This Document Contains Chapters 16 to 17 Chapter 16 The Conduct of Monetary Policy: Strategy and Tactics 16.1 Monetary Targeting 1) Under monetary targeting, a central bank announces an annual growth rate target for ________. A) a monetary aggregate B) a reserve aggregate C) the monetary base D) GDP Answer: A 2) During the years 1979 to 1982, the Federal Reserve's announced policy was monetary targeting. During this time period the Federal Reserve A) hit all of their monetary targets. B) did not hit any of their monetary targets because it is believed that controlling the money supply was not the intent of the Federal Reserve. C) did not hit any of their monetary targets because they were unrealistic. D) hit about half of their monetary targets. Answer: B 3) Compared to the United States, Japan's experience with monetary targeting performed A) better with regard to the inflation rate and output fluctuations. B) worse with regard to the inflation rate and output fluctuations. C) better with regard to the inflation rate, but worse with regard to output fluctuations. D) worse with regard to the inflation rate, but better with regard to output fluctuations. Answer: A 4) One of the factors that contributed to the success German policymakers had using a monetary targeting type policy was that A) they used a rigid target for the money growth rate. B) they implemented policy so their inflation rate goal was met in the short run. C) the money target was flexible to allow the Bundesbank to concentrate on other goals as needed. D) they rarely communicated the intentions of policy to the public in order to keep the public from panicking. Answer: C 5) Which of the following is the best description of the monetary policy strategy followed by the European Central Bank (ECB)? A) The ECB follows monetary targeting. B) The ECB follows inflation targeting. C) The ECB has a hybrid strategy with elements of both monetary targeting and inflation targeting. D) The ECB has a Fed-like "just do it" approach. Answer: C 6) Which of the following is an advantage to money targeting? A) There is an immediate signal on the achievement of the target. B) It does not rely on a stable money-inflation relationship. C) It implies lack of transparency. D) It implies smaller output fluctuations. Answer: A 7) Which of the following is a disadvantage to monetary targeting? A) It relies on a stable money-inflation relationship. B) There is a delayed signal about the achievement of a target. C) It implies larger output fluctuations. D) It implies a lack of transparency. Answer: A 8) If the relationship between the monetary aggregate and the goal variable is weak, then A) monetary aggregate targeting is superior to exchange-rate targeting. B) monetary aggregate targeting is superior to inflation targeting. C) inflation targeting is superior to exchange-rate targeting. D) monetary aggregate targeting will not work. Answer: D 9) The monetary policy strategy that provides an immediate signal on target achievement is A) exchange-rate targeting. B) monetary targeting. C) inflation targeting. D) the implicit nominal anchor. Answer: B 10) The monetary policy strategy that relies on a stable money-income relationship is A) exchange-rate targeting. B) monetary targeting. C) inflation targeting. D) the implicit nominal anchor. Answer: B 16.2 Inflation Targeting 1) The type of monetary policy that is used in Canada, New Zealand, and the United Kingdom is A) monetary targeting. B) inflation targeting. C) targeting with an implicit nominal anchor. D) interest-rate targeting. Answer: B 2) Which of the following is NOT an element of inflation targeting? A) A public announcement of medium-term numerical targets for inflation B) An institutional commitment to price stability as the primary long-run goal C) An information-inclusive approach in which only monetary aggregates are used in making decisions about monetary policy D) Increased accountability of the central bank for attaining its inflation objectives Answer: C 3) The first country to adopt inflation targeting was A) the United Kingdom. B) Canada. C) New Zealand. D) Australia. Answer: C 4) In both New Zealand and Canada, what has happened to the unemployment rate since the countries adopted inflation targeting? A) The unemployment rate increased sharply. B) The unemployment rate remained constant. C) The unemployment rate has declined substantially after a sharp increase. D) The unemployment rate declined sharply immediately after the inflation targets were adopted. Answer: C 5) Which of the following is NOT an advantage of inflation targeting? A) There is simplicity and clarity of the target. B) Inflation targeting does not rely on a stable money-inflation relationship. C) There is an immediate signal on the achievement of the target. D) Inflation targeting reduces the effects of inflation shocks. Answer: C 6) Which of the following is NOT a disadvantage to inflation targeting? A) There is a delayed signal about achievement of the target. B) Inflation targets could impose a rigid rule on policymakers. C) There is potential for larger output fluctuations. D) There is a lack of transparency. Answer: D 7) The decision by inflation targeters to choose inflation targets ________ zero reflects the concern of monetary policymakers that particularly ________ inflation can have substantial negative effects on real economic activity. A) below; high B) below; low C) above; high D) above; low Answer: D 8) Inflation targets can increase the central bank's flexibility in responding to declines in aggregate spending. Declines in aggregate ________ that cause the inflation rate to fall below the floor of the target range will automatically stimulate the central bank to ________ monetary policy without fearing that this action will trigger a rise in inflation expectations. A) demand: tighten B) demand; loosen C) supply; tighten D) supply; loosen Answer: B 9) Explain what inflation targeting is. What are the advantages and disadvantages of this type of monetary policy strategy? Answer: There are five main elements to inflation targeting: 1. a public announcement of a medium-term target for the inflation rate; 2. a commitment to price stability as the primary long-term goal of policy; 3. many variables are used in making decisions about policy moves; 4. increased transparency about policy strategy with the public; 5. the central bank has increased accountability for attaining policy goals. The advantages of inflation targeting include: 1. the simplicity and clarity of a numerical target for the inflation rate; 2. does not rely on a stable money-inflation relationship; 3. there is increased accountability of the central bank; 4. reduces the effects of inflationary shocks. The disadvantages of inflation targeting include: 1. there is a delayed signal about the achievement of the target; 2. it could lead to a rigid rule where the only focus is the inflation rate (has not happened in practice); 3. if sole focus is the inflation rate, larger output fluctuations can occur (has not happened in practice). 16.3 Monetary Policy with an Implicit Nominal Anchor 1) The type of monetary policy regime that the Federal Reserve has been following in recent years can best be described as A) monetary targeting. B) inflation targeting. C) policy with an implicit nominal anchor. D) exchange-rate targeting. Answer: C 2) Estimates suggest that, in the United States economy, it takes just over ________ for monetary policy to affect output and just over ________ for monetary policy to affect the inflation rate. A) 1 year; 2 years B) 2 years; 1 year C) 1 year; 6 months D) 6 months; 1 year Answer: A 3) Which of the following is an advantage of the Fed's "just do it" approach to monetary policy? A) It does not rely on the money-inflation relationship. B) It is simplistic and has clarity. C) There is increased accountability of central bankers. D) There is an immediate signal if the target has been achieved. Answer: A 4) Which of the following is NOT a disadvantage of of the Fed's "just do it" approach to monetary policy? A) There is low transparency of policy. B) There is low accountability for central bankers. C) This type of policy relies on the policy-makers in charge. D) It relies on a stable money-inflation relationship. Answer: D 5) When compared to the Fed's ________ anchor approach, ________ targeting can make the