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Determinants of Exchange Rate

Description: This quiz aims to assess your understanding of the various factors that influence the exchange rate between currencies.
Number of Questions: 15
Created by:
Tags: economics foreign trade balance of payments exchange rate
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What is the primary function of an exchange rate?

  1. To determine the value of one currency relative to another.

  2. To regulate the flow of goods and services between countries.

  3. To control the level of inflation in a country.

  4. To manage the country's foreign exchange reserves.

Show answer
Correct Option: A
Explanation:

The exchange rate is the price of one currency in terms of another. It is used to convert the value of goods and services from one currency to another.

Which of the following is NOT a determinant of the exchange rate?

  1. Inflation

  2. Interest rates

  3. Government policies

  4. Economic growth

Show answer
Correct Option: D
Explanation:

Economic growth is not a direct determinant of the exchange rate. However, it can indirectly affect the exchange rate through its impact on inflation, interest rates, and government policies.

How does inflation affect the exchange rate?

  1. Higher inflation leads to a stronger currency.

  2. Higher inflation leads to a weaker currency.

  3. Inflation has no effect on the exchange rate.

  4. The relationship between inflation and the exchange rate is unpredictable.

Show answer
Correct Option: B
Explanation:

Higher inflation makes a country's goods and services more expensive relative to those of other countries. This leads to a decrease in demand for the country's currency, which causes it to depreciate.

How do interest rates affect the exchange rate?

  1. Higher interest rates lead to a stronger currency.

  2. Higher interest rates lead to a weaker currency.

  3. Interest rates have no effect on the exchange rate.

  4. The relationship between interest rates and the exchange rate is unpredictable.

Show answer
Correct Option: A
Explanation:

Higher interest rates make a country's financial assets more attractive to foreign investors. This leads to an increase in demand for the country's currency, which causes it to appreciate.

How do government policies affect the exchange rate?

  1. Government policies can strengthen or weaken the currency.

  2. Government policies have no effect on the exchange rate.

  3. The impact of government policies on the exchange rate is unpredictable.

  4. Government policies only affect the exchange rate in the short term.

Show answer
Correct Option: A
Explanation:

Government policies, such as fiscal and monetary policies, can have a significant impact on the exchange rate. For example, a government may implement policies to stimulate economic growth, which can lead to a stronger currency. Alternatively, a government may implement policies to reduce inflation, which can lead to a weaker currency.

What is the relationship between the exchange rate and the balance of payments?

  1. A positive balance of payments leads to a stronger currency.

  2. A positive balance of payments leads to a weaker currency.

  3. The balance of payments has no effect on the exchange rate.

  4. The relationship between the balance of payments and the exchange rate is unpredictable.

Show answer
Correct Option: A
Explanation:

A positive balance of payments means that a country is exporting more goods and services than it is importing. This leads to an increase in demand for the country's currency, which causes it to appreciate.

What is the relationship between the exchange rate and the current account?

  1. A positive current account leads to a stronger currency.

  2. A positive current account leads to a weaker currency.

  3. The current account has no effect on the exchange rate.

  4. The relationship between the current account and the exchange rate is unpredictable.

Show answer
Correct Option: A
Explanation:

A positive current account means that a country is earning more foreign exchange from exports than it is spending on imports. This leads to an increase in demand for the country's currency, which causes it to appreciate.

What is the relationship between the exchange rate and the capital account?

  1. A positive capital account leads to a stronger currency.

  2. A positive capital account leads to a weaker currency.

  3. The capital account has no effect on the exchange rate.

  4. The relationship between the capital account and the exchange rate is unpredictable.

Show answer
Correct Option: A
Explanation:

A positive capital account means that a country is attracting more foreign investment than it is investing abroad. This leads to an increase in demand for the country's currency, which causes it to appreciate.

What is the relationship between the exchange rate and the terms of trade?

