Deck 15: Exchange Rates, Interest Rates, and Interest Parity

Question 1

What approach assumes that assets are imperfect substitutes internationally because investors perceive foreign exchange risk to be attached to foreign assets?

A) Balance of payments approach
B) Equilibrium approach
C) Portfolio-balance approach
D) Trade balance approach

Answer 1

Portfolio-balance approach

Question 2

In general, the basic Monetary Approach to Exchange Rate MAER) does not capture the short run volatility of:

A) Prices
B) Money supply
C) Exchange rates
D) Foreign currency inflation

Answer 2

Exchange rates

Question 3

If the portfolio balance approach is true then which of the following will directly lead to changes in the exchange rate?

A) A monetary policy announcement
B) A fiscal policy announcement
C) A shift in the demand for foreign bonds
D) A shift in the relative cost of a substitute currency

Answer 3

A shift in the demand for foreign bonds

Question 4

According to the general equilibrium approach of open-economy macroeconomic model, if South Korea had a significant technological progress in the past decade, which allowed them to produce more goods at much lower prices than the rest of the world, then we would expect the Korean won to __________.

A) appreciate
B) depreciate
C) stay the same
D) None of the above is correct, since productivity has nothing to do with exchange rate.

Question 5

The following example supports which extension to the Monetary Approach to Exchange rates: The chairman of a central bank announces a new monetary policy. Immediately, there is a change in the exchange rate.

A) News approach
B) Trade balance approach
C) Equilibrium approach
D) Overshooting approach

Question 6

If a country has a trade surplus, the domestic holdings of foreign currency will tend to _______ and the foreign currency will _______.

A) decrease; depreciate
B) decrease; appreciate
C) increase; depreciate
D) increase; appreciate

Question 7

___________ assumes that domestic and foreign bonds are imperfect substitutes.

A) The monetary approach to exchange rate
B) The portfolio-balance approach
C) The currency substitution approach
D) The overshooting theory

Question 8

The following example supports which extension to the Monetary Approach to Exchange rates: Suppose the money supply increases. The initial change of the spot price exceeds that of its long-run value.

A) General equilibrium approach
B) Trade balance approach
C) Overshooting approach
D) Currency substitution approach

Question 9

According to the _______, high exchange rate volatility is explained by the failure of PPP to hold in the short run.

A) Overshooting approach
B) News approach
C) Portfolio-balance approach
D) Trade balance approach

Question 10

Which of the following is correct about the 'news' approach to exchange rate determination?

A) Government must control the news to prevent excessive exchange rate volatilities.
B) News reduces the information costs and thus stabilizes the exchange rate movements.
C) News make people act irrationally.
D) News affects people's expectations about the future, causing high swings in exchange rates.

Question 11

If people expect the domestic currency to depreciate against foreign currency in the near future, they will immediately shift from _______ currency to ______ currency, causing an immediate _________ of the foreign currency.

A) domestic; foreign; appreciation
B) domestic; foreign; depreciation
C) foreign; domestic; appreciation
D) foreign; domestic; depreciation

Question 12

The following example supports which extension to the Monetary Approach to Exchange rates: Due to changes in the pricing of risk premiums, investors adjust holdings of foreign assets causing an appreciation of domestic currency.

A) Portfolio balance approach
B) Trade balance approach
C) Overshooting approach
D) Currency substitution approach

Question 13

If the currency substitution approach is true, then a change to domestic money supply that causes currency depreciation could mean:

A) Further depreciation as individuals switch the substitute currency.
B) Central banks must intervene to maintain the fixed exchange rate of substitute currencies.
C) The decline in money supply will offset any depreciation.
D) The increase in money supply will cause further depreciation.

Question 14

According to the ________, if the cost of holding one currency rises relative to the cost of holding another, then demand will shift to the lower relative cost currency.

A) Overshooting approach
B) Currency substitution approach
C) Portfolio-balance approach
D) Trade balance approach

Question 15

The following example supports which extension to the Monetary Approach to Exchange rates: Due to a sudden increase in American productivity, the U.S. dollar depreciated.

