Chapter 14
The International Financial System
◼ Multiple Choice Questions
1. A central bank sale of _________ to purchase _________ in the foreign exchange market results in
an equal rise in its international reserves and the monetary base.
(a) foreign assets; domestic currency
(b) foreign assets; foreign currency
(c) domestic currency; foreign assets
(d) domestic currency; domestic currency
2. A central bank sale of _________ to purchase _________ in the foreign exchange market results in
an equal decline in its international reserves and the monetary base.
(a) foreign assets; domestic currency
(b) foreign assets; foreign currency
(c) domestic currency; foreign assets
(d) domestic currency; domestic currency
3. A central bank _________ of domestic currency and corresponding _________ of foreign assets in
the foreign exchange market leads to an equal _________ in its international reserves and the
monetary base.
(a) sale; purchase; decline
(b) sale; sale; increase
(c) purchase; sale; increase
(d) purchase; sale; decline
4. A central bank _________ of domestic currency and corresponding _________ of foreign assets in
the foreign exchange market leads to an equal _________ in its international reserves and the
monetary base.
(a) sale; purchase; increase
(b) sale; sale; decline
(c) purchase; sale; increase
(d) purchase; purchase; decline
170 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
5. When the central bank allows the purchase or sale of domestic currency to have an effect on the
monetary base, it is called
(a) a sterilized foreign exchange intervention.
(b) an unsterilized foreign exchange intervention.
(c) an exchange rate feedback rule.
(d) a money neutral foreign exchange intervention.
6. A foreign exchange intervention with an offsetting open market operation that leaves the monetary
base unchanged is called
(a) an unsterilized foreign exchange intervention.
(b) a sterilized foreign exchange intervention.
(c) an exchange rate feedback rule.
(d) a money neutral foreign exchange intervention.
7. An unsterilized intervention in which domestic currency is sold to purchase foreign assets leads to
(a) a gain in international reserves.
(b) an increase in the money supply.
(c) an appreciation in the domestic currency.
(d) all of the above.
(e) only (a) and (b) of the above.
8. An unsterilized intervention in which domestic currency is sold to purchase foreign assets leads to
(a) a gain in international reserves.
(b) a decrease in the money supply.
(c) an appreciation in the domestic currency.
(d) all of the above.
(e) only (a) and (b) of the above.
9. A Federal Reserve decision to sell dollars in order to buy foreign assets in the foreign exchange
market has the same effect as an open market _________ of bonds to _________ the monetary base
and the money supply.
(a) sale; decrease
(b) purchase; decrease
(c) sale; increase
(d) purchase; increase
Chapter 14 The International Financial System 171
10. A Federal Reserve decision to purchase dollars by selling foreign assets in the foreign exchange
market has the same effect as an open market _________ of bonds to _________ the monetary base
and the money supply.
(a) sale; decrease
(b) purchase; decrease
(c) sale; increase
(d) purchase; increase
11. An unsterilized intervention in which the domestic currency is sold to purchase foreign assets results
in an expected _________ of the domestic currency that shifts the RF schedule to the _________
(a) depreciation; right.
(b) appreciation; right.
(c) depreciation; left.
(d) appreciation; left.
12. An unsterilized intervention in which the domestic currency is purchased by selling foreign assets
results in an expected _________ of the domestic currency that shifts the RF schedule to the
_________
(a) depreciation; right.
(b) appreciation; right.
(c) depreciation; left.
(d) appreciation; left.
13. An expected appreciation of the domestic currency that shifts the RF schedule to the left is caused by
a(n) _________ intervention in which the domestic currency is _________.
(a) sterilized; sold to purchase foreign assets
(b) sterilized; purchased by selling foreign assets
(c) unsterilized; sold to purchase foreign assets
(d) unsterilized; purchased by selling foreign assets
14. Because sterilized interventions mean offsetting open market operations, there is no impact on the
monetary base and the money supply, and therefore a sterilized intervention
(a) causes the exchange rate to overshoot in the short run.
(b) causes the exchange rate to undershoot in the short run.
(c) causes the exchange rate to depreciate in the short run, but has no effect on the exchange rate in
the long run.
(d) has no effect on the exchange rate.
172 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
15. Because sterilized interventions mean offsetting open market operations,
(a) there is no impact on the monetary base.
(b) there is no impact on the money supply.
(c) there is no effect on the exchange rate.
(d) all of the above occur.
(e) only (a) and (b) of the above occur.
16. The difference between merchandise exports and imports is called the
(a) current account balance.
