What is the advantage of a pegged exchange rate in comparison to a flexible exchange rate?

November 26, 2021

What is the advantage of a pegged exchange rate in comparison to a flexible exchange rate?

In each case below you are first told about a country’s exchange rate regime – whether its exchange rate is floating or pegged, and also whether it is sterilizing the effects of any exchange-market intervention that it may do. You are then given, in each subpart, several events that might occur. For each of these events (separately) indicate the requested effects of that event by circling the appropriate answer from among those provided.
The UK is allowing its currency, £, to float against the US dollar, US$. It does not sterilize.
The interest rate in the UK rises. As a result:

the £	appreciates	depreciates	does not change.
US exports to the UK	increase	decrease	do not change.

The UK central bank makes a large purchase of dollars in the foreign exchange market. As a result:

the £

appreciates

depreciates

does not change.

Assume in b and c that peg is initially at equilibrium, i.e., neither under- nor over-valued.

China is pegging its currency, CN¥, to the US dollar, US$. It does sterilize.
A new type of Chinese clothing, made of soybeans, becomes popular in the US, and trade in it is not restricted. As a result:

the CN¥	appreciates	depreciates	does not change.
Chinese foreign exchange reserves	increase	decrease	do not change.

Wealthy Chinese households, previously holding wealth in dollars, switch back to CN¥-denominated assets. As a result:

Chinese foreign exchange reserves	increase	decrease	do not change.
the Chinese money supply	rises	falls	is unchanged.

Venezuela is pegging its currency, VEF, to the US dollar, US$. It does not sterilize.
Venezuelans, having invested heavily in the US, find themselves earning and taking home a larger flow of income on those investments. As a result:

Venezuelan foreign exchange reserves	increase	decrease	do not change.
the Venezuelan money supply	increases	decreases	does not change.

Political instability in Venezuela causes international investors to fear a Venezuelan devaluation. As a result:

Venezuelan foreign exchange reserves	increase	decrease	do not change.
the Venezuelan money supply	increases	decreases	does not change.

Which of the following is FDI?

	i:	A US investor buys 1,000 shares of stock of BMW AG, the German automobile company.
	ii:	Intel builds a plant in Brazil and sends all American workers to operate it.
	iii:	Procter and Gamble lends US$2 million to a firm in Japan.
	iv:	Mattel contracts a Mexican firm to do some of the Barbie processing.
	v:	Whirlpool buys a Chinese firm that produces washer and dryers, and adapts it to produce its own products.

Identify each of the following transactions by whether it belongs in the current account or in the financial account of the United States.

		Current Account	Financial Account
a.	Warren Buffet buys a Chinese software company.
b.	The California governor buys an Italian-made suit.
c.	The Facebook CEO collects interest on a saving account in a Swiss bank.
d.	Australian Prime Minister pays his son’s Harvard tuition.
e.	A French farmer on vacation in Florida buys admission to Disneyworld.
f.	Your English professor wins the California Lottery and uses his winnings to buy stock in a Mexican cement company.
g.	Barak Obama buys a New York office building from Nelson Mandela (a South African).
h.	Richard Gere (an American) gives $10,000 to the Dalai Lama (in India).
i.	The Facebook CEO withdraws $50,000 from his account in a Swiss bank.
j.	Your little brother (an American) acquires a one euro note for his collection of foreign money.

Indicate whether each of the following items represents a debit or a credit o the US balance of payments.
A US importer purchases a shipload of French wine.
A British manufacturer exports machinery to Taiwan on a US vessel.
A US college student spends a year studying in Switzerland.
Japanese investors collect interest income on their holdings of US government securities.
A German resident sends money to her relatives in the United States.
Llyods of London sells an insurance policy to a US business firms.
A Swiss resident receives dividends on her IBM stock.

Figure 2 shows domestic supply and demand for a good in a small country, together with several prices and quantities labeled on the axes. Initially, with free trade, the country faces a world price equal to P₁. Using the prices, quantities, and areas labeled in the figure, answer the following.

Consider first a tariff on imports, set at a level that will raise the domestic price to P₂.

How much will producer gain from this tariff?
How much will consumers lose from this tariff?
How much is the dead weight loss due to this tariff?

Figure 2

Now suppose that, instead of the tariff, the country provides a domestic subsidy equal to (P₂–P₁) per unit supplied.

How much will producers gain from this subsidy?
How much will consumers lose from this subsidy?
How much does the country as a whole (including its government) lose from this subsidy?

