CHAPTER 2

1. The international monetary system can environment in which exchange rate changes
be defined as the institutional framework may adversely affect their competitive
within which positions in the marketplace. This situation, in
A. international payments are made. turn, makes it necessary for many firms to
B. movement of capital is accommodated. A. carefully manage their exchange risk
C. exchange rates among currencies are exposure.
determined. B. carefully measure their exchange risk
2. Corporations today are operating in an exposure.
3. The international monetary system went through several distinct stages of evolution. These stages
are summarized, in alphabetic order, as follows:
(i)- Bimetallism
(ii)- Bretton Woods system (iii)-
Classical gold standard
(iv)- Flexible exchange rate regime (v)-
Interwar period
The chronological order that they actually occurred $35 per ounce. This implies an exchange
is: (i), (iii), (v), (ii), and (iv) rate of $1.75 per pound. If the current
4. In the United States, bimetallism was market exchange rate is $1.80 per pound,
adopted by the Coinage Act of 1792 and
how would you take advantage of this
remained a legal standard until 1873, when
Congress dropped the silver dollar from situation? Hint: assume that you have
the list of coins to be minted. $350 available for investment.
The monetary system of bimetallism is  Start with $350. Buy 10 ounces of gold with
unstable. Due to the fluctuation of the dollars at $35 per ounce. Convert the gold to
commercial value of the metals, the metal £200 at £20 per ounce. Exchange the £200 for
dollars at the current rate of $1.80 per pound to
with a commercial value higher than the get $360.
currency value tends to be used as metal 8. Suppose that the pound is pegged to gold at
and is withdrawn from circulation as £20 per ounce and the dollar is pegged to
money (Gresham's Law). gold at
5. In the 1850s the French franc was valued by $35 per ounce. This implies an exchange
both gold and silver, under the official French rate of $1.75 per pound. If the current
ratio which equated a gold franc to a silver market exchange rate is $1.60 per pound,
franc 15½ times as heavy. At the same time, how would you take advantage of this
the gold from newly discovered mines in situation? Hint: assume that you have
California poured into the market, depressing
$350 available for investment.
the value of gold. As a result, the franc
effectively became a gold currency Start with $350. Exchange the dollars for
6. Gresham's Law states that bad money pounds at the current rate of $1.60 per pound.
drives good money out of circulation. Buy gold with pounds at £20 per ounce.
7. Suppose that the pound is pegged to gold at Convert the gold to dollars at $35 per ounce.
£20 per ounce and the dollar is pegged to 9. Suppose that the United States is on a
gold at bimetallic standard at $30 to one ounce of gold
and $2 for one ounce of silver. If new silver
 mines open and flood the market with silver, international means of payment and the
=>only the silver currency will circulate. exchange rates among currencies are
10. Suppose that your country officially determined by either their gold or silver
defines gold as ten times more valuable than contents. Suppose that the dollar was pegged to
silver (i.e. the central bank stands ready to gold at $20 per ounce, the Japanese yen is
redeem the currency in gold and silver and the pegged to gold at 120,000 yen per ounce and to
official price of gold is ten times the official silver at 8,000 yen per ounce of silver, and the
price of silver). If the market price of gold is Australian dollar is pegged to silver at $5 per
only eight times as much as silver. =>The ounce of silver. What would the exchange rate
central bank could go broke if enough between the U.S. dollar and Australian dollar be
arbitrageurs attempt to take advantage of under this system? $1 U.S. = $3 Australian
the pricing disparity 15. The United States adopted the gold standard
Prior to the 1870s, both gold and silver were in 1879.
used as international means of payment and the 16. The gold standard still has ardent supporters
who believe that it provides an effective
exchange rates among currencies were
hedge against price inflation.
determined by either their gold or silver 17. One potential drawback of the gold standard
contents. is that the world economy can be subject
11. Suppose that the dollar was pegged to gold at to deflationary pressure due to the
$30 per ounce, the French franc is pegged to limited supply of monetary gold.
