Chapter 10 – The Determination of Exchange Rates

 

Multiple Choice Questions

 

WHAT IS THE INTERNATIONAL MONETARY FUND (IMF)?  WHAT ARE ITS OBJECTIVES?

 

1.      Which of the following was organized to promote exchange-rate stability and facilitate the international flow of currencies?

a.      the International Monetary Fund (moderate, page 291)

b.      the World Bank

c.       the Federal Reserve

d.      the Ministry of Finance

 

2.      Which of the following is NOT a major objective of the International Monetary Fund?

a.       to facilitate the expansion and balanced growth of international trade

b.      to regulate inflation rates among under developed countries (moderate, page 291)

c.       to promote exchange-rate stability

d.      to establish a multilateral system of payments

 

3.      A(n) _______________ is the sum of the total assessment to each country, which becomes a pool of money that the IMF can draw on to lend to other countries.

a.       World Trade Quota

b.      Soft Quota

c.       IMF Quota (moderate, page 291)

d.      Hard Quota

 

4.      The _______________ lends money to countries to help ease balance of payments difficulties.

a.       United Nations

b.      World Bank

c.       Federal Reserve

d.      International Monetary Fund (moderate, page 291)

 

WHAT IS A SPECIAL DRAWING RIGHT (SDR)?  HOW IS IT USED?

 

5.      Which of the following is an international reserve asset given to each country to help increase their reserves?

a.      the special drawing right (moderate, page 292)

b.      the  balance of payment

c.       the quota

d.      the exchange rate

 

6.      ______________ is the unit of account in which the IMF keeps its financial records.

a.       The IMF dollar

b.      The Special Drawing Right (moderate, page 292)

c.       The Quota

d.      The Exchange Rate

 

7.      The IMF’s system was initially based on which of the following types of exchange rates?

a.       floating

b.      smooth

c.       fixed (moderate, page 292)

d.      weak


 

LIST AND DEFINE THE CATEGORIES OF EXCHANGE RATE REGIMES.

 

8.      Which of the following best describes the following exchange-rate regime? “The currency of another country circulates as the sole legal tender or the member belongs to a monetary or currency union in which the members of the union share the same legal tender.”

a.       currency board arrangements

b.      pegged exchange rates within horizontal bands

c.       crawling pegs

d.      exchange arrangements with no separate legal tender (difficult, page 294)

 

9.      A monetary regime based on an implicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation is best described as:

a.      currency board arrangements. (difficult, page 294)

b.      exchange arrangements with no separate legal tender.

c.       pegged exchange rates within horizontal bands.

d.      independent floating.

 

10.    Which of the following best describes the following exchange-rate regime? “The value of the currency is maintained within margins of fluctuation around a formal or de factor fixed peg that are wider than +/- 1% around a central rate.”

a.       exchange arrangements with no separate legal tender

b.      pegged exchange rates within horizontal bands (difficult, page 294)

c.       currency board arrangements

d.      crawling pegs

 

11.    In which of the following types of exchange-rate regimes is the currency adjusted periodically in small amounts at a fixed, preannounced rate or in response to changes in selective quantitative indicators?

a.       exchange arrangements with no separate legal tender

b.      currency board arrangements

c.       crawling pegs (moderate, page 294)

d.      pegged exchange rates within horizontal bands

 

WHAT IS A BLACK MARKET?

 

12.    A _______________ closely approximates a price based on supply and demand for a currency instead of a government-controlled price.

a.       gold market

b.      fixed market

c.       crawling peg market

d.      black market (easy, page 295)

 

13.    Which of the following is likely to exist when people are willing to pay more for dollars than the official rate?

a.       gray market

b.      black market (easy, page 295)

c.       gold market

d.      crawling peg market


 

14.    Which of the following statements regarding a “black market” is FALSE?

a.       A black market exists when people are willing to pay more for a hard foreign currency than the official rate.

b.     The more flexible a country’s exchange-rate arrangement, the more there will be a thriving black market.  (difficult, page 295)

c.       The movement to floating rates eliminates the need for a black market.

d.      A black market parallels the official market in many countries that control their currencies fairly rigidly.

