FINS3616 International Business Finance - Week 2

A. Conceptual questions
1. What is likely to happen if a central bank suddenly prints a large amount of new money?
Whereas there are theories that predict that changes in the supply of money have real
effects on the economy in the short run, it is likely that if the central bank showers the
economy suddenly with money, the only result will be higher inflation. This is because
the demand for money ultimately depends on the amount of real transactions in the
economy and how much money is needed to facilitate these transactions. Additional
supply of money is unlikely to make people consume more or work harder.
2. How can you quantify currency risk in a floating exchange rate system?
To characterize the risk of a currency position, you must try to characterize the
conditional distribution of the future exchange rate changes. With floating exchange
rates, historical information provides useful information about this distribution. For
example, you can use data to measure the average historical dispersion (standard
deviation or volatility) of the distribution. The higher this volatility, the riskier are
positions in this currency. Finally, we should point out that volatility is an adequate
indicator of risk when exchange rate changes are approximately normally distributed. In
reality, the distribution of exchange rate changes displays fat tails, even in floating
exchange rate systems, and this increases the risk of currency positions.
3. What was the Bretton Woods currency system?
In the Bretton Woods System, in place between 1944 and 1971, the participating
countries agreed to an exchange rate regime that linked their exchange rates to the dollar.
They could fluctuate in a 1% band around a fixed parity. The dollar itself had a fixed gold
parity ($35 per ounce). When a country ran into a temporary balance of payments
problem (a current account deficit) that threatened the currency peg, it could draw on the
lending facilities of the IMF, also established at Bretton Woods in 1944, to help it defend
the currency. Countries were also allowed to change their parities when their balances of
payments were considered to be in fundamental disequilibrium. The system broke
down in 1971.
4. Describe two different currency systems that have been introduced in countries such as
Hong Kong and Ecuador to improve the credibility of pegged exchange rate systems.
Hong Kong has a currency board system. A currency board is a monetary institution that
issues base money (notes and coins, and required reserves of financial institutions) that is
fully backed by a foreign reserve currency and fully convertible into the reserve currency
at a fixed rate and on demand. Hence, the domestic currency monetary base is 100%
backed by assets payable in the reserve currency. In practical terms, this requirement bars
the currency board from extending credit to either the government or the banking sector.
Ecuador instead has officially adopted the U.S. dollar as its currency. This is an example
of (Official) dollarization, which occurs when a foreign currency has exclusive or

predominant status as full legal tender in a particular country.

5. What is the difference between a target zone and a crawling peg?
In a target zone, the currency is allowed to fluctuate in a percentage band around a
central value. One can view a pegged system as a target zone system with a very
narrow band. In a crawling peg system, the fixed rate or band is adjusted over time,
typically in a pre-determined way as a function of the inflation differential between the
crawling peg country and the country to whose currency the peg is set. Such a system is
often used in developing countries, where the crawl of the band prevents the country
from losing too much competitiveness when its inflation rate is higher than that of the
benchmark country.
6. What was the EMS?
EMS stands for European Monetary System, a target zone system that operated in Europe
between 1979 and 1999. Exchange rates were, for most of the time, maintained between
bands of 2.25% around central rates. The countries participating in the EMS were a
gradually increasing number of European Union countries.
7. What did the Maastricht Treaty try to accomplish?
The 1991 Maastricht Treaty mapped out the road to economic and monetary union within
the European Union to be finalized by 1999. The Treaty called for eliminating all
remaining restrictions on the movement of capital and payments between member states
and between member states and third countries; the creation of a European central bank,
and the introduction of a new currency, the euro, in 1999. The monetary union was
indeed established (but not all EU countries participate).

8. Do you believe its monetary union will be beneficial for Europe?

The gains are already being realized throughout Europefor example, car prices have
decreased and converged across Europe. Academic research documents sizable economic
benefits following the introduction of the euro in terms of price convergence, lower costs
of capital, and increased trade. For example, the European Commission has estimated the
microeconomic gains of monetary union to amount to 0.5% of GDP of the entire EUa
substantial sum. On the other hand, the sovereign debt crises in Greece, Ireland, and
Portugal, and potentially in Spain, and the persistent high unemployment rates in these
countries while Germany thrives suggest that asymmetric macroeconomic adjustment
costs are present and are causing strain within Europe.

9. What factors contributed to the Mexican peso crisis of 1995 and to the Asian crises of
1997

In each instance, the government tried to maintain the value of the local currency at
artificially high levels. This depleted foreign currency reserves. Local businesses and
governments were also borrowing in non-local currencies (primarily the dollar), which
heavily exposed them to a drop in the value of the local currency.
10. What is the moral hazard of IMF rescue packages for emerging markets which
experienced crises?
Moral hazard occurs when the existence of a contract changes the behaviors of parties to
the contract. When the IMF assists countries in defending their currencies, it changes the
expectations and hence the behaviors of lenders, borrowers, and governments. For
example, lenders might underestimate the risks of lending to struggling economies if
there is an expectation that the IMF will intervene during difficult times.
B. True or False questions
1.

The exchange rate system in which a country allows the value of the currency to be
determined by the market forces of supply and demand is known as a pegged exchange rate
system.
False

2.

In the pegged exchange rate system, the currency has limited flexibility and the rate is kept
within a fixed band.
False

3.

Decreases in currency values within a floating rate system are called devaluations.
False

4.

IMF loans to troubled economies are unlikely to change the behaviors of investors, because
investors can assess the risks of moral hazard for themselves.
False

5.

Currency in circulation should be included in the asset section of a central bank balance
sheet.
False

6.

Official international reserves consist of the major components like gold reserves and
foreign exchange reserves
True

7.

Capital control means the set of regulations pertaining to flows of capital into and out of a
country
True

8. if a central bank suddenly prints a large amount of new money, it may result in high inflation
True
C. MCQ
1.

Which of the following currencies is currently linked to the price of gold?

a. British pound
b. Japanese yen
c. U.S. dollar
d. All of the above
e. None of the above

2.

Common elements in many currency crises include each of the following except:
a. a fixed exchange rate system that overvalued the local currency
b. a large amount of foreign currency debt
c. a steep drop in the value of the local currency
d. IMF intervention to provide short-term assistance
e. All of the above are common during currency crises

3. Which account should NOT be included in the asset section of a central bank balance sheet?
a. deposits of domestic financial institutions
b. official international reserves
c. domestic credit
d. government bonds
e. All of the above should be included
4. What is the negative side effect on the money supply of a non-sterilized foreign exchange intervention?
a. A higher money supply eventually leads to lower inflation, and the foreign exchange objective of the
IMF's policy may conflict with its abroad goal of price stability.
b. A higher money supply eventually leads to higher inflation, and the foreign exchange objective of the
IMF's policy may conflict with its domestic goal of price stability.
c. A higher money supply eventually leads to lower inflation, and the foreign exchange objective of the
central bank's policy may conflict with its domestic goal of price stability.
d. A higher money supply eventually leads to higher inflation, and the foreign exchange objective of
the central bank's policy may conflict with its domestic goal of price stability.
e. None of the above
5. When a central bank buys foreign currency, its international reserves ________.
a. decrease
b. increase
c. remain unchanged
d. are difficult to determine
e. All of the above are possible

6. What is the most likely outcome if a central bank suddenly prints a large amount of new money?
a. no change in the inflation rate
b. higher inflation
c. recession
d. prosperity
e. nothing will be changed