Final Examination, Econ 457, Spring 2012
Name: __________________________ Date: _____________
All multiple choice questions are worth 4 points each.
1. In 1990, Britain joined the ERM. If the German Bundesbank increased interest rates,
assuming Britain maintains its exchange rate peg:
A) the British would be forced to increase their interest rates.
B) the British would increase their money supply.
C) the British would have to lower their interest rates.
D) the British government would have to use expansionary fiscal policy.
2. The greater the degree of economic integration between markets in the home country
and the base country:
A) the greater the volume of transactions and the greater the benefit to the home
country of fixed exchange rates.
B) the smaller the volume of transactions and the lesser the benefit to the home
country of fixed exchange rates.
C) the greater the volume of transactions and the greater the benefit to the home
country of flexible exchange rates.
D) the less important the volume of transactions and the greater the importance of
3. Why do symmetric shocks not disturb fixed exchange rate systems?
A) Symmetric shocks happen only once and cause a one-time shift in interest rates.
B) Symmetric shocks imply differences in rates of interest, which is irrelevant to fixed
exchange rate systems.
C) A demand shock can easily be dealt with using domestic policies that do not
involve other nations.
D) Symmetric shocks require the same medicine in both economies, so monetary
policy will be in a direction to help both situations.
4. What is the most powerful argument against a fixed exchange rate?
A) The nation must administer the rates at all currency exchange venues, and it is
expensive to do.
B) The nation usually gets opposition from other trading partners who are excluded.
C) The nation has to have a large store of gold on hand to exchange at fixed rates.
D) The nation gives up its ability to control its money supply and affect its own
5. A country is using a beggar-thy-neighbor policy whenever:
A) it uses contractionary monetary policy to attract capital inflows from other
B) it devalues its currency to improve its macroeconomic position at the expense
of its trading partners.
C) it revalues its currency to improve its macroeconomic position and that of its
D) it cooperates with other countries in establishing its monetary policy.
6. Suppose that the United States and the United Kingdom return to the gold standard. The
United States sets the price of gold equal to $500 per ounce, and the United Kingdom
sets the price of gold at £200 per ounce. What is the $–£ exchange rate?
A) $0.40 = £1
B) $2.50 = £1
C) $500 = 1 ounce
D) £200 = 1 ounce
7. Which statement below is correct?
A) The likelihood of an exchange rate crisis increases if a country is having a
B) The likelihood of an exchange rate crisis decreases if a country is having a banking
and default crisis.
C) There is no relationship between an exchange rate crisis and banking or default
D) When a banking or default crisis occurs, countries typically are forced to appreciate
8. Foreign investors add all of the following premiums to an investment in an emerging
market country, except:
A) default risk premium.
B) interest risk premium.
C) expected exchange rate changes.
D) government budget deficit premium.
9. Once a nation "runs out" of reserves to back the currency, the peg cannot be maintained
A) the supply of money grows uncontrollably at the same rate that the central
bank monetizes deficits.
B) the central bank cannot raise or lower the supply of money.
C) the IMF will refuse to lend reserves to such a nation.
D) the nation's currency is overvalued so that its exports diminish.
10. Expected depreciation threatens a peg because of all the following except:
A) When investors expect the peg to fail it will fail in multiple equilibrium situations.
B) Market sentiment will raise the currency premium and lower confidence.
C) Economic fundamentals are crucial to whether a peg holds or fails.
D) Investor confidence may wane and cause a rise in interest rates.
11. In general, when there is a large shock to domestic output, the government finds that:
A) it is less difficult to maintain the peg.
B) maintaining the peg carries a higher present and future cost, especially if
credibility is low.
C) it is impossible to maintain the peg.
D) central bankers are insensitive to the concerns of the population.
Use the following figure, which shows hypothetical OCA economic criteria for several South
American countries, to answer the question(s).
Figure: Shocks and Integration
12. (Figure: Shocks and Integration) Which countries best satisfy the OCA criteria for
forming a monetary union?
A) Peru and Colombia
B) Peru and Uruguay
C) Venezuela and Uruguay
D) Colombia and Venezuela
13. Which would be easier to reverse? For Denmark, which now pegs its national currency
to the euro, to choose monetary autonomy and abandon its peg, or for Italy to switch
back from the euro to the lira?
A) Italy because all it has to do is cash euros for lire.
B) Italy because it can change over to an electronic payments system.
C) Denmark because it would only have to return all the euros in its treasury.
D) Denmark because it would not have to change its currency, accounting
structure, nor reprint domestic currency.
14. A nation whose labor market is highly integrated with other nations in a currency union
is more ______ to join because ______.
