Managing Exchange Rates Flashcards
Challenge Questions
A country under a pegged exchange rate regime is experiencing persistent trade deficits and rapidly depleting its foreign exchange reserves. What is the most likely immediate consequence if the central bank fails to adjust the peg?
A. A sudden appreciation of the domestic currency due to investor confidence in the peg.
B. An increase in domestic investment as businesses take advantage of lower borrowing costs.
C. The emergence of a parallel market with a different exchange rate, undermining the official peg.
D. Enhanced foreign direct investment inflows as investors take advantage of low domestic prices.
Answer: C. The emergence of a parallel market with a different exchange rate, undermining the official peg.
Explanation: When a country maintains an unsustainable peg without sufficient reserves, a parallel (black) market often emerges where the currency trades at a rate that reflects the true market conditions. This parallel rate usually diverges significantly from the official rate, eroding the credibility of the peg.
Option A incorrectly assumes an appreciation of the currency, which is unlikely under reserve depletion.
Option B misinterprets the economic conditions; investment typically declines as reserves are depleted and confidence wanes.
Option D mistakenly assumes increased FDI, whereas the lack of credible monetary policy typically deters foreign investment.
Which exchange rate regime provides the most flexibility for a country to pursue independent monetary policy while still attempting to stabilize the currency in the short term?
A. Currency board arrangement
B. Managed floating exchange rate
C. Conventional fixed peg arrangement
D. Monetary union
Answer: B. Managed floating exchange rate
Explanation: A managed float allows the central bank to intervene in the FX market to stabilize the currency without committing to a fixed rate, thereby preserving the flexibility of pursuing independent monetary policy.
Option A is incorrect because a currency board severely restricts monetary policy.
Option C limits monetary flexibility as the central bank is bound to maintain the peg.
Option D eliminates national monetary policy in favor of shared policy within the union.
A country experiencing significant capital outflows due to rising domestic inflation and currency depreciation implements strict capital controls. Which of the following is a likely long-term consequence of this policy?
A. Permanent stabilization of the currency and reduction in inflation rates.
B. Reduction in asset market volatility as investors gain confidence in policy stability.
C. A short-term reduction in outflows, but eventual economic isolation and reduced growth prospects.
D. Immediate improvement in trade balances due to lower import demand.
Answer: C. A short-term reduction in outflows, but eventual economic isolation and reduced growth prospects.
Explanation: Capital controls can provide temporary relief by reducing outflows, but over the long term, they can lead to economic isolation, reduced foreign investment, and lower growth as markets distrust the stability of the economic environment.
Option A is incorrect as capital controls do not address the root causes of inflation and currency depreciation.
Option B overstates the impact of controls, as they often lead to increased risk perceptions.
Option D suggests improved trade balances without acknowledging the broader economic damage and reduced foreign confidence.
Which of the following best describes the effect of an independently floating exchange rate on a country’s ability to manage its trade balance?
A. It allows the central bank to set a target rate for the currency, directly influencing the trade balance.
B. It makes the trade balance more responsive to market conditions, adjusting with currency fluctuations.
C. It stabilizes the currency against major trading partners, reducing trade balance volatility.
D. It provides a stable environment for capital flows, ensuring consistent trade surpluses.
Answer: B. It makes the trade balance more responsive to market conditions, adjusting with currency fluctuations.
Explanation: An independently floating exchange rate responds to market forces, allowing the trade balance to adjust naturally as currency values shift, influencing the competitiveness of exports and imports.
Option A is incorrect as independently floating rates do not involve direct targeting.
Option C is misleading because floating rates do not stabilize against trading partners.
Option D misstates the impact of floating rates, which can lead to fluctuating trade balances.
A country implements capital restrictions to maintain a fixed exchange rate during an economic downturn. What is a potential downside of this approach in the context of international trade and investment?
A. The fixed rate will cause a permanent appreciation of the currency, harming export competitiveness.
B. Capital restrictions will lead to greater foreign direct investment as investors seek stable returns.
C. The restrictions may lead to inefficient allocation of resources and reduced economic growth.
D. The restrictions will ensure that the country maintains a balanced trade position regardless of external conditions.
Answer: C. The restrictions may lead to inefficient allocation of resources and reduced economic growth.
