Chapter 6

GovernmentsandExchangeRates

1. To force the value of the pound to appreciate against the dollar, the Federal Reserve should:
A) sell dollars for pounds in the foreign exchange market and the European Central Bank
(ECB) should sell dollars for pounds in the foreign exchange market.
B) sell pounds for dollars in the foreign exchange market and the European Central Bank
(ECB) should sell dollars for pounds in the foreign exchange market.
C) sell pounds for dollars in the foreign exchange market and the European Central Bank
(ECB) should not intervene.
D) sell dollars for pounds in the foreign exchange market and the European Central Bank
(ECB) should sell pounds for dollars in the foreign exchange market.

ANSWER: A

2. A weak dollar is normally expected to cause:

A) high unemployment and high inflation in the U.S.
B) high unemployment and low inflation in the U.S.
C) low unemployment and low inflation in the U.S.
D) low unemployment and high inflation in the U.S.

ANSWER: D

3. A strong dollar is normally expected to cause:

A) high unemployment and high inflation in the U.S.
B) high unemployment and low inflation in the U.S.
C) low unemployment and low inflation in the U.S.
D) low unemployment and high inflation in the U.S.

ANSWER: B

165
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166 International Corporate Finance
4. To force the value of the British pound to depreciate against the dollar, the Federal Reserve
should:
A) sell dollars for pounds in the foreign exchange market and the Bank of England should sell
dollars for pounds in the foreign exchange market.
B) sell pounds for dollars in the foreign exchange market and the Bank of England should sell
dollars for pounds in the foreign exchange market.
C) sell pounds for dollars in the foreign exchange market and the Bank of England should sell
pounds for dollars in the foreign exchange market.
D) sell dollars for pounds in the foreign exchange market and the Bank of England should sell
pounds for dollars in the foreign exchange market.

ANSWER: C

5. Consider two countries that trade with each other, called X and Y. According to the text,
inflation in Country X will have a greater impact on inflation in Country Y under the _______
system. Now, consider two other countries that trade with each other, called A and B.
Unemployment in Country A will have a greater impact on unemployment in Country B under
the _______ system.
A) floating rate; fixed rate
B) floating rate; floating rate
C) fixed rate; fixed rate
D) fixed rate; floating rate

ANSWER: C

6. A primary result of the Bretton Woods Agreement was:

A) the establishment of the European Monetary System (EMS).
B) establishing specific rules for when tariffs and quotas could be imposed by governments.
C) establishing that exchange rates of most major currencies were to be allowed to fluctuate
1% above or below their initially set values.
D) establishing that exchange rates of most major currencies were to be allowed to fluctuate
freely without boundaries (although the central banks did have the right to inter vene when
necessary).

ANSWER: C

7. A primary result of the Smithsonian Agreement was:

A) the establishment of the European Monetary System (EMS).
B) establishing that exchange rates of most major countries were to be allowed to fluctuate
2.25% above or below their initially set values.
C) establishing specific rules for when tariffs and quotas could be imposed by governments.
D) establishing that exchange rates of most major currencies were to be allowed to fluctuate
freely without boundaries (although the central banks did have the right to inter vene when
necessary).

ANSWER: B

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Chapter 6: Governments and Exchange Rates 167
8. Under a fixed exchange rate system:
A) a foreign exchange market does not exist.
B) central bank intervention in the foreign exchange market is not necessary.
C) central bank intervention in the foreign exchange market is often necessary.
D) central bank intervention in the foreign exchange market is not allowed.

ANSWER: C

9. Under a managed float exchange rate system, the Fed may attempt to stimulate the U.S.
economy by _______ the dollar. Such an adjustment in the dollar’s value should _______ the
U.S. demand for products produced by major foreign countries.
A) weakening; increase
B) weakening; decrease
C) strengthening; increase
D) strengthening; decrease

ANSWER: B

10. The value of the Canadian dollar, Japanese yen, and Australian dollar with respect to the U.S.
dollar are part of a:
A) pegged system.
B) fixed system.
C) managed float system.
D) crawling peg system.

