Question 1

When policy makers decide to devalue the currency, such an action generally represents:

Accepted Answer

Devaluing the currency means reducing its value in relation to other currencies. This is typically done by policy makers by decreasing the pegged value of the domestic currency (i.e. the value at which it is fixed in relation to another currency). This makes the domestic currency worth less compared to other currencies, which can make exports cheaper and more attractive to buyers abroad, thereby stimulating economic growth.

Question 2

t n+ The expected future nominal exchange rate in the medium run, E e, is assumed to be the
Nominal exchange rate at which:

Accepted Answer

The expected future nominal exchange rate in the medium run is often assumed to be the rate at which the current account is in balance. This is because a balanced current account suggests that the exchange rate is at a level where the value of imports is equal to the value of exports, indicating a sustainable position that does not necessitate adjustments in the exchange rate to correct imbalances.

Question 3

Assume that policy makers are pursuing a fixed exchange rate regime. Assume that the economy is initially operating at the natural level of output. Now suppose that households as a result of an increase in consumer confidence increase consumption. Given this information, we know that:

Accepted Answer

In the medium run, the increase in consumption will lead to an increase in aggregate demand, which will put upward pressure on the price level. This will cause the real exchange rate to appreciate, making domestic goods more expensive relative to foreign goods.

Question 4

Assume that policy makers are pursuing a fixed exchange rate regime and that output is initially greater than the natural level of output. The economy will tend to move toward the natural level of output when which of the following occur?

Accepted Answer

An increase in the price level will reduce real money balances, leading to higher interest rates and reduced investment and consumption, which will decrease output back towards the natural level.

Question 5

Assume that the interest parity condition holds, the future expected exchange rate is constant, the current nominal exchange rate is 2.2, the one- year foreign interest rate is 7% and the one- year domestic interest rate is 4%. One could conclude that:

Accepted Answer

According to interest parity condition, the difference between two countries' interest rates equals the expected change in exchange rates. Therefore, the expected increase in exchange rate can be calculated as (7%-4%) = 3%. So, financial market participants expect that the exchange rate will increase by 3% over the coming year.

Question 6

Suppose a country that has been pegging its currency is faced with a situation where financial market participants now expect some future devaluation. In such a situation, we would generally expect which of the following to occur?

Accepted Answer

In a situation where financial market participants expect a devaluation of the country's currency, the central bank may need to increase interest rates to prevent capital outflows and maintain the value of the currency. This is because higher interest rates would make the country's assets more attractive to foreign investors, leading to an increase in demand for the currency. A) and B) are unlikely as investors and traders may be wary of investing in stocks or making new investments until the situation stabilizes. C) is unlikely as the expectation of devaluation would lead to a decrease in demand for the currency. E) is unlikely as such an announcement would only worsen the situation and potentially lead to a currency crisis.

Question 7

Use the following information to answer the question(s) below:
The exchange rate between the Australian dollar and the British pound is 0.65 (i.e., 0.65 pounds per Australian dollar). In the U.K., the price level is 1.0 and the interest rate is 15%. In Australia, the price level is 0.5 and the interest rate is 10%. The inflation rate in both countries is zero.
-Refer to the information above. The real exchange rate, from the Australian perspective, is:

Accepted Answer

The real exchange rate is calculated as the nominal exchange rate adjusted for price levels. It is given by (Nominal Exchange Rate) * (Price Level in Australia / Price Level in UK) = 0.65 * (0.5 / 1.0) = 0.325.

Question 8

Suppose the country that pegs its currency has an overvalued real exchange rate and that output is currently above the natural level of output. Which of the following will occur as the economy adjusts to this situation?

Accepted Answer

EWhen a country has an overvalued real exchange rate, its domestic goods become less competitive on the international market because they are relatively more expensive than foreign goods. This situation leads to a decrease in net exports, which is consistent with choice C. As for choice E, a decrease in the pegged value of the domestic currency (a devaluation) would make domestic goods cheaper relative to foreign goods, potentially decreasing demand for domestic goods as the currency's value is adjusted downward. This could lead to a leftward shift of the Aggregate Demand (AD) curve as domestic and foreign consumers adjust their spending in response to the new exchange rate, affecting the overall demand for the country's goods and services.

Question 9

An adjustment of central parities in the EMS is called a:

Accepted Answer

An adjustment of central parities in the EMS is called a realignment.

Question 10

Assume that policy makers are pursuing a fixed exchange rate regime and that output is initially less than the natural level of output. The economy will tend to move toward the natural level of output when which of the following occur?