 

WHAT IS THE ROLE OF CENTRAL BANKS?  HOW DO THEY CARRY OUT THIS ROLE?

 

15.    Which of the following is the central bank of the United States?

a.       the Federal Reserve Bank of California

b.      the Federal Reserve Bank of Washington

c.       the Federal Reserve Bank of New York (moderate, page 295)

d.      the Federal Reserve Bank of Chicago

 

16.    The Fed will sell dollars in exchange for foreign currency if the goal is to do which of the following?

a.       counter downward pressure of the dollar

b.      counter lateral pressure of the dollar

c.       increase counter upward pressure of the dollar (moderate, page 295)

d.      increase the demand for the dollar

 

17.    The Fed will purchase dollars through the sale of foreign currency if which of the following is the goal?

a.      counter downward pressure of the dollar (moderate, page 295)

b.      counter upward pressure of the dollar

c.       counter lateral pressure of the dollar

d.      decrease the demand for the dollar

 

18.    Which of the following central banks serves as fiscal agent in the United States for foreign central banks and official international financial organizations?

a.       the Federal Reserve Bank of California

b.      the Federal Reserve Bank of New York (moderate, page 295)

c.       the Federal Reserve Bank of Washington

d.      the Federal Reserve Bank of Chicago

 

IN WHAT FORMS DO CENTRAL BANKS HOLD THEIR ASSETS?

 

19.    Which of the following is NOT one of the three major forms of central bank reserve assets?

a.       gold

b.      foreign-exchange

c.       IMF-related assets

d.      silver (moderate, page 296)

 

20.    The _______________ is the most widely used currency as a central bank reserve asset, with 68.3% of the total in 2001.

a.       euro

b.      Japanese yen

c.       British pound

d.      U.S. dollar (moderate, page 296)


 

21.    _______________ tend(s) to be more heavily weighted toward gold as a reserve asset than other countries in the world, even though they have more foreign exchange than gold as reserve assets.

a.      European countries (moderate, page 296)

b.      The United States

c.       Asian countries

d.      Latin American countries

 

HOW DOES A FLOATING EXCHANGE RATE SYSTEM WORK?

 

22.    Which of the following best describes the type of currencies that respond to supply-and-demand conditions free from government intervention?

a.       currencies that are pegged to stronger currencies

b.      currencies that float freely (moderate, page 299)

c.       currencies that are pegged to weaker currencies

d.      currencies that are fixed to treasury bills

 

23.    A strengthening of the Japanese yen would result in which of the following outcomes?

a.       unemployment in Japanese import industries

b.      higher employment in Japanese import industries

c.       unemployment in Japanese export industries (moderate, page 299)

d.      higher employment in Japanese export industries

 

HOW DOES A GOVERNMENT MAINTAIN A CURRENCY VALUE IN A MANAGED FIXED RATE SYSTEM?

 

24.    When a country adjusts its currency’s value, which of the following types of exchange rates will seek the correct level according to the laws of supply and demand?

a.       currency that is pegged to another currency

b.      currency that is pegged to a basket of currencies

c.       fixed currency

d.      free floating currency (difficult, page 300)

 

25.    A strengthening of U.S. interest rates relative to Japanese interest rates would result in a:

a.      strengthening of the dollar and a weakening of the yen. (moderate, page 300).

b.      strengthening of the yen and weakening of the dollar.

c.       strengthening of the Mexican peso in comparison to the Japanese yen.

d.      strengthening of the Japanese yen in comparison to the Mexican peso.

 

26.     A drop in U.S. interest rates relative to European interest rates would result in a:

a.       strengthening of the dollar and weakening of the euro.

b.      a weakening of the dollar and a strengthening of the euro. (moderate, page 300).

c.       no change in the dollar or the euro.

d.      a weakening of both the dollar and the euro.

