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1. The international monetary system refers to the institutional arrangements that govern exchange
rates.
True False
2. The gold standard called for fixed exchange rates against the U.S. dollar.
True False
3. The agreement reached at Bretton Woods established the International Monetary Fund (IMF) and the
World Bank.
True False
4. Implementing a fixed exchange rate regime increases the price inflation in countries.
True False
5. World Bank offers low-interest loans to risky customers whose credit rating is often poor.
True False
6. The fixed exchange rate system established at Bretton Woods failed due to speculative pressures on
the U.S. dollar.
True False
7. Gold was declared as the formal reserve asset in the Jamaica agreement of 1976.
True False
8. Market forces have produced a stable dollar exchange rate under a floating exchange rate regime.
True False
9. Fixed exchange rates lead to speculation and uncertainty in the value of currencies.
True False
10. Adopting a pegged exchange rate regime increases the inflationary pressures in a country.
True False
11. A country that introduces a currency board commits itself to converting its domestic currency on
demand into another currency at a fixed exchange rate.
True False
12. Interest rates adjust automatically under a strict currency board system.
True False
13. The International Monetary Fund's original function was to provide a pool of money from which
members could borrow in the short term.
True False
14. The International Monetary Fund made pegging the Mexican peso to the dollar, a condition for
lending money to the Mexican government in the 1980s.
True False
15. Government projects were a factor behind the investment boom in most Southeast Asian economies.
True False
16. The quality of investments declined significantly in the Asian countries during the 1990s.
True False
17. In the 1990s, most of the borrowing by the companies who invested in Asian countries had been in
local currencies.
True False
18. Moral hazard arises when people behave recklessly because they know they will be saved if things
go wrong.
True False
19. The current system of foreign exchange is a mixed system of government intervention and
speculative activity.
True False
20. Firms should not utilize the forward exchange market when they are faced with uncertainty about the
future value of currencies.
True False
21. An effective business strategy to reduce economic exposure is to contract out high value-added
manufacturing.
True False
A. World Bank
B. international monetary system
C. currency exchange
D. gold standard
23. A _____ means the value of a currency is fixed relative to a reference currency.
24. When a country tries to hold the value of their currency within some range against an important
reference currency such as the U.S. dollar without adopting a formal pegged rate, it is referred to as a
_____.
A. gold standard
B. pegged float
C. dirty float
D. currency peg
25. The amount of a currency needed to purchase one ounce of gold was referred to as the _____.
A. golden rule
B. gold standard
C. pegged gold value
D. gold par value
26. A country is said to be in balance-of-trade equilibrium when:
A. the income its residents earn from exports is equal to the money its residents pay to other
countries for imports.
B. it produces all the goods needed for domestic consumption.
C. the income its residents earn from imports is equal to the money its residents pay to other
countries for exports.
D. it produces all the goods needed for exportation.
A. commits itself to converting its domestic currency on demand into another currency at a fixed
exchange rate.
B. will peg the value of its currency to that of a major currency.
C. valuates its currency without attaching it to a reference currency.
D. follows the foreign exchange market to determine the relative value of a currency.
29. International Monetary Fund members were _____ in the Jamaica agreement.
31. The rise in the value of the dollar between 1985 and 1988:
32. Advocates of a _____ argue that removal of the obligation to maintain exchange rate parity would
restore monetary control to a government.
A. a dirty-float system
B. fixed exchange rates
C. pegged exchange rates
D. floating exchange rates
34. Supporters of floating exchange rates:
35. Exchange rates are _____ under a pure "free float" system.
A. completely balanced
B. determined by market forces
C. wildly variable and unpredictable
D. determined by the government
36. The great virtue claimed for a _____ is that it imposes monetary discipline on a country and leads to
low inflation.
37. _____ limits the ability of the government to print money and, thereby, create inflationary pressures.
A. A dirty-float system
B. A managed-float system
C. The European Monetary System
D. A currency board system
38. Currencies of countries with currency boards will become uncompetitive and overvalued if:
A. local inflation rates remain higher than the inflation rate in the country to which the currency is
pegged.
B. the country to which the currency is pegged experiences a trade deficit.
C. local inflation rates are lower than the inflation rate in the country to which the currency is pegged.
D. the country to which the currency is pegged experiences a trade surplus.
40. A _____ is a situation in which a country cannot service its foreign debt obligations.
A. currency crisis
B. banking crisis
C. foreign debt crisis
D. moral crisis
41. In the 1990s, most of the borrowing by the companies who invested in Asian countries had been in
_____.
A. Japanese yen
B. local currencies
C. Chinese yuan
D. U.S. dollars
42. Most of the loans issued by the IMF:
43. The Asian economic crisis and the global financial of 2008-2009 crisis were caused by _____.
44. It is difficult if not impossible to get adequate insurance coverage for exchange rates that:
45. The international monetary system refers to the institutional arrangements that govern _____.
A. microeconomic parameters
B. exchange rates
C. gross domestic produce
D. foreign direct investment
46. When the foreign exchange market determines the relative value of a currency, we say that the
country is adhering to a _____ regime.
47. A pegged exchange rate means that the value of a currency is:
A. a set of currencies are fixed against each other at some mutually agreed on exchange rate.
B. many countries join hands to form a monetary system and an exchange rate.
C. more than one foreign currency is used as the formal reference for a country's currency.
D. a country tries to hold its currency against an important reference currency without a formal
pegged rate.
49. After World War II, the world's major industrial nations arranged their currencies against each other at
a mutually agreed on exchange rate. This is an example of a _____ system.
