Question 1

Compare the costs and benefits of flexible and fixed exchange rates.

Accepted Answer

Flexible exchange rates refer to a system where the value of a currency is determined by the foreign exchange market based on supply and demand. On the other hand, fixed exchange rates are set and maintained by the government or central bank.

The costs and benefits of flexible exchange rates include:

Costs:
1. Exchange rate volatility: Flexible exchange rates can lead to increased volatility in currency values, which can create uncertainty for businesses and investors.
2. Speculative attacks: Flexible exchange rates can make a country's currency vulnerable to speculative attacks, which can lead to destabilization of the economy.
3. Inflation: Flexible exchange rates can lead to inflationary pressures as currency values fluctuate, impacting the prices of imported goods.

Benefits:
1. Automatic adjustment: Flexible exchange rates allow for automatic adjustment to external shocks, such as changes in trade balances or capital flows, without the need for government intervention.
2. Independence: Countries with flexible exchange rates have more independence in their monetary policy, as they are not tied to a fixed exchange rate regime.
3. Market-driven: Flexible exchange rates are determined by market forces, which can lead to more efficient allocation of resources and better reflect the true value of a currency.

On the other hand, the costs and benefits of fixed exchange rates include:

Costs:
1. Loss of monetary policy independence: Countries with fixed exchange rates may have limited ability to conduct independent monetary policy, as they need to maintain the pegged exchange rate.
2. Speculative attacks: Fixed exchange rates can make a country's currency vulnerable to speculative attacks, as maintaining the pegged rate may require significant foreign exchange reserves.
3. Economic imbalances: Fixed exchange rates can lead to economic imbalances, as the exchange rate does not adjust to changes in trade balances or capital flows.

Benefits:
1. Stability: Fixed exchange rates provide stability and predictability for businesses and investors, as they know the value of the currency will remain constant.
2. Reduced exchange rate risk: Fixed exchange rates can reduce exchange rate risk for businesses engaged in international trade, as they know the value of their transactions will not fluctuate.
3. Lower inflation: Fixed exchange rates can help to lower inflation by anchoring the value of the currency to a stable benchmark.

In conclusion, the choice between flexible and fixed exchange rates involves trade-offs. Flexible exchange rates offer more independence and automatic adjustment, but come with increased volatility and potential for speculative attacks. Fixed exchange rates provide stability and reduced exchange rate risk, but can lead to loss of monetary policy independence and economic imbalances. The decision between the two depends on a country's specific economic circumstances and policy objectives.

Question 2

What are the key elements of the Bretton Woods System (BWS)?

Accepted Answer

The key elements of the Bretton Woods System (BWS) include the establishment of the International Monetary Fund (IMF) and the World Bank, the fixed exchange rate system, and the gold standard. The IMF was created to promote international monetary cooperation, exchange rate stability, and provide resources to member countries in need of financial assistance. The World Bank was established to provide financial and technical assistance for the reconstruction and development of war-torn and developing countries.

Under the fixed exchange rate system, member countries agreed to peg their currencies to the US dollar, which was in turn pegged to gold. This system aimed to promote stability in international trade and finance by preventing competitive devaluations and currency fluctuations. However, the system eventually collapsed in the early 1970s due to the inability to maintain the fixed exchange rates and the growing US trade deficit.

Overall, the Bretton Woods System aimed to create a stable and cooperative international monetary system to support post-World War II economic reconstruction and development.

Question 3

What is the likely impact of an expected depreciation of the home currency on domestic interest rates?

Accepted Answer

An expected depreciation of the home currency can have several impacts on domestic interest rates, influenced by the actions of the central bank, the state of the economy, and the reactions of market participants. Here's a detailed explanation of the likely impact:

1. **Inflationary Pressures**: When a currency is expected to depreciate, it typically means that imported goods will become more expensive, leading to higher inflation. Central banks, whose mandate often includes maintaining price stability, may respond to these inflationary pressures by increasing domestic interest rates. Higher interest rates can help to curb inflation by cooling down economic activity and reducing demand.

