Canadian Institute of Technology
Monetary & Fiscal Policies, Sh. Cani
Fall Semester 2018 - 2019
Name: ___________________
Score: 100 points (100%)
20 minutes
December 5, 2018
Quiz 3 Chap. 10 - Foreign Exchange
I.
Multiple-Choice Questions 74 points (2 point each)
1. An American traveling to Europe will find it easier to make purchases now because:
a. most countries in Europe accept U.S. dollars.
b. most of the countries of Europe have adopted the British pounds as the standard currency.
c. many of the countries in Europe now use the same currency, the euro.
d. all of the countries in Europe now use the same currency, the euro.
2. The nominal exchange rate:
a. is the amount of one country's goods that could be obtained with a basket of goods of another
country.
b. is always expressed as units of a foreign currency per U.S. dollar.
c. is the rate that one can exchange the currency of one country for the currency of another country.
d. is a synonymous term for the swap rate.
3. If an American traveling abroad can obtain 115 euros for $100 U.S. the current euro per $
exchange rate is:
a. 0.870 euros/$.
b. 1.15 euros/$.
c. 115euros/$.
d. 1euro/1.15$.
4. If in late 2016 100 U.S. dollars exchanged for 118 euros and in mid-2017 100 U.S. dollars
exchanged for 127 euros, then:
a. the euro appreciated relative to the dollar.
b. the dollar appreciated relative to the euro.
c. European goods became more expensive to Americans.
d. American goods became more expensive to Americans.
5. If the Japanese yen appreciates against the U.S. dollar:
a. Americans should find Japanese goods are now less expensive.
b. Japanese residents would find Japanese goods are relatively less expensive than American goods.
c. U.S. goods should have an easier time competing against Japanese goods in both countries.
d. Japanese goods should have an easier time competing against U.S. goods in both countries.
6. The nominal exchange rate:
a. is the price of a good in one country expressed in units of the same good in another country.
b. is fixed by the central banks of countries.
c. is the price of one country's currency stated in units of another country's currency.
d. is adjusted once a year and is the price at which goods are traded.
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7. Which of the following statements is most correct?
a. If the U.S. $ depreciates relative to the yen, then it is likely also depreciating relative to the euro.
b. If the U.S. $ is appreciating relative to the euro, the euro is likely depreciating relative to the yen.
c. If the U.S. $ is depreciating relative to the euro it is likely depreciating relative to all currencies.
d. If the U.S. $ is appreciating relative to the yen, the yen is depreciating relative to the U.S. $.
8. In quoting exchange rates:
a. one should always quote these as units of foreign currency over a unit of domestic currency.
b. one should always quote the rate as the units of domestic currency over a unit of foreign currency.
c. usually one should quote the rate in such a way that the value is greater than one.
d. each country's central bank determines how the rate is to be quoted.
9. The forward exchange rate:
a. is the rate at which foreign exchange dealers are willing to commit today to buying or selling a
currency in the future.
b. is a synonymous term for the nominal exchange rate.
c. is the same as the spot rate.
d. is always above the spot rate since it carries greater risk.
10. The answer to the question of whether or not a U.S. dollar will buy more in the U.S. or in
a foreign country is determined by:
a. the nominal exchange rate.
b. the real exchange rate.
c. whether the nominal exchange rate is > or < than 1.
d. you cannot determine the answer until you travel to the foreign country and convert U.S. dollars
to the foreign currency.
11. The real exchange rate is defined as:
a. the nominal exchange rate plus the rate of inflation.
b. the spot exchange rate.
c. the cost of a basket of goods and services in one country compared to the cost of the same basket
in another country.
d. the exchange rate that would exist if nominal rates were not fixed by governments.
12. If a Japanese Toyota sells for 2,500,000 yen and the nominal exchange rate is 110 yen/$
U.S., then the dollar price of the Japanese automobile is:
a. 22,727 yen.
b. $20,000.
c. $25,000.
d. $22,727.
13. Appreciation of the real exchange rate:
a. makes U.S. exports more expensive to foreigners.
b. makes U.S. exports less expensive to foreigners.
c. means a basket of U.S. goods would exchange for fewer foreign goods.
d. benefits all U.S. producers.
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14. The real and nominal exchange rates differ in the sense that:
a. the real exchange rate does not express differences in the purchasing power of a currency.
b. the nominal exchange rate is adjusted for price differences between countries and the real is not.
c. the nominal exchange rate does not reflect differences in purchasing power between currencies.
d. nominal exchange rates are fixed but real rates are flexible.
