Study Guide for the 1st Midterm 1.

Explain how the adoption of the euro as the single currency by European countries could be beneficial to MNCs based in Europe and to MNCs based in the U.S. ANSWER: There is now no exchange rate risk between the eleven countries participating in the euro. This makes it easier to compare prices across countries and to compete for MNCs based in Europe. The advantages are the same for MNCs based in the U.S. 2. A relatively small U.S. balance-of-trade deficit is commonly attributed to a strong demand for U.S. exports. What do you think is the underlying reason for the strong demand for U.S. exports? ANSWER: The strong demand for U.S. exports is commonly attributed to strong foreign economies or to a weak dollar. 3. What are some of the major objectives of the IMF? ANSWER: Major IMF objectives are to (1) promote cooperation among countries on international monetary issues, (2) promote stability in exchange rates, (3) provide temporary funds to member countries attempting to correct imbalances of international payments, (4) promote free mobility of capital funds across countries, and (5) promote free trade 4. How would a relatively high home inflation rate affect the home countrys current account, other things being equal? ANSWER: A high inflation rate tends to increase imports and decrease exports, thereby increasing the current account deficit, other things equal 5. What is the current account generally composed of? ANSWER: The current account balance is composed of (1) the balance of trade, (2) the net amount of payments of interest to foreign investors and from foreign investment, (3) payments from international tourism, and (4) private gifts and grants. 6. What is the capital account generally composed of?

ANSWER: The capital account is composed of all capital investments made between countries, including both direct foreign investment and purchases of securities with maturities exceeding one year. 7. Explain how the existence of the euro could affect U.S. international trade. The euro allowed for a single currency among many European countries. It could encourage firms in those countries to trade among each other since there is no exchange rate risk. This would possibly cause them to trade less with the U.S. The euro can increase trade within Europe because it eliminates the need for several European countries to exchange currencies when trading with each other.

9. If a euro is worth $.80, what is the value of a dollar in euros? ANSWER: 1/0.8 =0.1.25 11. Why do interest rates vary among countries? Why are interest rates similar for those European countries that use the euro as their currency? ANSWER: Interest rates in each country are based on the supply of funds and demand for funds for a given currency. However, the supply and demand conditions for the euro is dictated by all participating countries in aggregate, and do not vary among participating countries. 12.Compute the forward discount or premium for the British pound whose 180-day forward rate is $1.75 and spot rate is $1.78. State whether your answer is a discount or premium. ANSWER: [($1.75 $1.78)/$1.78] 360/180 = -0.0337 or 3.37% (minus sign implies discount) 13. Assume the spot rate of the British pound is $1.73. The expected spot rate one year from now is assumed to be $1.66. What percentage depreciation does this reflect?

ANSWER: ($1.66 $1.73)/$1.73 = 4.05%. Expected depreciation of 4.05% percent 14. Assume that the U.S. income level rises at a much higher degree than does the Canadian income level. Other things being equal, how should this affect the (a) U.S. demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the Canadian dollar? ANSWER: Assuming no effect on U.S. interest rates, demand for CAD should increase, supply of CAD for sale may not be affected, and the CAD value should increase. 15.What are the basic factors that determine the value of a currency? In equilibrium, what is the relationship between these factors? ANSWER: The basic factors that determine the value of a currency are the supply of the currency for sale and the demand for the currency. A high level of supply of a currency generally decreases the currencys value, while a high level of demand for a currency increases its value. In equilibrium, the supply of the currency equals the demand for the currency. Supply of a currencycurrencys value; demand for currencyvalue of currency 16. What are some advantages and disadvantages of a freely floating exchange rate system versus a fixed exchange rate system? ANSWER: A freely floating system may help correct balance-of-trade deficits since the currency will adjust according to market forces. Also, countries are more insulated from problems of foreign countries under a freely floating exchange rate system. However, a disadvantage of freely floating exchange rates is that firms have to manage their exposure to exchange rate risk. Also, floating rates still can often have a significant adverse impact on a countrys unemployment or inflation. 17. Compare and contrast the fixed, freely floating, and managed float exchange rate systems. ANSWER: Under a fixed exchange rate system, the governments attempted to maintain exchange rates within 1% of the initially set value.

Under a freely floating system, government intervention would be non-existent. Under a managed float system, governments will allow exchange rates move according to market forces; however, they will intervene when they believe it is necessary. Extra Credit Questions 1. U.K. inflation is expected to decline, while U.S. inflation is expected to rise. British interest rates are expected to decline, while U.S. interest rates are expected to increase a. Explain how the international trade flows should initially adjust in response to the changes in inflation (holding exchange rates constant). Explain how the international capital flows should adjust in response to the changes in interest rates (holding exchange rates constant). ANSWER: The U.S. balance-of-trade deficit should increase in response to the changes in inflation, since prices of U.S. exports will increase if U.S. inflation rises, causing a decline in the British demand for U.S. exports. In addition, the U.S. demand for British exports should increase if U.S. prices increase. The capital flows from the U.S. to the U.K. should decrease in response to lower British interest rates; while the capital flows from the U.K. to the U.S. should increase (assuming exchange rates are held constant). b. Using the information provided, expect the pound to appreciate or depreciate in the future? Explain. ANSWER: The pounds equilibrium value will change in response to changes in the capital flows and changes in the trade flows. The information on interest rates suggests that capital flows from the U.S. to the U.K. will decrease, (because British interest rates are expected to decline), while flows from the U.K. to the U.S. will increase (because U.S. interest rates are expected to rise). These forces will place downward pressure on the pounds value

2. Suppose the bid-ask quote for Swedish Krona is $ .1395-99, and for Mexican Peso is $.1130-33. What is the bid-ask quote for Swedish Krona/Mexican Peso? a. b. c. d. 1.2312-81 1.2414-37 .0806-11 .0973-81

ANSWER: A Figure it on your own