Answers to End of Chapter Questions
1. Exchange Rate Systems. Compare and contrast the fixed, freely floating, and managed float
exchange rate systems. What are some advantages and disadvantages of a freely floating exchange
rate system versus a fixed exchange rate system?
ANSWER: Under a fixed exchange rate system, the governments attempted to maintain exchange
A freely floating system may help correct balance-of-trade deficits since the currency will adjust
according to market forces. Also, countries are more insulated from problems of foreign countries
2. Intervention with Euros. Assume that Belgium, one of the European countries that uses the euro as
its currency, would prefer that its currency depreciate against the dollar. Can it apply central bank
intervention to achieve this objective? Explain.
ANSWER: It can not apply intervention on its own because the European Central Bank (ECB)
3. Direct Intervention. How can a central bank use direct intervention to change the value of a
currency? Explain why a central bank may desire to smooth exchange rate movements of its currency.
ANSWER: Central banks can use their currency reserves to buy up a specific currency in the foreign
Abrupt movements in a currency’s value may cause more volatile business cycles, and may cause
4. Indirect Intervention. How can a central bank use indirect intervention to change the value of a
currency?
ANSWER: To increase the value of its home currency, a central bank could attempt to increase
5. Intervention Effects. Assume there is concern that the United States may experience a recession.
How should the Federal Reserve influence the dollar to prevent a recession? How might U.S.
exporters react to this policy (favorably or unfavorably)? What about U.S. importing firms?
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Government Influence on Exchange Rates 2
ANSWER: The Federal Reserve would normally consider a loose money policy to stimulate the
economy. However, to the extent that the policy puts upward pressure on economic growth and
If the U.S. interest rates rise in response to the possible increase in economic growth and inflation in
6. Currency Effects on Economy. What is the impact of a weak home currency on the home economy,
other things being equal? What is the impact of a strong home currency on the home economy, other
things being equal?
ANSWER: A weak home currency tends to increase a country’s exports and decrease its imports,
thereby lowering its unemployment. However, it also can cause higher inflation since there is a
A strong home currency can keep inflation in the home country low, since it encourages consumers to
buy abroad. Local producers must maintain low prices to remain competitive. Also, foreign supplies
7. Feedback Effects. Explain the potential feedback effects of a currency’s changing value on inflation.
ANSWER: A weak home currency can cause inflation since it tends to reduce foreign competition
A strong home currency can reduce inflation since it reduces the prices of foreign goods and forces
8. Indirect Intervention. Why would the Fed’s indirect intervention have a stronger impact on some
currencies than others? Why would a central bank’s indirect intervention have a stronger impact than
its direct intervention?
ANSWER: Intervention may have a more pronounced impact when the market for a given currency is
A central bank’s indirect intervention can affect the factors that influence exchange rates and therefore
9. Effects on Currencies Tied to the Dollar. The Hong Kong dollar’s value is tied to the U.S. dollar.
Explain how the following trade patterns would be affected by the appreciation of the Japanese yen
against the dollar: (a) Hong Kong exports to Japan and (b) Hong Kong exports to the United States.
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Government Influence on Exchange Rates 3
ANSWER:
a. Hong Kong exports to Japan should increase because the yen will have appreciated against the
b. Hong Kong exports to the U.S. should increase because Japanese goods become more expensive
to U.S. importers as a result of yen appreciation. Therefore, some U.S. importers may find that
This answer assumes that Japanese exporters did not reduce their prices to compensate U.S.
10. Intervention Effects on Bond Prices. U.S. bond prices are normally inversely related to U.S.
inflation. If the Fed planned to use intervention to weaken the dollar, how might bond prices be
affected?
ANSWER: Expectations of a weak dollar can cause expectations of higher inflation, because a weak
dollar places upward pressure on U.S. prices for reasons mentioned in the chapter. Higher inflation
11. Direct Intervention in Europe. If most countries in Europe experience a recession, how might the
European Central Bank use direct intervention to stimulate economic growth?
ANSWER: The ECB could sell euros in the foreign exchange market, which may cause the euro to
12. Sterilized Intervention. Explain the difference between sterilized and nonsterilized intervention.
ANSWER: Sterilized intervention is conducted to ensure no change in the money supply while
13. Effects of Indirect Intervention. Suppose that the government of Chile reduces one of its key
interest rates. The values of several other Latin American currencies are expected to change
substantially against the Chilean peso in response to the news.
a. Explain why other Latin American currencies could be affected by a cut in Chile’s interest rates.
ANSWER: Exchange rates are partially driven by relative interest rates of the countries of concern.
When Chile’s interest rates decline, there is a smaller flow of funds to be exchanged into Chilean
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Government Influence on Exchange Rates 4
b. How would the central banks of other Latin American countries be likely to adjust their interest
rates? How would the currencies of these countries respond to the central bank intervention?