A) General equilibrium approach
B) Trade balance approach
C) Overshooting approach
D) Currency substitution approach

Question 16

When a high degree of currency substitution exists, in order to prevent currencies from becoming too variable:

A) Central banks must not intervene.
B) Countries need international coordination of monetary policy.
C) Fixed currency rates must be adopted.
D) Exchange markets must be temporarily closed.

Question 17

The following example supports which extension to the Monetary Approach to Exchange rates: The announcement of a new trade deal between South Korea and Japan, lead investors to predict that Japan may be a path to a trade deficit. Thus, the Japanese yen saw an immediate decline in value.

A) Portfolio balance approach
B) Trade balance approach
C) News approach
D) Currency substitution approach

Question 18

According to the ________, the current exchange rate is affected by changes in expectation about future trade flow.

A) Overshooting approach
B) News approach
C) Portfolio-balance approach
D) Trade balance approach

Question 19

In the ________, changes in exchange rates occur because of changes in tastes or technology and are part of the adjustment to a shock to the world economy.

A) Balance of payments approach
B) Equilibrium approach
C) News approach
D) Exchange rate approach

Question 20

The following example supports which extension to the Monetary Approach to Exchange rates: The cost of holding a U.S. dollar rises relative to the cost of holding U.K. Pounds. The demand shifts away from dollars to Pounds.

A) General equilibrium approach
B) Trade balance approach
C) Overshooting approach
D) Currency substitution approach

Question 21

Since news is unexpected and catches people off-guard,

A) it is easy to forecast the future exchange rate.
B) it causes exchange rates to fluctuate substantially.
C) it causes prices of goods and services to vary more than exchange rates.
D) it has no effect on exchange rates.

Question 22

When a high degree of currency substitution exists, to prevent currencies from becoming too variable, countries need international coordination of monetary policy.

Question 23

The Theory of Exchange Rate Overshooting explains high exchange rate volatility by assuming that ________ does not hold in the ________, but ________ does.

A) PPP, short run, CIRP
B) CIRP, short run, PPP
C) PPP, long run, CIRP
D) CIRP, long run, PPP

Question 24

Which of the following is NOT a factor that causes substantial exchange rate volatility?

A) Unexpected news
B) Changes in expectations about future trade flows
C) Instantaneous adjustments by goods and services prices to shocks.
D) Instantaneous reactions by financial assets markets to shocks

Question 25

Assume that two Caribbean countries announce that they will be coordinating monetary policy. This is because their currencies are considered:

A) Substitutes
B) Compliments
C) Inferior
D) Vulnerable

Question 26

Exchange rates appear to be more volatile than the monetary approach would predict, because:

A) the monetary approach holds better in the short run than in the long run.
B) prices of goods and services adjust instantaneously, while prices of assets are sluggish.
C) prices of goods and services are sluggish to adjust, while prices of assets adjust instantaneously.
D) the monetary approach is based on many unrealistic assumptions so that it fails to predict exchange rates in both short run and long run.

Question 27

The Portfolio-Balance Approach assumes:

A) imperfect capital mobility
B) perfectly elastic demand for foreign bonds
C) interest rate equalization across countries
D) imperfect substitution between domestic and foreign bonds

Question 28

The Theory of Exchange Rate Overshooting explains high exchange rate volatility by assuming that CIRP does not hold in the short run, but PPP does.

Question 29

When citizens anticipate a country to experience trade deficits in the near future, the domestic currency would:

A) Appreciate immediately
B) Appreciate only in the future
C) Depreciate immediately
D) Depreciate only in the future

Question 30

Use the Portfolio-Balance Approach to answer this question. Other things remaining constant, if the supply of foreign bonds increases, what would happen to the domestic currency?

A) The domestic currency would appreciate.
B) The domestic currency would depreciate.
C) The domestic currency would not change.
D) The domestic currency would sharply depreciate and then appreciate later.

Question 31

With imperfect substitutability, investors will hold more foreign assets only if they are compensated for risks.

Question 32

The exchange rate can "overshoot" its long-run value because the ________ are sluggish in the short run, whereas the __________ adjust instantaneously to a shock.

A) prices in goods and services markets; prices in assets markets
B) foreign exchange markets; prices in assets markets
C) prices in assets markets; prices in goods and services markets
D) prices in bond markets; money balance markets

Question 33

Which of the following options correctly reflect the assumptions in the Overshooting Approach?

