READING 18 CAPITAL FLOWS AND THE FX MARKET

Question 1

Which of the following best describes the primary function of the foreign exchange market?
A. To issue foreign currency bonds
B. To facilitate cross-border flows of goods, services, and capital
C. To control domestic inflation rates

Answer 1

Correct Answer: B

Explanation:
The primary function of the foreign exchange (FX) market is to facilitate international trade and capital flows by enabling the conversion of one currency to another.
Option A is incorrect because issuing foreign bonds is a function of capital markets, not FX markets.
Option C is incorrect because controlling inflation is typically the role of central banks, not FX markets.

Question 2

Which of the following is most likely a use of foreign exchange by a multinational corporation?
A. Buying forward contracts to speculate on currency appreciation
B. Purchasing foreign currencies for vacation travel
C. Hedging payment obligations in a foreign currency

Answer 2

Correct Answer: C

Explanation:
Corporations use foreign exchange markets primarily to hedge currency risks from international transactions.
Option A describes speculation, not hedging.
Option B is more typical of retail FX users, not multinational corporations.

Question 3

A Japanese exporter expects to receive EUR 5 million in 60 days. To hedge this exposure, the firm enters a forward contract to sell EUR for JPY. This strategy is best described as:
A. Speculating
B. Hedging
C. Arbitraging

Answer 3

Correct Answer: B

Explanation:
The firm is reducing risk by locking in a rate today to convert future euro receipts to yen.
Option A is incorrect as speculation involves taking on additional risk.
Option C is incorrect; arbitrage involves riskless profit from price differences, which is not the case here.

Question 4

Which of the following would most likely be a participant on the sell-side of the foreign exchange market?
A. Hedge fund
B. Multinational bank
C. Pension fund

Answer 4

Correct Answer: B

Explanation:
Sell-side participants are usually large financial institutions like banks that provide liquidity and deal in FX contracts.
Hedge funds and pension funds are buy-side participants.

Question 5

Which of the following would most likely describe the activity of a leveraged account in FX markets?
A. Avoiding derivatives and using long-term investment strategies
B. Using derivatives for speculative trading
C. Implementing government policies on exchange rates

Answer 5

Correct Answer: B

Explanation:
Leveraged accounts actively use derivatives to amplify returns, often speculating on currency movements.
Option A describes real money accounts.
Option C refers to central bank operations.

Question 5

Which of the following best describes a real money account in FX markets?
A. An account that uses high leverage and derivatives
B. An account held by a central bank for monetary operations
C. An institutional investment account that does not use derivatives

Answer 5

Correct Answer: C

Explanation:
Real money accounts include mutual funds, pension funds, and insurance companies that typically avoid derivatives.
Option A describes leveraged accounts.
Option B refers to central bank operations.

Question 6

Which of the following best describes the retail FX market?
A. Comprised primarily of multinational banks
B. Dominated by central banks and monetary authorities
C. Involves individuals and small institutions engaging in FX for travel or investment

Answer 6

Correct Answer: C

Explanation:
Retail FX market includes tourists, individual investors, and small institutions.
Option A is sell-side.
Option B relates to official interventions.

Question 7

Which entity is most likely to use the FX market to affect short-term exchange rates?
A. Commercial bank
B. Sovereign wealth fund
C. Central bank

Answer 7

Correct Answer: C

Explanation:
Central banks engage in FX transactions as part of monetary policy or exchange rate management.
Other institutions might trade for investment, but not typically for policy reasons.

Question 8

A U.S. investor holds assets in British pounds. If the value of the pound increases relative to the dollar, the investor:
A. Suffers a loss in dollar terms
B. Gains in dollar terms
C. Experiences no change

Answer 8

Correct Answer: B

Explanation:
When the foreign currency strengthens against the domestic currency, the value of foreign assets rises in domestic currency terms.

Question 9

What is the percentage change in the exchange rate if the EUR/USD goes from 1.20 to 1.25?
A. 4.17%
B. 5.00%
C. 6.25%

Answer 9

Correct Answer: B

Explanation:
Percentage change = (New rate - Old rate) / Old rate = (1.25 - 1.20)/1.20 = 0.05 / 1.20 = 4.17%.
Correct answer is A.
(Note: adjust to A based on math)

Question 9

Which of the following is most accurate regarding nominal exchange rates?
A. They reflect differences in purchasing power between currencies.
B. They are adjusted for inflation differentials.
C. They represent the current quoted rate between two currencies.

