Mid-term Practice Questions

JM chpt. 1 and 2

International capital mobility refers to

A. the ease with which manufacturing equipment can be transported across countries.
B. the ease with cash may be transferred from one country to another without having to be
converted into a foreign currency.
C. the ease with which investors move funds among international financial markets.
D. the ease with which exchange rates may be adjusted to reflect changes in the relative economic
strengths of countries.

If the interest rate in the United States rises

A. investors increase their demand for dollars and the U.S. exchange rate appreciates.
B. investors increase their demand for dollars and the U.S. exchange rate depreciates.
C. investors decrease their demand for dollars and the U.S. exchange rate appreciates.
D. investors decrease their demand for dollars and the U.S. exchange rate depreciates.

Foreign-exchange market interventions will always

A. lead to a decline in domestic interest rates relative to foreign interest rates.
B. lead to a rise in domestic interest rates relative to foreign interest rates.
C. lead to a decline in the domestic money supply.
D. alter a central bank’s holdings of international reserves.

When the Fed sells foreign assets to buy domestic assets,

A. its assets and liabilities rise by the same amount.
B. its assets and liabilities fall by the same amount.
C. the composition of its assets changes, but its liabilities are unaffecteD.
D. the composition of its liabilities changes, but its assets are unaffecteD.

A sale of foreign assets by a central bank has the same effect on the monetary base as
A. a decrease in the discount rate.
B. a decrease in the required reserve ratio.
C. an open market sale of government bonds.
D. an open market purchase of government bonds.

If the Fed sterilizes the purchase of foreign assets,

A. the monetary base is left unchangeD.
B. the monetary base rises by the amount of the purchase.
C. the monetary base falls by the amount of the purchase.
D. the monetary base may rise, fall, or remain unchanged depending on the reaction of domestic
interest rates to the purchase.

The main reason central banks engage in foreign-exchange interventions is to

A. stabilize the domestic money supply.
B. stabilize domestic interest rates.
C. stabilize foreign interest rates.
D. stabilize the exchange rate.
The equilibrium exchange rate
A. is determined by the relative amounts of gold contained in each country’s currency.
B. is determined monthly by the International Monetary FunD.
C. in the short run reflects the relative purchasing power of each country’s currency.
D. makes investors indifferent between holding domestic and foreign assets.

If the central bank buys foreign assets,

A. the domestic monetary base will decline.
B. domestic short-term interest rates will decline.
C. the foreign-exchange value of the domestic currency will rise.
D. its holdings of international reserves will rise.

A sterilized intervention will not affect the exchange rate if

A. capital controls are in place.
B. domestic and foreign assets are perfect substitutes.
C. domestic assets are more liquid than foreign assets.
D. domestic assets are less liquid than foreign assets.

When domestic and foreign assets are imperfect substitutes, an increase in the supply of domestic
assets
A. implies greater exchange rate risk.
B. implies lower exchange rate risk.
C. raises the exchange rate.
D. implies lower exchange rate risk and raises the exchange rate

The current account balance plus the capital account and financial account balance
A. equals the trade balance.
B. equals the net outflow of currency from the domestic economy.
C. will be negative during economic expansions and positive during economic contractions.
D. equals zero.

Fixed exchange rate regimes

A. existed prior to the nineteenth century but were then superseded by the gold standarD.
B. lower the transactions costs of buying and selling goods and assets.
C. result in higher world interest rates.
D. were first established by the GATT in 1971.

The Bretton Woods system lasted from

A. 1801 to 1861.
B. 1863 to 1914.
C. 1945 to 1971.
D. 1981 to 1993.

The formal name of the World Bank is

A. the International Monetary FunD.
B. the International Bank for Reconstruction and Development.
C. the United Nations Bank for Economic Stability.
D. the Bank for International Financial Stability and Reform.
The fixed exchange rates of the Bretton Woods system were maintained
A. by central bank interventions in the foreign-exchange market.
B. by the requirement that short-term interest rates be equalized in all participating countries.
C. by the requirement that long-term interest rates be equalized in all participating countries.
D. through the automatic workings of the foreign-exchange market.

Which of the following statements is correct?

A. A devaluation of the British pound would result in more dollars to the pounD.
B. A revaluation of the British pound would raise the prices of U.S. goods in Britain.
C. A devaluation of the British pound would lower the prices of British goods in the United States.
D. Revaluations and devaluations of a country's currency were not allowed under the Bretton
Woods system.

Members of the ERM

A. agreed to buy and sell gold at a fixed rate.
B. promised to maintain the values of their currencies within a fixed range.
C. attempted to maintain a fixed exchange rate against the dollar.
D. agreed to all charge the same interest rate on central bank loans.

