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Economics Dr.

Katie Sauer

Chapter 11 Reading Guide: International Economics I. Introduction Explain what the European Exchange Rate Mechanism (ERM) is:

In 1992, the value of 1 British pound was pegged to be ________ German marks. At the time, the British economy was _____________________________. An exchange rate is:

- the value of the exchange rate is determined by ___________________________________ Because the British economy was in recession, investors were looking to invest elsewhere. - the demand for the pound was ____________________________ - the value of the pound was _______________________________ The British government said it was committed to maintaining its ERM target. Tools: 1. 2. Problem:

What did George Soros do?

What did Britain do?

International economics isnt different from economics within countries. - National borders are _________________________ drawn, not economically. - Transactions across borders must still make both parties better off or else _______________ __________________________________________________. There is a layer of complexity though:

II. Exchange Rates An exchange rate is:

Explain the theory of Purchasing Power Parity:

If a currency is losing purchasing power within a nation, wed also expect it to lose value relative to _________________________________. Explain the difference between real exchange rates and nominal exchange rates:

The concept of Purchasing Power Parity is useful for:

In the long run, economic logic tells us exchange rates should be:

How do current official exchange rates differ from PPP?

Explain why this is the case.

An overvalued currency means:

An undervalued currency means:

Explain what the Big Mac Index is.

In July 2009, a Big Mac in the US cost on average $3.57 and cost 12.5 renminbi in China. This suggests that $3.57 should equal 12.5renminbi or $1 should equal ________. The actual exchange rate in July 2009 was ___________________________. This means the renminbi was _________________________ versus the dollar.

Exchange Rate Fluctuations Explain what it means to say a currency has depreciated versus another currency:

Explain what it means to say a currency has appreciated versus another currency:

Explain some implications of a weak US dollar:

There is nothing inherently good or bad about a strong or weak currency. The most important factors affecting the relative demand for currencies are ______________ _______________________________________.

When the demand for a currency increases, the currency ____________________________. Saudi Arabia example:

High interest rates example:

Fluctuations in exchange rates are hard to predict. 2007 financial crisis example:

Individual governments can try to influence their nations exchange rates by _______________ ____________________________________.

III. Types of Exchange Rate Systems A. Gold Standard Explain how the gold standard worked: 3

An advantage of the gold standard is:

A disadvantage of the gold standard is:

In the US, in 1933, ____________________________ could no longer exchange paper currency for gold, but ________________________________ still were able to. In _________, the US went off the gold standard entirely. - Why?

B. Floating Exchange Rates Most __________________________ economies have floating exchange rates. - currencies are traded on foreign exchange markets - at any given time, the exchange rate reflects:

An advantage is that governments:

A disadvantage is:

C. Fixed Exchange Rates Explain how fixed exchange rates work:

An advantage is a stable exchange rate. Investors, importers and exporters can conduct transactions without worrying that the exchange rate will change. A disadvantage is:

D. Currency Boards Explain Argentinas currency problem.

Explain how they tried to solve it.

Explain some of the consequences.

E. Soft Currencies Explain what a soft currency is and give some examples.

How did the Pepsi company deal with the problem of soft currencies?

IV. Currency Crises List 7 countries that have had major currency crises:

While each currency crisis is unique, they tend to follow a pattern: 1. 2. 3.

A. Icelands currency crisis Act I: The value of the krona was ____________ and interest rates were ____________. Icelands banking sector was relatively unregulated and was attracting ________________. - banks used the funds for: Because of the high interest rates, the people of Iceland:

Act II: The US financial crisis hits in 2008 and goes global. In Iceland, the banks were: The value of the krona _______________________________. - This impacted the consumer loans: 5

Act III: The krona lost _________________________. The Icelandic stock market ______________________________. GDP fell by ____________________________. Unemployment ________________________________.

B. Preventing Currency Crises 1. Capital Controls What is a capital control?

Problems to requiring capital controls:

2. Common Currency Benefits:


What we really care about is the flow of goods and services. Currencies are simply a tool for making it easier to exchange goods and services.

V. The Current Account The Current Account measures:

There is nothing inherently good or bad about a current account surplus or deficit. When the US buys more goods and services from the rest of the world than the rest of the world buys from the US, then to make up the difference, the US could - sell ___________________________. - buy ___________________________. Why does the US run a current account deficit?

The Current Account and National Savings Any country that consumes more than it produces must be running a current account deficit because: 1. 2.

Farming analogy:

Normally, a country with a large current account will see its currency _________________________. New Zealand example:

The US-China situation is different. Explain.

In the long run, this has consequences for both the US and China. Explain.

VI. Global Financial Stability After World War II, world leaders gathered together with the mission of ______________________ _________________________________. The World Bank was created to:

The International Monetary Fund was created to:

___________________________________________________________________________________ In your own words, summarize the main points of this chapter.