Multiple Choice Questions

If a country’s currency is undervalued, and if its central bank is pegging its exchange rate but not sterilizing the effects of its intervention, then which of the following will happen?
Its central bank will sell its own currency on the foreign exchange market.
Its central bank will gain reserves of foreign currency.
The country’s money supply will expand.
All of the above.

Under a crawling peg
The exchange rate moves, but by amounts too little to notice.
The exchange rate is permitted to change only slowly within the band.
The par value of the currency is kept secret and changed slowly over time.
The central value of a pegged exchange rate is changed frequently, by small amounts, and with advance notice.

Developing countries have often chosen to establish pegged exchange rates because
this prevents the depreciation that would otherwise occur due to their high inflation.
with small economies, it is easier for them to peg their currency than it would be for a large country.
a pegged rate imposes discipline on their government and central bank, helping to prevent inflation.
economists advise that countries with pegged exchange rates are able to grow faster than countries with floating exchange rates.
a pegged exchange rate can be used to make their exports more competitive on world markets.

Which of the following is included in the current account?
Interest payments
Gifts
Imports of services
All of the above

Use the information in the following table to answer the following question.

Exports of goods and services 1000

Imports of goods and services 800

Net change in assets owned abroad 500

Net change in foreign owned assets at home 400

Unilateral transfers received 100

Unilateral transfers paid 200

Investment income paid to foreigners 300

Investment income received from foreigners 400

Based on the table above, the balance on the current account is
+200.
+100.
-200.

People sometimes worry that American trade with other countries will lead to large US trade deficits and the movement of massive amounts of American capital out of the country. This worry is unfounded because countries cannot
have both current account and financial account deficits at the same time.
increase savings at the same time that a trade deficit grows.
increase their trade with other countries without increasing their savings.
invest more than they save.

If a country pegs its exchange rate at a level that is, and continues to be, overvalued, then it will eventually be the case that
Its exports will expand as foreign markets recognize the high value.
It will run out of foreign reserves.
People will engage in smuggling to avoid the official exchange rate.
Prices in the country will rise.

Based on the Big Mac Index and because of the fact that burgers are not traded internationally, “emerging economies” tend to have
Over-valued exchange rates because their wages are low.
Over-valued exchange rates because their wages are high.
Under-valued exchange rates because their wages are low.
Under-valued exchange rates because their wages are high.

A depreciation of the U.S. dollar leads to a higher volume of U.S. exports.

True False

According to the theory of purchasing power parity, if inflation in the rest of the world is lower than inflation in Brazil, Brazil’s currency (the real) would tend to depreciate.

True False

If Mexicans increasingly lose confidence in their domestic financial markets and move their assets to other countries, the peso will depreciate.

True False

Imports tend to fall whenever a nation’s currency appreciates because foreign products become more expensive to domestic consumers.

True False

1. The graphs below show demand for labor in two countries, A and B, and several vertical labor supply curves. Use these diagrams to answer the question about the effects of migration from one country to the other in search of a higher wage. Let the amount of migration (change in labor supply) be equal to the (identical) horizontal distance between the supply curves in both graphs.

What is the effect of this migration on the welfare of factors other than labor in Country B?
a. They lose area (d+e).
b. They gain area (d+e)
c. They gain area d
d. They gain area (d+e+f)

2. Which of the following reasons for people migrating from one country to another is the most important in today’s world?
a. To escape persecution
b. For a better climate
c. Higher wages
d. For religious freedom

3. The Escape Clause permits the United States to
a. Limit imports in an industry if they are causing injury to domestic interests.
b. Resign from the World Trade Organization.
c. Limit imports in an industry if those imports are being priced unfairly.
d. Shift its trade in a good to a different trading partner.

4. Foreign direct investment was not large during the 1950s and 1960s. Why?
a. The World Bank discouraged FDI as being detrimental to economic growth.
b. Many countries did not trust foreign corporations, viewing them as agents of colonialism and imperialism.
c. The IMF required that FDI be restricted in order to facilitate the regime of pegged exchange rates.
d. Levels of investment generally were small, so that there was little available for FDI.

5. If a tariff levied by a small country causes the welfare of the country to fall, why would such a country ever use a tariff?
a. Because the producers who gain from the tariff are much more numerous than the consumers
who lose.
b. Because it always improves the country’s terms of trade.
c. Because the many consumers who lose from the tariff each lose so little that they do not bother to object.
d. Because the revenue from the tariff is larger than the dead weight loss from the tariff.

