CFA Level 2 - Economics Session 4 - Reading 17 The Exchange Rate and the Balance of Payments - LOS c 1. 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 conditionsin the foreign exchange market are causing theJapanese yen to appreciate. Which of the followingactions would most likely achieve their objective? A) A shift to a more expansionary monetary policy. B) Reduce taxes and create a budget deficit in order toincrease domestic interest rates.C) A shift to a more restrictive monetary policy Explanation: If the Japanese government wants tomaintain a constant exchange rate between yen and theU.S. dollar, then it would most likely shift to amore expansionary monetary policy, decrease itstariffs, or eliminate its quotas. A more expansionarymonetary policy will decrease real yen interestrates, reducing investment by foreigners in Japan(decrease yen demand), and increasing investmentabroad by Japanese investors (increases yen supplied) 2. A country’s real interest rate has declined relative to its major trading partners. What willmost likely be the effects on the demand for thecountry’s currency and on aggregate demand,respectively?
A) Both will decrease.B) Both will increase. C) Only one will increase Explanation: A decrease in a country’s domesticinterest rates relative to those of other countrieswill cause demand for its currency to decreasebecause investments denominated in that currencybecome relatively less attractive. The resultingdecrease in the value of its currency will lead togreater demand for its exports and less imports, sonet exports, and therefore aggregate demand, willincrease 3. If a German electronics manufacturer builds an electronics plant in Mexico, this action will createwhich of the following with regard to the demand andsupply of the euro and the peso in the foreignexchange market? This action creates a: A) demand for both pesos and euros in the foreign exchangemarket. B) demand for pesos and a supply of euros in theforeign exchange market. C) supply of pesos and demand for euros in the foreignexchange market Explanation: Building an electronics plant in Mexicowill require the German electronics manufacturer topay for expenses (construction fees, salaries,administrative expenses, etc.) associated with theproject in pesos. Therefore, the manufacturer willneed to convert euros to pesos thereby increasing thesupply of euros in the foreign exchange market andincreasing the demand for pesos
4. Which of the following would increase the supply of dollars in foreign exchange markets? The: A) purchase of Korean televisions by an Americandistributor. B) sale of a U.S. company to a Dutch investor.C) sale of U.S. made automobiles to Vietnamese consumers Explanation: If an American distributor is purchasingKorean televisions, then the distributor will need tosell dollars and purchase won. This action willsupply dollars to the foreign exchange market. Thesale of U.S. automobiles to Vietnamese consumerswould increase the demand for dollars as Vietnameseconsumers sell dongs and buy dollars. The sale of aU.S. company to a Dutch investor would also increasethe demand for the dollar in the foreign exchangemarket and increase the supply of euros as the Dutchinvestor sells euros and buys dollars 5. Which one of the following factors will most likely cause a country’s domestic currency toappreciate on the foreign exchange market? Anincrease in: A) the real rate of interest in others countries. B) its exports relative to its imports. C) its domestic rate of inflation Explanation: If a country’s exports are increasing ata faster rate than its imports it means that itsexports are being purchased by foreigners at a fasterrate than imports from abroad are being purchased bydomestic consumers. In order for foreigners to buy acountry’s exports they must first buy the exportingcountry’s currency causing it to appreciate. Anincrease in the domestic rate of inflation and real
interest rates in other countries will each lead todepreciation of a country’s domestic currency on theforeign exchange market