(b) capital account balance.
(c) balance of payments.
(d) trade balance.
17. A current account _________ indicates that the United States is _________ its claims on foreign
wealth.
(a) surplus; increasing
(b) surplus; decreasing
(c) deficit; increasing
(d) balance; decreasing
18. A current account _________ indicates that the United States is _________ its claims on foreign
wealth.
(a) deficit; decreasing
(b) deficit; increasing
(c) surplus; decreasing
(d) balance; increasing
19. Holding other factors constant, which of the following would decrease the size of the U.S. current
account deficit?
(a) A increase in the amount of services purchased from foreigners
(b) An increase in the amount of goods purchases from foreigners
(c) An increase in the amount of goods sold to foreigners
(d) Only (a) and (b) of the above
20. Holding other factors constant, which of the following would increase the size of the U.S. current
account deficit?
(a) Sales of U.S. farm products in Europe
(b) Visits by European tourists to the U.S.
(c) Increasing travel by American college students in Europe
(d) Both (a) and (b) of the above
Chapter 14 The International Financial System 173
21. The current account balance plus the capital account balance equals
(a) the amount of unsterilized exchange market intervention.
(b) the trade balance.
(c) the net change in government international reserves.
(d) both (a) and (c) of the above.
22. If the current account balance shows a surplus, and capital account receipts exceed capital account
payments, then the net change in government international reserves must be _________, indicating
a(n) _________ in U.S. international reserves.
(a) positive; increase
(b) negative; increase
(c) negative; decrease
(d) positive; decrease
23. Which of the following statements is correct?
(a) current account balance = capital account balance.
(b) current account balance = capital account balance + net change in government international
reserves.
(c) current account balance + capital account balance = net change in government international
reserves.
(d) current account balance + net change in government international reserves = capital account
balance.
24. The Bretton Woods system was one in which central banks
(a) agreed to limit domestic money growth to the average of the seven largest industrial nations.
(b) agreed not to intervene in the foreign exchange market to maintain a fixed exchange rate regime
that had existed prior to World War I.
(c) agreed to limit domestic money growth to the average of the five largest industrial nations.
(d) bought and sold their own currencies to keep their exchange rates fixed.
25. The Bretton Woods agreement created the _________, which was given the task of promoting the
growth of world trade by setting rules for the maintenance of fixed exchange rates and by making
loans to countries that were experiencing balance of payments difficulties.
(a) IMF
(b) World Bank
(c) Central Settlements Bank
(d) Bank of International Settlements
(e) European Exchange Rate Mechanism (ERM)
174 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
26. The Bretton Woods agreement set up the _________, which currently provides long-term loans to
assist developing countries to build dams, roads, and other physical capital that contributes to
economic development.
(a) International Monetary Fund
(b) World Bank
(c) Central Settlements Bank
(d) Bank of International Settlements
(e) European Exchange Rate Mechanism (ERM)
27. What kind of exchange rate system did the Bretton Woods agreement establish?
(a) floating
(b) managed float
(c) dirty float
(d) fixed
28. In the Bretton Woods system, the anchor currency was the
(a) euro.
(b) British pound.
(c) German mark.
(d) U.S. dollar.
29. Which of the following are true statements about the Bretton Woods system?
(a) The Bretton Woods system was a fixed exchange rate regime, in which central banks bought
and sold their own currencies to keep their exchange rates fixed.
(b) To maintain fixed exchange rates when countries had balance of payments deficits and were
losing international reserves, the IMF would loan deficit countries international reserves
contributed by other members.
(c) The German mark was called a reserve currency because it was used to denominate the
securities central banks held as international reserves.
(d) All of the above are true.
(e) Only (a) and (b) of the above are true.
30. Which of the following are true statements about the Bretton Woods system?
(a) The Bretton Woods system was a flexible exchange rate regime, in which central banks allowed
their currencies to float within a wide trading band.
(b) The U.S. dollar was called a reserve currency because it was used to denominate the securities
central banks held as international reserves.
(c) The Bretton Woods agreement broke down in 1945.
(d) Only (a) and (b) of the above are true.
Chapter 14 The International Financial System 175
31. Under a fixed exchange rate regime, when the domestic currency is undervalued, the central bank
must _________ the domestic currency to keep the exchange rate fixed and as a result it _________
international reserves.
(a) purchase; gains
(b) sell; gains
(c) purchase; loses
(d) sell; loses
32. Under a fixed exchange rate regime, when the domestic currency is overvalued, the central bank
must _________ the domestic currency to keep the exchange rate fixed and as a result it _________
international reserves.
