chapter 13

Question 1

what is a floating currency

Answer 1

A currency whose exchange rate is determined by the demand for and supply of the currency in the foreign exchange market.

Question 2

Exchange rate system

Answer 2

An agreement between countries on how exchange rates should be determined.

Question 3

managed float exchange rate system

Answer 3

Australia has been using a managed float system since 1983 where the $AU is determined by market forces with the occasional intervention of the central bank

Question 4

the Australian currency is one of the world’s currencies with the

Answer 4

least amount of central bank intervention

Question 5

fixed exchange rate systems

Answer 5

countries agree to keep the exchange rates between their currencies fixed. e.g. gold standard and Bretton Woods system

Question 6

The current exchange rate system has three important aspects:

Answer 6

1 Australia, like Britain and the United States, allows its currency to float against other major currencies.

2 Most countries in Western Europe have adopted a single currency, the euro.

3 Some developing countries have attempted to keep their currencies’ exchange rates fixed against the US dollar or another major currency.

Question 7

TWI

Answer 7

measure the value of the Australian dollar against a basket of currencies of its major trading partners based on volume of trade carried out in that currency

e.g. If Australia carries out most of its trade in Japanese yen, then the index will give a higher weight to the exchange rate against the yen than against the currency of a country with which Australia trades less, such as Thailand.

Question 8

when was Australian dollar floated

Answer 8

December 1983

Question 9

by 2011 had reached its highest level in more than 28 years, largely due to

Answer 9

the depreciation of the US dollar against many major currencies and the strong foreign demand for Australia’s minerals and energy.

Question 10

In the short run, the two most important causes of exchange rate movements are

Answer 10

changes in interest rates and speculators’ expectations

Question 11

What determines exchange rates in the long run?

describe purchasing power parity

Answer 11

long run exchange rates move to equalise the purchasing power of different currencies.

the purchasing power of every country’s currency should be the same

Question 12

If exchange rates are not at the values indicated by purchasing power parity

Answer 12

there are opportunities to make profits

as people attempted to make these profits by exchanging pounds for Australian dollars they would bid up the value of the Australian dollar until it reached the purchasing power exchange rate of $1 = £1

Question 13

§Three real-world complications keep purchasing power parity from being a complete explanation of exchange rates, even in the long run.

Answer 13

1. not all products are traded internationally –> exchange rate will not reflect purchasing power of the currencies
2. products and consumer tastes are different internationally –> higher price in one country b/c consumers prefer it. identical products may have same price, but similar products do not
3. countries impose barriers to trade

Question 14

The four determinants of exchange rates in the long run

Answer 14

1. relative price levels
2. relative rates of productivity growth
3. preferences for domestic and foreign goods
4. tariffs and quotas

Question 15

The four determinants of exchange rates in the long run

relative price levels

is the purchasing power parity theory correct?

Answer 15

If prices of goods and services rise faster in Australia than in the United States, the value of the Australian dollar has to decline to maintain demand for Australian products.

it is correct

Question 16

The four determinants of exchange rates in the long run

relatives rates of productivity growth

Answer 16

productivity –> more goods and servicies produced using fewer inputs –> production costs fall –> product price falls

so if jap’s productivity rises faster than australia, value of yen will rise against $AU

Question 17

The four determinants of exchange rates in the long run

Preferences for domestic and foreign goods

Answer 17

prefer foreign goods, foreign currency will appreciate

Question 18

The four determinants of exchange rates in the long run

tariffs and quotas

Answer 18

reduced demand for imports –> demand for foreign currencies fell

$AU rises

Question 19

what is the euro

Answer 19

a common currency used by Eurozone (the EU countries who have adopted the euro)

Question 20

what happend in 2002?

Answer 20

On 1 January 2002 euro coins and paper currency were introduced

ECB was established

Question 21

Role of ECB

Answer 21

§The ECB determines monetary policy for the euro zone member nations (but member countries continue to have their own central bank)

Question 22

adv of common euro

Answer 22

makes it easier for consumers and firms to buy and sell across borders.

reduce costs and increase competition.

Question 23

cons of euro

Answer 23

participating countries cannot run independent monetary policies

currency cannot depreciate during an economic contraction or a recession, which would normally expand net exports to help revive aggregate demand.

Question 24

what have some developing economies attempted to do in terms of their exchange rate?

Answer 24

some developing countries have attempted to keep their exchange rates fixed against the US dollar or another major currency.

Question 25

benefits of a fixed exchange rate

Answer 25

§Formerly used by some developing or emerging nations: e.g. Thailand, South Korea, Indonesia and Malaysia. –Makes business planning easier. –Fixes foreign debt levels and repayments. –Reduces fluctuations in import prices.

Question 26

§Pegging a currency can create problems.

Answer 26

–Can lead to persistent surpluses or shortages of currency. –The central bank becomes burdened to buy up currency surpluses to maintain the fixed exchange rate. –This has meant some countries have had to borrow money from overseas to buy up their own currency surplus, e.g. Thailand.

