Topic 1 and 2

Question 1

What are 5 factors that cause shifts in the supply / demand curve for local currency?

Answer 1

1. Level of domestic income
2. Changes in Foreign Income levels
3. Interest rate differentials
4. Expectations
5. Exogeneous factors

Question 2

What is an exchange rate regime?

Answer 2

How government, through the central bank / an appointed authority, manages the currency of the country & the foreign exchange market.

Question 3

What is a floating exchange rate?

Answer 3

Entirely market-determined. No government restrictions or interventions

Question 4

What two floating exchange rates do the IMF distinguish between?

Answer 4

1. Free-floating rate: fx intervention limited. Moderate rate of change and prevent undue fluctuations
2. Floating rate: intervene more regularly to influence, but not specific exchange rate path or target

Question 5

What are the 5 types of soft pegs used in exchange rate regimes?

Answer 5

1. Conventional fixed to currency or basket
2. Stabilised arrangement
3. Pegged with horizontal bands
4. Crawling peg exchange rate
5. Crawl-like arrangement

Question 6

What is a stabilised arrangement soft peg?

Answer 6

The spot rate is fixed at a 2% margin of another currency for 6+ months, but does not imply a policy commitment

Question 7

What is a soft peg with horizontal bands?

Answer 7

aka. Targeted exchange rate regime.

Fluctuate within a band around a fixed reference point.

Question 8

What is a crawling peg exchange rate?

Answer 8

Adjusted periodically at preannounced fixed rate or in response to changes in selective indicators (ie. inflation)

Question 9

What is a crawl-like arrangement?

Answer 9

Within crawling bands. Pegged within bands that periodically shifts

Question 10

What are examples of hard pegs?

Answer 10

No separate legal tender. Includes dollarization, monetary unions and currency boards.

Question 11

What are the 3 different factors in Mundell-fleming’s impossible trinity?

Answer 11

Fixed exchange rate, free capital movement, independent monetary policy

Question 12

What are the central issues when comparing pegged vs floating regimes?

Answer 12

1. Independence of the monetary policy
2. Ability to handle shocks to the domestic economy & those of other countries
3. Need for capital controls
4. Need for foreign exchange reserves
5. Stability
6. Speculation & hot money flows

Question 13

What is a non-sterilized form of exchange rate intervention?

Answer 13

The central bank uses foreign reserves to purchase domestic currency from a commercial bank. Over time, reduced money supply will lead to higher interest rates and lower inflation, with such effects also contributing to an appreciation of the domestic currency over time.

Question 14

What is a sterilized form of exchange rate intervention?

Answer 14

Offsetting the balance sheet position, to avoid the inflation threat. The same time the Central Bank sells the foreign currency, they buy domestic government bonds, therefore increasing the money supply. This doesn’t influence the domestic interest rate, but can still influence the exchange rate

Question 15

How can a sterilized exchange rate intervention still influence the exchange rate?

Answer 15

• the portfolio balance channel
• the microstructure channel
• the signalling or expectations channel

Question 16

What is a monetary union?

Answer 16

the portfolio balance channel
the microstructure channel
the signalling or expectations channel

An economic and monetary union combines a monetary union with an economic union (a common market and a customs union) e.g. Eurozone.

Question 17

Dollarization

Answer 17

Dollarization occurs when the US dollar (or other foreign currency) is used alongside or instead of the domestic currency as money, essentially as a means of payment and unit of account (currency substitution). It also includes holding foreign currency-denominated assets in a domestic bank (asset substitution)

Question 18

What are the pro’s of dollarization?

Answer 18

Reduce country risk - investment climate

Protect against inflation & devaluation

Question 19

What are the cons of dollarization?

Answer 19

1. Loss of monetary policy
2. Loses seigniorage
3. Lose lender of last resort

Question 20

What are the two types of dollarization?

Answer 20

Official (de jure) - almost permanent, formal agreement

Unofficial (de facto) - use forex in transactions but no formal policy

Question 21

What drove dollarization in Angola?

Answer 21

• a long conflict
• poor macroeconomic conditions in the early 2000s (hyperinflation)
• the value of the kwanza and
• the reliance of the country on oil revenue.

Question 22

What are key success factors to dedollarization?

Answer 22

1. Strong macroeconomic policies
2. Presence of inflation targeting
3. lower international interest rates
4. lower volatility in global stock markets

Question 23

Explain the controversy regarding the Chinese Yuan?

Answer 23

The Chinese maintained a peg within fixed bands to the USD, making their exports more competitive. This is achieved by buying dollars and selling Yuan, and has lead to $3.82 million in USD reserves. The general opinion is that this exchange rate regime has left the currency undervalued (and therefore increases the competitiveness)