(a) purchase; loses
(b) sell; loses
(c) purchase; gains
(d) sell; gains
33. Under a fixed exchange rate regime, if the domestic currency is initially _________, that is
_________ par, the central bank must intervene to sell the domestic currency by purchasing foreign
assets.
(a) overvalued; below
(b) overvalued; above
(c) undervalued; below
(d) undervalued; above
34. Under a fixed exchange rate regime, if the domestic currency is initially _________, that is
_________ par, the central bank must intervene to buy the domestic currency by selling foreign
assets.
(a) overvalued; below
(b) overvalued; above
(c) undervalued; below
(d) undervalued; above
35. If the domestic currency is initially undervalued, that is below par, the central bank must intervene
to sell the _________ currency by purchasing _________ assets.
(a) domestic; foreign
(b) domestic; domestic
(c) foreign; foreign
(d) foreign; domestic
176 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
36. If a central bank does not want to see its currency fall in value, it may pursue _________ monetary
policy to _________ the domestic interest rate, thereby strengthening its currency.
(a) expansionary; raise
(b) contractionary; raise
(c) expansionary; lower
(d) contractionary; lower
37. If a central bank does not want to see its currency rise in value, it may pursue _________ monetary
policy to _________ the domestic interest rate, thereby weakening its currency.
(a) expansionary; raise
(b) contractionary; raise
(c) expansionary; lower
(d) contractionary; lower
38. If a country’s central bank eventually runs out of international reserves, it cannot keep its currency
from _________ and a _________ must occur in which the par exchange value is reset at a
_________ level.
(a) appreciating; revaluation; higher
(b) depreciating; revaluation; higher
(c) depreciating; devaluation; lower
(d) appreciating; devaluation; lower
39. Depreciation of a currency occurs when
(a) a floating exchange rate adjusts upward.
(b) a floating exchange rate adjusts downward.
(c) a fixed exchange rate is adjusted upward.
(d) a fixed exchange rate is adjusted downward.
40. Policy makers may not want to see their country’s currency appreciate because
(a) this would hurt consumers in their country by making foreign goods more expensive.
(b) this would hurt domestic businesses by making foreign goods cheaper in their country.
(c) this would increase inflation in their country.
(d) this would decrease the wealth of the country.
41. Under a managed float exchange rate regime, policymakers frequently do not want to see their
currencies depreciate because it makes _________ goods more expensive for _________ consumers
and contributes to inflation.
(a) foreign; foreign
(b) foreign; domestic
(c) domestic; foreign
(d) domestic; domestic
Chapter 14 The International Financial System 177
42. Revaluation of a currency’s value occurs when
(a) a floating exchange rate adjusts upward.
(b) a floating exchange rate adjusts downward.
(c) a fixed exchange rate is adjusted upward.
(d) a fixed exchange rate is adjusted downward.
43. Leading up to the foreign exchange crisis of September 1992, the Bank of England wanted to pursue
a(n) _________ monetary policy and the German Bundesbank wanted to pursue a(n) _________
monetary policy.
(a) expansionary, expansionary
(b) expansionary; contractionary
(c) contractionary; expansionary
(d) contractionary; contractionary
44. When the Bundesbank lowered German mark interest rates in September 1992,
(a) there was a massive sell-off of German marks, requiring intervention to support the value of
the mark.
(b) there was a massive sell-off of British pounds, requiring intervention to support the value of
the pound.
(c) there was a gradual sell-off of German marks, which avoided the need for intervention to
support the value of the mark.
(d) there was a gradual sell-off of British pounds, which avoided the need for intervention to
support the value of the pound.
45. In September 1992, the Bundesbank attempted to keep the mark from appreciating relative to the
British pound, but it failed because participants in the foreign exchange market came to expect the
(a) appreciation of the mark.
(b) depreciation of the mark.
(c) revaluation of the dollar.
(d) the end of the Exchange Rate Mechanism.
46. Under the Bretton Woods system, when a nonreserve-currency country was running a balance of
payments deficit,
(a) it gained international reserves.
(b) it lost international reserves.
(c) it was necessary for the policymakers to implement a contractionary monetary policy.
(d) both (a) and (c) of the above.
(e) both (b) and (c) of the above.
178 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
47. Under a fixed exchange rate system,
(a) an anchor country loses control over its monetary policy.
(b) a country that ties its currency to that of another country gains control of the other country’s
monetary policy.
