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TUTORIAL 7

FOREIGN EXCHANGE RATE MARKET

I. Review questions
1. Explain the theory of law of one price and purchasing power parity.
2. Explain exchange rates determination and movement in the long run. Give
examples.
3. Describe the asset market approach and factors affecting exchange rate movement
in the short run.

II. Multiple-choice questions


1. Suppose the exchange rate between U.S. dollars and British pounds is $1.51/£.
Then
A. a £100 U.K. good will cost $151 in the U.S.
B. a $100 U.S. good will cost £100 in the U.K.
C. a £100 U.K. good will cost $100 in the U.S.
D. a $100 U.S. good will cost £151 in the U.K.

2. When a currency increases in value compared to other currencies


A. It is elastic.
B. It is inelastic.
C. It depreciates.
D. It appreciates.

3. When a currency appreciates in value compared to other currencies, then


A. the rest of the world's goods become more expensive to that country.
B. that country's goods do not change in price to the rest of the world.
C. that country's goods become less expensive to the rest of the world.
D. that country's goods become more expensive to the rest of the world.
iPhone $1000; E1: 22000 (22mil)=$ -> E2: 23000=$(23mil) => for foreigner price of
iPhone is more expensive

4. According to the law of one price, if the French price level rises by 10%, and the
U.S. price level increases by 5%, then:
A. the dollar will depreciate by 10%.
B. the dollar will depreciate by 5%.
C. the dollar will appreciate by 10%.
D. the dollar will appreciate by 5%.
Et↑= S= Pf (↑10/ Fr)/ Pd (↑5/ US)
higher rel. PL -> lower domestic currency value

5. Which of the following does not account for the inability of PPP to fully explain
exchange rate movements? -> goods not traded, not identical, trade barrier
A. goods that are not identical
B. different methods of calculating growth rates
C. goods that are not identical
D. trade barriers

6. Which of the following can cause a country’s currency to appreciate in the long
run?
A. A decrease in the demand for a country’s exports. Dg&s↓ -> Et↓
B. A rise in a country's relative price level. -> Pg&s↑ -> Dg&s↓ -> Et↓

C. A relative decrease in the productivity of a country. -> Pg&s↑ -> Dg&s↓ -> Et↓
D. Increasing tariffs. (tax on imported prod.) -> Pim↑ -> Df↓ -> Ed↑

7. Suppose that you, in the U.S., are considering a one-year deposit of $100 in a
U.K. bank that currently has an interest rate of 5%. Currently, the
dollar/pound exchange rate is $1.50. Your best guess is that in one year the
exchange rate will be $1.60. At the end of the year, your investment will be
worth:
A. $98
B. $112 [$100/ 1.5 * (1+5%) * 1.6]
C. $67
D. $105

8. The relative expected return on deposits in terms of dollars is given by:


A. Relative RETD = iF – iD + (Eet+1 – Et)/Et-1
B. Relative RETD = iF – iD + (Eet+1 – Et)/Et
C. Relative RETD = iD – iF + (Eet+1 – Et)/Et exp. Approximate domestic currency
D. Relative RETD = iD – iF - (Eet+1 – Et)/Et

9. Which of the following will tend to cause domestic currency to depreciate?


A. an increase in the domestic interest rate.
B. an increase in foreign interest rates.
-> Rel. E(R)d= id – if↑ + (Et+1-Et)/ Et => Dd↓ -> Ddomesic currency↓
C. An increase in the expected export demand
D. An increase in productivity.

