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CHAPTER 7 REVIEW QUESTION ANSWERS 1. Briefly summarize the six major factors that influence foreign exchange rates. The basic factor is the supply and demand for a currency as affected by the following five factors: (1) relative price differences (the impact of purchasing power parity), (2) interest rates and monetary supply (interest rates in a country will affect demand for a currency and monetary policy affects supply of the currency), (3) productivity and balance of payments (productivity affects the cost of a country’s goods and that cost will impact exports which in turn affects the balance of payments), (4) exchange rate policies (a currency which can be freely exchanged will be more desirable than one which cannot), and (5) investor psychology - positive or negative expectations will affect the extent to which a currency is desirable. 2. How would you describe the theory of purchasing power parity (PPP)? Purchasing power parity: a theory that suggests that in the absence of trade barriers (such as tariffs), the price for identical products sold in different countries must be the same. 3. What is the relationship between a country’s current account balance and its currency? A country experiencing a current account surplus will see its currency appreciate; conversely, a country experiencing a current account deficit will see its currency depreciate. 4. What is the difference between a floating exchange rate policy and a fixed exchange rate policy? Floating (or flexible) exchange rate policy: the willingness of a government to let the demand and supply conditions determine exchange rates. Fixed exchange rate policy; fixing the exchange rate of a currency relative to other currencies. 5. How is the phenomenon of capital flight an example of the bandwagon effect or herd mentality? Capital flight: a phenomenon in which a large number of individuals and companies exchange domestic currencies for a foreign currency. Bandwagon effect: the result of investors moving as a herd in the same direction at the same time. 6.
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