(b) foreign; foreign
(c) domestic; domestic
(d) domestic; foreign
23. Higher tariffs and quotas cause a country’s currency to _________ in the _________ run.
(a) depreciate; short
(b) appreciate; short
(c) depreciate; long
(d) appreciate; long
24. Lower tariffs and quotas cause a country’s currency to _________ in the _________ run.
(a) depreciate; short
(b) appreciate; short
(c) depreciate; long
(d) appreciate; long
25. If the inflation rate in the United States is higher than that in Germany and productivity is growing at
a slower rate in the United States than it is in Germany, in the long run,
(a) the euro should appreciate relative to the dollar.
(b) the euro should depreciate relative to the dollar.
(c) there should be no change in the euro price of dollars.
(d) it is not clear what will happen to the euro price of dollars.
26. If the French demand for American exports rises at the same time that U.S. productivity rises
relative to French productivity, then, in the long run,
(a) the euro should appreciate relative to the dollar.
(b) the dollar should depreciate relative to the euro.
(c) the dollar should appreciate relative to the euro.
(d) it is not clear whether the euro should appreciate or depreciate relative
to the dollar.
160 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
27. The theory of asset demand suggests that the most important factor affecting the demand for
domestic and foreign deposits is
(a) the level of trade and capital flows.
(b) the expected return on these assets relative to one another.
(c) the liquidity of these assets relative to one another.
(d) the riskiness of these assets relative to one another.
28. When François the Foreigner considers the expected return on dollar deposits in terms of foreign
currency, the expected return must be adjusted for
(a) any expected appreciation or depreciation of the dollar.
(b) the interest rates on foreign deposits.
(c) both (a) and (b) of the above.
(d) neither (a) nor (b) of the above.
29. The expected return on dollar deposits in terms of foreign currency is the _________ the interest rate
on dollar deposits and the expected appreciation of the dollar.
(a) product of
(b) ratio of
(c) sum of
(d) difference in
30. If the interest rate on foreign deposits (iF) increases, holding everything else constant,
(a) the expected return on these deposits must also increase.
(b) the expected return on domestic deposits must decrease.
(c) the expected return on domestic deposits must increase.
(d) both (a) and (b) of the above.
(e) both (a) and (c) of the above.
31. If the interest rate on dollar deposits is 10 percent, and the dollar is expected to appreciate by
7 percent over the coming year, the expected return on dollar deposits in terms of the foreign
currency is
(a) 3 percent.
(b) 10 percent.
(c) 13.5 percent.
(d) 17 percent.
(e) 24 percent.
Chapter 13 The Foreign Exchange Market 161
32. If the interest rate is 7 percent on euro deposits and 5 percent on dollar deposits, and if the dollar is
expected to appreciate at a 4 percent rate,
(a) euro deposits have a higher expected return than dollar deposits.
(b) the expected return on euro deposits in terms of dollars is 11 percent.
(c) the expected return on dollar deposits in terms of euros is 1 percent.
(d) the expected return on euro deposits in terms of dollars is 3 percent.
(e) the expected return on dollar deposits equals the expected return on euro deposits.
33. If the interest rate is 13 percent on euro deposits and 15 percent on dollar deposits, and if the euro is
expected to appreciate at a 4 percent rate relative to the dollar, then
(a) euro deposits have a lower expected return than dollar deposits.
(b) the expected return on euro deposits in terms of dollars is 9 percent.
(c) the expected return on dollar deposits in terms of euros is 19 percent.
(d) both (a) and (b) of the above will occur.
(e) none of the above will occur.
34. The expected return on dollar deposits in terms of dollars, RD, is
(a) always the interest rate on dollar deposits, iD, for any exchange rate.
(b) the interest rate on dollar deposits, iD, only when
e
t t 1
EE
+
.
(c) the interest rate on dollar deposits, iD, only when
e
t t 1
EE
+
.
(d) the interest rate on dollar deposits, iD, only when
e
t t 1
EE
+
=
.
35. The condition which states that the domestic interest rate equals the foreign interest rate minus the
expected appreciation of the domestic currency is called
(a) the purchasing power parity condition.
(b) the interest parity condition.
(c) money neutrality.
(d) the theory of foreign capital mobility.
36. In a world with few impediments to capital mobility, the domestic interest rate equals the sum of the
foreign interest rate and the expected depreciation of the domestic currency, a situation known as the
(a) interest parity condition.
(b) purchasing power parity condition.
