DEPARTMENT OF ECONOMICS
INTERNATIONAL TRADE I
October 28, 2010
ANSWER ANY THREE OF THE FOLLOWING QUESTIONS.
1. If country A is committed to maintaining a fixed exchange rate between its currency and
that of country B, would it be better off with this policy and its own currency, or would it be
better off giving up it currency and joining into a currency union with country B where the
union used country B’s currency?
Only advantage in retaining own currency is ability to periodically change exchange rate
o Reduces credibility of commitment to fixed exchange rate
o Limits the sue of monetary policy for domestic purposes
o Opens the currency to speculative attacks, especially when the country lacks
adequate foreign reserves
Fixed exchange rate requires holding of foreign reserves – usually low yielding assets,
especially compared to alternative uses for the money
If country really is committed to fixed exchange rate with no intention of ever changing the
rate, then joining into currency union superior option
o Reduces currency risks and trading costs
o Eliminates speculation and need for foreign reserves
o Reduces interest rates if currency of larger country is adopted
Currency union makes sense if two countries are quite similar in many important
o There needs to be alternative adjustment mechanisms to changes in exchange rate –
labor mobility, fiscal transfers, debt guarantees
2. Short-term interest rates in Canada are higher than the short-term interest rates in the US.
Despite this, the Canadian dollar declined in value against the US dollar this week when
investors anticipated that the Bank of Canada would not raise short-term interest rates. Why
did the Canadian dollar depreciate?
Covered interest parity can result in stable exchange rates even when interest rates differ,
especially if there is a risk premium require for investments in Canadian dollar financial
Financial markets may have anticipated an increase in short-term interest rates in Canada
and built this expectation into the spot and future exchange rates
o When B. of C. failed to increase rates, markets reacted by reducing value of
Canadian dollar both in spot and future markets
1 Investors may have taken B. of C. action as signal that Canadian economy was weakening
and future returns on investment in Canadian dollar financial assets would be lower than
Other variables may have changed to put downward pressure on Canadian dollar – e.g.,
lower commodity prices, increase in risk premium, improved expectations for investments
in US dollar financial assets
3. The Bank of Japan reduced interest rates to 0% and intervened directly in the currency
markets to force down the value of the Yen against the US dollar (depreciation of the Yen).
Since the Bank took these actions, the Yen has appreciated against the US dollar. Why?
Financial markets might have expected as a result that government would take every
measure possible to stimulate Japanese economy and thus increase returns on investments in
select Yen denominated financial assets