Chapter 6: Government Influence on Exchange Rates

It has been argued that the exchange rate can be used as a policy tool. Assume that the U.S. government would like to reduce inflation. Which of the following is an appropriate action given this scenario? a. Buy dollars with foreign currency b. Lower interest rates c. Sell dollars for foreign currency d. None of these choices are correct.

A

The currency of Country X is pegged to the currency of Country Y and will remain pegged. Assume that Country Y's currency appreciated against the dollar during the last week. In this case, the currency of Country X _______ against the dollar during the last week. a. appreciated b. depreciated c. remained stable d. may have changed value[but the direction cannot be determined from the information provided]

A

To strengthen the dollar using sterilized intervention, the Fed would ________ dollars and simultaneously ________ Treasury securities. a. Buy; buy b. Sell; sell c. Buy; sell d. Sell; buy

A

Which of the following is an appropriate form of indirect intervention? a. To strengthen the dollar in the long run, the Fed attempts to reduce U.S. inflation. b. To weaken the dollar in the long run, the Fed attempts to reduce U.S. inflation. c. To strengthen the dollar, the Fed increases the money supply to lower interest rates. d. To weaken the dollar, the Fed reduces the money supply to increase interest rates.

A

devaluation

A central bank's actions to devalue a currency in a fixed exchange rate system

A currency board a. Does little to stabilize a currency's value. b. Is worth considering only if the government can convince investors that the exchange rate will be maintained. c. May reduce fears that the local currency will weaken even if the currency board is expected to remain in place for only a few weeks. d. All of these choices are correct.

B

A weak dollar places ____ pressure on U.S. inflation, which in turn places ____ pressure on U.S. interest rates. a. downward; upward b. upward; upward c. upward; downward d. downward; downward

B

Assume that the dollar has been consistently depreciating over a long period. The Fed decides to counteract this movement by intervening in the foreign exchange market using sterilized intervention. The Fed would a. Sell dollars for foreign currency and simultaneously buy Treasury securities with dollars. b. Buy dollars with foreign currency and simultaneously buy Treasury securities with dollars. c. Sell dollars for foreign currency and simultaneously sell Treasury securities for dollars. d. Buy dollars with foreign currency and simultaneously sell Treasury securities for dollars. e. None of these choices are correct.

B

In a fixed exchange rate system, the managerial duties of an MNC are less difficult. Which of the following will most likely not create a problem for MNCs under a fixed exchange rate system (assume the MNC has payables and receivables denominated in foreign currencies)? a. The local government devalues the local currency. b. The local inflation rate increases. c. The local government revalues the local currency. d. All of these choices will cause problems for an MNC.

B

In evaluating fixed versus freely floating exchange rate systems, one must realize that a. A freely floating exchange rate system is always superior to a fixed exchange rate system. b. The designation of one system as more desirable may depend on a country's political environment, economic conditions, goals, and policies. c. A country's problems can sometimes be alleviated by freely floating exchange rates. d. A country's problems are more contagious to other countries in a freely floating exchange rate environment.

B

It has been argued that the exchange rate can be used as a policy tool. Assume that the U.S. government would like to reduce unemployment. Which of the following is an appropriate action given this scenario? a. Buy dollars with foreign currency in the foreign exchange market b. Weaken the dollar c. Implement a tight monetary policy d. Strengthen the dollar

B

The value of the Canadian dollar, Japanese yen, and Australian dollar with respect to the U.S. dollar are part of a a. fixed system. b. managed float system. c. crawling peg system. d. pegged system.

B

Which of the following is not true regarding the euro? a. It enables participating countries to engage in cross-border trade and capital flows throughout the euro-zone. b. It allows for a separate money supply for each participating currency. c. It prevents any individual European country from solving local economic problems with its own unique monetary policy. d. It replaced the national currencies of participating countries by June 1, 2002. e. All of these choices are true.