Answer 9

Correct Answer: C

Explanation:
Nominal rates are the raw quoted exchange rates, not adjusted for inflation.
Option A and B describe real exchange rates.

Question 10

If a firm enters into a forward contract to buy foreign currency in 3 months to pay an invoice, it is:
A. Speculating
B. Hedging
C. Arbitraging

Answer 10

Correct Answer: B

Explanation:
The firm is managing expected payment risk by locking in the future rate.
Speculation would involve taking a risk without a real underlying need.

Question 11

Central banks intervening in FX markets primarily aim to:
A. Earn speculative profits
B. Meet investment objectives
C. Stabilize or influence exchange rates

Answer 11

Correct Answer: C

Explanation:
Central banks intervene to manage volatility or target specific currency values.
Speculation and investing are not primary objectives.

Question 12

The primary purpose of a forward FX contract is to:
A. Speculate on future interest rate changes
B. Hedge against potential currency movements
C. Earn arbitrage profits from currency spreads

Answer 12

Correct Answer: B

Explanation:
Forward contracts are used to fix exchange rates for future transactions, reducing uncertainty.
Arbitrage involves riskless profit from price discrepancies, which is not the same as hedging.

Question 13

Which of the following best describes the meaning of the quote 1.416 USD/EUR?
A. One euro can be exchanged for 1.416 U.S. dollars
B. One U.S. dollar can be exchanged for 1.416 euros
C. One unit of U.S. goods costs 1.416 times more than eurozone goods

Answer 13

Correct Answer: A

Explanation:
The quote 1.416 USD/EUR means $1.416 per euro, i.e., one euro costs 1.416 dollars.
B is incorrect because it reverses the base and price currencies.
C is incorrect because the quote refers to currency exchange, not relative goods prices.

Question 14

A U.S.-based investor sees a quote of 0.90 EUR/USD. This quote is best described as:
A. A direct quote
B. An indirect quote
C. A cross-currency quote

Answer 14

Correct Answer: B

Explanation:
For a U.S. investor, EUR/USD (price in euros per dollar) is an indirect quote.
A is incorrect—it would be direct if quoted as USD/EUR.
C is not relevant unless three currencies are involved.

Question 14

In the quote 1.25 USD/EUR, which is the base currency and which is the price currency?
A. USD is the base currency; EUR is the price currency
B. USD is the price currency; EUR is the base currency
C. Both currencies are base currencies

Answer 14

Correct Answer: B

Explanation:
In a quote of 1.25 USD/EUR, EUR is the base (bottom), and USD is the price (top).
A incorrectly reverses the terms.
C is nonsensical — only one currency is the base.

Question 15

If the price level in the Eurozone increases while U.S. prices stay constant, what is the most likely effect on the real USD/EUR exchange rate?
A. It increases
B. It decreases
C. It remains unchanged

Answer 15

Correct Answer: A

Explanation:
A higher Eurozone price level means less purchasing power for USD in the Eurozone → real exchange rate increases.
B is incorrect—it would decrease only if Eurozone prices fell.
C assumes no relative price change.

Question 16

If the nominal USD/EUR exchange rate increases from 1.10 to 1.20, what does this indicate?
A. The EUR has depreciated relative to the USD
B. The USD has depreciated relative to the EUR
C. The EUR has become cheaper for U.S. residents

Answer 16

Correct Answer: B

Explanation:
When USD/EUR increases from 1.10 to 1.20, it takes more USD to buy 1 EUR.
→ This means the USD has lost value (depreciated)
→ And the EUR has gained value (appreciated)
A is Incorrect. This is the opposite. If USD/EUR increases, the EUR is becoming more expensive — it has appreciated, not depreciated.
C is incorrect. The EUR has become more expensive, not cheaper, for U.S. residents. If you previously paid $1.10 for 1 EUR and now have to pay $1.20, then it’s more expensive.