ANSWER: C

11. The interest rate of a country with a currency board:

A) is less stable than it would be without a currency board.
B) is typically below the interest rate of the currency to which it is tied.
C) will move in tandem with the interest rate of the currency to which it is tied.
D) is completely independent of the interest rate of the currency to which it is tied.

ANSWER: C

12. The currency of country X is pegged to the currency of country Y. Assume that county Y’s
currency depreciates against the currency of country Z. It is likely that country X will export
_______ to country Z and import _______ from country Z.
A) more; more
B) less; less
C) more; less
D) less; more

ANSWER: C

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168 International Corporate Finance
13. Assume countries A, B, and C produce goods that are substitutes of each other and that these
countries engage in trade with each other. Assume that country A’s currency floats against
country B’s currency, and that country C’s currency is pegged to B’s. If A’s currency
depreciates against B, then A’s exports to C should _______, and A’s imports from C should
_______.
A) decrease; increase
B) decrease; decrease
C) increase; decrease
D) increase; increase

ANSWER: C

14. Assume a central bank exchanges its currency for other foreign currencies in the foreign
exchange market, but does not adjust for the resulting change in the money supply. This is an
example of:
A) pegged intervention.
B) indirect intervention.
C) nonsterilized intervention.
D) sterilized intervention.
E) A and D

ANSWER: C

15. If the Fed desires to weaken the dollar without affecting the dollar money supply, it should:
A) exchange dollars for foreign currencies, and sell some of its existing Treasury security
holdings for dollars.
B) exchange foreign currencies for dollars, and sell some of its existing Treasury security
holdings for dollars.
C) exchange dollars for foreign currencies, and buy existing Treasury securities with dollars.
D) exchange foreign currencies for dollars, and buy existing Treasury securities with dollars.

ANSWER: A

16. Which of the following is an example of direct intervention in foreign exchange markets?
A) lowering interest rates.
B) increasing the discount rate.
C) exchanging dollars for foreign currency.
D) imposing barriers on international trade.

ANSWER: C

17. A strong dollar places _______ pressure on inflation, which in turn places _______ pressure on
the dollar.
A) upward; upward
B) downward; upward
C) upward; downward
D) downward; downward

ANSWER: B

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Chapter 6: Governments and Exchange Rates 169
18. The Fed may use a stimulative monetary policy with least concern about causing inflation if the
dollar’s value is expected to:
A) remain stable.
B) strengthen.
C) weaken.
D) none of the above will have an impact on inflation.

ANSWER: B

19. A weaker dollar places _______ pressure on U.S. inflation, which in turn places _______
pressure on U.S. interest rates, which places _______ pressure on U.S. bond prices.
A) upward; downward; upward
B) upward; downward; downward
C) upward; upward; downward
D) downward; upward; upward
E) downward; downward; upward

ANSWER: C

20. The euro is the currency:

A) adopted in all western European countries as of 1999.
B) adopted in all eastern European countries as of 1999.
C) adopted in all European countries as of 1999.
D) none of the above

ANSWER: D

21. Assume that Lithuania (a member of the European Union) wishes to adopt the euro as its
currency. Which of the following is not a requirement Lithuania must meet?
A) restrict the movements of the euro relative to its home currency within a range of plus or
minus 15 percent from an initially set exchange rate.
B) limit inflation.
C) limit the Lithuanian budget deficit.
D) increase GDP growth by 3% annually.

ANSWER: D

22. The exchange rate mechanism (ERM) refers to the method of linking __________ currencies to
each other within boundaries.
A) Latin American
B) European
C) Asian
D) North American

ANSWER: B

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170 International Corporate Finance
23. Countries that have adopted the euro must agree on a single ________ policy.
A) monetary
B) fiscal
C) worker compensation
D) foreign relations

ANSWER: A

24. The exchange rate mechanism (ERM) crisis in 1992 represents the __________ in German
interest rates that caused other European interest rates to __________, and resulted in less
aggregate spending.
A) increase; increase
B) increase; decrease
C) decrease; decrease
D) decrease; increase

ANSWER: A

25. The risk-free interest rates among countries that have adopted the euro should:
A) are not necessarily similar to risk-free rates in other countries.
B) should equal the U.S. risk-free rate.
C) should equal the risk-free rates in other European countries.
D) should equal the risk-free rates in Asian countries.

