Chapter 14 showed how the exchange rate between currencies depends ontwo factors, the interest that can be earned on deposits of those currenciesand the expected future exchange rate. To understand fully thedetermination of exchange rates, however, we have to learn how interest ratesthemselves are determined and how expectations of future exchange rates areformed. In this and the next two chapters we examine these topics by building aneconomic model that links exchange rates, interest rates, and other importantmacroeconomic variables such as the inflation rate and output.The first step in building the model is to explain the effects of a country’smoney supply and of the demand for its money on its interest rate and exchangerate. Because exchange rates are the relative prices of national monies, factorsthat affect a country’s money supply or demand are among the most powerfuldeterminants of its currency’s exchange rate against foreign currencies. It istherefore natural to begin a deeper study of exchange rate determination with adiscussion of money supply and money demand.Monetary developments influence the exchange rate by changing both inter-est rates and people’s expectations about future exchange rates. Expectationsabout future exchange rates are closely connected with expectations about thefuture money prices of countries’ products; these price movements, in turn,depend on changes in money supply and demand. In examining monetaryinfluences on the exchange rate, we therefore look at how monetary factorsinfluence output prices along with interest rates. Expectations of future ex-change rates depend on many factors other than money, however, and thesenonmonetary factors are taken up in the next chapter.Once the theories and determinants of money supply and demand are laidout, we use them to examine how equilibrium interest rates are determined bythe equality of money supply and money demand. Then we combine our modelof interest rate determination with the interest parity condition to study theeffects of monetary shifts on the exchange rate, given the prices of goods andservices, the level of output, and market expectations about the future. Finally,we take a first look at the long-term effects of monetary changes on outputprices and expected future exchange rates.

The fundamental value of a country's exchange rate is:Group of answer choicesdetermined by the demand for the country's currency in the foreign exchange marketdetermined by the supply of and demand for the country's currency in the foreign exchange marketconstant over a prolonged period of timedetermined by the supply of the country's currency in the foreign exchange market

Exchange rates and the open economy

In economics, an exchange rate describes:A.the amount of currency available in fixed exchanges.B.how much one currency is worth compared to another.C.the total value of a country's imports and exports.D.how quickly prices are rising in an international market.

The impact of changes in exchange rates on the economy includes:Question 49Answera.Influencing trade balances and capital flowsb.Shifting monetary policy goalsc.Changing labor force participation ratesd.Determining government spending priorities

1. A fixed exchange rate regime (a) forces a country to give up free international flows of capital. (b) forces a country to abandon independent monetary policy (c) can eliminate exchange rate uncertainty (d) is the model used by the U.S. Federal Reserve. 2. If the exchange rate between the Australian dollar and the US dollar is expressed in direct quotation from an Australian perspective, then a rise in the exchange rate implies (a) appreciation of the US dollar. (b) depreciation of the US dollar. (c) appreciation of the Australian dollar. (d) (b) and (c). (Direct from Australian perspective – AUD/USD. An increase from, say, AUD 1.2 to AUD 1.3 per USD implies that the USD is now buying more AUD. Note than when the exchange rate is in direct terms and increase in the exchange rate is actually a depreciation of the domestic currency.) 3. If the AUD/USD exchange rate declines from 1.2500 to 1.2430, then the fall is equal to (a) 70 points. (b) 7000 pips. (c) 700 points. (d) 70 pips. (1 point = 0.0001) 4. Bank XYX quotes 1.2500 – 1.2550 for the AUD/USD exchange rate to a customer. What is the price at which the customer can buy one unit of the Australian dollar? (a) 1.2500. (b) 1.2550. (c) 0.8000. (d) 0.7968. (Answer: USD: 0.7968 – 0.8000/ AUD [Customer buys at the higher price]) 5. If a fixed exchange rate is set below the equilibrium rate in a fixed exchange rate system it will create (a) a deficit in the balance of payments. (b) a surplus in the balance of payments. (c) inflation. (d) deflation. (Here we are referring to the BOT model, which only considers the balance of the merchandise trade account. Keep in mind that the currency of interest is the one in the denominator, and this allows us to get around the confusion caused by direct/indirect quotations. If the ex/r is set above the equilibrium rate the country, whose currency is in the denominator, will run a trade deficit. Refer to the lecture notes or the tutorial solutions for the explanation.) 6. Which of the following items is not a flow? (a) Unilateral transfers. (b) The increase in foreign assets held by Australian investors over a period of six months. (c) Foreign exchange reserves lost by the Reserve Bank as a result of intervention in the foreign exchange market. (d) The foreign currency and gold reserves of the Reserve Bank. (Foreign currency and gold reserves are a STOCK). 7. The balancing item appears on the balance of payments to (a) account for errors and omissions in the data. (b) equate the trade and services accounts. (c) account for changes in official reserves. (d) balance the current account. 8. The sale of foreign bonds leads to (a) an increase in the supply of the foreign currency. (b) an increase in the demand for the foreign currency. (c) an increase in the supply of the domestic currency. (d) (b) and (c). (It is the equivalent of a sale of foreign assets or issue of foreign bonds by Australian companies. For example, BHP (Australian firm) issues bonds denominated in USD in the US. The sale would result in an increase in foreign currency (i.e. USD) 9. If the US inflation rate is lower than the Australian inflation rate by 5 per cent then according to relative PPP (Hint: please use the approximate version of PPP to answer this question) (a) the Australian dollar should depreciate by 5 per cent. (b) the Australian dollar should depreciate by less than 5 per cent. (c) the Australian dollar should appreciate by 5 per cent. (d) anything could happen depending on the interest rate differential. [This is an implication of the approximate version of PPP. However, should you know the exact inflation rate of the two countries, say 10% (Aust.) and 5% (US), using the “proper” PPP formula we find that the US$ will appreciate by 4.8%.] 10. If the foreign currency equivalent of the domestic price of a commodity is less than the foreign price of the same commodity, then the LOP implies that (a) the foreign currency is overvalued. (b) the foreign currency is undervalued. (c) the domestic currency is overvalued. (d) none of the above. (PPP states that P = SP*. The foreign currency equivalent of the domestic price is just P/S and this should be equal to P*. Here P/S < P*. For example, refer to the LOP problem in the lecture. The British pound (foreign currency) price of Australian wheat is GBP 2.35, which is less than the price of British wheat. The reason for