Deck 20: Output, the Interest Rate and the Exchange Rate

Question 1

As the economy moves down and to the right along the IS curve, which of the following will occur when exchange rates are flexible?

A) The domestic currency depreciates.
B) Consumption increases.
C) Investment spending increases.
D) All of the above.
E) None of the above.

Answer 1

All of the above.

Question 2

When the interest parity condition holds, we know that the domestic interest rate must be equal to:

A) the expected rate of appreciation of the domestic currency.
B) the foreign interest rate minus the expected rate of appreciation of the domestic currency.
C) the foreign interest rate plus the expected rate of appreciation of the domestic currency.
D) the expected rate of depreciation of the domestic currency.
E) the foreign interest rate.

Answer 2

the foreign interest rate minus the expected rate of appreciation of the domestic currency.

Question 3

Assume that the interest parity condition holds. Also assume that the Australian interest rate is 5% while the U.K. interest rate is 7%. Given this information, financial markets expect the pound to:

A) appreciate by 6%.
B) appreciate by 2%.
C) depreciate by 2%.
D) appreciate by 4%.
E) depreciate by 4%.

Answer 3

depreciate by 2%.

Question 4

Assume that the current exchange rate between the Australian dollar and the U.K. pound is E = 0.66. If interest parity holds, and the Australian interest rate is 5% while the U.K. interest rate is 7%, the expected exchange rate in one year is:

A) 0.87.
B) 0.57.
C) 0.67.
D) 0.47.
E) 0.77.

Question 5

The exchange rate policy of Australia is:

A) part of the EMS.
B) a currency board.
C) a flexible regime.
D) a fixed rate within a band.
E) a crawling peg.

Question 6

A common argument for fixed exchange rates is that they:

A) make trade more costly, and thus encourage domestic citizens to buy domestically produced output.
B) give central banks greater freedom in adjusting their economy's level of output.
C) forever free the central bank from have to adjust the exchange rate to fundamental changes in the economy.
D) All of the above.
E) None of the above.

Question 7

Assume that the economy is operating in a fixed exchange rate regime and that perfect capital mobility exists. Given this information, which of the following will occur?

A) The central bank cannot use monetary policy independently to affect domestic output.
B) Contractionary fiscal policy will require the central bank to decrease the money supply.
C) The domestic and foreign interest rates must be equal.
D) All of the above.
E) None of the above.

Question 8

Assume that policy makers are pursuing a fixed exchange rate regime. Now suppose a budget is passed that calls for a decrease in government spending. This government spending cut will cause which of the following to occur?

A) No change in net exports.
B) No change in output.
C) An increase in imports.
D) A decrease in the interest rate.
E) A decrease in investment.

Question 9

Assume policy makers in a fixed exchange rate regime decide to peg the exchange rate at a higher level. This is called:

A) a depreciation.
B) an appreciation.
C) a revaluation.
D) a misalignment.
E) a devaluation.

Question 10

Suppose a country with a fixed exchange rate decides to decrease the price of its currency. This change in policy is called:

A) a revaluation.
B) a peg.
C) a depreciation.
D) a devaluation.
E) an appreciation.

Question 11

A monetary expansion in a flexible exchange rate regime will cause:

A) the IP curve to become horizontal.
B) an appreciation of the domestic currency.
C) no change in the exchange rate.
D) a downward shift of the IP curve.
E) a depreciation of the domestic currency.

Question 12

Suppose a country switches from a flexible to a fixed exchange rate. Which of the following will occur as a result of this change?

A) Both fiscal and monetary policy will become more effective in changing GDP.
B) A given change in government spending will now have a greater effect on output.
C) Both fiscal and monetary policy will become completely ineffective in changing GDP.
D) Monetary policy will become a more effective tool for changing output.
E) A given change in government spending will now have a smaller effect on output.

Question 13

In 2005, China increased the price of its currency while continuing to pursue a fixed exchange rate. This change in policy is called:

A) an appreciation.
B) a revaluation.
C) a devaluation.
D) a depreciation.
E) a peg.