ANSWER: The central banks would likely attempt to lower interest rates, which causes the currency
c. How would a U.S. firm that exports products to Latin American countries be affected by the
central bank intervention? (Assume the exports are denominated in the corresponding Latin
American currency for each country.)
ANSWER: The exporter is adversely affected if the Chilean peso and other currencies depreciate. It
14. Freely Floating Exchange Rates. Should the governments of Asian countries allow their currencies
to float freely? What would be the advantages of letting their currencies float freely? What would be
the disadvantages?
ANSWER: A freely floating currency may allow the exchange rate to adjust to market conditions,
which can stabilize flows of funds between countries. If there is a larger amount of funds going out
15. Indirect Intervention. During the Asian crisis (see Appendix 6 at the end of this chapter), some Asian
central banks raised their interest rates to prevent their currencies from weakening. Yet, the
currencies weakened anyway. Offer your opinion as to why the central banks’ efforts at indirect
intervention did not work.
ANSWER: The higher interest rates did not attract sufficient funds to offset the outflow of funds, as
Advanced Questions
16. Monitoring the Fed’s Intervention. Why do foreign market participants monitor the Fed’s direct
intervention efforts? How does the Fed attempt to hide its intervention actions? The media frequently
reports that “the dollar’s value strengthened against many currencies in response to the Federal
Reserve’s plan to increase interest rates.” Explain why the dollar’s value may change even before the
Federal Reserve affects interest rates.
ANSWER: Foreign market participants make investment and borrowing decisions that can be
influenced by anticipated exchange rate movements and therefore by the Fed’s direct intervention
Foreign exchange market participants may anticipate that once the Fed increases interest rates, there
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Government Influence on Exchange Rates 5
17. Effects of September 11. Within a few days after the September 11, 2001 terrorist attack on the U.S.,
the Federal Reserve reduced short-term interest rates in the U.S. to stimulate the U.S. economy. How
might this action have affected the foreign flow of funds into the U.S. and affected the value of the
dollar? How could such an effect on the dollar increase the probability that the U.S. economy would
strengthen?
ANSWER: The lower interest rates are expected to stimulate the U.S. economy, by encouraging
18. Intervention Effects on Corporate Performance. Assume you have a subsidiary in Australia. The
subsidiary sells mobile homes to local consumers in Australia, who buy the homes using mostly
borrowed funds from local banks. Your subsidiary purchases all of its materials from Hong Kong. The
Hong Kong dollar is tied to the U.S. dollar. Your subsidiary borrowed funds from the U.S. parent, and
must pay the parent $100,000 in interest each month. Australia has just raised its interest rate in order
to boost the value of its currency (Australian dollar, A$). The Australian dollar appreciates against
the dollar as a result. Explain whether these actions would increase, reduce, or have no effect on:
a. The volume of your subsidiary’s sales in Australia (measured in A$),
b. The cost to your subsidiary of purchasing materials (measured in A$)
c. The cost to your subsidiary of making the interest payments to the U.S. parent (measured in A$).
Briefly explain each answer.
ANSWER:
a. The volume of the sales should decline as the cost to consumers who finance their purchases
b. The cost of purchasing materials should decline because the A$ appreciates against the HK$ as it
c. The interest expenses should decline because it will take fewer A$ to make the monthly payment
19. Pegged Currencies. Why do you think a country suddenly decides to peg its currency to the dollar or
some other currency? When a currency is unable to maintain the peg, what do you think are the
typical forces that break the peg?
ANSWER: A country will usually attempt a peg to reduce speculative flows that occur because of
exchange rate volatility. It tries to comfort investors by making them believe that the currency will be
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Government Influence on Exchange Rates 6
20. Impact of Intervention on Currency Option Premiums. Assume that the central bank of the
country Zakow periodically intervenes in the foreign exchange market to prevent large upward or
downward fluctuations in its currency (the zak) against the U.S. dollar. Today, the central bank
announced that it would no longer intervene in the foreign exchange market. The spot rate of the zak
against the dollar was not affected by this news. Will the news affect the premium on currency call
options that are traded on the zak? Will the news affect the premium on currency put options that are
traded on the zak? Explain.
ANSWER: It should cause the call option premium and put option premium to increase, because
21. Impact of Information on Currency Option Premiums. As of 10:00 a.m., the premium on a
specific one-year call option on British pounds is $.04. Assume that the Bank of England had not been
intervening in the foreign exchange markets in the last several months. However, it announces at
10:01 a.m. that it will begin to frequently intervene in the foreign exchange market in order to reduce
fluctuations in the pound’s value against the dollar over the next year, but it will not attempt to push
the pound’s value higher or lower than what is dictated by market forces. Also, the Bank of England
has no plans to affect economic conditions with this intervention. Most participants who trade
currency options did not anticipate this announcement. When they heard the announcement, they
expected that the intervention would be successful in achieving its goal. Will this announcement
cause the premium on the one-year call option on British pounds to increase, decrease, or to be
unaffected? Explain.
