Question

1. Which of the following is true of flexible exchange rates?

a. Their value is tied to gold

b. most countries have used flexible exchange rates since the 70s

c. they require constant central bank management

d. they are the best form of exchange rate

2. In order to credibly defend a fixed currency central banks need U?

a. full employment

b. low inflation

c. adequate reserves

d. political independence

3. how might the central bank intervene in FX markets to prevent a depreciation?

a. sell domestic currency and buy FX

b. Buy domestic currency and sell FX

c. do nothing, laissez-faire

d. adopt the foreign currency as the new national currency

4. according to the theory of optima currency areas, which of the following might be a good reasons to link your currency with that of another country?

a. both countries experience symmetric economic shocks

b. both countries experience asymmetric economic shocks

c. immigration is difficult between coutnries

d. one country has high inflation, the other does not

Answer 1

1. Answer: b. most countries have used flexible exchange rates since the 70s

The shift from fixed to more flexible exchange rates has been gradual, dating from the breakdown of the Bretton Woods system of fixed exchange rates in the early 1970s, when the world’s major currencies began to float.

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2. Answer: c. adequate reserves

In a fixed exchange rate system, a country’s central bank typically uses an open market mechanism and is committed at all times to buy and/or sell its currency at a fixed price in order to maintain its pegged ratio and, hence, the stable value of its currency in relation to the reference to which it is pegged. Therefore adequate reserves are required.

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3. Answer: b. Buy domestic currency and sell FX

The central bank can reduce the value of a currency by flooding the market with it. A rise in the supply of a specific currency will lead to its depreciation in value. Conversely, the central bank can raise the value of a currency by purchasing large amounts of it. The increased demand for the currency will cause it to appreciate.

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4. Answer: a. both countries experience symmetric economic shocks

An optimal currency area (OCA) is the geographic area in which a single currency would create the greatest economic benefit. The case for separate currency areas clearly holds good only if the impact of a shock varies between areas: i.e. is asymmetric. If the impact were to be the same on all, the exchange-rate changes needed for adjustment would be the same for all, in which case separate currencies would serve no purpose. OCA theory indeed implies that any two countries generally experiencing symmetric shocks, and trading significant proportions of their GDP bilaterally, should fix their exchange rates.