Ch002-International-Monetary-System1.doc

Eun & Resnick 4e
CHAPTER 2 International Monetary System

Evolution of the International Monetary System
Bimetallism: Before 1875
Classical Gold Standard: 1875–1914
Interwar Period: 1915–1944
Bretton Woods System: 1945–1972
The Flexible Exchange Rate Regime: 1973–Present
The Current Exchange Rate Arrangements
European Monetary System
The Euro and the European Monetary Union
A Brief History of the Euro
What Are the Benefits of Monetary Union?
Costs of Monetary Union
Prospects of the Euro: Some Critical
Questions
The Mexican Peso Crisis
The Asian Currency Crisis
Origins of the Asian Currency Crisis
Lessons from the Asian Currency Crisis
The Argentine Peso Crisis
Fixed versus Flexible Exchange Rate Regimes
Summary
MINI CASE: Will the U.K. Join the Euro Club?

Evolution of the International Monetary System

1) The international monetary system can be defined as the institutional framework within which:
a) international payments are made
b) movement of capital is accommodated
c) exchange rates among currencies are determined
d) all of the above
Answer: d page 25.

2) The international monetary system went through several distinct stages of evolution. These stages are summarized, in alphabetic order, as follows
(i)- Bimetallism
(ii)- Bretton Woods system
(iii)- Classical gold standard
(iv)- Flexible exchange rate regime
(v)- Interwar period

The chronological order that they actually occurred is:

a) (iii), (i), (iv), (ii), and (v)
b) (i), (iii), (v), (ii), and (iv)
c) (vi), (i), (iii), (ii), and (v)
d) (v), (ii), (i), (iii), and (iv)
Answer: b

Bimetallism: Before 1875

3) Gresham’s Law states that ( )
a) Bad money drives good money out of circulation.
b) Good money drives bad money out of circulation
c) If a country bases its currency on both gold and silver, at an official exchange rate, it will be the more valuable of the two metals that circulate.
d) None of the above.
Answer: a

4) In the 1850s the French franc was valued by both gold and silver, under the official French ratio which equated a gold franc to a silver franc 15½ times as heavy. At the same time, the gold from newly discovered mines in California poured into the market, depressing the value of gold. As a result,
a) The franc effectively became a silver currency.
b) The franc effectively became a gold currency.
c) Silver became overvalued under the French official ratio
d) Answers a) and c) are correct
Answer: b

5) Suppose that the pound is pegged to gold at £20 per ounce and the dollar is pegged to gold at $35 per ounce. This implies an exchange rate of $1.75 per pound. If the current market exchange rate is $1.80 per pound, how would you take advantage of this situation? Hint: assume that you have $350 available for investment.
a) Start with $350. Buy 10 ounces of gold with dollars at $35 per ounce. Convert the gold to £200 at £20 per ounce. Exchange the £200 for dollars at the current rate of $1.80 per pound to get $360.
b) Start with $350. Exchange the dollars for pounds at the current rate of $1.80 per pound. Buy gold with pounds at £20 per ounce. Convert the gold to dollars at $35 per ounce.
c) a) and b) both work
d) none of the above
Answer: a

6) Prior to the 1870s, both gold and silver were used as international means of payment and the exchange rates among currencies were determined by either their gold or silver contents. Suppose that the dollar was pegged to gold at $30 per ounce, the French franc is pegged to gold at 90 francs per ounce and to silver at 6 francs per ounce of silver, and the German mark pegged to silver at 1 mark per ounce of silver. What would the exchange rate between the U.S. dollar and German mark be under this system?
a) 1 German mark = $2
b) 1 German mark = $0.50
c) 1 German mark = $45
d) 1 German mark = $1
Answer: a page 26.
Rationale: Start with $30, buy one ounce of gold. Sell that ounce of gold for FF 90. Sell the FF90 for 15 ounces of silver. Buy 15 German marks. Thus, $30 = DM15.