gold at 90 francs per ounce and to silver at 9 18. The first full-fledged gold standard was not
francs per ounce of silver, and the German mark established until 1821 in Great Britain,
pegged to silver at 1 mark per ounce of silver. when notes from the Bank of England
What would the exchange rate between the U.S. were made fully redeemable for gold.
dollar and German mark be under this system? 19. An "international" gold standard can be said
1 German mark = $3 to exist when
12. Prior to the 1870s, both gold and silver were A. gold alone is assured of unrestricted coinage.
used as international means of payment and the B. there is two-way convertibility between gold
exchange rates among currencies were and national currencies at stable ratios.
determined by either their gold or silver C. gold may be freely exported or imported
contents. Suppose that the dollar was pegged to 20. Under a gold standard, if Britain
gold at $30 per ounce, the French franc is exported more to France than France
pegged to gold at 90 francs per ounce and to exported to Great Britain,
silver at 6 francs per ounce of silver, and the A. such international imbalances of payment
German mark pegged to silver at 1 mark per will be corrected automatically.
ounce of silver. What would the exchange rate B. this type of imbalance will not be able to
between the U.S. dollar and German mark be persist indefinitely.
under this system? 1 German mark = $2 C. net export from Britain will be accompanied
13. Suppose that country A and country B are by a net flow of gold in the opposite
both on a bimetallic standard. In country A the direction.
ratio is 15 to one (i.e. an ounce of gold is worth 21. Suppose that Britain pegs the pound to
15 times as much as an ounce of silver in that gold at six pounds per ounce, whereas the
currency), while in country B the ratio is ten to exchange rate between pounds and U.S.
one. If the free flow of capital is allowed dollars is $5 = £1. What should an ounce of
between countries A and B is this a sustainable gold be worth in U.S. dollars?$30.00
framework? No 22. During the period of the classical gold
14. Suppose that both gold and silver are used as standard (1875-1914) there were stable
 exchange rates. matching inflows and outflows of gold
23. The majority of countries got off gold in respectively with reductions and increases
1914 when World War I broke out in domestic money and credit.
24. Suppose that the British pound is pegged to 30. The price-specie-flow mechanism will
gold at £6 per ounce, whereas one ounce of work only if governments are willing to play
gold is worth €12. Under the gold standard, by the rules of the game by letting the money
any misalignment of the exchange rate will be stock rise and fall as gold flows in and out.
automatically corrected by cross border flows Once the government demonetizes
of gold. Calculate the possible gains for (neutralizes) gold, the mechanism will break
buying down. In addition, the effectiveness of the
€1,000, if the British pound becomes mechanism depends on the price elasticity of
undervalued and trades for €1.80. (Assume zero the demand for imports.
shipping costs). 31. During the period between World War I
(Hint: Gold is first purchased using the and World War II, the political reality was
devalued British pound from the Bank of characterized by panicky flights of capital
England, then shipped to France and sold for across borders.
€1,000 to the Bank of France). 32. At the outbreak of World War I,major
A. £55.56 countries such as Great Britain, France,
25. Suppose that Britain pegs the pound to Germany and Russia imposed embargoes
gold at the market price of £6 per ounce, and the on the export of gold.
United States pegs the dollar to gold at the A. The core of the Bretton Woods system was
market price of $36 per ounce. If the official the World Bank.
exchange rate between pounds and U.S. dollars 33. The Bretton Woods system was named after
is $5 = £1. Which of the following trades is Bretton Woods, New Hampshire, where the
profitable? Articles of Agreement of the International
Start with $500 and trade for £100 at the Monetary Fund (IMF) were hammered out.
official exchange rate. Redeem the £100 for 16 34. The Bretton Woods agreement resulted in
2/3 ounces of gold. Trade the gold for $600. the creation of the World Bank.