(c) exchange rate parity condition.
(d) foreign asset parity condition.
162 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
37. According to the interest parity condition, the domestic interest rate is equal to the foreign
interest rate
(a) plus the expected appreciation of the domestic currency.
(b) less the expected appreciation of the domestic currency.
(c) less the expected depreciation of the domestic currency.
(d) less the expected depreciation of the domestic currency weighted by the domestic interest rate.
38. According to the interest parity condition, if the domestic interest rate is _________ the foreign
interest rate, then
(a) above; there is expected appreciation of the foreign currency.
(b) above; there is expected depreciation of the foreign currency.
(c) below; there is expected appreciation of the foreign currency.
(d) below; the interest parity condition is violated.
39. According to the interest parity condition, if the domestic interest rate is 12 percent and the foreign interest
rate is 10 percent, then the expected _________ of the foreign currency must be _________ percent.
(a) appreciation; 4
(b) appreciation; 2
(c) depreciation; 2
(d) depreciation; 4
40. According to the interest parity condition, if the domestic interest rate is 10 percent and the foreign interest
rate is 12 percent, then the expected _________ of the foreign currency must be _________ percent.
(a) appreciation; 4
(b) appreciation; 2
(c) depreciation; 2
(d) depreciation; 4
41. When Americans and foreigners expect the return on _________ deposits to be high relative to the
return on _________ deposits, there is a higher demand for dollar deposits and a correspondingly
lower demand for foreign deposits.
(a) dollar; dollar
(b) dollar; foreign
(c) foreign; dollar
(d) foreign; foreign
Chapter 13 The Foreign Exchange Market 163
42. When Americans and foreigners expect the return on dollar deposits to be high relative to the return
on foreign deposits, there is a _________ demand for dollar deposits and a correspondingly
_________ demand for foreign deposits.
(a) higher; higher
(b) higher; lower
(c) lower; higher
(d) lower; lower
43. As the relative expected return on dollar deposits increases, foreigners will want to hold more
_________ deposits and less _________ deposits.
(a) foreign; foreign
(b) foreign; dollar
(c) dollar; foreign
(d) dollar; dollar
44. As the relative expected return on dollar deposits increases,
(a) foreigners will want to hold fewer dollar deposits and more foreign deposits.
(b) Americans will want to hold more dollar deposits and less foreign deposits.
(c) Americans will want to hold fewer dollar deposits and more foreign deposits.
(d) Americans and foreigners will be indifferent towards holding dollar deposits or foreign deposits.
45. An increase in the foreign interest rate shifts the expected return schedule for _________ deposits to
the _________ and causes the domestic currency to depreciate.
(a) domestic; right
(b) domestic; left
(c) foreign; right
(d) foreign; left
46. A decrease in the foreign interest rate shifts the expected return schedule for _________ deposits to
the _________ and causes the domestic currency to appreciate.
(a) domestic; right
(b) domestic; left
(c) foreign; right
(d) foreign; left
164 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
47. A rise in the expected future exchange rate shifts the expected return schedule for _________
deposits to the _________ and causes the domestic currency to appreciate.
(a) domestic; right
(b) domestic; left
(c) foreign; right
(d) foreign; left
48. A fall in the expected future exchange rate shifts the expected return schedule for _________
deposits to the _________ and causes the domestic currency to depreciate.
(a) domestic; right
(b) domestic; left
(c) foreign; right
(d) foreign; left
49. An increase in the domestic interest rate shifts the expected return schedule for _________ deposits
to the _________ and causes the domestic currency to appreciate.
(a) domestic; right
(b) domestic; left
(c) foreign; right
(d) foreign; left
50. A decrease in the domestic interest rate shifts the expected return schedule for _________ deposits
to the _________ and causes the domestic currency to depreciate.
(a) domestic; right
(b) domestic; left
(c) foreign; right
(d) foreign; left
51. Which of the following causes a depreciation of the domestic currency?
(a) A lower domestic interest rate due to a lower expected inflation rate.
(b) A decline in the domestic real interest rate.
(c) A decrease in the domestic money supply.
(d) All of the above.
52. Which of the following causes an appreciation of the domestic currency?
(a) A lower domestic interest rate due to a lower expected inflation rate.
(b) A decline in the domestic real interest rate.
(c) An increase in the domestic money supply.
(d) All of the above.