Question 17

Which of the following best defines the real exchange rate?
A. The cost of exchanging one currency for another in nominal terms
B. The amount of goods and services a currency can buy abroad relative to a base period
C. The interest rate parity between two currencies

Answer 17

Correct Answer: B

Explanation:
The real exchange rate measures relative purchasing power of two currencies.
A describes the nominal rate.
C refers to arbitrage/forward rates, not real exchange rate.

Question 18

A quote of 0.85 EUR/USD is a direct quote for:
A. A U.S.-based investor
B. A Eurozone-based investor
C. Neither

Answer 18

Correct Answer: B

Explanation:
EUR/USD = 0.85 means 0.85 euros per dollar, direct for Euro-based investor.
A is incorrect it’s indirect for a USD investor.
C is incorrect it is direct for someone.

Question 18

When the nominal USD/EUR exchange rate is unchanged but Eurozone prices rise by 10%, the real exchange rate:
A. Decreases
B. Increases
C. Remains unchanged

Answer 18

Correct Answer: B

Explanation:
U.S. dollars now buy fewer goods in the Eurozone → real exchange rate increases.
A is incorrect—it would decrease if Eurozone prices fell.
C only applies if relative prices are stable.

Question 19

If the nominal USD/EUR exchange rate decreases from 1.15 to 1.10, what happens to the purchasing power of the USD in the Eurozone?
A. It increases
B. It decreases
C. It stays the same

Answer 19

Correct Answer: A

Explanation:
USD/EUR falling means each euro costs less in dollars → USD buys more euros → higher purchasing power.
B is the opposite.
C applies only if rate doesn’t change.

Question 20

Which of the following is true when comparing direct and indirect exchange rate quotes?
A. A quote can only be direct or indirect based on the base currency
B. Direct and indirect quotes are reciprocals of each other
C. The terms are universally standardized and not investor-specific

Answer 20

Correct Answer: B

Explanation:
Direct quote = 1 / indirect quote and vice versa.
A is incomplete.
C is incorrect they’re investor-location-specific.

Question 21

If the real USD/EUR exchange rate has decreased, which of the following is most likely? A. U.S. goods have become more expensive relative to Eurozone goods B. Eurozone prices have fallen relative to U.S. prices C. USD has become stronger in real terms

Answer 21

Correct Answer: C Explanation: Decrease in real rate means USD can buy more goods abroad → stronger in real terms. A is the opposite. B is a possible cause of C, but C is the more comprehensive effect.

Question 22

An increase in the nominal USD/EUR rate, with price levels unchanged, implies: A. Decrease in real exchange rate B. Increase in real exchange rate C. No change in real exchange rate

Answer 22

Correct Answer: B Explanation: Nominal increase → USD buys fewer euros → real rate goes up if prices unchanged. A is incorrect. rate rises. C only applies if nominal and price levels are unchanged.

Question 23

Which of the following scenarios will cause the real USD/EUR exchange rate to fall? A. Eurozone prices rise faster than U.S. prices B. Eurozone prices fall relative to U.S. prices C. USD/EUR nominal rate rises

Answer 23

Correct Answer: B Explanation: Falling Eurozone prices → USD buys more → real exchange rate falls. A would increase it. C also increases real exchange rate.

Question 24

The nominal exchange rate is most accurately defined as: A. The purchasing power parity rate B. The rate adjusted for inflation C. The current price of one currency in terms of another

Answer 24

Correct Answer: C Explanation: Nominal = actual spot exchange rate, unadjusted for inflation. A and B describe real or theoretical rates.

Question 25

If the USD/EUR rate is 1.20, how much would 1,000 EUR cost in USD? A. $1,200 B. $833 C. $1,000

Answer 25

Correct Answer: A Explanation: 1,000 EUR × 1.20 USD/EUR = $1,200. B is if you inverted the rate (EUR/USD). C is just the euro amount, not converted.

Question 26

A nominal exchange rate increases, but the base currency's price level rises proportionally. The real exchange rate: A. Increases B. Decreases C. Remains unchanged

Answer 26

Correct Answer: C Explanation: If both nominal rate and prices rise equally, the real rate stays flat. A or B imply unequal changes.

