Foreign Exchange Rates Overview
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Foreign Exchange Rates Overview

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Questions and Answers

What primarily influences the determination of exchange rates in most cases?

  • Currency pegging
  • Market monopolization
  • Government regulations
  • Supply and demand (correct)

    • What occurs when a country's central bank buys its own currency?

  • It enhances the demand for foreign currency.
  • It leads to immediate devaluation.
  • It increases the currency supply.
  • It eliminates the excess supply. (correct)

    • What does a downward-sloping demand curve indicate regarding the exchange rate and quantity of pounds demanded?

  • Exchange rates have no impact on quantity demanded.
  • Lower exchange rates increase the quantity demanded. (correct)
  • Higher exchange rates increase the quantity demanded.
  • Lower exchange rates decrease the quantity demanded.

    • What happens when the exchange rate is fixed above the equilibrium rate?

    <p>A foreign currency crisis may occur.</p> Signup and view all the answers

    Which of the following is included in the M1 money supply?

    <p>Traveler's checks.</p> Signup and view all the answers

    Which factor would lead to a rightward shift in the demand curve for pounds?

    <p>An increase in relative price levels compared to the British market</p> Signup and view all the answers

    What does the term 'devaluation' refer to in currency exchange?

    <p>A change from a higher fixed value to a lower fixed value.</p> Signup and view all the answers

    An increase in interests and taste for British goods would result in what movement for the demand curve for pounds?

    <p>A rightward shift</p> Signup and view all the answers

    How is money viewed in terms of its functions?

    <p>Primarily as a store of value.</p> Signup and view all the answers

    How do relative interest rates affect demand for foreign currency?

    <p>Lower U.S. interest rates make British assets more attractive.</p> Signup and view all the answers

    Which of the following creates a demand for pounds from Americans?

    <p>Purchasing British stocks and bonds</p> Signup and view all the answers

    What is one effect of rising U.S. real GDP on the demand for pounds?

    <p>Demand for British goods increases.</p> Signup and view all the answers

    If U.S. prices rise by 10% while British prices remain stable, what is the likely outcome for the demand for pounds?

    <p>Demand for pounds will increase.</p> Signup and view all the answers

    What happens to the supply curve of pounds when the British anticipate a gain from holding U.S. assets?

    <p>It shifts rightward</p> Signup and view all the answers

    In a floating exchange rate system, what does appreciation of a currency indicate?

    <p>An increase in the price of that currency</p> Signup and view all the answers

    What primarily determines exchange rates in the very short run?

    <p>Relative interest rates and expectations</p> Signup and view all the answers

    What is the consequence when traders expect the pound to depreciate against the dollar?

    <p>The pound will depreciate due to market actions</p> Signup and view all the answers

    What characterizes the very short run in exchange rate fluctuations?

    <p>Able to move large volumes with immediate effects</p> Signup and view all the answers

    Which of the following factors does NOT shift the demand and supply curves for foreign currency exchange?

    <p>Government intervention in trade balances</p> Signup and view all the answers

    What is defined as depreciation of the dollar in a floating-rate system?

    <p>A decrease in the price of a currency</p> Signup and view all the answers

    How are exchange rates expected to fluctuate over months or years considered?

    <p>Short run</p> Signup and view all the answers

    What happens to the currency of a country with a higher inflation rate compared to a country with a lower inflation rate in the long run?

    <p>It depreciates against the currency of the lower inflation country.</p> Signup and view all the answers

    Which scenario would most likely disrupt the purchasing power parity (PPP) theory?

    <p>Goods that are difficult to trade.</p> Signup and view all the answers

    What is the primary goal of a managed float exchange rate system?

    <p>To maintain a stable exchange rate by buying and selling currency.</p> Signup and view all the answers

    What occurs when a fixed exchange rate is set above the equilibrium exchange rate?

    <p>An excess supply of the currency.</p> Signup and view all the answers

    Which of the following is NOT a reason why PPP might fail to predict long-term exchange rate trends?

    <p>Rapid technological advancements.</p> Signup and view all the answers

    How does a central bank intervene in the foreign exchange market under a fixed exchange rate system?

    <p>By buying or selling currency to maintain the fixed rate.</p> Signup and view all the answers

    In what time frame is a managed float exchange rate system primarily utilized?

    <p>Short-term adjustments only.</p> Signup and view all the answers

    What is the effect of declining GDP on a country's currency?

    <p>The currency depreciates.</p> Signup and view all the answers

    What is the role of the Federal Reserve when acting as a bank for banks?

    <p>It holds reserves and pays interest on those funds.</p> Signup and view all the answers

    How does the Federal Reserve influence the money supply through open market operations?

    <p>By buying or selling government bonds.</p> Signup and view all the answers

    What effect does the Federal Reserve's purchase of government bonds have on the money supply?

    <p>It increases the money supply.</p> Signup and view all the answers

    What is the formula for calculating the money multiplier?

