Foreign Exchange and Monetary Models Quiz
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Questions and Answers

What is the primary effect of increasing the money supply in the long run according to the monetary models of exchange rates?

  • No change in the currency value
  • Immediate increase in interest rates
  • Appreciation of the currency
  • Depreciation of the currency (correct)

What occurs in the short run after a change in money supply due to rational expectations from agents?

  • Exchange rates decrease instantly
  • Interest rates rise immediately
  • Expectations for future exchange rates decrease
  • Exchange rates begin to adjust slowly (correct)

How does uncovered interest parity (UIP) function in the forex markets?

  • It guarantees the same future exchange rates regardless of interest rate differentials
  • It eliminates all transaction costs in currency trading
  • It forces investors to always choose the currency with the highest interest rate
  • It leaves investors indifferent between investing in two different currencies (correct)

What phenomenon is often observed in the forex markets due to price rigidities?

<p>Overshooting of exchange rates in response to monetary policy changes (C)</p> Signup and view all the answers

What does the liquidity of forex markets mainly ensure?

<p>Ease of executing large volume transactions without significant price changes (B)</p> Signup and view all the answers

What does an appreciation of a currency indicate?

<p>The currency is more valuable compared to another currency. (B)</p> Signup and view all the answers

What happens to the exchange rate when the euro depreciates against the dollar?

<p>It takes more euros to buy a dollar. (A)</p> Signup and view all the answers

How are exchange rates generally quoted?

<p>As foreign currency per unit of domestic currency. (B)</p> Signup and view all the answers

If the exchange rate between the euro and the dollar is quoted as $1 = 𝐸!€ and 𝐸! is equal to ½, how many euros are needed to buy one dollar?

<p>0.5 euros (B)</p> Signup and view all the answers

What is the effect of a currency's appreciation on exports?

<p>Exports become more expensive for foreign buyers. (B)</p> Signup and view all the answers

Which of the following is a type of exchange rate quotation?

<p>Direct quotation (D)</p> Signup and view all the answers

What does depreciation of a currency lead to when comparing to another currency?

<p>Less of the foreign currency can be bought with it. (A)</p> Signup and view all the answers

If the quoted exchange rate allows you to buy 100€ worth of goods for 100$, what would you conclude?

<p>Both currencies have equal value. (B)</p> Signup and view all the answers

Which factor primarily influences the demand for currency deposits?

<p>Expected rates of return (A)</p> Signup and view all the answers

According to the uncovered interest parity condition (UIP), when is equilibrium achieved in the foreign exchange market?

<p>When expected returns on all currencies are equal (D)</p> Signup and view all the answers

What is a key assumption about risk for a risk-neutral investor in the given context?

<p>Be indifferent between investing in domestic or foreign currencies (B)</p> Signup and view all the answers

What does an increase in the expected euro/dollar exchange rate indicate about the euro?

<p>Euro is appreciating against the dollar (A)</p> Signup and view all the answers

What happens to the expected return on dollar assets if the euro depreciates and the interest rates are unchanged?

<p>Expected return decreases (D)</p> Signup and view all the answers

Which scenario would motivate a profit maximizer investor to choose euro assets over dollar assets?

<p>Higher expected appreciation of the euro (A)</p> Signup and view all the answers

What is less influential in the exchange rate markets compared to other factors?

<p>Risk factors associated with investments (D)</p> Signup and view all the answers

What is the expected effect on dollar assets if the expected euro/dollar exchange rate is lower?

<p>Lower expected returns on dollar investments (D)</p> Signup and view all the answers

What happens when the share of € assets increases in a risk-averse investor's portfolio?

<p>The investor will demand a higher return on € assets. (D)</p> Signup and view all the answers

According to the Uncovered Interest Parity (UIP), what is implied by an unexpected increase in the interest rate differential (r€ - r$)?

<p>An appreciation of the € today. (B)</p> Signup and view all the answers

What is the primary limitation of using UIP as a predictor for future exchange rates in the short run?

<p>It only works for the medium/long-run. (C)</p> Signup and view all the answers

Which statement about the relationship between the future expected exchange rate and today's exchange rate is correct?

<p>The best predictor for the future exchange rate is usually today's exchange rate. (A)</p> Signup and view all the answers

What does the covered interest parity condition link together?

<p>Exchange rates, the forward rate, and interest rate differentials. (A)</p> Signup and view all the answers

What role does the risk premium play for risk-averse investors holding currency assets?

<p>It compensates for potential currency fluctuations. (D)</p> Signup and view all the answers

What is one reason why the empirical validity of UIP might be questioned?