Question 27

A U.S.-based investor interprets a quote of 1.40 USD/EUR as: A. Indirect B. Direct C. Cross rate

Answer 27

Correct Answer: B Explanation: USD/EUR is direct for a U.S. investor (price per unit of foreign). A is the opposite. C involves a third currency.

Question 28

If the real USD/EUR exchange rate increases, this implies: A. U.S. goods have become relatively cheaper B. U.S. goods have become relatively more expensive C. Eurozone prices have decreased

Answer 28

Correct Answer: A Explanation: An increase in the real USD/EUR exchange rate means that Eurozone goods have become relatively more expensive compared to U.S. goods. Therefore, U.S. goods are relatively cheaper for Eurozone buyers. Option B is incorrect because a higher real exchange rate indicates the base currency (EUR) goods are pricier, making U.S. goods cheaper in comparison. Option C is incorrect because a decrease in Eurozone prices would lower the real exchange rate, not increase it.

Question 29

Which of the following best describes an indirect quote for a U.S. investor? A. The price of one U.S. dollar in foreign currency B. The price of one foreign currency in USD C. The real exchange rate adjusted for inflation

Answer 29

Correct Answer: A Explanation: Indirect quote = foreign per USD. B is a direct quote. C is unrelated to quote type.

Question 30

If 1.00 USD = 0.85 EUR and the price level in Europe rises 5%, what is the real exchange rate impact? A. USD purchasing power rises B. USD purchasing power falls C. USD purchasing power remains the same

Answer 30

Correct Answer: B Explanation: Price inflation in Europe → same dollars buy fewer goods, even if currency value unchanged. A reverses the effect. C assumes stable prices.

Question 30

At the end of a period, the nominal exchange rate is $1.60/£. The U.K. CPI is 112, and the U.S. CPI is 110. What is the real exchange rate? A. $1.54/£ B. $1.60/£ C. $1.63/£

Answer 30

Correct Answer: C Explanation: Real exchange rate = Nominal × (Foreign CPI / Domestic CPI) = 1.60 × (112 / 110) = 1.629 A is incorrect. underestimates the real rate. B is incorrect. reflects only the nominal rate, not adjusted for inflation.

Question 31

If the nominal exchange rate (USD/JPY) increases, and all else remains equal, what happens to the real exchange rate? A. Increases B. Decreases C. Remains unchanged

Answer 31

Correct Answer: A Explanation: A higher nominal exchange rate increases the real exchange rate if price levels are unchanged. B is incorrect. decrease would require falling nominal rate or rising domestic CPI. C is incorrect. real rate changes unless offset by inflation differences.

Question 32

If the nominal exchange rate and price levels in both countries rise proportionally, the real exchange rate will: A. Increase B. Decrease C. Remain unchanged

Answer 32

Correct Answer: C Explanation: Equal changes in nominal and relative price levels offset each other. A/B are incorrect unless there is a mismatch in relative price changes.

Question 33

If U.K. prices rise faster than U.S. prices, what happens to the real $/£ rate? A. Increases B. Decreases C. No effect

Answer 33

Correct Answer: A Explanation: Higher foreign inflation increases the real exchange rate, making U.S. goods cheaper. B is incorrect. would require U.S. prices rising faster. C is incorrect. price changes always impact real rate.

Question 34

If the real USD/EUR exchange rate increases, this suggests: A. U.S. goods are cheaper relative to Eurozone goods B. U.S. goods are more expensive relative to Eurozone goods C. Eurozone prices have decreased

Answer 34

Correct Answer: B Explanation: Higher real exchange rate = base currency goods are relatively more expensive. A is incorrect. would be true if real rate fell. C is incorrect. falling EU prices would reduce the real rate.

Question 35

A falling real exchange rate for USD/GBP implies: A. Increased U.S. purchasing power in the U.K. B. Increased U.K. purchasing power in the U.S. C. Decreased real exchange rate due to U.K. price increases

Answer 35

Correct Answer: A Explanation: Lower real rate = U.S. consumers can buy more U.K. goods. B is incorrect. that would occur if rate increased. C is inaccurate. U.K. price increases would increase the rate.