26. Assume that a country is on the gold 35. The Triffin paradox
standard. In order to support unrestricted A. was first proposed by Professor Robert
convertibility into gold, banknotes need to be Triffin.
backed by a gold reserve of some minimum B. warned that the gold-exchange system of
stated ratio. In addition, the domestic money the Bretton Woods agreement was
stock should rise and fall as gold flows in programmed to collapse in the long run.
and out of the country. C. was indeed responsible for the eventual
27. Under the gold standard, international collapse of the dollar-based gold-exchange
imbalances of payment will be corrected system in the early 1970s.
automatically under the Price-specie-flow 36. Under the Bretton Woods system
mechanism A. there was an explicit set of rules about the
28. During the period between World War I conduct of international monetary policies.
and World War II,the U.S. dollar emerged as B. each country was responsible for
the dominant world currency, gradually maintaining its exchange rate within 1
replacing the British pound for the role. percent of the adopted par value by
29. During the period between World War I buying or selling foreign exchanges as
and World War II, many central banks necessary.
followed a policy of sterilization of gold by C. the U.S. dollar was the only currency that
 was fully convertible to gold. it is comprised of.
37. Under the Bretton Woods system each C. used in addition to gold and foreign
country established a par value for its exchanges, to make international payments.
currency in relation to the dollar. And the 45. The
U.S. dollar was pegged to gold at $35 per Bretton
ounce. Woods
38. Under the Bretton Woods system, system
each country was responsible for ended in
maintaining its exchange rate within 1973
1 percent of the adopted par value 46. Since the end of the fixed exchange rate
by buying or selling foreign system of the Smithsonian
exchanges as necessary agreement,exchange rates have been
39. Under the Bretton Woods system, the U.S. allowed to float.
dollar was the only currency that was 47. Since the SDR is a "portfolio" of currencies
fully convertible to gold; other currencies its value tends to be more stable than the
were not directly convertible to gold value of any of the individual currencies
40. In 1963, President John Kennedy included in the SDR.
imposed the Interest Equalization Tax 48. Put the following in correct date order:
(IET) on U.S. purchases of foreign Bretton Woods Agreement, Smithsonian
securities. The IET was designed to Agreement, Jamaica Agreement.
increase the cost of foreign borrowing 49. Put the following in correct date order:
in the U.S. bond market Jamaica Agreement, Plaza Agreement,
41. The growth of the Eurodollar market, which Louvre Accord.
is a transnational, unregulated fund market 50. The G-7 is composed of Canada, France,
=>was encouraged by U.S. legislation designed Japan, Germany, Italy, the U.K., and the
to stem the outflow of dollars from the U.S. United States.
42. In the years leading to the collapse of the 51. Gold was officially abandoned as an
Bretton Woods system it became clear that international reserve asset in the January
the dollar was overvalued. 1976 Jamaica Agreement.
43. Under the Bretton Woods system 52. Following the demise of the Bretton Woods
A. each country established a par value for its system, the IMF,created a new role for
currency in relation to the dollar. itself, providing loans to countries facing
B. the U.S. dollar was pegged to gold at $35 per balance-of-payments and exchange rate
ounce. difficulties.
C. each country was responsible for 53. Under a flexible exchange rate
maintaining its exchange rate within 1 regime, governments can retain
percent of the adopted par value by monetary policy independence
buying or selling foreign exchanges as because the external balance will be
necessary. achieved by the exchange rate
44. Special Drawing Rights (SDR) are adjustments
A. an artificial international reserve allotted to 54. The choice between the alternative
the members of the International Monetary exchange rate regimes (fixed or floating) is
Fund (IMF), who can then use it for likely to involve a trade-off between
transactions among themselves or with the national monetary policy autonomy and
IMF. international economic integration
B. a "portfolio" of currencies, and its value 55. Under a purely flexible exchange rate
tends to be more stable than the currencies that system,supply and demand set the
 exchange rates. countries collectively manage their exchange
56. A currency board arrangement is a rates.
monetary regime based on an explicit B. based on a "parity-grid" system, which is a
legislative commitment to exchange system of par values among ERM countries.
domestic currency for a specified foreign 65. The Maastricht Treaty
currency at a fixed exchange rate, A. irrevocably fixed exchange rates among the
combined with restrictions on the issuing member currencies.
authority to ensure the fulfillment of its B. commits the members of the European Union
legal obligation. to political union as well as monetary union.