(c) a country that ties its currency to that of another country loses control over its monetary policy.
(d) a country that ties its currency to that of another country acquires greater control over its
monetary policy.
48. The euro is unlikely to seriously challenge the dollar as a reserve currency as long as
(a) the European Union’s share of world GDP remains significantly smaller than that of the
United States.
(b) the European Union’s share of world exports remains significantly smaller than that of the
United States.
(c) Europe neglects to integrate its financial markets.
(d) the European Union is unable to function as a cohesive political entity.
49. Under dollarization a country
(a) backs its currency 100 percent with foreign reserves.
(b) earns seignorage because it no longer bears the cost of issuing its own currency.
(c) abandons its own currency and adopts the money of another country.
(d) must worry about a speculative attack on its currency.
50. A disadvantage of dollarization is that it
(a) prevents a central bank from creating inflation.
(b) avoids the possibility of a speculative attack on the domestic currency.
(c) does not allow a country to pursue its own independent monetary policy.
(d) is a strong commitment to exchange rate stability.
51. (I) Controls on capital outflows may increase capital flight by weakening confidence in the
government. (II) Controls on capital outflows are an inadequate substitute for financial reform to
deal with currency crises.
(a) (I) is true; (II) false.
(b) (I) is false; (II) true.
(c) Both are true.
(d) Both are false.
52. The most effective way to deal with currency crises is to
(a) impose controls on capital inflows.
(b) impose controls on capital outflows.
(c) impose controls on both capital inflows and outflows.
(d) improve bank regulation and supervision.
Chapter 14 The International Financial System 179
53. An argument that supports the view that the world needs an international lender of last resort such as
the IMF is that
(a) central banks in emerging-market countries lack credibility as inflation fighters.
(b) an international lender of last resort creates a safety net that protects bank depositors.
(c) the IMF is slow to lend, which ultimately reduces the amount that must be borrowed.
(d) the IMF imposes requirements that borrowing countries must enact microeconomic policies to
reform their financial systems.
Questions for Chapter 14 Web Appendix: Balance of Payments
54. In the balance of payments bookkeeping system, payments from foreigners to Americans are entered
in the
(a) “Receipts” column with a plus (+) sign to reflect that they are credits.
(b) “Receipts” column with a minus (–) sign to reflect that they are debits.
(c) “Payments” column with a minus (–) sign to reflect that they are debits.
(d) “Payments” column with a plus (+) sign to reflect that they are credits.
55. In the balance of payments bookkeeping system, all payments to foreigners are entered in the
(a) “Receipts” column with a plus (+) sign to reflect that they are credits.
(b) “Receipts” column with a minus (–) sign to reflect that they are debits.
(c) “Payments” column with a minus (–) sign to reflect that they are debits.
(d) “Payments” column with a plus (+) sign to reflect that they are credits.
56. Which of the following appear as credits in the U.S. balance of payments?
(a) Capital outflows
(b) Foreign aid
(c) Merchandise exports
(d) All of the above
57. Which of the following appear as debits in the U.S. balance of payments?
(a) Capital inflows
(b) Merchandise and service exports
(c) Foreign aid
(d) All of the above
58. In the balance of payments accounting system, the sale of Dell computers abroad are entered in the
_________ column with a _________ sign.
(a) receipts; negative
(b) receipts; positive
(c) payments; negative
(d) payments; positive
180 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
59. In the balance of payments accounting system, American purchases of BMW automobiles from
Germany are entered in the _________ column with a _________ sign.
(a) receipts; negative
(b) receipts; positive
(c) payments; negative
(d) payments; positive
60. In the balance of payments accounting system, American gifts to foreigners are entered in the
_________ column with a _________ sign.
(a) receipts; negative
(b) receipts; positive
(c) payments; negative
(d) payments; positive
61. In the balance of payments accounting system, foreign aid is entered in the _________ column with
a _________ sign.
(a) receipts; negative
(b) receipts; positive
(c) payments; negative
(d) payments; positive
62. In the balance of payments accounting system, capital inflows are entered in the _________ column
with a _________ sign.
(a) receipts; negative
(b) receipts; positive
(c) payments; negative
(d) payments; positive
63. In the balance of payments accounting system, capital outflows are entered in the _________
column with a _________ sign.
(a) receipts; negative
(b) receipts; positive
(c) payments; negative
(d) payments; positive
64. An examination of the U.S. balance of payments indicates that the current account balance can
(a) show a surplus only if the trade balance shows a surplus.