institutional framework for the conduct of monetary policy more consistent with democratic principles. A) nominal; inflation B) implicit; monetary C) nominal; monetary D) implicit; inflation Answer: D 6) The monetary policy strategy that suffers a lack of transparency is A) exchange-rate targeting. B) monetary targeting. C) inflation targeting. D) the implicit nominal anchor. Answer: D 7) The monetary policy strategy that provides the least accountability is A) exchange-rate targeting. B) monetary targeting. C) inflation targeting. D) the implicit nominal anchor. Answer: D 8) Explain the Federal Reserve's "just do it" approach to monetary policy. What are the advantages and disadvantages to this type of strategy? Answer: The Federal Reserve doesn't use an explicit nominal anchor such as a monetary aggregate or the inflation rate. Its strategy revolves around using an implicit nominal anchor in the form of an overriding concern to control inflation in the long run. This involves forward-looking behavior and "pre-emptive strikes" by policy actions to prevent inflation. This forward-looking behavior is necessary because of the long time lags between monetary policy action and its impact on inflation. The advantages of this policy strategy include: 1. it doesn't rely on a stable money-inflation relationship; 2. the demonstrated success it has had in the United States. The disadvantages of this policy strategy include: 1. there is a lack of transparency; 2. its success depends on the individuals in charge of policy; 3. there is low accountability of the central bank. 16.4 Tactics: Choosing the Policy Instrument 1) Which of the following is not an operating instrument? A) Nonborrowed reserves B) Monetary base C) Federal funds interest rate D) Discount rate Answer: D 2) Which of the following is a potential operating instrument for the central bank? A) The monetary base B) The M1 money supply C) Nominal GDP D) The discount rate Answer: A 3) Due to the lack of timely data for the price level and economic growth, the Fed's strategy A) targets the exchange rate, since the Fed can control this variable. B) targets the price of gold, since it is closely related to economic activity. C) uses an intermediate target, such as an interest rate. D) stabilizes the consumer price index, since the Fed can control the CPI. Answer: C 4) If the central bank targets a monetary aggregate, it is likely to lose control over the interest rate because A) of fluctuations in the demand for reserves. B) of fluctuations in the consumption function. C) bond values will tend to remain stable. D) of fluctuations in the business cycle. Answer: A 5) If the Fed pursues a strategy of targeting an interest rate when fluctuations in money demand are prevalent, A) fluctuations of nonborrowed reserves will be small. B) fluctuations of nonborrowed reserves will be large. C) the Fed will probably quickly abandon this policy, as it did in the 1960s. D) the Fed will probably quickly abandon this policy, as it did in the 1950s. Answer: B 6) Fluctuations in the demand for reserves cause the Fed to lose control over a monetary aggregate if the Fed targets A) a monetary aggregate. B) the monetary base. C) an interest rate. D) nominal GDP. Answer: C 7) Interest rates are difficult to measure because A) data on them are not available in a timely manner. B) real interest rates depend on the hard-to-determine expected inflation rate. C) they fluctuate too often to be accurate. D) they cannot be controlled by the Fed. Answer: B 8) Which of the following criteria need not be satisfied for choosing an intermediate target? A) The variable must be measurable. B) The variable must be controllable. C) The variable must be predictable. D) The variable must be transportable. Answer: D 9) Which of the following is not a requirement in selecting an intermediate target? A) Measurability B) Controllability C) Flexibility D) Predictability Answer: C 10) When it comes to choosing an policy instrument, both the ________ rate and ________ aggregates are measured accurately and are available daily with almost no delay. A) three-month T-bill; monetary B) three-month T-bill; reserve C) federal funds; monetary D) federal funds; reserve Answer: D 11) If the desired intermediate target is an interest rate, then the preferred policy instrument will be a(n) ________ variable like the ________. A) interest rate; three-month T-bill rate B) interest rate; federal funds rate C) monetary aggregate; monetary base D) monetary aggregate; nonborrowed base Answer: B 12) If the desired intermediate target is a monetary aggregate, then the preferred policy instrument will be a(n) ________ variable like the ________. A) interest rate; three-month T-bill rate B) interest rate; federal funds rate C) reserve aggregate; monetary base D) reserve aggregate; narrow money supply M1 Answer: C 13) If the desired intermediate target is a monetary aggregate, which of the following would be the most preferred policy instrument? A) The federal funds rate B) The 90-day T-bill rate C) The 180-day T-bill rate D) The monetary base Answer: D 14) If the desired intermediate target is an interest rate, the preferred policy instrument would be A) the federal funds rate. B) the monetary base. C) nonborrowed reserves. D) borrowed reserves. E) the discount rate. Answer: A 15) Explain and demonstrate graphically how targeting nonborrowed reserves can result in federal funds rate instability. Answer: See figure below. When nonborrowed reserves are held constant, increases in the demand for reserves result in the federal funds rate increasing and decreases in the demand for nonborrowed reserves result in the federal funds rate declining. Since fluctuations in demand do not cause monetary policy actions, the result is the federal funds rate will fluctuate (assuming the equilibrium federal funds rate is below the discount rate). 16) Explain and demonstrate graphically how targeting the federal funds rate can result in fluctuations in nonborrowed reserves. Answer: See figure below. With a federal funds rate target, fluctuations in demand for reserves require similar changes in the nonborrowed reserves to keep the federal funds rate constant. 16.5 Tactics: The Taylor Rule 1) According to the Taylor rule, the Fed should raise the federal funds interest rate when inflation ________ the Fed's inflation target or when real GDP ________ the Fed's output target. A) rises above; drops below B) drops below; drops below C) rises above; rises above D) drops below; rises above Answer: C 2) Using Taylor's rule, when the equilibrium real federal funds rate is 3 percent, the positive output gap is 2 percent, the target inflation rate is 1 percent, and the actual inflation rate is 2 percent, the nominal federal funds rate target should be A) 5 percent. B) 5.5 percent. C) 6 percent. D) 6.5 percent. Answer: D 3) Using Taylor's rule, when the equilibrium real federal funds rate is 2 percent, there is no output gap, the actual inflation rate is zero, and the target inflation rate is 2 percent, the nominal federal funds rate should be A) 0 percent. B) 1 percent. C) 2 percent. D) 3 percent. Answer: B 4) According to the Taylor Principle, when the inflation rate rises, the nominal interest rate should be ________ by ________ than the inflation rate increase. A) increased; more B) increased; less C) decreased; more D) decreased; less Answer: A 5) If the Taylor Principle is not followed and nominal interest rates are increased by less than the increase in the inflation rate, then real interest rates will ________ and monetary policy will be too ________. A) rise; tight B) rise; loose C) fall; tight D) fall; loose Answer: D 6) The rate of inflation tends to remain constant when A) the unemployment rate is above the NAIRU. B) the unemployment rate equals the NAIRU. C) the unemployment rate is below the NAIRU. D) the unemployment rate increases faster than the NAIRU increases. Answer: B 7) The rate of inflation increases when A) the unemployment rate equals the NAIRU. B) the unemployment rate exceeds the NAIRU. C) the unemployment rate is less than the NAIRU. D) the unemployment rate increases faster than the NAIRU increases. Answer: C 8) Explain the Taylor rule, including the formula for setting the federal funds rate target, and the components of the formula. If the Fed were to use this rule, how many goals would it use to set monetary policy? Answer: The Taylor rule specifies that the target federal fund rates should be set to equal the equilibrium real federal funds rate, plus the rate of inflation (for the Fisher effect), plus one-half times the output gap, plus one-half times the inflation gap. The formula is Federal funds rate target = equilibrium real federal funds rate + inflation rate + 1/2 (output gap) + 1/2 (inflation gap) The output gap is the percentage deviation of real GDP from potential full-employment real GDP. The inflation gap is the difference between actual inflation and the central bank's target rate of inflation. The equilibrium real federal funds rate is the real rate consistent with full employment in the long run. The inflation rate is the actual rate of inflation. The Taylor rule sets the federal funds rate recognizing the goals of low inflation and full employment (or equilibrium long-run economic growth). 