Question 14

Suppose policy makers in a fixed exchange rate regime decide to peg the exchange rate at a lower level. Such a policy is called:

A) a misalignment.
B) a depreciation.
C) a revaluation.
D) an appreciation.
E) a devaluation.

Question 15

Under a fixed exchange rate regime, we know that a tax increase will cause which of the following?

A) An increase in the exchange rate.
B) An increase in investment.
C) An increase in imports.
D) An increase in net exports.
E) An increase in the interest rate.

Question 16

Assume that there is a simultaneous tax cut and monetary contraction. In a flexible exchange rate regime, we know with certainty that:

A) the exchange rate would increase.
B) the exchange rate would increase and output would decrease.
C) the exchange rate would decrease and output would increase.
D) the exchange rate and output would both increase.
E) the exchange rate would increase and output would remain unchanged.

Question 17

In practice, under the EMS, a member country:

A) had complete freedom in choosing the interest rate it wanted.
B) had complete freedom in choosing its interest rate only if it is a very small country.
C) could change its interest rate only if other countries changed theirs as well.
D) could never change its interest rate.
E) must apply to a special European Commission in order to change its interest rate.

Question 18

Assume that policy makers are pursuing a fixed exchange rate regime. Now suppose that a fiscal contraction is implemented. Such a policy will tend to cause which of the following to occur?

A) A decrease in the exchange rate.
B) A decrease in Y.
C) A decrease in the domestic interest rate.
D) An increase in the money supply.
E) An increase in the price level.

Question 19

In a flexible exchange rate regime, a decrease in the foreign interest rate will cause:

A) the IP curve to shift to the right/down.
B) the IP curve to shift to the left/up.
C) a movement along the IP curve.
D) the IP curve to become vertical.
E) the IP curve to become horizontal.

Question 20

Suppose policy makers are pursuing a policy to fix the exchange rate. In such a system with perfect capital mobility, an open market purchase of domestic bonds by the domestic central bank will eventually result in:

A) a gradual decrease in the domestic interest rate.
B) a change in the composition of the monetary base.
C) a permanent increase in the monetary base.
D) a permanent decrease in the monetary base.
E) a gradual increase in the domestic interest rate.

Question 21

In an open economy under flexible exchange rates, contractionary monetary policy in the short run will always cause:

A) an increase in the interest rate.
B) a decrease in output.
C) an increase in the exchange rate.
D) All of the above.
E) Both B and C.

Question 22

Suppose policy makers are pursuing a policy to fix the exchange rate. In such a system with perfect capital mobility, an open market sale of domestic bonds by the domestic central bank will eventually result in:

A) a change in the composition of the monetary base.
B) a permanent increase in the monetary base.
C) a gradual decrease in the domestic interest rate.
D) a gradual increase in the domestic interest rate.
E) a permanent decrease in the monetary base.

Question 23

In a flexible exchange rate regime, an increase in the foreign interest rate will cause:

A) the IP curve to shift to the right/down.
B) the IP curve to shift to the left/up.
C) a movement along the IP curve.
D) the IP curve to become vertical.
E) the IP curve to become horizontal.

Question 24

An individual will be indifferent between holding foreign or domestic bonds when which of the following conditions holds?

A) Interest parity must hold.
B) The J- curve effect must hold.
C) The expected rate of depreciation of the domestic currency must be zero.
D) The Marshall- Lerner condition must hold.
E) The foreign and domestic interest rates must be equal.

Question 25

Assume the interest parity condition holds and that initially i = i*. A decrease in the foreign interest rate will cause:

A) an increase in the demand for the domestic currency.
B) an expected depreciation of the domestic currency.
C) an increase in the exchange rate.
D) All of the above.
E) None of the above.

Question 26

The European Monetary System represented a(n):

A) crawling peg.
B) monetary union.
C) exchange rate regime with "bands".
D) currency board.
E) flexible exchange rate regime.

Question 27

In an open economy, we know that individuals must choose between which of the following?

A) Domestic bonds and foreign currency.
B) Domestic goods and foreign currency.
C) Foreign goods and domestic currency.
D) Domestic bonds and foreign stocks.
E) Domestic and foreign bonds.