Explanation: Capital restrictions can distort market signals, leading to inefficient resource allocation and potentially stifling economic growth as domestic businesses lack access to foreign capital and competitive pressures.
Option A is incorrect because fixed rates do not necessarily cause appreciation; competitiveness depends on other factors.
Option B incorrectly assumes increased investment, whereas capital restrictions usually deter foreign investors.
Option D is incorrect as restrictions do not guarantee balanced trade and can create imbalances elsewhere.
What is the primary short-term driver of exchange rates between two countries with significant trade imbalances, such as the U.S. and China?
A. Long-term adjustments in savings and investment behavior.
B. Capital flows, particularly investments in government securities.
C. Changes in tariffs and trade barriers.
D. Labor market adjustments in response to trade deficits.
Answer: B. Capital flows, particularly investments in government securities.
Explanation: In the short term, capital flows, such as China’s purchase of U.S. debt securities, primarily drive exchange rates. These flows offset trade imbalances, influencing the currency value between the two countries.
Option A refers to longer-term adjustments rather than short-term determinants.
Option C affects trade directly but is not the primary immediate driver of exchange rates.
Option D addresses labor market impacts, which are less relevant to immediate exchange rate adjustments.
If the USD/EUR exchange rate decreases significantly, which of the following effects would most likely occur in the U.S. and Eurozone?
A. U.S. exports to the Eurozone would increase, and Eurozone exports to the U.S. would decrease.
B. U.S. imports from the Eurozone would increase, and U.S. exports to the Eurozone would decrease.
C. Both U.S. imports and exports would decrease due to the higher cost of foreign goods.
D. U.S. imports would remain constant as exchange rates have minimal impact on trade flows.
Answer: B. U.S. imports from the Eurozone would increase, and U.S. exports to the Eurozone would decrease.
Explanation: A decrease in the USD/EUR exchange rate indicates that the USD has appreciated relative to the euro. This makes Eurozone goods cheaper for U.S. consumers, increasing U.S. imports, while U.S. goods become more expensive for Eurozone consumers, decreasing U.S. exports.
Option A incorrectly reverses the direction of trade effects.
Option C misstates the impact, as exchange rate changes typically alter trade flows rather than reduce both imports and exports simultaneously.
Option D ignores the significant impact of exchange rates on the relative costs of goods and services between trading partners.
A country facing a persistent trade deficit funds its domestic investment through foreign capital inflows. According to the balance of payments identity, what must also be true in this scenario?
A. The country’s private savings exceed its total domestic investment.
B. The country is likely to have a government surplus offsetting the trade deficit.
C. The country’s capital account must have a surplus that offsets the trade deficit.
D. The country’s currency will automatically appreciate to correct the trade imbalance.
Answer: C. The country’s capital account must have a surplus that offsets the trade deficit.
Explanation: The balance of payments identity dictates that a trade deficit must be offset by a surplus in the capital account, reflecting foreign capital inflows that finance the deficit.
Option A is incorrect as private savings are insufficient to cover investment; hence, foreign capital is needed.
Option B does not necessarily hold, as government fiscal positions can vary independently of trade balances.
Option D incorrectly assumes automatic currency adjustments, which are not guaranteed and often influenced by capital flows.
Which of the following best explains why a country with a fixed exchange rate might impose capital restrictions?
A. To ensure continuous capital inflows to support economic expansion.
B. To protect domestic investors from volatile foreign markets.
C. To simplify fiscal policy management by eliminating exchange rate fluctuations.
D. To maintain the exchange rate target and control domestic monetary policy independently.
Answer: D. To maintain the exchange rate target and control domestic monetary policy independently.
Explanation: Capital restrictions help a country maintain its fixed exchange rate target, as limiting capital flows reduces pressure on the domestic currency and allows the central bank to pursue domestic economic goals.
Option A misrepresents the purpose, as capital restrictions often aim to prevent outflows rather than encourage inflows.
Option B is not a primary reason; the focus is on managing exchange rate stability.
Option C misunderstands the impact, as fiscal policy is separate from direct exchange rate interventions.
What is a likely long-term impact on international trade when a country frequently adjusts its capital flow restrictions to maintain a fixed exchange rate?