16.6 Central Banks' Response to Asset-Price Bubbles: Lessons From The Subprime Crisis 1) When asset prices increase above their fundamental values it is called an ________. A) asset-price bubble B) irrational bubble C) asset-price spike D) irrational spike Answer: A 2) Suppose interest rates are kept very low for a long time such that there is a spike in the amount of lending. Everything else held constant, this could cause ________ bubble. A) an irrational exuberance B) a credit-driven C) a stock D) a debt-driven Answer: B 3) A credit-driven bubble arises when ________ in lending causes ________ in asset prices which can cause ________ in lending. A) a decrease; a decrease; an increase B) a decrease; an increase; an increase C) an increase; an increase; a further increase D) a decrease; a decrease; a further decrease Answer: C 4) ________ bubble is driven entirely by unrealistic optimistic expectations. A) An irrational exuberance B) A credit-driven C) A stock D) A debt-driven Answer: A 5) Everything else held constant, a credit-drive bubble is generally considered to have the potential to cause ________ damage to an economy compared to an irrational exuberance bubble. A) less B) about the same amount of C) more D) either more, less, or the same amount of Answer: C 6) A central bank has ________ chance to identify a credit-driven bubble compared to an irrational exuberance bubble. A) a greater B) less of a C) about the same level of a D) a greater, less or about the same level of a Answer: A 7) Which of the following is NOT an argument against using monetary policy to prick asset-price bubbles? A) The effect of increasing interest rates on asset prices is uncertain. B) A bubble may only exist in some asset-prices and monetary policy will affect all asset prices. C) Using monetary policy to prick an asset-price bubble may have adverse effect on the aggregate economy. D) Even though credit-drive bubbles are easier to identify, they are still relatively hard to identify. Answer: D 16.7 Fed Policy Procedures: Historical Perspective 1) In its earliest years, the Federal Reserve's guiding principle for the conduct of monetary policy was known as the A) real bills doctrine. B) liberal liquidity doctrine. C) free reserves doctrine. D) quantity theory of money. Answer: A 2) The guiding principle for the conduct of monetary policy that held that as long as loans were being made for "productive" purposes, then providing reserves to the banking system to make these loans would not be inflationary became known as the A) free reserves doctrine. B) Benjamin Strong doctrine. C) efficient liquidity doctrine. D) real bills doctrine. Answer: D 3) The real bills doctrine was the guiding principle for the conduct of monetary policy during the A) 1910s. B) 1940s. C) 1950s. D) 1960s. Answer: A 4) The Fed accidentally discovered open market operations in the early A) 1920s. B) 1910s. C) 1900s. D) 1890s. Answer: A 5) The Fed accidentally discovered open market operations when A) it came to the rescue of failing banks in the early 1930s, and found that its purchases of bank loans injected reserves into the banking system. B) it purchased securities for income following the 1920-1921 recession. C) it attempted to slow inflation in 1919 by selling securities and found that its sales drained reserves from the banking system. D) it reinterpreted a key provision of the Federal Reserve Act. Answer: B 6) The Fed's mistakes of the early 1930s were compounded by its decision to A) raise reserve requirements in 1936-1937. B) lower reserve requirements in 1936-1937. C) raise the monetary base in 1936-1937. D) lower the monetary base in 1936-1937. Answer: A 7) During World War II, whenever interest rates would ________ and the price of bonds would begin to ________, the Fed would make open market purchases. A) rise; rise B) rise; fall C) fall; rise D) fall; fall Answer: B 8) During World War II, whenever interest rates would rise and the price of bonds would begin to fall, the Fed would A) lower reserve requirements. B) raise reserve requirements. C) make open market purchases of government securities. D) make open market sales of government securities. Answer: C 9) During World War II, the Fed in effect relinquished its control of monetary policy through its policy of A) continually lowering reserve requirements. B) continually raising reserve requirements. C) pegging interest rates. D) targeting free reserves. Answer: C 10) The Fed was committed to keeping interest rates low to assist Treasury financing of budget deficits A) only during World War I. B) during the Great Depression. C) during World War I and World War II. D) throughout the entire existence of the Fed. Answer: C 11) The Fed-Treasury Accord of March 1951 provided the Fed greater freedom to A) let interest rates increase. B) let unemployment increase. C) let inflation accelerate. D) let exchange rates increase. Answer: A 12) During the 1950s, the Fed targeted A) M1. B) M2. C) the monetary base. D) money market conditions. Answer: D 13) During the 1950s, Fed monetary policy targeted A) the monetary base. B) the exchange rate. C) discount loans. D) interest rates. Answer: D 14) Targeting interest rates can be procyclical because A) an increase in income increases interest rates, causing the Fed to buy bonds, increasing the monetary base and money supply, leading to further increases in income. B) an increase in interest rates increases income, causing the Fed to buy bonds, increasing the monetary base and money supply, leading to further increases in income. C) an increase in the monetary base increases the money supply, causing the Fed to buy bonds, increasing the monetary base and money supply, leading to further increases in income. D) an increase in income increases the monetary base and money supply, causing the Fed to buy bonds to increase interest rates and income. Answer: A 15) High inflation can spiral out of control when A) expected inflation increases nominal interest rates, causing the Fed to buy bonds, increasing the money supply and further increasing inflation. B) expected inflation decreases nominal interest rates, causing the Fed to buy bonds, increasing the money supply and further increasing inflation. C) expected inflation increases nominal interest rates, causing the Fed to sell bonds, increasing the money supply and further increasing inflation. D) expected inflation decreases nominal interest rates, causing the Fed to sell bonds, increasing the money supply and further increasing inflation. Answer: A 16) In practice, the Fed's policy of targeting money market conditions in the 1960s proved to be A) countercyclical, helping to stabilize the economy. B) procyclical, destabilizing the economy. C) procyclical, helping to stabilize the economy. D) countercyclical, destabilizing the economy. Answer: B 17) In practice, the Fed's policy of targeting ________ in the 1960s proved to be ________, destabilizing the economy. A) money market conditions; countercyclical B) money market conditions; procyclical C) monetary aggregates; countercyclical D) monetary aggregates; procyclical Answer: B 18) Although the Fed professed employment of a monetary aggregate targeting strategy during the 1970s, its behavior suggests that it emphasized A) free-reserve targeting. B) interest-rate targeting. C) a real-bills doctrine. D) price-index targeting. Answer: B 19) Although the Fed professed employment of ________ targeting during the 1970s, its behavior suggests