Question 1

An exchange rate is said to follow a random walk when:

Accepted Answer

The definition of a random walk in the context of exchange rates is that the period-to-period changes are random and unpredictable, meaning future changes cannot be predicted based on past movements.

Question 2

A rise in the domestic inflation rate and a simultaneous fall in the foreign inflation rate lead to:

Accepted Answer

A rise in domestic inflation relative to foreign inflation tends to decrease the value of the domestic currency because higher inflation reduces the purchasing power of the currency, making foreign currencies relatively more valuable. This leads to a depreciation of the domestic currency.

Question 3

Some countries have high interest rates and depreciating currencies because:

Accepted Answer

High inflation rates can lead to high nominal interest rates, but if inflation is higher than these rates, the real interest rates become low, which can lead to currency depreciation.

Question 4

A rise in the domestic and foreign growth rates leads to:

Accepted Answer

The effect on currency value depends on the relative growth rates and other factors, not just the fact that both are rising.

Question 5

The government can affect the exchange rate by:

Accepted Answer

The government can influence the exchange rate through various means: by choosing the exchange rate regime (fixed, floating, or pegged), by directly intervening in the foreign exchange market (buying or selling currencies to influence their value), and by implementing monetary policies that affect economic variables (like interest rates) which in turn influence the exchange rate.

Question 6

Central banks intervene in the foreign exchange market to:

Accepted Answer

The answer of Central banks intervene in the foreign exchange...

Question 7

Which of the following is NOT an argument for central bank intervention?

Accepted Answer

The argument that "the market knows better than economic policy makers the appropriate level of the exchange rate" is not an argument for central bank intervention, but rather an argument against it, suggesting that market forces should determine exchange rates without interference from central banks.

Question 8

Which of the following is NOT conducive to the success of central bank intervention?

Accepted Answer

Central bank interventions are more likely to succeed when they align with existing market trends rather than attempting to reverse them. Coordinated efforts, whether announced or not, tend to have a stronger impact.

Question 9

Expectations affect the exchange rate because:

Accepted Answer

Speculators play a significant role in the foreign exchange market by buying and selling currencies based on their expectations of future movements, which can influence the exchange rate.

Question 10

A speculative attack on a currency is triggered when:

Accepted Answer

A speculative attack is often triggered when a currency is perceived to be overvalued relative to economic fundamentals, leading speculators to bet against it.

Question 11

'News' as used in the exchange rate literature refers to:

Accepted Answer

Unanticipated changes in the variables that affect the exchange rate are referred to as 'news' in the context of exchange rate literature. This encompasses any unexpected economic or political information that could influence currency values.

Question 12

Stabilising speculation occurs when speculators:

Accepted Answer

Stabilising speculation involves buying assets when their prices are low and selling them when their prices are high. This activity can help to stabilize market prices by reducing volatility, as speculators are essentially betting against the prevailing market momentum by buying undervalued assets and selling overvalued ones.

Question 13

Destabilising speculation occurs when speculators:

Accepted Answer

Destabilising speculation occurs when speculators buy high and sell low, which can exacerbate price movements and lead to increased volatility in the market.

Question 14

If the foreign currency equivalent of the domestic price of a commodity is less than the foreign price of the same commodity, then the derivation of PPP implies that:

Accepted Answer

The foreign currency is overvalued because the domestic price of the commodity is lower than the foreign price, but the foreign currency equivalent of the domestic price is also lower than the foreign price. This implies that the foreign currency is overvalued.

Question 15

If the domestic currency price of a commodity is greater than the domestic currency equivalent of the foreign price of the same commodity, then the derivation of PPP implies that:

Accepted Answer

Purchasing Power Parity (PPP) theory suggests that in the long run, exchange rates should adjust so that the same good in different countries has the same price when expressed in a common currency. If the domestic price of a commodity is higher than its foreign currency equivalent, it implies that either the foreign price must increase or the exchange rate must adjust (or both) to equalize the prices when expressed in the same currency.

Question 16

The price of a commodity in the US is USD2.54, while the price of the same commodity in Australia is AUD3.00 and the AUD/USD exchange rate is 1.8769. What is the Australian dollar price of the commodity compatible with the derivation of PPP?

Accepted Answer

Purchasing Power Parity (PPP) suggests that the price of a commodity should be the same in different countries when expressed in a common currency. To find the Australian dollar price compatible with PPP, convert the US price to AUD: USD2.54 * 1.8769 = AUD4.77.

Question 17

The price of a commodity in the US is USD2.54, while the price of the same commodity in Australia is AUD3.00 and the AUD/USD exchange rate is 1.8769.
 What is the AUD/USD exchange rate compatible with the derivation of PPP?

Accepted Answer

The Purchasing Power Parity (PPP) exchange rate can be calculated by dividing the price of the commodity in one currency by the price in another currency. So, $ \frac{AUD3.00}{USD2.54} = AUD/USD 1.1811 $.

Question 18

Which of the following assumptions is NOT compatible with PPP in its strict form?

Accepted Answer

The Purchasing Power Parity (PPP) theory, in its strict form, assumes perfect arbitrage conditions, meaning that traders will immediately exploit differences in price levels between countries to make a profit. This assumption implies that traders are risk-neutral, as they are willing to engage in arbitrage whenever there is an opportunity, without fear of potential losses. Therefore, the assumption that traders are risk averse is not compatible with PPP in its strict form, as it would deter them from engaging in arbitrage due to fear of potential risks.

Question 19

At the beginning of 2002 the AUD/USD exchange rate was 1.9585 and the forecast inflation rates for 2002 were 4.00% for Australia and 2.50% for the US.
 What is the AUD/USD exchange rate forecast to be at the end of 2002, according to PPP theory?

Accepted Answer

According to PPP theory, the exchange rate should adjust to equalize the purchasing power of the two currencies. The formula for PPP is:S = P*/Pwhere S is the exchange rate, P* is the price level in the foreign country, and P is the price level in the domestic country.In this case, the AUD/USD exchange rate is 1.9585 at the beginning of 2002. The forecast inflation rates for 2002 are 4.00% for Australia and 2.50% for the US. This means that the price level in Australia is expected to increase by 4.00% and the price level in the US is expected to increase by 2.50%.Using the PPP formula, we can calculate the expected exchange rate at the end of 2002:S = P*/PS = (1.04 * 1.9585) / 1.025S = 1.9872Therefore, the AUD/USD exchange rate is forecast to be 1.9872 at the end of 2002, according to PPP theory.

Question 20

At the beginning of 2002 the AUD/USD exchange rate was 1.9585 and the forecast inflation rates for 2002 were 3.00% for Australia and 4.00% for the US.
 What is the AUD/USD exchange rate forecast to be at the end of 2002, according to PPP theory?

Accepted Answer

According to PPP theory, the exchange rate should adjust based on inflation differentials. The formula is: New Rate = Old Rate * (1 + Inflation Domestic) / (1 + Inflation Foreign). Applying this: 1.9585 * (1 + 0.03) / (1 + 0.04) = 1.9397.

Quiz 4: Exchange Rate Determination