Econ Of Globalization. Spring 2008; Practice Problems For Exam 3

Front 1

1.Suppose that real incomes increase more rapidly in the United States than in Mexico. In the United States, this situation would likely result in a (an):

Back 1

Increase in the demand for pesos

Front 2

If Canadian speculators believed the Swiss franc was going to appreciate against the U.S. dollar, they would:

Back 2

Purchase Swiss francs

Front 3

Grain shortages in countries that buy large amounts of grain from the United States would increase the demand for American grain and:

Back 3

Increase the demand for dollars

Front 4

Under a system of floating exchange rates, the Swiss franc would depreciate in value if which of the following occurs?

Back 4

d) Falling interest rates in Switzerland

Front 5

An increase in the dollar price of other currencies tends to cause:

Back 5

a) U.S. goods to be cheaper than foreign goods

Front 6

Suppose the exchange value of the British pound is $2 per pound while the exchange value of the Swiss franc is 50 cents per pound. The cross exchange rate between the pound and the franc is:

Back 6

4 francs per pound

2/.50 = 4

Front 7

Refer to Figure 11.2. A shift in the demand for francs from D0 to D1 or a shift in the supply of
francs from S0 to S2, would result in a (an):

Back 7

Depreciation in the dollar against the franc

Front 8

Refer to Figure 11.2. A shift in the demand for francs from D0 to D2, or a shift in the supply of francs from S0 to S1, would result in a (an):

Back 8

Appreciation in the dollar against the franc

Front 9

If the exchange rate between Swiss francs and British pounds is 5 francs per pound, then the number of pounds that can be obtained for 200 francs equals:

Back 9

40 pounds

200/5 = 40

Front 10

Assume that the United States faces an 8 percent inflation rate while no (zero) inflation exists in Japan. According to the purchasing-power parity theory, the dollar would be expected to:

Back 10

Depreciate by 8 percent against the yen

Front 11

Given a system of floating exchange rates, stronger U.S. preferences for imports would trigger:

Back 11

An increase in the demand for imports and an increase in the demand for foreign currency

Front 12

Which of the following is likely to result in long-run appreciation of the U.S. dollar relative to the peso?

Back 12

Stronger Mexican preferences for goods produced in the United States

Front 13

Which of the following is likely to result in long-run depreciation of the U.S. dollar relative to the euro?

Back 13

Stronger American preferences for goods produced in Europe

Front 14

Suppose the exchange rate between the U.S. dollar and the Japanese yen is initially 90 yen per dollar. According to purchasing-power parity, if the price of traded goods rises by 5 percent in the United States and 15 percent in Japan, the exchange rate will become:

Back 14

99 yen per dollar

Front 15

In the presence of purchasing-power parity, if one dollar exchanges for 2 British pounds and if a VCR costs $400 in the United States, then in Great Britain the VCR should cost:

Back 15

800 pounds

400 x 2 = 800

Front 16

Under a floating exchange-rate system, if American exports decrease and American imports rise, the value of the dollar will:

Back 16

Depreciate

Front 17

Given an initial equilibrium in the money market and foreign exchange market, suppose the
Federal Reserve decreases the money supply of the United States. Under a floating exchange rate system the dollar would:

Back 17

Appreciate in value relative to other currencies

Front 18

If the Japanese yen depreciates against other currencies in the exchange markets, this will:

Back 18

Tend to improve the Japanese balance of trade

Front 19

Assume that interest rates in London rise relative to those in Switzerland. Under a floating
exchange-rate system, one would expect the pound (relative to the franc) to:

Back 19

Appreciate due to the increased demand for pounds

Front 20

A market-determined increase in the dollar price of the pound is associated with:

Back 20

Depreciation of the dollar

Front 21

In a managed floating exchange-rate system, temporary stabilization of the dollar's exchange
value requires the Federal Reserve to adopt a (an) ____ monetary policy when the dollar is appreciating and a (an) ____ policy when the dollar is depreciating.