A. Gold standard was adopted only by the smaller nations of the world.
B. Currencies were pegged to gold under the gold standard.
C. Convertibility to gold was not guaranteed under the gold standard.
D. Gold standard was not helpful in maintaining balance-of-trade equilibrium.
A. it has the potential to produce all goods that its residents want without engaging in foreign trade.
B. the income its residents earn from exports is equal to the money its residents pay for imports.
C. the country import all goods that its residents want by engaging in foreign trade.
D. it has the potential to balance the production and procurement of the basic amenities that it needs.
A. The standard makes sure that goods are not priced out from markets due to inflation.
B. The standard does not require a commitment from nations to maintain its currency's value.
C. The standard effectively prevents the devaluation of currencies across the world.
D. The standard contains a powerful mechanism for achieving balance-of-trade equilibrium by all
countries.
56. Which of the following observations is true of the Bretton Woods agreement?
A. All countries agreed to fix the value of their currency in terms of gold under the agreement.
B. The system accepted Pound as the official reference currency against gold.
C. The agreement established a floating system of monetary exchange.
D. Two multinational institutions, World Economic Forum and WTO, were formed under the
agreement.
57. The World Bank was established at the at Bretton Woods conference to:
A. Pound
B. Yen
C. Euro
D. Dollar
59. What will happen if a country increases its money supply rapidly under fixed exchange rate regime?
60. Which of the following is a disadvantage of using a rigid policy of fixed exchange rates?
63. Which of the following changes were made to the International Monetary Fund's Articles of
Agreement in the Jamaica agreement?
A. IMF members were permitted to use the U.S. dollar as the convertible currency.
B. Gold was declared as a formal reserve asset for IMF members.
C. IMF members were permitted to sell their gold reserves at the market price.
D. IMF members were restricted from entering the foreign exchange market.
64. _____ exchange rates were declared as acceptable in the Jamaica agreement of the International
Monetary Fund.
A. Pegged
B. Fixed
C. Floating
D. Gold standard
65. The United States had large and growing trade deficit between 1980 and 1985. Despite this, the
value of U.S. dollar rose during this period. Which of the following is a factor that caused this
occurrence?
A. United States attracted heavy inflows of capital from foreign investors during this period.
B. Banks in the United States offered low interest rates to investors during this period.
C. Markets across the world witnessed strong economies during this period.
D. Developed countries in Europe maintained trade equilibrium and supplied goods to
underdeveloped countries.
66. Which of the following is the reason why the current foreign-exchange system is sometimes thought
of as a managed-float system?
A. A country's ability to expand or contract its money supply should be limited by the need to maintain
exchange rate parity.
B. Maintaining balance of trade equilibrium is not in the best interest of a country.
C. Countries can isolate themselves from uncertainties when they trade using a mutually agreed on
exchange rate.
D. Governments can restore monetary control by removing the obligation to maintain exchange rate
parity.
69. Which of the following arguments is against the use of fixed exchange rates?
72. Which of the following is an exchange rate policy where the exchange rate is determined completely
by market forces?
A. Managed float
B. Fixed peg
C. Free float
D. Currency board
73. Which of the following is the exchange rate policy where the government intervenes in the exchange
rate system only in a limited way?
A. Managed-float
B. Fixed peg
C. Free-float
D. Currency board
74. Under a _____ exchange rate regime, a country will attach the value of its currency to that of a major
currency.
A. managed-float
B. pegged
C. free-float
D. currency board
76. A country that introduces a currency board commits itself to converting its domestic currency on
demand into:
80. Which of the following is a common criticism against the International Monetary Fund?
A. Most of the currencies can be converted to gold in the current system of foreign exchange.
B. The current system is driven by fixed exchange rates.
C. Currencies float freely against others in the current system.
D. The current system is a combination of government intervention and speculative activity.
83. Which of the following will help a company hedge against currency fluctuations?
84. Contracting out manufacturing allows companies to reduce economic exposure because:
85. Increasingly the _____ has been acting as macroeconomic police of the world economy, insisting that
countries seeking significant borrowings adopt certain macroeconomic policies.
88. The world's four major trading currencies, the Japanese yen, the U.S. dollar, the British pound, and
the European Union's euro are all free to float against each other. What is this an example of?
89. Prior to the introduction of the euro, many EU countries participated in a _____.
91. The International Monetary Fund has been criticized for exacerbating moral hazard:
92. A _____ refers to a loss of confidence in the banking system that leads to a run on banks as
individuals and companies withdraw their deposits.
A. currency crisis
B. banking crisis
C. foreign debt crisis
D. domestic debt crisis
Essay Questions
93. What is international monetary system? What are the major trading currencies?
94. Compare and contrast a pegged exchange system with a dirty-float system of exchange rates.
95. What is gold standard? What was the major advantage of the system?
96. With the help of an example, explain how balance-of-trade equilibrium is maintained under the gold
standard.
97. What is the Bretton Woods agreement? How was it different from the gold standard?
98. Identify the multinational institutions that were established at the Bretton Woods agreement. What
were their roles in the international monetary system?
99. Explain the events that led to the failure of the Bretton Woods system.
101.Discuss the arguments that favor a floating exchange rate system against a fixed exchange rate
system.
102.Present the common arguments that favor fixed exchange rates.
103.Describe the different exchange rate policies that are in practice today.
104.What is a currency board? Why do countries choose this type of system? What are the
disadvantages of this type of arrangement?
105.Recent policies of the International Monetary Fund have drawn a lot of criticism. Discuss these
criticisms.
