The International Money System

Question 1

When the US economy expands, then the level of income and output will ____ in other countries.

Answer 1

Rise. Conversely, when the US economy contracts, then income and output levels in other countries will fall.

The US and foreign economies are dependent on each other through international trade and finance. When the US economy expands, then domestic spending on imported goods tends to rise as domestic income rises. Hence, US economic expansion stimulates economic growth in other countries.

Question 2

Between 1982 and 1989, US imports were extremely high but US exports did not rise as quickly thereby causing a large foreign trade _______.

Answer 2

Deficit. There is a deficit in the foreign trade balance of payments because the US is importing more goods than it is exporting, thereby creating this deficit.

Question 3

The ________________ market is one which trades in the currencies of various countries.

Answer 3

Foreign Exchange. In this market, currencies such as the US dollar, Japanese yen and British pound are bought and sold.

Question 4

The _____ market is not a centralized market such as the New York Stock Exchange but an over-the-counter market.

Answer 4

Forex. This means that the market is decentralized with firms specializing in the forex market.

Question 5

The exchange rate is the price of one currency relative to another, so that when one currency rises in value against another, it is said to have ___________ in value.

Answer 5

Appreciated. For example, if originally US$1=British pound 1, then the US dollar appreciates in value if US$1=British pound 2. Now, one US dollar can buy twice as much British goods as it was able to previously. Its value has appreciated.

The opposite effect is called depreciation.

Question 6

When Country A’s currency appreciates in value relative to Country B, then that country can buy ____ of Country B’s goods for the same price but Country A’s exported goods will be more expensive in Country B.

Answer 6

More. This makes sense. If country A’s money appreciates, that means that it’s worth more in country B, so it will buy more of country B’s goods. Conversely, country B’s money is now worth less in country A, so it will buy less of country A’s exported goods.

Question 7

Foreign exchange transactions are either spot or _______ transactions.

Answer 7

Forward. Spot transactions are currency sales where the delivery is immediate.

Question 8

Forward transactions are currency sales arranged for a future date, so the 30 forward exchange rate refers to the exchange rate of the currency in 30 ____ time.

Answer 8

Days.

Question 9

In a competitive market, floating exchange rates are based on the supply and demand for a particular ________.

Answer 9

Currency. As the market is competitive, the price will be determined by supply and demand forces for that currency, and hence the term ‘floating’.

Question 10

A fixed exchange rate is one where the government pegs the rates at a particular level, whereas a _______ float exchange rate system is an intermediate system between the fixed and floating systems.

Answer 10

Managed. This system means that the central bank trades in the foreign exchange to try and stabilize the rate in the short term, but there is no continuous interference that pegs rates at a particular level.

Question 11

The central bank (the FED) may also institute the ________ peg system where a specific exchange rate is targeted in the short run but this is adjusted to avoid fixing the rate.

Answer 11

Creeping.

Question 12

The US Balance of ________ is the flow of funds from the US to other countries.

Answer 12

Payments.

Question 13

The BOP (Balance of Payments) is made up of to two accounts: the current account and the _______ account.

Answer 13

Capital. The capital account is a record of purchases and sales of securities and other assets. These entries may be negative (payment of funds to another country) or positive (payment of funds to the US).

Question 14

_______ are a positive entry in the current account.

Answer 14

Exports. Exports are a positive account because US producers are being paid and their products are being sold abroad. Imports are negative because a foreign producer is being paid.

Question 15

The difference between goods exports and imports is called the _____________ and when imports exceed exports, the US must sell enough assets to cover the current account deficit.

Answer 15

Trade balance. A deficit is produced because the value of imports exceeds exports.

Question 16

An __________ currency is one whose market value is higher than the value predicted by an economic theory or model.

Answer 16

Overvalued. In the opposite situation, the currency would be called undervalued.

Question 17

The law of one price states that prices of a traded good in _________ locations will be the same.

Answer 17

Different. Assuming that competition is permitted, then the law of one price will apply, as people will always be looking for the best price when buying goods, so prices will eventually equalize.

Question 18

The _______ exchange rate is the exchange rate between two countries that does not consider price levels.

Answer 18

Nominal. This exchange rate gives the present market value of one currency as compared to another currency.