ANSWER: A

26. Which of the following is true regarding the euro?

A) Exchange rate risk between participating European currencies is completely eliminated,
encouraging more trade and capital flows across European borders.
B) It allows for more consistent economic conditions across countries.
C) It prevents each country from conducting its own monetary policy.
D) All of the above are true.

ANSWER: D

27. It has been argued that the exchange rate can be used as a policy tool. Assume that the U.S.
government would like to reduce unemployment. Which of the following is an appropriate
action given this scenario?
A) weaken the dollar.
B) strengthen the dollar.
C) buy dollars with foreign currency in the foreign exchange market.
D) implement a tight monetary policy.

ANSWER: A

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Chapter 6: Governments and Exchange Rates 171
28. It has been argued that the exchange rate can be used as a policy tool. Assume that the U.S.
government would like to reduce inflation. Which of the following is an appropriate action
given this scenario?
A) sell dollars for foreign currency.
B) buy dollars with foreign currency.
C) lower interest rates.
D) none of the above

ANSWER: B

29. To strengthen the dollar using sterilized intervention, the Fed would _____________
dollars and simultaneously ____________ Treasury securities.
A) buy; sell
B) sell; buy
C) buy; buy
D) sell; sell

ANSWER: C

30. As foreign exchange activity has grown:

A) central bank intervention has become more effective.
B) central bank intervention has become more frequent.
C) central bank intervention has become less effective.
D) none of the above

ANSWER: C

31. When using indirect intervention, a central bank is likely to focus on:
A) inflation.
B) interest rates.
C) income levels.
D) expectations of future exchange rates.

ANSWER: B

32. Which of the following countries was probably the least affected (directly or indirectly) by
the Asian crisis?
A) Thailand.
B) Indonesia.
C) Russia.
D) China.
E) Malaysia.

ANSWER: D

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172 International Corporate Finance
33. Which of the following is not true regarding Thailand?
A) Thailand was one of the slowest growing countries over the 1985-1994 period.
B) High levels of spending and low levels of saving placed upward pressure on prices of real
estate, products, and on Thailand’s local interest rate.
C) Thailand’s baht was linked to the dollar prior to July 1997, which made Thailand an
attractive site for foreign investors.
D) Thai banks provided many loans that were very risky in their attempt to make use of all of
their funds.
E) All of the above are true.

ANSWER: A

34. The term “target zone arrangement” refers to a:

A) situation where countries adjust their national economic policies to maintain exchange rates
within some predetermined limits.
B) system where several central banks act in a coordinated intervention to keep the price of one
country’s currency within reasonable trading ranges.
C) system where currencies are pegged to gold, or to hard currency.
D) system where local currencies are replaced by dollars.

ANSWER: A

35. During the period 1944-1971, the U.S. used a __________ system.
A) euro exchange rate
B) fixed
C) dirty float
D) flexible

ANSWER: B

36. Which of the following are examples of currency controls?

A) import restrictions.
B) prohibition of remittance of funds.
C) ceilings on granting credit to foreign firms.
D) all of the above

ANSWER: D

37. From a financial management perspective, which of the following is true regarding the
introduction of the Euro?
A) U.S.-based MNCs are not subject to exchange rate risk when they have transactions in euros.
B) The euro is pegged to all other European currencies.
C) Transactions costs decline for MNCs that conduct transactions within Europe.
D) The euro replaced the British pound.

ANSWER: C

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Chapter 6: Governments and Exchange Rates 173
38. Which of the following countries have not adopted the Euro as of January 1, 2004?
A) Germany
B) Italy
C) Iceland
D) Denmark

ANSWER: C

39. Which of the following are true about the Southeast Asian currency crisis?
A) It was preceded by several years of large capital inflows to Asia.
B) It was preceded by a five-year recession in Asia.
C) Asian interest rates declined during the crisis.
D) Asian exchange rates were converted from floating to fixed to resolve the crisis.

ANSWER: D

40. Under a fixed exchange rate system, U.S. inflation would have a greater impact on
inflation in other countries than it would under a freely floating exchange rate system.
A) true.
B) false.