Question 36

A firm enters a forward contract to exchange 10 million GBP at 1.192 EUR/GBP. What will they receive? A. €11.92 million B. €10.00 million C. €12.00 million

Answer 36

Correct Answer: A Explanation: 10 million × 1.192 = €11.92 million B/C are miscalculations.

Question 37

Which statement best distinguishes a spot rate from a forward rate? A. Spot rate is a future-dated contract; forward is immediate B. Spot rate is used for immediate delivery; forward is for future settlement C. Spot and forward rates are always equal

Answer 37

Correct Answer: B Explanation: Spot = immediate (usually T+2), forward = future contract A is reversed. C is incorrect. forward includes interest rate differentials.

Question 38

USD/EUR moves from 1.42 to 1.39. What is the % appreciation of the USD? A. 2.11% B. 2.16% C. 3.00%

Answer 38

Correct Answer: B Explanation: Convert to EUR/USD: 1/1.42 = 0.7042, 1/1.39 = 0.7194 Change = (0.7194 / 0.7042) − 1 = 2.16% A is euro depreciation, not dollar appreciation.

Question 39

Using the same scenario as Q9, what is the euro’s % depreciation? A. -2.16% B. -2.11% C. -3.00%

Answer 39

Correct Answer: B Explanation: (1.39 / 1.42) - 1 = -2.11% A is a slightly incorrect estimate. C is too large.

Question 40

Which best explains a fall in the real exchange rate? A. Nominal exchange rate increases, domestic CPI unchanged B. Nominal exchange rate decreases, foreign CPI increases faster than domestic C. Both CPIs rise equally

Answer 40

Correct Answer: B Explanation: Rate falls when nominal rate drops & domestic prices rise slower. A would increase the real rate. C keeps rate stable.

Question 41

Question 12: CPI and Real Exchange Rate Dynamics If domestic inflation rises faster than foreign inflation, the real exchange rate: A. Increases B. Decreases C. Depends on nominal movement

Answer 41

Correct Answer: B Explanation: High domestic inflation = home currency loses purchasing power = real rate falls A is incorrect. that would happen if foreign inflation was higher C is incomplete. CPI alone affects real rate.

Question 42

Which scenario improves the competitiveness of domestic exports? A. Rising real exchange rate B. Falling real exchange rate C. Stable real exchange rate with rising nominal rate

Answer 42

Correct Answer: B Explanation: Lower real rate = domestic goods are relatively cheaper A is the opposite C doesn't affect competitiveness unless real rate changes

Question 43

A company expects to receive foreign currency in the future. To hedge FX risk, it should: A. Enter a forward contract to sell the currency B. Buy options to buy more foreign currency C. Do nothing and accept the exchange rate risk

Answer 43

Correct Answer: A Explanation: Forward contracts lock in the exchange rate for a known amount B is incorrect unless hedging purchase, not receivable C ignores risk management.

Question 44

Which best defines the real exchange rate? A. Nominal rate adjusted for purchasing power parity B. Average of spot and forward rates C. Nominal rate adjusted for interest rate differentials

Answer 44

Correct Answer: A Explanation: Real rate = nominal × (foreign price / domestic price) B is unrelated C refers to covered interest parity.

Question 45

Which of the following best describes formal dollarization? A. The country pegs its currency to another but retains its central bank. B. The country adopts another country's currency and gives up its own. C. The country allows its currency to float but intervenes occasionally.

Answer 45

Correct Answer: B Explanation: Formal dollarization means a country adopts another country's currency, giving up its own and any control over monetary policy. A describes a pegged regime, not formal dollarization. C describes a managed float.

Question 46

A key disadvantage of a currency board arrangement is that: A. The country earns no income from its foreign reserves. B. The monetary authority cannot engage in open market operations. C. The country cannot influence its domestic interest rates at all.

Answer 46

Correct Answer: B Explanation: Under a currency board, the central bank's ability to conduct monetary policy (e.g., open market operations) is highly restricted. A is false. the country can still earn interest on its reserves. C is too strong. while constrained, there may be minor short-term interest rate flexibility.

Question 47

Which regime gives the monetary authority the most flexibility in conducting monetary policy? A. Currency board B. Managed floating C. Conventional fixed peg

Answer 47

Correct Answer: B Explanation: Managed floating gives the central bank discretion to influence rates without a fixed exchange target. A offers almost no flexibility. C allows some intervention, but policy is constrained by the peg.

