1. Study Questions #1. Ch 14.
Evaluate the following statement explaining a nation’s decision to adopt floating exchange rates or fixed exchange rates.
True or False: Fixed exchange rates tend to be used primarily by small, developing nations whose currencies are anchored to a key currency such as the U.S. dollar.
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Explanation:
The choice of floating exchange rates versus pegged exchange rates relates to the economic and political characteristics of nations. Among the characteristics making a country more suited for fixed rather than flexible exchange rates are the size of the nation, openness to trade, the degree of labor mobility, the inflation rate in the country, and the availability of fiscal policy to cushion downturns. For example, small nations, whose financial and trade relationships are mainly with a single trading partner, often choose to adopt fixed exchange rates. Large countries with large and diversified economies often prefer floating rates. See section: “Exchange Rate Practices.”
2. Study Questions #2. Ch 14.
Which of the following characterizes the operation of a managed floating exchange rate?
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Explanation:
Managed floating exchange rates utilize the philosophy of leaning against the wind, in which exchange market intervention is conducted to reduce short-term fluctuations in exchange rates without attempting to adhere to any particular rate over the long run. See section: “Managed Floating Rates.”
3. Study Questions #3. Ch 14.
Evaluate the following statement explaining why some developing countries adopt and/or dollarize their monetary systems.
True or False: A currency board is a monetary authority that issues notes and coins convertible into a foreign anchor currency at a fixed exchange rate. Usually the fixed exchange rate is set by law, making changes to the exchange rate costly for governments. Currency boards offer the strongest form of a fixed exchange rate that is possible short of full currency union.
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Explanation:
Currency boards and dollarization are seen as methods of stabilizing exchange rates of developing countries and thus preventing currency crises. With a currency board, a monetary authority issues notes and coins convertible into a foreign currency at a fixed exchange rate. With dollarization, a country’s monetary authority uses the dollar alongside or instead of the country’s own currency. A currency board is a monetary authority that issues notes and coins convertible into a foreign anchor currency at a fixed exchange rate. Usually the fixed exchange rate is set by law, making changes to the exchange rate costly for governments. Currency boards offer the strongest form of a fixed exchange rate that is possible short of full currency union. See section: “Increasing the Credibility of Fixed Exchange Rates.”
4. Study Questions #4. Ch 14.
Evaluate the following statement explaining the philosophy and operation of the Bretton Woods system of adjustable pegged exchange rates.
True or False: The main feature of the adjustable pegged system was that currencies were set independently from each other to provide stable exchange rates for commercial and financial transactions. When the balance of payments moved away from its long-run equilibrium position, a nation could independently reevaluate its exchange rate.
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Explanation:
This statement is false because currencies were not set independently from each other, but rather they were tied to each other. The adjustable-pegged exchange rate system attempted to provide essentially fixed exchange rates for international transactions. When the balance of payments moved away from its long-run equilibrium position, a country could devalue or revalue its currency to restore payments balance. See section: “Bretton Woods System of Fixed Exchange Rates.”
5. Study Questions #5. Ch 14.
Evaluate the following statement explaining why nations use a crawling peg exchange rate system.
True or False: The term crawling peg implies that par value changes are implemented in a large number of small steps. The crawling peg mechanism has been used primarily by nations having high inflation rates.
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Explanation:
Nations sometimes use crawling pegged exchange rates to make small but frequent exchange rate adjustments promoting payments balance. Deficit and surplus nations both keep adjusting until the desired exchange rate level is attained. The term crawling peg implies that par value changes are implemented in a large number of small steps, making the process of exchange rate adjustment continuous for all practical purposes. The peg crawls from one par value to another. The crawling peg mechanism has been used primarily by nations having high inflation rates. See section: “The Crawling Peg.”
6. Study Questions #6. Ch 15.
What is the purpose of capital controls?
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Explanation:
Exchange controls, including the rationing of foreign exchange among domestic importers, are sometimes used to help a nation gain control over its balance-of-payments position. See section: “Capital Controls.”