15. If we let P = the domestic price of a basket of goods and Pf the foreign price of the same
basket of goods, and Ɛ = the nominal exchange rate of U.S. $/foreign currency, the real
exchange rate is best expressed as:
a. P / Pf × Ɛ
b. Pf / P
c. Pf / P × Ɛ
d. Ɛ × P / Pf
16. Depreciation of the real exchange rate:
a. makes U.S. exports more expensive to foreigners.
b. makes U.S. exports less expensive to foreigners.
c. means a basket of U.S. goods would exchange for more foreign goods.
d. means an appreciation of the nominal exchange rate.
17. The law of one price:
a. is based on arbitrage.
b. applies only to real goods and not financial assets.
c. can explain short-run exchange rates but not long-run exchange rates.
d. is a mathematical concept that is not useful in explaining exchange rates.
18. If the euro/U.S.$ exchange rate is 1.1€/U.S. $ in New York but 1.05€/U.S. $ in London, we
should see:
a. people selling U.S. dollars and buying euros in New York and then selling those euros and
buying $'s in London.
b. people selling euros and buying dollars in New York and then buying euros by selling dollars in
London.
c. the price differential between the markets increase as people seek to take advantage of the
situation.
d. the dollar should appreciate in New York relative to the euro.
19. If we ignore transportation costs and the price of a pair of Nike shoes in Detroit is 100
U.S. dollars what should be the price of the Nike shoes in Windsor, Canada (in Canadian
dollars) if the nominal exchange rate is 1.36 Canadian dollars/1 U.S. dollar?
a. 74
b. 100
c. 136
d. 64
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20. Considering the law of one price, evidence in the foreign exchange markets over brief
intervals shows:
a. the law works most of the time.
b. this is the closest thing to a perfect law in economics.
c. that the law fails most of the time.
d. the law only works in the very short run.
21. Which of the following does not contribute to the failure of the law of one price?
a. Tariffs
b. Transportation costs
c. Technical specifications
d. Tastes are similar across countries
22. With regard to exchange rate determination, the law of one price is a useful theory only
when applied to:
a. long-run periods of time.
b. forward exchange rates.
c. very short-run periods of time.
d. futures contracts.
23. The theory of purchasing power parity says:
a. the real exchange rate is always greater than one.
b. a dollar should buy the same goods no matter where in the world you go.
c. the dollar price of a basket of goods in the U.S. should equal the yen price of a basket of goods in
Japan.
d. the real exchange rate is always less than one.
24. Purchasing power parity says that:
a. differences in inflation rates between countries should have no impact on the exchange rate
between those countries.
b. differences in inflation rates between countries will create changes in exchange rates.
c. the changes in exchange rates move independently from inflation.
d. for inflation to change the exchange rate, the rate of inflation has to be the same between
countries.
25. The theory of purchasing power parity:
a. contradicts the law of one price.
b. explains exchange rate movements in the short run, while the law of one price explains exchange
rate movements over the long run.
c. assumes away inflation to have any validity.
d. extends the law of one price to a basket of goods.
26. If inflation in the United States averages more than inflation in the euro area over a long
period of time, we should expect:
a. the dollar to appreciate relative to the euro.
b. the euro/U.S. dollar exchange rate to fluctuate in a narrow range set by the European Central
Bank.
c. the dollar to depreciate relative to the euro.
d. no effect; there isn't a link between inflation and exchange rates over the long run.
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27. Considering the theory of purchasing power parity, if inflation in Mexico is 5% while
prices in the U.S. are stable; we should expect over the period of a year:
a. the dollar to appreciate 5% relative to the peso.
b. the peso to appreciate 5% relative to the dollar.
c. the nominal exchange rate to stay fixed.
d. the real exchange rate of U.S. goods / Mexican goods to appreciate 5%.
28. The empirical evidence on purchasing power parity over the long run seems to point out
that:
a. the higher a country's inflation rate, the greater is the appreciation in the country's currency.
b. the theory of purchasing power parity cannot explain long-run changes in exchange rates.
c. the higher a country's inflation rate the greater is the depreciation in the country's currency.
d. there isn't any clear link between inflation rates and exchange rates.
29. Differences in inflation rates between two countries can explain:
a. short-run changes in the exchange rate but not long-run changes.
b. changes in the real exchange rate over the long run, but not changes in the nominal exchange rate.
c. long-run changes in the exchange rate but not short-run changes.
d. changes in the exchange rate in both the short run and the long run.
30. A U.S. resident who wants to purchase an automobile that comes from Japan:
a. will be supplying yen on the foreign exchange market.
b. will make up part of the demand for dollars on the foreign exchange market.
c. will make up part of the supply of dollars on the foreign exchange market.
d. will not be a participant in the foreign exchange market.
