Chapter 10

TheForeignExchangeMarket

.1

Multiple Choice Questions

1.

Americanfirmsbecamelesscompetitivecomparedtoforeignfirmsduringthe1980s
because
(a) thequalityandproductivityofAmericanworkersdeclined.
(b) foreignfirmswereyoungerthanAmericanfirmsandasaresulthadmoremodern
facilitiesthatmadeuseofthelatesttechnology.
(c) theU.S.dollarbecameworthmoreintermsofforeigncurrencies.
(d) theU.S.dollarbecameworthlessintermsofforeigncurrencies.
Answer: C

2.

Aspottransactionintheforeignexchangemarketinvolvesthe
(a) exchangeofexportsandimportsataspecifiedfuturedate.
(b) exchangeofbankdepositsataspecifiedfuturedate.
(c) immediate(withintwodays)exchangeofexportsandimports.
(d) immediate(withintwodays)exchangeofbankdeposits.
Answer: D

3.

WhenthevalueoftheBritishpoundchangesfrom$1.50to$1.25,thenthepoundhas
_________andthedollarhas_________.
(a) appreciated;appreciated
(b) depreciated;appreciated
(c) appreciated;depreciated
(d) depreciated;depreciated
Answer: B

4.

Whenthevalueofthedollarchangesfrom0.5to0.75,thenthepoundhas
_________andthedollarhas_________.
(a) appreciated;appreciated
(b) depreciated;appreciated
(c) appreciated;depreciated
(d) depreciated;depreciated
Answer: B

5.

Whentheexchangeratechangesfrom1.0eurostothedollarto1.2eurostothedollar,
thentheeurohas_________andthedollarhas_________.
(a) appreciated;appreciated
(b) depreciated;appreciated
(c) appreciated;depreciated
(d) depreciated;depreciated
Answer: B

6.

Whentheexchangeratechangesfrom1.0eurostothedollarto0.8eurostothedollar,
thentheeurohas_________andthedollarhas_________.
(a) appreciated;appreciated
(b) depreciated;appreciated
(c) appreciated;depreciated
(d) depreciated;depreciated
Answer: C

7.

Ifthedollar_________from1.2eurosperdollarto0.8eurosperdollar,theeuro
_________from0.83dollarsto1.25dollarspereuro.
(a) appreciates;appreciates
(b) appreciates;depreciates
(c) depreciates;depreciates
(d) depreciates;appreciates
Answer: D

8.

Ifthedollarappreciatesfrom0.8eurosperdollarto1.2eurosperdollar,theeuro
depreciatesfrom_________dollarsto_________dollarspereuro.
(a) 1.25;0.83
(b) 0.83;1.25

(c) 0.67;1.50
(d) 1.50;0.67
Answer: A
9.

IfthedollardepreciatesrelativetotheSwissfranc,
(a) SwisschocolatewillbecomemoreexpensiveintheUnitedStates.
(b) AmericancomputerswillbecomelessexpensiveinSwitzerland.
(c) SwisschocolatewillbecomecheaperintheUnitedStates.
(d) both(a)and(b)oftheabove.
Answer: D

10.

IfthedollarappreciatesrelativetotheSwissfranc,
(a) SwisschocolatewillbecomemoreexpensiveintheUnitedStates.
(b) AmericancomputerswillbecomelessexpensiveinSwitzerland.
(c) SwisschocolatewillbecomecheaperintheUnitedStates.
(d) both(a)and(b)oftheabove.
Answer: C

11. Whentheexchangeratefortheeurochangesfrom$1.00to$1.20then,holding
everythingelseconstant,theeurohas
(a) appreciatedandGermancarssoldintheUnitedStatesbecomemoreexpensive.
(b) appreciatedandGermancarssoldintheUnitedStatesbecomelessexpensive.
(c) depreciatedandAmericanwheatsoldinGermanybecomesmoreexpensive.
(d) depreciatedandAmericanwheatsoldinGermanybecomeslessexpensive.

Answer: A
12.

Whentheexchangeratefortheeurochangesfrom$1.20to$1.00,then,holding
everythingelseconstant,theeurohas
(a) appreciatedandGermancarssoldintheUnitedStatesbecomemoreexpensive.
(b) appreciatedandGermancarssoldintheUnitedStatesbecomelessexpensive.
(c) depreciatedandAmericanwheatsoldinGermanybecomesmoreexpensive.
(d) depreciatedandAmericanwheatsoldinGermanybecomeslessexpensive.
Answer: C

13.