Back 21

Expansionary, contractionary

Front 22

Suppose that Japan maintains a pegged exchange rate that overvalues the yen. This would likely result in:

Back 22

Unemployment for Japanese workers

Front 23

Given a two-country world, suppose Japan devalues the yen by 20 percent and South Korea devalues the won by 15 percent. This results in:

Back 23

A depreciation in the value of the yen against the won

Front 24

Refer to Figure 15.1. With a system of floating exchange rates, the equilibrium exchange rate is:

Back 24

$0.50 per franc

Front 25

Refer to Figure 15.1. Suppose that the United States increases its imports from Switzerland,
resulting in a rise in the demand for francs from D0 to D1. Under a floating exchange rate system, the new equilibrium exchange rate would be:

Back 25

$0.60 per franc

Front 26

Refer to Figure 15.1. Suppose the demand for francs increases from D0 to D1. Under a fixed
exchange rate system, the U.S. exchange stabilization fund could maintain a fixed exchange rate of $0.50 per franc by:

Back 26

Selling francs for dollars on the foreign exchange market

Front 27

To offset an appreciation of the dollar against the yen, the Federal Reserve would:

Back 27

Sell dollars on the foreign exchange market and lower domestic interest rates

Front 28

Under managed floating exchange rates, if the rate of inflation in the United States is less than the rate of inflation of its trading partners, the dollar will likely:

Back 28

Appreciate against foreign currencies

Front 29

In a managed floating exchange-rate system, temporary stabilization of the dollar's exchange
value requires the Federal Reserve to adopt a (an) ____ monetary policy when the dollar is appreciating and a (an) ____ policy when the dollar is depreciating.

Back 29

Expansionary, contractionary

Front 30

The exchange rate for the euro changed from 0.9968 on December 2, 2002 to 0.9966 (U.S.
dollar equivalent) on December 3, 2002. If you used $1 million to buy euros on December 2 and sold them on December third you made

Back 30

+$200

0.9968-0.9966 x 1,000,000
= 200

Front 31

A devaluation is when a country:

Back 31

lowers the fixed value of its currency

Front 32

Suppose that on the gold standard, the U.S. fixes the price of an ounce of gold at $25. Great Britain fixes the price of gold at £16 per ounce. What is the implied exchange rate between the dollar and the pound?

Back 32

$1.5625 / £

Front 33

The organization that was founded to lend reserves to member countries experiencing a temporary shortage in foreign exchange reserves is the

Back 33

International Monetary Fund

Front 34

Rather than constructing their own currency baskets, many nations peg the value of their currencies to a currency basket defined by the International Monetary Fund. Which of the following illustrates this basket?

Back 34

Special Drawing Rights

Front 35

Proponents of freely floating exchange rates maintain that:

Back 35

The system allows the central bank independency in pursuing domestic economic goals

Front 36

As a result of the __________, the dollar became the world’s chief reserve currency.

Back 36

Bretton-Woods Conference

Front 37

The original purpose of the World Bank, as discussed at the Bretton Woods conference, was to

Back 37

lend funds to war-torn countries to rebuild infrastructure

Front 38

Small nations (e.g., the Ivory Coast) whose trade and financial relationships are mainly with a single partner tend to utilize:

Back 38

Pegged (Fixed) exchange rates

Front 39

The central bank of the United Kingdom could prevent the pound from appreciating by:

Back 39

Selling pounds on the foreign exchange market

Front 40

If Canadian speculators believed the Swiss franc was going to depreciate against the U.S. dollar, they would:

Back 40

Purchase U.S. dollars

Front 41

Equilibrium exchange rate equates the demand for and supply of the home currency
Central Bank – independent monetary policy – target either unemployment, inflation or both

Back 41

Flexible exchange rates

Front 42

Central bank defends the official rate
- Purchases and sales of foreign currencies to iron out short-term fluctuations.
- Loss of independent monetary policy
If pegging against a currency – same inflation rate and interest rate

Back 42

Fixed exchange rate

Front 43

Informal guidelines established by IMF (1973)

Based on two concerns
- Nations intervening in exchange markets
- Clean float and dirty float
Disorderly markets with erratic fluctuations

