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# Study Questions (Ch 12)

## 1. Study Questions #1. Ch 12.

In a free market, which factors apply to long run exchange rates? Check all that apply.
Points:
1 / 1
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Explanation:
Long run exchange rates are best explained by factors including real income differentials, inflation rate differentials, productivity changes, and trade barriers. In the short run, exchange rates respond to real interest rate differentials, news about market fundamentals, and speculative opinion about future exchange rates. See section: “Determining Short Run Exchange Rates: The Asset Market Approach.”

## 2. Study Questions #2. Ch 12.

Evaluate the following statement explaining why international investors are concerned about the real interest rate as opposed to the nominal rate.
True or False: International investors are especially concerned about the real interest rate because unlike the nominal interest rate, the real interest rate equals the nominal interest rate minus the inflation rate.
Points:
1 / 1
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Explanation:
The nominal interest rate refers to the interest rate, unadjusted for inflation, while the real interest rate equals the nominal interest rate minus the inflation rate. An increase in the nominal interest rate would not necessarily cause a change in the exchange rate if the inflation rate were to increase by the same proportion, leaving the real interest rate unchanged. In this case, any increase in the return on a domestic asset would be offset by higher inflation in the domestic economy, leading investors to believe that the domestic currency will depreciate in the future as domestic goods become more expensive relative to foreign goods. Thus, only changes in real interest rates (that is, the nominal interest rate changing by a different proportion than the inflation rate) are predicted to affect the exchange rate. See section: “Determining Short Run Exchange Rates: The Asset Market Approach.”

## 3. Study Questions #3. Ch 12.

Which of the following describe limitations of the purchasing-power-parity theory? Check all that apply.
Points:
0.75 / 1
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Explanation:
The simplest concept of purchasing power parity is the law of one price. It asserts that identical goods should be sold everywhere at the same price when converted to a common currency, assuming that it is costless to ship the good between nations, there are no barriers to trade, and markets are competitive. It rests on the assumption that sellers will seek out the highest possible prices and buyers the lowest ones.
The purchasing-power-parity theory predicts that a country’s currency will depreciate by an amount equal to the excess of domestic inflation over foreign inflation. The theory also predicts that a country’s exchange rate will appreciate by an amount equal to the excess of foreign inflation over domestic inflation. The theory does not consider the impact of international capital movements, and it suffers from the choice of an appropriate price index used in price calculations. The law of one price holds reasonably well for globally tradable commodities such as oil, metals, chemicals, and some agricultural crops. The law does not appear to apply well to nontradable goods and services such as cab rides, housing, and personal services like haircuts.
See section: “Inflation Rates, Purchasing Power Parity, and Long Run Exchange Rates.”

## 4. Study Questions #4. Ch 12.

If a currency becomes overvalued in the foreign exchange market, what will be the likely impact on the home country’s trade balance?
Points:
1 / 1
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Explanation:
An overvalued currency tends to lead to a balance-of-payments deficit for the home country, while an undervalued currency leads to a balance-of-payments surplus. For example, a currency that is undervalued according to purchasing power parity is one in which domestic prices are lower than foreign prices, when expressed in a common currency. You would expect the domestic country to export more and import less, leading to a balance-of-payments surplus. See section: “Inflation Rates, Purchasing Power Parity, and Long Run Exchange Rates.”

## 5. Study Questions #5. Ch 12.

Identify the factors that account for changes in a currency’s value over the long run? Check all that apply.
Points:
1 / 1
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Explanation:
In the long run, four key factors account for changes in exchange rates: (1) relative productivity levels, (2) relative price levels, (3) preferences for domestic goods or foreign goods, and (4) barriers to trade. See section: “Determining Long Run Exchange Rates.”

