A. Multiple choice questions
1. Arbitrage is:
A) capital controls.
B) interest rate management by the central bank.
C) exploiting profit opportunities in the market resulting from price differences.
D) investing in junk bonds or businesses that are not ethical.
2. Suppose $1 = 10.5 pesos in New York and $1 = 9.6 pesos in Mexico City. If you had $10,000 using arbitrage, your profits would be:
A) $937.50.
B) 937 pesos.
C) 9600 pesos.
D) $790.
3. An exchange rate crisis is:
A) when the currency is stable.
B) when the value of a currency declines dramatically.
C) when the value of a currency increases dramatically.
D) when a country fixes the price of its currency.
4. From uncovered interest parity, we know that when the domestic interest rate is greater than the foreign one:
A) the domestic currency is expected to appreciate.
B) the domestic currency is expected to depreciate.
C) the foreign currency is expected to appreciate.
D) the foreign currency is expected to depreciate.
5. If an automobile costs $32,000 in New York and $1 = 0.8 euros, then under the condition of the law of one price, the cost of the automobile in Rome should be:
A) 32,000 euros.
B) 40,000 euros.
C) 35,000 euros.
D) 25,600 euros.
6. In equilibrium, with purchasing power parity, the nominal exchange rate will be equal to:
A) the two nations' real exchange rate.
B) the ratio of the two nations' GDPs.
C) the ratio of the two nations' price levels.
D) 1.
7. Which of the following situations would exhibit relative PPP?
A) Europe's yearly inflation rate rises from 5% to 7%, ceteris paribus, and the euroyen rate depreciates by 7%.
B) Europe's yearly inflation rate rises from 5% to 7%, ceteris paribus, and the euroyen rate depreciates by 2%.
C) Europe's yearly inflation rate rises from 5% to 7%, ceteris paribus, and the euroyen rate appreciates by 2%.
D) Europe's yearly inflation rate rises from 5% to 7%, ceteris paribus, and the euroyen rate appreciates by 5%.
8. If the real exchange rate for a foreign currency rises (a real depreciation), what is the situation?
A) It takes more home goods to purchase the same quantity of foreign goods.
B) It takes fewer home goods to purchase the same quantity of foreign goods.
C) The nominal exchange rate has risen as well.
D) The nominal exchange rate has fallen.
9. If there is an increase in the money supply in the United States, using the monetary model of the exchange rate, one would predict that the U.S. dollar would:
A) become stronger.
B) appreciate in the short run, but not in the long run.
C) depreciate.
D) depreciate in the short run, but not in the long run.
10. The trilemma refers to all the following except:
A) a fixed exchange rate.
B) international capital mobility.
C) monetary policy autonomy.
D) price controls.
11. When traders perceive a permanent money supply adjustment, long-term nominal interest rates ___ affected, the expected exchange rate ____ affected, and the spot exchange rate _____ affected.
A) are not; is; is
B) are; is; is not
C) are not; is not; is not
D) are; is not; is
12. When an increase in the quantity of money is considered to be permanent and prices are sticky, then in the short run the exchange rate depreciates and overshoots because:
A) domestic nominal returns fall relative to foreign returns, and traders expect a permanent depreciation in future exchange rates.
B) traders do not change their expectations of the exchange rate, and lower domestic rates make it easier to borrow.
C) inflationary expectations eventually cause a rise in domestic real returns.
D) traders quickly realize that their expectations of future exchange rates are incorrect, and that eventually prices will become unstuck.
13. Which of the following statements is NOT a reason for explaining the deviations from PPP?
A) Some goods are not tradeable.
B) Markets are imperfect and there could be legal obstacles.
C) Prices can be sticky in different countries.
D) There are no transportation costs.
14. If all else is equal, a nation with greater income will have:
A) lower prices.
B) higher prices.
C) lower money supply.
D) higher prices and higher money supply.
15. The Fisher effect creates a link between _____ and ______.
A) expected profits; unemployment rates
B) exchange rates; expected profits
C) inflation rates; unemployment rates
D) inflation rates; interest rates
B. Short answer questions:
1. Nations adopt a wide variety of exchange rate regimes, from freely floating with almost no intervention, to rigid and fixed with complete control by the government. Discuss two such systems and comment on their differences.
2. Apply the asset approach and monetary approach of exchange rate behaviors to fixed regimes and discuss the macroeconomic implications of fixing exchange rates.
3. If PPP and uncovered interest parity hold, then the long-run real rate of interest in each nation will equalize. Explain.
C. Answer the following questions
1. How would a permanent increase in the money supply in Japan affect the yen/euro exchange rate and the Japan interest rate in the short run? Illustrate your answer graphically and explain.
2. In 1992, several European countries had their individual currencies pegged to the ECU (a precursor to the euro) in anticipation of forming a common currency area. In practice, this meant that countries were pegged to the German deutschmark (DM).
This question considers how different countries responded to the European Exchange Rate Mechanism (ERM) Crisis. For the following questions, you need only consider short-run effects. Also, treat Germany as the foreign country.
a. Following the economic consequences of German reunification in 1990, the Bundesbank (Germany's central bank) raised its interest rate. On September 14, 1992, Great Britain decided to float the British pound (£) against the DM. Using the FX and money market and treating Britain as the home country, illustrate the effects of Germany increasing its interest rate on E£/DM.
b. After Britain abandoned the ERM (e.g., allowed its currency to float against the DM), investors grew concerned that France would no longer be able to maintain its currency peg. The Banquede France (France's central bank) wanted to keep its currency (French franc, FF) pegged to the DM. Using the FX and money market and treating France as the home country, illustrate the effects of Germany increasing its interest rate on EFF/DM, assuming the currency peg is maintained.
c. Denmark had a similar experience to that of Britain and France. Suppose Denmark's prime minister approaches you about how to respond. He doesn't want to give up monetary policy autonomy, but wants to maintain the exchange rate peg. Is this possible? Explain why or why not.
3. This question considers long-run policies in Turkey relative to its largest trading partner: Europe. Assume the demand for real money balances is strictly proportional to real income (refer to the money supply target) then we know, μ - g = π. Assume Turkey's money growth rate (μ) is currently 15% and Turkey's output growth (g) is 9%. Europe's money growth rate is 4% and its output growth is 3%. Use the monetary approach. Treat Turkey as the home country and define the exchange rate as Turkish lira per euro, EL/€.
a. Calculate the inflation rate in Turkey.
b. Calculate the inflation rate in Europe.
c. Calculate the expected rate of depreciation in the Turkish lira relative to the euro.
d. Suppose the Central Bank of the Republic of Turkey decreases the money growth rate from 15% to 11%. If nothing in Europe changes, what is the new inflation rate in Turkey?
e. Illustrate how the change in (d) affects the following variables: Mt, Pt, real money supply, and EL/€ over time.