Question 19

The exchange rate that factors the ___________ between the two countries price levels, thereby measuring the purchasing power of domestic goods and services in exchange for foreign goods and services, is called the real exchange rate.

Answer 19

Differences.

Question 20

The theory that is commonly used to determine if a country’s currency is overvalued or undervalued is the purchasing power ______.

Answer 20

Parity. Purchasing Power Parity (PPP) states that in the long term, the price of a good in one country should be the same as an exchange-rate-adjusted price in another country if international arbitrage is unobstructed.

Question 21

The two types of Purchasing Power Parity (PPP) commonly used by economists are the ________ PPP and relative PPP.

Answer 21

Absolute. Absolute PPP refers to price levels and the nominal exchange rate. This means that the US price of pears should equal the Japanese price multiplied by the spot exchange rate.

Question 22

The limitations on absolute PPP include the fact that it does not consider ancillary costs such as transportation and taxes and assumes that trade is ____________.

Answer 22

Barrier-free. Some countries apply legal restraints on the trade of certain goods to certain countries.

Question 23

________ PPP relates the two nations’ inflation rates to the rate of change in the exchange rate.

Answer 23

Relative. The proportionate changes in the exchange rates are compared with the changes in price levels.

Question 24

According to the interest rate parity theory, in the short term, the exchange rate will adjust until the expected rates of return from investing in ________ assets equal the rates of return from investing in overseas assets.

Answer 24

Domestic.

Question 25

The interest rate parity theory indicates that the domestic currency will appreciate when domestic interest rates rise, foreign interest rates fall, the expected exchange rate falls, domestic income _____, foreign income rises, the US government sells foreign currency and is paid in dollars, or foreign governments buy dollars with their currencies.

Answer 25

Falls. If domestic income rises, the money supply is rising, so it would make sense that the money would depreciate (be worth less).

When domestic income falls, domestic demand for foreign assets also falls. When foreign income rises, then foreign demand for foreign assets also rises.

Question 26

As a result of the Great Depression and problems with the gold standard, the _____________ agreement was concluded in 1944 and remained in force until 1971.

Answer 26

Bretton Woods. This fixed rate exchange agreement required the US to maintain a fixed price of gold relative to the dollar and other countries had to fix their exchange rates in terms of the dollar.

Question 27

The International _____________ was created to ensure compliance with the Breton Woods agreement and assist countries with a Balance of Payments (BOP) problem.

Answer 27

Monetary Fund.

Question 28

When the PPP required a devaluation or revaluation of a currency or if a country could not meet its exchange rate targets, then a fundamental ______________ resulted and member countries could agree to set a new rate.

Answer 28

Disequilibrium. Devaluation refers to lowering the value of a country’s currency relative to other countries. This would make exports cheaper to purchasers in other countries.

Question 29

The Bretton Woods conference led to the formation of the World Bank to provide loans to __________ countries.

Answer 29

Developing. The idea was to give assistance to poorer, developing nations, so that they could build their economy.

Question 30

The Bretton Woods arrangement started to fall apart when speculations about devaluations resulted in some central banks suffering great difficulties in keeping their currencies pegged. There was concern with heavy US deficits and their ability to protect the dollar, and so the _____ rate system was abandoned in 1973.

Answer 30

Fixed. The US stopped converting dollars to gold and the fixed rate system was stopped in 1973 in favor of flexible exchange rates.

Question 31

What does the Dodd Frank bill from 2010 aim to do?

Answer 31

1. Improve accountability and transparency in the financial system.
2. End “too big to fail”.
3. Protect taxpayers by ending bailouts.
4. Protect consumers from abusive financial practices.

Question 32

In a fixed exchange environment with perfect capital mobility, the central bank has very little power to control ________ interest rates.

Answer 32

Domestic. Perfect capital mobility means that if the expected returns on domestic assets exceed expected returns on foreign assets then investors would shift their money to domestic assets until rates improved.

If the FED bought securities causing the money supply to increase, then the domestic interest rate would fall. This would cause investors to shift to foreign assets causing a depreciation in the dollar relative to other currencies.

The FED would then have to buy back dollars to ensure that the exchange rate remained at the agreed level. So ultimately, because investors can just switch to foreign investments, the FED really would not be able to manipulate the money supply, and therefore would have little power to manipulate interest rates.