week 24

Question 1

what is the importance of exchange rates

Answer 1

domestic purchases are made with local currency, exchange rate measures the rate of conversion between currencies
exchange rates are set in the foreign exchange markets with a small number of exceptions
rates are determined by supply and demand
affect the value of imported goods and the value of financial investments made across borders

Question 2

what is the nominal exchange rate

Answer 2

rate at which two currencies can be traded for each other

Question 3

what is appreciation

Answer 3

an increase in the value of a currency relative to other currencies

Question 4

what is depreciation

Answer 4

a decrease in the value of a currency relative to other currencies

Question 5

what is the foreign exchange market

Answer 5

the market on which currencies of various nations are traded
exchange rate can be set independently or by agreement with a number of other governments
fixed rates can be set relative to the dollar, the euro or gold

Question 6

what is a flexible exchange rate

Answer 6

an exchange rate whose value is not officially fixed but varies according to the supply and demand market for the currency in the foreign exchange market

Question 7

what is a fixed exchange rate

Answer 7

an exchange rate set by official government policy

Question 8

what is the real exchange rate

Answer 8

the price of the average domestic good relative to the price of the average foreign good when prices are expressed in a common currecny

Question 9

how do you calculate real exchange rate

Answer 9

price of domestic good / price of foreign good in $

Question 10

what does it mean if real exchange rate is high

Answer 10

domestic goods are expensive relative to foreign goods
net exports will be low when the real exchange rate is high

Question 11

what is a strong currency

Answer 11

unrelated to a strong economy
reduce net exports, lowers domestic sales and profits

Question 12

what is the law of one price

Answer 12

states that if transportation costs are relatively small, the price of an internationally traded commodity must be the same in all locations

Question 13

what is purchasing power parity

Answer 13

the theory that nominal exchange rates are determined as necessary for the law of one price to hold
in the long run, the currencies of countries that experience significant inflation will tend to depreciate

Question 14

how are dollars supplied in a foreign exchange market

Answer 14

anyone who holds dollars is a potential supplier
US households and firms are the most common suppliers
supply curve has a positive slope
the more foreign currency each dollar can buy, the larger the quantity of dollars supplied

Question 15

what does the demand curve for dollars look like

Answer 15

demand curve has a negative slope
the more foreign currency needed to buy a dollar, the smaller the quantity demanded
makes US goods more expensive

Question 16

what does the graph for the dollar-euro market look like

Answer 16

the market equilibrium of the exchange rate equates the quantities of the currency supplied and demanded in the foreign exchange market

Question 17

how is the supply of dollars for euros determined

Answer 17

the preference for european goods, the stronger the preference the greater the supply of dollars
US real GDP, the higher the GDP, the greater the supply of dollars
real interest rate on European assets and the real interest rate on US assets - supply on dollars is higher if real interest rate on european assets is higher and on us assets in lower

Question 18

how is the demand for dollars determined

Answer 18

preference for US goods - the stronger the preference, the greater the demand for dollars
the real GDP in europe - higher GDP, greater demand for dollars
real interest rate on european assets and real interest rate on US assets - supply of dollars greater if Euro interest rate is lower

Question 19

how does monetary policy affect changes in dollar exchange rate

Answer 19

flexible exchange rates make monetary policy more effective
the FED tightens monetary policy, sets off a chain of domestic events
r increases, C and Ip decrease, PAE decreases, Y decreases
and international events
r increases, e* increases, NX decreases, PAE decreases, Y decreases

Question 20

how do fixed exchange rates effect effect monetary policy

Answer 20

reduce the effectiveness of monetary policy as a stabilisation tool

Question 21

how do govs establish fixed exchange rate

Answer 21

gov states the value of currency in terms of a major currency
attempt to maintain the fixed exchange rate at its existing level

Question 22

what is devaluation

Answer 22

reduction in the official value of a currency

Question 23

what is revaluation

Answer 23

increase in the official value of a currency

Question 24

how do you fix an exchange rate

Answer 24

response to an overvalued currency
devalue the currency
impose trade barriers
purchase the currency - a country must hold international reserves
balance of payments deficit occurs if a country has a net decline in international reserves over a year
balance of payments surplus occurs if a country has a net increase in international reserves over a year

Question 25

what are the benefits of fixed rates

Answer 25

predictability and stability in foreign transactions
certainty of future value of currencies

Question 26

what are the disadvantages of fixed rates

Answer 26

sudden and unforeseen large changes are possible
predicting exchange rates over the long term is difficult under fixed or flexible rates

Question 27

what is a speculative attack

Answer 27

a massive selling of domestic currency assets by financial investors

Question 28

how is monetary policy effected by fixed and flexible exchange rates

Answer 28

flexible exchange rates can strengthen the impact of monetary policy
fixed exchange rates can prevent used of monetary policy to stabilise the economy

Question 29

how is trade and economic integration effected by fixed and flexible exchange rates

Answer 29

fixed exchange rate proponents argue that fixed rates promote international trade
the risk of speculative attack may make the country less attractive to investors and trade

Question 30

what are features of the euro

Answer 30

european central bank controls the currency
countries sacrifice some control to be part of the euro
economic conditions vary between countries and the central bank cannot respond to each