106.How can international companies reduce their economic exposure in a world of constantly fluctuating
exchange rates?
107.Do you think businesses can influence government policies? Explain your answer.
Chapter 11 The International Monetary System Answer Key
1. The international monetary system refers to the institutional arrangements that govern exchange
rates.
TRUE
The international monetary system refers to the institutional arrangements that govern exchange
rates.
2. The gold standard called for fixed exchange rates against the U.S. dollar.
FALSE
Pegging currencies to gold and guaranteeing convertibility is known as the gold standard. By
1880, most of the world's major trading nations, including Great Britain, Germany, Japan, and the
United States, had adopted the gold standard.
TRUE
4. Implementing a fixed exchange rate regime increases the price inflation in countries.
FALSE
A fixed exchange rate regime imposes monetary discipline on countries, thereby curtailing price
inflation.
5. World Bank offers low-interest loans to risky customers whose credit rating is often poor.
TRUE
World Bank offers low-interest loans to risky customers whose credit rating is often poor, such as
the governments of underdeveloped nations.
6. The fixed exchange rate system established at Bretton Woods failed due to speculative pressures
on the U.S. dollar.
TRUE
U.S. dollar was the only currency that could be converted into gold in the fixed exchange rate
system established at Bretton Woods. As the currency that served as the reference point for all
others, the dollar occupied a central place in the system. The system failed when its key currency
U.S. dollar faced speculative pressure.
7. Gold was declared as the formal reserve asset in the Jamaica agreement of 1976.
FALSE
In the Jamaica agreement, gold was abandoned as a reserve asset. The IMF returned its gold
reserves to members at the current market price, placing the proceeds in a trust fund to help poor
nations.
FALSE
Under a floating exchange rate regime, market forces have produced a volatile dollar exchange
rate. Governments have sometimes responded by intervening in the market—buying and selling
dollars—in an attempt to limit the market's volatility and to correct what they see as overvaluation
or potential undervaluation of the dollar.
9. Fixed exchange rates lead to speculation and uncertainty in the value of currencies.
FALSE
Speculation can make exchange rates volatile in the floating exchange rate system. Speculation
also adds to the uncertainty surrounding future currency movements that characterizes floating
exchange rate regimes. A fixed exchange rate eliminates such uncertainty.
FALSE
Evidence shows that adopting a pegged exchange rate regime moderates inflationary pressures
in a country.
11. A country that introduces a currency board commits itself to converting its domestic currency on
demand into another currency at a fixed exchange rate.
TRUE
A country that introduces a currency board commits itself to converting its domestic currency on
demand into another currency at a fixed exchange rate. To make this commitment credible, the
currency board holds reserves of foreign currency equal at the fixed exchange rate to at least 100
percent of the domestic currency issued.
TRUE
Under a strict currency board system, interest rates adjust automatically. If investors want to
switch out of domestic currency into, for example, U.S. dollars, the supply of domestic currency
will shrink. This will cause interest rates to rise until it eventually becomes attractive for investors
to hold the local currency again.
13. The International Monetary Fund's original function was to provide a pool of money from which
members could borrow in the short term.
TRUE
The IMF's original function was to provide a pool of money from which members could borrow,
short term, to adjust their balance-of-payments position and maintain their exchange rate.
TRUE
The Mexican peso had been pegged to the dollar since the early 1980s when the International
Monetary Fund made it a condition for lending money to the Mexican government.
15. Government projects were a factor behind the investment boom in most Southeast Asian
economies.
TRUE
An added factor behind the investment boom in most Southeast Asian economies was the
government. In many cases, the governments had embarked on huge infrastructure projects.
TRUE
Volume of investments increased in the Asian countries during the 1990s. As the volume of
investments ballooned, often at the bequest of national governments, the quality of many of these
investments declined significantly.
17. In the 1990s, most of the borrowing by the companies who invested in Asian countries had been
in local currencies.
FALSE
The companies that had made the investments in Asia, in 1990s, were under huge debt burdens
and they were finding it difficult to service. Much of the borrowing had been in U.S. dollars, as
opposed to local currencies.
TRUE
Moral hazard arises when people behave recklessly because they know they will be saved if
things go wrong.
19. The current system of foreign exchange is a mixed system of government intervention and
speculative activity.
TRUE
The current system of foreign exchange is a mixed system in which a combination of government
intervention and speculative activity can drive the foreign exchange market.
FALSE
Faced with uncertainty about the future value of currencies, firms can utilize the forward exchange
market.
21. An effective business strategy to reduce economic exposure is to contract out high value-added
manufacturing.
FALSE
Another way of building strategic flexibility and reducing economic exposure involves contracting
out manufacturing. This allows a company to shift suppliers from country to country. However, this
kind of strategy may work only for low value-added manufacturing (e.g., textiles) in which the
individual manufacturers have few if any firm-specific skills that contribute to the value of the
product.
A. World Bank
B. international monetary system
C. currency exchange
D. gold standard
The international monetary system refers to the institutional arrangements that govern exchange
rates.
23. A _____ means the value of a currency is fixed relative to a reference currency.
A pegged exchange rate means the value of the currency is fixed relative to a reference currency,
such as the U.S. dollar, and then the exchange rate between that currency and other currencies is
determined by the reference currency exchange rate.
A. gold standard
B. pegged float
C. dirty float
D. currency peg
Countries, while not adopting a formal pegged rate, try to hold the value of their currency within
some range against an important reference currency such as the U.S. dollar, or a "basket" of
currencies. This is often referred to as a dirty float.
