Reading 17- LOS b ～ Q1－6

1.Which one of the following factors will most likely cause a country’s domestic currency to appreciate on the foreign exchange market? An increase in:

A)   its exports relative to its imports.

B)   its domestic rate of inflation.

C)   the real rate of interest in others countries.

D)   the amount of assets the country has purchased from foreigners (i.e., the country’s foreign investment).

The correct answer was A)

If a country’s exports are increasing at a faster rate than its imports it means that its exports are being purchased by foreigners at a faster rate than imports from abroad are being purchased by domestic consumers. In order for foreigners to buy a country’s exports they must first buy the exporting country’s currency causing it to appreciate. An increase in the domestic rate of inflation, real interest rates in other countries and the nation’s foreign investments will all lead to depreciation of a country’s domestic currency on the foreign exchange market.

2.Phil Howell, a foreign exchange trader, makes the following two statements about foreign exchange rates:

Statement 1: A decrease in the expected future exchange value of a currency will increase supply and decrease demand for that currency.

Statement 2: Interest rate parity is the idea that exchange rates will adjust to reflect the difference in inflation rates between different countries.

Are Howell’s statements correct?

                  Statement 1              Statement 2

A)        Correct                               Correct

B)        Incorrect                             Correct

C)        Incorrect                             Incorrect

D)        Correct                               Incorrect

The correct answer was D)

Statement 1 is correct. A decrease in the expected future exchange rate has opposite effects on the supply and demand for a currency, decreasing demand for the currency and increasing its supply on the foreign exchange market. Statement 2 is incorrect. The idea that exchange rates will adjust to reflect the difference in inflation rates between different countries is purchasing power parity.

3.Which of the following would increase the supply of dollars in foreign exchange markets? The:

A)   sale of U.S. made automobiles to Vietnamese consumers.

B)   purchase of 100,000 shares of GE common stock by a Japanese pension fund.

C)   sale of a U.S. company to a Dutch investor.

D)   purchase of Korean televisions by an American distributor.

The correct answer was D)

If an American distributor is purchasing Korean televisions, then the distributor will need to sell dollars and purchase won. This action will supply dollars to the foreign exchange market. The sale of U.S. automobiles to Vietnamese consumers would increase the demand for dollars as Vietnamese consumers sell dongs and buy dollars. The purchase of 100,000 shares of GE common stock would increase the demand for dollars in the foreign exchange market as the Japanese pension fund sells yen and buys dollars. The sale of a U.S. company to a Dutch investor would also increase the demand for the dollar in the foreign exchange market and increase the supply of euros as the Dutch investor sells euros and buys dollars.

4.If a German electronics manufacturer builds an electronics plant in Mexico, this action will create which of the following with regards to the demand and supply of the euro and the peso in the foreign exchange market? This action creates a:

A)   supply of pesos and demand for euros in the foreign exchange market.

B)   demand for pesos and a supply of euros in the foreign exchange market.

C)   supply of both pesos and euros in the foreign exchange market.

D)   demand for both pesos and euros in the foreign exchange market.

The correct answer was B)

Building an electronics plant in Mexico will require the German electronics manufacturer to pay for expenses (construction fees, salaries, administrative expenses, etc.) associated with the project in pesos. Therefore, the manufacturer will need to convert euros to pesos thereby increasing the supply of euros in the foreign exchange market and increasing the demand for pesos.

5.A country’s real interest rate has declined relative to its major trading partners. What will most likely be the effects on the demand for the country’s currency and on aggregate demand?

          Demand for currency           Aggregate demand

A)        Decrease                               Decrease

B)        Increase                                 Increase

C)        Decrease                               Increase

D)        Increase                                 Decrease

The correct answer was C)

A decrease in a country’s domestic interest rates relative to those of other countries will cause demand for its currency to decrease because investments denominated in that currency become relatively less attractive. The resulting decrease in the value of its currency will lead to greater demand for its exports and less imports, so net exports, and therefore aggregate demand, will increase.

6.The Japanese government has decided that it wants to maintain a constant exchange rate with the U.S. dollar at a time when supply and demand conditions in the foreign exchange market are causing the Japanese yen to appreciate. Which of the following actions would most likely achieve their objective?

A)   A shift to a more expansionary monetary policy.

B)   A shift to a more restrictive monetary policy.

C)   Increase its tariffs and restrictive quotas.

D)   Reduce taxes and create a budget deficit in order to increase domestic interest rates.

The correct answer was A)

If the Japanese government wants to maintain a constant exchange rate between yen and the U.S. dollar, then it would most likely shift to a more expansionary monetary policy, decrease its tariffs, or eliminate its quotas. A more expansionary monetary policy will decrease real yen interest rates, reducing investment by foreigners in Japan (decrease yen demand), and increasing investment abroad by Japanese investors (increases yen supplied).