Macroeconomics Quiz: Foreign Exchange Markets
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Foreign Exchange MarketsQuestion 1 of 20

According to purchasing power parity theory, if Country X has an inflation rate of 8% while Country Y has an inflation rate of 3%, and the current exchange rate is 2 units of X's currency per 1 unit of Y's currency, what should the exchange rate be after one year?

Approximately 2.10 units of X's currency per 1 unit of Y's currency
Approximately 1.90 units of X's currency per 1 unit of Y's currency
Approximately 2.16 units of X's currency per 1 unit of Y's currency
Approximately 1.84 units of X's currency per 1 unit of Y's currency
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Macroeconomics Quiz

Macroeconomics Quiz: Foreign Exchange Markets

Practice Foreign Exchange Markets in Macroeconomics with focused quiz questions that help you check what you know, review explanations, and build confidence with test-style prompts.

What this quiz covers

This quiz focuses on Foreign Exchange Markets, giving you a quick way to practice the rules, question types, and explanations that matter most for Macroeconomics.

How to use this quiz

Try each quiz question before looking at the correct answer. Use the explanations to review missed ideas, then come back to similar questions until the pattern feels familiar.

All questions

Question 1

According to purchasing power parity theory, if Country X has an inflation rate of 8% while Country Y has an inflation rate of 3%, and the current exchange rate is 2 units of X's currency per 1 unit of Y's currency, what should the exchange rate be after one year?

  1. Approximately 2.10 units of X's currency per 1 unit of Y's currency (correct answer)
  2. Approximately 1.90 units of X's currency per 1 unit of Y's currency
  3. Approximately 2.16 units of X's currency per 1 unit of Y's currency
  4. Approximately 1.84 units of X's currency per 1 unit of Y's currency
Explanation: According to PPP, the currency of the country with higher inflation should depreciate relative to the country with lower inflation by approximately the inflation differential. Country X has 5 percentage points higher inflation (8% - 3% = 5%), so X's currency should depreciate by about 5%. Starting at 2.00, the new rate should be 2.00 × (1.05) = 2.10. Choice B shows appreciation instead of depreciation. Choice C uses an incorrect calculation method. Choice D shows excessive depreciation.

Question 2

An emerging market economy maintains a crawling peg exchange rate system where the currency is devalued by 0.5% monthly against the U.S. dollar. If the current exchange rate is 20 domestic currency units per dollar and annual inflation in the emerging market is 15% while U.S. inflation is 3%, what is the likely outcome after one year?

  1. The real exchange rate will depreciate by approximately 6%, improving export competitiveness beyond the nominal devaluation
  2. The real exchange rate will appreciate by approximately 6%, making exports less competitive despite the crawling peg (correct answer)
  3. The real exchange rate will remain constant because the crawling peg exactly matches the inflation differential
  4. The real exchange rate will depreciate by approximately 12%, significantly improving export competitiveness over the year
Explanation: When analyzing crawling peg exchange rate systems, you need to distinguish between nominal and real exchange rates. The nominal rate is what's officially set, while the real rate accounts for inflation differentials between countries and determines actual competitiveness. Let's calculate what happens over one year. The crawling peg devalues the currency by 0.5% monthly, which compounds to approximately 6% annually (0.5% × 12 ≈ 6%). So the nominal exchange rate moves from 20 to about 21.2 units per dollar. However, the real exchange rate depends on relative inflation. The emerging market has 15% inflation versus 3% in the U.S., creating a 12% inflation differential. This means domestic prices are rising much faster than the 6% nominal devaluation rate. The real exchange rate change equals the nominal change minus the inflation differential: 6% - 12% = -6%. This negative result indicates a real appreciation of 6%, making exports less competitive despite the nominal devaluation. Answer B captures this outcome correctly. Answer A incorrectly suggests real depreciation and improved competitiveness. Answer C wrongly assumes the crawling peg matches the inflation differential (6% ≠ 12%). Answer D dramatically overstates the real depreciation by confusing it with the inflation differential. Key takeaway: In crawling peg questions, always compare the devaluation rate to the inflation differential. If domestic inflation exceeds the devaluation rate, the real exchange rate appreciates, hurting export competitiveness regardless of the nominal policy.