Question 48

Which of the following is a feature of a conventional fixed peg exchange rate system? A. The exchange rate is allowed to float within broad bands. B. The currency is pegged to another within ±1%. C. The monetary authority allows exchange rates to float independently.

Answer 48

Correct Answer: B Explanation: Conventional pegs maintain currency values within tight margins, typically ±1%. A describes a target zone or crawling band. C describes independently floating regimes.

Question 49

In which exchange rate regime is monetary policy least constrained? A. Currency board B. Managed float C. Crawling peg

Answer 49

Correct Answer: B Explanation: Managed floats allow central banks to target domestic goals like inflation or employment without strict exchange rate targets. A and C both restrict policy to maintain exchange rate stability.

Question 50

A crawling peg is typically used: A. To influence trade by targeting capital flows. B. To adjust for inflation differentials over time. C. To replace fixed pegs with market-determined exchange rates.

Answer 50

Correct Answer: B Explanation: Crawling pegs involve regular adjustments to account for inflation differentials. A is incorrect. it targets inflation, not trade flows. C describes a crawling band, not a peg.

Question 51

Which of the following best describes an active crawling peg? A. The exchange rate adjusts in response to inflation. B. A preset path of exchange rate changes is announced in advance. C. The exchange rate floats but is subject to occasional central bank intervention.

Answer 51

Correct Answer: B Explanation: An active crawling peg involves a pre-announced schedule of rate changes. A describes a passive crawling peg. C describes a managed float.

Question 52

A country plans to shift from a fixed peg to a floating exchange rate but lacks credibility. What regime might it use as a transition? A. Currency board B. Crawling bands C. Monetary union

Answer 52

Correct Answer: B Explanation: Crawling bands help transition gradually by widening exchange rate bands. A would not be used as a transition; it limits flexibility. C gives up currency control entirely, not a transition to floating.

Question 53

In a monetary union such as the Eurozone, individual countries: A. Retain full control over their monetary policy. B. Share a common monetary authority. C. Issue their own currencies but peg them to the euro.

Answer 53

Correct Answer: B Explanation: In a monetary union, countries share a central bank (e.g., the ECB). A is false. they lose individual control. C is false. they no longer issue separate currencies.

Question 54

Which exchange rate regime provides the most predictable inflation expectations? A. Active crawling peg B. Managed floating C. Independently floating

Answer 54

Correct Answer: A Explanation: By announcing future rate changes, an active crawling peg can anchor inflation expectations. B and C are market-based and offer less predictability.

Question 55

Which of the following describes a target zone regime? A. Exchange rate fluctuates freely within a ±1% band. B. Exchange rate allowed to move within a wider horizontal band, e.g., ±2%. C. Exchange rate follows a predetermined path regardless of inflation.

Answer 55

Correct Answer: B Explanation: Target zones allow wider exchange rate fluctuations than conventional pegs. A is too narrow. it describes a conventional peg. C is incorrect. it would be closer to a crawling peg.

Question 56

Under a currency board, money can only be issued if: A. The exchange rate remains stable. B. The country earns sufficient export revenue. C. It is fully backed by foreign currency reserves.

Answer 56

Correct Answer: C Explanation: A currency board issues domestic currency only when backed by reserves. A is a consequence, not a condition. B is not a requirement for issuance

Question 57

Which regime best describes the Hong Kong dollar's system? A. Conventional fixed peg B. Currency board C. Independently floating

Answer 57

Correct Answer: B Explanation: Hong Kong operates a currency board that strictly links its dollar to the U.S. dollar. A offers more flexibility. C allows market-determined rates.

Question 58

Which of the following is most likely to respond directly to inflation, employment, or balance of payments without a fixed exchange rate target? A. Managed float B. Crawling peg C. Currency board

Answer 58

Correct Answer: A Explanation: Managed float allows flexible policy based on economic indicators without targeting specific exchange rates. B and C are constrained by peg or fixed rules.

