Multinational Business Finance Chatper One Qestion Answer Essay

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End-of-Chapter Question Solutions 1 ____________________________________________________________________________________________

1. The gold standard and the money supply. Under the gold standard all national governments promised to follow the “rules of the game”. This meant defending a fixed exchange rate. What did this promise imply about a country’s money supply? A country’s money supply was limited to the amount of gold held by its central bank or treasury. For example, if a country had 1,000,000 ounces of gold and its fixed rate of exchange was 100 local currency units per ounce of gold, that country could have 100,000,000 local currency units outstanding. Any change in its holdings of
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Fixed rates, once in place, may be maintained at rates that are inconsistent with economic fundamentals. As the structure of a nation’s economy changes, and as its trade relationships and balances evolve, the exchange rate itself should change. Flexible exchange rates allow this to happen gradually and efficiently, but fixed rates must be changed administratively—usually too late, too highly publicized, and at too large a one-time cost to the nation’s economic health.


The Impossible Trinity. Explain what is meant by the term “Impossible Trinity” and why it is true.


Countries with floating rate regimes can maintain monetary independence and financial integration but must sacrifice exchange rate stability. Countries with tight control over capital inflows and outflows can retain their monetary independence and stable exchange rate, but surrender being integrated with the world’s capital markets. Countries that maintain exchange rate stability by having fixed rates give up the ability to have an independent monetary policy.

Currency board or dollarization. Fixed exchange rate regimes are sometimes implemented through a currency board (Hong Kong) or dollarization (Ecuador). What is the difference between the two approaches?

2 End-of-Chapter Question Solutions

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