# Consider the four situations depicted below. They show for each situation the prices of an overcoat in the USA and the United Kingdom (UK) as well as the currency exchange rate in each situation. Because our keys do not have the correct symbol for the pound, the British currency, we will use “&” which bears, maybe, a faint resemblance for the actual pound currency symbol (£).

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IMPORTANT Note:  Be sure that your answers reflect a technical understanding of the Economics of Exchange Rates as presented in the Module 2, Chapter 10 YouTube video: “Exchange Rates, a Pencast Introduction.” – (This is the you tube video link)

1. Consider the four situations depicted below. They show for each situation the prices of an overcoat in the USA and the United Kingdom (UK) as well as the currency exchange rate in each situation. Because our keys do not have the correct symbol for the pound, the British currency, we will use “&” which bears, maybe, a faint resemblance for the actual pound currency symbol (£).

Situation          USA overcoat       Exchange Rate           UK overcoat

A                      \$50                              \$3 = &1                            &20

B                      \$50                              \$2 = &1                            &20

C                      \$50                              \$2 = &1                            &30

D                      \$50                              \$1 = &1                            &30

1. In situation A, where will Americans choose to buy their overcoats? Where will the British choose to buy their overcoats? Explain.
2. Moving from situation A to B, has the \$ gone up in value relative to the &, or down in value relative to the &? Explain.
3. In situation B, where will Americans choose to buy their overcoats? Where will the British choose to buy their overcoats? Explain.
4. In moving from A to B, who (to include consumers & producers in each country) benefited and who was hurt? Explain.
5. Situation C: Inflation in the UK. Now, where will Americans buy their overcoats and where will the British buy their overcoats?
6. Moving from situation C to D, has the \$, relative to the &, gone up or down in value? Compared with situation C, will this affect where the Americans and British buy their overcoats? Explain.
7. Might the change in exchange rate shown in situation D be the result of–or reaction to–the inflation that occurred in situation C? Explain.

Ch 10 Review Quiz

ECO 116, Chapter 10 Review Quiz

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1. The euro/dollar exchange rate is €1 = \$1.20. If it costs \$36 to buy a European product, the stated price of the product would be €36.
True    False

1. Carry trade is a kind of speculation whose success is based upon a belief that there will be no adverse movement in exchange rates.
True    False

1. When companies wish to convert currencies, they typically enter the foreign exchange market directly.
True    False

1. If the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices.
True    False

1. For price discrimination to work, arbitrage opportunities must be unlimited.
True    False

1. Relative monetary growth, relative inflation rates, and nominal interest rate differentials are all moderately good predictors of long-run changes in exchange rates.
True    False

1. When residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency, the phenomenon is generally referred to as capital flight.
True    False

1. Leading and lagging strategies involve accelerating payments from weak-currency to strong-currency countries and delaying inflows from strong-currency to weak-currency countries.
True    False

1. The euro/dollar exchange rate is €1 = \$1.20. If it costs \$36 to buy a European product, the stated price of the product would be €36.
True    False

1. Currency swaps are transacted between international businesses and their banks, between banks, and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange risk.
True    False

1. Inflation occurs when the money supply in a country increases faster than output increases.
True    False

1. When residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency, the phenomenon is generally referred to as capital flight.
True    False

1. Steven converted \$1,000 to ´105,000 for a trip to Japan. However, he spent only ´50,000. During this period, the value of the dollar weakened against the yen. Considering a current exchange rate of \$1 = ´100, how many dollars did Steven spend on the trip?
\$550
B. \$523
C. \$450
D. \$600
E. \$500

1. Which of the following caused a decline in the dollar/yen carry trade during 2008-2009?
Increase in risk appetite making the carry trade less attractive
B. Decrease in interest rate differentials as the U.S. rates came down
C. Increase in interest rate differentials as Japanese interest rates came down
D. Decrease in interest rate differentials as the U.S. interest rates went up
E. Decrease in interest rate differentials as the Japanese rates went up

1. Assume that the yen/dollar exchange rate quoted in London at 3 p.m. is ´120 = \$1, and the New York yen/dollar exchange rate at the same time (10 a.m. New York time) is ´123 = \$1. Which of the following transactions would yield immediate profit?
Forward exchange
C. Currency swap
D. Arbitrage
E. Currency speculation

1. If a basket of goods costs \$100 in the United States and €120 in Europe, what would the purchasing power parity theory’s prediction of the dollar/euro exchange rate be?
\$1 = €1.20
B. \$1 = €1
C. \$1 = €0.80
D. \$1 = €0.90
E. \$1 = €1.10

1. During inflation, an increase in the amount of currency available leads to:
overheating of the economy thereby reducing the production levels in the economy.
B. changes in the relative demand-and-supply conditions in the foreign exchange market.
C. a reduction in the rate of inflation thus leading to an appreciation of the currency.
D. decreased lending by banks thereby resulting in more savings.
E. a decrease in the demand for goods and services, which drives currency value higher.

1. Which of the following weakens the link between relative price changes and changes in exchange rates predicted by purchasing power parity (PPP) theory by violating the assumption of efficient markets?
B. The relationship between money supply and price inflation
C. The impact of increase in currency on relative demand and supply conditions of currencies
D. Excessive growth in money supply
E. The insignificant impact of transportation costs on international trade

1. The nominal interest rate is 9 percent in Brazil and 6 percent in Japan. Applying the international Fisher effect, the Brazilian real should:
appreciate by 3 percent against the Japanese yen.
B. depreciate by 3 percent against the Japanese yen.
C. appreciate by 1.5 percent against the Japanese yen.
D. depreciate by 1.5 percent against the Japanese yen.
E. appreciate by 15 percent against the Japanese yen.

1. Which of the following is true of a country that is running a deficit on a balance-of-payments current account?
It is importing fewer goods and services than it is exporting.
B. It may result in depreciation of the country’s currency on the foreign exchange market.
C. It will lead to very low interest rates in the country.
D. It will lead to a shortage of the country’s currency in the foreign exchange market.
E. It is engaging in neo-mercantilism.

1. Which of the following is a reason why governments limit convertibility of their currency?
To encourage foreign investments
B. To control currency appreciation
C. To encourage capital flight
D. To preserve their foreign exchange reserves
E. To promote neo-mercantilism

1. Which of the following refers to countertrade?
A short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates
B. The exchange rate at which a foreign exchange dealer will convert one currency into another that particular day
C. Simultaneous purchase and sale of a given amount of foreign exchange for two different value dates
D. The purchase of securities in one market for immediate resale in another to profit from a price discrepancy
E. A range of barter-like agreements by which goods and services can be exchanged for other goods and services

1. What is meant by economic exposure?
The extent to which a firm’s future international earning power is affected by changes in exchange rates
B. The impact of currency exchange rate changes on the reported financial statements of a company
C. The extent to which the income from individual transactions is affected by fluctuations in foreign exchange values
D. The extent to which the quantity of money in circulation rises faster than the stock of goods and services
E. The extent of disparity in prices, when expressed in the same currency, of similar products in different countries

ANSWER ECO 116, Chapter 10 Review Quiz

1. FALSE

1. TRUE

1. FALSE

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1. FALSE

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1. FALSE

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1. TRUE

1. C

1. B

1. D

1. A

1. B

1. A

1. B

1. B

1. D

1. E

1. A