RobertA

In response to exchange rate volatility, a central bank intervenes in the currency market by buying foreign currencies. What effect will this intervention most likely have on the foreign exchange value of the domestic currency and on the country’s official reserves, respectively?

A) Only one will increase.

B) Both will decrease.

C) Both will increase.

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If the central bank intervenes by buying foreign currencies, then it is selling its domestic currency, which will decrease the domestic currency’s foreign exchange value. Official reserves consist of a government’s foreign currency holdings. Buying foreign currencies will increase official reserves.

RobertA

Which of these statements about international finance is most accurate?

A) Purchasing power parity implies that exchange rates should adjust so that investments in any country offer the same risk-adjusted return.

B) Investments in a country by foreign citizens and foreign investments by that country’s own citizens will be reflected in the capital account.

C) Exchange rates tend to be more volatile than the quantity of a currency traded because the factors that affect the supply of a currency are independent of the factors that affect the demand for a currency.

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The capital account measures the principal value of inward investments by foreign citizens and outward investments by domestic citizens. The idea that investments in any country with the same amount of risk should offer the same return is an implication of interest rate parity, not purchasing power parity. Volatility in exchange rates that is large compared to changes in trading volume arises from the fact that the same factors (domestic interest rates and expected future exchange rates) affect both supply and demand for a currency.

RobertA

Which of the following statements is most accurate?

A) Running a deficit in the current account balance simply means a country imports more than it exports, but a country can do this only for a short time.

B) Capital inflows from foreigners are not bad even if the foreigners buy up domestic real estate, domestic industries and own other productive assets.

C) A nation's current account surplus or deficit is a good measure of the health of its economy.

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All statements except for the capital inflows statement are incorrect. Current account deficits are neither good nor bad and countries can run such deficits for long periods of time. Current account deficits are usually accompanied by financial account surpluses that can sustain current account deficits for long periods.

RobertA

Current account deficits are:

A) the result of a country importing less than it exports.

B) an indication that the economy is growing rapidly.

C) not an indication of a nation's economic health.

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A current account deficit occurs when a country imports more than it exports, and it is not an indication of economic health. There is no requirement that the current account balance be zero, in surplus or in deficit.

RobertA

A current account surplus:

A) occurs when a country exports less than it imports.

B) is an indication of significant foreign investment in the domestic market.

C) is not an indication of a nation's economic health.

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A current account surplus occurs when a country exports more than it imports, and it is not an indication of economic health. There is no requirement that the current account balance be zero, in surplus, or in deficit.

RobertA

Under a flexible exchange rate system, a nation that offers more attractive investment opportunities than its trading partners will be likely to experience a:

A) surplus on current account transactions.

B) deficit on its capital account transactions.

C) deficit on current account transactions.

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Higher interest rates attract foreign investment and discourage domestic investment from leaving the country. Thus, the increased aggregate demand encourages imports, which moves the current account towards deficit.

RobertA

The primary reason why the balance of payments method is difficult to implement in determining exchange rates is that:

A) the timeliness of trade flow data tends to affect the current account more dramatically than the capital account and thus gives rise to volatility in the foreign exchange markets.

B) foreign exchange markets affect trade flows and help determine the values of the balance of payments and not the other way around.

C) data on trade flow elasticity is difficult to obtain and the sensitivity of such trade flows to the movement of exchange rates is not determinable.

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The traditional approach to foreign exchange rate determination suggests that exchange rate adjustments are required to restore balance of payments equilibrium. This is a difficult model to implement, however. An analysis of these potential adjustments requires an estimate of trade flow elasticity in response to movements in exchange rates. Further, the model must be dynamic and complex enough to handle the impact of capital flows and the effect on the balance of payment components. Ultimately, small changes in current account flows cannot substantiate the dramatic points of inflection and volatility in the exchange rate markets, meaning an analysis of the elements of the balance of payments is not useful in explaining how exchange rates are determined.

RobertA

Larry Goren, CFA, is an economist for the Federal Reserve Bank. He is interested in using a country’s balance of payments as a forecasting tool in determining exchange rates. He notices that China has a high current account balance resulting in a large surplus in its balance payments. It can be implied that:

A) China provided a great deal of financial assistance to other nations.

B) China’s international currency reserve holdings have increased.

C) China received a great deal of income flows from the sale of trade merchandise and services and payments on its existing investments.

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A large increase in China’s current account can only mean that it has received income from the sale of its trade merchandise (exports) and payments on its existing investments. Both remaining transactions affect the other elements of the balance of payment accounts. If China lends financial assistance to other nations, it shows up in its capital account and if its foreign currency reserves increase, it shows up in its official reserve account.

RobertA

Under a system of flexible exchange rates, which one of the following is more likely to cause a nation's currency to appreciate on the foreign exchange market?

A) A domestic inflation rate lower than the nation's trading partners.

B) A decrease in real domestic interest rates.

C) A domestic inflation rate higher than the nation's trading partners.

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If a nation's trading partners prices are increasing twice as fast as the domestic country A, then foreign citizens will increase their demand for A's goods. This increased demand will appreciate country A's currency making country A's goods more expensive offsetting the effects of inflation.

RobertA

The U.S. imposes a high tariff on a major imported item. Under a system of flexible exchange rates, this would tend to:

A) cause the dollar to appreciate in value.

B) cause the dollar to depreciate in value.

C) increase the balance of trade deficit of the U.S.

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The demand for imports would decrease due to their higher price because of the tariff. This would cause U.S. exports to increase relative to imports. When a country has increased exports relative to its imports, its currency will appreciate.