"economics"exercise: Currency Exchange Rates

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Questions 1:

If the domestic currency is trading at a forward premium, then relative to the

interest rate of the domestic country, the interest rate in the foreign country is

most likely:

A、lower.

B 、higher.

C 、the same.

Questions 2:

In the classification of currency regimes, a currency board system (CBS) most

likely differs from a fixed-rate parity system in that:

A 、a CBS can peg to a basket of currencies but a fixed-rate system cannot.

B 、the monetary authority within a CBS does not act as a traditional lender of

last resort.

C、 a CBS has a discretionary target level of foreign exchange reserves

View answer resolution

【Answer to question 1】B

【analysis】

B is correct. The currency with the higher (lower) interest rate will always trade at a discount (premium) in the forward market. The lower interest rate in the domestic country will be offset by the appreciation of the domestic country’s currency over the investment horizon.

A is incorrect because the forward rate is trading at a premium and not at a discount.

C is incorrect because the forward rate does not equal the spot rate.

【Answer to question 2】B

【analysis】

B is correct. In a CBS, the monetary authority has an obligation to maintain 100% foreign currency reserves against the monetary base. It therefore cannot lend to troubled financial institutions. As long as the country under a fixed parity regime maintains its exchange peg, the central bank can serve as a lender of last resort.

A is incorrect. It is the fixed-rate system that can use a basket of currencies for the peg.

C is incorrect. In a fixed parity system the monetary authority has a discretionary target level of reserves, but in a CBS it does not because there is a commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate

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