Accepted Answer

A devaluation of the currency under a fixed exchange rate regime can help an economy move toward its natural level of output by making domestic goods cheaper relative to foreign goods. This can increase exports and decrease imports, thus stimulating domestic production and moving output closer to the natural level.

Question 11

European currencies were taken out of circulation and replaced with the Euro in:

Accepted Answer

The Euro officially became the currency for many European countries in 1999, but physical Euro coins and banknotes were introduced on January 1, 2002, replacing the national currencies of the participating countries.

Question 12

Suppose country A pegs its nominal exchange rate to country B, and that country A has a higher inflation rate than country B. In this situation, country A will experience:

Accepted Answer

When country A has a higher inflation rate than country B while pegging its nominal exchange rate to country B, it effectively makes its goods more expensive relative to country B's goods. This leads to a worsening trade position as its exports become less competitive and imports from country B become cheaper. The real exchange rate, which adjusts the nominal rate for inflation differences, increases, making country A's goods relatively more expensive internationally. This can also lead to a decrease in domestic demand for locally produced goods as imports become more attractive, affecting all the mentioned aspects.

Question 13

Which of the following is an advantage of a common currency in Europe?

Accepted Answer

With a common currency, there would no longer be any need for currency exchanges between member nations. This would eliminate exchange rate uncertainty and make trade and investments within the common currency area much easier.

Question 14

Which of the following will occur in the medium run as a result of a revaluation?

Accepted Answer

The answer of Which of the following will occur in...

Question 15

In a fixed exchange rate regime, which of the following policies could be implemented to increase a trade deficit and leave aggregate demand constant?

Accepted Answer

Increasing government spending would increase the trade deficit by boosting imports, while revaluing the currency would make exports more expensive and imports cheaper, further increasing the trade deficit. The revaluation offsets the increase in aggregate demand from higher government spending, keeping it constant.

Question 16

Suppose that policy makers decide to revalue the currency, such an action generally represents:

Accepted Answer

Revaluing a currency means increasing the value of the domestic currency in relation to a foreign currency. This can be achieved by either increasing the pegged value of the domestic currency or decreasing the pegged value of the foreign currency. Therefore, the correct answer is D, which states an increase in the pegged value of the domestic currency.

Question 17

Assume that policy makers are pursuing a fixed exchange rate regime and the economy is initially operating at the natural level of output. Which of the following will occur as a result of a revaluation?

Accepted Answer

A revaluation means that the domestic currency becomes stronger relative to the foreign currency. In a fixed exchange rate regime, this means that the central bank must intervene in the foreign exchange market to buy up the excess supply of domestic currency and sell foreign currency, thereby decreasing the supply of domestic currency and increasing the supply of foreign currency. This will lead to a decrease in the nominal exchange rate, making the domestic goods more expensive relative to foreign goods. However, since the economy is initially at the natural level of output, there is no excess demand or supply in the goods market. Therefore, the increase in the price of domestic goods relative to foreign goods will lead to a decrease in net exports, and hence a decrease in aggregate demand. This decrease in aggregate demand will lead to a decrease in the price level and output in the short run, but in the medium run, output will return to the natural level and the real exchange rate will be unchanged because there is no change in the relative prices of domestic and foreign goods. Thus, the answer is B - the real exchange rate will be unchanged in the medium run.

Question 18

Suppose foreign exchange markets anticipate a revaluation for country A. Further assume that policy makers in country A will continue to fix its nominal exchange rate. In order to peg the currency at its original level, which of the following must occur?

Accepted Answer

In order to peg the currency at its original level, policy makers in country A must decrease their domestic interest rate. This will make their currency less attractive to foreign investors, decreasing demand for their currency and thus keeping their exchange rate at the original level. The other choices are not directly related to maintaining a fixed nominal exchange rate.

Question 19

A number of situations can arise that will cause individuals to believe that policy makers might change the pegged value of a fixed exchange rate. Suppose financial market participants expect a devaluation in the future. The interest rate parity condition will be maintained if which of the following policy actions are taken in the current period?

Accepted Answer

According to the interest rate parity condition, a decrease in the domestic interest rate will cause the value of the domestic currency to decrease relative to other currencies, leading to a devaluation. Therefore, option A is incorrect. An increase in taxes or a decrease in government spending would not directly affect the exchange rate, so options C and E are also incorrect. A decrease in the pegged value of the domestic currency would lead to an immediate devaluation, so option D is also incorrect. In contrast, an increase in the domestic interest rate would make the domestic currency more attractive to investors, leading to an appreciation and maintaining the interest rate parity condition.

Question 20

The European Central Bank is located in which country?

Accepted Answer

The European Central Bank is located in Frankfurt, Germany.

Quiz 21: Exchange Rate Regimes