Question 28

In an open economy under flexible exchange rates, an increase in wealth that causes an increase in consumption will cause which of the following?

A) A decrease in the exchange rate.
B) A decrease in output.
C) An appreciation of the domestic currency.
D) An increase in net exports.
E) A decrease in taxes.

Question 29

Assume that the interest parity condition holds and that the Australian dollar is expected to appreciate against the pound. Given this information, we know that:

A) the Australian interest rate exceeds the U.K. interest rate.
B) individuals will prefer to hold the U.K. bonds because the U.K. interest rate exceeds the Australian interest rate.
C) individuals will prefer to hold Australian bonds because the Australian interest rate exceeds the U.K. interest rate.
D) the Australian and European interest rates are equal.
E) the U.K. interest rate exceeds the Australian interest rate.

Question 30

Under a fixed exchange rate regime, the central bank must act to keep:

A) E = 1.
B) i+E = P.
C) P = P*.
D) i = i*.
E) NX = 0.

Question 31

Suppose there are two countries that are identical in every way with the following exception. Country A is pursuing a fixed exchange rate regime and country B is pursuing a flexible exchange rate regime. Suppose taxes are increased in both countries and rise by the same amount. Given this information, we know that:

A) the change in output in A will be greater than in B.
B) the relative output effects are ambiguous.
C) the relative output effects depend on relative prices.
D) the change in output will be the same in both countries.
E) the change in output in B will be greater than in A.

Question 32

Suppose a country is pursuing a fixed exchange rate regime with imperfect capital mobility. The ability of that country to move its domestic interest rate while maintaining its exchange rate will depend on:

A) the degree of capital controls.
B) the degree of development of its financial markets.
C) the amount of foreign exchange it holds.
D) All of the above.
E) Both B and C.

Question 33

Assume that there is a simultaneous increase in government spending and a monetary contraction. In a flexible exchange rate regime, we know with certainty that such a policy mix will cause which of the following?

A) A decrease in net exports.
B) An increase in the domestic interest rate.
C) An increase in the exchange rate.
D) Both A and B.
E) Both B and C.

Question 34

Assume that policy makers are pursuing a fixed exchange rate regime. Now suppose that households decide to decrease consumption because of falling consumer confidence. Given this information, we would expect which of the following to occur?

A) A decrease in the domestic interest rate.
B) An increase in investment.
C) An increase in the exchange rate.
D) A decrease in investment.
E) A decrease in the exchange rate.

Question 35

For this question, assume that all price levels are fixed. Now suppose that there is a real exchange rate depreciation. This real depreciation will cause which of the following to occur?

A) A decrease in net exports.
B) A decrease in exports.
C) An increase in net exports.
D) An increase in imports.
E) A decrease in demand for domestic output.

Question 36

In a flexible exchange rate regime, a decrease in the expected future exchange rate will cause:

A) the IP curve to shift to the right/down.
B) the IP curve to shift to the left/up.
C) a movement along the IP curve.
D) the IP curve to become vertical.
E) the IP curve to become horizontal.

Question 37

In a flexible exchange rate regime, an increase in the expected future exchange rate will cause:

A) the IP curve to shift to the right/down.
B) the IP curve to shift to the left/up.
C) a movement along the IP curve.
D) the IP curve to become vertical.
E) the IP curve to become horizontal.

Question 38

In an open economy under flexible exchange rates and represented by the IS- LM- IP model, a tax increase will cause a decrease in which of the following?

A) Exports.
B) Net exports.
C) The exchange rate.
D) Both A and B.
E) Both B and C.

Question 39

Assume the interest parity condition holds and that initially i = i*. A decrease in the domestic interest rate will cause:

A) a decrease in the exchange rate.
B) an expected appreciation of the domestic currency.
C) a decrease in the demand for the domestic currency.
D) All of the above.
E) None of the above.

Question 40

In the early 1990s, European unemployment rose largely because of:

A) overvalued currencies.
B) low budget deficits.
C) high real interest rates.
D) high inflation.
E) undervalued currencies.

Question 41

In an economy operating under flexible exchange rates, explain why the IS curve is downward sloping.