that it emphasized ________ targeting. A) free-reserve; interest-rate B) interest-rate; monetary aggregate C) monetary aggregate; interest-rate D) free reserve; monetary aggregate Answer: C 20) The Fed's use of the federal funds rate as an operating target in the 1970s resulted in A) countercyclical monetary policy. B) too slow growth in M1 throughout the decade. C) procyclical monetary policy. D) too rapid growth in M1 throughout the decade. Answer: C 21) The Fed's use of the ________ as an operating target in the 1970s resulted in ________ monetary policy. A) federal funds rate; countercyclical B) federal funds rate; procyclical C) M1 money supply; countercyclical D) M1 money supply; procyclical Answer: B 22) In the 1970s, the Fed selected an interest rate as an operating target rather than a reserve aggregate primarily because it A) had no interest in targeting a monetary aggregate, as evidenced by its unwillingness to target a reserve aggregate. B) was still very concerned with achieving interest rate stability. C) was committed to targeting free reserves. D) was committed to the real bills doctrine. Answer: B 23) The Fed operating procedures employed between 1979 and 1982 resulted in ________ swings in the federal funds rate and ________ swings in the M1 growth rate. A) increased; increased B) increased; decreased C) decreased; decreased D) decreased; increased Answer: A 24) The fluctuations in both money supply growth and the federal funds rate during 1979-1982 suggest that the Fed A) had shifted to borrowed reserves as an operating target. B) had shifted to total reserves as an operating target. C) had shifted to the monetary base as an operating target. D) never intended to target monetary aggregates. Answer: D 25) The Fed's failure to exercise effective control over the money supply during the 1979-1982 period A) proves that such control is not possible. B) resulted because forces outside of its control removed the link between open market operations and the money supply. C) occurred despite evidence of a strong link between open market operations and the money supply. D) stems from the Treasury-Federal Reserve Accord. Answer: C 26) Large fluctuations in money supply growth and smaller fluctuations in the federal funds rate between October 1982 and the early 1990s indicate that the Fed had shifted to ________ as an operating target. A) borrowed reserves B) nonborrowed reserves C) excess reserves D) required reserves Answer: A 27) The strengthening of the dollar between 1980 and 1985 contributed to a ________ in American competitiveness, putting pressure on the Fed to pursue a more ________ monetary policy. A) decrease; contractionary B) increase; expansionary C) increase; contractionary D) decrease; expansionary Answer: D 28) A borrowed reserves target is ________ because increases in income ________ interest rates and discount loans, causing the Fed to ________ the monetary base, everything else held constant. A) procyclical; increase; increase B) countercyclical; increase; increase C) procyclical; reduce; reduce D) countercyclical; reduce; reduce Answer: A 29) Fed policy since the early 1990s indicates that it is pursuing a policy of targeting the A) monetary base. B) money supply. C) federal funds interest rate. D) exchange rate. Answer: C 30) Since the early 1990s, the Fed has conducted monetary policy by setting a target for the A) level of borrowed reserves. B) monetary base. C) federal funds rate. D) inflation rate. Answer: C 31) The Fed can engage in pre-emptive strikes against a rise in inflation by ________ the federal funds interest rate; it can act pre-emptively against negative demand shocks by ________ the federal funds interest rate. A) raising; lowering B) raising; raising C) lowering; lowering D) lowering; raising Answer: A 16.8 International Considerations 1) International policy coordination refers to A) central banks in major nations acting without regard to the global consequences of their policies. B) central banks in major nations pursuing only domestic objectives. C) central banks adopting policies in pursuit of joint objectives. D) central banks all adopting identical policies. Answer: C 2) The Federal Reserve has been ________ pre-emptive because of the changing view that monetary policy has to be ________ looking. A) more; forward B) more; backward C) less; forward D) less; backward Answer: A Chapter 17 The Foreign Exchange Market 17.1 Foreign Exchange Market 1) The exchange rate is A) the price of one currency relative to gold. B) the value of a currency relative to inflation. C) the change in the value of money over time. D) the price of one currency relative to another. Answer: D 2) Exchange rates are determined in A) the money market. B) the foreign exchange market. C) the stock market. D) the capital market. Answer: B 3) Although foreign exchange market trades are said to involve the buying and selling of currencies, most trades involve the buying and selling of A) bank deposits denominated in different currencies. B) SDRs. C) gold. D) ECUs. Answer: A 4) The immediate (two-day) exchange of one currency for another is a A) forward transaction. B) spot transaction. C) money transaction. D) exchange transaction. Answer: B 5) An agreement to exchange dollar bank deposits for euro bank deposits in one month is a A) spot transaction. B) future transaction. C) forward transaction. D) deposit transaction. Answer: C 6) Today 1 euro can be purchased for $1.10. This is the A) spot exchange rate. B) forward exchange rate. C) fixed exchange rate. D) financial exchange rate. Answer: A 7) In an agreement to exchange dollars for euros in three months at a price of $0.90 per euro, the price is the A) spot exchange rate. B) money exchange rate. C) forward exchange rate. D) fixed exchange rate. Answer: C 8) When the value of the British pound changes from $1.25 to $1.50, the pound has ________ and the U.S. dollar has ________. A) appreciated; appreciated B) depreciated; appreciated C) appreciated; depreciated D) depreciated; depreciated Answer: C 9) When the value of the British pound changes from $1.50 to $1.25, then the pound has ________ and the U.S. dollar has ________. A) appreciated; appreciated B) depreciated; appreciated C) appreciated; depreciated D) depreciated; depreciated Answer: B 10) When the value of the dollar changes from £0.5 to £0.75, then the British pound has ________ and the U.S. dollar has ________. A) appreciated; appreciated B) depreciated; appreciated C) appreciated; depreciated D) depreciated; depreciated Answer: B 11) When the value of the dollar changes from £0.75 to £0.5, then the British pound has ________ and the U.S. dollar has ________. A) appreciated; appreciated B) depreciated; appreciated C) appreciated; depreciated D) depreciated; depreciated Answer: C 12) When the exchange rate for the Mexican peso changes from 9 pesos to the U.S. dollar to 10 pesos to the U.S. dollar, then the Mexican peso has ________ and the U.S. dollar has ________. A) appreciated; appreciated B) depreciated; appreciated C) appreciated; depreciated D) depreciated; depreciated Answer: B 13) When the exchange rate for the Mexican peso changes from 10 pesos to the U.S dollar to 9 pesos to the U.S. dollar, then the Mexican peso has ________ and the U.S. dollar has ________. A) appreciated; appreciated B) depreciated; appreciated C) appreciated; depreciated D) depreciated; depreciated Answer: C 14) On January 25, 2009, one U.S. dollar traded on the foreign exchange market for about 0.75 euros. Therefore, one euro would have purchased about ________ U.S. dollars. A) 0.75 B) 1.00 C) 1.33 D) 1.75 Answer: C 15) On January 25, 2009, one U.S. dollar traded on the foreign exchange market for about 49.0 Indian rupees. Thus, one Indian rupee would have purchased about ________ U.S. dollars. A) 0.02 B) 1.20 C) 7.00 D) 49.0 Answer: A 16) On January 25, 2009, one U.S. dollar traded on the foreign exchange market for about 1.15 Swiss francs. Therefore, one Swiss franc would have purchased about ________ U.S. dollars. A) 0.30 B) 0.87 C) 1.15 D) 3.10 Answer: B 17) On January 25, 2009, one U.S. dollar traded on the foreign exchange market for about 3.33 Romanian new lei. Therefore, one Romanian new lei would have purchased about ________ U.S. dollars. A) 0.30 B) 1.86 C) 2.86 D) 3.33 Answer: A 18) If the U.S. dollar appreciates from 1.25 Swiss franc per U.S. dollar