Question 3

In the foreign exchange market, the bid price for British pounds is $1.2580/£ and the ask price is $1.2590/£. A currency trader believes the pound will appreciate and wants to profit from this view. If the trader's prediction is correct and the bid-ask spread remains constant, what must happen for the trader to earn a profit?

  1. The pound must appreciate by more than the bid-ask spread of $0.0010 to overcome transaction costs
  2. The new ask price must exceed $1.2590/£ since the trader must sell at the ask price after buying at the bid price
  3. The new bid price must exceed $1.2580/£ since the trader can buy at the bid price and sell at the ask price
  4. The new bid price must exceed $1.2590/£ since the trader must buy at the ask price and later sell at the bid price (correct answer)
Explanation: When analyzing currency trading scenarios, you need to understand bid-ask spreads and transaction costs. The bid price is what dealers will pay you for currency, while the ask price is what they charge you to buy currency. As a trader, you always face the unfavorable side: you buy at the higher ask price and sell at the lower bid price. Since this trader believes the pound will appreciate, they must first buy pounds at the current ask price of $1.2590/£. Later, when they want to profit from the appreciation, they'll sell those pounds at whatever the new bid price becomes. For the trader to earn a profit, the new bid price must exceed their original purchase price of $1.2590/£. Answer A incorrectly focuses on the spread amount ($0.0010) rather than recognizing that the trader must overcome the full spread by having the new bid exceed the original ask. Answer B confuses the transaction sequence—the trader doesn't sell at ask prices. Answer C misunderstands the trading mechanics, incorrectly suggesting traders can buy at bid prices and sell at ask prices, which would be the dealer's advantage, not the trader's reality. Answer D correctly identifies that the new bid price must exceed 1.2590/£.Thetraderbuysattoday′sask(1.2590/£. The trader buys at today's ask (1.2590) and will later sell at the future bid price. Only when that future bid exceeds $1.2590 will the trader profit. Remember: currency traders always face transaction costs because they buy high (at ask) and sell low (at bid). Factor in these costs when analyzing trading scenarios.

Question 4

Consider two countries with identical economic fundamentals except for their current account balances: Country A has a current account surplus of 3% of GDP, while Country B has a current account deficit of 3% of GDP. According to international macroeconomic theory, how should this difference most likely affect their currencies in the long run?

  1. Country A's currency should appreciate because current account surpluses always indicate strong economic performance and currency strength
  2. Country B's currency should appreciate because current account deficits require capital inflows that increase demand for the currency
  3. Country A's currency should appreciate because sustained current account surpluses reduce external debt and improve long-term creditworthiness (correct answer)
  4. The currencies should converge to equal values because current account balances are temporary and self-correcting through exchange rate adjustments
Explanation: Current account surpluses mean the country is a net lender to the world, building foreign assets and reducing external debt, which improves long-term creditworthiness and supports currency strength. Choice A overstates by saying surpluses 'always' indicate strength. Choice B confuses short-term capital flows with long-term sustainability - deficits requiring financing create vulnerability. Choice D incorrectly assumes automatic convergence to equal values rather than relative strength differences.

Question 5

A multinational corporation expects to receive €10 million in 90 days and is concerned about euro depreciation against the dollar. The current spot rate is $1.20/€, the 90-day forward rate is $1.18/€, and a 90-day euro put option with a strike price of $1.19/€ costs $0.02 per euro. Which hedging strategy provides the highest guaranteed minimum dollar receipt?

