International Economics, 7e (Husted/Melvin)

Chapter 18 Exchange Rate Theories

Multiple-Choice Questions
1)

Perfect capital mobility

A)

implies currency substitution.

B)

is a common assumption used by all asset approach models.

C)

means uncovered IRP holds.

D)

All of the above.

Answer:

2)

________ refers to central banks offsetting international reserve flows in order to follow an independent
monetary policy.
A)

Monetary Approach
B)

Portfolio-Balance Approach
C)

Sterilization
D)

Currency Substitution
Answer:

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C

3)

Sterilized intervention under flexible exchange rates is "ultimately" an exchange of

A)

domestic bonds for foreign money.

B)

domestic money for foreign bonds.

C)

domestic bonds for foreign bonds.

D)

All of the above.

Answer:

4)

The main reason why "overshooting" occurs is

A)

not known.
B)

trade flows.
C)

a slow adjustment of goods markets relative to financial markets.

D)

currency substitution.
Answer:

5)

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Countries cannot become independent in terms of their ability to formulate domestic monetary policy
when
A)

exchange rates are fixed.

B)

exchange rates are flexible.

C)

there is a high degree of currency substitution.

D)

Both A and C.
Answer:

6)

The independence of domestic monetary policy under flexible exchange rates may be reduced if there is
A)

sterilization.
B)

currency substitution.
C)

overshooting of exchange rates.

D)

All of the above.

Answer:

7)

With ________ exchange rates, central banks make currencies perfect substitutes on the supply side of the
market.

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 A)

flexible
B)

managed float
C)

fixed
D)

Both A and B
Answer:

8)

The issue of currency substitution deals with substitutability among currencies on the ________ of the
market.
A)

left side
B)

supply side
C)

demand side
D)

All of the above

Answer:

9)

When countries follow different policies, currency substitution leads to

A)

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high -risk currencies.
B)

low-inflation currencies.
C)

more volatile exchange rates.

D)

less volatile exchange rates.

Answer:

10)

We should expect currency substitution to be most important

A)

in less developed countries with immobile resources.

B)

in highly developed countries.

C)

in a regional setting with a high degree of mobility of resources

D)

All of the above.

Answer:

11)

The usefulness of asset market models for predicting future exchange rates
A)

is limited by the propensity for the unexpected to occur.

B)

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has been verified by how well they predict unexpected events.
C)

was established in the 1950s.

D)

Both B and C.
Answer:

12)

Modern exchange rate models

A)

emphasize financial asset markets.

B)

emphasize goods markets.

C)

assume that covered IRP holds.

D)

Both A and B.
Answer:

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 13)

________ assume perfect substitutability of assets internationally.

A)

All asset approach models

B)

Portfolio-balance approach models

C)

Monetary approach models

D)

No models
Answer:

14)

The assumption of imperfect substitution between assets in the asset market models implies that
A)

domestic and foreign money are perfect substitutes.

B)

uncovered IRP holds.

C)

there is no foreign exchange risk premium.

D)

None of the above.

Answer:

15)

The assumption of perfect substitutability among assets in the monetary approach models implies

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 A)

uncovered IRP.
B)

a foreign exchange risk premium.

C)

that the forward rate will be a biased predictor of the future spot rate.
D)

perfect capital mobility.

Answer:

16)

A foreign exchange market intervention that leaves the domestic money supply unchanged is called
A)

non-sterilized intervention.
B)

sterilized intervention.
C)

open market operation.

D)

coordinated intervention.
Answer:

17)

A high degree of currency substitution

A)

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breeds currency union.
B)

adds an additional source of exchange rate variability.

C)

limits the ability of central banks to follow an independent domestic monetary policy.
D)

All of the above.

Answer:

18)

The ________ assumes that assets are imperfect substitutes internationally because investors perceive
foreign exchange risk to be attached to foreign currency denominated bonds.
A)

portfolio-balance approach
B)

monetary approach
C)

traditional exchange rate model

D)

All of the above

Answer:

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 19)

If sterilization exists, then this implies that

A)

there is no causality between domestic credit and reserve changes.

B)

domestic credit changes cause reserve flows.

C)

reserve changes cause domestic credit changes.

D)

the monetary approach cannot be useful as a theory of exchange rate determination.