Question 59

Which regime involves market determination of exchange rates, with minimal intervention only to reduce volatility? A. Managed float B. Independently floating C. Target zone

Answer 59

Correct Answer: B Explanation: Independently floating currencies rely on the market; central bank intervention is rare and non-targeted. A involves more active management. C involves maintaining exchange rates within a range.

Question 60

Which of the following best explains the short-term impact of capital flows on exchange rates? A. Capital flows adjust slowly and have little impact on exchange rates B. Capital flows adjust rapidly and significantly influence short-term exchange rates C. Capital flows only influence long-term exchange rates through changes in asset prices

Answer 60

Correct Answer: B Explanation: B is correct. Capital flows, such as foreign investment in securities, adjust quickly and are the primary driver of short-term and intermediate-term exchange rate changes. A is incorrect. Capital flows adjust quickly, not slowly. C is incorrect. Capital flows primarily influence short-term exchange rates; trade flows influence the long term.

Question 61

An appreciation of the U.S. dollar (USD) relative to the euro (EUR) is most likely to: A. Increase U.S. exports to the Eurozone B. Increase U.S. imports from the Eurozone C. Decrease Eurozone exports to the United States

Answer 61

Correct Answer: B Explanation: B is correct. A stronger USD means Eurozone goods become cheaper for U.S. consumers, increasing U.S. imports. A is incorrect. A stronger USD makes U.S. goods more expensive, so exports to the Eurozone will decrease. C is incorrect. Eurozone exports to the U.S. will likely increase because U.S. buyers can now purchase more with their stronger dollars.

Question 62

According to the balance of payments identity, a trade deficit must be offset by: A. A decrease in domestic investment B. A surplus in the capital account C. An increase in private savings

Answer 62

Correct Answer: B Explanation: B is correct. A trade deficit (X − M < 0) means the country is importing more than it exports, so foreign capital inflows (capital account surplus) are needed to fund the deficit. A is incorrect. Investment can remain high, funded by foreign capital. C is incorrect. If private savings increased enough, the trade deficit wouldn't exist or would be smaller.

Question 63

Which component of domestic savings includes budget surpluses or deficits? A. Private savings B. Corporate retained earnings C. Government savings

Answer 63

Correct Answer: C Explanation: C is correct. Government savings = Taxes − Government spending. A deficit occurs when spending exceeds tax revenue. A is incorrect. Private savings refer to household and business savings, not the government. B is incorrect. While corporate retained earnings are part of private savings, they do not represent government savings.

Question 64

If a country has a government deficit and a trade deficit, this most likely implies: A. Domestic investment exceeds total domestic savings B. Exports exceed imports C. The country has a capital account deficit

Answer 64

Correct Answer: A Explanation: A is correct. With both a government and trade deficit, total savings (private + government) is less than investment, requiring foreign capital to fund the difference. B is incorrect. A trade deficit means imports exceed exports, not the reverse. C is incorrect. The country would have a capital account surplus, not a deficit, to offset the trade deficit.

Question 64

Which of the following best describes the long-term driver of exchange rates? A. Central bank intervention B. Capital flows and investor sentiment C. Trade flows and saving-investment decisions

Answer 64

Correct Answer: C Explanation: C is correct. Over the long term, trade balances and saving/investment patterns adjust and influence exchange rates. A is incorrect. Central bank intervention may impact the short-term exchange rate but not the long term. B is incorrect. Investor sentiment affects short/intermediate-term capital flows.

Question 65

If a country’s exports exceed its imports and it is not investing the excess savings domestically, this situation will likely lead to: A. A capital account surplus B. A capital account deficit C. An increase in the country’s fiscal deficit

Answer 65

Correct Answer: B Explanation: B is correct. A trade surplus (exports > imports) means the country is lending abroad or investing overseas, leading to a capital account deficit (net outflow of capital). A is incorrect. A capital account surplus would offset a trade deficit, not a surplus. C is incorrect. Fiscal balance is unrelated to this specific trade and capital flow dynamic.

Question 66

Which of the following is a direct result of capital inflows into a country? A. A decrease in the country’s net exports B. A capital account surplus C. A reduction in government savings

Answer 66

Correct Answer: B Explanation: B is correct. Capital inflows increase the capital account, resulting in a surplus. A is incorrect. Capital inflows help fund a trade deficit but don’t directly cause a change in net exports. C is incorrect. Government savings are determined by fiscal policy, not capital flows.