Chapter 13 The Foreign Exchange Market 165
53. When the domestic nominal interest rate rises because of an increase in expected inflation, the
expected appreciation of the dollar declines, _________ shifts out more than _________, and the
exchange rate declines.
(a) RF; RD
(b) RF; RF
(c) RD; RD
(d) RD; RF
54. When an increase in the money supply causes the exchange rate to fall by more in the short run than
it does in the long run, it is called
(a) exchange rate disequilibrium.
(b) exchange rate overshooting.
(c) the J-curve effect.
(d) none of the above.
55. In the long run, a one-time percentage increase in the money supply is matched by the same
one-time percentage rise in the price level,
(a) leaving unchanged the real money supply and all other economic variables such as interest rates.
This proposition is called money neutrality.
(b) leaving unchanged the real money supply and the nominal exchange rate. This proposition is
called money neutrality.
(c) leaving unchanged the real money supply and all other economic variables such as interest rates.
This proposition is called money illusion.
(d) leaving unchanged the real money supply and the nominal exchange rate. This proposition is
called money illusion.
56. Money neutrality means that in the long run the domestic interest rate and RD remain unchanged,
implying that the fall in the exchange rate is greater in the _________ run than in the _________
run, a phenomenon called exchange rate overshooting.
(a) short; short
(b) short; long
(c) long; short
(d) long; long
57. A lower domestic money supply causes the domestic currency to
(a) depreciate in the short run.
(b) depreciate in the long run.
(c) appreciate in the short run.
(d) do both (a) and (b) of the above.
(e) do both (b) and (c) of the above.
166 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
58. A higher domestic money supply causes the domestic currency to
(a) depreciate more in the short run than in the long run.
(b) depreciate more in the long run than in the short run.
(c) appreciate more in the short run than in the long run.
(d) appreciate more in the long run than in the short run.
59. The weakness of the dollar in the late 1970s and the strength of the dollar in the early 1980s can be
explained by movements in
(a) real interest rates, but not nominal interest rates.
(b) nominal interest rates, but not real interest rates.
(c) relative price levels, but not real interest rates.
(d) none of the above.
60. Evidence from the United States during the period 1973–2001 indicates the correspondence between
nominal interest rates and exchange rate movements is
(a) much closer than that between real interest rates and exchange rate movements.
(b) not nearly as close as that between government spending and exchange rate movements.
(c) not nearly as close as that between government deficits and exchange rate movements.
(d) not nearly as close as that between real interest rates and exchange rate movements.
Chapter 13 The Foreign Exchange Market 167
◼ True/False
1. The foreign exchange market is organized as an over-the-counter market in which deposits
denominated in foreign currencies are bought and sold.
2. When the value of the dollar changes from 0.5 pounds to 0.75 pounds, then the pound has
appreciated and the dollar has depreciated.
3. When the exchange rate for the euro changes from $0.90 to $0.85, then holding everything else
constant, the euro has depreciated and American wheat sold in Germany becomes more expensive.
4. The theory of purchasing power parity cannot fully explain exchange rate movements because fiscal
policy differs across countries.
5. If the dollar depreciates relative to the British pound, British sweaters will become more expensive
in the United States.
6. If the dollar appreciates relative to the Swiss franc, Swiss chocolate will become cheaper in the
United States.
7. If the exchange rate between the dollar and the Swiss franc changes from 1.8 to 1.5 francs per dollar,
the franc depreciates and the dollar appreciates.
8. An increase in tariffs and quotas on imports causes a country’s currency to appreciate.
9. Increased demand for a country’s exports causes its currency to depreciate.
10. As the relative expected return on dollar deposits increases, Americans will want to hold fewer
dollar deposits and more foreign deposits.
11. According to the interest rate parity condition, if the domestic interest rate is 12 percent and the
foreign interest rate is 10 percent, then the expected appreciation of the foreign currency must be
2 percent.
12. A fall in the expected future exchange rate shifts the expected return schedule for domestic deposits
to the right and causes the domestic currency to depreciate.
168 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
◼ Essay
1. Explain the logic underlying the law of one price and the theory of purchasing power parity.
2. Explain graphically how a change in the domestic price level will affect exchange rates, holding
everything else constant.
3. Explain the theory of interest rate parity.
4. Explain graphically how a change in the foreign interest rate will affect exchange rates.
5. Discuss the relationship between changes in domestic real and nominal interest rates and exchange
rates.
6. Explain graphically how an increase in a country’s money supply will affect the exchange rate for its
currency.