<p>Risk premiums can vary and are not directly observable. (C)</p> Signup and view all the answers

In the context of exchange rates, what is often regarded as a better predictor than UIP for short investment horizons?

<p>Today's exchange rate. (A)</p> Signup and view all the answers

What happens to money demand when interest rates increase?

<p>Money demand decreases as firms and households buy less liquid assets. (C)</p> Signup and view all the answers

In the context of money demand, what does the term 𝑌€ represent?

<p>The level of economic activity or GDP. (A)</p> Signup and view all the answers

What is the long-term effect of an increase in money supply on exchange rates?

<p>The exchange rate should depreciate in the long run. (D)</p> Signup and view all the answers

According to the Dornbush's overshooting model, what occurs immediately after a permanent increase in money supply?

<p>The exchange rate overshoots its long-run value by depreciating more. (A)</p> Signup and view all the answers

What does monetary neutrality imply in the long run?

<p>Money supply changes only affect prices, not real output. (C)</p> Signup and view all the answers

Which of the following represents the liquidity demand in the money demand equation?

<p>𝐿(𝑟€, 𝑌€) (B)</p> Signup and view all the answers

What is the expected effect of a booming economy on money demand?

<p>Money demand increases due to higher transaction needs. (A)</p> Signup and view all the answers

Which factor is NOT a determinant of money demand?

<p>The age demographic of a population. (A)</p> Signup and view all the answers

What happens if the covered interest parity condition (CIP) is not satisfied?

<p>Riskless profit can be made through arbitrage. (D)</p> Signup and view all the answers

What does a forward exchange rate (F) greater than the spot exchange rate (E) imply regarding interest rates?

<p>Investors are compensated with a higher interest rate on euro investments compared to dollars. (D)</p> Signup and view all the answers

Which factor does NOT directly affect the demand for money according to the provided content?

<p>Non-liquid asset returns. (D)</p> Signup and view all the answers

What is the main assumption behind the empirical validity of the covered interest parity condition (CIP)?

<p>Arbitrage leads to profit maximization behaviors. (B)</p> Signup and view all the answers

In the context of exchange rates, what does the overshooting result refer to?

<p>The quick adjustment of exchange rates but slow goods price adjustments. (A)</p> Signup and view all the answers

How do monetary policies directly affect exchange rates in the long run?

<p>They influence interest rates significantly, which affects demand for currencies. (D)</p> Signup and view all the answers

Which statement accurately describes the relationship between interest rates and the opportunity cost of holding money?

<p>Both A and B are correct. (D)</p> Signup and view all the answers

During exceptional circumstances, like the 2008 financial crisis, what happens to the covered interest parity condition (CIP)?

<p>It becomes less reliable due to market distortions. (D)</p> Signup and view all the answers

Flashcards

Exchange Rate

The relative price of one currency in terms of another. It allows us to compare prices of goods and services from different countries.

Appreciation

An increase in the value of a currency relative to another currency. It means the currency can buy more of the other currency.

Depreciation

A decrease in the value of a currency relative to another currency. It means the currency can buy less of the other currency.

Direct Quotation

A currency rate quotation that expresses the price of a foreign currency in terms of the domestic currency (e.g., 1 USD = 1.10 EUR).

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Indirect Quotation

A currency rate quotation that expresses the price of the domestic currency in terms of the foreign currency (e.g., 1 EUR = 0.91 USD).

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What happens to the exchange rate if the euro appreciates against the dollar?

A situation where a currency's value increases compared to another currency. This means you can buy more of the other currency with your currency.

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How does 𝐸! change if the euro appreciates against the dollar?

If a euro appreciates against the dollar, then the value of 𝐸! will decrease.

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How do exchange rates affect trade?

The exchange rate can impact the cost of imports and exports, potentially affecting the competitiveness of domestic businesses in international markets.

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Expected Exchange Rate (E')

The anticipated change in a currency's value against another currency over a specific period.

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Rate of Return

The percentage change in value of an asset over a given time period.

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Profit Maximiser Assumption

The assumption that investors will choose the investment with the highest expected return, all else being equal.

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Uncovered Interest Parity (UIP)

The condition where the expected rate of return on deposits in any currency should be the same after taking into account the expected exchange rate change.

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Expected Exchange Rate Premium

The expected change in the exchange rate needed to compensate for interest rate differentials between two currencies.

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Relationship Between Interest Rates and Exchange Rates

The tendency for a currency to depreciate if its interest rates are lower than those of another currency.

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Equilibrium in the Foreign Exchange Market

Investors are indifferent between investing in a domestic bond or buying a foreign currency bond, converting it back to the domestic currency, and earning the expected return.