6. Suppose a German manufacturer of household appliances wants to take advantage of the cheaper labor available in the Czech Republic. Which of the following is not foreign direct investment?
a. License a Czech firm to produce its products under its own label.
b. Build a manufacturing subsidiary there and employ Czech workers.
c. Build a plant in the Czech Republic and send all German workers to operate it.
d. Buy a Czech firm that produces similar products, and adapt it to produce its own products.

7. Which of the following countries and groups of countries is not a significant host of FDI?
a. Europe
b. United States
c. China
d. Japan

8. The original name of the World Bank was
a. International Bank for Reconstruction and Development
b. International Trade Organization
c. International Monetary Fund
d. Bretton Woods Institute

9. Comparing multinational firms to local firms in the same industry, studies show that in general
a. MNCs pay higher wages than local firms.
b. MNCs make less extensive use of machinery than do local firms.
c. The products of MNCs are less likely to be protected by import tariffs.
d. MNCs do not buy raw materials from the local economy

10. Anti-dumping duty is
a. A tax on exports from abroad equal to the difference between their price in their home market and their price for export.
b. Tariff on imports that are in excess supply in foreign markets.
c. The international agreement not to dispose of waste products in international waters.
d. A requirement imposed by the International Monetary Fund on countries requesting assistance, designed to prevent them from undermining IMF objectives.

11. Which of the following would be an example of foreign direct investment from the United States to
Taiwan?
a. US bank buys bonds issued by a Taiwan computer manufacturer.
b. Warren Buffet (a US citizen) buys a controlling share in a Taiwanese electronics firm.
c. A US car manufacturer enters into a contract with a Taiwan firm for the latter to make and sell it
spark plugs.
d. The state of California rents space in Taipei for one of its employees to use promoting tourism in
California.

12. What is the connection, if any, between comparative advantage (CA) and foreign direct investment (FDI)?
a. Nothing. CA has nothing to do with FDI.
b. When a country’s firms invest abroad, this helps to create CA in the same industry at home.
c. When a country’s firms invest abroad, this helps to create CA in the same industry in the country where they undertake the investment.
d. Countries often engage in FDI in industries where the country they invest in has a comparative advantage.

13. The following include several reasons that government might give for using a tariff on imports. Which reason is not valid, in the sense that the effect described will not happen?
a. To help consumers.
b. To raise government revenue.
c. To raise incomes of producers.
d. To increase national welfare at the expense of foreigners.

15. The Smoot-Hawley Tariff Act
a. Created NAFTA.
b. Raised US tariffs on hundreds of products at the start of the 1930s.
c. Changed US tariffs to be in compliance with the GATT.
d. Raised tariffs on tulips imported into the Netherlands to over 100%.

16. If a country pegs its exchange rate at a level that is, and continues to be, overvalued, then it will eventually be the case that
a. Its exports will expand as foreign markets recognize the high value.
b. It will run out of foreign reserves.
c. People will engage in smuggling to avoid the official exchange rate.
d. Prices in the country will rise.

17. If a country’s currency is undervalued, and if its central bank is pegging its exchange rate but not sterilizing the effects of its intervention, then which of the following will happen?
a. Its central bank will sell its own currency on the foreign exchange market.
b. Its central bank will gain reserves of foreign currency.
c. The country’s money supply will expand.
d. All of the above.

18. If Canada were pegging the Canadian dollar to the U.S. dollar and also trying to sterilize the effects of its exchange market intervention, then when it buys U.S. dollars on the foreign exchange market, it should
a. Sell Canadian government bonds.
b. Buy Canadian government bonds..
c. Sell U.S. government bonds.
d. Buy U.S. government bonds.

19. Sterilization of exchange-market transactions by a central bank means to prevent those transactions from affecting
a. The level of its reserves
b. The level of the domestic money supply
c. The level of the foreign money supply
d. The spot exchange rate

20. Under a crawling peg
a. The exchange rate moves, but by amounts too little to notice.
b. The exchange rate is permitted to change only slowly within the band.
c. The par value of the currency is kept secret and changed slowly over time.
d. The central value of a pegged exchange rate is changed frequently, by small amounts, and with advance notice.