57. Ecuador does not have its own national C. was signed and subsequently ratified by the
currency, circulating the U.S. dollar instead. 12 member states.
About how many countries do not have their 66. The single European currency, the euro,
own national currency? =>40 was adopted by 11 member nations on January
58. With regard to the current exchange rate 1 of what year? 1999
arrangement between the U.S. and the U.K., it is 67. Benefits from adopting a common European
best characterized as independent floating currency include
(market determined). A. reduced transaction costs.
59. With regard to the current exchange rate B. elimination of exchange rate risk.
arrangement between Italy and Germany, it is C. increased price transparency that will
best characterized as an exchange promote Europe-wide competition.
arrangement with no separate legal tender 68. Monetary policy for the countries using the
60. On January 1, 1999, an epochal event took euro as a currency is now conducted by
place in the arena of international finance European Central Bank.
when 69. Following the introduction of the euro, the
 eleven of 15 EU countries adopted a common national central banks of the euro-12 nations
currency called the euro. A. formed the ESCB, which is analogous to the
61. The advent of the euro marks the first time Federal Reserve System in the U.S.
that sovereign countries have voluntarily B. continue to perform important functions in
given up their monetary independence to their jurisdictions.
foster economic integration. 70. The main cost of European monetary union
62. To pave the way for the European is the loss of national monetary and
Monetary Union, the member countries of the exchange rate policy independence.
European Monetary System agreed to achieve 71. The euro zone is remarkably comparable to
a convergence of their economies. Which of the United States in terms of population
the following is NOT a condition of size.
convergence: maintain its currency at a 72. Which country is NOT using the euro?
fixed exchange rate to the ERM. Sweden
63. The European Monetary System (EMS) has 73. Once the changeover to the euro was
the chief objective(s) completed by July 1, 2002, the legal-tender
A. to establish a "zone of monetary stability" in status of national currencies in the euro zone
Europe. was canceled, leaving the euro as the sole
B. to coordinate exchange rate policies vis-à-vis legal tender in the euro zone countries.
the non-EMS currencies. 74. According to the theory of optimum
C. to pave the way for the eventual European currency areas, the relevant criterion for
monetary union. identifying and designing a common
64. The Exchange Rate Mechanism (ERM) is currency zone is the degree of factor (i.e.
A. the procedure by which ERM member capital and labor) mobility within the
 zone. weak, underdeveloped domestic
75. Willem Duisenberg, the first financial system tends to create an
president of the European Central Bank, environment susceptible to currency
defined "price stability" as an annual and financial crises.
inflation rate of "less than but close to
2 percent."
76. Robert A. Mundell won the Nobel Memorial
Prize in Economic Science. He was
one of the intellectual fathers of both the new
European common currency and Reagan-era
Keynesian economics.
77. In the EU, there is a low degree of fiscal
integration among EU countries.
78. When money can move freely across
borders, policy makers must choose
between
exchange-rate stability and an independent
monetary policy.
79. The Mexican Peso Crisis was touched off by
an unexpected announcement by the
Mexican government to devalue to peso
against the dollar by 14 percent.
80. Prior to the peso crisis, Mexico
depended on foreign portfolio capital
to finance its economic development.
This foreign capital influx
A. caused higher domestic inflation.
B. led to an overvalued peso.
81. The Mexican peso crisis is significant in that
A. it is perhaps the first serious international
financial crisis touched off by cross-border
flight of portfolio capital.
B. selling by international portfolio managers
had a highly destabilizing, contagious effect
on the world financial system.
C. it provides a cautionary tale that as
the world's financial markets are
becoming more integrated, this type of
contagious financial crisis is likely to
occur more often.
82. The Asian Currency Crisis turned out to be
far more serious than the Mexican peso
crisis in terms of the extent of contagion.
83. Generally speaking, liberalization of
financial markets when combined with a