  1. An improvement in the terms of trade leads to a stronger currency.

  2. An improvement in the terms of trade leads to a weaker currency.

  3. The terms of trade have no effect on the exchange rate.

  4. The relationship between the terms of trade and the exchange rate is unpredictable.

Show answer
Correct Option: A
Explanation:

An improvement in the terms of trade means that a country is getting more foreign exchange for its exports than it is paying for its imports. This leads to an increase in demand for the country's currency, which causes it to appreciate.

What is the relationship between the exchange rate and the real exchange rate?

  1. The real exchange rate is the exchange rate adjusted for inflation.

  2. The real exchange rate is the exchange rate adjusted for interest rates.

  3. The real exchange rate is the exchange rate adjusted for government policies.

  4. The real exchange rate is the exchange rate adjusted for the terms of trade.

Show answer
Correct Option: A
Explanation:

The real exchange rate is the exchange rate adjusted for inflation. It is calculated by dividing the nominal exchange rate by the ratio of the price levels in the two countries.

What is the relationship between the exchange rate and the effective exchange rate?

  1. The effective exchange rate is the exchange rate weighted by the trade volumes of the country's trading partners.

  2. The effective exchange rate is the exchange rate weighted by the GDP of the country's trading partners.

  3. The effective exchange rate is the exchange rate weighted by the population of the country's trading partners.

  4. The effective exchange rate is the exchange rate weighted by the foreign exchange reserves of the country's trading partners.

Show answer
Correct Option: A
Explanation:

The effective exchange rate is the exchange rate weighted by the trade volumes of the country's trading partners. It is calculated by multiplying the nominal exchange rate by the trade weights of the country's trading partners.

What is the relationship between the exchange rate and the forward exchange rate?

  1. The forward exchange rate is the exchange rate that is expected to prevail in the future.

  2. The forward exchange rate is the exchange rate that is prevailing in the spot market.

  3. The forward exchange rate is the exchange rate that is prevailing in the futures market.

  4. The forward exchange rate is the exchange rate that is prevailing in the options market.

Show answer
Correct Option: A
Explanation:

The forward exchange rate is the exchange rate that is expected to prevail in the future. It is determined by the spot exchange rate, the interest rate differential between the two countries, and the time to maturity of the forward contract.

What is the relationship between the exchange rate and the risk premium?

  1. A higher risk premium leads to a stronger currency.

  2. A higher risk premium leads to a weaker currency.

  3. The risk premium has no effect on the exchange rate.

  4. The relationship between the risk premium and the exchange rate is unpredictable.

Show answer
Correct Option: B
Explanation:

A higher risk premium means that investors demand a higher return for investing in a country's assets. This leads to a decrease in demand for the country's currency, which causes it to depreciate.

What is the relationship between the exchange rate and the speculative demand for currency?

  1. An increase in speculative demand for currency leads to a stronger currency.

  2. An increase in speculative demand for currency leads to a weaker currency.

  3. Speculative demand for currency has no effect on the exchange rate.

  4. The relationship between speculative demand for currency and the exchange rate is unpredictable.

Show answer
Correct Option: A
Explanation:

An increase in speculative demand for currency means that investors are buying a country's currency in the expectation that it will appreciate in value. This leads to an increase in demand for the country's currency, which causes it to appreciate.

What is the relationship between the exchange rate and the central bank intervention?

  1. Central bank intervention can strengthen or weaken the currency.

  2. Central bank intervention has no effect on the exchange rate.

  3. The impact of central bank intervention on the exchange rate is unpredictable.

  4. Central bank intervention only affects the exchange rate in the short term.

Show answer
Correct Option: A
Explanation:

Central bank intervention can strengthen or weaken the currency, depending on the type of intervention. For example, if a central bank buys its own currency in the foreign exchange market, this will lead to an increase in demand for the currency and cause it to appreciate. Conversely, if a central bank sells its own currency in the foreign exchange market, this will lead to a decrease in demand for the currency and cause it to depreciate.

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