2. **Central Bank Policy**: Central banks may preemptively raise interest rates if they anticipate a currency depreciation in order to support the currency's value. Higher interest rates can attract foreign capital, as investors seek higher returns, which can help to stabilize or even appreciate the currency.

3. **Market Expectations**: Financial markets are forward-looking, and if market participants expect the currency to depreciate, they may demand higher interest rates on bonds and other fixed-income securities to compensate for the anticipated loss in the currency's value. This can lead to an increase in the overall level of interest rates in the economy.

4. **Capital Flows**: Expected currency depreciation can lead to capital outflows, as investors move their funds to currencies that are expected to hold their value or appreciate. To prevent capital flight, a country may need to offer higher interest rates to retain and attract investment.

5. **Economic Conditions**: The broader economic context is important. If the economy is strong, the central bank may be more inclined to raise interest rates to prevent overheating and control inflation. However, if the economy is weak, the central bank may be reluctant to raise interest rates, even in the face of a depreciating currency, due to the potential negative impact on economic growth.

6. **Exchange Rate Regime**: The impact on interest rates also depends on the exchange rate regime in place. For countries with a floating exchange rate, the market largely determines the currency's value, and the central bank may allow the currency to depreciate without intervening. In contrast, countries with fixed or pegged exchange rate systems may be more active in using interest rates to defend the currency's value.

In summary, an expected depreciation of the home currency is likely to lead to higher domestic interest rates, primarily as a response to inflationary pressures and the need to attract foreign capital. However, the magnitude and timing of the interest rate changes will depend on the central bank's policy objectives, the state of the economy, and the prevailing exchange rate regime.

Question 4

What is an "Optimum Currency Union" (OCA) and - in your opinion - is the European Monetary Union (EMU) and OCA?

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Question 5

What is meant by (capital account) convertibility of a currency?

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Question 6

What is a "balance of payments" equilibrium (deficit, surplus) and how does it relate to foreign reserves?

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Question 7

What is meant by the "current account" and the "capital (or financial) account"?

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Question 8

What could be reasons for a country to experience (high) current account deficits (surpluses)?

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Question 9

Identify the 5 correct statements 
1. Portfolio investment comprise both equity and bond investments.
2. The global interbank market is the market where banks lend to corporations worldwide.
3. Global finance contributes to a globally optimal allocation of capital.
4. Sudden stops can constitute a major risk in foreign finance.
5. The term "twin crisis" is used to signify a currency crisis that occurs in two countries at the same time.
6. When expecting a currency devaluation, a (temporary) purchase of foreign currency can be profitable.
7. A country can defend its currency by lowering interest rates.
8. A key factor for the EMS crisis of 1992/93 was that EMS member countries preferred a devaluation of their currencies over high interest rates.
9. It is undisputed among economist that excessive government budget deficits in southern EMU member countries are the cause of the eurozone crisis.
10. Joint risk sharing in the EMU would make the currency union even more unstable.

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1. Portfolio...

Question 10

What is the role of the liquidity system of a currency system?

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Question 11

(How) are government budget deficits related to current account deficits?

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Question 12

What are the policy options to deal with a devaluation expectation?

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Question 13

What is the difference between flexible and fixed exchange rate regimes?

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Question 14

What is the difference between the nominal and real exchange rate and when do both measures differ in their information about a country's price competitiveness?

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Question 15

What is the Real Effective Exchange Rate (REER) and what are its determinants?

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Question 16

What are the costs and benefits of a currency union?

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Question 17

Does it make economic sense for a country to have a very high current account surplus?

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Question 18

How to speculate against a fixed exchange rate?

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Question 19

Which price indices can best be used for calculating the real exchange rate?

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Question 20

What are the two major benefits of global finance?

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Exam 6: Global Money and Finance