Unit 5

Question 1

Give a brief explanation of the gold standard:

Answer 1

A monetary system which defines the value of a currency in terms of the fixed amount of Gold
▪ This system allows a government to convert its currency into gold, and vice versa, which aids in
stabilizing the economy and enhancing trade relations among nations.
▪ Simply put; currencies converted to gold and gold back to currency within a country

Question 2

What were some problems with the gold standard?

Answer 2

▪ Inability to carry large amounts of gold
▪ Not stable for purchases across markets
▪ Earn no interest rates.

Question 3

Briefly explain the Bretton Wood system:

Answer 3

▪ Post WW2, countries came together to decide on a stable exchange rate to facilitate peaceful and
international trade; based on gold and the dollar. 1 ounce of gold=$35
▪ The IMF was then established to monitor exchange rates
▪ Everyone around the world wanted to have the dollar due to its link to gold

Question 4

What were some problems with the Bretton Wood system?

Answer 4

It became very unsustainable as the outflows of the US dollar exceeded the inflow of the dollar back to the
US making people doubt the USAs ability to convert gold back to cash. Why did USA not produce more
money?
▪ Other foreign central banks held dollars
▪ There were also balance of payment surpluses and deficits across countries

Question 5

Briefly explain Floating exchange rates (Jamaica agreement, 1976)

Answer 5

▪ Due to foreign central banks holding large amounts of dollars Pre. Nixon in 1971 declared that USA
would not exchange gold for dollars held by foreign central banks.
▪ Therefore, central banks could not exchange gold for $ (1ounce=$35) which resulted in currencies
floating in foreign exchange markets and their value determined by demand.
▪ The Jamaica Agreement in 1976 by IMF member states then established guiding rules for the floating
system and established flexible exchange rates for—IMF member countries.

Question 6

Explain the Current Currency Arrangements:
1. No separate legal tender

Answer 6

One country adopts the currency of another, or a group of countries adopt a common currency

Question 7

Explain the Current Currency Arrangements:
2. Currency board

Answer 7

▪ Fixed rate with foreign currency

Question 8

Explain the Current Currency Arrangements:
3. Conventional fixed-peg

Answer 8

Allows a currency’s exchange rates with one or a basket of currencies to fluctuate around a
fixed rate within a narrow band of less than 1 percent

Question 9

Explain the Current Currency Arrangements:
4. Stabilized arrangement: Pegged exchange rate within a horizontal band

Answer 9

Fixed rate, but exchange rate fluctuations greater than 1 percent are allowed

Question 10

Explain the Current Currency Arrangements:
5. Crawling peg

Answer 10

a currency is pegged to another currency or a basket of currencies, but the peg is readjusted
periodically at a fixed, preannounced rate (e.g. <2%)

Question 11

Explain the Current Currency Arrangements:
6. Crawling band

Answer 11

▪ readjusts the country’s currency to maintain fluctuation margins around a central rate, within a fixed
bandwidth of adjustment (e.g. ±3%), and the central rate or margins are adjusted periodically

Question 12

Explain the Current Currency Arrangements:
7. Managed floating

Answer 12

the currency fluctuates, while the country’s monetary authority actively intervenes on the exchange
market

Question 13

Explain the Current Currency Arrangements:
8. Free floating exchange rates

Answer 13

rely on the market. Governments may intervene, but to moderate the rate of change rather than to
establish the currency’s level

Question 13

Explain Exchange Rate Quotations and the FX Market

Answer 13

▪ Buyers want to purchase in own currency, so sellers assume risk as part of their offering
▪ It is therefore important to know how much of a currency you can purchase per US$ or its
reciprocal, i.e., how many dollars a unit of other currencies can buy.
▪ Risk of movement may be substantial, as freely floating currencies can shift considerably

Question 13

What is a spot rate?

Answer 13

o The exchange rate between two currencies for delivery within two business days

Question 14

What is a Forward rate?

Answer 14

The exchange rate between two currencies for delivery in the future, usually 30, 60,
90, or 180 days

Question 15

What do you call the buy and sell price on the FX market? Explain these prices:

Answer 15

They are called the bid price (buy price) and the ask price (sell price)

▪ Bid price
o Highest-priced buy order currently in the market
▪ Ask price
o Lowest-priced sell order currently in the market
o The difference between the two provides a margin for the bank/agency

Question 16

Explain The Law of One Price & Arbitrage:

Answer 16

Law of One Price: in an efficient market, like products will have like prices [otherwise,
arbitrage will occur]
o Arbitrage: The process of buying and selling instantaneously to make profit with no risk

Question 17

Explain the Fisher effect:

Answer 17

The higher the inflation in a country, the higher interest rates will be (an
investor will want to earn more in a high-inflation environment to compensate for the
effect of inflation on the investment)

Question 18

Explain the International Fisher effect:

Answer 18

the interest rate differentials for any two currencies will
reflect the expected change in their exchange rates (countries with higher interest rates
will have higher inflation, which leads to a currency’s depreciation)

Question 19

Explain Purchasing power parity (PPP):

Answer 19

o The amount of adjustment that must be made in the exchange rates for two currencies in
order for them to have equivalent purchasing power
o If they don’t have equivalent purchasing power, arbitrage would lead to buying of
undervalued currencies and purchasing undervalued goods
o PPP is used to show the number of units of a currency required to buy the same basket
of goods and services in two markets with different currencies.