A) both PPP and CIRP hold in the short run.
B) PPP holds in the short run, but CIRP does not.
C) CIRP holds in the short run, but PPP does not.
D) Neither PPP nor CIRP holds in the short run.

Question 34

In the equilibrium approach, changes in exchange rates occur because of changes in tastes or technology and are part of the adjustment to a shock to the world economy.

Question 35

Assume that in a free country, people in the country can choose to hold assets in any currency. As the domestic inflation rise, the opportunity cost of holding the domestic currency _________ and people will switch to hold assets in _________ currency.

A) increases; foreign
B) increases; domestic
C) decreases; foreign
D) decreases; domestic

Question 36

Which of the following statements describes the Currency Substitution Approach?

A) As expectations of a trade deficit change, the exchange rate today will change due to the expected change in asset holdings.
B) Exchange rate adjusts to compensate for changes in international currency portfolios.
C) Slowly adjusting goods prices may cause the exchange rate to over-react in the short run.
D) All of the above are correct.

Question 37

People in the Bahamas use both Bahamian dollars and U.S. dollars to pay for goods and services. Suppose that the Fed increases money supply, causing higher inflation rate in the U.S. If the exchange rate were allowed to float, the U.S. dollar will ________ against the Bahamian dollar and Bahamians will substitute toward more __________ holding.

A) appreciate; Bahamian dollars
B) appreciate; U.S. dollars
C) depreciate; Bahamian dollars
D) depreciate; U.S. dollars

Question 38

In general, the basic Monetary Approach to Exchange Rate MAER) does not capture the short run volatility of prices.

Question 39

Which of the following best describe the process of "overshooting" when money supply increases?

A) Exchange rates depreciate more than necessary due to overreaction in financial markets, but are restored as prices fall in response to the greater money supply.
B) Exchange rates depreciate more than necessary due to overreaction in financial markets, but are restored as prices rise in response to the greater money supply.
C) Exchange rates appreciate more than necessary due to overreaction in financial markets, but are restored as prices rise in response to the greater money supply.
D) Exchange rates appreciate more than necessary due to overreaction in financial markets, but are restored as prices fall in response to the greater money supply.

Question 40

Use the Portfolio-Balance Approach to answer this question. Other things remaining constant, if the supply of domestic bonds increases, what would happen to the domestic currency?

A) The domestic currency would appreciate.
B) The domestic currency would depreciate.
C) The domestic currency would not change.
D) The domestic currency would sharply depreciate and then appreciate later.

Question 41

"Changes in market expectations have their greatest impact on exchange-rate changes over the long run as opposed to the short run."

Question 42

"News approach describes how the equilibrium exchange rate can be achieved when government controls news about market fundamentals, profitability, and riskiness of investments."

Question 43

"The portfolio-balance approach of exchange rate determination assumes that households can choose to hold their wealth in money, domestic bonds, and foreign bonds."

Question 44

"In the trade balance approach, if people anticipate a country to experience trade deficit in the near future, the expectations will cause the country's currency to appreciate now."

Question 45

"Following a shock to the equilibrium, prices will adjust slowly to the new equilibrium level, whereas exchange rates and interest rates adjust quickly. This causes the spot exchange rate to move too much before returning to the equilibrium level." This idea is called _______.

A) hyper-exchange rate effect
B) panic effect
C) overshooting effect
D) imperfect equilibrium effect

Question 46

"Exchange rate overshooting occurs because product prices are slow to change while asset prices adjust immediately."

Question 47

Perfect capital mobility between countries implies that:

A) the covered interest parity holds
B) the interest rate on domestic bonds equals to the interest rate on similar foreign bond plus the forward premium on foreign exchange.
C) The actual portfolio composition adjusts instantaneously to desired portfolio composition.
D) All of the above are correct.

Question 48

The overshooting theory by Dornbusch is based on the assumption that:

A) covered interest parity does not hold in the short run.
B) uncovered interest parity does not hold in the short run.
C) fisher equation does not hold in the short run.
D) purchasing power parity does not hold in the short run.