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The answers print on a separate page at the end. Higher levels include the lower-level questions.

ExamPass · AS Level worksheet

Exchange rates

NameClassDate

Key terms

Define each term.

1
Exchange rate
2
Floating exchange rate

Multiple choice

Circle the correct answer.

3

A country's currency depreciates. Which is the most likely immediate effect?

  1. Exports become dearer abroad and imports cheaper at home
  2. Exports become cheaper abroad and imports dearer at home
  3. Both exports and imports become cheaper
  4. Neither is affected until the government intervenes
4

Which would increase demand for a country's currency on the foreign exchange market?

  1. Domestic residents taking more foreign holidays
  2. A rise in foreign demand for the country's exports
  3. Domestic firms importing more raw materials
  4. Domestic investors buying more foreign shares
5

A country with a fixed exchange rate faces persistent downward pressure on its currency. Which pair of actions would defend the peg?

  1. Sell foreign reserves to buy the domestic currency, and raise interest rates
  2. Buy foreign reserves with domestic currency, and cut interest rates
  3. Cut interest rates and impose tariffs
  4. Allow the currency to float and cut taxes

Worked problems

Show your working.

6

What an appreciation does to importers and exporters. A currency appreciates from $1 = 4 pesos to $1 = 5 pesos. A domestic exporter sells a machine for 20,000 pesos. An importer buys components priced at $6,000. Calculate the effect on each, and state who gains.

Chains of reasoning

The steps are in the wrong order. Write the letters in the order that makes a linked chain.

7

Why a fixed rate constrains domestic policy

  • A Capital outflow means the currency is being sold, putting downward pressure on the pegged rate.
  • B The domestic economy enters recession, so the appropriate domestic policy is a cut in interest rates to stimulate demand.
  • C Lower interest rates make domestic assets less attractive to foreign investors, so capital flows out.
  • D A government pegs its currency and commits to defending the rate.
  • E Raising interest rates is the opposite of what the recession requires, so output falls further and unemployment rises.
  • F To defend the peg the central bank must buy its own currency with foreign reserves, and raise interest rates to attract capital back.
  • G The government must choose between the peg and the domestic economy, and if reserves run down before confidence returns, the choice is made for it and the peg breaks.

Diagrams

8

Draw a foreign exchange market diagram with the exchange rate on the vertical axis and quantity of the currency on the horizontal axis. Show demand and supply meeting at an equilibrium rate. Then show separately the effect of a rise in exports, and the effect of a rise in domestic interest rates attracting foreign investment.

9

Draw a foreign exchange market showing the equilibrium rate below a government's target fixed rate. Mark the excess supply of the currency at the fixed rate. Show how central bank purchases of its own currency shift demand right to hold the rate, and mark the reserves used.

Answers

1

Exchange rate: The price of one currency expressed in terms of another.

2

Floating exchange rate: An exchange rate determined by the demand for and supply of the currency on the foreign exchange market, without government intervention to fix its value.

3

B. A weaker currency means foreigners need less of their own money to buy a given amount of it, so exports priced in the domestic currency become cheaper to them. Domestic buyers need more of their own currency to obtain foreign currency, so imports become dearer. This is SPICED read in reverse.

4

B. Foreign buyers of exports must obtain the domestic currency to pay for them, which raises demand for it. The other three all involve domestic residents needing foreign currency, so they supply the domestic currency to the market and push its value down.

5

A. Downward pressure means the currency is being sold, so the central bank must be the buyer, using foreign reserves to do it. Raising interest rates makes domestic assets more attractive and pulls capital back in. Both actions support the rate, and both have domestic costs, which is the constraint a peg imposes.

6

Step 1. Read the rate change correctly. Each dollar now buys 5 pesos rather than 4, so the dollar has appreciated against the peso. Equivalently, the peso has depreciated: it was worth $0.25 and is now worth $0.20.

Step 2. Calculate the export price in dollars, before and after. Before: 20,000 / 4 = $5,000. After: 20,000 / 5 = $4,000. The machine is $1,000 cheaper to a dollar-paying buyer, so peso exports have become more competitive.

Step 3. Calculate the import cost in pesos, before and after. Before: $6,000 x 4 = 24,000 pesos. After: $6,000 x 5 = 30,000 pesos. The components cost 6,000 pesos more, so imports have become dearer for the peso economy.

Step 4. State who gains and who loses. From the peso economy's point of view its currency has depreciated: exporters gain because their goods are cheaper abroad, and importers lose because foreign goods cost more. From the dollar economy's point of view the reverse holds. Every exchange rate movement helps one side of each economy and harms the other.

Step 5. Remember the mnemonic and its limits. SPICED captures it: Strong Pound, Imports Cheap, Exports Dear. It works for any currency. But it describes prices only. Whether the trade balance actually improves depends on how much quantities respond, which is a separate question.

Always state which currency you are viewing the change from. The same movement is an appreciation for one country and a depreciation for the other, and answers that do not fix a viewpoint contradict themselves halfway through.

7

D, B, C, A, F, E, G

  1. A government pegs its currency and commits to defending the rate.
  2. The domestic economy enters recession, so the appropriate domestic policy is a cut in interest rates to stimulate demand.
  3. Lower interest rates make domestic assets less attractive to foreign investors, so capital flows out.
  4. Capital outflow means the currency is being sold, putting downward pressure on the pegged rate.
  5. To defend the peg the central bank must buy its own currency with foreign reserves, and raise interest rates to attract capital back.
  6. Raising interest rates is the opposite of what the recession requires, so output falls further and unemployment rises.
  7. The government must choose between the peg and the domestic economy, and if reserves run down before confidence returns, the choice is made for it and the peg breaks.

This is the impossible trinity in narrative form: a country cannot simultaneously have a fixed exchange rate, free capital movement and an independent monetary policy. It can have any two. Naming that trade-off explicitly is a reliable way into the higher bands.

8

Both shocks shift demand right and appreciate the currency, but for different reasons, and questions expect the reason rather than just the direction. Label the vertical axis with actual units, such as dollars per peso, because 'exchange rate' alone leaves it ambiguous which way an increase means the currency has moved.

9

The gap between quantity supplied and quantity demanded at the pegged rate is what the central bank must absorb every period, and it is the reason defence is finite. Reserves are a stock and the excess supply is a flow, so a persistently overvalued peg exhausts the stock eventually however large it is. That is the mechanism behind every currency crisis.