Back 43

Managed Floating Rates:

Front 44

Under managed floating, a nation:

Back 44

- Can alter the degree of intervention
- Can intervene to reduce short-term fluctuations: Leaning against the wind
- Should not act aggressively with respect to their currency exchange rates
- Can choose target rates and intervene to support them

Front 45

Market intervention is used to stabilize exchange rates in the short run

In the long run, a managed float allows market forces to determine exchange rates

Example: Theory of a managed float in a two-country framework

Back 45

Under a managed float

Front 46

A weak currency experiences heavy selling pressure
Indications of selling pressure include:
- Sizable losses in the foreign reserves held by a country’s central bank
- Depreciating exchange rates in the forward market
- Widespread flight out of domestic currency into foreign currency or into goods

Back 46

Currency crises or speculative attack

Front 47

Crisis ends when selling pressure stops

Ways to end pressure...

Back 47

- Devalue the currency
- Adopt a floating exchange rate

Front 48

Crises that end in devaluations or accelerated depreciations

Back 48

Currency crashes

Front 49

- Impose restrictions on the ability of people to buy and sell foreign currency
- Obtain a loan to bolster the foreign reserves
- Restore confidence in the existing exchange rate

Back 49

Avoiding a currency crash

Front 50

Budget deficits financed by inflation
Weak financial systems
Weak economy
Political factors
External factors
Choice of an exchange-rate system

Back 50

Sources of Currency Crises

Front 51

- 1970’s, 1980’s - Latin America, 1994 – Mexico
- Persistent current account and government deficit
The government announces fixed exchange rate and expansionary fiscal policy (inconsistent)
Finance the deficit: print money

Capital outflow: Countries run low on reserves
Possibility that they won’t be able to maintain the fixed exchange rate
Foreign exchange intervention: government buys domestic currency and sell foreign reserves
Speculators bet against the currency

Central bank forced to devalue

Back 51

Currency Crisis: First generation models

Front 52

1992 and 1993 – European Monetary System
Clash between internal (inflation and unemployment) and external (fixed exchange rate) objectives

- Reunification of Germany
- Expansionary fiscal and contractionary monetary policy
German interest rates rose
- United Kingdom, France, and Italy raised their interest rates to fix their exchange rates
Interest Rates increased dramatically in 1992 and 1993

All three countries devalued against the mark

Back 52

Currency Crisis: Second generation model

Front 53

- 1997 – Asia
- Fast growing economies
- Liberalization, free flows of capital – large amounts of capital inflow
* Link between banking and currency crises
* Mismatches between borrowing and lending
* Decrease in the investors’ confidence: stop in the external financing
* Investors withdraw funds: bank run
- Central Bank intervention to buy domestic currency: borrow from IMF
- Eventually the currency devalued: increase in interest rate and capital outflows - recessions
- Contagion: Thailand ,Indonesia, Malaysia, South Korea, Philippine, some pressure in Taiwan, Singapore and Hong Kong, spreads to Russia, Brazil, etc

Back 53

Currency Crisis: Third generation model

Front 54

1998 – Russia
1999 – Brazil
2000 – Turkey
2001 – Argentina

Back 54

More on third generation models

Front 55

- Failed attempts to maintain fixed exchange rates
- Cannot have a currency crisis with a flexible exchange rate
- Nothing to destabilize
- Problem with fixed exchange rates that can be changed
- No currency crises in 2002 – 2006
Why? because gave up floating

Back 55

Currency Crisis

Front 56

- During the 1990s and 2000s, more countries chose to abandon fixed exchange rates
- Adopted a monetary policy based on
Flexible exchange rates
Permanently connected their monetary policy to other countries
Monetary union, dollarization, or a currency board

Back 56

Demise of Fixed Exchange Rates

Front 57

Currency boards – Argentina
Dollarization – Ecuador
Single Currency – The Euro

Back 57

Increasing the Credibility of Fixed Exchange Rates

Front 58

Interbank lending rates at zero
Excess reserves: Now $800 Billion in U.S.
Deflation???

