Question 1

Which of the following explains why a monetary policy in a nation with an exchange rate peg, such as Denmark, would NOT be possible?
A) The nation must keep its import tariffs in sync with the import tariffs of the nation to which it pegs.
B) The nation must keep its price level and nominal interest rate equal to the price level and nominal interest rate in the nation to which it pegs.
C) The nation must keep its taxes and budget deficit in sync with taxes and budget deficit in the nation to which it pegs.
D) The nation is no longer able to print its own money, since it is using the currency of the nation to which it pegs.

Accepted Answer

When a country pegs its currency to another, it must align its monetary policy, including interest rates and price levels, with the nation to which it is pegged to maintain the peg. This limits its ability to conduct independent monetary policy.

Question 2

If Bulgaria, for instance, wished to keep its exchange rate with the dollar fixed, what monetary policy options are available to lower unemployment in the short run?
A) Bulgaria has all the options available to it, because domestic monetary policy is conducted inside the nation and has no bearing on its international variables.
B) Traders would realize that any monetary policy actions taken inside a nation would improve economic conditions without affecting international variables.
C) Bulgaria cannot use any monetary policy that would cause its short-run exchange rate to depreciate against the dollar.
D) Bulgaria's monetary action would restore confidence and help keep its currency stable.

Accepted Answer

If Bulgaria wishes to keep its exchange rate with the dollar fixed, it cannot use any monetary policy that would cause its short-run exchange rate to depreciate against the dollar. This limits the options available to Bulgaria for lowering unemployment in the short run.

Question 3

If an economy wants to maintain monetary policy autonomy, then:
A) it can maintain a fixed exchange rate and international capital mobility.
B) it can impose strict capital controls and maintain a fixed exchange rate.
C) it can maintain capital mobility but not a fixed exchange rate.
D) it can impose strict capital controls and maintain a fixed exchange rate or it can maintain capital mobility but not a fixed exchange rate.

Accepted Answer

An economy can maintain monetary policy autonomy by either imposing strict capital controls and maintaining a fixed exchange rate or by allowing capital mobility and having a flexible exchange rate. This is based on the "impossible trinity" or "trilemma" in international economics, which states that it is impossible to have all three: a fixed foreign exchange rate, free capital movement, and an independent monetary policy.

Question 4

Comparing the examples of Denmark and the United Kingdom in relationship to the European Monetary Union, the krone is pegged to the euro, whereas the British pound is not. What can be predicted then about their interest rates?
A) The United Kingdom has the ability to set its own interest rates and pursue an independent monetary policy, whereas Denmark's rates are virtually the same as those of the euro.
B) Denmark gets the benefits of having fixed exchange rates as well as having an independent monetary policy and the ability to set its own rates of interest.
C) Denmark's price level in the long run will be much higher than the Eurozone because it has to keep exchange rates fixed.
D) The United Kingdom will discover that it cannot lower its own interest rates after all, or the pound will depreciate so far that no investors will make investments in the United Kingdom.

Accepted Answer

Since Denmark has pegged its currency, the krone, to the euro, it cannot pursue an independent monetary policy and must have virtually the same interest rates as those in the eurozone. On the other hand, the United Kingdom has the freedom to set its own interest rates and pursue an independent monetary policy since it has not joined the European Monetary Union and has not pegged its currency, the pound, to the euro. Therefore, option A is the best choice.

Question 5

The outcome of the Civil War in the United States was that:
A) the Confederates were allowed to keep their currency.
B) the value of the Confederate dollar increased at the end of the war.
C) the Confederate dollar became worthless.
D) the North's currency declined in value.

Accepted Answer

The outcome of the Civil War led to the defeat of the Confederacy, resulting in the Confederate dollar becoming worthless as it was no longer recognized as legal tender. The Union's victory also solidified the value of the U.S. dollar as the official currency of the United States, while Confederate currency was left worthless.