31. In the foreign exchange market, the demand for U.S. dollars is made up from:
a. foreigners desiring to purchase U.S. goods, services, and assets.
b. Americans who want to hold more currency.
c. Americans wishing to purchase foreign goods, services, and assets.
d. Americans who want to invest in foreign assets.
32. A decrease in Americans' preference for foreign goods will lead to the following in the
foreign exchange market:
a. an increase in the demand for dollars.
b. a decrease in the supply of dollars.
c. a depreciation of the dollar relative to foreign currencies.
d. a movement down the demand curve for dollars.
33. An increase in the real interest rate on U.S. bonds, everything else equal, will have the
following impact on the foreign exchange market:
a. the demand for dollars will decrease.
b. the supply of dollars will increase.
c. the dollar will depreciate relative to foreign currencies.
d. the demand for dollars will increase.
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34. If a dollar will currently purchase 120 Japanese yen but it is expected that one year from
now a dollar will purchase 130 yen:
a. the demand for dollars now will increase.
b. the demand for dollars now will decrease.
c. the dollar is expected to depreciate.
d. the yen is expected to appreciate.
35. If government policymakers intervene in foreign exchange markets to cause the domestic
currency to appreciate:
a. this will benefit all residents of the country.
b. this will be beneficial to exporters.
c. this would be harmful to exporters.
d. this would be harmful to importers.
36. A foreign exchange intervention is:
a. synonymous with a fixed exchange rate.
b. the use of public statements by government officials to influence inflation expectations.
c. only used in crisis situations.
d. the buying/selling of currencies to affect supply or demand which impacts the exchange rate.
37. If the Federal Reserve in the United States begins to purchase foreign currency and pay
for these purchases with dollars, this should cause:
a. the dollar to appreciate.
b. the dollar to depreciate.
c. import prices to decrease.
d. exports to decrease.
Short Answer Question 78 points (6 point each)
1. Explain why an appreciating U.S. dollar does not benefit everyone in the U.S.
Ans: An appreciating U.S. $ will benefit importers and individuals who want to purchase foreign
assets. On the other hand, it will make the price of foreign goods and services, as well as foreign
assets, more expensive.
2. Assuming the law of one price, explain what the exchange rate between U.S. dollars and yen
has to be if the price of steel in Japan is 15,000 yen per ton and the price in the U.S. is $125 per
ton (assume no transaction costs).
Ans: Given the price for steel in each country, the exchange rate has to be 120 yen per U.S. dollar.
This makes the prices of steel equal in each country. If this weren't the exchange rate, steel buyers
would have an incentive to buy in the country where steel was cheaper, and steel producers would
have the incentive to sell in the country where the steel price was higher. The increased demand
and decreased supply in the relatively cheaper country would increase the price there. The increased
supply and decreased demand in the relatively higher priced country would decrease the price there.
This process would continue until prices in both countries were the same.
3. Please state whether you agree or disagree with the following statement, and why: "An
increase in the price level of a country, relative to another country's price level, will cause
its currency to appreciate."
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Ans: Disagree. An increase in the price level of one country relative to another will cause that
country's currency to depreciate. As the text points out, countries with relatively high rates of
inflation experience relatively high rates of currency depreciation.
4. The price of a Big Mac in the U.S. is $4.93; the price in France is 3.72 euros. The current
exchange rate is 1.07€/$. What is the real exchange rate?
Ans: The real Big Mac exchange rate is the U.S. price of a Big Mac divided by the foreign price
(converted into U.S. dollars at the nominal exchange rate) of a Big Mac. When the calculations are
done we find the real Big Mac exchange rate is 1.42. This means that one U.S. Big Mac will purchase
1.42 French Big Macs.
4.93*1.07/3.72 = 1.418
5. In looking at the foreign exchange rates in the Wall Street Journal you notice the U.S. dollareuro spot rate is 1.085€/U.S.$ and the six-month forward rate is 1.098€/$. What does this
imply?
Ans: This implies that people expect the dollar is going to appreciate relative to the euro over the
next six months. The spot rate is the current exchange rate, the six-month forward rate is the
price at which a foreign exchange dealer will agree to sell euros for six months from now. This
implies that dealers expect the price of euros to be lower six months hence.
6. The same laptop computer cost $2,000 in the United States, 220,000 Japanese yen, £1,300
British pounds and €1900 in Germany. If the law of one price holds, what are the yen/$; £/$ and
€/$ exchange rates?
Ans: If the law of one price holds the yen/$ exchange rate is 110 yen/$; the £/$ exchange rate is
0.65£/$ and the €/$ exchange rate is 0.95€/$.