Question 27

how may a surplus be created by pegging the exchange rate to the US

Answer 27

in thailand, a surplus in Baht was created b/c it was above the market equlibrium rate. It is overvalued

Question 28

# define overvalued undervalued

Answer 28

A currency pegged at a value above the market equilibrium exchange rate is said to be overvalued. A currency pegged at a value below the market equilibrium exchange rate is said to be undervalued.

Question 29

what did thailand do to keep keep the exchange rate at the pegged level

Answer 29

the Thai central bank, the Bank of Thailand, had to buy these baht with US dollars. gradually used up its US dollar reserves ---\> the Bank of Thailand borrowed additional US dollar reserves from the International Monetary Fund (IMF). also raised interest rates to attract more foreign investors to investments in Thailand, thereby increasing the demand for the baht --\> lowered AD --\> recession

Question 30

destabilising speculation?

Answer 30

As investors became convinced that Thailand would have to abandon its pegged exchange against the US dollar and allow the value of the baht to fall, they decreased their demand for baht from D1 to D2 This increased the quantity of baht the Bank of Thailand had to purchase in exchange for US dollars from 70 million per day to 140 million to defend the pegged exchange rate. The destabilising speculation by investors caused Thailand to abandon its pegged exchange rate in July 1997

Question 31

Destabilising speculation may occur in

Answer 31

–in anticipation of abandoning the peg, which makes maintaining the peg even more difficult.

Question 32

–capital flight.

Answer 32

Foreign investors also began to sell off their investments in Thailand and exchange the baht they received for US dollars. This capital flight forced the Bank of Thailand to run through its US dollar reserves quickly. Dollar loans from the IMF temporarily allowed Thailand to defend the pegged exchange rate.

Question 33

speculative attacks

Answer 33

Many currency traders became convinced that other East Asian countries, such as South Korea, Indonesia and Malaysia, would have to follow Thailand and abandon their pegged exchange rates. The result was a wave of speculative selling of these countries’ currencies.

Question 34

Even if a country’s currency was not initially overvalued at the pegged exchange rate, the speculative attacks would

Answer 34

cause a large reduction in the demand for the country’s currency. The demand curve for the currency would shift to the left, which would force the country’s central bank to run through its US dollar reserves quickly.

Question 35

Due to speculative attacks

Answer 35

a few months, South Korea, Indonesia, the Philippines and Malaysia abandoned their pegged currencies. All these countries also plunged into recession.

Question 36

what happened to pegged exchange rates after the east asian exchange rate crisis?

Answer 36

sharply declined

Question 37

graph destabilising speculation

Answer 37

Question 38

what happened to china in 1994

Answer 38

The chinese yuan was peggeed against the US dollar at a fixed rate of 8.28 yuan to the US dollar it was undervalued against the US dollar

Question 39

pegging against the US dollar assured what?

Answer 39

US dollar ensured that Chinese exporters would face stable US dollar prices for the goods they sold to the United States

Question 40

what did the undervalued yuan give?

Answer 40

e undervaluation of the yuan gave Chinese firms an unfair competitive advantage on international markets.

Question 41

how did China support their undervalued yuan?

Answer 41

the Chinese central bank had to buy large amounts of US dollars with yuan. By 2005 the Chinese government had accumulated more than US$700 billion

Question 42

what did China's trading partners pressure it to do?

Answer 42

to allow the yuan to increase in value b/c it chinese textile exports drove textile producers out of business in Japan, US, Australia and Europe

Question 43

why was the chinese gov reluctant to revalue the yuan

Answer 43

since China’s had large holdings of US dollars, it would also incur significant losses if the yuan increases in value.

Question 44

what happened in July 2005 in China?

Answer 44

switched from a peg to a managed floating exchange rate he government announced that it would switch from pegging the yuan against the US dollar to ***linking the value of the yuan to the average value of a basket of currencies***—the dominant currencies were the US dollar, the Japanese yen, the euro and the Korean won, while several other currencies were also considered, including the Australian dollar

Question 45

what did economists argue after 2005

Answer 45

Some economists and policy-makers were sceptical that anything had changed b/c because initial increase in the value of the yuan was small and because the Chinese central bank did not explain the details of how the yuan would be linked to the basket of other currencies in 2010, they believed the yuan was still undervalued

Question 46

In 2010 China announced

Answer 46

a renewed commitment to moving towards a more flexible exchange rate system and the value of the yuan slowly increased and by 2014 had reached above US$1 = 6 yuan

Question 47

after 2010, what was argued

Answer 47

ome economists and policy-makers still believe the yuan is undervalued and urged the Chinese government to allow its currency to become more responsive to changes in demand and supply in the foreign exchange market

Question 48

2014: how much $US did China hold

Answer 48

3.4 trillion

Question 49

One important reason exchange rates fluctuate is that

Answer 49

nvestors seek out the best investments they can find anywhere in the world. For instance, if Chinese investors increase their demand for Australian securities, the demand for Australian dollars will increase and the value of the Australian dollar will rise. But if interest rates in Australia decline, foreign investors may sell Australian securities and the value of the Australian dollar will fall.