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Treasury Bond

A risk-free bond issued by a government, typically with a very short maturity.

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Risk Premium

A phenomenon where investors demand a premium for holding assets denominated in a particular currency due to risk aversion and portfolio diversification preferences.

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Forward Premium

The difference between the forward exchange rate and the spot exchange rate. It reflects the interest rate differential between two currencies.

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UIP Puzzle

The deviation of realized exchange rate changes from those predicted by the UIP.

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Random Walk Hypothesis

The tendency for the spot exchange rate to follow a random walk, making it difficult to predict future movements.

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Speculation

A strategy that aims to exploit potential discrepancies between the spot exchange rate and the forward rate, or between interest rate differentials and expected exchange rate movements.

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Asset Bubbles

A situation where asset prices rise rapidly and excessively, often driven by optimistic expectations and market psychology, often resulting in a sudden crash.

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Demand for money and interest rate

The quantity of money demanded decreases as the interest rate increases, because individuals and firms prefer to hold less cash when they can earn higher returns on assets like bonds.

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Demand for money and GDP

The quantity of money demanded increases with economic activity, as more transactions require cash.

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Money Market Equilibrium

The equilibrium in the money market is reached when the quantity of money supplied equals the quantity of money demanded.

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Expansionary Monetary Policy

A policy by the central bank to increase the money supply, typically achieved by lowering interest rates or buying government bonds.

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Monetary Neutrality

The assumption that in the long run, a change in the money supply only affects prices and has no real effect on the economy.

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Nominal Exchange Rate

The price of a foreign currency in terms of the domestic currency.

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Money Supply and Exchange Rate in the Long Run

In the long run, an increase in the money supply leads to a depreciation of the domestic currency and an increase in the price level.

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Overshooting

A situation where the exchange rate instantaneously depreciates by more than its long-run value following a permanent increase in the money supply.

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Empirical Validity of CIP

CIP holds true when capital moves freely and agents are profit maximizers, allowing for arbitrage opportunities to eliminate price discrepancies. Exceptions exist, such as the 2008 financial crisis.

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Monetary Policy's Influence on Exchange Rates

Short-term exchange rate adjustments are driven by monetary policy while long-term changes reflect differences in money supply. The transition from short-term to long-term leads to the concept of overshooting.

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Factors Influencing Money Demand

The demand for money is influenced by three factors: the interest rate, the price level, and the level of transactions.

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Overshooting Result

Monetary policies that result in short-term fluctuations (e.g., due to interest rate changes) can cause the exchange rate to overshoot its long-term equilibrium point due to the flexibility of exchange rates and the rigid nature of prices. This overshooting is a temporary adjustment process.

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Long-Run Exchange Rate Determination

In the long run, differences in money supply drive changes in nominal exchange rates.

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Opportunity Cost of Holding Money

The opportunity cost of holding money, which doesn't pay interest, is the interest rate earned on other assets like government bonds (TBs).

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Exchange Rate vs. Price Adjustment

The exchange rate adjusts instantaneously, but goods prices are slower to react, creating the overshooting scenario.

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Exchange Rate Overshooting

In the short term, exchange rates might overshoot their long-term equilibrium level due to price rigidity, meaning prices don't adjust immediately to changes in economic conditions.

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Monetary Policy and Exchange Rate Overshooting

When a central bank increases the money supply, it can lead to a depreciation of the currency in the long run, but in the short term, the currency might depreciate even more due to expectations of future depreciation and price rigidities.

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Price Rigidity

Price rigidities refer to the phenomenon where prices of goods and services adjust slowly to changes in economic conditions. This can lead to exchange rate overshooting as expectations of future changes are incorporated into current exchange rates.

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Interest Rates and Exchange Rate Depreciation

When a central bank increases the money supply, it lowers interest rates in the short term. This can lead to a depreciation of the currency due to the lower return on domestic assets, encouraging investors to invest in foreign assets with higher returns.

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Study Notes

Economic Environment Analysis - Lecture 6

  • The lecture covers economic environment analysis, specifically focusing on exchange rates.
  • Topics from previous weeks included financial globalization, national income accounting, and balance of payments accounting.
  • This week's topics are the Foreign Exchange Market, International interest parity conditions, and Monetary models of exchange rates.