to 1.5 francs per dollar, then the franc depreciates from ________ U.S. dollars per franc to ________ U.S. dollars per franc. A) 0.80; 0.67 B) 0.67; 0.80 C) 0.50; 0.33 D) 0.33; 0.50 Answer: A 19) If the British pound appreciates from $0.50 per pound to $0.75 per pound, the U.S. dollar depreciates from ________ per dollar to ________ per dollar. A) £2; £2.5 B) £2; £1.33 C) £2; £1.5 D) £2; £1.25 Answer: B 20) If the Japanese yen appreciates from $0.01 per yen to $0.02 per yen, the U.S. dollar depreciates from ________ per dollar to ________ per dollar. A) 100¥; 50¥ B) 10¥; 5¥ C) 5¥; 10¥ D) 50¥; 100¥ Answer: A 21) If the dollar appreciates from 1.5 Brazilian reals per dollar to 2.0 reals per dollar, the real depreciates from ________ per real to ________ per real. A) $0.67; $0.50 B) $0.33; $0.50 C) $0.75; $0.50 D) $0.50; $0.67 E) $0.50; $0.75 Answer: A 22) When the exchange rate for the British pound changes from $1.80 per pound to $1.60 per pound, then, holding everything else constant, the pound has ________ and ________ expensive. A) appreciated; British cars sold in the United States become more B) appreciated; British cars sold in the United States become less C) depreciated; American wheat sold in Britain becomes more D) depreciated; American wheat sold in Britain becomes less Answer: C 23) If the dollar depreciates relative to the Swiss franc A) Swiss chocolate will become cheaper in the United States. B) American computers will become more expensive in Switzerland. C) Swiss chocolate will become more expensive in the United States. D) Swiss computers will become cheaper in the United States. Answer: C 24) Everything else held constant, when a country's currency appreciates, the country's goods abroad become ________ expensive and foreign goods in that country become ________ expensive. A) more; less B) more; more C) less; less D) less; more Answer: A 25) Everything else held constant, when a country's currency depreciates, its goods abroad become ________ expensive while foreign goods in that country become ________ expensive. A) more; less B) more; more C) less; less D) less; more Answer: D 17.2 Exchange Rates in the Long Run 1) According to the law of one price, if the price of Colombian coffee is 100 Colombian pesos per pound and the price of Brazilian coffee is 4 Brazilian reals per pound, then the exchange rate between the Colombian peso and the Brazilian real is: A) 40 pesos per real. B) 100 pesos per real. C) 25 pesos per real. D) 0.4 pesos per real. Answer: C 2) The starting point for understanding how exchange rates are determined is a simple idea called ________, which states: if two countries produce an identical good, the price of the good should be the same throughout the world no matter which country produces it. A) Gresham's law B) the law of one price C) purchasing power parity D) arbitrage Answer: B 3) The ________ states that exchange rates between any two currencies will adjust to reflect changes in the price levels of the two countries. A) theory of purchasing power parity B) law of one price C) theory of money neutrality D) quantity theory of money Answer: A 4) The theory of PPP suggests that if one country's price level rises relative to another's, its currency should A) depreciate. B) appreciate. C) float. D) do none of the above. Answer: A 5) The theory of PPP suggests that if one country's price level falls relative to another's, its currency should A) depreciate. B) appreciate. C) float. D) do none of the above. Answer: B 6) The theory of PPP suggests that if one country's price level falls relative to another's, its currency should A) depreciate in the long run. B) appreciate in the long run. C) appreciate in the short run. D) depreciate in the short run. Answer: B 7) The theory of purchasing power parity cannot fully explain exchange rate movements because A) all goods are identical even if produced in different countries. B) monetary policy differs across countries. C) some goods are not traded between countries. D) fiscal policy differs across countries. Answer: C 8) The theory of purchasing power parity states that exchange rates between any two currencies will adjust to reflect changes in A) the trade balances of the two countries. B) the current account balances of the two countries. C) fiscal policies of the two countries. D) the price levels of the two countries. Answer: D 9) If the real exchange rate between the United States and Japan is ________, then it is cheaper to buy goods in Japan than in the United States. A) greater than 1.0 B) greater than 0.5 C) less than 0.5 D) less than 1.0 Answer: A 10) According to PPP, the real exchange rate between two countries will always equal ________. A) 0.0 B) 0.5 C) 1.0 D) 1.5 Answer: C 11) The theory of PPP suggests that if one country's price level rises relative to another's, its currency should A) depreciate in the long run. B) appreciate in the long run. C) depreciate in the short run. D) appreciate in the short run. Answer: A 12) In the long run, a rise in a country's price level (relative to the foreign price level) causes its currency to ________, while a fall in the country's relative price level causes its currency to ________. A) appreciate; appreciate B) appreciate; depreciate C) depreciate; appreciate D) depreciate; depreciate Answer: C 13) If the 2005 inflation rate in Canada is 4 percent, and the inflation rate in Mexico is 2 percent, then the theory of purchasing power parity predicts that, during 2005, the value of the Canadian dollar in terms of Mexican pesos will A) rise by 6 percent. B) rise by 2 percent. C) fall by 6 percent. D) fall by 2 percent. Answer: D 14) Assume that the following are the predicted inflation rates in these countries for the year: 2% for the United States, 3% for Canada; 4% for Mexico, and 5% for Brazil. According to the purchasing power parity and everything else held constant, which of the following would we expect to happen? A) The Brazilian real will depreciate against the U.S. dollar. B) The Mexican peso will depreciate against the Brazilian real. C) The Canadian dollar will depreciate against the Mexican peso. D) The U.S. dollar will depreciate against the Canadian dollar. Answer: A 15) According to the purchasing power parity theory, a rise in the United States price level of 5 percent, and a rise in the Mexican price level of 6 percent cause A) the dollar to appreciate 1 percent relative to the peso. B) the dollar to depreciate 1 percent relative to the peso. C) the dollar to depreciate 5 percent relative to the peso. D) the dollar to appreciate 5 percent relative to the peso. Answer: A 16) Higher tariffs and quotas cause a country's currency to ________ in the ________ run, everything else held constant. A) depreciate; short B) appreciate; short C) depreciate; long D) appreciate; long Answer: D 17) Lower tariffs and quotas cause a country's currency to ________ in the ________ run, everything else held constant. A) depreciate; short B) appreciate; short C) depreciate; long D) appreciate; long Answer: C 18) Anything that increases the demand for foreign goods relative to domestic goods tends to ________ the domestic currency because domestic goods will only continue to sell well if the value of the domestic currency is ________, everything else held constant. A) depreciate; lower B) depreciate; higher C) appreciate; lower D) appreciate; higher Answer: A 19) Everything else held constant, increased demand for a country's ________ causes its currency to appreciate in the long run, while increased demand for ________ causes its currency to depreciate. A) imports; imports B) imports; exports C) exports; imports D) exports; exports Answer: C 20) Everything else held constant, increased demand for a country's exports causes its currency to ________ in the long run, while increased demand for imports causes its currency to ________. A) appreciate; appreciate B) appreciate; depreciate C) depreciate; appreciate D) depreciate; depreciate Answer: B 21) Everything else held constant, if a factor increases the demand for ________ goods relative to ________ goods, the domestic currency will appreciate. A) foreign; domestic B) foreign; foreign C) domestic; domestic D) domestic; foreign Answer: D 22) Everything else held constant, if a factor decreases the demand for ________ goods relative to ________ goods, the domestic currency will depreciate. A) foreign; domestic