(220,000/$2,000 = 110 yen…)
7. Explain why the law of one price may best be applied to financial assets.
Ans: Financial assets, for example shares of Microsoft stock, are ideal for explaining the law of one
price. First of all, they are a homogeneous good; all shares of Microsoft stock are identical. Secondly,
the transaction costs of shipping them can be extremely low, especially if they are sent electronically.
Third, there are stock exchanges and dealers all over the world who are diligently watching for price
differentials to profit from and so act on these differentials (arbitrage).
8. In theory, the law of one price makes a lot of sense. So why do we see it fail so often?
Ans: The law of one price fails often because in many cases countries will place tariffs on imports.
Also many products do not trade or ship easily, for example concrete. As a result, they can have
significantly different prices across markets and countries. Also there can be technical differences
in products; many home appliances would have to be re-wired to be used in other countries. Finally,
many services simply do not transport well, for example haircuts and restaurant meals.
9. A basket of goods cost $100 in the U.S. and £65 in the United Kingdom. If purchasing power
parity holds, what is the dollar-pound exchange rate?
Ans: We can answer this using the following equation:
Substituting the information in the question, we divide $100 by £65 and the answer is $1.538/£.
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10. What is the link between purchasing power parity, inflation and the exchange rate?
Ans: Purchasing power parity implies when prices change in one country but not in another, the
exchange rate should change as well. Specifically, if prices double in one country and not in another,
the currency of the country experiencing the inflation will see its currency depreciate to the point
where a unit of its currency will purchase half as many units of foreign currency as it did before.
11. If a country is running a current account deficit year after year, what should we expect
to happen to the exchange rate for that country? Explain.
Ans: A country running a current account deficit is exporting less than it is importing. This cannot
go on forever; in fact, the exchange rate should adjust to move the current account towards a balance.
A country with a current account deficit should see its exchange rate decrease (its currency
depreciates). The depreciating currency will make imports less attractive and exports more attractive,
eventually decreasing the current account deficit.
12. Considering the foreign exchange market, identify four causes for an increase in the supply
of dollars.
Ans: The supply of dollars on the foreign exchange market will increase if there is an increased
preference for foreign goods. The supply can also increase if the riskiness of foreign assets
decreases compared to the U.S. assets, or an increase in wealth in the U.S., or if there is an expected
depreciation of the dollar.
13. The government of a country that is experiencing strong currency appreciation might find
itself under pressure from some of its own citizens. Who would be likely to be bringing pressure
and why?
Ans: A country experiencing strong currency appreciation will find that as a result imports are
relatively cheaper but it may be more difficult to sell abroad. As a result, domestic manufacturers
who sell abroad or who compete with imports will want the government to intervene in the foreign
exchange market to slow the appreciation.
Essay Questions 30 points (10 point each)
1. Briefly describe the foreign exchange market.
Ans: The foreign exchange market is enormous in terms of volume of transactions. On an average
day, more than $5.1 trillion in foreign currency might be traded in a market that operates 24 hours
a day. Significant foreign exchange trading takes place in London, New York, Tokyo, Singapore,
Frankfurt and Zurich, with London having by far the greatest percentage of transactions (the U.K.
is home to roughly 37 percent of foreign exchange trades). In terms of currency, though, the U.S.
dollar is one side of roughly 88 percent of currency transactions.
2. Explain how a currency speculator would use something like the Big Mac Index in order to
make a profit trading currency.
Ans: The Big Mac Index is meant to be a simplified illustration of the theory of purchasing power
parity (PPP). PPP really looks at a basket of goods, not one single good, and would consider goods
that are transportable since it is an extension of the law of one price. Big Macs are really not
transportable. Finally, the price of the Big Mac is highly dependent on local costs
such as wages, taxes and rent. That being said, a speculator would look at something like the Big Mac
Index to determine which currencies are overvalued and which are undervalued. A speculator could
profit by buying undervalued currencies (expecting their values to rise to where they "should be" in
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accordance with PPP) or by making forward transactions in overvalued currencies (sell them when
they are high and expect to buy them at a lower price over the course of the contract). A speculator
would use a much more sophisticated tool than the Big Mac Index for such trading, but the index
does give us a general idea of what is possible.
3. Is it possible for a country to run a trade deficit and yet have the value of its currency not
change? Use a supply and demand model of a foreign exchange market to explain how this
could occur.
Ans: A trade deficit means that the country is importing more than it is exporting, which means a
decreased demand for its currency and a depreciation of the currency; the exchange rate falls.
However, the country's assets may be attractive to foreign investors. This would increase the demand
for the currency, and if this upward pressure is strong enough to balance the downward pressure, the
exchange rate may not change. In fact, based on which effect is stronger, the exchange rate might
decrease or even increase.
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