Question 20

Name and explain the three exchange rate forecasting techniques:

Answer 20

1. Efficient market approach
   ▪ Assumption that current market prices fully reflect all available relevant information
   ✓ Based on; Random walk hypothesis: Assumption that the unpredictability of
   factors suggests that the best predictor of tomorrow’s prices is today’s prices.
2. Fundamental approach
   o Exchange rate prediction based on econometric models that attempt to capture the variables and their correct relationships.
3. Technical analysis
   o An approach that analyzes data for trends and then projects these trends forward.

Question 21

What are monetary policies?

Answer 21

▪ Government policies that control the amount of money in circulation and its growth rate
▪ Governments can control currency exchange of their currency and other currencies within
their borders
▪ Motivation is to manage foreign reserves
▪ With currency controls, exchange rates are usually above open market rates

Question 22

Explain the difference between convertible and nonconvertible currencies:

Answer 22

• Convertible currencies can be exchanged for other currencies without restrictions.
• When a currency is nonconvertible, its value is arbitrarily fixed, typically at a rate higher than its value in the free market, and the government imposes exchange controls to limit or prohibit the legal use of its currency in international transactions.
  o The government also requires that all purchases or sales of other currencies be made through a government agency

Question 23

What are Fiscal policies?

Answer 23

▪ Policies that address the collecting and spending of money by the government
▪ One major aspect of fiscal policies is taxation

Question 24

What are the Three major types of taxes:

Answer 24

1. Income—direct tax on corp. and individual income.
2. Value-added—really a sales tax, and collected at each step of value added, then credited back on earlier payments.
3. Withholding tax-indirect tax on passive income.

Question 25

How do companies cope with high taxes?

Answer 25

Management techniques involve profit shifting (often through transfer pricing) and inversion (moving to a lower-tax environment)

Question 26

Define inflation:

Answer 26

Inflation is a sustained increase in prices.

Question 27

How is inflation related to exchange rates?

Answer 27

o Determines real cost of borrowing in capital markets
o Rising rates encourage borrowing
o Inflated currencies tend to weaken
o Interest rates rise with inflation

Question 28

How does inflation determine real cost of borrowing in capital markets?

Answer 28

o via the Fisher Effect (rr=(rn): an increase in the expected inflation rate will lead to an
increase in the interest rate;
o a higher interest rate means that it is costlier to raise capital in this currency, and firms
will opt to raise capital in other currencies;
o therefore, there will be less demand for the inflated currency, leading it to depreciate;
o the International Fisher Effect also states that a higher interest rate leads the currency to depreciate.

Question 29

How does Rising inflation rates encourage borrowing?

Answer 29

• If the inflation rate is higher than the interest rate, an inflated currency may encourage borrowing, because loans can be repaid in the future with inflated, cheaper money;
• this means an increase in demand for the domestic currency, leading it to appreciate.

Question 30

Why does Inflated currencies tend to weaken?

Answer 30

o High inflation in one country means that its goods increase in price quicker than goods in
other countries. Therefore, domestic goods become less competitive. Demand for
exports of domestic goods will fall. Therefore, there will be less demand for the domestic
currency.

o Also, consumers in the country in question will find it more attractive to buy imports from
other countries. Therefore, they will sell domestic currency to be able to buy foreign
currency and imports. This increase in the supply of domestic currency decreases value
of the domestic currency.

Question 31

Why does Interest rates rise with inflation?

Answer 31

o Via the Fisher Effect: The higher the inflation in a country, the higher interest rates will be
(an investor will want to earn more in a high-inflation environment to compensate for the
effect of inflation on the investment)

Question 32

Explain Balance of payments (BOP):

Answer 32

▪ Record of a country’s transactions with the rest of the world
▪ Shows flow of capital in and out of the country

Question 33

Name and explain the three Balance of payments accounts:

Answer 33

▪ Current account
o Tracks tangible goods - trade balance, services
o Intangibles – services
o Unilateral transfers (gifts, aid, migrant worker earnings)

▪ Capital account
o Tracks financial assets and liabilities, direct investment, portfolio investment, short-term capital flows (credit when resident sells stock to nonresident)

▪ Official reserves
o Gold imports and exports
o Foreign exchange
o Liabilities to foreign central banks

Question 34

How does imports and exports affect the strength and demand of a currency?

Answer 34

▪ If a country exports more than it imports, there will be a high demand for its currency in other countries, so its customers can pay for the exported goods. This demand may well create pressure on the exporter’s currency, in which case it might be expected to strengthen.

▪ Conversely, when a country imports more than it exports, its currency might be expected to weaken, or, if it is not a floating currency, to be devalued, that is, its value reduced by the
government.

▪ Current account deficit may mean economic problems (inflation, low productivity, inadequate saving) OR that demand into the country (Treasury bills, investment property) exceeds outward flows (as in U.S.)

▪ To give meaning to a deficit, you need to look at total picture.

Question 35

How does political developments create causes of exchange rate movement?

Answer 35

▪ Consumer and investor confidence are affected

▪ Greater/lower consumption/investments in the country = greater/lower demand for the
currency = appreciation/depreciation