LOS o: Contrast the traditional trade approach (J-curve) and the money demand approach to modeling the relationship between real exchange rate changes and domestic economic activity.

Q1. Assume that a country has a negative trade balance. In the traditional model of the impact of currency appreciation on domestic economic activities, what is the likely short-run impact of currency depreciation?

A)   Domestic industry becomes more competitive narrowing the trade balance.

B)   The cost of imports decreases narrowing the trade balance.

C)   The cost of imports increases widening the trade balance.

Q2. According to the traditional model, a decline in the value of a country’s currency has what effect upon national competitiveness in the long run and domestic inflation in the short run?

A)   Both will increase.

B)   Both will decrease.

C)   Only one will increase.

Q3. Suppose a nation’s monetary authority increases real interest rates. What does economic theory tell us will happen to the value of the nation’s currency?

A)   Changes in the nominal rate, not the real rate, cause appreciation.

B)   The value of the currency will fall.

C)   The value of the currency will rise.

Q4. In the money demand model, what is the relationship between appreciation in the domestic currency and the equity markets? Currency appreciation:

A)   is negatively correlated with equity returns.

B)   hurts competitiveness and stock market returns.

C)   is positively correlated with equity returns.

LOS o: Contrast the traditional trade approach (J-curve) and the money demand approach to modeling the relationship between real exchange rate changes and domestic economic activity. fficeffice" />

Q1. Assume that a country has a negative trade balance. In the traditional model of the impact of currency appreciation on domestic economic activities, what is the likely short-run impact of currency depreciation?

A)   Domestic industry becomes more competitive narrowing the trade balance.

B)   The cost of imports decreases narrowing the trade balance.

C)   The cost of imports increases widening the trade balance.

Correct answer is C)

In the short run, if a country’s currency depreciates in real terms, the cost of imports increases causing a widening in the trade balance (exports – imports) and an increase in domestic inflation. Currency depreciation tends to reduce economic activity in the short run.

Q2. According to the traditional model, a decline in the value of a country’s currency has what effect upon national competitiveness in the long run and domestic inflation in the short run?

A)   Both will increase.

B)   Both will decrease.

C)   Only one will increase.

Correct answer is A)

Under the traditional model, a decline in the value of a country’s currency increases national competitiveness in the long run and increases domestic inflation in the short run. This will occur due to an increase in exports for the country whose currency is less valuable. In the short run the cost of imports increases for the country with the decline in currency value.

Q3. Suppose a nation’s monetary authority increases real interest rates. What does economic theory tell us will happen to the value of the nation’s currency?

A)   Changes in the nominal rate, not the real rate, cause appreciation.

B)   The value of the currency will fall.

C)   The value of the currency will rise.

Correct answer is C)

If the monetary authority (e.g., the central bank) increases real rates, capital will flow into the country. The increased demand for the nation's currency will cause the currency to appreciate.

Q4. In the money demand model, what is the relationship between appreciation in the domestic currency and the equity markets? Currency appreciation:

A)   is negatively correlated with equity returns.

B)   hurts competitiveness and stock market returns.

C)   is positively correlated with equity returns.

Correct answer is C)

In the money demand model, an increase in real economic activity leads to an increase in the demand for the domestic currency. The increased currency demand causes the value of the currency to appreciate. Because stock prices are highly correlated with gross domestic product growth, the money demand model explains the positive short-run correlation between exchange rate movements and stock returns.

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