21. The infant industry argument says that
a. free trade creates the greatest benefit to an industry when it is newly established.
b. a country with a high rate of population growth, because of its high proportion of children, will have a natural comparative advantage in producing toys
c. when a country’s producers of a product are just starting, tariff protection may offset the disadvantage of high costs and allow them to learn to be more efficient over time.
d. developing countries tend to specialize in production of primary products, the prices of which tend to fall over time.

22. Based on the Big Mac Index and because of the fact that burgers are not traded internationally, “emerging economies” tend to have
a. Over-valued exchange rates because their wages are low.
b. Over-valued exchange rates because their wages are high.
c. Under-valued exchange rates because their wages are low.
d. Under-valued exchange rates because their wages are high.

23. The price at which one can enter into a contract today to buy or sell a currency 30 days from now is called a
a. Reciprocal exchange rate.
b. Effective exchange rate.
c. Exchange rate option.
d. Forward exchange rate.

24. An advantage of a pegged exchange rate in comparison to a flexible exchange rate is that
a. The pegged rate permits the country to use inflation to reduce the value of a government debt.
b. By keeping the exchange rate unchanged, prices of different goods and services are forced to move together, avoiding disruptive changes in relative prices.
c. It provides investors with confidence that markets are being allowed to do their work.
d. If the peg is able to be sustained over time, it avoids costly movements up and down in exchange rates.

25. An increase in the U.S. demand for the Mexican peso
a. causes the U.S. dollar to depreciate.
b. causes Mexican goods to be relatively more expensive.
c. causes an increase in the U.S. dollar price of a Mexican peso.
d. All of the above.

Part B: Short Answer Questions
Points for each part are in parentheses.
Instructions: Write your answers on this exam sheet.

1. (18) Suppose that Mexico has previously had restrictions on inflows of foreign direct investment from all sources, including the United States. Then suppose that they remove those restrictions on flows from the United States in a particular industry, say hammocks. As a result, several hammock producers in the US move production to Mexico via FDI. Indicate for each of the groups below whether you expect them to gain or to lose from this flow of investment. If you think it could go either way please write a one sentence justification for your answer!

i. Workers previously employed in hammock production in the US.

Gain Lose Unchanged (check one)

ii. Workers previously employed in hammock production in Mexico.

Gain Lose Unchanged (check one)

iii. Owners of firms that move production to Mexico.

Gain Lose Unchanged (check one)

iv. Owners of US hammock firms that do not move production to Mexico.

Gain Lose Unchanged (check one)

v. Owners of firms in Mexico that previously produced hammocks.

Gain Lose Unchanged (check one)

vi. US consumers of hammocks (assume that there already was free trade in hammocks).

Gain Lose Unchanged (check one)

2. (10) Which of the following is FDI?

i: Procter and Gamble deposits money in its bank account in Japan.
ii: Microsoft builds a plant in Brazil and sends all American workers to operate it.
iii: A US investor buys 60% of the stocks of BMW AG, the German automobile company.
iv: General Electric buys an Indian firm that produces refrigerators, and adapts it to produce its own products.
v: Mattel contracts a Mexican firm to do some of the Barbie processing.
vi: Intel builds a plant in Malaysia and hires young Malaysians to work in producing microprocessors.
vii: A rich American lends money to a rich Brazilian, to be used in expanding the Brazilian’s business.

3. (12) Fill in the blanks in the following:

The two fundamental principles of the WTO, are (1) the _____________________________________Principle and (2) ___________________________________________. Under principle (1), a country must extend the same _____________________to each _________________________________ as it would to its ________________________________nation, thereby eliminating discrimination between trading partners within the WTO. Principle (2), on the other hand, eliminates discrimination between domestic and foreign __________________, once they enter the domestic market.

4. (16) The world’s largest exporter of cotton is the United States, whose cotton farmers are given $4 billion a year in production subsidies. The world’s largest producer of cotton is China, but because it uses even more cotton than it produces, it is also the world’s largest importer of cotton. However, there are other countries that depend even more on cotton trade than these two, since the US and China both export and import lots of other things as well. For example, in five countries of Africa – Benin, Burkina Faso, Chad, Mali and Togo – cotton makes up more than 50% of their exports, and contributes a significant share to their (small) GDPs. In contrast, other poor countries such as Bangladesh, depend heavily on cotton imports to supply inputs to their manufacture of clothing.
From the facts in the preceding paragraph, indicate which of the groups below gain, and which lose, from the US cotton subsidies:
i. Cotton farmers in the United States