Question 6

If Japan seeks to control its exchange rates so that ¥100 = $1, which of the following policies should it NOT maintain?
A) interest rates that provide the same return as alternative international rates
B) a stable rate of price level changes that will not cause currency depreciation or appreciation
C) a willingness to raise interest rates when its currency begins to depreciate
D) a willingness to raise price levels

Accepted Answer

If Japan seeks to maintain an exchange rate of ¥100 = $1, it should not be willing to raise price levels. Higher price levels would cause currency appreciation, which would make it more difficult to maintain the desired exchange rate. Therefore, (D) is the policy that Japan should not maintain.

Question 7

Why would making a permanent change in a monetary aggregate have an effect on exchange rates in a nation?
A) Permanent rates are mostly set by short-run fluctuations in the rate of interest caused by monetary instability.
B) A permanent change is never quite as permanent as policy makers claim-people form expectations on past performance rather than declarations.
C) The central bank is always aware of the effect on exchange rates as it formulates policy, so it is very careful to make small permanent changes that have no effect on exchange rates.
D) Traders form expectations of future exchange rates based on the anticipated long-run effects of monetary operations.

Accepted Answer

Traders form expectations of future exchange rates based on the anticipated long-run effects of monetary operations. If a central bank makes a permanent change in a monetary aggregate, traders will anticipate its long-run effects on the economy and make adjustments to their expectations of future exchange rates, which could affect the current exchange rate.

Question 8

In 2003, which of the following currencies was used in Iraq?
A) Swiss dinar
B) Saddam (or print) dinar
C) American dinar
D) Swiss dinar and Saddam (or print) dinar

Accepted Answer

In 2003, Iraq used both the Swiss dinar and the Saddam (or print) dinar as its currencies. The Swiss dinar was used in the Kurdish regions in the north, while the Saddam dinar was used in the rest of Iraq.

Question 9

In the short run, the chain of causality between monetary policy and the exchange rate under fixed rates differs from a floating rate. How?
A) In a fixed rate regime, the money supply is determined first, then interest rates, then the short-run exchange rate.
B) In a fixed rate regime, interest rates are determined first, then the money supply, and then the short-run exchange rate.
C) In a floating rate regime, exchange rates are determined first, then the nominal interest rate (according to uncovered interest parity), and then the money supply.
D) In a fixed rate regime, exchange rates are determined first, then the nominal interest rate (according to uncovered interest parity), and then the money supply.

Accepted Answer

The answer of In the short run, the chain of...

Question 10

After the United States dropped an atomic bomb on Japan, what do you expect happened to the yen?
A) The yen appreciated.
B) The yen was unaffected.
C) The yen depreciated.
D) There is no way to predict the effect on the yen.

Accepted Answer

The detonation of an atomic bomb on Japan caused widespread destruction and loss of life, leading to a period of instability and uncertainty. In response, investors may have increased their selling of the yen, causing its value to decline. Therefore, the yen likely depreciated after the atomic bomb was dropped on Japan.

Question 11

Two currencies existed in Iraq before the U.S. invasion and subsequent conflict. What lessons are there for students of exchange rates?
A) Exchange rate values are influenced not only by economic fundamentals but by political events that change long-run expectations of future currency values.
B) Iraq did not back its currency with gold and, therefore, it was worth much less than the U.S. dollar.
C) Eventually each Iraqi sect developed its own currency and payments system.
D) Exchange rate values are solely influenced by economic policy.

Accepted Answer

The existence of two currencies in Iraq before the U.S. invasion and subsequent conflict demonstrates that political events can have a significant impact on exchange rate values, in addition to economic fundamentals.

Question 12

The trilemma refers to all the following, EXCEPT:
A) a fixed exchange rate.
B) international capital mobility.
C) monetary policy autonomy.
D) price controls.

Accepted Answer

The trilemma, also known as the impossible trinity, is a concept in international economics that states a country cannot have all three of the following at the same time: a fixed exchange rate, free international capital flows, and monetary policy independence. Price controls are not related to the trilemma.