Question 67

Which of the following most accurately explains why capital flows impact exchange rates more quickly than trade flows? A. Capital flows involve physical goods, which are slower to move B. Capital flows respond quickly to changes in returns and investor expectations C. Trade flows are driven by speculation, making them highly volatile in the short term

Answer 67

Correct Answer: B Explanation: B is correct. Capital flows—like buying bonds, stocks, or real estate—react quickly to changes in interest rates, risk, or returns. A is incorrect. Capital flows involve financial assets, not physical goods. C is incorrect. Trade flows are based on real goods/services, not speculation, and they adjust more slowly.

Question 68

Which of the following is most likely a reason a government would restrict capital outflows during a financial crisis? A. To increase foreign investment in domestic equities B. To reduce volatility in domestic asset prices C. To raise domestic interest rates

Answer 68

Correct Answer: B Explanation: Restricting capital outflows helps reduce the sudden drop in asset prices during crises, especially for liquid assets like stocks and bonds. A is incorrect. The goal is to reduce volatility, not to attract foreign investment directly. C is incorrect. Restrictions on outflows help lower interest rates, not raise them.

Question 69

A country with a fixed exchange rate is most likely to restrict capital flows in order to: A. Allow free capital movement globally B. Simplify meeting exchange rate targets C. Increase currency volatility for competitiveness

Answer 69

Correct Answer: B Explanation: Limiting capital flows helps governments keep their currency at a fixed rate and manage domestic policy more easily. A is incorrect. Capital restrictions do the opposite—they limit movement. C is incorrect. Fixed exchange rate systems aim to reduce—not increase—currency volatility.

Question 70

One objective of restricting capital outflows is to: A. Encourage foreign investors to acquire strategic industries B. Allow monetary policy to operate without external pressures C. Prevent trade deficits

Answer 70

Correct Answer: B Explanation: Restricting outflows allows countries to set interest rates as needed, without being forced to raise them to match global markets. A is incorrect. Restrictions often prevent foreign control of strategic sectors. C is incorrect. Trade deficits are not directly addressed by capital flow restrictions.

Question 71

Which of the following is an example of protecting a strategic industry through capital flow restrictions? A. Blocking foreign investment in telecom companies B. Imposing tariffs on imported electronics C. Decreasing the money supply to control inflation

Answer 71

Correct Answer: A Explanation: Governments may block foreign ownership in sensitive sectors like telecommunications or defense to protect national security. B is incorrect. Tariffs are trade restrictions, not capital flow restrictions. C is incorrect. That’s a tool of monetary policy, not capital control.

Question 72

A country wants to keep its domestic interest rates low while maintaining a fixed exchange rate. Which policy is most consistent with this goal? A. Liberalizing capital markets B. Allowing free capital outflows C. Restricting capital outflows

Answer 72

Correct Answer: C Explanation: Restricting outflows prevents domestic capital from chasing higher foreign returns, helping maintain low local interest rates. A is incorrect. Liberalizing markets increases volatility and reduces control. B is incorrect. Free outflows would raise interest rates to retain capital.

Question 73

Which of the following best explains why smaller economies are more likely to use capital controls? A. They lack stock exchanges to attract foreign investment B. Their asset markets are more vulnerable to foreign capital flows C. They do not use exchange rates in monetary policy

Answer 73

Correct Answer: B Explanation: In small economies, even modest foreign capital movement can cause large swings in asset prices. A is incorrect. Capital controls are about flow volatility, not market existence. C is incorrect. Most countries use exchange rates as part of policy decisions.

Question 74

Which of the following statements about capital flow restrictions is most accurate? A. They are used to increase currency flexibility in a floating exchange rate system B. They ensure trade balances are always zero C. They allow governments to stabilize asset markets and support monetary policy

Answer 74

Correct Answer: C Explanation: Capital restrictions help governments stabilize their financial systems and maintain control over monetary and exchange rate policies. A is incorrect. They are typically used in fixed systems to reduce currency flexibility. B is incorrect. Trade balances can still vary even with capital controls.