Question 1

If domestic credit is constant, then any change in the demand for money will result in:
A) a change in foreign credit.
B) a change in the rate of interest.
C) an inverse change in the price level.
D) an equal change in foreign currency reserves.

Accepted Answer

The answer of If domestic credit is constant, then any...

Question 2

Emerging markets and developing economies may have to raise domestic rates of interest suddenly if:
A) the supply of money unexpectedly drops.
B) the IMF calls in loans with no warning.
C) the risk premium for its currency rises dramatically.
D) domestic investors wish to repatriate their profits earned overseas.

Accepted Answer

When the risk premium for a country's currency rises dramatically, it means that investors perceive the country as being riskier and demand higher returns to hold its currency. This can lead to a sudden outflow of foreign capital, putting pressure on the currency and leading to inflation. To combat this, the central bank may need to raise interest rates in order to make the country's assets more attractive to foreign investors and stabilize the currency.

Question 3

When the backing ratio is higher, the peg is:
A) less stable.
B) higher.
C) safer.
D) less credible.

Accepted Answer

A higher backing ratio means that there is more reserve currency available to support the pegged currency, making the peg safer because it is better supported against speculative attacks or fluctuations in demand.

Question 4

An economy is better able to withstand a shock to the money demand if:
A) the backing ratio is lower.
B) the country holds more domestic assets.
C) the backing ratio is higher.
D) the country holds fewer reserves.

Accepted Answer

A higher backing ratio means that the country has a larger share of its money supply backed by reserves, making it more capable of withstanding a shock to the money demand. This is because there are more reserves available to satisfy the demand for money, while a lower backing ratio would mean there are fewer reserves to meet the demand. Holding more domestic assets or fewer reserves may not necessarily improve the economy's ability to withstand a shock to money demand.

Question 5

When other emerging market nations experience an exchange rate crisis, it affects healthy emerging market economies (raises risk premiums) because of investor worry. This phenomenon is known as:
A) emerging market dysfunction.
B) the law of like outcomes.
C) experiential judgment.
D) contagion.

Accepted Answer

When an exchange rate crisis in one emerging market spreads to other emerging market economies, it is called contagion. This is because investors become worried about the stability of all emerging markets and may start pulling their investments out of these countries, causing risk premiums to increase.

Question 6

Consider an economy with a fixed exchange rate and money supply equal to 2 billion pesos. The country has 1 billion in reserves and 1 billion in domestic credit. If the output in the country were to increase by 5%, then:
A) the money demand would increase by 10%.
B) the central bank would have to increase reserves by 5%.
C) the central bank would have to decrease reserves by 5%.
D) the central bank would have to decrease domestic credit.

Accepted Answer

With an increase in output, the demand for money is likely to increase as businesses and consumers engage in more transactions. To maintain the fixed exchange rate while accommodating the increased demand for money, the central bank may need to increase its reserves, thereby injecting more money into the economy. This action helps to prevent the currency from appreciating, which would be inconsistent with maintaining a fixed exchange rate.

Question 7

Consider an economy with a fixed exchange rate and money supply equal to 2 billion pesos. The country has 1 billion in reserves and 1 billion in domestic credit. If as a result of some exogenous events, foreign interest rate increases, then the central bank in the home country:
A) will have to decrease the reserves to maintain the peg.
B) will have to decrease the domestic assets.
C) will have to increase the reserves to maintain the peg.
D) will do nothing.

Accepted Answer

When foreign interest rates increase, investors will likely move their capital to foreign assets to take advantage of the higher returns. To maintain the fixed exchange rate (or the peg), the central bank will need to sell foreign currency (from its reserves) in exchange for domestic currency to support the domestic currency's value. This action will decrease the reserves.

Question 8

Which of the following is NOT likely to cause a money demand shock under a fixed exchange rate system?
A) a decline in foreign interest rates
B) a sudden decline in domestic output
C) a sudden increase in domestic output
D) a change in marginal tax rate in the foreign country

Accepted Answer

A change in marginal tax rate in the foreign country is not likely to cause a money demand shock because it does not directly affect the domestic economy or exchange rate. A sudden decline or increase in domestic output can cause a money demand shock as it impacts the demand for money in the economy. A decline in foreign interest rates can cause a money demand shock as it increases the attractiveness of foreign assets, leading to capital outflows and a decrease in the demand for domestic money.