JM chpt 3 Foreign Exchange Markets/International Flow of Funds or Models

The Irawash Co. of Canada has set up a website to sell products to US consumers. Prices are listed
in US dollars but all their costs are in Canadian dollars. Which of the following is a major risk faced
by the company?
A. Exchange rate risk.
B. An American boycott.
C. Investment risk.
D. All of the above.

Which of the following is an example of foreign exchange?

A. Exchange of cash issued by a foreign central bank.
B. Exchange of claims denominated in another currency.
C. Exchange of bank deposits.
D. All of the above.

If a company contracts today for some future date of actual currency exchange, they will be
making use of a:
A. futures rate.
B. stock rate.
C. forward rate.
D. variable rate.

_____________ contracts are more widely accessible to firms and individuals than ____________
contracts.
A. Forward; futures
B. Arbitrageur; forward
C. Forward; arbitrageur
D. Futures; forward
According to which theory will differences in nominal interest rates be eliminated in the exchange
rate?
A. The Leontief paradox.
B. The PPP.
C. The combined equilibrium theory.
D. (International) Fisher effect.

Short Essay Question:

What is the Balanceof Payments (BOP), and what does it mean to have a surplus or deficit Explain
what the two primary accounts are, and what having a surplus or deficit in these accounts implies.
In which account will a deficit most likely lead to a depreciation of our currency if it is sustained over
a long period of time? Why? (15p)

The balance of payments is a measurement of all transactions between domestic and foreign residents
over a specified period of time. (It accounts for transactions by businesses, individuals, and the
government.)

Each transaction is recorded as both a credit and a debit, i.e. double-entry bookkeeping. (Thus, total
credits (cash inflows=exports and income receipts by the US) and debits (cash outflows=imports and
income payments by the US) for a country’s BOP will be identical in aggregate. BOP=0. But, for any
subset of the BOP, there may be deficit or surplus position.)

The transactions are presented in three groups – a current account, a capital account, and a financial
account.

BOP= Current Acc. + Capital Acc. + Financial Acc.=0 (capital account items are relatively minor
compared to the financial items)

The current account summarizes the flow of funds between one specified country and all other
countries due to the purchases of goods or services, the provision of income on financial assets, or
unilateral current transfers (e.g. government grants and pensions, private remittances).

A current account deficit suggests a greater outflow of funds from the specified country for its current
transactions.

The current account is commonly used to assess the balance of trade, which is simply the difference
between merchandise exports and merchandise imports.

What two primary accounts is the BOP composed of?

• Current Account
➢ ¤ Payments for merchandise and services
➢ ¤ Factor Income Payments (interest and dividend payments received by foreign investors on
investments in financial assets in the US-called capital outflows- and interest and dividend
payments received by US investors on investments in financial assets-called capital inflows)
➢ ¤ Transfer Payments (grants, gifts)
Capital Account

It includes unilateral current transfers that are really shifts in assets, not current income. E.g. debt
forgiveness, transfers by immigrants, the sale or purchase of rights to natural resources or patents.

Capital account includes the value of financial assets transferred across country borders by people who
move to a different country. It also includes the value of nonproduced nonfinancial assets that are
transferred across country borders, such as patents and trademarks. (if a U.S. firm sells its patent rights
to a canadian firm, this will be counted as a credit [cash inflow] to US BOP and vice versa.)

Financial Account

The financial account (which was called the capital account previously) summarizes the flow of funds
resulting from the sale of assets between one specified country and all other countries.

Assets include official reserves, other government assets, direct foreign investments, investments in
securities, etc.

• Financial Account comprises

¤ FDI (investment in fixed assets in foreign country= a firm’s acquisition of a foreign company, its
construction of a new manufacturing plant, or its expansion of an existing plant in a foreign country)
¤ Portfolio Investment (represent transactions involving long-term financial assets such as stocks and
bonds=a purchase of heineken (netherland) by a US investor)
¤ Other Capital Investment (represents transactions involving short-term financial assets such as
money market securities)
¤ Difference between FDI, PI and OCI is FDI measures the expansion of firms’ foreign operations
whereas PI and OCI measure the net flow of funds due to financial asset transactions between
individual or institutional investors.
¤ Errors and Omissions and Reserves

Can you explain how BOP has deficit/surplus under fixed exchange rates? Floating rates?

Balance of payment deficit is related to trade balance. If a country’s imports are more than exports,
the demand of foreign exchange will increase, and then the trade deficit will occur. For example, a
floating exchange rate system may correct a trade imbalance automatically since the trade imbalance
will affect the demand and supply of the currencies involved.

What account does the book specify that I’veleft out, and why am I ignoring it? Explain what the
two primary accounts are, and what having a surplus or deficit in these accounts implies.

because entries in the financial account are net entries that offset credits with debits, they may not
appear in a country's balance of payments, even if transactions are occurring between residents and
nonresidents.