  1. Use a collar strategy combining put and call options to minimize hedging costs
  2. Buy put options, guaranteeing $11.7 million after option costs
  3. Remain unhedged to benefit from potential euro appreciation above $1.20/€
  4. Sell euros forward at $1.18/€, guaranteeing $11.8 million (correct answer)
Explanation: When facing currency risk, you need to compare hedging strategies by calculating the actual guaranteed dollar receipts after all costs. This question tests your ability to evaluate different risk management tools and identify which provides the best downside protection. Let's calculate the guaranteed minimum receipts for each viable strategy. With the forward contract (option D), you lock in the 90-day forward rate of $1.18/€, guaranteeing exactly $10 \text{ million} \times \1.18/€ = $11.8 \text{ million} with no additional costs. For the put option strategy (option B), you pay an upfront premium of 10 \text{ million} \times $0.02/€ = $200,000 . The put guarantees you can sell euros at $1.19/€, giving you $10 \text{ million} \times \1.19/€ = $11.9 \text{ million}.However,subtractingtheoptioncostyields. However, subtracting the option cost yields $11.9 \text{ million} - $0.2 \text{ million} = $11.7 \text{ million}$$ net. Option A mentions a collar strategy but doesn't provide the necessary call option details to calculate the actual outcome, making it incomplete. Option C recommends staying unhedged, which provides no guaranteed minimum protection against the corporation's stated concern about euro depreciation. Comparing the calculable strategies: the forward contract guarantees $11.8 million versus $11.7 million from the put option strategy. The forward provides $100,000 more in guaranteed minimum receipts. Study tip: When comparing hedging strategies, always calculate the net guaranteed amount after all costs. Forward contracts typically provide the highest guaranteed amounts because they have no upfront premiums, while options offer flexibility at the cost of premium payments.

Question 6

Under a fixed exchange rate regime, a country's central bank intervenes to maintain the currency peg when facing speculative attacks. If foreign exchange reserves decline from $50 billion to $30 billion while the monetary base shrinks from $100 billion to $80 billion, what can be concluded?

  1. The central bank sold $20 billion in foreign reserves and the domestic money supply contracted by exactly $20 billion through unsterilized intervention (correct answer)
  2. The central bank sold $20 billion in foreign reserves but also conducted sterilized intervention to prevent any monetary base contraction
  3. The central bank bought $20 billion in foreign reserves while implementing contractionary monetary policy to defend the peg
  4. The central bank sold $20 billion in foreign reserves while simultaneously purchasing domestic assets to fully offset the monetary impact
Explanation: The central bank sold 20billioninreserves(20 billion in reserves (50B - $30B) to defend the peg, and the monetary base fell by exactly 20billion(20 billion (100B - $80B). This 1:1 relationship indicates unsterilized intervention, where foreign exchange operations directly affect the monetary base without offsetting domestic asset purchases. Choice B incorrectly suggests sterilization occurred when the monetary base clearly contracted. Choice C incorrectly states reserves were bought. Choice D describes sterilized intervention, which would prevent monetary base changes.

Question 7

A country's central bank implements an expansionary monetary policy that reduces domestic interest rates from 5% to 3%, while foreign interest rates remain at 4%. Assuming perfect capital mobility and initially balanced capital flows, what is the most likely sequence of effects on the foreign exchange market?

  1. Capital outflows increase, domestic currency depreciates, then net exports rise as the currency becomes more competitive internationally (correct answer)
  2. Capital inflows increase, domestic currency appreciates, then the trade balance improves due to lower import prices
  3. Capital outflows decrease, domestic currency appreciates, then export competitiveness improves due to lower production costs
  4. Capital inflows decrease, domestic currency depreciates, then import demand falls due to higher foreign currency costs
Explanation: With domestic interest rates (3%) now below foreign rates (4%), investors will move capital abroad seeking higher returns, causing capital outflows. This increases demand for foreign currency and supply of domestic currency, leading to domestic currency depreciation. The weaker currency then makes exports more competitive and imports more expensive, improving net exports. Choice B incorrectly suggests capital inflows when rates are relatively lower. Choice C incorrectly states capital outflows would decrease and currency would appreciate. Choice D incorrectly suggests import demand falls due to currency effects rather than the primary capital flow mechanism.

Question 8

Suppose the nominal exchange rate between the U.S. dollar and the British pound is $1.25 per pound. A specific basket of goods costs $200 in the U.S. and £150 in the United Kingdom. Based on this information, which of the following statements is correct?

