Midterm Review

Question 1

Drivers of currency demand

Answer 1

-Demand: demand for foreign goods. Eg. Canadian buying Turkish goods. Must convert to Lira to buy goods

Question 2

Official reserves

Answer 2

-in a free floating system, these do not change

Question 3

What are the components of a monetary policy trilemma

Answer 3

1 Free capital mobility
2 Exchange rate management
3 Monetary autonomy

Question 4

BoP

Answer 4

• current account + capital account + official reseves = 0

* credits are inflow, debits are outflow

Question 5

Fischer effect asumptions

Answer 5

real interest rate equals to the nominal interest rate minus the expected inflation rate.

shows how the money supply affects nominal interest rate and inflation rate as a tandem.

Question 6

Relative PPP

Answer 6

states that the exchange rate between the home currency and any foreign
currency will adjust to reflect changes in the price levels of the two countries.

For example, if inflation is
5% in the United States and 1% in Japan, then the dollar value of the Japanese yen must rise by about 4%
to equalize the dollar price of goods in the two countries

Question 7

Five parity conditions result from arbitrage activities:

Answer 7

Purchasing power parity (PPP)
	Fisher effect (FE)
	International Fisher effect (IFE)
	Interest rate parity (IRP)
	Forward rates are unbiased predictors of future spot rates (UFR)

Question 8

How to cope with a current account deficit

Answer 8

• depreciate currency
• protectionism
• boost savings rate
• end foreign ownership of assets

Question 9

According to the Fisher effect, countries with higher inflation rates

Answer 9

have higher interest rates

Question 10

PPP

Answer 10

price levels should be equal
worldwide when expressed in a common currency

two “levels”
Absolute
Relative

Question 11

Drivers of currency supply

Answer 11

foreign country’s demand for local goods

¥ e.g. Turkish demand for Canadian goods means Turks convert TL to C$ in order to buy.

Question 12

Uncovered interest parity

Answer 12

difference in interest rates between two countries is equal to the expected change in exchange rates between the countries’ currencies.

Question 13

Current Account deficit due to

Answer 13

• low private savings
• high private investment
• large government deficit

Question 14

Quoting currency

Answer 14

S1,2 - amount of currency 1 required to buy a unit of currency 2 → if S1,2 rises, currency 1 has depreciated

S1,2 = S2/S1

Question 15

Interest rate parity

Answer 15

interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.

Question 16

Interest Rate Parity (IRP) theory, we know that the currency that is at a “forward discount”, i.e., the one that buys

Answer 16

one that buys less in the forward market than in the spot market, is the currency with the higher interest rate, higher inflaiton, expect depreciation

Question 17

F1,2(n) > S1,2

Answer 17

Currency 2 trades at a forward premium

Currency 1 trades at a forward discount

Question 18

What is sterilized intervention

Answer 18

intervention in the currency market while simultaneously engaging in open market operation
-in the long term it Is ineffective and depletes foreign reserve accounts

Question 19

Possible explanations for higher interest rates

Answer 19

higher inflation expectations

Question 20

Best conditions for PPP

Answer 20

1. Over long term
2. short run during periods
   of hyperinflation since with high inflation changes in the general level of prices quickly swamp the effects
   of relative price change

Question 21

Are current account deficits bad?

Answer 21

• it depends what it is being used to finance
• if you are financing high ROI investments, its okay
• bad if you are using it to consumer more today at the expense of tomorrow

Question 22

Trading at forward premium ie. F>S

Answer 22

Currency that trades at a premium has lower interest rates, currency appreciates, possibly lower inflation

Question 23

Trading at forward discount

Answer 23

implies higher interest rate,

• higher inflation
• lower exchange rate

Question 24

International fischer effect

Answer 24

currency with low inflation is expected to appreciate