Back 58

Characteristics of Liquidity Trap

Front 59

describes a situation in which expansionary monetary policy becomes powerless. The increase in money falls into a liquidity trap: People are willing to hold more money (more liquidity) at the same nominal interest rate

The central bank can increase “liquidity” but the additional money is willingly held by financial investors at an unchanged interest rate, namely, zero.

Back 59

The liquidity trap

Front 60

The robust growth that Japan had experienced since the end of World War II came to an end in the early 1990s.
Since 1992, the economy has suffered from a long period of low growth—what is called the Japanese slump.
Low growth has led to a steady increase in unemployment, and a steady decrease in the inflation rate over time.

Back 60

Few words about the Japanese Slump

Front 61

Monetary policy was used, but it was used too late, and when it was used, it faced the twin problems of the liquidity trap and deflation.
The Bank of Japan (BoJ) cut the nominal interest rate, but it did so slowly, and the cumulative effect of low growth was such that inflation had turned to deflation. As a result, the real interest rate was higher than the nominal interest rate.

Back 61

The Failure of Monetaryand Fiscal Policy

Front 62

The financial crisis was triggered by the subprime mortgage fiasco...

Finance companies (e.g. Countrywide) began making subprime mortgages in 1990s.

This lending was highly profitable, so it expanded. Investment banks began securitizing subprime mortgages. Credit standards relaxed... starting around 2005, “no documentation” loans

Back 62

Back to the US Financial Crisis 2008 - ???

Front 63

Default rates on mortgages were low because of rising house prices.... if you can’t make your payments, you can borrow more or sell your house for a profit.

In retrospect, rising house prices were a bubble that burst in 2006. This produced defaults on subprime mortgages and eventually prime mortgages as well.

Back 63

US Financial Crisis 2008 - ???

Front 64

Losses on subprime MBS caused large losses to financial institutions in 2007-2008... started threatening solvency.


Worries about bank solvency first showed up in the disruption of interbank lending in August 2007 (which the Fed dealt with effectively with the Term Auction Facility).


In March 2008, Bear Stearns almost failed... the Fed intervened, arranging acquisition by JP Morgan Chase. Bear stockholders lost, but creditors did not.


The rationale for the Bear Stearns rescue: a failure of Bear could badly hurt the financial system through losses to Bear’s counterparties and a blow to confidence.

Financial markets calmed down over Summer 2008... and at that point it was not obvious a recession was occurring.


In September 2008, Lehman Brothers failed. This time, no rescue by Fed or Treasury.


(Why not? Hard to find a private buyer... and policymakers chastened by criticism of Bear Stearns rescue?)

Back 64

US Financial Crisis 2008 - ???

Front 65

Lehman failure hurt counterparties (e.g. Iceland!). And it caused panic in financial markets. Who was exposed to Lehman? If Lehman can fail, is any institution safe? There was a general flight from anything risky to Treasury bills:

• Fall in stock prices
- Halt to issue of asset-backed securities –- even those backed by government- guaranteed loans!
• Yield on Treasury bills dips below zero

Back 65

US Financial Crisis 2008 - ???

Front 66

A money market mutual fund with lots of Lehman commercial paper “breaks the buck”... produces a run on money market funds, which in turn threatens firms’ ability to issue commercial paper.

• Bank capital falls –> banks cut lending

Back 66

More panic:

Front 67

How bad will it get?

Romer and Romer (1994), “What Ends Recessions?”

Answer: the Fed cuts its interest-rate target.

Unfortunately, the Fed’s target has reached the zero bound... so we can no longer rely on the usual recession cure.

Back 67

We are now in a vicious cycle, with the recession depressing asset prices and further weakening banks

So we need different policies to spur lending and spending.

• Fiscal stimulus
• Various Fed policies, such as TALF and purchases of MBS

• Fix the problem of undercapitalized banks. (But how? Equity injections? Purchases of risky assets? Nationalization?)

Front 68

How do we reduce the risk of future disasters?