Question 50

capital markets?

Answer 50

where shares in companies and long-term debt, including corporate and government bonds and bank loans are bought and sold

Question 51

what happened In the 1980s and 1990s

Answer 51

European governments removed many restrictions on foreign investments in financial markets. It became possible for foreign investors to invest freely in Europe and for European investors to invest freely in foreign markets.

Question 52

in the 1980s, what happened in Australia?

Answer 52

§Australia deregulated its capital markets to allow the free flow of capital into and out of Australia.

Question 53

The globalisation of financial markets has

Answer 53

helped increase growth and efficiency in the world economy.

Question 54

The globalisation of financial markets has made it possible

Answer 54

for the savings of households around the world to be channelled to the best investments available firms borrow from overseas to finance investment

Question 55

Disadvantage of globalisation of financial markets?

Answer 55

financial securities are held by investors around the world, if they decline in value, the financial impact will be widespreading e.g. the sharp decline in the value of mortgage-backed securities issued in the United States hurt not only US investors and financial institutions but investors and financial institutions in many other countries as well.

Question 56

If the average rate of productivity growth in South Korea is greater than in Australia over the next five years, then, all else being equal, will the savings that you accumulate (in Korean won) be worth more or less in Australian dollars than it would have been worth without the relative gains in Korean productivity?

Answer 56

the value of the faster-growing (productivity) country’s currency should—all else being equal—rise against the slower-growing (productivity) country’s currency. * savings that you accumulate in won while you are in South Korea are **likely to be worth more in Australian dollars** than they would have been worth without the gains in Korean productivity

Question 57

describe feature of the gold standard

Answer 57

the currency of a country consisted of gold coins and paper currency that could be redeemed for gold. the exchange rate between two currencies was automatically determined by the quantity of gold in each currency.

Question 58

why was the gold standard abandoned?

Answer 58

* country's money supply relied on gold supply which dependend on disoveries of gold --\> central bank had no control of money supply (to pursue monetary policy) b/c it did not know how much gold would be discovered

Question 59

when was the gold standard abandoned

Answer 59

before, during and after the Great Depression to allow the Central Bank to expand the money supply in pursuit of an expansionary monetary policy the later the gold standard was abandoned, the further the fall in productoin

Question 60

The Bretton Woods System

Answer 60

§An exchange rate system that lasted from 1944 to 1971, under which countries pledged to buy and sell their currencies at a fixed rate against the US dollar.

Question 61

distinguish between revaluation and devaluation

Answer 61

§Devaluation: A reduction in a fixed exchange rate. §Revaluation: An increase in a fixed exchange rate.

Question 62

The collapse of the Bretton Woods System what happened in the 1960s?

Answer 62

1. The number of $US held by foreign banks was more than the gold reserves in the US. 2. Some countries with undervalued currencies refused to revalue them, e.g. West Germany.

Question 63

Under the Bretton Woods System central banks were committed to

Answer 63

selling US dollars in exchange for their own currencies. They had to hold US dollar reserves. If a central bank ran out of US dollar reserves it could borrow them from IMF

Question 64

Under the Bretton Woods System, a fixed exchange rate was

Answer 64

Under the Bretton Woods System, a fixed exchange rate was known as a par exchange rate.

Question 65

explain this graph

Answer 65

Qty of British pounds demanded is lower than the Qty of british pounds supplied in exchage for $US so Bank of England must use US dollars to buy the surplus

Question 66

when is there a fundamental disequilibrium in a country's exchange rate?

Answer 66

when there is a persistent shortage or surplus of a currency

Question 67

in the early years of the Bretton Woods system,

Answer 67

many countries found that their currencies were overvalued against the US dollar, meaning that their par exchange rates were too high.

Question 68

The collapse of the bretton woods why was it a problem that the US dollars held by foreign central banks was larger than the gold reserves of the United States?

Answer 68

Due to the large gap, the US could not redeem US for gold

Question 69

Collapse of the Bretton Wood why did gov with undervalued exchange rates refuse to revalue it?

Answer 69

it would have increased the prices of their countries’ exports.

Question 70

diagram of an undervalued exchange rate

Answer 70

Question 71

Under the Under the Bretton Woods System, what did Germany's central bank have to do?

Answer 71

Bundesbank had sell deutsche marks and buy $US. The supply = the shortage at the par exchange rate

Question 72

what happpened in the 1960s in europe

Answer 72

most European countries, including Germany, relaxed their capital controls (limits on the flow of foreign exchange and financial investment across countries)

Question 73

what were effects of loosening capital control?

Answer 73

made it easier for investors to speculate on changes in exchange rates. §Destabilising speculation made it very difficult to maintain a fixed exchange rate: investors expectated Bundasbek to revalue so they demanded marks to make profit

Question 74

draw diagram to show DESTABILISING SPECULATION AGAINST THE DEUTSCHE MARK

Answer 74