 

27.    A change in exchange rate for a freely fluctuating currency is more a function of which of the following?

a.      supply and demand of the currency in the foreign-exchange market (difficult, page 300)

b.      supply and demand of the currency in the domestic money market

c.       supply and demand of SDRs in the IMF

d.      supply and demand of quotas in the IMF


 

28.    If the domestic inflation rate is lower than that in the foreign country, which of the following is TRUE?

a.       The domestic currency should be weaker than that of a foreign country.

b.      The domestic currency should be stronger than that of a foreign country. (difficult, page 300)

c.       Taxes will be higher in the domestic country than in the foreign country.

d.      Taxes will be lower in the foreign country than in the domestic country.

 

EXPLAIN HOW INFLATION AFFECTS CURRENCY VALUES ACCORDING TO THE PURCHASING-POWER PARITY (PPP).

 

29.    Which of the following is a well-known theory based on relative inflation that seeks to define relationships between currencies?

a.       the Fisher Effect

b.      the International Fisher Effect

c.       purchasing-power parity (moderate, page 301)

d.      foreign exchange parity

 

30.    _______________ means a comparison of the countries’ rates of inflation.

a.       The International Fisher Effect

b.      Currency-power parity

c.       Foreign exchange parity

d.      Relative Inflation (moderate, page 301)

 

31.    Which of the following theories would best describe the following example? “If Japanese inflation were 2% and U.S. inflation were 3.5%, the dollar would be expected to fall by the difference in inflation rates.”

a.      purchasing-power parity (moderate, page 301)

b.      the Fisher Effect

c.       the International Fisher Effect

d.      foreign exchange parity

 

WHAT IS THE BIG MAC INDEX, AND WHAT ARE ITS LIMITATIONS?

 

32.    Which of the following is also known as “McParity”?

a.       the Fisher Effect

b.      the Big Mac index (easy, page 301)

c.       the International Fisher Effect

d.      foreign exchange parity

 

33.       The Big Mac index is an attempt to describe exchange rate differences based on:

a.       differences in relative prices. (moderate, page 301)

b.      differences in interest rates.

c.       differences in the cost of production inputs.

d.      none of the above

 

34.    All of the following describe short-run problems that affect purchasing power parity EXCEPT:

a.      Prices of the Big Mac in different countries are distorted by taxes.

b.     The Big Mac is not just a basket of commodities; its price also includes nontraded costs such as rent and insurance.

c.      PPP assumes that a country’s government is democratic. (difficult, page 301)

d.     Profit margins vary by the strength of the competition.


 

35.    The _______________ is the real interest rate plus inflation.

a.       lateral interest rate

b.      exotic interest rate

c.       global interest rate

d.      nominal interest rate (moderate, page 301)

 

36.    Because the real interest rate should be the same in every country, which of the following is TRUE?

a.      The country with the higher interest rate should have higher inflation. (moderate, page 301)

b.      The country with the higher interest rate should have lower inflation.

c.       The country with the higher interest rate should have lower taxes.

d.      The country with the higher interest rate should have higher taxes.

 

WHAT IS THE RELATIONSHIP BETWEEN THE FISHER EFFECT AND THE INTERNATIONAL FISHER EFFECT IN TERMS OF CURRENCY VALUES?

 

37.    Which of the following best describes the theory that the nominal interest rate in a country is determined by the real interest rate?

a.       the “Big Mac” Effect

b.      the Fisher Effect (moderate, page 303)

c.       purchasing-power parity

d.      foreign exchange parity

 

38.    The theory that the interest-rate differential is an unbiased predictor of future changes in the spot exchange rate is called the:

a.       “Big Mac” Effect.

b.      purchasing-power parity.

c.       International Fisher Effect. (moderate, page 303)

d.      foreign exchange parity.

 

39.    _______________ implies that the currency of the country with the lower interest rate, and therefore the lower inflation, will strengthen in the future.

a.       The “Big Mac” Effect

b.      Purchasing-power parity

c.       Foreign exchange parity

d.      The International Fisher Effect (moderate, page 303)

 

40.    According to which of the following theories would the country with the higher inflation have the weaker currency and the country with the higher interest rate should have the weaker currency?

a.      the International Fisher Effect (moderate, page 303)

b.      the “Big Mac” Effect

c.       purchasing-power parity

d.      foreign exchange parity

 

WHAT IS THE DIFFERENCE BETWEEN FUNDAMENTAL FORECASTING AND TECHNICAL FORECASTING OF EXCHANGE RATES?