  1. British goods are relatively more expensive, and the real exchange rate from the U.S. perspective is greater than one.
  2. U.S. goods are relatively more expensive, and the real exchange rate from the U.S. perspective is less than one. (correct answer)
  3. Purchasing power parity holds, and there is no relative price difference in goods between the two countries.
  4. U.S. goods are relatively cheaper, and the real exchange rate from the U.S. perspective is less than one.
Explanation: First, find the dollar price of the British basket of goods: £150 \times \1.25/£ = $187.50.ComparingthistotheU.S.priceof$200,theBritishbasketischeaper.Therefore,U.S.goodsarerelativelymoreexpensive.Therealexchangerate(RER)fromtheU.S.perspectiveiscalculatedas. Comparing this to the U.S. price of $200, the British basket is cheaper. Therefore, U.S. goods are relatively more expensive. The real exchange rate (RER) from the U.S. perspective is calculated as RER = \frac{E \times P_{foreign}}{P_{domestic}} = \frac{$1.25/£ \times £150}{$200} = \frac{$187.50}{$200} = 0.9375$. Since the real exchange rate is less than one, foreign goods are relatively cheaper than domestic goods.

Question 9

The central bank of Mexico unexpectedly implements a significant contractionary monetary policy to combat high inflation. Assuming capital is mobile and other countries' monetary policies are unchanged, which sequence of events is most likely to follow?

  1. Higher Mexican interest rates cause a capital inflow, increasing the demand for the peso and leading to its appreciation. (correct answer)
  2. Higher Mexican interest rates reduce domestic investment, lowering aggregate income, which decreases import demand and causes the peso to depreciate.
  3. Fear of a recession in Mexico causes a capital outflow, increasing the supply of the peso and leading to its depreciation.
  4. The policy reduces expected inflation, leading to a long-run depreciation of the peso according to purchasing power parity.
Explanation: Contractionary monetary policy leads to higher domestic interest rates. These higher rates make Mexican financial assets more attractive to foreign investors. The resulting increase in demand for these assets leads to a capital inflow into Mexico. To purchase these assets, foreign investors must first buy Mexican pesos, which increases the demand for the peso in the foreign exchange market, causing the peso to appreciate.

Question 10

A credible announcement is made that a massive, easily accessible oil reserve has been discovered in Norway. This discovery is expected to significantly boost Norway's future export revenues. In a flexible exchange rate system, what is the most likely immediate impact on the Norwegian krone (NOK)?

  1. The NOK depreciates as markets wait for oil production to begin before reacting.
  2. The NOK appreciates immediately as speculators buy NOK in anticipation of its future strengthening. (correct answer)
  3. The NOK's value remains unchanged until the oil is actually exported and foreign currency is converted to NOK.
  4. The NOK depreciates immediately due to concerns about the inflationary impact of the future oil wealth.
Explanation: Foreign exchange markets are forward-looking. A credible announcement about future economic strength (like a major oil discovery boosting future exports) will lead to expectations of a stronger currency in the future. Speculators will act on this information immediately, buying the Norwegian krone now to profit from its expected future appreciation. This immediate increase in demand for the NOK causes it to appreciate long before the oil revenues are actually realized.

Question 11

A country has been running a large and persistent current account deficit. According to the balance of payments identity, which of the following must be true, and what does it imply about the country's currency?

  1. The country must have a financial account surplus, implying a net demand for its currency from asset sales, which supports its value. (correct answer)
  2. The country must have a financial account deficit, implying a net outflow of capital that causes the currency to depreciate.
  3. The country's central bank must be decreasing its foreign reserves to finance the deficit, causing the currency to appreciate.
  4. The country must be experiencing high inflation, which causes both the current account deficit and currency depreciation.
Explanation: The balance of payments must sum to zero (or close to it). A current account (CA) deficit means a country is spending more abroad than it earns. This must be financed by a surplus in the financial account (FA), which represents net borrowing from or selling assets to foreigners (CA + FA ≈ 0). A financial account surplus means there is a net inflow of capital. This net inflow creates demand for the domestic currency (as foreigners need it to buy domestic assets), which, all else equal, helps to support or increase the value of the currency, preventing the depreciation that might otherwise result from the trade imbalance.