25. The amount of a currency needed to purchase one ounce of gold was referred to as the _____.
A. golden rule
B. gold standard
C. pegged gold value
D. gold par value
Under the gold standard, the amount of a currency needed to purchase one ounce of gold was
referred to as the gold par value.
A. the income its residents earn from exports is equal to the money its residents pay to other
countries for imports.
B. it produces all the goods needed for domestic consumption.
C. the income its residents earn from imports is equal to the money its residents pay to other
countries for exports.
D. it produces all the goods needed for exportation.
A country is said to be in balance-of-trade equilibrium when the income its residents earn from
exports is equal to the money its residents pay to other countries for imports (the current account
of its balance of payments is in balance).
A. commits itself to converting its domestic currency on demand into another currency at a fixed
exchange rate.
B. will peg the value of its currency to that of a major currency.
C. valuates its currency without attaching it to a reference currency.
D. follows the foreign exchange market to determine the relative value of a currency.
Under a pegged exchange rate regime, a country will peg the value of its currency to that of a
major currency so that, for example, as the U.S. dollar rises in value, its own currency rises too.
One of the funding schemes of the World Bank is overseen by the International Development
Association (IDA), an arm of the bank created in 1960. Resources to fund IDA loans are raised
through subscriptions from wealthy members such as the United States, Japan, and Germany.
In the Jamaica agreement, gold was abandoned as a reserve asset. IMF also permitted its
members to sell their own gold reserves at the market price.
30. The value of U.S dollar increased between 1980 and 1985:
The rise in the value of the dollar between 1980 and 1985 occurred when the United States was
running a large and growing trade deficit, importing substantially more than it exported. A number
of favorable factors overcame the unfavorable effect of a trade deficit.
Rise in dollar will make U.S. goods less competitive. The rise in the dollar priced U.S. goods out of
foreign markets and made imports relatively cheap.
32. Advocates of a _____ argue that removal of the obligation to maintain exchange rate parity would
restore monetary control to a government.
Advocates of a floating exchange rate regime argue that removal of the obligation to maintain
exchange rate parity would restore monetary control to a government.
A. a dirty-float system
B. fixed exchange rates
C. pegged exchange rates
D. floating exchange rates
Advocates of floating rates argue that each country should be allowed to choose its own inflation
rate. This is called the monetary autonomy argument. Advocates of fixed rates argue against this.
Those in favor of floating exchange rates argue that floating rates help adjust trade imbalances.
Critics of floating rates claim that trade deficits are determined by the balance between savings
and investment in a country, not by the external value of its currency.
A. completely balanced
B. determined by market forces
C. wildly variable and unpredictable
D. determined by the government
Under a pure "free float" system, exchange rates are determined by market forces.
36. The great virtue claimed for a _____ is that it imposes monetary discipline on a country and leads
to low inflation.
As with a full fixed exchange rate regime, the great virtue claimed for a pegged exchange rate is
that it imposes monetary discipline on a country and leads to low inflation.
37. _____ limits the ability of the government to print money and, thereby, create inflationary
pressures.
A. A dirty-float system
B. A managed-float system
C. The European Monetary System
D. A currency board system
The currency board can issue additional domestic notes and coins only when there are foreign
exchange reserves to back it. This limits the ability of the government to print money and, thereby,
create inflationary pressures.
A. local inflation rates remain higher than the inflation rate in the country to which the currency is
pegged.
B. the country to which the currency is pegged experiences a trade deficit.
C. local inflation rates are lower than the inflation rate in the country to which the currency is
pegged.
D. the country to which the currency is pegged experiences a trade surplus.
If local inflation rates remain higher than the inflation rate in the country to which the currency is
pegged, the currencies of countries with currency boards can become uncompetitive and
overvalued.
A currency crisis occurs when a speculative attack on the exchange value of a currency results in
a sharp depreciation in the value of the currency or forces authorities to expend large volumes of
international currency reserves and sharply increase interest rates to defend the prevailing
exchange rate.
40. A _____ is a situation in which a country cannot service its foreign debt obligations.
A. currency crisis
B. banking crisis
C. foreign debt crisis
D. moral crisis
A foreign debt crisis is a situation in which a country cannot service its foreign debt obligations,
whether private-sector or government debt.
41. In the 1990s, most of the borrowing by the companies who invested in Asian countries had been
in _____.
A. Japanese yen
B. local currencies
C. Chinese yuan
D. U.S. dollars
The companies that had made the investments in Asia, in 1990s, were under huge debt burdens
and they were finding it difficult to service. Much of the borrowing had been in U.S. dollars, as
opposed to local currencies.
All IMF loan packages come with conditions attached. Until very recently, the IMF has insisted on
a combination of tight macroeconomic policies, including cuts in public spending, higher interest
rates, and tight monetary policy.
43. The Asian economic crisis and the global financial of 2008-2009 crisis were caused by _____.
The Asian economic crisis and the global financial of 2008-2009 crisis were caused not by high
inflation rates, but by excessive debt.
It is difficult if not impossible to get adequate insurance coverage for exchange rates that might
occur several years in the future. The forward market tends to offer coverage for exchange rate
changes a few months—not years—ahead.
45. The international monetary system refers to the institutional arrangements that govern _____.
A. microeconomic parameters
B. exchange rates
C. gross domestic produce
D. foreign direct investment
The international monetary system refers to the institutional arrangements that govern exchange
rates.
When the foreign exchange market determines the relative value of a currency, we say that the
country is adhering to a floating exchange rate regime. Four of the world's major trading
currencies—the U.S. dollar, the European Union's euro, the Japanese yen, and the British
pound—are all free to float against each other.