 

41.    _______________ forecasting uses trends in economic variables to predict future exchange rates.

a.       Technical

b.      Fundamental (moderate, page 304)

c.       Exponential

d.      Multidimensional


 

42.    Which of the following types of forecasting uses past trends in exchange-rate movement to spot future trends?

a.       fundamental

b.      exponential

c.       technical (moderate, page 304)

d.      multidimensional

 

43.    Managers can forecast exchange rates by using which of the following two approaches?

a.       fundamental or exponential forecasting

b.      fundamental or multidimensional

c.       multidimensional or cultural

d.      fundamental or technical (moderate, page 304)

 

WHAT FACTORS SHOULD BE MONITORED WHEN PREDICTING EXCHANGE-RATE MOVEMENTS?

 

44.    All of the following are biases that can skew forecasts EXCEPT:

a.       focusing on a particular subset of information at the expense of the overall set of information

b.      insufficient adjustment for subjective matters, such as market volatility

c.       overconfidence in one’s ability to forecast currencies accurately

d.      cultural background of the forecaster (moderate, page 306)

 

45.    _______________ include(s) predicting the timing, direction, and magnitude of an exchange-rate change.

a.      Forecasting (moderate, page 306)

b.      Environmental scanning

c.       Cross rates

d.      The Fisher Effect

 

46.    All of the following are factors managers can monitor in order to try to predict values EXCEPT:

a.       the institutional setting

b.      cultural factors (moderate, page 306)

c.       fundamental analysis

d.      confidence factors

 

WHY DO WE NEED TO BOTHER WITH PREDICTING EXCHANGE-RATE CHANGES?

 

47.    A strengthening of a country’s currency value could do which of the following?

a.       create problems for importers

b.      be beneficial for exporters

c.       create problems for exporters (moderate, page 306)

d.      raise the tax rate

 

48.    Companies might locate production in a weak currency country because of which of the following?

a.       Government subsidies are a main source of investment.

b.      Inflation rate is low.

c.       Tax rate is low.

d.      Initial investment is relatively cheap. (moderate, page 306)

 

49.    Exchange rates can affect financial decisions is all of the following areas EXCEPT:

a.      increasing productivity among workers (moderate, page 306)

b.      sourcing financial resources

c.       remittance of funds across national borders

d.      reporting of financial results

 

Essay Questions

 

50.    What is the International Monetary Fund (IMF)?  What are its objectives?

 

         Answer

In 1944, toward the close of World War II, the major allied governments met in Bretton Woods, New Hampshire, to determine what was needed to bring economic stability and growth to the postwar world. Twenty-nine countries initially signed the IMF agreement. There were 192 member countries at the end of 1999. The IMF’s major objectives are:

a.       to promote international monetary cooperation.

b.      to facilitate the expansion and balanced growth of international trade.

c.       to promote exchange-rate stability.

d.      to establish a multilateral system of payments.

e.       to make its resources available to its members experiencing balance of payment difficulties.

(moderate, page 291)

 

51.    What is a Special Drawing Right (SDR)?  How is it used?

 

         Answer

The Special Drawing Right is an international reserve asset created to supplement members’ existing reserve assets (official holdings of gold, foreign exchange, and reserve positions in the IMF). SDRs serve as the IMF’s unit of account and are used for IMF transactions and operations. The value of the SDR is based on the weighted average of five currencies. On January 1, 1981, the IMF began to use a simplified basket of five currencies for determining valuation. At the end of 1999, the U.S. dollar made up 39% of the value of the SDR; the euro (Germany), 21 percent; the Japanese yen, 18 percent; and the euro (France) and the British pound, 11 percent each. The weights were chosen because they broadly reflected the importance of the particular currency in international trade and payments. Unless the Executive Board decides otherwise, the weights of each currency in the valuation basket change every five years. Although the SDR was intended to serve as a substitute for gold, it has not taken over the role of gold or the dollar as a primary reserve asset.