Question 12

The current spot exchange rate for the Japanese yen (JPY) is 150 JPY per USD. The one-year interest rate in the U.S. is 5.0%, and the one-year interest rate in Japan is 0.5%. According to the theory of uncovered interest parity, what is the market's expectation for the spot exchange rate one year from now?

  1. 156.75 JPY per USD (correct answer)
  2. 143.25 JPY per USD
  3. 150.00 JPY per USD
  4. 149.25 JPY per USD
Explanation: Uncovered interest parity (UIP) states that the expected return on assets should be equal across currencies, once adjusted for expected exchange rate changes. The approximate formula is that the expected percentage appreciation of the foreign currency should equal the interest rate differential: E[%Δe]≈iUSD−iJPY=5.0%−0.5%=4.5%E[\%\Delta e] \approx i_{USD} - i_{JPY} = 5.0\% - 0.5\% = 4.5\%. This means the dollar is expected to appreciate (and the yen to depreciate) by 4.5%. The expected future exchange rate is 150×(1+0.045)=150×1.045=156.75150 \times (1 + 0.045) = 150 \times 1.045 = 156.75 JPY per USD.

Question 13

A 'carry trade' is a strategy where an investor borrows in a currency with a low interest rate and invests in a currency with a high interest rate. What is the primary risk associated with this strategy?

  1. The high-interest-rate currency unexpectedly appreciates.
  2. The low-interest-rate currency unexpectedly appreciates. (correct answer)
  3. Both countries' central banks might raise their interest rates simultaneously.
  4. Transaction costs of converting currencies may eliminate all profits.
Explanation: The carry trade profits from the interest rate differential. However, the investor is exposed to exchange rate risk. The strategy is profitable as long as the high-yield currency does not depreciate by more than the interest rate differential. The primary risk is that the funding currency (the one with the low interest rate) unexpectedly appreciates against the investment currency (the one with the high interest rate). If this happens, when the investor converts the investment back to the original currency to pay off the loan, the appreciated currency will buy back less than the amount borrowed, potentially leading to large losses that wipe out the interest earnings.

Question 14

The law of one price states that identical goods should sell for the same price in different markets when expressed in a common currency. Which of the following is the most significant reason why purchasing power parity (PPP), the macroeconomic extension of this law, often fails to hold true in the short to medium term?

  1. Countries tend to have very similar inflation rates, making exchange rate adjustments unnecessary.
  2. Official exchange rates are manipulated by governments and do not reflect market forces.
  3. Interest rate differentials cause capital flows that overwhelm trade-based currency pressures.
  4. Many goods and services, such as haircuts and housing, are not easily traded internationally. (correct answer)
Explanation: When you encounter questions about purchasing power parity (PPP), think about what prevents the law of one price from working perfectly across countries. PPP suggests that exchange rates should adjust so that identical goods cost the same everywhere, but this theoretical relationship often breaks down in practice. The key insight is that PPP relies on arbitrage—the ability to buy goods cheaply in one country and sell them expensively in another. However, many goods and services simply cannot be traded internationally, which eliminates the arbitrage mechanism that would equalize prices. A haircut in Mumbai cannot be sold in Manhattan, and you cannot ship an apartment from Mexico City to Montreal. These "non-tradable" goods represent a huge portion of most economies—think healthcare, education, retail services, utilities, and housing. Since their prices are determined purely by local supply and demand conditions, they can vary dramatically between countries without any corrective pressure from international trade. Looking at the wrong answers: Choice A is backwards—countries often have quite different inflation rates, which is precisely why exchange rates need to adjust. Choice B overstates government manipulation; most major currencies float relatively freely in modern markets. Choice C describes a real phenomenon, but capital flows typically affect short-term exchange rate volatility rather than systematically preventing PPP from holding. Study tip: Remember the "tradable vs. non-tradable" distinction when analyzing international economics questions. PPP works best for standardized, easily shipped goods (like commodities) but fails for services and location-specific goods that dominate modern economies.

Question 15

In the international Fisher effect, if the nominal interest rate in Japan is 1% and in Australia is 4%, while expected inflation is 0% in Japan and 2% in Australia, what does the theory predict about the Japanese yen relative to the Australian dollar over the investment horizon?