ANSWER: The premium on the call option should decrease because pound’s anticipated volatility
22. Speculating Based on Intervention. Assume that you expect that the European central bank (ECB)
plans to engage in central bank intervention in which it plans to use euros to purchase a substantial
amount of U.S. dollars in the foreign exchange market over the next month. Assume that this direct
intervention is expected to be successful at influencing the exchange rate.
a. Would you purchase or sell call options on euros today?
b. Would you purchase or sell futures on euros today?
ANSWER:
23. Implications of a Fixed Currency for International Trade. Assume the Hong Kong dollar
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Government Influence on Exchange Rates 7
(HK$) value is tied to the U.S. dollar and will remain tied to the U.S. dollar. Last month, a HK$ =
0.25 Singapore dollars. Today, a HK$=0.30 Singapore dollars. Assume that there is much trade in the
computer industry among Singapore, Hong Kong, and the U.S. and that all products are viewed as
substitutes for each other and are of about the same quality. Assume that the firms invoice their
products in their local currency and do not change their prices.
a. Will the computer exports from the U.S. to Hong Kong increase, decrease, or remain the same?
Briefly explain.
ANSWER: Decrease. The H.K. dollar appreciated against the Singapore dollar while fixed against
b. Will the computer exports from Singapore to the U.S. increase, decrease, or remain the same?
Briefly explain.
ANSWER: Increase. The U.S. dollar appreciated against the Singapore dollar, so it is cheaper to buy
24. Implications of a Revised Peg. The country of Zapakar has much international trade with the
U.S. and other countries, as it has no significant barriers on trade or capital flows. Many firms in
Zapakar export common products (denominated in zaps) that serve as substitutes for products
produced in the U.S. and many other countries. Zapakar’s currency (called the zap) has been pegged
at 8 zaps =$1 for the last several years. Yesterday, the government of Zapakar reset the zap’s currency
value so that is now pegged at 7 zaps=$1.
a. How should this adjustment in the pegged rate against the dollar affect the volume of exports by
Zapakar firms to the U.S.?
b. Will this adjustment in the pegged rate against the dollar affect the volume of exports by Zapakar
firms to non-U.S. countries? If so, explain.
c. Assume that the Federal Reserve significantly raises U.S. interest rates today. Do you think
Zapakar’s interest rate would increase, decrease, or remain the same?
ANSWER:
a. The zap’s value is higher. Demand for Zapakar’s exports will be reduced.
25. Pegged Currency and International Trade. Assume that Canada decides to peg its currency (the
Canadian dollar) to the U.S. dollar and that the exchange rate will remain fixed. Assume that Canada
commonly obtains its imports from the U.S. and Mexico. The U.S. commonly obtains its imports
from Canada and Mexico. Mexico commonly obtains its imports from the U.S. and Canada. The
traded products are always invoiced in the exporting country’s currency. Assume that the Mexican
peso appreciates substantially against the U.S. dollar during the next year.
a. What is the likely effect (if any) of the peso’s exchange rate movement on the volume of
Canada’s exports to Mexico? Explain.
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Government Influence on Exchange Rates 8
b. What is the likely effect (if any) of the peso’s exchange rate movement on the volume of
Canada’s exports to the U.S.? Explain.
ANSWER:
26. Impact of Devaluation. The inflation rate in Yinland was 14% last year. The government of Yinland
just devalued its currency (the yin) by 40 % against the dollar. Even though it produces similar types
of products as the U.S., it has much trade with the U.S. and very little trade with other countries. It
presently has trade restrictions imposed on all non-U.S. countries. Will the devaluation of the yin
increase or reduce inflation in Yinland? Briefly explain.
ANSWER: The devaluation would increase inflation, because there is no competition from foreign
27. Intervention and Pegged Exchange Rates. Interest rate parity exists and will continue to exist. The
one-year interest rate in the U.S. and in the eurozone is 6% and will continue to be 6%. Assume that
the country of Latvia’s currency (called the Lat) is presently pegged to the euro and will remain
pegged to the euro in the future. Assume that you expect that the European central bank (ECB) to
engage in central bank intervention in which it plans to use euros to purchase a substantial amount of
U.S. dollars in the foreign exchange market over the next month. Assume that this direct intervention
is expected to be successful at influencing the exchange rate.
a. Will the spot rate of the Lat against the dollar increase, decrease, or remain the same as a result of
central bank intervention?
b. Will the forward rate of the euro against the dollar increase, decrease, or remain the same as a
result of central bank intervention?
c. Would the ECB’s intervention be intended to reduce unemployment or reduce inflation in the
Eurozone?
d. If the ECB decided to use indirect intervention instead of direct intervention to achieve its objective
of influencing the exchange rate, would it increase or reduce the interest rate in the Eurozone?
e. Based on your answer to part (d), will the interest rate of Latvia increase, decrease, or remain the
same as a result of the ECB’s indirect intervention?
ANSWER:
a. The spot rate of the euro will decline, and therefore the spot rate of the Lat will decline as well.
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