(difficult, page 292)

 

52.    List and define the categories of exchange rate regimes.

 

         Answer

a.      Exchange arrangements with no separate legal tender—The currency of another country circulates as the sole legal tender or the member belongs to a monetary or currency union in which the members of the union share the same legal tender. An example would be the countries in the euro area.

b.     Currency board arrangements—A monetary regime based on an implicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation. Two examples would be Argentina and Hong Kong.

c.      Other conventional peg arrangements—The country pegs its currency (formal or de facto) at a fixed rate to a major currency or a basket of currencies where the exchange rate fluctuates within a narrow margin of at most +/- 1% around a central rate. For example, China pegs it currency to the U.S. dollar.

d.     Pegged exchange rates within horizontal bands—The value of the currency is maintained within margins of fluctuation around a formal or de facto fixed peg that are wider than +/- 1% around a central rate. Many countries that used to be considered managed floating are in this category because they basically peg their currency to something else.

e.      Crawling pegs—The currency is adjusted periodically in small amounts at a fixed, preannounced rate or in response to changes in selective quantitative indicators. Costa Rica and Turkey are two examples.

f.      Exchange rates within crawling bands—The currency is maintained within certain fluctuation margins around a central rate that is adjusted periodically at a fixed preannounced rate or in response to changes in selective quantitative indicators. Hungary, Poland, and Chile are three examples.

g.      Managed floating with no preannounced path for the exchange rate—The monetary authority influences the movements of the exchange rate through active intervention in the foreign exchange market without specifying, or precommitting to, a preannounced path for the exchange rate. The Czech Republic is an example.

h.     Independent floating—The exchange rate is market determined, with any foreign intervention aimed at moderating the rate of change and preventing undue fluctuations in the exchange rate, rather than at establishing a level for it. Canada, the United States, and Mexico are three examples of countries in this category.

(difficult, page 294)

 

53.    What is a black market?

 

         Answer

Of the 186 IMF member countries, 92 have currencies that are reasonably flexible, 40 of which float independently. Many of the others control their currencies fairly rigidly. In many of these countries, a black market parallels the official market and is aligned more closely with the forces of supply and demand than is the official market. The less flexible a country’s exchange-rate arrangement, the more there will be a thriving black market. A black market exists when people are willing to pay more for dollars than the official rate.  The movement of floating regimes eliminates the need for a black market.

(moderate, page 295)

 

54.    In a short essay, discuss the role of the Federal Reserve Bank of New York and the European Central Bank.

 

         Answer

The central bank in the United States is the Federal Reserve System (the Fed), a system of 12 regional banks. The New York Fed, representing the Federal Reserve System and the U.S. Treasury, is responsible for intervening in foreign exchange markets to achieve dollar exchange-rate policy objectives and to counter disorderly conditions in foreign exchange markets. It makes such transactions in close coordination with the U.S. Treasury and Board of Governors of the Fed, and most often coordinates with the foreign exchange operations of other central banks. The Federal Reserve Bank of New York serves as fiscal agent in the United States for foreign central banks and official international financial organizations. It acts as the primary contact with other foreign central banks.

 

In the European Union, the European Central Bank coordinates the activities of each member country’s Central Bank to establish a common monetary policy in Europe, much as the Federal Reserve Bank does in the United States. Central bank reserve assets are kept in three major forms: gold, foreign-exchange reserves, and IMF-related assets.

(easy, page 295)

 

55.    In a short essay, discuss purchasing-power parity (PPP) and the short-run problems that affect PPP.

 

         Answer

Purchasing-power parity (PPP) is a well-known theory that seeks to define relationships between currencies. It claims that a change in relative inflation between two countries must cause a change in exchange rates to keep the prices of goods in two countries fairly similar. According to the PPP theory, if for example, Japanese inflation were 2% and U.S. inflation were 3.5%, the dollar would be expected to fall by the difference in inflation rates. Then the dollar would be worth fewer yen than before the adjustment, and the yen would be worth more dollars than before the adjustment.