B) foreign; foreign C) domestic; domestic D) domestic; foreign Answer: D 23) An increase in productivity in a country will cause its currency to ________ because it can produce goods at a ________ price, everything else held constant. A) depreciate; lower B) appreciate; lower C) depreciate; higher D) appreciate; higher Answer: B 24) If, in retaliation for "unfair" trade practices, Congress imposes a 30 percent tariff on Japanese DVD recorders, but at the same time, U.S. demand for Japanese goods increases, then, in the long run, ________, everything else held constant A) the Japanese yen should appreciate relative to the U.S. dollar B) the Japanese yen should depreciate relative to the U.S. dollar C) there is no effect on the Japanese yen relative to the U.S. dollar D) the Japanese yen could appreciate, depreciate or remain constant relative to the U.S. dollar Answer: D 25) If the U.S. Congress imposes a quota on imports of Japanese cars due to claims of "unfair" trade practices, and Japanese demand for American exports increases at the same time, then, in the long run ________, everything else held constant. A) the Japanese yen will appreciate relative to the U.S. dollar B) the Japanese yen will depreciate relative to the U.S. dollar C) the Japanese yen will either appreciate, depreciate or remain constant against the U.S. dollar D) there will be no effect on the Japanese yen relative to the U.S. dollar Answer: B 26) If the inflation rate in the United States is higher than that in Mexico and productivity is growing at a slower rate in the United States than in Mexico, then, in the long run, ________, everything else held constant. A) the Mexican peso will appreciate relative to the U.S. dollar B) the Mexican peso will depreciate relative to the U.S. dollar C) the Mexican peso will either appreciate, depreciate, or remain constant relative to the U.S. dollar D) there will be no effect on the Mexican peso relative to the U.S. dollar Answer: A 27) If the Brazilian demand for American exports rises at the same time that U.S. productivity rises relative to Brazilian productivity, then, in the long run, ________, everything else held constant. A) the Brazilian real will appreciate relative to the U.S. dollar B) the Brazilian real will depreciate relative to the U.S. dollar C) the Brazilian real will either appreciate, depreciate, or remain constant relative to the U.S. dollar D) there is no effect on the Brazilian real relative to the U.S. dollar Answer: B 28) Explain the law of one price and the theory of purchasing power parity. Why doesn't purchasing power parity explain all exchange rate movements? What factors determine long-run exchange rates? Answer: With no trade barriers and low transport costs, the law of one price states that the price of traded goods should be the same in all countries. The purchasing power parity theory extends the law of one price to total economies. PPP states that exchange rates should adjust to reflect changes in the price levels between two countries. PPP may fail to fully explain exchange rates because goods are not identical, and price levels include traded and nontraded goods and services. Long-run exchange rates are determined by domestic price levels relative to foreign price levels, trade barriers, import and export demand, and productivity. 17.3 Exchange Rates in the Short Run: A Supply and Demand Analysis 1) The theory of asset demand suggests that the most important factor affecting the demand for domestic and foreign assets is A) the level of trade and capital flows. B) the expected return on these assets relative to one another. C) the liquidity of these assets relative to one another. D) the riskiness of these assets relative to one another. Answer: B 2) The ________ suggests that the most important factor affecting the demand for domestic and foreign assets is the expected return on domestic assets relative to foreign assets. A) theory of asset demand B) law of one price C) interest parity condition D) theory of foreign capital mobility Answer: A 3) The theory of asset demand suggests that the most important factor affecting the demand for domestic and foreign assets is the ________ on these assets relative to one another. A) interest rate B) risk C) expected return D) liquidity Answer: C 4) As the relative expected return on dollar assets increases, foreigners will want to hold more ________ assets and less ________ assets, everything else held constant. A) foreign; foreign B) foreign; dollar C) dollar; foreign D) dollar; dollar Answer: C 5) When Americans or foreigners expect the return on ________ assets to be high relative to the return on ________ assets, there is a higher demand for dollar assets and a correspondingly lower demand for foreign assets. A) dollar; dollar B) dollar; foreign C) foreign; dollar D) foreign; foreign Answer: B 6) When Americans or foreigners expect the return on ________ assets to be high relative to the return on ________ assets, there is a ________ demand for dollar assets, everything else held constant. A) dollar; foreign; constant B) dollar; foreign; higher C) foreign; dollar; higher D) foreign; dollar; constant Answer: B 7) When Americans or foreigners expect the return on dollar assets to be high relative to the return on foreign assets, there is a ________ demand for dollar assets and a correspondingly ________ demand for foreign assets. A) higher; higher B) higher; lower C) lower; higher D) lower; lower Answer: B 8) Everything else held constant, when the current value of the domestic currency increases, the ________ domestic assets ________. A) demand for; increases B) quantity demanded of; increases C) demand for; decreases D) quantity demanded of; decreases Answer: D 9) Everything else held constant, when the current value of the domestic exchange rate increases, the ________ of domestic assets ________. A) quantity supplied; does not change B) supply; decreases C) quantity supplied; increases D) supply; increases Answer: A 17.4 Explaining Changes in Exchange Rates 1) An increase in the domestic interest rate causes the demand for domestic assets to ________ and the domestic currency to ________, everything else held constant. A) increase; appreciate B) increase; depreciate C) decrease; appreciate D) decrease; depreciate Answer: A 2) An increase in the domestic interest rate causes the demand for domestic assets to shift to the ________ and the domestic currency to ________, everything else held constant. A) right; appreciate B) right; depreciate C) left; appreciate D) left; depreciate Answer: A 3) A decrease in the domestic interest rate causes the demand for domestic assets to ________ and the domestic currency to ________, everything else held constant. A) increase; appreciate B) increase; depreciate C) decrease; appreciate D) decrease; depreciate Answer: D 4) A decrease in the domestic interest rate causes the demand for domestic assets to shift to the ________ and the domestic currency to ________, everything else held constant. A) right; appreciate B) right; depreciate C) left; appreciate D) left; depreciate Answer: D 5) ________ in the domestic interest rate causes the demand for domestic assets to increase and the domestic currency to ________, everything else held constant. A) An increase; appreciate B) An increase; depreciate C) A decrease; appreciate D) A decrease; depreciate Answer: A 6) ________ in the domestic interest rate causes the demand for domestic assets to shift to the right and the domestic currency to ________, everything else held constant. A) An increase; appreciate B) An increase; depreciate C) A decrease; appreciate D) A decrease; depreciate Answer: A 7) ________ in the domestic interest rate causes the demand for domestic assets to decrease and the domestic currency to ________, everything else held constant. A) An increase; appreciate B) An increase; depreciate C) A decrease; appreciate D) A decrease; depreciate Answer: D 8) ________ in the domestic interest rate causes the demand for domestic assets to shift to the left and the domestic currency to ________, everything else held constant. A) An increase; appreciate B) An increase; depreciate C) A decrease; appreciate D) A decrease; depreciate Answer: D 9) ________ in the domestic interest rate causes the demand for domestic assets to ________ and the domestic currency to appreciate, everything else held constant. A) An