Question 42

Assume the exchange rate is allowed to fluctuate freely. Using the IS- LM- IP model, graphically illustrate and explain what effect a monetary contraction will have on the domestic economy. In your graphs, clearly label all curves and equilibria.

Question 43

Assume that the price levels in two countries are constant. In this situation, we know that:

A) the real and nominal exchange rate must move together, changing by the same percentage.
B) neither the real nor the nominal exchange rate can change.
C) the nominal exchange rate can change, while the real exchange rate is constant.
D) the nominal exchange rate will fluctuate more widely than the real exchange rate.
E) the real exchange rate can change, while the nominal exchange rate is constant.

Question 44

In an open economy under flexible exchange rates, an increase in the interest rate will cause an increase in which of the following?

A) Output.
B) Investment.
C) The exchange rate.
D) Government spending.
E) Consumption.

Question 45

Explain what the IP curve is and why it is upward sloping.

Question 46

Suppose the domestic and foreign interest rates are initially equal to 5%. Now suppose the foreign interest rate rises to 7%. Explain what effect this will have on the exchange rate. Also explain what must occur for the interest parity condition to be restored.

Question 47

In the early 1990s, which nation took the lead in driving up European interest rates?

A) Spain.
B) France.
C) Germany.
D) United Kingdom.
E) Belgium.

Question 48

Assume the exchange rate is allowed to fluctuate freely. Using the IS- LM- IP model, graphically illustrate and explain what effect an increase in foreign output (Y*) will have on the domestic economy. In your graphs, clearly label all curves and equilibria.

Question 49

Assume the exchange rate is allowed to fluctuate freely. Using the IS- LM- IP model, graphically illustrate and explain what effect a tax increase will have on the domestic economy. In your graphs, clearly label all curves and equilibria.

Question 50

Assume that policy makers are pursuing a fixed exchange rate regime. Now suppose that the foreign interest rate increases. Discuss what policy makers must do to maintain the pegged exchange rate. Also discuss what effect this will have on domestic output and net exports.

Question 51

Explain what effect each of the following events will have on the IS curve in a flexible exchange rate regime: (1) an increase in foreign output; (2) a decrease in the foreign interest rate; and (3) an increase in the domestic interest rate.

Question 52

Under a "crawling peg" system, a country's exchange rate:

A) changes at a predetermined rate against the dollar or some other major currency.
B) is fixed except for small, surprise changes.
C) is determined by the central bank of another country.
D) can change, but the changes are kept secret from the public.
E) can fluctuate within a narrow band.

Question 53

Assume the exchange rate is fixed. Using the IS- LM model, graphically illustrate and explain what effect falling consumer confidence will have on the domestic economy. In your graphs, clearly label all curves and equilibria.

Question 54

Explain what sudden stops are and their role during the crisis in 2008 and 2009.

Question 55

Suppose the domestic and foreign interest rates are initially equal to 4%. Now suppose the domestic interest rate rises to 6%. Explain what effect this will have on the exchange rate. Also explain what must occur for the interest parity condition to be restored.

Question 56

Under a fixed exchange rate regime, we know that an increase in stock market wealth that increases consumption will cause:

A) a decrease in net exports.
B) an increase in investment.
C) an increase in imports.
D) All of the above.
E) None of the above.

Question 57

To what extent can monetary policy be used to affect output in a fixed exchange rate regime? Explain.

Question 58

Suppose there is a decrease in the real exchange rate. Which of the following will occur as a result of this change in the real exchange rate?

A) An increase in net exports.
B) A decrease in exports.
C) A decrease in government spending.
D) A decrease in output.
E) An increase in imports.

Question 59

For a country pursuing a fixed exchange rate regime, what does the interest parity condition imply about domestic and foreign interest rates? Explain.

Question 60

Assume that the interest parity condition holds and that both the expected exchange rate and the foreign interest rate are constant. Given this information, a decrease in the domestic interest rate will cause:

A) a decrease in the current exchange rate.
B) a decrease in the exchange rate expected in the future.
C) greater appreciation of the domestic currency expected in the future.
D) an increase in the current exchange rate.
E) greater depreciation of the domestic currency expected in the future.