Chapter 20: Quiz Answers -- Exchange Rate Regimes and Crises

1. Which of the following is not a possible exchange rate regime?
   devaluation. Flexible and floating exchange rates mean the same thing. The other two legitimate options are crawling peg and fixed regimes.

2. Which of the following in an advantage of a fixed exchange rate regime?
   more credibility to fight inflation. Recall that fixed exchange rates implicitly commit the government to limit inflation to the inflation rate of the anchor currency.

3. Which of the following are disadvantages to flexible exchange rate regimes?
   all of the above. Option three is simply the definition of exchange rate risk, which is one of the disadvantages to flexible exchange rate regimes. Option two is also a disadvantage of flexible exchange rate regimes. The very last option--loss of flexibility to conduct domestic monetary policy--is a disadvantage of fixed exchange rates.

4. A government can support an overvalued currency by all of the following except
   raising taxes for increased government expenditures. A government may need to increase taxes to increase its stock of foreign reserves (i.e. use the tax money to buy foreign assets), but increased taxes for more government spending will not support an overvalued currency. Each of the other choices will support an overvalued currency.

5. The Mexican Peso Crisis of 1994 occurred because
   the peso gradually became overvalued as Mexican inflation exceeded U.S. inflation. Foreign reserves were falling, not rising. Finally, capital inflows may have been part of the cause of the appreciation, but not the primary cause.

6. Sudden and severe exchange rate devaluations are harmful to the domestic citizens in part because
   the central bank typically has to increase interest rates to stabilize the currency. Recall that rising interest rates, all else equal, attract foreign investment, which does help to stabilize the currency. Devaluation does not lead to deflation. In fact, inflation tends to rise sharply after devaluation because imports become more expensive.

7. Monetary policy in an open economy
   all of the above. Yes, they are all true statements. If the capital account is in surplus and the current account is in deficit, expansionary monetary policy, all else equal, narrows (reduces) the capital account surplus and narrows the current account deficit, which increases the current account balance.

8. Each of the members of the EMU must do all the following except
   relinquish control of domestic fiscal policy. Each EMU member will retain control over government spending and tax decisions.

9. A currency board puts a unit of domestic currency into circulation every time it accumulates another unit of the pegged foreign currency. A domestic bank run, therefore, is impossible.
   False. Although the first statement is true (assuming a one-to-one exchange rate), the second statement is false. Bank runs are still possible because recall that the money supply as measured by M1 includes cash and checking account balances. The currency board ensures only that there are enough foreign reserves to cover the notes in circulation. M1 is likely to exceed the stock of foreign reserves.

10. The Bretton Woods system was essentially a fixed exchange rate regime that failed partly because the U.S. dollar became severely overvalued.
    True. Because all participating countries' exchange rates were tied to the dollar, the end result was a fixed exchange rate regime. The instability of the value of the U.S. dollar did lead to the demise of the system.