A) unlikely; workers would suffer real wage declines if they have competition from
B) unlikely; firms would find it expensive to hire workers if they have to pay in the
C) likely; labor market integration means that when there are asymmetric
demand shocks the adjustment can be eased by migration of workers
D) likely; labor force rules and policies can be harmonized more easily
15. When nations enter into currency unions, their fiscal affairs continue to be separate. The
exception to this situation is whenever a confederation of states has:
A) a system whereby monetary policy is decided by consensus rather than centrally.
B) a system of government subsidies for firms exporting outside the union.
C) a system of fiscal mechanisms that permit interstate transfers.
D) a system of common tax policies and regulatory rule.
16. Criticisms of the ECB center on its primary focus on ______ with less (but perhaps
more needed) focus on _______.
A) unemployment and GDP growth; exchange rates
B) exchange rates; inflation problems
C) price stability; unemployment and GDP growth
D) political cohesiveness; price stability
17. The ECB, like the U.S. Federal Reserve, is ______, and unlike the U.S. Federal
Reserve, is not ______.
A) independent; a lender of last resort
B) subject to scrutiny by the legislature; able to lend to large corporations
C) dependent on congressional approval for its policies; committed to price stability
D) able to lend to member governments; able to lend directly to banks
18. After the financial crisis of 2008, how did some Eurozone governments finance the
bailout of their financial sectors?
A) by raising taxes
B) by issuing new government bonds, which were purchased by private banks,
funded by ECB lending
C) by printing more domestic currency to accompany infusions of euros from the ECB
D) by selling foreign currency reserves and gold
19. The Economist article “Message to Ankara” argues that
A) Turkey should be inducted in the EU since it has fulfilled the EU zone
B) Turkey should not be inducted into the EU because of its questionable human
C) Turkey should continue to promote growth enhancing policies and increase credit
D) Turkey should increase its savings and improve competitiveness in order to
reduce its large current account deficits
20. The Economist article “The return of euro crises” informs that
A) The crises had completely subsided but with ongoing French election politics there
is an increased speculation of Euro’s demise
B) Spanish government bond yields are rising because banks who were buying it
earlier have exhausted their cash given to them by the ECB
C) Holland government fell because its parliament refused to pass the deficit
D) Greece is going through riots; Both Italy and Spain are going through crisis and
want to withdraw from Euro
Table: Mexico's Central Bank Balance Sheet
Simplified Central Bank Balance Sheet (millions of pesos)
Reserves R 750 Money supply M 2,250
Foreign assets (dollar reserves) Currency in circulation
Domestic credit B 1,500
Domestic assets (peso bonds)
(Table: Mexico's Central Bank Balance Sheet) If the country sells 325 million pesos of
foreign assets and issues domestic credit worth 425 million pesos, then how much will
be its money supply? [6 points]
Its assets increase in the net by 100. So does liabilities. The new money supply is 2350.
22. Suppose that the one-year forward price of euros in terms of dollars is equal to $1.1 per euro.
Further, assume that the spot exchange rate is $1 per euro, and the interest rate on dollar deposits
is 21 percent and on euro it is 10 percent. Show that the Covered Interest Parity condition holds in
this case. [6 points]
Answer: One has to plug in the numbers to check whether
1 + i_US = (1/spot rate)* (1+i_euro) * Forward rate holds or not. It does indeed.
23. Discuss graphically (using the return schedules for dollar and euro deposits) the impact on the
spot exchange rate of an expected dollar depreciation while the dollar and euro deposit interest
rates are kept fixed. [6 points]
Answer: See Figure 13 – 6 that graphically exhibits how an expected Euro appreciation shifts the
Euro rate of return schedule to the right and therefore Euro spot rate appreciates.
24. Suppose Russia's inflation rate is 10% over one year but the inflation rate in
Switzerland is only 2%. According to relative PPP, what should happen over the
year to the Swiss franc's exchange rate [i.e., appreciation/depreciation] against the
Russian ruble? Be precise in your calculations. [5 points]
Answer: The Ruble should depreciate against SFr by 10 – 2 = 8 percent, by
relative purchasing power parity.
25. Suppose the price of a big mac in China is 16 Yuan, while in the US its price is
$4. If the Yuan dollar exchange rate is 8 Yuan/dollar, by how much is the Yuan
under/overvalued? Show your work. [5 points]
Answer: The price of Big Mac in China is 16/8 = 2$, whereas in US it is $4. Had
the exchange rate been 4 Yuan/dollar, the law of one price would hold. Thus,
Yuan is undervalued by 100% = (8-4)/4, if you take 4 (the “correct” exchange
rate) as the base. If you instead take the prevailing exchange rate 8 as the base
then Yuan is undervalued by 50% = (8-4)/8. [Note: Full credit for both answers.]