Classical Gold Standard: 1875-1914

7) An “international” gold standard can be said to exist when
a) gold alone is assured of unrestricted coinage
b) there is two-way convertibility between gold and national currencies at stable ratios
c) gold may be freely exported or imported
d) all of the above
Answer: d - p. 28

8) Suppose that the British pound is pegged to gold at £6 per ounce, whereas one ounce of gold is worth €12. Under the gold standard, any misalignment of the exchange rate will be automatically corrected by cross border flows of gold. Calculate the possible savings for buying €1,000, if the British pound becomes undervalued and trades for €1.80. (Assume zero shipping costs).
(Hint: Gold is first purchased using the devalued British pound from the Bank of England, then shipped to France and sold for €1,000 to the Bank of France).
a) £55.56
b) £65.56
c) £75.56
d) £85.56
Answer: a - p. 28

Rationale: Since an ounce of gold should be worth the same north or south of the English Channel, it should be €12 = £6. So our exchange rate implied by gold prices is €2 = £1, therefore buying €1,000 should cost £500:
€1,000×£1/€2 = £500.00

If the pound is undervalued at €1.80, we find that €1,000 costs £555.56:
€1,000×£1/€1.80 = £555.56

Savings in buying €1,000 by using gold and not posted exchange rates:
£555.56 - £500.00 = £55.56

9) Under a gold standard, if Britain exported more to France than France exported to Great Britain,
a) Such international imbalances of payment will be corrected automatically.
b) This type of imbalance will not be able to persist indefinitely
c) Net export from Britain will be accompanied by a net flow of gold in the opposite direction.
d) All of the above
Answer: d page 27.

10) Suppose that Britain pegs the pound to gold at six pounds per ounce, whereas the exchange rate between pounds and U.S. dollars is $5 = £1. What should an ounce of gold be worth in U.S. dollars?
a) $29.40
b) $30.00
c) $0.83
d) $1.20
Answer: b)
Rationale: 1oz. Au = £6 and £1 = $5 so £6 = $30 = 1oz. Au

11) Under the gold standard, international imbalances of payment will be corrected automatically under the
a) Gresham Exchange Rate regime
b) European Monetary System
c) Price-specie-flow mechanism
d) Bretton Woods Accord
Answer: c

Interwar Period

12) During the period between World War I and World War II
a) The major European powers and the U.S. returned to the gold standard and fixed exchange rates.
b) While most countries abandoned the gold standard during World War I, international trade and investment flourished during the interwar period under a coherent international monetary system.
c) The U.S. dollar emerged as the dominant world currency, gradually replacing the British pound for the role.
d) None of the above.
Answer: c 29.

13) During the period between World War I and World War II, many central banks followed a policy of sterilization of gold
a) This restricted the rate of growth in the supply of gold
b) By matching inflows and outflows of gold respectively with reductions and increases in domestic money and credit.
c) By matching inflows and outflows of gold respectively with increases and reductions in domestic money and credit.
d) None of the above.
Answer: b page 29.

14) At the outbreak of World War I
a) Major countries such as Great Britain, France, Germany and Russia suspended redemption of banknotes in gold
b) Major countries such as Great Britain, France, Germany and Russia imposed embargoes on the export of gold
c) The classical gold standard was abandoned
d) All of the above.
Answer: b page 28

Bretton Woods System: 1945-1972

15) Under the Bretton Woods system
a) there was an explicit set of rules about the conduct of international monetary policies
b) each country was responsible for maintaining its exchange rate within 1 percent of the adopted par value by buying or selling foreign exchanges as necessary
c) the U.S. dollar was the only currency that was fully convertible to gold
d) all of the above
Answer: d.

16) Under the Bretton Woods system:
a) Each country established a par value for its currency in relation to the dollar.
b) The U.S. dollar was pegged to gold at $35 per ounce.
c) each country was responsible for maintaining its exchange rate within 1 percent of the adopted par value by buying or selling foreign exchanges as necessary
d) all of the above
Answer: d.

17) Since the SDR is a “portfolio” of currencies
a) Its value tends to be more stable than the value of any of the individual currencies included in the SDR
b) Its value tends to be less stable than the value of any of the individual currencies included in the SDR
c) Its value tends to be as stable as the average of the individual currencies included in the SDR
d) None of the above
Answer: a)
Rationale: while this is in the book on page 31, many students tend to miss this one. Any portfolio is less volatile than the average volatility of the individual securities, as long as at least two securities are not perfectly positively correlated. This is certainly the case with currencies.

