Exchange rates practice questions.

Under a floating exchange rate system, which of the following would most likely cause a country's currency to appreciate?

• A rise in the country's imports of consumer goods
• A fall in domestic interest rates relative to other countries
• Increased foreign demand for the country's exports
• Residents buying more financial assets abroad

Answer: Increased foreign demand for the country's exports

Foreigners must buy the domestic currency to pay for the country's exports, shifting the demand curve for the currency to the right and raising its value; the other options increase the supply of the currency or reduce demand for it.

A central bank operating a managed exchange rate wants to stop its currency from depreciating. Which action is most appropriate?

• Selling foreign currency reserves to buy its own currency
• Lowering the policy interest rate
• Increasing the domestic money supply
• Buying foreign currency with newly issued domestic currency

Answer: Selling foreign currency reserves to buy its own currency

Buying its own currency with foreign reserves increases demand for the domestic currency and supports its value; lower interest rates or a larger money supply would push the currency down.

Which of the following is a likely consequence of a sustained appreciation of a country's currency?

• An improvement in the current account balance
• Downward pressure on the domestic rate of inflation
• Lower prices of the country's exports for foreign buyers
• An increase in the domestic price of imported goods

Answer: Downward pressure on the domestic rate of inflation

Appreciation makes imports cheaper in domestic currency, reducing imported cost-push and demand-pull pressures; at the same time exports become dearer abroad, tending to worsen the current account.

Under a fixed exchange rate system, an official decision by the authorities to reduce the value of the currency is called a

• revaluation
• appreciation
• depreciation
• devaluation

Answer: devaluation

Devaluation (and revaluation) refer to deliberate changes of a fixed peg by the authorities; depreciation and appreciation describe market-driven changes under floating rates.

A UK firm exports machinery priced at 300 GBP per unit. The exchange rate changes from 1 GBP = 2.00 AUD to 1 GBP = 2.50 AUD. What happens to the machine's price in Australian dollars?

• It rises from 600 AUD to 750 AUD
• It falls from 750 AUD to 600 AUD
• It falls from 150 AUD to 120 AUD
• It stays at 300 AUD because the GBP price is unchanged

Answer: It rises from 600 AUD to 750 AUD

300 × 2.00 = 600 AUD before and 300 × 2.50 = 750 AUD after: the pound has appreciated, making UK exports more expensive for Australian buyers.

Speculators come to believe that the Northland dollar will depreciate in the near future. What is their most likely immediate action on the foreign exchange market, and its effect?

• buy the currency, increasing demand and pushing its value up
• buy the currency, reducing supply and pushing its value up
• sell the currency, increasing supply and pushing its value down
• sell the currency, reducing demand and pushing its value down

Answer: sell the currency, increasing supply and pushing its value down

Expecting a fall, speculators sell now to avoid holding a currency that will be worth less, which adds to its supply and makes the depreciation self-fulfilling. The frequent confusion is describing those sales as a fall in demand rather than a rise in supply.