Question 13

Which of the following is correct?
A) If a nation changes its money supply, it disrupts the long-run PPP equilibrium, which causes traders to purchase in the cheaper markets and sell in the pricier markets, which, in turn, causes demand for the domestic currency (vis-à-vis the international currency) to be lower.
B) The peg changes the long-run expectation of exchange rates, and this is a determinant of short-run rates which, in turn, affect deposit rates of return.
C) The Federal Reserve has complete control of monetary policy; it is independent of political control, so, in the United States at least, monetary policy can coexist with an exchange rate peg.
D) Pegging its own currency causes a nation to lose political control, and it is then forced to sell its own resources at world prices.

Accepted Answer

If a nation changes its money supply, it disrupts the long-run PPP equilibrium, which causes traders to purchase in the cheaper markets and sell in the pricier markets, which, in turn, causes demand for the domestic currency (vis-à-vis the international currency) to be lower.

Question 14

What are the consequences for a nation that keeps its exchange rate fixed, holds its own domestic interest rates below market to encourage domestic spending, and allows free foreign investment?
A) Foreign investors will not invest, so the only consequence will be a decline in the inflow of foreign investment.
B) Domestic and foreign investors will invest in other nations, causing a sell-off of the domestic currency and, to maintain fixed rates, the central bank will have to buy its own currency, depleting its treasury reserves.
C) There will be upward pressure on the rate of interest as more borrowing occurs, so the central bank will have to increase the stock of money.
D) Interest rates in other nations will also fall as banks and other firms have to compete for international borrowers.

Accepted Answer

By keeping the exchange rate fixed and holding domestic interest rates below market, there will be increased demand for domestic goods and services, leading to higher spending. However, allowing free foreign investment means there will be a high supply of domestic currency in the foreign exchange market, causing the currency to depreciate. This will lead to a sell-off of the domestic currency by both domestic and foreign investors. To maintain the fixed exchange rate, the central bank will have to buy its own currency, depleting its treasury reserves.

Question 15

Which of the following describes the role of the government in a fixed exchange rate regime?
A) establishing capital controls
B) controlling budget deficits
C) the buying and selling of currency by the central bank
D) expanding the money supply

Accepted Answer

In a fixed exchange rate regime, the government plays a key role in maintaining the exchange rate by buying and selling its currency in the foreign exchange market through its central bank. This helps to stabilize the exchange rate at a predetermined level. Establishing capital controls (A) and controlling budget deficits (B) can also help to maintain the fixed exchange rate, but they are not the primary role of the government in such a regime. Expanding the money supply (D) could cause inflation and negatively affect the fixed exchange rate, so it is not a desirable action for the government to take in this situation.

Question 16

A country with a fixed exchange rate faces:
A) no monetary policy constraints in the long run.
B) no monetary policy constraints in the short run.
C) no monetary policy constraints in the long run and the short run.
D) monetary policy constraints in the long run and the short run.

Accepted Answer

A country with a fixed exchange rate has to maintain the exchange rate pegged to a foreign currency. This means that the country's central bank must have enough foreign currency reserves to intervene in the foreign exchange market to buy or sell the domestic currency in order to maintain the exchange rate target. As a result, the central bank is constrained in its ability to pursue independent monetary policies, as it must adjust its domestic interest rates to match those of the country to which its currency is pegged. This constraint applies in both the short and long run, making option D the correct answer.

Question 17

International variables are linked through trade and financial flows. Therefore, what trilemma is faced by a nation that wishes to keep its exchange rates with other nations fixed?
A) It can have fixed exchange rates only when it allows free flows of capital and maintains control of its interest rates.
B) If it wants to control its own monetary policy under fixed exchange rates, then it must restrict foreign investment.
C) Fixed exchange rates are not possible if the nation allows free flows of capital both into and out of the nation.
D) Fixed exchange rates are not possible if the nation also wants to control its monetary policy.

Accepted Answer

The answer of International variables are linked through trade and...

Question 18

Why would lowering its own interest rates affect a nation's exchange rate?
A) International interest arbitrage (the ability to borrow in low-rate markets and deposit in higher-rate markets) would cause investors to sell domestic currency assets and purchase foreign assets based in other currencies.
B) A nation's central bank controls both interest rates and exchange rates. Unfortunately, they do not have sufficient funds to take care of both at the same time.
C) When interest rates fall, borrowing is cheaper, spending and GDP rise and so do exports, thus causing the exchange rate to appreciate.
D) In the short run, exchange rates have to adhere to PPP; otherwise, traders will make profits by purchasing in the cheap market and selling in the more expensive market, thus aligning exchange rates at the proper level.