  1. The yen should appreciate by approximately 1% because the real interest rate differential favors Japan
  2. The yen should appreciate by approximately 3% because the nominal interest rate differential favors Australia (correct answer)
  3. The yen should depreciate by approximately 3% to offset Australia's higher nominal returns
  4. The yen should remain stable because real interest rates are equal between the countries
Explanation: The International Fisher Effect (IFE) is a key theory in international finance that predicts currency movements based on interest rate differentials. When you see nominal interest rates and inflation data for different countries, the IFE suggests that currencies will adjust to equalize real returns across markets. Let's work through the calculation. The IFE predicts that the currency with the higher nominal interest rate will depreciate by approximately the amount of the interest rate differential. Here, Australia has a 4% nominal rate while Japan has 1%, creating a 3% differential (4% - 1% = 3%). According to the IFE, the yen should appreciate by this 3% differential to offset Australia's higher nominal returns, preventing arbitrage opportunities. Looking at the wrong answers: Choice A incorrectly focuses on the real interest rate differential. While both countries do have equal real rates (Japan: 1% - 0% = 1%, Australia: 4% - 2% = 2%), wait - that's actually 1% vs 2%, not equal. More importantly, the IFE specifically uses nominal rate differentials for currency predictions. Choice C gets the direction backwards - it suggests the yen should depreciate when logic dictates it should strengthen to offset Australia's higher yields. Choice D incorrectly assumes the real rates are equal (they're not: 1% vs 2%) and misunderstands that the IFE predicts currency movement even when real rates differ. Study tip: Remember that in IFE questions, the currency of the country with the higher nominal interest rate is predicted to weaken by approximately the interest rate differential. Higher rates signal expected depreciation, not strength.

Question 16

The central bank of Switzerland is committed to maintaining a fixed exchange rate ceiling, preventing the Swiss franc (CHF) from appreciating above a certain level against the euro. If a surge in global risk aversion causes a massive capital inflow into Switzerland, what action must the Swiss central bank take to defend the ceiling?

  1. Sell Swiss francs and buy foreign assets (e.g., euros), thereby increasing its foreign reserves. (correct answer)
  2. Buy Swiss francs and sell foreign assets (e.g., euros), thereby decreasing its foreign reserves.
  3. Raise domestic interest rates to make holding Swiss francs more attractive to investors.
  4. Implement contractionary fiscal policy to reduce the demand for imported goods.
Explanation: A massive capital inflow increases the demand for the Swiss franc, putting upward (appreciation) pressure on its value. To prevent the franc from rising above the ceiling, the central bank must intervene in the foreign exchange market to increase the supply of francs. It does this by creating new francs and using them to buy foreign currency (euros). This action, selling CHF and buying foreign assets, increases the central bank's stock of foreign reserves and counteracts the upward pressure on the exchange rate.

Question 17

A country imposes significant new tariffs on a wide range of imported goods. In a system of flexible exchange rates and mobile capital, what is the likely secondary effect of this policy on the country's international trade?

  1. The domestic currency appreciates, partially offsetting the trade-reducing effect of the tariff. (correct answer)
  2. The domestic currency depreciates, reinforcing the trade-reducing effect of the tariff.
  3. Domestic interest rates fall, leading to an increase in both imports and exports.
  4. Retaliatory tariffs from other countries cause the domestic currency to depreciate.
Explanation: The tariffs reduce the demand for imported goods. This, in turn, reduces the demand for foreign currency in the foreign exchange market (or, equivalently, reduces the supply of the domestic currency). This leads to an appreciation of the domestic currency. The stronger domestic currency makes the country's exports more expensive to foreigners and makes imports (even with the tariff) relatively cheaper than they would have been otherwise. This currency appreciation works to counteract the initial goal of the tariff, which was to reduce imports and protect domestic industry.

Question 18

Over a five-year period, the nominal exchange rate between the currency of Country A and Country B remained constant. However, the cumulative inflation over this period was 25% in Country A and 5% in Country B. Which of the following is the most likely consequence?

