Financial Markets and Institutions Questions I Got Wrong Flashcards
(3 cards)
An unexpected increase in the U.S. money supply leads to:
a. an immediate reduction in the U.S. interest rate
b. an immediate larger dollar depreciation
c. a gradual appreciation of the dollar over time
d. all of the above
Why?
✅ Correct Answer: d. all of the above
Let’s break it down:
a. An immediate reduction in the U.S. interest rate
✔️ True.
When the U.S. money supply increases unexpectedly, there’s more liquidity.
This pushes interest rates down, because banks have more funds to lend and need to lower rates to encourage borrowing.
Monetary expansion = ↓ interest rates (short-term).
b. An immediate larger dollar depreciation
✔️ Also true.
Lower U.S. interest rates → foreign investors pull out capital to seek higher returns elsewhere.
Demand for the dollar falls, so the dollar depreciates.
Since the change was unexpected, markets adjust quickly and sharply — causing a larger immediate depreciation.
This is aligned with the overshooting model (Dornbusch) — where currencies overreact in the short run due to sticky prices and flexible exchange rates.
c. A gradual appreciation of the dollar over time
✔️ Still true.
After the initial overshoot depreciation, the dollar slowly appreciates back toward its long-run value.
Why? Because:
Prices begin to rise with the increased money supply.
Real interest rates adjust.
Markets factor in expectations of inflation and future monetary tightening.
This is classic in exchange rate theory:
Short-run overshooting → Long-run correction.
✅ Final Answer: d. all of the above
Let me know if you want more on the Dornbusch Overshooting Model — it’s central to these kinds of FX questions.
Using a supply and demand framework and the dollar pound exchange rate, with an
initial equilibrium exchange rate of $1.50/£1, explain what would happen to the pound if there were an increase in the demand
for pounds in a floating exchange rate regime.
demand curve for pounds to shift to the right putting upward pressure on the value of
the pound. The exchange rate appreciates until a new equilibrium is reached where
demand equals supply again. The new exchange rate will be stronger than $1.50/£1, e.g.,
moving to $1.65/£1 (using same framework, same but opposite analysis for increase in supply)
What’s the formula for interest rate parity for futures pricing?
t is always as a fraction of a year