## 6. Study Questions #6. Ch 12.

What factors underlie changes in a currency’s value in the short run? Check all that apply.
Points:
1 / 1
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Explanation:
Over short periods of time, decisions to hold domestic or foreign financial assets play a much greater role in exchange rate determination than the demand for imports and exports does. According to the asset market approach to exchange rate determination, investors consider two key factors when deciding between domestic and foreign investments: (1) relative interest rates and (2) expected changes in exchange rates. Changes in these factors, in turn, account for fluctuations in exchange rates that we observe in the short run. See section: “Determining Short Run Exchange Rates: The Asset Market Approach.”

## 7. Study Questions #7. Ch 12.

Use the dropdown menus in the following table to indicate how each factor listed affects the dollar’s exchange rate under a system of market-determined exchange rates.
Factor
Appreciates or Depreciates
An increase in U.S. money demand Appreciates
Rising productivity in the United States relative to other countries Appreciates
Rising real interest rates overseas, relative to U.S. rates Depreciates
An increase in U.S. money growth Depreciates
Points:
1 / 1
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Explanation:
An increase in the demand for money will cause U.S. interest rates to rise. All else equal, this will make U.S. assets more attractive, increasing the demand for dollars and causing the dollar to appreciate.
Productivity growth measures the increase in a country’s output for a given level of input. If the United States becomes more productive than other countries, it can produce goods more cheaply than its foreign competitors can. The U.S. exports tend to increase and imports tend to decrease. As U.S. goods become relatively less expensive, foreigners demand more U.S. goods, which results in an increase in the supply of foreign currency. At the same time, U.S. consumers desire fewer foreign goods that have become relatively more expensive, causing the demand for foreign currency to decrease. Therefore, the dollar appreciates relative the foreign currency.
You can expect to see appreciating currencies in countries whose real interest rates are higher because these countries will attract investment funds from all over the world. Countries that experience relatively low real interest rates tend to find their currencies depreciating. Therefore, if real interest rates overseas are higher than those in the United States, the U.S. dollar depreciates.
If money growth in the United States increases relative to the rest of the world, it means that inflation is much higher in the United States, and its currency loses purchasing power. You would expect that currency to depreciate to restore parity with prices of goods abroad (the depreciation would make imported goods more expensive to domestic consumers while making domestic exports less expensive to foreigners).
See section: “Expected Change in the Exchange Rate.”

## 8. Study Questions #8. Ch 12.

Evaluate the following statement.
True or False: Exchange rate overshooting occurs because exchange rates tend to be more flexible than other prices; exchange rates often fluctuate more in the short run than in the long run so as to compensate for other prices that are slower to adjust to their long run equilibrium levels.
Points:
1 / 1
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Explanation:
An exchange rate is said to overshoot when its short run response (either depreciation or appreciation) to a change in market fundamentals is greater than its long run response. Exchange rate overshooting occurs because exchange rates tend to be more flexible than other prices; exchange rates often depreciate/appreciate more in the short run than in the long run so as to compensate for other prices that are slower to adjust to their long run equilibrium levels. See section: “Exchange Rate Overshooting.”

## 9. Study Questions #9. Ch 12.

Evaluate the following statement.
True or False: Most currency forecasters use a combination of the purchasing-power-parity analysis, the Big Mac Index, and judgmental analysis.
Points:
1 / 1
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Explanation:
Most forecasters tend to use a combination of fundamental, technical, and judgmental analysis, with the emphasis on each shifting as conditions change. They form a general view about whether a particular currency is over- or undervalued in a longer-term sense. Within that framework, they assess all current economic forecasts, news events, political developments, statistical releases, rumors, and changes in sentiment, while also carefully studying the charts and technical analysis. See section: “Forecasting Foreign Exchange Rates.”