10. A higher domestic money supply will tend to:


A. cause the domestic currency to appreciate.
B. cause the domestic currency to either depreciate or appreciate, depending on the
size of the change.
C. cause the domestic currency to depreciate.
In SR: MS↑ -> id↓ -> Rel. E(R)d↓ -> Et↓
Rel. PL expected ↑ -> Et+1↓ -> -> Et↓
In LR: PL -> PL↑ -> Et↓

D. cause the domestic currency tod not change in value.


11. Which of the following expresses the interest-parity condition?
A. The domestic interest rate equals the foreign interest minus the expected
appreciation of the domestic currency.
B. The expected return on domestic deposits equals the inverse of the expected return
on foreign deposits.
C. The domestic interest rate equals the foreign interest rate.
D. The expected return on domestic deposits equals the negative of the expected return
on foreign deposits.

12. The demand curve for domestic assets is downward sloping because
A. As the expected appreciation on dollar assets rises the quantity demanded of dollar
assets rises
B. As the exchange rate rises the quantity demanded of dollar assets rises
C. As the price of domestic assets rises the quantity demanded of dollar assets rises
D. As the relative price of domestic assets rises the quantity demand of domestic assets
rises

13. Suppose the domestic nominal interest rate rises. The domestic currency
________ if this results from an increase in the domestic real interest rate and
________ if it results from an increase in the expected inflation rate -> Et+1↓ -> ->
Et↓
A. depreciates; depreciates
B. depreciates; appreciates
C. appreciates; appreciates
D. appreciates; depreciates

14. If people expect the dollar to appreciate in value against the euro,
A. Then they will buy euros and the euro will appreciate.
B. Then they will buy dollars and the dollar will depreciate.
C. Then they will buy dollars and the dollar will appreciate. Et+1↑ -> Ddomestic ↓,
Et↑, $ appr
D. Then they will buy euros and the dollar will depreciate.

15. Exchange rate overshooting


A. Occurs because the market has difficulty interpreting changes in the money supply.
B. Occurs because an increase in the domestic money supply lowers domestic interest
rates in the short run, but they return to previous levels in the long run.
C. Occurs because an increase in the domestic money supply has no effects on
domestic interest rates, but does raise foreign interest rates.
D. Occurs because an increase in the domestic money supply lowers domestic interest
rates in the long run but not the short run.

III. Practice exercises


Questions taken and adapted from chapter 18 (Mishkin, 2019)

1. “A country is always worse off when its currency is weak (falls in value).” Is this
statement true, false, or uncertain? Explain your answer.

False. Although a weak currency has the negative effect of making it more expensive to
buy foreign goods or to travel abroad, it may help domestic industry. Domestic goods
become cheaper relative to foreign goods, and the demand for domestically produced
goods increases. The resulting higher sales of domestic products may lead to higher
employment, a beneficial effect on the economy

2. If the Japanese price level rises by 5% relative to the price level in the United
States, what does the theory of purchasing power parity predict will happen to the
value of the Japanese yen in terms of dollars?

It predicts that the value of the yen will fall 5% in terms of dollars.

3. If the demand for a country’s exports falls at the same time that tariffs on imports
are raised, will the country’s currency tend to appreciate or depreciate in the long
run?
In the long run, the fall in the demand for a country's exports leads to a depreciation of
its currency, but the higher tariffs lead to an appreciation. Therefore, the effect on the
exchange rate is uncertain.

4. If the Indian government unexpectedly announces that it will be imposing higher


tariffs on foreign goods one year from now, what will happen to the value of the
Indian rupee today?
The Indian rupee will appreciate. The announcement of tariffs will raise the expected
future exchange rate for the rupee and so increase the expected appreciation of the
rupee. This means that the demand for rupee-denominated assets will increase, shifting
the demand curve to the right, and the rupee exchange rate therefore rises
5. Through the summer and fall of 2008, as the global financial crisis began to take
hold, international financial institutions and sovereign wealth funds significantly
increased their purchases of U.S. Treasury securities as a safe haven investment.
How should this have affected U.S. dollar exchange rates?
This should (and did) lead to a sharp appreciation of the dollar relative to many other
currencies.
The strong demand for U.S. treasuries led to a rise in the demand for U.S. dollar-
denominated assets during this time, hence appreciating the dollar.

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