(b) show a deficit only if the trade balance shows a deficit.
(c) show a deficit even if the trade balance shows a surplus.
(d) only (a) and (b) of the above.
Chapter 14 The International Financial System 181
65. Financial analysts closely follow the current account balance because they believe it can provide
information on the future movement of
(a) interest rates.
(b) gold flows.
(c) exchange rates.
(d) special drawing rights.
66. The capital account describes the flow of capital between the United States and other countries.
Capital inflows are
(a) American purchases of foreign assets.
(b) foreign purchases of American assets.
(c) both (a) and (b) of the above.
(d) neither (a) nor (b) of the above.
67. Which of the following appears in the capital account part of the balance of payments?
(a) A gift to an American from his English aunt
(b) A purchase by the Honda corporation of a U.S. Treasury bill
(c) A purchase by the Bank of England of a U.S. Treasury bill
(d) Income earned by the Honda corporation on its automobile plant in Ohio
68. Given the size of the statistical discrepancy needed to balance the balance of payments account, one
can infer that
(a) hidden capital flows into the U.S. are inconsequential.
(b) items in the balance of payments are measured quite accurately.
(c) many international transactions go unrecorded.
(d) all of the above.
69. Many believe that the statistical discrepancy is primarily the result of
(a) large hidden capital flows into the U.S.
(b) large hidden capital flows out of the U.S.
(c) measurement errors due to exchange rate calculations.
(d) none of the above.
70. A balance of payments _________ is associated with a _________ of international reserves.
(a) deficit; loss
(b) deficit; gain
(c) surplus; loss
(d) balance; gain
182 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
71. A balance of payments _________ is associated with a _________ of international reserves.
(a) surplus; loss
(b) surplus; gain
(c) deficit; gain
(d) balance; loss
72. The official reserve transactions balance
(a) equals the current account balance plus the items in the capital account.
(b) tells us the net amount of international reserves that must move between central banks in order
to finance international transactions.
(c) has an important impact on the money supply.
(d) all of the above.
73. Because other countries hold dollars as international reserves, a U.S. official reserve transactions
deficit can be financed by
(a) an increase in U.S. international reserves.
(b) an increase in foreign holdings of dollars.
(c) a decrease in foreign holdings of dollars.
(d) only (a) and (b) of the above.
74. When a reserve currency country runs a balance of payments deficit and a nonreserve currency
country buys the reserve currency to finance the reserve country’s deficits, the monetary base in the
nonreserve country _________ and the monetary base in the reserve country _________
(a) increases; decreases.
(b) increases; does not change.
(c) decreases; does not change.
(d) decreases; increases.
Chapter 14 The International Financial System 183
◼ True/False
1. An unsterilized intervention in which domestic currency is sold to purchase foreign assets leads to
a gain in international reserves.
2. The difference between merchandise exports and imports is called the current account balance.
3. The current account balance plus the capital account balance equals the net change in government
international reserves.
4. A central bank’s international reserves are its holdings of assets denominated in foreign currencies.
5. In contrast to other countries’ currencies, the Japanese yen and yen-denominated assets are the
major component of international reserves held by countries.
6. An anchor currency provides the base for a floating exchange rate system.
7. In a fixed exchange rate system, a country whose currency is undervalued will lose international
reserves.
8. The Bretton Woods system was a fixed exchange rate regime, in which central banks bought and
sold their own currencies to keep their exchange rates fixed.
9. If a country’s central bank eventually runs out of international reserves, it cannot keep its currency
from depreciating and a devaluation must occur.
10. When it acts as a lender of last resort, the IMF may increase the likelihood that financial institutions
take excessive risks and thus increase moral hazard.
184 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
◼ Essay
1. How does a sterilized foreign exchange intervention differ from an unsterilized one in terms of its
effects on the exchange rate, international reserves, and the monetary base?
2. How does a fixed exchange rate regime differ from a system of floating exchange rates?
3. Briefly explain what it means to be a “reserve-currency” country. What are the advantages? Can you
think of any disadvantages?
4. What was the European Monetary System? How did its exchange rate mechanism work?
5. Explain graphically how a country must intervene in the foreign exchange market under a fixed
exchange rate regime if its currency is undervalued.
6. Explain graphically the speculative attacks that occurred against the British pound in 1992, the
Mexican peso in 1994, the Thai baht in 1997, the Brazilian real in 1999, and the Argentine peso
in 2002.
7. What are the arguments for and against the IMF acting as an international lender of last resort?