47. A pegged exchange rate means that the value of a currency is:
A pegged exchange rate means the value of the currency is fixed relative to a reference currency,
such as the U.S. dollar, and then the exchange rate between that currency and other currencies is
determined by the reference currency exchange rate.
A. a set of currencies are fixed against each other at some mutually agreed on exchange rate.
B. many countries join hands to form a monetary system and an exchange rate.
C. more than one foreign currency is used as the formal reference for a country's currency.
D. a country tries to hold its currency against an important reference currency without a formal
pegged rate.
Countries, while not adopting a formal pegged rate, try to hold the value of their currency within
some range against an important reference currency such as the U.S. dollar, or a "basket" of
currencies. This is often referred to as a dirty float.
49. After World War II, the world's major industrial nations arranged their currencies against each
other at a mutually agreed on exchange rate. This is an example of a _____ system.
With a fixed exchange rate system, the values of a set of currencies are fixed against each other
at some mutually agreed on exchange rate.
A. Gold standard was adopted only by the smaller nations of the world.
B. Currencies were pegged to gold under the gold standard.
C. Convertibility to gold was not guaranteed under the gold standard.
D. Gold standard was not helpful in maintaining balance-of-trade equilibrium.
Pegging currencies to gold and guaranteeing convertibility is known as the gold standard. By
1880, most of the world's major trading nations, including Great Britain, Germany, Japan, and the
United States, had adopted the gold standard.
The amount of a currency needed to purchase one ounce of gold is referred to as the gold par
value.
A. it has the potential to produce all goods that its residents want without engaging in foreign
trade.
B. the income its residents earn from exports is equal to the money its residents pay for imports.
C. the country import all goods that its residents want by engaging in foreign trade.
D. it has the potential to balance the production and procurement of the basic amenities that it
needs.
A country is said to be in balance-of-trade equilibrium when the income its residents earn from
exports is equal to the money its residents pay to other countries for imports (the current account
of its balance of payments is in balance).
A country's trade balance is in surplus when it exports more than what it imports.
A. The standard makes sure that goods are not priced out from markets due to inflation.
B. The standard does not require a commitment from nations to maintain its currency's value.
C. The standard effectively prevents the devaluation of currencies across the world.
D. The standard contains a powerful mechanism for achieving balance-of-trade equilibrium by all
countries.
The great strength claimed for the gold standard was that it contained a powerful mechanism for
achieving balance-of-trade equilibrium by all countries.
56. Which of the following observations is true of the Bretton Woods agreement?
A. All countries agreed to fix the value of their currency in terms of gold under the agreement.
B. The system accepted Pound as the official reference currency against gold.
C. The agreement established a floating system of monetary exchange.
D. Two multinational institutions, World Economic Forum and WTO, were formed under the
agreement.
The Bretton Woods agreement called for a system of fixed exchange rates that would be policed
by the IMF. Under the agreement, all countries were to fix the value of their currency in terms of
gold but were not required to exchange their currencies for gold.
The agreement reached at Bretton Woods established the World Bank. The task of the World
Bank was to promote general economic development.
58. Identify the currency that was convertible to gold under the Bretton Woods system.
A. Pound
B. Yen
C. Euro
D. Dollar
Under the Bretton Woods agreement, all countries were to fix the value of their currency in terms
of gold but were not required to exchange their currencies for gold. Only the dollar remained
convertible into gold.
A fixed exchange rate regime imposes monetary discipline on countries and curtails price inflation.
For example, if a country increases its money supply by printing more currency, the increase in
money supply would lead to price inflation. Given fixed exchange rates, inflation would make the
country's goods uncompetitive in world markets, while the prices of imports would become more
attractive in that country. The result would be a widening trade deficit in the country, with the
country importing more than it exports.
60. Which of the following is a disadvantage of using a rigid policy of fixed exchange rates?
A rigid policy of fixed exchange rates would be too inflexible. In some cases, a country's attempts
to reduce its money supply growth and correct a persistent balance-of-payments deficit could
force the country into recession and create high unemployment.
The World Bank was established to reconstruct world economies. The bank lends money to
entities such as governments.
U.S. dollar had a special role in the fixed exchange rate system as the only currency that could be
converted into gold. This meant that any pressure on the dollar would devalue the system. The
increase in inflation and the worsening of the U.S. foreign trade position gave rise to speculation in
the foreign exchange market that the dollar would be devalued. This initiated the demise of the
fixed exchange rate system.
63. Which of the following changes were made to the International Monetary Fund's Articles of
Agreement in the Jamaica agreement?
A. IMF members were permitted to use the U.S. dollar as the convertible currency.
B. Gold was declared as a formal reserve asset for IMF members.
C. IMF members were permitted to sell their gold reserves at the market price.
D. IMF members were restricted from entering the foreign exchange market.
IMF members met in Jamaica in January 1976 and agreed to the rules for the international
monetary system that are in place today. In the meeting, gold was abandoned as a reserve asset.
IMF members were permitted to sell their own gold reserves at the market price.
64. _____ exchange rates were declared as acceptable in the Jamaica agreement of the International
Monetary Fund.
A. Pegged
B. Fixed
C. Floating
D. Gold standard
Floating rates were declared acceptable in the Jamaica agreement. IMF members were also
permitted to enter the foreign exchange market to even out "unwarranted" speculative fluctuations.