 

The short-run problems that affect PPP include:

a.      the theory of PPP falsely assumes that there are no barriers to trade and that transportation costs are zero.

b.     the prices of the Big Mac in different countries are distorted by taxes.

c.      the Big Mac is not just a basket of commodities; its price includes nontraded costs such as rent, insurance, etc.

d.     Profit margins vary by the strength of competition. The higher the competition, the lower the profit margin and therefore the price.

(difficult, page 301)

 

56.    In a short essay, explain the International Fisher Effect.

 

         Answer

The International Fisher Effect is the theory that the interest-rate differential is an unbiased predictor of future changes in the spot exchange rate. For example, if the International Fisher Effect predicts that nominal interest rates in the United States are higher than those in Japan, the dollar’s value should fall in the future by that interest-rate differential, which would be an indication of a weakening, or depreciation, of the dollar. That is because the interest rate differential is based on differences in inflation rates. According to the theory of purchasing-power parity, the country with the higher inflation should have the weaker currency. Thus, the country with the higher interest rate (and the higher inflation) should have the weaker currency. During periods of general price stability, a country that raises its interest rates is likely to attract capital and see its currency rise in value due to the increased demand. However, if the reason for the increase in interest rates is because inflation is higher than that of its major trading partners and the country’s central bank is trying to reduce inflation, the currency will eventually weaken until inflation cools down.

(moderate, page 303)

 

57.    In a short essay, compare fundamental and technical forecasting.

 

         Answer

Fundamental forecasting uses trends in economic variables to predict future rates. The data can be plugged into an econometric model or evaluated on a more subjective basis. Technical forecasting uses past trends in exchange rates themselves to spot future trends in rates. Technical forecasters, or chartists, assume that if current exchange rates reflect all facts in the market, then under similar circumstances future rates will follow the same patterns.

(moderate, page 304)

 

58.    In a short essay, list the various factors governments follow in an attempt to predict market value. Include in your answer the types of questions that would apply to each factor.

 

         Answer

a.      The institutional setting—Does the currency float, or is it managed—and if so, is it pegged to another currency, basket, or other standard? What are the intervention practices? Are the credible, sustainable?

b.     Fundamental analysis—Does the currency appear undervalued or overvalued in terms of PPP, balance of payments, foreign exchange reserves, or other factors? What is the cyclical situation, in terms of employment, growth, savings, investment, and inflation? What are the prospects for government monetary, fiscal, and debt policy?

c.      Confidence factors—What are market views and expectations with respect to the political environment and the credibility of the government and central bank?

d.     Events—Are their national or international incidents in the news; possibly of crises or emergencies; governmental or other important meetings coming up?

e.       Technical analysis—What trends do the charts show? Are there signs of trend reversals? At what rates do there appear to be important buy and sell orders? Are they balanced? Is the market overbought, oversold? What are the thinking and expectations of other market players and analysts?

(moderate, page 306)


 

59.    In a short essay, discuss how exchange-rate changes can affect companies’ marketing, production, and financial decisions.

 

         Answer

a.      Marketing decisions—Marketing managers watch exchange rates because they can affect demand for a company’s product at home and abroad.

b.     Production decisions—Exchange-rate changes affect production decisions. For example, a manufacturer in a country where wages and operating expenses are high might be tempted to locate production in a country with a currency that is rapidly losing value. The company’s currency would buy a significant amount of the weak currency, making the company’s initial investment cheap. Furthermore, goods manufactured in that country would be relatively cheap in world markets.

c.      Financial decisions—Exchange rates can affect financial decisions, primarily in the areas of sourcing of financial resources, remittance of funds across national borders, and reporting of financial results. In the first area, a company might be tempted to borrow money where interest rates are lowest. In deciding about cross-border financial flows, a company would want to convert local currency into its home-country currency when exchange rates are most favorable so that it can maximize its return. However, countries with weak currencies often have currency controls, making it difficult for MNEs to do so. Finally, exchange-rate changes can influence the reporting of financial results.

(easy, page 306)