Thestartingpointforunderstandinghowexchangeratesaredeterminedisasimpleidea
called_________,whichstatesthatiftwocountriesproduceanidenticalgood,the
priceofthegoodshouldbethesamethroughouttheworldnomatterwhichcountry
producesit.
(a) Greshamslaw
(b) thelawofoneprice
(c) purchasingpowerparity
(d) arbitrage
Answer: B

14.

Thetheoryofpurchasingpowerparityisatheoryofhowexchangeratearedetermined
in
(a) thelongrun.
(b) theshortrun.
(c) both(a)and(b).
(d) noneoftheabove.
Answer: A

15.

The_________statesthatexchangeratesbetweenanytwocurrencieswilladjustto
reflectchangesinthepricelevelsofthetwocountries.
(a) theoryofpurchasingpowerparity

(b) lawofoneprice
(c) theoryofmoneyneutrality
(d) quantitytheoryofmoney
Answer: A
16.

Thetheoryofpurchasingpowerparitystatesthatexchangeratesbetweenanytwo
currencieswilladjusttoreflectchangesin
(a) thetradebalancesofthetwocountries.
(b) thecurrentaccountbalancesofthetwocountries.
(c) fiscalpoliciesofthetwocountries.
(d) thepricelevelsofthetwocountries.
Answer: D

17.

Inthelongrun,ariseinacountryspricelevel(relativetotheforeignpricelevel)
causesitscurrencyto_________,whileariseinthecountrysrelativeproductivity
causesitscurrencyto_________
(a) appreciate;appreciate.
(b) appreciate;depreciate.
(c) depreciate;appreciate.
(d) depreciate;depreciate.
Answer: C

18.

Ifthe2005inflationrateinBritainis6percent,andtheinflationrateintheU.S.is4
percent,thenthetheoryofpurchasingpowerparitypredictsthat,during2005,thevalue
oftheBritishpoundintermsofU.S.dollarswill
(a) riseby10percent.
(b) riseby2percent.
(c) fallby10percent.

(d) fallby2percent.
(e) dononeoftheabove.
Answer: D
19.

Thetheoryofpurchasingpowerparitycannotfullyexplainexchangeratemovements
because
(a) notallgoodsareidenticalindifferentcountries.
(b) monetarypolicydiffersacrosscountries.
(c) somegoodsarenottradedbetweencountries.
(d) both(a)and(c)oftheabove.
(e) both(b)and(c)oftheabove.
Answer: D

20.

Thetheoryofpurchasingpowerparitycannotfullyexplainexchangeratemovements
because
(a) allgoodsareidenticalevenifproducedindifferentcountries.
(b) monetarypolicydiffersacrosscountries.
(c) somegoodsarenottradedbetweencountries.
(d) fiscalpolicydiffersacrosscountries.
Answer: C

21.

Increaseddemandforacountrys_________causesitscurrencytoappreciateinthe
longrun,whileincreaseddemandfor_________causesitscurrencytodepreciate.
(a) imports;imports
(b) imports;exports
(c) exports;imports
(d) exports;exports

Answer: C
22.

Ifthedemandfor_________goodsdecreasesrelativeto_________goods,the
domesticcurrencywilldepreciate.
(a) foreign;domestic
(b) foreign;foreign
(c) domestic;domestic
(d) domestic;foreign
Answer: D

23.

Highertariffsandquotascauseacountryscurrencyto_________inthe_________
run.
(a) depreciate;short
(b) appreciate;short
(c) depreciate;long
(d) appreciate;long
Answer: D

24.

Lowertariffsandquotascauseacountryscurrencyto_________inthe_________
run.
(a) depreciate;short
(b) appreciate;short
(c) depreciate;long
(d) appreciate;long
Answer: C

25.

IftheinflationrateintheUnitedStatesishigherthanthatinGermanyandproductivity
isgrowingataslowerrateintheUnitedStatesthanitisinGermany,inthelongrun,

(a) theeuroshouldappreciaterelativetothedollar.
(b) theeuroshoulddepreciaterelativetothedollar.
(c) thereshouldbenochangeintheeuropriceofdollars.
(d) itisnotclearwhatwillhappentotheeuropriceofdollars.
Answer: A
26.

IftheFrenchdemandforAmericanexportsrisesatthesametimethatU.S.productivity
risesrelativetoFrenchproductivity,then,inthelongrun,
(a) theeuroshouldappreciaterelativetothedollar.
(b) thedollarshoulddepreciaterelativetotheeuro.
(c) thedollarshouldappreciaterelativetotheeuro.
(d) itisnotclearwhethertheeuroshouldappreciateordepreciaterelative
tothedollar.
Answer: C

27.

