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ECN209 International Finance – 2014
Questions and Answers
Section A
Question 1. Central banks can influence the exchange rate without altering the nominal money
supply through sterilized intervention. [10 marks]
TRUE.
Buying and selling of foreign bonds in the foreign exchange markets affects the domestic money
supply, a central bank may want to offset this effect by using sterilization. If the central bank sells
foreign bonds in the foreign exchange markets, it can buy domestic government bonds in bond
markets hoping to leave the amount of money in circulation unchanged.
Sterilized intervention involves two separate transactions: 1) the sale or purchase of foreign
currency assets, and 2) an open market operation involving the purchase or sale of domestic assets
(in the same size as the first transaction). The open market operation effectively offsets or sterilizes
the impact of the intervention on the monetary base.
This can be demonstrated graphically in the diagram below:
Question 2. Following an increase in the domestic interest rate, the country’s currency
appreciates. [10 marks]
TRUE.
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To see, this, consider the interest parity requirement. This states that:
R = R* + (Ee – E)/E
This demonstrates that in equilibrium, an increase in the domestic interest rate (R) must be
accompanied by a decrease in E (in order for the right-hand side of the formula).
Diagrammatically, this can be seen by the shift in the money demand leading to an increase in the
real interest rate. This shifts the equilibrium in the foreign exchange market from 1’ to 2’, where the
exchange rate has decrease (i.e. an appreciation of the currency).
Question 3. An appreciation of the domestic currency raises the relative price of the country’s
imports and lowers the relative price of the country’s exports. [10 marks]
FALSE.
An appreciated currency is more valuable, and therefore it can buy more foreign-produced goods
with prices that are quoted in foreign currency terms. A currency appreciation also increases the
cost of a country's exports, rendering them less competitive in the global market, which in turn,
decreases the cost of imports, so domestic consumers are more likely to purchase them.
Question 4. If the exchange rate market is in equilibrium and people expect relative Purchasing
Power Parity (PPP) to hold, the difference between the domestic and the foreign interest rates is
ECONOMICS HELP, visit LondonEconomicsTutors.co.uk.
Discounted prices compared to all other websites
ECN209 International Finance – 2014
Questions and Answers
Section A
Question 1. Central banks can influence the exchange rate without altering the nominal money
supply through sterilized intervention. [10 marks]
TRUE.
Buying and selling of foreign bonds in the foreign exchange markets affects the domestic money
supply, a central bank may want to offset this effect by using sterilization. If the central bank sells
foreign bonds in the foreign exchange markets, it can buy domestic government bonds in bond
markets hoping to leave the amount of money in circulation unchanged.
Sterilized intervention involves two separate transactions: 1) the sale or purchase of foreign
currency assets, and 2) an open market operation involving the purchase or sale of domestic assets
(in the same size as the first transaction). The open market operation effectively offsets or sterilizes
the impact of the intervention on the monetary base.
This can be demonstrated graphically in the diagram below:
Question 2. Following an increase in the domestic interest rate, the country’s currency
appreciates. [10 marks]
TRUE.
, FOR MORE HIGH-QUALITY PAST PAPER MODEL ANSWERS, ONLINE TUTORING AND
ECONOMICS HELP, visit LondonEconomicsTutors.co.uk.
Discounted prices compared to all other websites
To see, this, consider the interest parity requirement. This states that:
R = R* + (Ee – E)/E
This demonstrates that in equilibrium, an increase in the domestic interest rate (R) must be
accompanied by a decrease in E (in order for the right-hand side of the formula).
Diagrammatically, this can be seen by the shift in the money demand leading to an increase in the
real interest rate. This shifts the equilibrium in the foreign exchange market from 1’ to 2’, where the
exchange rate has decrease (i.e. an appreciation of the currency).
Question 3. An appreciation of the domestic currency raises the relative price of the country’s
imports and lowers the relative price of the country’s exports. [10 marks]
FALSE.
An appreciated currency is more valuable, and therefore it can buy more foreign-produced goods
with prices that are quoted in foreign currency terms. A currency appreciation also increases the
cost of a country's exports, rendering them less competitive in the global market, which in turn,
decreases the cost of imports, so domestic consumers are more likely to purchase them.
Question 4. If the exchange rate market is in equilibrium and people expect relative Purchasing
Power Parity (PPP) to hold, the difference between the domestic and the foreign interest rates is