A. Increased foreign direct investment as investors gain confidence in predictable exchange rates.
B. Decreased trade volume due to reduced trust in the country’s financial policies.
C. Greater competitiveness of exports due to a consistently undervalued currency.
D. Balanced trade flows as restrictions eliminate currency volatility.
Answer: B. Decreased trade volume due to reduced trust in the country’s financial policies.
Explanation: Frequent changes in capital restrictions can undermine investor confidence, leading to decreased trade and investment as partners view the country as unstable or unpredictable.
Option A is incorrect as frequent policy changes typically deter investment.
Option C is not necessarily true; competitiveness depends on a range of factors beyond exchange rate valuation.
Option D mistakenly assumes restrictions eliminate volatility; they often create additional uncertainty.
According to the balance of payments identity (X - M) ≡ (S - I) + (T - G), which of the following scenarios would most likely explain a persistent trade deficit in a country?
A. The country has a large government surplus funded by high private savings.
B. Private savings consistently exceed domestic investment in physical capital.
C. The country has a fiscal deficit that is not offset by an excess of private savings over investment.
D. The country’s exports are rising faster than imports, but government spending also increases rapidly.
Answer: C. The country has a fiscal deficit that is not offset by an excess of private savings over investment.
Explanation: According to the identity (X - M) ≡ (S - I) + (T - G), a trade deficit (X - M < 0) occurs when the right-hand side is negative. This implies that domestic savings (S) plus government savings (T - G) are insufficient to fund domestic investment (I), requiring capital inflows from abroad to offset the deficit. Specifically, a fiscal deficit (T - G < 0) that is not counterbalanced by sufficient private savings over investment (S - I > 0) leads to a trade deficit.
Option A is incorrect because a large government surplus would reduce the trade deficit, not cause it.
Option B is incorrect as it suggests a positive contribution from private savings, which would not lead to a deficit.
Option D misinterprets the balance, as rising exports would decrease the deficit, and increased government spending would need further context about funding.
Given the equation (X - M) ≡ (S - I) + (T - G), which of the following statements accurately describes the impact of a large increase in government spending without a corresponding increase in tax revenue?
A. It would likely lead to a trade surplus as government spending stimulates economic growth.
B. It would increase domestic investment, thereby reducing the need for foreign capital inflows.
C. It would contribute to a trade deficit unless offset by an increase in private savings relative to investment.
D. It would have no direct impact on the trade balance as long as private savings remain constant.
Answer: C. It would contribute to a trade deficit unless offset by an increase in private savings relative to investment.
Explanation: An increase in government spending without a matching increase in tax revenue creates a fiscal deficit (T - G < 0), which must be offset by a surplus in private savings over investment (S - I > 0) to avoid a trade deficit. If private savings do not sufficiently increase relative to investment, the overall effect will be a negative right-hand side of the equation, leading to a trade deficit.
Option A is incorrect as increased government spending, without adequate savings, would worsen the trade balance, not improve it.
Option B misrepresents the impact; increased investment would need to be funded and might exacerbate the trade deficit.
Option D is incorrect because fiscal deficits directly impact the trade balance unless private sector behavior changes correspondingly.
Which of the following is a primary objective of imposing capital restrictions in countries with fixed exchange rate regimes?
A. To ensure foreign investors can freely enter strategic industries such as defense.
B. To allow the central bank to independently pursue domestic monetary policy goals.
C. To enhance the volatility of domestic asset prices in response to foreign investment flows.
D. To increase the flexibility of domestic interest rates in response to global market conditions.
Answer: B. To allow the central bank to independently pursue domestic monetary policy goals.
Explanation:
Capital restrictions, especially in countries with fixed exchange rate regimes, help maintain the exchange rate target by limiting the impact of foreign investment flows on the currency. By controlling capital inflows and outflows, policymakers can focus on domestic monetary policy objectives without the added pressure of responding to volatile foreign investment flows.
Option A is incorrect because capital restrictions often prevent foreign access to strategic industries rather than ensuring it.
Option C is incorrect because one of the primary aims of capital restrictions is to reduce volatility in asset prices, not enhance it.
Option D is incorrect as capital restrictions often aim to stabilize, not increase, the flexibility of domestic interest rates by limiting foreign capital movements.