Back 68

• Reform banking regulation. But how? Restrict risk-taking? Return to separation of commercial and investment banking?

• Raise long-run inflation target to 3-4% to reduce problem of zero bound on interest rates

Front 69

Reinhart and Rogoff (2008a) included all the major postwar banking crises in the developed world (a total of 18) :
Spain 1977, Norway 1987, Finland, 1991, Sweden, 1991, and Japan, 1992)
Asian countries
Argentina

Back 69

The aftermath of severe financial crises

Front 70

Real housing price declines average 35 % and equity price collapses average 55% over a downturn of about 4 years.

Back 70

Asset market collapses are deep and prolonged

Front 71

The unemployment rate rises an average of 7% over the down phase of the cycle, which lasts on average over four years. Output falls (from peak to trough) an average of over 9 percent, although the duration of the downturn, averaging roughly two years, is considerably shorter than for unemployment.

Back 71

Profound declines in output and employment

Front 72

rising an average of 86 % in the major post–World War II episodes. Interestingly, the main cause of debt explosions is not the widely cited costs of bailing out and recapitalizing the banking system.

Back 72

The real value of government debt tends to explode

Front 73

The exchange-rate system that prevailed from 1946 until 1973 is known as:

Back 73

the Bretton Woods system of adjustable pegged exchange rates.

Front 74

Since 1971

Back 74

flexible or floating exchange rates have become prevalent, with only some small developing nations maintaining fixed exchange rates.

Front 75

Fixed exchange rates today are used primarily by developing countries rather than by industrial nations.

Back 75

True

Front 76

The most common exchange-rate arrangement adopted by IMF members today is:

Back 76

managed floating or independently floating exchange rates

Front 77

The most common key currency held today as official reserves by governments is:

Back 77

the U.S. dollar.

Front 78

Currencies that today are widely traded on international exchanges, relatively stable, convertible and accepted as a means of payment, and used by some developing nations as pegs to which they fix their own currencies are known as:

Back 78

key currencies.

Front 79

Many Southeast Asian nations affected by the 1997 Asian financial crisis

Back 79

shifted from fixed to floating exchange-rate systems.

Front 80

The SDR is all of the following except:

Back 80

a specified discount rate established by the U.S. Federal Reserve Board.

Front 81

The reason for the SDR to be valued as a weighted average of several currencies is:

Back 81

to keep the SDR more stable than most individual currencies, with its value rising relative to currencies that are depreciating and falling relative to currencies that are appreciating.

Front 82

Under a fixed exchange-rate system, the official exchange rate between two currencies can be determined by comparing the par values established by the national governments for those two currencies.

Back 82

True

Front 83

Differences between countries in basic flows of goods, services and investment capital are most likely to influence exchange rate movements:

Back 83

in the long run

Front 84

Differences in real interest rates between countries are most likely to influence exchange rate movement:

Back 84

in the short run.

Front 85

Market fundamentals that might be expected to influence exchange rate movements include all of the following factors except

Back 85

speculative opinion about future exchange rates

Front 86

In foreign exchange markets, rapid growth of the U.S. economy and of U.S. household incomes accompanied by no growth in Britain would

Back 86

increase the demand for pounds and cause the dollar to depreciate relative to the pound

Front 87

If interest rates are lower in the United States than in Britain, all other things being equal this would lead to:

Back 87

capital flows from the United States to Britain and a depreciation of the dollar relative to the pound.

Front 88

If a nation's currency is overvalued, this most likely will contribute to a trade deficit.

Back 88

True

Front 89

If inflation is higher in Mexico than in the United States, the law of one price would predict that:

Back 89

the peso would depreciate relative to the dollar by an amount equal in percentage terms to the difference between the two inflation rates.

Front 90

The law of one price states that in command economies products must be sold at the price determined by the central government.

Back 90

False

Front 91

The relative purchasing power parity theory:

Back 91

does not take into account the potential impact of capital movements on exchange rates

Front 92

When short-term interest rates become lower in Tokyo than in New York, interest
arbitrage operations will most likely result in a:

Back 92

Sale of dollars in the forward market

Front 93

Assume the following: (1) the interest rate on 6-month treasury bills is 8 percent per
annum in the United Kingdom and 4 percent per annum in the United States; (2) today's
spot price of the pound is $1.50 while the 6-month forward price of the pound is $1.485.