A. United States attracted heavy inflows of capital from foreign investors during this period.
B. Banks in the United States offered low interest rates to investors during this period.
C. Markets across the world witnessed strong economies during this period.
D. Developed countries in Europe maintained trade equilibrium and supplied goods to
underdeveloped countries.
A number of favorable factors overcame the unfavorable effect of a trade deficit. Strong economic
growth in the United States was one such factor. It attracted heavy inflows of capital from foreign
investors seeking high returns on capital assets.
66. Which of the following is the reason why the current foreign-exchange system is sometimes
thought of as a managed-float system?
High frequency of government intervention in the foreign exchange market explains why the
current system is sometimes thought of as a managed-float system or a dirty-float system.
A. A country's ability to expand or contract its money supply should be limited by the need to
maintain exchange rate parity.
B. Maintaining balance of trade equilibrium is not in the best interest of a country.
C. Countries can isolate themselves from uncertainties when they trade using a mutually agreed
on exchange rate.
D. Governments can restore monetary control by removing the obligation to maintain exchange
rate parity.
Advocates of a floating exchange rate regime argue that removal of the obligation to maintain
exchange rate parity would restore monetary control to a government. If a government faced with
unemployment wanted to increase its money supply to stimulate domestic demand and reduce
unemployment, it could do so unencumbered by the need to maintain its exchange rate.
Advocates of floating rates argue that each country should be allowed to choose its own inflation
rate. This is called the monetary autonomy argument.
69. Which of the following arguments is against the use of fixed exchange rates?
Advocates of floating rates argue that each country should be allowed to choose its own inflation
rate. This is called the monetary autonomy argument.
The supporters of floating exchange rates argue that floating rates can correct trade deficit by
making its exports cheaper and its imports more expensive. They argue that exchange rate
depreciation should correct the trade deficit.
Those in favor of floating exchange rates argue that floating rates help adjust trade imbalances.
A. Managed float
B. Fixed peg
C. Free float
D. Currency board
Governments around the world pursue a number of different exchange rate policies. One such
policy is a pure "free float" where the exchange rate is determined by market forces.
73. Which of the following is the exchange rate policy where the government intervenes in the
exchange rate system only in a limited way?
A. Managed-float
B. Fixed peg
C. Free-float
D. Currency board
In a managed-float system governments intervene in only a limited way. About 26 percent of IMF's
members use this system.
74. Under a _____ exchange rate regime, a country will attach the value of its currency to that of a
major currency.
A. managed-float
B. pegged
C. free-float
D. currency board
Under a pegged exchange rate regime, a country will attach the value of its currency to that of a
major currency so that, for example, as the U.S. dollar rises in value, its own currency rises too.
Under a pegged exchange rate regime, a country will peg the value of its currency to that of a
major currency. Pegged exchange rates are popular among many of the world's smaller nations.
76. A country that introduces a currency board commits itself to converting its domestic currency on
demand into:
A country that introduces a currency board commits itself to converting its domestic currency on
demand into another currency at a fixed exchange rate. To make this commitment credible, the
currency board holds reserves of foreign currency equal at the fixed exchange rate to at least 100
percent of the domestic currency issued.
Under a currency board system, government lacks the ability to set interest rates. Interest rates in
Hong Kong, for example, are effectively set by the U.S. Federal Reserve.
A currency crisis occurs when a speculative attack on the exchange value of a currency results in
a sharp depreciation in the value of the currency or forces authorities to expend large volumes of
international currency reserves and sharply increase interest rates to defend the prevailing
exchange rate.
Moral hazard arises when people behave recklessly because they know they will be saved if
things go wrong.
80. Which of the following is a common criticism against the International Monetary Fund?
One criticism of the IMF is that it has become too powerful for an institution that lacks any real
mechanism for accountability.
Foreign debt crises tend to have common underlying macroeconomic causes: high relative price
inflation rates, a widening current account deficit, excessive expansion of domestic borrowing,
high government deficits, and asset price inflation (such as sharp increases in stock and property
prices).
82. Which of the following observations is true of the current system of the foreign exchange market?
A. Most of the currencies can be converted to gold in the current system of foreign exchange.
B. The current system is driven by fixed exchange rates.
C. Currencies float freely against others in the current system.
D. The current system is a combination of government intervention and speculative activity.
The current system of foreign exchange is a mixed system in which a combination of government
intervention and speculative activity can drive the foreign exchange market.
83. Which of the following will help a company hedge against currency fluctuations?
Maintaining strategic flexibility can take the form of dispersing production to different locations
around the globe as a real hedge against currency fluctuations.
84. Contracting out manufacturing allows companies to reduce economic exposure because:
One way of building strategic flexibility and reducing economic exposure involves contracting out
manufacturing. This allows a company to shift suppliers from country to country in response to
changes in relative costs brought about by exchange rate movements.
85. Increasingly the _____ has been acting as macroeconomic police of the world economy, insisting
that countries seeking significant borrowings adopt certain macroeconomic policies.
Increasingly the IMF has been acting as macroeconomic police of the world economy, insisting
that countries seeking significant borrowings adopt IMF-mandated macroeconomic policies.
86. Countries that require substantial loans from the International Monetary Fund to survive will _____
due to IMF-mandated economic policies.
Increasingly, the IMF has been acting as the macroeconomic police of the world economy,
insisting that countries seeking significant borrowings adopt IMF-mandated macroeconomic
policies. These policies typically include anti-inflationary monetary policies and reductions in
government spending. In the short run, such policies usually result in a sharp contraction of
demand.
It makes sense for businesses to pursue strategies that will increase the company's strategic
flexibility in the face of unpredictable exchange rate movements—that is, to pursue strategies that
reduce the economic exposure of the firm.