18) Special Drawing Rights (SDR) are:
a) an artificial international reserve allotted to the members of the International Monetary Fund (IMF), who can then use it for transactions among themselves or with the IMF
b) a “portfolio” of currencies, and its value tends to be more stable than the currencies that it is comprised of
c) used in addition to gold and foreign exchanges, to make international payments
d) all of the above
Answer: d - p. 32

The Flexible Exchange Rate System

19) Gold was officially abandoned as an international reserve asset:
a) In the January 1976 Jamaica Agreement
b) In the 1971 Smithsonian Agreement
c) In the 1944 Bretton Woods Agreement
d) None of the above
Answer: a

20) Following the demise of the Bretton Woods system, the IMF
a) Created a new role for itself, providing loans to countries facing balance-of-payments and exchange rate difficulties.
b) Ceased to exists, since the era of fixed exchange rates had ended.
c) Became the sole agent responsible for maintaining fixed exchange rates.
d) Became the central bank of the United Nations
Answer a page 32.

21) Under a purely flexible exchange rate system
a) Supply and demand set the exchange rates
b) Governments can set the exchange rate by buying or selling reserves
c) Governments can set exchange rates with fiscal policy
d) B) and c) are correct.
Answer a
Rationale: under a purely flexible system, the government doesn’t interfere.

Current Exchange Rate Arrangements

22) A currency board arrangement is:
a) When the currency of another country circulates as the sole legal tender
b) When the country belongs to a monetary or currency union in which the same legal tender is shared by the members of the union.
c) A monetary regime based on an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation.
d) Where the country pegs its currency at a fixed rate to a major currency where the exchange rate fluctuates within a narrow margin of less than one percent.
Answer: c page 34.

23) Ecuador does not have its own national currency, circulating the U.S. dollar instead. About how many countries do not have their own national currency?
a) 10
b) 20
c) 30
d) 40
Answer: d page 35.

24) With regard to the current exchange rate arrangement between the U.S. and the U.K., it is best characterized as
a) Independent floating (market determined)
b) Managed float
c) Currency board
d) Pegged exchange rate within a horizontal band.
Answer: a page 34-35.

25) With regard to the current exchange rate arrangement between Italy and Germany., it is best characterized as
a) Independent floating (market determined)
b) Managed float
c) An exchange arrangement with no separate legal tender.
d) Pegged exchange rate within a horizontal band.
Answer: c page 34.

European Monetary System

26) To pave the way for the European Monetary Union, the member countries of the European Monetary System agreed to achieve a convergence of their economies. Which of the following is NOT a condition of convergence:
a) Keep the ratio of government budget deficits to GDP below 3 percent
b) Keep gross public debts below 60 percent of GDP
c) Achieve a high degree of price stability
d) Maintain its currency at a fixed exchange rate to the ERM
Answer d) page 38.
For d) to be true, it should read “Maintain its currency within the prescribed exchange rate ranges of the ERM.”

27) The European Monetary System (EMS) has the following chief objectives:
a) to establish a “zone of monetary stability” in Europe
b) to coordinate exchange rate policies vis-à-vis the non-EMS currencies
c) to pave the way for the eventual European monetary union
d) all of the above
Answer: d - p. 38

28) The Exchange Rate Mechanism (ERM) is
a) the procedure by which ERM member countries collectively manage their exchange rates
b) based on a “parity-grid” system, which is a system of par values among ERM countries
c) a and b
d) none of the above
Answer: c - p. 38

29) The Maastricht Treaty
a) Irrevocably fixed exchange rates among the member currencies
b) Commits the members of the European Union to political union as well as monetary union.
c) Was signed and subsequently ratified by the 12 member states.
d) All of the above.
Answer d) page 38.

30) The single European currency, the euro, was adopted by 11 member nations on January 1 of what year?
a) 1984
b) 1991
c) 1999
d) 2001
Answer c) page 39.

Euro and the European Monetary Union

31) Benefits from adopting a common European currency include
a) Reduced transaction costs
b) Elimination of exchange rate risk
c) Increased price transparency will promote Europe-wide competition
d) All of the above
Answer d) page 41-42.

32) Monetary policy for the euro-12 countries is now conducted by:
a) The Federal Reserve
b) The Bundesbank
c) European Central Bank
d) None of the above
Answer c) page 40.

33) Following the introduction of the euro, the national central banks of the euro-12 nations
a) disbanded
b) Formed the ESCB, which is analogous to the Federal Reserve System in the United States
c) Continue to perform important functions in their jurisdictions
d) b) and c) are correct.
Answer d) page 40.

34) The main cost of monetary union is
a) The loss of national monetary and exchange rate policy independence
b) Increased exchange rate uncertainty
c) Lessened political integration
d) None of the above
Answer a) page 42. Costs of Monetary Union

35) The euro zone remarkably comparable to the United States in terms of
a) Population size