ANSWER: A

41. An advantage of a fixed exchange rate system is that governments are not required
to constantly intervene in the foreign exchange market to maintain exchange rates within
specified boundaries.
A) true.
B) false.

ANSWER: B

42. Under the system known as the “dirty” float, official boundaries for the exchange
rate exist, but they are wider than they are under a fixed exchange rate system.
A) true.
B) false.

ANSWER: B

43. Under a pegged exchange rate system, the home currency’s value is pegged to a foreign
currency or to some unit of account.
A) true.
B) false.

ANSWER: A

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174 International Corporate Finance
44. A major advantage of the euro is the complete elimination of exchange rate risk on
transactions between participating European countries, which encourages more trade and
capital flows within Europe.
A) true.
B) false.

ANSWER: A

45. The European countries conforming to the euro are completely insulated from
movements in the euro’s value with respect to other currencies.
A) true.
B) false.

ANSWER: B

46. The establishment of the euro allows for more consistent economic conditions
across countries but eliminates the power of any individual European country to solve local
economic problems with its own unique monetary policy.
A) true.
B) false.

ANSWER: A

47. The Asian crisis is generally believed to have started in Japan.

A) true.
B) false.

ANSWER: B

48. A possible reason why China was less affected by the Asian crisis is that its
government exerts more influence on private enterprise than the governments of other Asian
countries.
A) true.
B) false.

ANSWER: A

49. Currency devaluation can boost a country’s exports, but currency revaluation can
increase foreign competition.
A) true.
B) false.

ANSWER: A

50. Market forces are the determinant of exchange rates in a freely floating exchange
rate system.
A) true.
B) false.

ANSWER: A

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Chapter 6: Governments and Exchange Rates 175
51. If a government wishes to stimulate its economy in the form of increased foreign
demand for its country’s products, it could attempt to weaken its currency.
A) true.
B) false.

ANSWER: A

52. In a sterilized exchange rate arrangement, a country’s home currency value is

pegged to a foreign currency or to some unit of account.
A) true.
B) false.

ANSWER: B

53. The Bank of England is responsible for setting the monetary policy for the European
countries participating in the euro.
A) true.
B) false.

ANSWER: B

54. The Fed’s indirect method of intervention is to trade dollars for or against other
currencies.
A) true.
B) false.

ANSWER: B

55. A potential advantage of exchange rate target zones is that they may stabilize
international trade patterns by reducing exchange rate volatility.
A) true.
B) false.

ANSWER: A

56. The Bretton Woods Agreement created a system under which exchange rates are
determined by market forces without intervention by various governments.
A) true.
B) false.

ANSWER: B

57. Nonsterilized intervention is intervention by a central bank in the foreign exchange

market without adjusting for the change in money supply.
A) true.
B) false.

ANSWER: A

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176 International Corporate Finance
58. The euro is pegged to other currencies of European countries that have not adopted
the euro.
A) true.
B) false.

ANSWER: A

59. The Smithsonian Agreement was reached in September 1985 by seven major
industrialized countries to systematically weaken the dollar.
A) true.
B) false.

ANSWER: B

60. An example of indirect intervention by the Bank of Japan would be for the Bank of
Japan to use interest rates to increase the value of the Yen vs. the dollar.
A) true.
B) false.

ANSWER: A

61. A strong home currency can harm exports; exporters typically benefit from a
weaker home country currency.
A) true.
B) false.

ANSWER: A

62. An advantage of freely floating exchange rates is that a country with floating
exchange rates is more insulated from unemployment problems in other countries.
A) true.
B) false.

ANSWER: A

63. All European countries now use the euro as their currency.
A) true.
B) false.

ANSWER: B

64. A country with a currency board does not have control over its local interest rates.
A) true.
B) false.

ANSWER: A

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Chapter 6: Governments and Exchange Rates 177
65. Dollarization refers to the replacement of local currency with U.S. dollars.
A) true.
B) false.

ANSWER: A

66. A country with fixed exchange rates often faces constraints on growth.
A) true.
B) false.

ANSWER: A

67. The Bretton Woods Agreement called for the establishment of a single European
currency.
A) true.
B) false.

ANSWER: B

68. The European Central Bank is responsible for monetary policy in all participating
European countries.
A) true.
B) false.

ANSWER: A

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