Thetheoryofassetdemandsuggeststhatthemostimportantfactoraffectingthe
demandfordomesticandforeigndepositsis
(a) theleveloftradeandcapitalflows.
(b) theexpectedreturnontheseassetsrelativetooneanother.
(c) theliquidityoftheseassetsrelativetooneanother.
(d) theriskinessoftheseassetsrelativetooneanother.
Answer: B

28.

WhenFranoistheForeignerconsiderstheexpectedreturnondollardepositsinterms
offoreigncurrency,theexpectedreturnmustbeadjustedfor
(a) anyexpectedappreciationordepreciationofthedollar.
(b) theinterestratesonforeigndeposits.

(c) both(a)and(b)oftheabove.
(d) neither(a)nor(b)oftheabove.
Answer: A
29.

Theexpectedreturnondollardepositsintermsofforeigncurrencyisthe_________
theinterestrateondollardepositsandtheexpectedappreciationofthedollar.
(a) productof
(b) ratioof
(c) sumof
(d) differencein
Answer: C

30.

Iftheinterestrateonforeigndeposits(iF)increases,holdingeverythingelseconstant,
(a) theexpectedreturnonthesedepositsmustalsoincrease.
(b) theexpectedreturnondomesticdepositsmustdecrease.
(c) theexpectedreturnondomesticdepositsmustincrease.
(d) both(a)and(b)oftheabove.
(e) both(a)and(c)oftheabove.
Answer: A

31.

Iftheinterestrateondollardepositsis10percent,andthedollarisexpectedto
appreciateby
7percentoverthecomingyear,theexpectedreturnondollardepositsintermsofthe
foreigncurrencyis
(a) 3percent.
(b) 10percent.
(c) 13.5percent.
(d) 17percent.

(e) 24percent.
Answer: D

True/False
1.

Theforeignexchangemarketisorganizedasanoverthecountermarketinwhich
depositsdenominatedinforeigncurrenciesareboughtandsold.
Answer:

2.

Whenthevalueofthedollarchangesfrom0.5poundsto0.75pounds,thenthepound
hasappreciatedandthedollarhasdepreciated.
Answer:

3.

FALSE

Anincreaseintariffsandquotasonimportscausesacountryscurrencytoappreciate.
Answer:

9.

TRUE

IftheexchangeratebetweenthedollarandtheSwissfrancchangesfrom1.8to1.5
francsperdollar,thefrancdepreciatesandthedollarappreciates.
Answer:

8.

TRUE

IfthedollarappreciatesrelativetotheSwissfranc,Swisschocolatewillbecome
cheaperintheUnitedStates.
Answer:

7.

FALSE

IfthedollardepreciatesrelativetotheBritishpound,Britishsweaterswillbecome
moreexpensiveintheUnitedStates.
Answer:

6.

TRUE

Thetheoryofpurchasingpowerparitycannotfullyexplainexchangeratemovements
becausefiscalpolicydiffersacrosscountries.
Answer:

5.

FALSE

Whentheexchangeratefortheeurochangesfrom$0.90to$0.85,thenholding
everythingelseconstant,theeurohasdepreciatedandAmericanwheatsoldin
Germanybecomesmoreexpensive.
Answer:

4.

TRUE

TRUE

Increaseddemandforacountrysexportscausesitscurrencytodepreciate.

Answer:
10.

Astherelativeexpectedreturnondollardepositsincreases,Americanswillwantto
holdfewerdollardepositsandmoreforeigndeposits.
Answer:

11.

FALSE

Accordingtotheinterestrateparitycondition,ifthedomesticinterestrateis12percent
andtheforeigninterestrateis10percent,thentheexpectedappreciationoftheforeign
currencymustbe
2percent.
Answer:

12.

FALSE

TRUE

Afallintheexpectedfutureexchangerateshiftstheexpectedreturnschedulefor
domesticdepositstotherightandcausesthedomesticcurrencytodepreciate.
Answer:

FALSE

Essay
1.

Explainthelogicunderlyingthelawofonepriceandthetheoryofpurchasingpower
parity.

2.

Explaingraphicallyhowachangeinthedomesticpricelevelwillaffectexchangerates,
holdingeverythingelseconstant.

3.

Explainthetheoryofinterestrateparity.

4.

Explaingraphicallyhowachangeintheforeigninterestratewillaffectexchangerates.

5.

Discusstherelationshipbetweenchangesindomesticrealandnominalinterestrates
andexchangerates.

6.

Explaingraphicallyhowanincreaseinacountrysmoneysupplywillaffectthe
exchangerateforitscurrency.