Refer to Exhibit 11.1. By investing in U.K. treasury bills rather than U.S. treasury bills,
and not covering exchange rate risk, U.S. investors earn an extra return of:

Back 93

4 percent per year, 2 percent for the 6 months

Front 94

When short-term interest rates become higher in Tokyo than in New York, interest
arbitrage operations will most likely result in a:

Back 94

Purchase of yen in the spot market

Front 95

Refer to Exhibit 11.1. If U.S. investors cover their exchange rate risk, the extra return for
the 6 months on the U.K. treasury bills is:

Back 95

1.0 percent

Front 96

Refer to Exhibit 11.1. If the price of the 6-month forward pound were to ____, U.S.
investors would no longer earn an extra return by shifting funds to the United Kingdom

Back 96

Fall to $1.47

Front 97

If Canadian speculators believed the Swiss franc was going to depreciate against the U.S. dollar, they would:

Back 97

Purchase U.S. dollars

Front 98

An decrease in the dollar price of other currencies tends to cause:

Back 98

U.S. goods to be more expensive than foreign goods

Front 99

Given a system of floating exchange rates, weaker U.S. preferences for imports would trigger:

Back 99

A decrease in the demand for imports and a decrease in the demand for foreign currency

Front 100

Under a floating exchange-rate system, if American exports increase and American imports fall, the value of the dollar will:

Back 100

Appreciate

Front 101

Given an initial equilibrium in the money market and foreign exchange market, suppose the
Federal Reserve increases the money supply of the United States. Under a floating exchange rate system, the dollar would

Back 101

Depreciate in value relative to other currencies

Front 102

If the Japanese yen appreciates against other currencies in the exchange markets, this will:

Back 102

Tend to worsen the Japanese balance of trade

Front 103

Assume that interest rates in London fall relative to those in Switzerland. Under a floating
exchange-rate system, one would expect the pound (relative to the franc) to:

Back 103

Depreciate due to the increased demand for francs

Front 104

A market-determined decrease in the dollar price of the pound is associated with:

Back 104

Appreciation of the dollar

Front 105

Suppose that Japan maintains a pegged exchange rate that undervalues the yen. This would likely result in:

Back 105

Full employment for Japanese workers

Front 106

Under managed floating exchange rates, if the rate of inflation in the United States is more than the rate of inflation of its trading partners, the dollar will likely:

Back 106

Depreciate against foreign currencies

Front 107

In first-generation models of currency crises, speculators

Back 107

exacerbate the crisis when foreign reserves are depleted to a critical level

Front 108

If the Japanese yen appreciates against other currencies in the exchange markets, this will:

Back 108

Tend to worsen the Japanese balance of trade

Front 109

If Mexico fully dollarizes its economy, it agrees to

Back 109

Replace pesos with U.S. dollars in its economy

Front 110

Which exchange-rate system involves a "leaning against the wind" strategy in which short-term fluctuations in exchange rates are reduced without adhering to any particular exchange rate over the long run?

Back 110

Managed floating exchange rates

Front 111

To offset an appreciation of the dollar against the yen, the Federal Reserve would:

Back 111

Sell dollars on the foreign exchange market and lower domestic interest rates

Front 112

The third generation financial crises occurred in

Back 112

Asia

Front 113

Which exchange-rate mechanism calls for frequent redefining of the par value by small amounts to remove a payments disequilibrium?

Back 113

Crawling pegged exchange rates

Front 114

To defend a pegged exchange rate that overvalues its currency, a country could:

Back 114

Purchase its own currency in international markets

Front 115

A surplus nation can reduce its payments imbalance by:

Back 115

Revaluing its national currency

Front 116

To help insulate their economies from inflation, currency depreciation, and capital flight, developing countries have implemented:

Back 116

Currency boards