Exchange Rates

  • Exchange rates are the relative price of currencies.
  • They play a crucial role in international trade by enabling comparisons of goods and services across countries.
  • Exchange rates are quoted as foreign currency per unit of domestic currency, or vice versa.
  • Quotation types include direct (foreign currency in terms of domestic currency) and indirect (domestic currency in terms of foreign currency). (e.g., 1 $ = ED €; E¹ $ = 1 €).
  • Exchange rates change through appreciation (increase in value relative to another currency) or depreciation (decrease in value relative to another currency). An appreciated currency becomes more expensive and can buy more of a foreign currency.
  • If the euro appreciates versus the dollar, it takes fewer euros to buy one dollar.
  • If the euro depreciates versus the dollar, it takes more euros to buy one dollar.

The Foreign Exchange Market

  • The Foreign Exchange Market is a decentralized market where currencies and assets are exchanged.
  • Interbank transactions are often dominant and concentrate most trading in locations like London and New York.
  • Transaction costs are typically very low.
  • High liquidity with high volumes of transactions occur daily (>$6,000 billion).
  • The US dollar plays a key role in the market.
  • Exchange rates are characterized by high volatility.

Spot and Forward Rates

  • Spot rate is the price agreed upon today for immediate FOREX transactions (immediate trade).
  • A forward rate is the price agreed upon today for future transactions (contract to buy and sell in the future).
  • Example of forward trading: A trade agreed on January 10, 2017, for settlement June 10, 2017.

How Exchange Rates Affect Trade

  • If the euro appreciates against the dollar, then Spanish sunglasses become more expensive for American consumers, and US sunglasses become cheaper for Spanish consumers.
  • Conversely, if the euro depreciates against the dollar, then Spanish sunglasses become cheaper for American consumers, and US sunglasses become more expensive for Spanish consumers.

International Interest Parity Conditions (UIP)

  • UIP is the condition where deposits of all currencies offer the same expected rate of return.
  • Expected returns on assets of different currencies are equalized if the market is in equilibrium.

The Demand of Currency Deposits

  • The demand of currency deposit is a function of its rate of return and expected fluctuations in value.
  • Rates of return are affected by prevailing interest rates for those assets and expectations on asset values appreciating or depreciating against the domestic currency.

The Investor’s Choice

  • Investors can choose between investing in euro-denominated bonds or dollar-denominated bonds.
  • An investor’s choice is dependent on the interest rates and the predicted rate of exchange between currencies in a given time frame.

Covered Interest Parity Condition

  • An arbitrage opportunity to make a riskless profit.
  • A market equilibrium condition based on the relationship between the forward rate, spot exchange rate and interest rate differential.

Monetary Models of Exchange Rates

  • Monetary policy affects exchange rates through varying interest rates and money supplies.
  • In the short term, exchange rates adjust, but prices are rigid to instantaneous changes.
  • In the long term, nominal exchange rates reflect differences in money supply.
  • The dynamics of exchange rates move from short to long terms and display overshooting results. The term overshooting refers to a fluctuation in an asset’s value that goes beyond its long-run equilibrium value.

The Money Market

  • Interest rates, the price level, and transactions all affect the demand for money.
  • Money demand increases with economic activity levels.
  • Increased demand for money will lead to an increased interest rate in the market.
  • Monetary policies affect the exchange rate through interest rates and money supply.

What about expectations on exchange rates?

  • Changes in monetary policy will have no impact on expected exchange rates unless prices are flexible.
  • Monetary neutrality in the long run refers to changes in money supply only affecting prices.
  • Output is determined by production factors.
  • Inflation moves with money growth over the long term, requiring nominal exchange rates to adjust accordingly.

Prices and Money in the Long Run

  • Increasing money supply increases prices in the long run.

Exchange Rate, Money, and Prices in the Long Run

  • Nominal exchange rates are equal to the price of the foreign currency in units of the domestic currency.
  • An increase in money supply is followed by a depreciation in the currency with respect to its counterpart currency.
  • Otherwise, relative prices between countries (e.g., European to US) may be real-effects.
  • Purchasing Power Parity states EP$ = P.

Exchange Rate and Money in the Long Run(Specific to East Asia)

  • Graph: A positive correlation exists between money supply growth and currency depreciation in East Asia.

Monetary Policy, Exchange Rates, and Overshooting

  • Permanent increases in money supply cause exchange rates to quickly change value, a phenomenon called “overshooting.”
  • Overshooting happens from differences between short-run and long-run exchange rate adjustments.
  • Rational agents that foresee future adjustments impact short-run exchange rates.

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Economic Environment Analysis Lecture 6 PDF

Description

Test your understanding of foreign exchange markets, monetary models, and the effects of currency appreciation and depreciation. The quiz covers key concepts including money supply impacts, uncovered interest parity, and exchange rate quotations. Dive into the dynamics of forex trading and enhance your financial knowledge.

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