    <p>1/Required Reserve Ratio</p> Signup and view all the answers

    Which statement correctly describes the relationship between open market sales and the money supply?

    <p>Open market sales decrease the money supply.</p> Signup and view all the answers

    What is one assumption made in the context of open market purchases by the Federal Reserve?

    <p>Banks do not hold excess reserves.</p> Signup and view all the answers

    What distinguishes Federal Reserve bond sales from treasury bond sales?

    <p>Fed bond sales do not change the government budget.</p> Signup and view all the answers

    When the Federal Reserve acts as a lender of last resort, what is its primary goal?

    <p>To ensure banks have sufficient reserves.</p> Signup and view all the answers

    Study Notes

    Foreign Exchange Rates

    • Exchange rates are determined by supply and demand just like other markets.
    • When looking at the dollar/pound market, the demand for pounds is driven by:
      • Americans buying goods and services from British firms.
      • Americans buying British assets like stocks, bonds, and real estate.
    • The demand curve slopes downwards meaning a lower exchange rate leads to higher demand for pounds.
    • Shifts in the demand curve are impacted by:
      • U.S. real GDP: Growth leads to increased demand for British goods, shifting the demand curve right.
      • Relative price levels: If U.S. prices rise faster than British prices, demand for British goods increases, shifting the demand curve right.
      • Increased interest in British goods: Demand for British goods increases, shifting the demand curve right.
      • Relative interest rates: Higher interest rates in Britain make British assets more attractive, leading to increased demand for pounds, shifting the demand curve right.
    • The supply of pounds is affected by:
      • British investors buying U.S. assets: This increases the supply of pounds, shifting the supply curve right.
      • Expected changes in the exchange rate: If the British expect the pound to depreciate, they'll buy more U.S. assets, increasing the supply of pounds, shifting the supply curve right.
    • A floating exchange rate is determined by supply and demand without government intervention.
    • Appreciation of a currency occurs when its price increases due to a shift in supply, demand, or both.
    • Depreciation of a currency occurs when its price decreases in a floating exchange rate system.
    • Very Short-Run: Exchange rate fluctuations occur over weeks and days, driven by traders moving large volumes of funds and expectations about future exchange rates.
    • Short-Run: Exchange rate fluctuations happen over months or years, influenced by economic fluctuations. A rising GDP leads to depreciation, and a falling GDP leads to appreciation.
    • Long-Run: Exchange rates are determined by relative price levels between two countries.
    • Purchasing Power Parity (PPP): The exchange rate between two countries adjusts in the long run to equalize the average price of goods in both countries.
    • PPP Theory Implication: The currency of a country with higher inflation will depreciate against the currency of a country with lower inflation.
    • Exceptions to PPP:
      • Goods difficult to trade (haircuts, non-tradable goods).
      • High transportation costs.
      • Artificial barriers to trade (taxes, quotas on imports).
    • Managed Float: A country's central bank actively manages its exchange rate by buying its own currency to prevent depreciation and selling its own currency to prevent appreciation.
    • Fixed Exchange Rate: A government declares a specific value for its exchange rate with another currency and intervenes in the market to maintain it.
    • Foreign Currency Crisis: Occurs when people lose confidence in a country's ability to maintain a fixed exchange rate above the equilibrium rate, leading to increased supply, decreased demand, and rapid depletion of reserves.
    • Devaluation: When a government lowers the fixed value of its currency.

    Money, Banking & The Federal Reserve

    • Money Supply: Refers to the total amount of money in circulation.
    • M1: Includes cash in the public, checking account deposits, and traveler’s checks.
    • M2: Includes M1 plus savings deposits, money market deposits, and other liquid assets.
    • Functions of the Federal Reserve (Fed):
      • Bank for banks: Holds reserves, pays interest on these funds, and lends to banks at the discount rate.
      • Issues paper currency: Prints money and puts it into circulation.
      • Clears checks: Transfers funds between banks.
      • Guides the macroeconomy: Uses macroeconomic tools to influence economic activity.
      • Deals with financial crisis: Acts as a "lender of last resort" to ensure banks have enough reserves.
    • Ways the Fed Changes the Money Supply:
      • Open Market Operations: The Fed buys or sells government bonds in the bond market.
        • Open Market Purchase: Buying bonds increases reserves and the money supply.
        • Open Market Sale: Selling bonds reduces reserves and the money supply.
    • Money Multiplier: The ratio of the change in the money supply to the initial change in reserves. It depends on the required reserve ratio (RRR), calculated as 1/RRR.
    • Treasury vs. Fed: The Treasury borrows money by issuing new government bonds, while the Fed does not borrow. Fed open market operations affect the money supply independent of the government budget.

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    Description

    This quiz explores the factors that determine foreign exchange rates, focusing on the dollar/pound market. It examines how supply and demand, U.S. economic conditions, and relative price levels influence the demand for pounds. Test your understanding of these economic dynamics and their implications for international trade.

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