## 10. Study Questions #10. Ch 12.

Assuming market determined exchange rates, use the supply and demand schedules for pounds to analyze the effect on the exchange rate (dollars per pound) between the U.S. dollar and the British pound under the following two circumstances:
1. Both the U.K. and U.S. economies slide into recession, but the U.K. recession is less severe than the U.S. recession.
Adjust the following graph to illustrate the effect of the observed economic developments on the supply of and demand for the British pound.
Points:
0.5 / 1
Points:
1 / 1
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Explanation:
Since the U.K. recession is less severe than the U.S. recession, more people will try to invest in the United Kingdom, and demand for the pound increases. At the same time, fewer people would like to invest in the U.S. dollar. Thus, the supply of the pound decreases. Overall, the exchange rate increases (more U.S. dollars are offered per British pound).
2. Britain’s oil production in the North Sea decreases, and exports to the United States fall.
Adjust the following graph to illustrate the effect of the observed economic developments on the supply of and demand for the British pound.
Points:
1 / 1
Points:
1 / 1
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Explanation:
As oil exports to the United States fall, the demand for pounds declines. At the same time, the supply of pounds does not change. Overall, the exchange rate decreases.
Which of the following events is likely to result in an increase of the exchange rate? Check all that apply.
Points:
1 / 1
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Explanation:
The exchange rate is likely to rise as a result of the British government inviting U.S. firms to invest in British oil fields. This causes an increase in demand for the pound, whereas the supply of pounds does not change.
See section: “Determining Long Run Exchange Rates.”

## 11. Study Questions #11. Ch 12.

Evaluate the following statement.
True or False: A nation’s currency will depreciate if its inflation rate is less than that of its trading partners.
Points:
1 / 1
Close Explanation
Explanation:
When a nation’s inflation rate is less than that of its trading partners, a nation’s currency will appreciate because lower inflation attracts more foreign investors. As a result, the demand for the domestic currency increases, whereas its supply does not change. Overall, the currency appreciates. See sections: “Determining Long-Run Exchange Rates,” and “Determining Short-Run Exchange Rates: The Asset Market Approach.”

## 12. Study Questions #12. Ch 12.

Complete the following statement.
The appreciation in the dollar’s exchange value from 1980 to 1985 made U.S. productsmore   expensive and foreign productsless   expensive, increased   U.S. imports, anddecreased   U.S. exports.
Points:
1 / 1
Close Explanation
Explanation:
The appreciation in the dollar’s exchange value from 1980 to 1985 made U.S. products more expensive and foreign products less expensive, increased U.S. imports, and decreased U.S. exports. See section: “Relative Levels of Interest Rates.”

## 13. Study Questions #13. Ch 12.

Suppose the dollar/franc exchange rate equals $0.50 per franc. Complete the following statement to show what will happen to the dollar’s exchange value according to the purchasing-power-parity theory. If the U.S. price level increases by 10% and the price level in Switzerland stays constant, the U.S. dollar willdepreciate by10% , to$0.55   per franc.
Points:
1 / 1
Close Explanation
Explanation:
According to the purchasing-power-parity theory, the U.S. dollar should appreciate against the franc if U.S. inflation is less than Switzerland’s inflation. Conversely, if U.S. inflation exceeds Switzerland’s inflation, the purchasing power of the dollar falls relative to the franc, so the exchange value of the dollar against the franc should depreciate.
In this example, the U.S. dollar will depreciate by 10%, to $0.5×(1+0.1)=$0.55 per franc$0.5×1+0.1=$0.55 per franc.

## 14. Study Questions #14. Ch 12.

Suppose that the nominal interest rate on three-month Treasury bills is 8% in the United States and 6% in the United Kingdom, and the rate of inflation is 10% in the United States and 4% in the United Kingdom.
Complete the following statements.
The real interest rate in the United States is-2%   , and the real interest rate in the United Kingdom is2%   .
Points:
1 / 1
In response to these real interest rates, international investment flows from theUnited States   to theUnited Kingdom   .
Points:
1 / 1
As a result of these investment flows, the dollar woulddepreciate   against the pound.
Points:
1 / 1
Close Explanation
Explanation:
The real interest rate in the United States is 8%10%=−2%8%−10%=−2%. The real interest rate in the United Kingdom is 6%4%=2%6%−4%=2%. The higher interest rate in the United Kingdom would induce investments to flow from the United States to the United Kingdom, and as a result of these investment flows, the dollar would depreciate against the pound as the demand for the pound strengthens. See section: “Relative Levels of Interest Rates.”