When the foreign exchange market determines the relative value of a currency, the country is
adhering to a floating exchange rate system. The world's four major trading currencies, the
Japanese yen, the U.S. dollar, the British pound, and the European Union's euro are all free to
float against each other. Consequently, their exchange rates are determined by market forces and
fluctuate against each other daily.
89. Prior to the introduction of the euro, many EU countries participated in a _____.
In a fixed exchange rate system, the values of a set of currencies are fixed against each other at
some mutually agreed upon exchange rate. Prior to the introduction of the euro, many EU
countries participated in a fixed exchange rate system.
90. _____ are popular among many of the world's smaller nations.
Under a pegged exchange rate regime, a country will peg the value of its currency to that of a
major currency so that, for example, as the U.S. dollar rises in value, its own currency rises too.
Pegged exchange rates are popular among many of the world's smaller nations. As with a full
fixed exchange rate regime, the great virtue claimed for a pegged exchange rate is that it imposes
monetary discipline on a country and leads to low inflation.
Moral hazard arises when people behave recklessly because they know they will be saved if
things go wrong. The IMF has been criticized for exacerbating moral hazard with its rescue
programs. According to critics, many Japanese and Western banks made loans to overleveraged
Asian companies during the 1990s, and should now be forced to pay the price for their actions.
Instead, the IMF, through its rescue package, is reducing the probability of debt default and
effectively bailing out the banks.
A. currency crisis
B. banking crisis
C. foreign debt crisis
D. domestic debt crisis
A currency crisis occurs when a speculative attack on the exchange value of a currency results in
a sharp depreciation in the value of the currency or forces authorities to expend large volumes of
international currency reserves and sharply increase interest rates to defend the prevailing
exchange rate. In contrast, a banking crisis refers to a loss of confidence in the banking system
that leads to a run on banks as individuals and companies withdraw their deposits. Finally, a
foreign debt crisis is a situation in which a country cannot service its foreign debt obligations,
whether private sector or government debt.
These crises tend to have common underlying macroeconomic causes: high relative price inflation
rates, a widening current account deficit, excessive expansion of domestic borrowing, and asset
price inflation (such as sharp increases in stock and property prices).
Essay Questions
93. What is international monetary system? What are the major trading currencies?
The international monetary system refers to the institutional arrangements that govern exchange
rates. The four major trading currencies are the U.S. dollar, the European Union's euro, the
Japanese yen, and the British pound.
94. Compare and contrast a pegged exchange system with a dirty-float system of exchange rates.
A pegged exchange rate means the value of the currency is fixed relative to a reference currency,
such as the U.S. dollar, and then the exchange rate between that currency and other currencies is
determined by the reference currency exchange rate. Some countries, while not adopting a formal
pegged rate, try to hold the value of their currency within some range against an important
reference currency such as the U.S. dollar, or a "basket" of currencies. This is referred to as a
dirty float.
Pegging currencies to gold and guaranteeing convertibility is known as the gold standard. By
1880, most of the world's major trading nations, including Great Britain, Germany, Japan, and the
United States, had adopted the gold standard. Because each currency was linked to gold under
the system, it was easy to determine the value of any currency in units of any other currency.
The great strength claimed for the gold standard was that it contained a powerful mechanism for
achieving balance-of-trade equilibrium by all countries.
96. With the help of an example, explain how balance-of-trade equilibrium is maintained under the
gold standard.
A country is in balance-of-trade equilibrium when the income its residents earn from exports is
equal to the money its residents pay to other countries for imports (the current account of its
balance of payments is in balance). Under the gold standard, when Japan has a trade surplus,
there will be a net flow of gold from the U.S. to Japan. These gold flows automatically reduce the
U.S. money supply and swell Japan's money supply. An increase in money supply will raise prices
in Japan, while a decrease in the U.S. money supply will push U.S. prices downward. The rise in
the price of Japanese goods will decrease demand for these goods, while the fall in the prices of
U.S. goods will increase demand for these goods. Thus, Japan will start to buy more from the
U.S., and the U.S. will buy less from Japan, until a balance-of-trade equilibrium is achieved.
The Bretton Woods agreement, signed in 1944, called for a system of fixed exchange rates
whereby countries would fix the value of their currency to gold. Unlike the gold standard, countries
were not required to exchange their currencies for gold. Instead, only the dollar remained
convertible to gold, and each country decided what its exchange rate relative to the dollar was to
be and then calculated the gold par value of the currency based on that selected dollar exchange
rate. All participating countries agreed to try to maintain the value of their currencies within 1
percent of the par value by intervening in the market as necessary.
98. Identify the multinational institutions that were established at the Bretton Woods agreement. What
were their roles in the international monetary system?
At the Bretton Woods meeting in 1944, two multinational institutions, the International Monetary
Fund (IMF) and the World Bank, were established. The IMF was established to maintain order in
the international monetary system. The IMF sought to achieve this goal through a combination of
discipline and flexibility. The World Bank, also known as the International Bank for Reconstruction
and Development, was established to help the war-torn economies of Europe rebuild. However,
the World Bank soon turned its attention to providing assistance to other countries, particularly
Third World countries.
The Bretton Woods system started to fall apart in the late 1960s, and finally collapsed in 1973.
The system fell apart because the U.S. dollar, which played a central role in the regime, was being
pressured to devalue. To finance both the Vietnam conflict and his welfare programs, President
Lyndon Johnson backed an increase in U.S. government spending that was not financed by an
increase in taxes. Instead, it was financed by an increase in the money supply, which led to a rise
in price inflation from less than 4 percent in 1966 to close to 9 percent by 1968.