Accepted Answer

Lowering interest rates in a nation would make its currency less attractive to foreign investors, as they would receive lower returns on their investments. This would lead to a decrease in the demand for the nation's currency, causing its exchange rate to decrease. Additionally, international interest arbitrage would create a situation where investors sell domestic currency assets and purchase foreign assets based in other currencies, further decreasing demand for the nation's currency and lowering its exchange rate.

Question 19

With fixed exchange rates and capital mobility:
A) interest rates in the home country and in foreign countries are equalized.
B) interest rates in the home country are higher.
C) interest rates in foreign countries are higher.
D) monetary policy maintains its autonomy.

Accepted Answer

With fixed exchange rates, interest rate parity holds and interest rates in the home country and foreign countries are equalized. Capital mobility implies that investors can freely move their funds between countries, putting pressure on interest rates to converge. Therefore, the answer is A.

Question 20

During the U.S. Civil War (1861-1865), the Confederate States printed their own currency. Events occurred during the war that affected the exchange value of the Confederate dollars. What evidence was there that supports the theory of long- and short-run exchange rate determination?
A) The Union soldiers burned Confederate dollars at every opportunity, making them more valuable than the Union dollar.
B) The Confederate dollar became worth more as it became clear that the South would lose, because the Confederacy's dollars would become collectibles.
C) The Confederate dollar's value was closely linked to the difference in the deposit rates in southern states' banks.
D) Speculators traded for profit and based their valuation on the long-run expectation of the exchange rate, which tracked closely the probability of a victory for the South.

Accepted Answer

Speculators typically base their valuations on long-run expectations, making D the best choice. Option A is not a strong theoretical explanation for exchange rate determination, as currency values generally reflect broader economic and political factors, not the actions of individual Union soldiers. Option B is more of a collector's item phenomenon rather than an exchange rate perspective. Option C may have had a short-term effect on the value of the Confederate dollar, but it is unlikely to have had a significant long-term impact.

Quiz 15: Exchange Rates II: the Asset Approach in the Short Run

Which of the following explains why a monetary policy in a nation with an exchange rate peg, such as Denmark, would NOT be possible?

If Bulgaria, for instance, wished to keep its exchange rate with the dollar fixed, what monetary policy options are available to lower unemployment in the short run?

If an economy wants to maintain monetary policy autonomy, then:

Comparing the examples of Denmark and the United Kingdom in relationship to the European Monetary Union, the krone is pegged to the euro, whereas the British pound is not. What can be predicted then about their interest rates?

The outcome of the Civil War in the United States was that:

If Japan seeks to control its exchange rates so that ¥100 = $1, which of the following policies should it NOT maintain?

Why would making a permanent change in a monetary aggregate have an effect on exchange rates in a nation?

In 2003, which of the following currencies was used in Iraq?

In the short run, the chain of causality between monetary policy and the exchange rate under fixed rates differs from a floating rate. How?

After the United States dropped an atomic bomb on Japan, what do you expect happened to the yen?

Two currencies existed in Iraq before the U.S. invasion and subsequent conflict. What lessons are there for students of exchange rates?

The trilemma refers to all the following, EXCEPT:

Which of the following is correct?

What are the consequences for a nation that keeps its exchange rate fixed, holds its own domestic interest rates below market to encourage domestic spending, and allows free foreign investment?

Which of the following describes the role of the government in a fixed exchange rate regime?

A country with a fixed exchange rate faces:

International variables are linked through trade and financial flows. Therefore, what trilemma is faced by a nation that wishes to keep its exchange rates with other nations fixed?

Why would lowering its own interest rates affect a nation's exchange rate?

With fixed exchange rates and capital mobility:

During the U.S. Civil War (1861-1865) , the Confederate States printed their own currency. Events occurred during the war that affected the exchange value of the Confederate dollars. What evidence was there that supports the theory of long- and short-run exchange rate determination?