B

Assume Countries A, B, and C produce goods that are substitutes of each other and that these countries engage in trade with each other. Assume that Country A's currency floats against Country B's currency, and that Country C's currency is pegged to B's. If A's currency appreciates against B, then A's exports to C should ____, and A's imports from C should ____. a. increase; increase b. increase; decrease c. decrease; increase d. decrease; decrease

C

Assume that the Fed intervenes by exchanging euros for dollars in the foreign exchange market. This will cause an ____ in the supply of euros in the foreign exchange market, and will place _______ pressure on the value of the euro. a. outward shift; upward b. inward shift; downward c. outward shift; downward d. inward shift; upward

C

If the Fed uses a stimulative monetary policy, it may be very concerned about causing inflation if the dollar's value is expected to a. remain stable. b. strengthen. c. weaken. d. none of the above will have an impact on inflation.

C

Which of the following countries has not adopted the euro? a. France b. Germany c. United Kingdom d. Spain

C

Which of the following is not true regarding government intervention? a. Under indirect intervention, the Fed would attempt to affect the dollar's value by indirectly influencing the factors that determine it, such as interest rates. b. Under sterilized intervention, the Fed would intervene simultaneously in the foreign exchange and Treasury markets. c. Under the direct method of intervention, an appreciation of the dollar would be accomplished by exchanging dollars for foreign currencies. d. Under nonsterilized intervention, the Fed would intervene in the foreign exchange market without adjusting the money supply. e. All of these choices are true.

C

A weak dollar is normally expected to cause a. high unemployment and low inflation in the U.S. b. high unemployment and high inflation in the U.S. c. low unemployment and low inflation in the U.S. d. low unemployment and high inflation in the U.S.

D

Among the reasons for government intervention are a. To respond to temporary disturbances. b. To establish implicit exchange rate boundaries. c. To smooth exchange rate movement. d. All of these choices are correct.

D

The European Monetary System a. Tied EEC member country currencies to the European Currency Unit. b. Superseded the "snake" arrangement. c. Established boundaries for the exchange rates of EEC member countries. d. All of these choices are correct.

D

Under a freely floating exchange rate system a. central bank intervention in the foreign exchange market is often necessary. b. a foreign exchange market does not exist. c. exchange rates remain very stable because of offsetting economic conditions. d. central bank intervention in the foreign exchange market is not necessary.

D

Which of the following is an appropriate form of indirect intervention? a. To weaken the dollar in the long run, the Fed attempts to reduce U.S. inflation. b. To weaken the dollar, the Fed reduces the money supply to increase interest rates. c. To strengthen the dollar, the Fed increases the money supply to lower interest rates. d. To strengthen the dollar in the long run, the Fed attempts to reduce U.S. inflation.

D

Which of the following is not a category of classification for exchange rate systems? a. Fixed b. Freely floating c. Managed float d. Managed peg

D

A ________ is a factor influencing the change in a currency's spot rate. a. Change in relative interest rates b. Change in government controls c. Change in relative income levels d. Change in relative inflation rates e. All of these choices are factors influencing the change in a currency's spot rate.

E

Assume that the dollar has been consistently appreciating over a long period. The Fed decides to counteract this movement by intervening in the foreign exchange market using nonsterilized intervention. The Fed would a. Sell dollars for foreign currency and simultaneously sell Treasury securities for dollars. b. Sell dollars for foreign currency and simultaneously buy Treasury securities with dollars. c. Buy dollars with foreign currency and simultaneously sell Treasury securities for dollars. d. Buy dollars with foreign currency and simultaneously buy Treasury securities with dollars. e. None of these choices are correct.

E

Bretton Woods Agreement, 1944-1971

Each currency was valued in terms of gold, their values with respect to each other were fixed. Governments intervened in the foreign exchange markets to ensure that exchange rates drifted no more than 1 percent above or below the initially set rates.