Question 9

Assume the money supply is backed by bonds and reserves, and the exchange rate is pegged. If the demand for money rises, how might the central bank maintain the peg?
A) by selling back domestic bonds and foreign currency reserves
B) by selling domestic bonds equal to the increase in demand
C) by purchasing reserves equal to the increase in demand
D) by selling reserves equal to the increase in demand

Accepted Answer

If the demand for money rises, the central bank can maintain the peg by purchasing reserves equal to the increase in demand. This will increase the supply of money in the economy, which can help meet the higher demand for money. By purchasing reserves, the central bank can also prevent the exchange rate from fluctuating, thus maintaining the peg. Selling back domestic bonds and foreign currency reserves (option A) would reduce the money supply, which might not be desirable if the demand for money is high. Selling domestic bonds equal to the increase in demand (option B) would not necessarily be effective in maintaining the peg, as the exchange rate can still fluctuate in response to changes in the supply and demand for the currency. Selling reserves equal to the increase in demand (option D) would reduce the central bank's ability to intervene in the foreign exchange market and maintain the peg.

Question 10

If a nation's interest rate on foreign currency deposits is higher inside than outside the nation, which of the following is the cause?
A) a fall in the domestic money supply
B) a country premium, meaning investors are concerned about defaults or capital controls
C) a currency premium
D) an exchange rate premium

Accepted Answer

A country premium, meaning investors are concerned about defaults or capital controls, can cause the interest rate on foreign currency deposits to be higher inside a nation than outside the nation. This is because investors demand compensation for the higher risk they perceive in keeping their money within that particular country.

Question 11

Special situations in emerging markets and developing economies, such as volatile output and an export dependent economy, usually mean:
A) the prudent level of reserves is much higher than for higher-income nations.
B) there is no way they are able to maintain an exchange rate peg.
C) pegging exchange rates is even more important.
D) pegging exchange rates is much easier because the economies are smaller.

Accepted Answer

Emerging markets and developing economies are more vulnerable to external shocks and fluctuations, making it important for them to have a higher level of reserves to cushion against any adverse effects on their currencies.

Question 12

If domestic credit is constant and the money supply changes, then:
A) reserves will remain constant.
B) foreign credit will remain constant.
C) reserves will change by a larger percentage than the change in the money supply.
D) foreign interest rates will begin to increase.

Accepted Answer

If domestic credit is constant, then changes in the money supply can only come from changes in reserves. Thus, if the money supply changes but domestic credit is constant, then reserves must also change, and they will change by a larger percentage than the change in the money supply. This relationship is known as the money multiplier effect. Foreign credit and interest rates are not directly related to the domestic credit and money supply situation described in the question.

Question 13

An example in the text of Argentina's convertibility plan during 1993-94 indicated that because of a growing economy, the central bank expanded the supply of money to maintain its U.S. dollar peg by:
A) acquiring foreign reserves.
B) buying domestic bonds.
C) issuing new government liabilities.
D) selling gold.

Accepted Answer

The most effective way for a central bank to maintain a fixed exchange rate is by acquiring foreign reserves. This means buying U.S. dollars (in the case of Argentina's convertibility plan) and holding them as a reserve to defend the exchange rate if necessary. Buying domestic bonds or issuing new government liabilities would increase the domestic money supply and potentially lead to inflation, which would undermine the exchange rate peg. Selling gold is generally not a preferred option for a central bank, as it reduces its overall reserve holdings and may not be as liquid as foreign currencies.

Question 14

Uncovered interest parity may actually result in domestic interest rates being ____ than foreign rates because of investors' perceived risk of holding assets based in the domestic currency.
A) lower
B) more unstable
C) higher
D) more stable

Accepted Answer

Uncovered interest parity suggests that the expected return on domestic assets should be equal to the expected return on foreign assets in a world without currency risk. However, investors may perceive greater risk in holding assets denominated in the domestic currency, leading them to demand higher returns to compensate for that risk. This can result in domestic interest rates being higher than foreign interest rates, despite uncovered interest parity.

Question 15

To what does global contagion refer?
A) an equalization of world interest rates
B) elimination of risk premiums between countries
C) adverse changes in market sentiment based on events in faraway places
D) switching to fixed exchange rates by emerging market economies

Accepted Answer

Global contagion refers to the spread of adverse changes in market sentiment based on events that occur in faraway places. It can result in a widespread sell-off of assets across different markets and countries.

Question 16

The risk premium is the difference between foreign and domestic rates of interest under parity. This premium has three distinct parts. Which of the following is NOT a factor in the risk premium?
A) the currency premium
B) the country premium
C) the default risk premium
D) the floating risk premium

Accepted Answer

The floating risk premium is not a factor in the risk premium. The three distinct parts of the risk premium include the currency premium (reflecting the expected change in exchange rates), the country premium (reflecting potential political and economic risks in the foreign country), and the default risk premium (reflecting the likelihood of default by the foreign borrower).

