624 #
© 2014 Pearson Canada Inc.#- Explain and demonstrate graphically the situation of an overvalued exchange rate in a fixed
exchange rate system. What alternative policies are available to eliminate the overvaluation of
the exchange rate?
Answer: See the figure below.
The par value is above the equilibrium value, resulting in overvaluation of the exchange rate.
One approach is to pursue contractionary monetary policies, raising interest rates and increasing
the demand for domestic assets. This process continues until equilibrium at par value is restored.
Another alternative is for the central bank to purchase domestic currency by selling foreign
assets.
Diff: 2 Type: SA Page Ref: 500
Skill: Recall
Objective List: 20.3 Summarize the arguments for and against capital controls
- What is the gold standard? What are the pros and cons of this system?
Answer: Before World War I, the world economy operated under the gold standard, a fixed
exchange rate regime in which most currencies were convertible directly into gold at fixed rates,
so exchange rates between countries were also fixed. The important advantage of this system of
exchange rates was that fixed exchange rates encouraged world trade by eliminating the
uncertainty that occurs when exchange rates fluctuate. The disadvantages are that the countries
that use the gold standard have no control over their monetary policy because its money supply is
determined by gold flows between countries. Moreover monetary policy throughout the world
was greatly influenced by the production of gold and gold discoveries.
Diff: 3 Type: SA Page Ref: 498
Skill: Recall
Objective List: 20.3 Summarize the arguments for and against capital controls