  1. The real exchange rate was stable, and Country A's trade competitiveness did not change.
  2. Purchasing power parity held, as the stable nominal exchange rate offset the inflation differential.
  3. Country A's currency experienced a real depreciation, making its exports more competitive.
  4. Country A's currency experienced a real appreciation, making its exports less competitive. (correct answer)
Explanation: When you encounter questions about exchange rates and inflation, focus on distinguishing between nominal and real exchange rates. The nominal rate is what you see quoted, while the real rate adjusts for inflation differences between countries. Here's the key calculation: Real exchange rate = Nominal exchange rate × (Foreign price level / Domestic price level). Since Country A experienced much higher inflation (25%) than Country B (5%) while the nominal rate stayed constant, Country A's goods became relatively more expensive. This represents a real appreciation of Country A's currency, making its exports less competitive internationally. Let's examine why the other answers miss the mark. Choice A incorrectly assumes the real exchange rate remained stable when inflation differentials clearly changed relative prices. Choice B misunderstands purchasing power parity (PPP) – if PPP held, the nominal exchange rate should have adjusted to offset the inflation differential, but it didn't. Choice C gets the direction wrong; higher relative inflation causes real appreciation, not depreciation, when the nominal rate is fixed. The correct answer is D because Country A's currency experienced real appreciation due to its higher inflation rate, making its goods more expensive relative to Country B's goods and reducing export competitiveness. Study tip: Remember this pattern: when nominal exchange rates are fixed but inflation differs between countries, the higher-inflation country always experiences real appreciation. This makes their exports less competitive – a crucial relationship for understanding international trade dynamics.

Question 19

Suppose the real GDP of the United Kingdom grows much faster than the real GDP of its major trading partners. Assuming all else remains constant, what is the most likely impact on the British pound (GBP) in the foreign exchange market?

  1. The pound will appreciate because higher GDP growth attracts foreign investment.
  2. The pound will depreciate because import spending in the U.K. will grow faster than its exports. (correct answer)
  3. The pound's value will remain unchanged, as real GDP growth affects trade volumes but not exchange rates.
  4. The effect is ambiguous, as the investment effect (appreciation) and the trade effect (depreciation) are of equal magnitude.
Explanation: While faster GDP growth can attract investment (the capital account effect), the most direct and certain impact is on the current account. As incomes rise in the U.K., its citizens and firms will increase their spending on all goods, including imports. This growth in import demand will outpace the growth of demand for U.K. exports in the slower-growing foreign countries. To buy more imports, Britons will supply more pounds to the foreign exchange market, causing the pound to depreciate. This trade effect is often considered the primary short-run impact of differential income growth.

Question 20

An arbitrageur in New York, London, and Tokyo observes the following simultaneous quotes:

  • USD/EUR: 1.10
  • EUR/GBP: 0.85
  • USD/GBP: 0.95

Given the quotes in the passage, which of the following statements correctly identifies the arbitrage opportunity?

  1. No arbitrage is possible; the implied cross rate is equal to the quoted direct rate.
  2. An arbitrageur can profit by buying pounds with dollars, then selling pounds for euros, and finally selling euros for dollars.
  3. An arbitrageur can profit by buying euros with dollars, then selling euros for pounds, and finally selling pounds for dollars. (correct answer)
  4. The market is in equilibrium, but the EUR/GBP rate is inconsistent with the other two rates.
Explanation: First, calculate the implied cross rate for USD/GBP from the first two quotes. The rate should be (USD/EUR) ×\times (EUR/GBP). Assuming the quotes mean $1.10/€ and €0.85/£, the implied rate is 1.10×0.85=0.9351.10 \times 0.85 = 0.935 USD/GBP. The market is quoting a direct rate of 0.95 USD/GBP. Since the actual market price for pounds ($0.95) is higher than the implied price ($0.935), an arbitrageur should 'create' pounds via the cross-rate market and sell them in the direct market. The profitable path is: use USD to buy EUR, use the EUR to buy GBP (at the implied cheaper rate), and then sell the GBP for USD (at the actual higher rate).