An advantage of a fixed exchange rate system is that governments are not required to constantly intervene in the foreign exchange market to maintain exchange rates within specified boundaries. a. True b. False

False

Currency boards can operate without maintaining currency reserves for the printed currency. a. True b. False

False

If the Fed engages in nonsterilized intervention, it would conduct simultaneous transactions in the foreign exchange markets and Treasury securities markets. a. True b. False

False

The decision of a country to use dollarization can be easily reversed by later establishing a currency board. a. True b. False

False

Under the system known as the "dirty" float, official boundaries for the exchange rate exist, but they are wider than they are under a fixed exchange rate system. a. True b. False

False

A Single European Currency

In 1992, the Maastricht Treaty called for the establishment of a single European currency. In January 1999, the euro replaced the national currencies of 11 European countries (with official implementation for all transactions in 2002). Since then, eight more countries have converted their home currency to the euro.

Mexico's Pegged System, 1994

Mexico's central bank used a special pegged exchange rate system that linked the peso to the U.S. dollar but allowed it to fluctuate against the dollar within a band.

Europe's Snake Arrangement, 1972-1979

Their goal was to maintain their currencies within established limits of each other. The snake was difficult to maintain, however, and market pressure caused some currencies to move outside their established limits.

Exchange rate systems can be classified according to the degree by which exchange rates are controlled by the government. a. True b. False

True

In order to stimulate a stagnant economy, a government operating under a managed float may attempt to weaken its currency. a. True b. False

True

The establishment of the euro allows for more consistent economic conditions across countries but eliminates the power of any individual European country to solve local economic problems with its own unique monetary policy. a. True b. False

True

Under a pegged exchange rate system, the home currency's value is pegged to a foreign currency or to some unit of account. a. True b. False

True

While countries with a pegged exchange rate may attract foreign investment because the exchange rate is expected to remain stable, weak economic or political conditions can cause forms and investors to question whether the peg will hold. a. True b. False

True

managed float exchange rate system

allows its currency's value to float on a daily basis, but the government can periodically intervene to achieve specific objectives.

revaluation

an upward adjustment of the exchange rate by the central bank

Smithsonian Agreement, 1971-1973

called for a devaluation of the U.S. dollar by about 8 percent against other currencies. In addition, boundaries for the currency values were expanded to within 2.25 percent above or below the rates initially set by the agreement.

Exchange rate systems

can be classified in terms of the extent to which the exchange rates are government controlled.

freely floating exchange rate system

exchange rate values are determined by market forces without intervention by governments.

fixed exchange rate system

exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries.

European Monetary System (EMS), 1979-1992

exchange rates of member countries were held together within specified limits and were also tied to the European Currency Unit (ECU), a weighted average of exchange rates of the member countries.

pegged exchange rate

home currency's value is pegged to one foreign currency or to an index of currencies. Although the home currency's value is fixed in terms of the foreign currency to which it is pegged, it moves in line with that currency against other currencies.

revalue

increase the value of its currency against other currencies.

European Central Bank (ECB)

is based in Frankfurt and is responsible for setting monetary policy for all participating European countries. Its objective is to control inflation in the participating countries and to stabilize (within reasonable boundaries) the value of the euro with respect to other major currencies.

exchange rate mechanism (ERM)

method of linking European currency values with the ECU

devalue

reduce the value of its currency against other currencies

Dollarization

replacement of a foreign currency with U.S. dollars.

currency board

system for pegging the value of the local currency to some other specified currency. The board must maintain currency reserves for all the currency that it has printed. This large amount of reserves may increase the ability of a country's central bank to maintain its pegged currency.

sterilized intervention

the Fed intervenes in the foreign exchange market and simultaneously engages in offsetting transactions in the Treasury securities markets. As a result, the dollar money supply is unchanged.

Black Market

underground (illegal) network that circumvents the legal (formal) network in the economy. A black market for foreign exchange enables residents to engage in foreign exchange transactions that may not be officially approved by the government.

nonsterilized intervention

when the Fed intervenes in the foreign exchange market without adjusting for the change in the money supply, it is engaging in a nonsterilized intervention.