Question 17

A ratio indicating how safe the peg is from breaking is calculated by _______ and is called ________.
A) foreign reserves as a percent of GDP; the safety margin
B) foreign reserves as a percent of the total money supply; the backing ratio
C) money demand as a percent of money supply; the financial adequacy quotient
D) foreign reserves as a percent of domestic credit; the marginal propensity to break

Accepted Answer

The ratio indicating the safety of the peg from breaking would be calculated by dividing foreign reserves by the total money supply and is therefore known as the backing ratio. Option A is incorrect because it compares foreign reserves to the GDP which is a measure of the size of the economy and not relevant to peg safety. Option C is incorrect because it compares money demand to money supply which is not relevant to peg safety. Option D is incorrect because it refers to the marginal propensity to break which is not a commonly used term in this context.

Question 18

What is a problem in emerging markets that affects a nation's ability to peg its currency?
A) The low level of GDP means the demand for money is always small.
B) The high level of GDP means the demand for money is always large.
C) As the nation develops, the ratio of the demand for money to GDP rises.
D) Because of the volatility of GDP, the demand for money is volatile and the nation must hold higher levels of reserves to peg.

Accepted Answer

The volatility of GDP in emerging markets makes the demand for money more volatile, which makes it difficult for a nation to peg its currency. As a result, the nation must hold higher levels of reserves to stabilize the currency.

Question 19

Whenever a nation opts to back its fixed exchange rate 100% with foreign currency reserves, it is known as:
A) a floating rate system.
B) a currency peg.
C) a currency board.
D) a full concentration ratio.

Accepted Answer

When a nation backs its fixed exchange rate 100% with foreign currency reserves, it is known as a currency board. A currency peg refers to a country's commitment to keep its currency at a fixed exchange rate with another currency, while a floating rate system allows the exchange rate to fluctuate based on market forces. Full concentration ratio, on the other hand, is a term used in economics to describe the degree of market share concentration in an industry.

Question 20

When the central bank adopts a currency board, it is considered ______, because a shock to money demand _______.
A) a hard peg; can be covered at any level without a change in domestic credit
B) a soft peg; can be absorbed by a change in domestic credit
C) a reversion to floating rates; is impossible
D) the reinstatement of a gold standard; cannot be covered any other way

Accepted Answer

When the central bank adopts a currency board, it is considered a hard peg because the exchange rate is fixed permanently, and a shock to money demand can be covered at any level without a change in domestic credit. In a currency board system, the central bank not only pegs the exchange rate but also commits to exchange domestic currency for a specified foreign currency at a fixed exchange rate. It must hold foreign exchange reserves equal to the amount of domestic currency in circulation that is backed by foreign currency. This means that the central bank cannot issue more domestic currency than it has foreign currency reserves, hence maintaining the exchange rate.

Quiz 20: Exchange Rate Crises: How Pegs Work and How They Break

If domestic credit is constant, then any change in the demand for money will result in:

Emerging markets and developing economies may have to raise domestic rates of interest suddenly if:

When the backing ratio is higher, the peg is:

An economy is better able to withstand a shock to the money demand if:

When other emerging market nations experience an exchange rate crisis, it affects healthy emerging market economies (raises risk premiums) because of investor worry. This phenomenon is known as:

Consider an economy with a fixed exchange rate and money supply equal to 2 billion pesos. The country has 1 billion in reserves and 1 billion in domestic credit. If the output in the country were to increase by 5%, then:

Consider an economy with a fixed exchange rate and money supply equal to 2 billion pesos. The country has 1 billion in reserves and 1 billion in domestic credit. If as a result of some exogenous events, foreign interest rate increases, then the central bank in the home country:

Which of the following is NOT likely to cause a money demand shock under a fixed exchange rate system?

Assume the money supply is backed by bonds and reserves, and the exchange rate is pegged. If the demand for money rises, how might the central bank maintain the peg?

If a nation's interest rate on foreign currency deposits is higher inside than outside the nation, which of the following is the cause?

Special situations in emerging markets and developing economies, such as volatile output and an export dependent economy, usually mean:

If domestic credit is constant and the money supply changes, then:

An example in the text of Argentina's convertibility plan during 1993-94 indicated that because of a growing economy, the central bank expanded the supply of money to maintain its U.S. dollar peg by:

Uncovered interest parity may actually result in domestic interest rates being ____ than foreign rates because of investors' perceived risk of holding assets based in the domestic currency.

To what does global contagion refer?

The risk premium is the difference between foreign and domestic rates of interest under parity. This premium has three distinct parts. Which of the following is NOT a factor in the risk premium?

A ratio indicating how safe the peg is from breaking is calculated by _ and is called __.

What is a problem in emerging markets that affects a nation's ability to peg its currency?

Whenever a nation opts to back its fixed exchange rate 100% with foreign currency reserves, it is known as:

When the central bank adopts a currency board, it is considered , because a shock to money demand _.