7. Study Questions #7. Ch 14.
Which of the following factors contribute to currency crises? Check all that apply.
Points:
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Explanation:
A currency crisis, also called a speculative attack, is a situation in which a weak currency experiences heavy selling pressure. Among the causes of currency crises are budget deficits financed by inflation, weak financial systems, political uncertainty, and changes in interest rates on world markets. Although a fixed exchange rate system has the advantage of promoting low inflation, it is especially vulnerable to speculative attacks. See section: “Sources of Currency Crises.”
8. Study Questions #8. Ch 15.
Complete the following statement explaining why small nations adopt currency baskets against which they peg their exchange rates.
Points:
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Explanation:
While developed nations tend to have many trading partners, very few developed nations maintain fixed exchange rates, having floating exchange rates instead. Small developing nations often peg their exchange rates to a single currency or a currency basket to reduce the impact of exchange rate fluctuations on their economies. While small developing nations that trade predominantly with a single trading partner typically anchor their currencies to a single currency, small developing countries with more than one major trading partner often peg their exchange rates to a basket of currencies of these trading partners. See section: “Fixed Exchange Rate System.”
9. Study Questions #9. Ch 14.
Which advantage does the special drawing right (SDR) offer to small nations seeking to peg their exchange rates?
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Explanation:
Anchoring a domestic currency to a basket of currencies enables a nation to average out fluctuations in export or import prices caused by exchange‑rate movements, thereby reducing the effects of such fluctuations on the domestic economy. Some nations anchor their currencies to the special drawing right (SDR), a currency basket composed of the four key currencies of IMF members. The basket valuation technique attempts to make the SDR’s value more stable than the foreign currency value of any single currency in the basket. See section: “Use of Fixed Exchange Rates.”
10. Study Questions #10. Ch 14.
Categorize each statement in the following table as an argument for or against a system of floating exchange rates.
|
Statement
|
For
|
Against
|
|---|---|---|
| It provides simplicity. | ||
| It increases the effectiveness of monetary policy. | ||
| It may be inflationary. | ||
| It encourages reckless financial policies. |
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Explanation:
Proponents of floating exchange rates emphasize that such a system (1) offers simplicity, (2) enables continuous adjustments of payments balances, (3) allows for the pursuit of independent economic policies, (4) increases the effectiveness of monetary policy, and (5) reduces the need for international reserves.
Critics of floating exchange rates, on the other hand, argue that such a system (1) may be inflationary, (2) may lead to disorderly exchange markets (thus disrupting trade patterns), and (3) may encourage reckless financial policies.
See section: “Arguments For and Against Floating Rates.”
11. Study Questions #11. Ch 14.
Which of the following techniques can a central bank use to offset a depreciation of its currency? Check all that apply.
Points:
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Explanation:
To offset a depreciation in the home currency’s exchange value, a central bank can (1) use its international reserves to purchase quantities of that currency on the foreign exchange market or (2) initiate a contractionary monetary policy, which leads to higher domestic interest rates, increased investment inflows, and increased demand for the home currency. To offset an appreciation in the home currency’s exchange value, a central bank can sell additional quantities of its currency on the foreign exchange market or initiate an expansionary monetary policy. See section: “Exchange Rate Stabilization and Monetary Policy.”
12. Study Questions #12. Ch 14.
Complete the following statement.
The purpose of a currency devaluation is to cause the home currency’s exchange value to![]()
depreciate , thus counteracting a payments![]()
deficit .
Points:
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Close Explanation
Explanation:
The purpose of a currency devaluation is to cause the home currency’s exchange value to depreciate, thus counteracting a payments deficit. The purpose of a currency revaluation is to cause the home currency’s exchange value to appreciate, counteracting a payments surplus. The terms devaluation and revaluation refer to a legal redefinition of a currency’s par value under a system of fixed exchange rates. See section: “Devaluation and Revaluation.”