increase; increase B) An increase; decrease C) A decrease; increase D) A decrease; decrease Answer: A 10) ________ in the domestic interest rate causes the demand for domestic assets to shift to the ________ and the domestic currency to appreciate, everything else held constant. A) An increase; right B) An increase; left C) A decrease; right D) A decrease; left Answer: A 11) ________ in the domestic interest rate causes the demand for domestic assets to ________ and the domestic currency to depreciate, everything else held constant. A) An increase; increase B) An increase; decrease C) A decrease; increase D) A decrease; decrease Answer: D 12) ________ in the domestic interest rate causes the demand for domestic assets to shift to the ________ and the domestic currency to depreciate, everything else held constant. A) An increase; right B) An increase; left C) A decrease; right D) A decrease; left Answer: D 13) Suppose that the Federal Reserve enacts expansionary policy. Everything else held constant, this will cause the demand for U.S. assets to ________ and the U.S. dollar to ________. A) increase; appreciate B) decrease; appreciate C) increase; depreciate D) decrease; depreciate Answer: D 14) Suppose that the Federal Reserve conducts an open market sale. Everything else held constant, this will cause the demand for U.S. assets to ________ and the U.S. dollar will ________. A) increase; appreciate B) increase; depreciate C) decrease; appreciate D) decrease; depreciate Answer: A 15) An increase in the foreign interest rate causes the demand for domestic assets to ________ and the domestic currency to ________, everything else held constant. A) increase; appreciate B) increase; depreciate C) decrease; appreciate D) decrease; depreciate Answer: D 16) An increase in the foreign interest rate causes the demand for domestic assets to shift to the ________ and the domestic currency to ________, everything else held constant. A) right; appreciate B) right; depreciate C) left; appreciate D) left; depreciate Answer: D 17) A decrease in the foreign interest rate causes the demand for domestic assets to ________ and the domestic currency to ________, everything else held constant. A) increase; appreciate B) increase; depreciate C) decrease; appreciate D) decrease; depreciate Answer: A 18) A decrease in the foreign interest rate causes the demand for domestic assets to shift to the ________ and the domestic currency to ________, everything else held constant. A) right; appreciate B) right; depreciate C) left; appreciate D) left; depreciate Answer: A 19) ________ in the foreign interest rate causes the demand for domestic assets to increase and the domestic currency to ________, everything else held constant. A) An increase; appreciate B) An increase; depreciate C) A decrease; appreciate D) A decrease; depreciate Answer: C 20) ________ in the foreign interest rate causes the demand for domestic assets to shift to the right and the domestic currency to ________, everything else held constant. A) An increase; appreciate B) An increase; depreciate C) A decrease; appreciate D) A decrease; depreciate Answer: C 21) ________ in the foreign interest rate causes the demand for domestic assets to decrease and the domestic currency to ________, everything else held constant. A) An increase; appreciate B) An increase; depreciate C) A decrease; appreciate D) A decrease; depreciate Answer: B 22) ________ in the foreign interest rate causes the demand for domestic assets to shift to the left and the domestic currency to ________, everything else held constant. A) An increase; appreciate B) An increase; depreciate C) A decrease; appreciate D) A decrease; depreciate Answer: B 23) ________ in the foreign interest rate causes the demand for domestic assets to ________ and the domestic currency to appreciate, everything else held constant. A) An increase; increase B) An increase; decrease C) A decrease; increase D) A decrease; decrease Answer: C 24) ________ in the foreign interest rate causes the demand for domestic assets to shift to the ________ and the domestic currency to appreciate, everything else held constant. A) An increase; right B) An increase; left C) A decrease; right D) A decrease; left Answer: C 25) ________ in the foreign interest rate causes the demand for domestic assets to ________ and the domestic currency to depreciate, everything else held constant. A) An increase; increase B) An increase; decrease C) A decrease; increase D) A decrease; decrease Answer: B 26) ________ in the foreign interest rate causes the demand for domestic assets to shift to the ________ and the domestic currency to depreciate, everything else held constant. A) An increase; right B) An increase; left C) A decrease; right D) A decrease; left Answer: B 27) Suppose that the European Central Bank enacts expansionary policy. Everything else held constant, this will cause the demand for U.S. assets to ________ and the U.S. dollar to ________. A) increase; appreciate B) decrease; appreciate C) increase; depreciate D) decrease; depreciate Answer: A 28) Suppose that the European Central Bank conducts a main refinancing sale. Everything else held constant, this would cause the demand for U.S. assets to ________ and the U.S. dollar will ________. A) increase; appreciate B) increase; depreciate C) decrease; appreciate D) decrease; depreciate Answer: D 29) An increase in the expected future domestic exchange rate causes the demand for domestic assets to ________ and the domestic currency to ________, everything else held constant. A) increase; appreciate B) increase; depreciate C) decrease; appreciate D) decrease; depreciate Answer: A 30) An increase in the expected future domestic exchange rate causes the demand for domestic assets to shift to the ________ and the domestic currency to ________, everything else held constant. A) right; appreciate B) right; depreciate C) left; appreciate D) left; depreciate Answer: A 31) A decrease in the expected future domestic exchange rate causes the demand for domestic assets to ________ and the domestic currency to ________, everything else held constant. A) increase; appreciate B) increase; depreciate C) decrease; appreciate D) decrease; depreciate Answer: D 32) A decrease in the expected future domestic exchange rate causes the demand for domestic assets to shift to the ________ and the domestic currency to ________, everything else held constant. A) right; appreciate B) right; depreciate C) left; appreciate D) left; depreciate Answer: D 33) ________ in the expected future domestic exchange rate causes the demand for domestic assets to increase and the domestic currency to ________, everything else held constant. A) An increase; appreciate B) An increase; depreciate C) A decrease; appreciate D) A decrease; depreciate Answer: A 34) ________ in the expected future domestic exchange rate causes the demand for domestic assets to shift to the right and the domestic currency to ________, everything else held constant. A) An increase; appreciate B) An increase; depreciate C) A decrease; appreciate D) A decrease; depreciate Answer: A 35) ________ in the expected future domestic exchange rate causes the demand for domestic assets to decrease and the domestic currency to ________, everything else held constant. A) An increase; appreciate B) An increase; depreciate C) A decrease; appreciate D) A decrease; depreciate Answer: D 36) ________ in the expected future domestic exchange rate causes the demand for domestic assets to shift to the left and the domestic currency to ________, everything else held constant. A) An increase; appreciate B) An increase; depreciate C) A decrease; appreciate D) A decrease; depreciate Answer: D 37) ________ in the expected future domestic exchange rate causes the demand for domestic assets to ________ and the domestic currency to appreciate, everything else held constant. A) An increase; increase B) An increase; decrease C) A decrease; increase D) A decrease; decrease Answer: A 38) ________ in the expected future domestic exchange rate causes the demand for domestic assets to shift to the ________ and the domestic currency to appreciate, everything else held constant. A) An increase; right B) An increase; left C) A decrease; right D) A decrease; left Answer: A 39) ________ in the expected future domestic exchange rate causes the demand for domestic assets to ________ and the domestic currency to depreciate, everything else held constant. A) An increase; increase B) An increase; decrease C) A decrease; increase D) A decrease; decrease Answer: D 40) ________ in the expected future domestic exchange rate causes the demand for domestic assets to shift to the ________ and the domestic currency to depreciate, everything else held constant. A) An increase; right B) An increase; left C) A decrease; right D) A decrease; left Answer: D 41) Suppose the Federal Reserve releases a policy statement today which leads people to believe that the Fed will be enacting expansionary monetary policy in the near future. Everything else held constant, the release of this statement would immediately cause the demand for U.S. assets to ________ and the U.S. dollar to ________. A) increase; appreciate B) decrease; appreciate C) increase; depreciate D) decrease; depreciate Answer: D 42) Suppose a report was released today that showed the Euro-Zone inflation rate is running above the European Central Bank's inflation rate target. This leads people to expect that the European Central Bank will enact contractionary policy in the near future. Everything else held constant, the release of this report would immediately cause the demand for U.S. assets to ________ and the U.S. dollar will ________. A) increase; appreciate B) increase; depreciate C) decrease; appreciate D) decrease; depreciate Answer: A 43) Suppose that the latest Consumer Price Index (CPI) release shows a higher inflation rate in the U.S. than was expected. Everything else held constant, the release of the CPI report would immediately cause the demand for U.S. assets to ________ and the U.S. dollar would ________. A) increase; appreciate B) increase; depreciate C) decrease; appreciate D) decrease; depreciate Answer: D 44) In the long run, a one-time percentage increase in the money supply is matched by the same one-time percentage rise in the price level, leaving unchanged the real money supply and ________. This proposition is called money ________. A) other economic variables such as interest rates; neutrality B) the nominal exchange rate; neutrality C) all other economic variables such as interest rates; illusion D) the nominal exchange rate; illusion Answer: A 45) Money neutrality means that in the long run the domestic interest rate remains unchanged from an increase in the money supply, implying that the fall in the exchange rate is greater in the ________ run than in the ________ run, a phenomenon called exchange rate overshooting. A) short; short B) short; long C) long; short D) long; long Answer: B 46) Evidence from the United States during the period 1973-2002 indicates that the value of the dollar and the measure of the ________ interest rate rose and fell together. A) real B) nominal C) expected D) actual Answer: A 47) During the beginning on the subprime crisis in the United States when the effects of the crisis were mostly confined within the United States, the U. S. dollar ________ because demand for U.S. assets ________. A) appreciated; increased B) depreciated; increased C) appreciated; decreased D) depreciated; decreased Answer: D 48) When the effects of the subprime crisis started to spread more quickly throughout the rest of the world, the U.S. dollar ________ because demand for U.S. assets ________. A) appreciated; increased B) depreciated; increased C) appreciated; decreased D) depreciated; decreased Answer: A 49) Explain and show graphically the effect of an increase in the expected future exchange rate on the equilibrium exchange rate, everything else held constant. Answer: See figure below. When the expected future exchange rate increases, the relative expected return on the domestic assets increases. This will cause the demand for domestic assets to increase and the current value of the exchange rate will appreciate. 50) Explain and show graphically the effect of an increase in the expected inflation rate on the equilibrium exchange rate, everything else held constant. Answer: See figure below. When the expected inflation rate increases, the relative expected return on domestic assets is affected two ways. First, through the Fisher effect, the domestic nominal interest rate will increase the expected return on domestic assets. Second, through purchasing power parity, the future value of the domestic exchange rate will decline which will decrease the expected return on domestic assets. Since it is generally believed that the effect of the change in the expected future value of the domestic exchange rate is larger than the Fisher effect, the net effect is a lower expected return on domestic assets. This will decrease the demand for domestic assets, which will cause the current value of the domestic exchange rate to depreciate. 17.5 APPENDIX: The Interest Parity Condition 1) The condition that states that the domestic interest rate equals the foreign interest rate minus the expected appreciation of the domestic currency is called A) the purchasing power parity condition. B) the interest parity condition. C) money neutrality. D) the theory of foreign capital mobility. Answer: B 2) If the interest rate is 7 percent on euro-denominated assets and 5 percent on dollar-denominated assets, and if the dollar is expected to appreciate at a 4 percent rate, for Francois the Frenchman the expected rate of return on dollar-denominated assets is A) 11 percent. B) 9 percent. C) 5 percent. D) 3 percent. E) 1 percent. Answer: B 3) If the interest rate is 7 percent on euro-denominated assets and 5 percent on dollar-denominated assets, and if the dollar is expected to appreciate at a 4 percent rate, the expected return on ________-denominated assets in ________ percent. A) dollar; euros is 3 B) euro; dollars is 1 C) dollar; euros is 1 D) euro; dollars is 3 Answer: D 4) If the interest rate on euro-denominated assets is 13 percent and it is 15 percent on peso-denominated assets, and if the euro is expected to appreciate at a 4 percent rate, for Manuel the Mexican the expected rate of return on euro-denominated assets is A) 11 percent. B) 13 percent. C) 17 percent. D) 19 percent. Answer: C 5) If the interest rate on euro-denominated assets is 13 percent and it is 15 percent on peso-denominated assets, and if the euro is expected to appreciate at a 4 percent rate, for Francois the Frenchman the expected rate of return on peso-denominated assets is A) 11 percent. B) 15 percent. C) 17 percent. D) 19 percent. Answer: A 6) With a 10 percent interest rate on dollar deposits, and an expected appreciation of 7 percent over the coming year, the expected return on dollar deposits in terms of the foreign currency is A) 3 percent. B) 10 percent. C) 13.5 percent. D) 17 percent. Answer: D 7) With a 10 percent interest rate on dollar deposits, and an expected appreciation of 7 percent over the coming year, the expected return on dollar deposits in terms of the dollar is A) 3 percent. B) 10 percent. C) 13.5 percent. D) 17 percent. Answer: B 8) The expected return on dollar deposits in terms of foreign currency can be written as the ________ of the interest rate on dollar deposits and the expected appreciation of the dollar. A) product B) ratio C) sum D) difference Answer: C 9) In a world with few impediments to capital mobility, the domestic interest rate equals the sum of the foreign interest rate and the expected depreciation of the domestic currency, a situation known as the A) interest parity condition. B) purchasing power parity condition. C) exchange rate parity condition. D) foreign asset parity condition. Answer: A 10) According to the interest parity condition, if the domestic interest rate is 12 percent and the foreign interest rate is 10 percent, then the expected ________ of the foreign currency must be ________ percent. A) appreciation; 4 B) appreciation; 2 C) depreciation; 2 D) depreciation; 4 Answer: B 11) According to the interest parity condition, if the domestic interest rate is 10 percent and the foreign interest rate is 12 percent, then the expected ________ of the foreign currency must be ________ percent. A) appreciation; 4 B) appreciation; 2 C) depreciation; 2 D) depreciation; 4 Answer: C Test Bank for The Economics of Money, Banking and Financial Markets Frederic S. Mishkin 9780321599797, 9780134734200, 9780133836790, 9780134734606, 9780134733821
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