Problem Set 3

Question 1

how do you measure change in exchange rate?

Answer 1

(ending rate-beginning rate)/beginning rate

Question 2

what is globalization

Answer 2

the development of an increasingly integrated global
economy marked especially by free trade, free flow of capital, and the tapping of cheaper foreign labor
markets.

Question 3

which assets play most critical role in linking major institutions that make up global financial marketplace?

Answer 3

Debt securities issued by governments (e.g., U.S. Treasury Bills and Bonds) are at the heart of the global
financial marketplace. The health and security of the global financial system is dependent on these
assets

Question 4

why have eurocurrencies and LIBOR remained the centerpiece of the global financial marketplace for so long?

Answer 4

Eurocurrencies have remained a centerpiece of the global financial marketplace because the
eurocurrency market is essentially a large money market relatively free from government regulation. A
major reason global depositors and borrowers are attracted to the eurocurrency market is because of
the narrow interest rate spread in the market. The reference rate of interest for the eurocurrency
market is the London Interbank Offered Rate (LIBOR).

Question 5

what was the gold standard?

Answer 5

Under the gold standard, the “rules of the game” were clear and simple. Each country set the rate at
which its currency unit (paper or coin) could be converted to a weight of gold. A country’s money supply
was limited to the amount of gold held by its central bank or treasury. For example, if a country had
1,000,000 ounces of gold and its fixed rate of exchange was 100 local currency units per ounce of gold,
that country could have 100,000,000 local currency units outstanding. The system also had the effect of
implicitly limiting the rate at which any individual country could expand its money supply. Any growth in
the amount of money was limited to the rate at which official authorities could acquire additional gold

Question 6

which macroeconomic variables could cause the fixed exchange rate to be devalued?

Answer 6

An interest rate that is too low compared to other competing currencies
 A continuing balance of payments deficit
 An inflation rate consistently higher than in other countries

Question 7

advantages and disadvantages of fixed exchange rates?

Answer 7

Fixed rates provide stability in international prices for the conduct of trade. Stable prices aid in
the growth of international trade and lessen risks for all businesses.
 Fixed exchange rates are inherently anti-inflationary, requiring the country to follow restrictive
monetary and fiscal policies. This restrictiveness, however, can often be a burden to a country
wishing to pursue policies that alleviate continuing internal economic problems, such as high
unemployment or slow economic growth.
 Fixed exchange rate regimes necessitate that central banks maintain large quantities of
international reserves (hard currencies and gold) for use in the occasional defense of the fixed
rate. As international currency markets have grown rapidly in size and volume, increasing
reserve holdings has become a significant burden to many nations.
 Fixed rates, once in place, may be maintained at rates that are inconsistent with economic
fundamentals. As the structure of a nation’s economy changes, and as its trade relationships
and balances evolve, the exchange rate itself should change. Flexible exchange rates allow this
to happen gradually and efficiently, but fixed rates must be changed administratively—usually
too late, too highly publicized, and at too large a one-time cost to the nation’s economic health.

Question 8

what’s the impossible trinity

Answer 8

The impossible trinity are

1. Exchange rate stability,
2. Full financial integration, and
3. Monetary independence.

Question 9

explain the impossible trinity

Answer 9

These qualities are termed the impossible trinity because a country must give up one of the three goals
described by the sides of the triangle: monetary independence, exchange rate stability, or full financial
integration. The forces of economics do not allow the simultaneous achievement of all three. For
example:
 Countries with tight control over capital inflows and outflows can retain their monetary
independence and stable exchange rate but surrender being integrated with the world’s capital
markets.
 Countries with floating rate regimes can maintain monetary independence and financial
integration but must sacrifice exchange rate stability.
 Countries that maintain exchange rate stability by having fixed rates give up the ability to have
an independent monetary policy

Question 10

currency board vs dollarization?

Answer 10

In a currency board arrangement, the country issues its own currency but that currency is backed 100%
by foreign exchange holdings of a hard foreign currency—usually the U.S. dollar. In dollarization, the
country abolishes its own currency and uses a foreign currency, such as the U.S. dollar, for all domestic
transactions.

Question 11

how does the euro affect the market? (3)

Answer 11

The euro affects markets in three ways: (1) countries within the euro zone enjoy cheaper transaction
costs; (2) currency risks and costs related to exchange rate uncertainty are reduced; and (3) all
consumers and businesses both inside and outside the euro zone enjoy price transparency and
increased price-based competition

Question 12

why was the IMF founded?

Answer 12

The IMF was established to render temporary assistance to member countries trying to defend the value
of their currencies against cyclical, seasonal, or random occurrences. In addition, it was to assist
countries having structural trade problems. More recently, it has attempted to help countries, like
Russia and other former Soviet republics, Brazil, Indonesia, and South Korea, to resolve financial crises

Question 13

what is the special drawing right?

Answer 13

The Special Drawing Right (SDR) is an international reserve asset created by the IMF to supplement
existing foreign exchange reserves. It serves as a unit of account for the IMF and other international and
regional organizations and is also the base against which some countries peg the exchange rate for their
currencies. Defined initially in terms of a fixed quantity of gold, the SDR has been redefined several
times. It is currently the weighted average of four major currencies: the U.S. dollar, the euro, the
Japanese yen, and the British pound. The weights are updated every five years by the IMF. Individual
countries hold SDRs in the form of deposits in the IMF. These holdings are part of each country’s
international monetary reserves, along with official holdings of gold, foreign exchange, and its reserve
position at the IMF. Members may settle transactions among themselves by transferring SDRs.

Question 14

why did the fixed exchange rate regime of 1945-73 fail?

Answer 14

The fixed exchange rate regime of 1945–1973 failed because of widely diverging national monetary and
fiscal policies, differential rates of inflation, and various unexpected external shocks. The U.S. dollar was
the main reserve currency held by central banks and was the key to the web of exchange rate values.
The United States ran persistent and growing deficits in its balance of payments, requiring a heavy
outflow of dollars to finance the deficits. Eventually, the heavy overhang of dollars held by foreigners
forced the United States to devalue the dollar because the United States was no longer able to
guarantee conversion of dollars into its diminishing store of gold.