The increase in inflation and the worsening of the U.S. foreign trade position gave rise to
speculation in the foreign exchange market that the dollar would be devalued. Things came to a
head in the spring of 1971 when U.S. trade figures showed that for the first time since 1945, the
United States was importing more than it was exporting.
Then President, Nixon finally announced in 1971 that the dollar was no longer convertible to gold,
and that a 10 percent tariff would remain in effect until all trading partners agreed to revalue their
currencies relative to the dollar. Even after this move and a subsequent revaluation of currencies
relative to the dollar, speculation continued that dollar would be further devalued until at last,
currencies were allowed to float freely, and the fixed exchange rate system ended.
The 1976 Jamaica Agreement formalized the floating exchange rate regime that followed the
collapse of Bretton Woods. The agreement established the rules for the international monetary
system that are in place today. Under the agreement, floating rates were declared to be
acceptable, gold was abandoned as a reserve asset, and total annual IMF quotas were increased.
Under the Jamaica Agreement, the IMF continued in its role of helping countries cope with
macroeconomic and exchange rate problems.
101. Discuss the arguments that favor a floating exchange rate system against a fixed exchange rate
system.
There are two main elements in the case for floating exchange rates: monetary policy autonomy
and automatic trade balance adjustments. Under a fixed exchange rate system, a country's ability
to expand or contract its money supply is limited by the need to maintain exchange rate parity.
Under a floating exchange rate system, however, monetary control is restored to the government
enabling a government to pursue domestic policies that involve expanding or contracting the
money supply without worrying about maintaining exchange rate parity. Similarly, a floating
exchange rate system a country can correct a trade imbalance through currency adjustments, a
practice that is impossible under a fixed rate system.
The case for fixed exchange rates revolves around arguments about monetary discipline,
speculation, uncertainty, and the lack of connection between the trade balance and exchange
rates. Supporters of a fixed exchange rate system suggest that the monetary discipline required
by a fixed exchange rate system allows a government to ignore political pressures that might
result in a rapid expansion of the money supply and high inflation.
Advocates of fixed exchange rates argue that the system limits the destabilizing effects of
speculation. Similarly, because the fixed rate system is more predictable, according to supporters,
international trade and investment will be encouraged. Finally, advocates of fixed exchange rates
suggest that trade deficits are determined by the balance between savings and investment in a
country, not by the external value of its currency. Therefore, the need for floating exchange rates
to correct trade imbalances is not valid.
Governments around the world pursue a number of different exchange rate policies. These range
from a pure "free float" where the exchange rate is determined by market forces to a pegged
system that has some aspects of the pre-1973 Bretton Woods system of fixed exchange rates.
Some 14 percent of the IMF's members allow their currency to float freely. Another 26 percent
intervene in only a limited way (the so-called managed float). A further 22 percent of IMF members
now have no separate legal tender of their own.
The remaining countries use more inflexible systems, including a fixed peg arrangement (28
percent) under which they peg their currencies to other currencies, such as the U.S. dollar or the
euro, or to a basket of currencies. Other countries have adopted a system under which their
exchange rate is allowed to fluctuate against other currencies within a target zone (an adjustable
peg system).
A country that introduces a currency board commits itself to converting its domestic currency on
demand into another currency at a fixed exchange rate. To make the commitment credible, the
currency board holds reserves of foreign currency equal at the fixed exchange rate to at least 100
percent of the domestic currency issued. The system is attractive because it limits the ability of the
government to print money, and thereby create inflationary pressure. Under a strict currency
board, interest rates will adjust automatically. However, critics point out that if local inflation rates
remain higher than the inflation rate in the country to which the currency is pegged, the currencies
of countries with currency boards can become uncompetitive and overvalued. Also, the system
does not permit governments to set interest rates.
105. Recent policies of the International Monetary Fund have drawn a lot of criticism. Discuss these
criticisms.
The IMF‘s policies designed to cool overheated economies by reining in inflation and reducing
government spending have been highly criticized. One criticism is that the IMF's "one-size-fits-all"
approach to macroeconomic policy is inappropriate for many countries. The IMF has also been
accused of intensifying moral hazard through its rescue packages. Finally, it has been suggested
that the IMF has become too powerful for an institution that lacks any real mechanism for
accountability.
106. How can international companies reduce their economic exposure in a world of constantly
fluctuating exchange rates?
For companies operating in a world of volatile exchange rates, it is important to pursue strategies
that reduce the economic exposure of the firm. One way to maintain strategic flexibility is to
disperse production to different locations around the globe. This strategy allows companies to
hedge currency fluctuations. Companies can also build strategic flexibility by contracting out their
manufacturing. This strategy allows a company to shift suppliers from country to country in
response to changes in relative costs brought about by exchange rate movements. Finally,
companies should be aware of IMF macroeconomic policies that might affect their operations. IMF
policies often result in a sharp contraction in demand in the short run, and an expansion of
demand in the long run. Companies need to follow the IMF policies and adjust their strategies
accordingly.
107. Do you think businesses can influence government policies? Explain your answer.
As major players in the international trade and investment environment, businesses can influence
government policy toward the international monetary system. For example, intense government
lobbying by U.S. exporters helped convince the U.S. government that intervention in the foreign
exchange market was necessary. With this in mind, business can and should use its influence to
promote an international monetary system that facilitates the growth of international trade and
investment. Student answers will vary for this question.