CFA Level 2 - Economics Session 4 - Reading 19 Foreign Exchange Parity Relations - LOS d

CFA Level 2 – Economics, Session 4 – Reading 19

Foreign Exchange Parity Relations – LOS d

(Practice Questions, Sample Questions)

1. Under a system of flexible exchange rates, which one of the following is more likely to cause a nation’s currency to appreciate on the foreign exchange market?

A) A domestic inflation rate lower than the nation’s trading partners. (Explanation: If a nation’s trading partners prices are increasing twice as fast as the domestic country A, then foreign citizens will increase their demand for A’s goods.

This increased demand will appreciate country A’s currency making country A’s goods more expensive offsetting the effects of inflation)

B) A decrease in real domestic interest rates.

C) A domestic inflation rate higher than the nation’s trading partners

2. The U.S. imposes a high tariff on a major imported item. Under a system of flexible exchange rates, this would tend to:

A) cause the dollar to depreciate in value.

B) cause the dollar to appreciate in value.

(Explanation: The demand for imports would decrease due to their higher price because of the tariff. This would cause U.S. exports to increase relative to imports. When a country has increased exports relative to its imports, its currency will appreciate)

C) increase the balance of trade deficit of the U.S

3. Which of the following factors is least likely to affect foreign exchange rates?

A) Income growth.

B) The government sets a price floor for the price of wheat. (Explanation: The three major factors that cause a country’s currency to appreciate or depreciate relative to another’s are:

Differences in income growth among nations will cause nations with the highest income growth to demand more imported goods.

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Heightened demand for imports will increase demand for foreign currencies, and foreign currencies will appreciate relative to the domestic currency.

Differences in inflation rates will cause the residents of the country with the highest inflation rate to demand more imported (cheaper) goods. If a country’s inflation rate is higher than its trading partner’s, the demand for the country’s currency will be low, and the currency will depreciate.

Differences in real interest rates will cause a flow of capital into those countries with the highest available real rates of interest. Therefore, there will be an increased demand for those currencies, and they will appreciate relative to countries whose available real rate of return is low)

C) Real interest rates

4. If incomes in the U.S. are increasing rapidly compared to those in Mexico, how will the value of the U.S. dollar and the Mexican peso move relative to each other?

U.S. Dollar Peso

A) Depreciate Appreciate (Explanation: Rapid growth of U.S. incomes relative to incomes in Mexico will stimulate imports from Mexico, causing an increased demand for the peso. The increased demand for pesos will cause the peso to appreciate relative to the dollar)

B) Appreciate Depreciate

C) Depreciate No change

5. How would an unanticipated shift to a more expansionary monetary policy in the United States typically affect the demand for foreign currencies and the value of the dollar?

Demand for

Foreign Currencies Foreign Exchange Value

of the Dollar

A) Increase Decrease (Explanation: An unanticipated shift to an expansionary monetary policy will lead to higher income, an accelerated inflation rate, and lower real interest rates. The higher income and higher domestic prices stimulate imports and discourage exports causing the current account balance to move toward deficit)

B) Increase No change

C) No change Decrease

6. If the domestic inflation rate is lower than the foreign rate of inflation:

A) the domestic currency will depreciate relative to the foreign currency.

B) the foreign currency will appreciate relative to the domestic currency.

C) the domestic currency will appreciate relative to the foreign currency (Explanation: If a nation’s trading partners prices are increasing twice as fast as the domestic country A, then foreign citizens will increase their demand for A’s goods. This increased demand will cause country A’s currency to appreciate making country A’s goods more expensive offsetting the effects of inflation differences)