Question 1

A situation in which maintaining the peg could cause worse harms to the economy (such as high interest rates) may sway even prudent and cautious central bankers to abandon it. This situation is called:

Accepted Answer

A contingent commitment refers to a commitment made by a central bank to maintain a fixed exchange rate system as long as certain conditions are met. However, if these conditions change and maintaining the fixed exchange rate system could lead to worse harms to the economy, the central bank may choose to abandon it. This is known as a contingent commitment and is a situation in which maintaining the peg could cause worse harms to the economy.

Question 2

(Table: Mexico's Central Bank Balance Sheet) Suppose output in Mexico rises, causing money demand to change by 75 million pesos. What will happen to reserves, domestic credit, and the backing ratio? Explain how these changes take place.

Accepted Answer

The answer of (Table: Mexico's Central Bank Balance Sheet) Suppose...

Question 3

Emerging markets and developing economies are more likely to want to maintain fixed exchange rates because of their dependence on exports. However, these regimes are often more difficult for them. Why?

Accepted Answer

The answer of Emerging markets and developing economies are more...

Question 4

What is the basic difference between the cause(s) of a currency crisis according to the first-generation model and the second-generation model?

Accepted Answer

The answer of What is the basic difference between the...

Question 5

Expected depreciation threatens a peg because of all the following, EXCEPT:

Accepted Answer

Expected depreciation threatens a peg because it puts pressure on the currency and the peg may become unsustainable. However, economic fundamentals are not directly related to the expectation of depreciation and therefore do not threaten the peg. Factors such as investor confidence, market sentiment and the possibility of multiple equilibrium situations all contribute to the threat of a peg failing.

Question 6

Under what circumstances will a peg have a longer grace period before investors get nervous and dump the currency?

Accepted Answer

A combination of factors can lead to a longer grace period before investors get nervous and dump a currency. If there is no coordinated effort to attack the currency, there is less likely to be a sudden loss of confidence. If there is a lower cost to the economy of maintaining the peg, the government can more easily defend the peg against speculators. And if traders and speculators are spread out and small in size with no common belief about the situation, there is less likely to be a sudden rush to sell the currency.

Question 7

What are the three types of crises discussed in the text? List and briefly explain.

Accepted Answer

The answer of What are the three types of crises...

Question 8

One may predict the timing of a crisis by analyzing the expectations of investors with respect to:

Accepted Answer

Investor expectations regarding the central bank's tendency to monetize debt can signal a potential crisis, as it may lead to inflationary pressures and loss of confidence in the currency.

Question 9

In general, whenever the costs of pegging outweigh the benefits of a non-credible peg, the government will always:

Accepted Answer

When the costs of pegging outweigh the benefits, it is not practical or sustainable to continue pegging the currency. In this situation, the government may choose to adopt a flexible exchange rate system and allow the currency to depreciate. This can help improve economic competitiveness and stimulate growth.

Question 10

Weighing the costs and benefits of maintaining the peg would involve comparing the cost of:

Accepted Answer

Maintaining a pegged exchange rate can lead to output gaps and a slower economy, as the central bank may need to raise interest rates to defend the peg. However, it may also bring the benefits of increased trade. Therefore, weighing the costs and benefits of maintaining the peg would involve comparing these factors. Option B is incorrect, as fixed prices are a characteristic of a pegged exchange rate and not a cost. Option C is also incorrect, as the trade deficit is a result of other factors and not directly related to maintaining the peg. Option D is not relevant, as international instability is not a direct cost of maintaining a pegged exchange rate.

Question 11

Among the solutions proposed for avoiding a foreign exchange crisis are all of the following, EXCEPT using:

Accepted Answer

Soft pegs or dirty floats can still lead to a foreign exchange crisis as they involve some level of government intervention, which can create uncertainty and instability.

Question 12

In general, when there is a large shock to domestic output, the government finds:

Accepted Answer

When there is a large shock to domestic output, maintaining the peg carries a higher present and future cost, especially if credibility is low. The government may have to spend a significant amount of foreign reserves to defend the peg, which can lead to a depletion of these reserves and hurt the country's ability to pay for imports. Additionally, if the government has a history of not honoring its commitments, its credibility may be low, and market participants may expect the peg to be abandoned in the future, leading to speculative attacks on the currency. Overall, maintaining the peg can be costly, and the government needs to assess whether it is worth it.

Question 13

Whenever the market believes there will be a depreciation (the peg will break) then:

Accepted Answer

If the market believes there will be a depreciation, it means that the value of the currency is expected to decrease against other currencies. In this case, the benefits of depreciation (such as improved trade competitiveness) would outweigh the costs of depreciation (such as inflation). Therefore, it would be more beneficial to allow for the currency to depreciate instead of maintaining the peg.

Question 14

Anticipating the outcome of a peg, economists believe the stable condition is a situation in which combinations of investor beliefs and government actions coincide. Such a condition is called:

Accepted Answer

The stable condition described in the question is a self-confirming equilibrium, which refers to a situation where everyone’s beliefs about what other people will do coincides with what those other people actually do. This creates a reinforcing cycle where everyone continues to act in the same way, allowing for the stability of the peg to be maintained.

Question 15

Who was the noted financier who speculated against the British pound in 1992 and put pressure on the exchange rate by selling pounds for German Deutsche Marks, eventually forcing Britain to float?

Accepted Answer

George Soros is the noted financier who speculated against the British pound in 1992 and put pressure on the exchange rate by selling pounds for German Deutsche Marks, eventually forcing Britain to float.

Question 16

In general, whenever the benefits of pegging outweigh the costs of a credible peg, what will the government always choose to do?

Accepted Answer

Whenever the benefits of pegging, such as stability for trade and investment, outweigh the costs of a credible peg, such as restriction of monetary policy autonomy and potential for speculative attacks, the government is likely to choose to peg their currency. Therefore, the best choice is B. Depreciation and floating exchange rates are not always optimal, and purchasing more government bonds is not directly related to exchange rate policy.

Question 17

What are the similarities and differences between the impact of a currency crisis on an advanced country and the impact on emerging country?

Accepted Answer

The answer of What are the similarities and differences between...

Question 18

The hypothesis that intermediate regimes or a lack of full commitment to a peg will eventually destroy it results in nations choosing the extremes of peg or float. This hypothesis is known as:

Accepted Answer

The hypothesis described in the question is known as the corners hypothesis, in which countries are forced to choose between extreme exchange rate regimes of either a fixed peg or a free float to avoid the potential destruction of an intermediate regime. The other answer choices do not accurately describe this hypothesis.

Question 19

The example of Peru during the mid-1980s demonstrates all of the following, EXCEPT:

Accepted Answer

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Question 20

In general, when market expectations indicate a non-credible peg, or when the costs of the peg are not greater than the benefits of pegging, what will be the equilibrium situation?

Accepted Answer

When market expectations indicate a non-credible peg, or when the costs of the peg are perceived to outweigh its benefits, the equilibrium situation becomes uncertain. This is because the lack of confidence in the peg's sustainability can lead to speculative attacks or shifts in investment that make the peg difficult to maintain, thus there is no clear, self-fulfilling equilibrium.

Quiz 20: Exchange Rate Crises: How Pegs Work and How They Break