Answer:

20)

Which of the following may not be consistent with the asset approach to exchange rate?
A)

the existence of trade flows

B)

the existence of financial asset flows

C)

the existence of news

D)

None of the above

Answer:

True or False Questions

1)

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Asset approach models to exchange rate determination put more emphasis on financial assets rather than
relying on international trade in goods to explain exchange rate changes. Therefore, there is no useful
role for trade flows in these models.
Answer:

False
Explanation:

None Given

2)

Currency substitution between monies makes it easier for central banks to follow an independent
monetary policy under flexible exchange rates since the currency substitution leads to less volatile
exchange rates.
Answer:

False
Explanation:

None Given

3)

We should expect currency substitution to be most important in highly developed industrial countries
rather than in a regional setting where there is a relatively high degree of mobility of resources between
countries.
Answer:

False
Explanation:

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None Given

4)

We find great difficulty in predicting future spot rates, because the exchange rate will be in part,
determined by events that cannot be expected or foreseen.
Answer:

True

Explanation:

None Given

5)

One of the most important implications of the asset approach exchange rate models is that exchange rates
should be much more variable than goods prices.
Answer:

True

Explanation:

None Given

6)

In the monetary approach to exchange rate determination, relative supplies of domestic and foreign
bonds have a crucial role in determining exchange rates.
Answer:

False
Explanation:

12
None Given

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 7)

With perfect capital mobility, uncovered interest parity holds.

Answer:

False
Explanation:

None Given

8)

Imperfect substitution between bonds implies that there is no foreign exchange risk premium, and thus,
covered interest parity holds.
Answer:

False
Explanation:

None Given

9)

If sterilization is a real world phenomenon, the implications of the MAER regarding the causality
between domestic credit and reserve changes must be reconsidered.
Answer:

True

Explanation:

None Given

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 10)

Understanding the foreign exchange market microstructure allows us to predict where exchange rates
tend to go in the long-run.
Answer:

False
Explanation:

None Given

Essay Questions
1)

What are the similarities and differences between the "monetary approach" and the "portfolio-balance
approach." Briefly explain.
Answer:

Both approaches emphasize trade in financial assets in determining the exchange rate, both assume
perfect capital mobility. Monetary approach models assume perfect substitutability between domestic
and foreign assets while portfolio balance models assume imperfect substitutability.

2)

Suppose, under fixed exchange rates, you find evidence of sterilization. What does it mean regarding the
ability of central banks to follow independent monetary policies? What does sterilization imply
regarding the causality between domestic credit and reserve flows under fixed exchange rates?
Answer:

Sterilization will permit central banks to offset the effects of international reserve flows on the domestic
money supply, at least in the short run. This will allow independent monetary policy. Causality is then
two-way. R affects D for sterilization, but D affects R through monetary approach effects.

3)

What is the role of "trade flows" in the modern asset market approach to exchange rate determination?
Suppose you are expecting a future U.S. trade deficit, how does this affect the dollar today?
Answer:

Since trade flows are matched by financial asset flows, trade flows will be reflected in changing asset

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holdings. The dollar would depreciate on news of a larger U.S. trade deficit since U.S. net holdings of
foreign assets would fall.

4)

Explain how exchange rates can overshoot their long-run equilibrium level.
Answer:

If money demand depends on Y and i, and P and Y are slow to adjust, then i will take initial adjustment
to a change in money supply. To maintain IRP, as i changes, the forward premium changes, but E
changes by more than F. So E overshoots F, the long-run value of E.

5)

How does currency substitution between monies affect the ability of central banks to follow independent
monetary policies under flexible exchange rates? Briefly discuss.
Answer:

Currency substitution will lead to portfolio adjustments between high-inflation and low-inflation monies.
A central bank that followed an inflationary policy would find the demand for its money would fall to
zero if a perfect substitute existed that had a stable value.

6)

Understanding the foreign exchange market microstructure allows us to explain the evolution of the
foreign exchange market in an intradaily sense, in which foreign exchange traders adjust their quotes
throughout the business day in the absence of any macro news. Define the following two market
microstructure terms:
(a) Inventory control effect.
(b) Asymmetric information effect. Why are they relevant?
Answer:

(a) Inventory control effect: basically says that traders will want to have no inventory at the end of the
day, so that their quotes reflect this desire.
(b) Asymmetric information effect: traders fear that they can be trading with agents who have better
information than themselves, so every trade they make, they gain information about where the market is
going. Both of these effects can help explain why exchange rates change throughout the day, even in the
absence of news regarding the fundamental determinants of exchange rates.

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