Exchange Rates: four questions to try now
Real past-paper questions, the answer key from the mark scheme, and the explanation that goes with it. No account needed to answer them.
Question 1
Why might a government wish to increase the value of its foreign exchange rate when the sum of the price elasticity of demand for imports and exports is greater than 1?
Answer: D.
A stronger currency makes everything bought from abroad cheaper in domestic money, so imported raw materials cost firms less, that benefit holds whatever the elasticities are, which is why D is the answer. The elasticity condition in the question is there to steer you away from B. When the price elasticities of demand for imports and exports sum to more than one, the Marshall-Lerner condition is met, and that means a change in the exchange rate moves the current account in the familiar direction, so an APPRECIATION would WORSEN the current account, not improve it. A also points the wrong way, since a dearer currency makes the country more expensive for tourists and deters them. C is wrong because a stronger currency lowers import prices and so dampens inflation rather than raising it.
Question 2
A country’s currency has depreciated against all the currencies of its main trading partners. How will the depreciation affect its terms of trade?
Answer: C.
The correct answer is:
C The terms of trade will worsen.
Explanation:
When a country's currency depreciates against its main trading partners, it means that the country's goods and services have become relatively cheaper for its trading partners, while imports have become more expensive for the country's residents. This will likely lead to an increase in exports and a decrease in imports, which can improve the trade balance initially. However, over time, as trading partners adjust their prices and demand, the terms of trade are likely to worsen for the depreciating country.
A depreciation in the currency can lead to a decrease in the real income of the country as the cost of imports increases, leading to a deterioration in the terms of trade. This is because the country will need to export more goods to import the same amount of goods from its trading partners when its currency is depreciating.
Therefore, in the given scenario, the terms of trade will worsen for the country whose currency has depreciated against its main trading partners.
C The terms of trade will worsen.
Explanation:
When a country's currency depreciates against its main trading partners, it means that the country's goods and services have become relatively cheaper for its trading partners, while imports have become more expensive for the country's residents. This will likely lead to an increase in exports and a decrease in imports, which can improve the trade balance initially. However, over time, as trading partners adjust their prices and demand, the terms of trade are likely to worsen for the depreciating country.
A depreciation in the currency can lead to a decrease in the real income of the country as the cost of imports increases, leading to a deterioration in the terms of trade. This is because the country will need to export more goods to import the same amount of goods from its trading partners when its currency is depreciating.
Therefore, in the given scenario, the terms of trade will worsen for the country whose currency has depreciated against its main trading partners.
Question 3
Following a long period of depreciation of the US$, both the US and UK monetary authorities raised their domestic interest rate. What will happen to the value of the exchange rate of the US$ in terms of UK£?
Answer: D.
An exchange rate responds to the DIFFERENCE in returns between two countries, not to the level of rates in either one. Money flows towards whichever currency now offers the better deal. Here both the United States and the United Kingdom raised their interest rates, and the question never says by how much. If the American rise is larger, dollars become relatively more attractive and the dollar strengthens; if the British rise is larger, it weakens; if the two rises match, the differential is unchanged and so, other things equal, is the rate. With the sizes unknown the direction genuinely cannot be determined, so D is the honest answer. The earlier depreciation of the dollar is background and does not settle what happens next.
Question 4
A country has a floating exchange rate.
An increase in which variable within that country can cause its exchange rate to appreciate?
Answer: C.
Under a floating rate the currency appreciates when foreigners want more of it than domestic residents are supplying to the market. A rise in interest rates achieves that by making financial assets in the country more attractive, so overseas investors buy the currency to acquire them and demand for it climbs. Rising domestic income levels pull in the opposite direction, because higher incomes mean more spending and a good part of that goes on imported goods, which requires selling domestic currency to pay foreign suppliers. A rise in employment works through the same channel, since more people earning means more imports bought, so it weakens rather than strengthens the currency. A rise in the domestic price level is the most clearly damaging of the three, as it makes exports less competitive abroad and imports better value at home, reducing demand for the currency while increasing its supply.
What this practice covers
These questions are drawn from past CIE 9708 papers and filtered to exchange rates. You answer, you find out immediately whether you were right, and you get the reasoning for the correct option and for each distractor. Wrong answers go to a mistakes locker so you can come back to exactly those.
Practice is free. You need an account only so your progress and your mistakes are still there next time.
What examiners see students get wrong here
These are the errors that cost marks on exchange rates, taken from our own topic notes. Read them before you practise and you will recognise the traps in the questions.
- Using devaluation for a floating rate. Use depreciation.
- Failing to specify the quotation. State dollars per pound, euros per dollar or another clear price.
- Treating an appreciation as good and depreciation as bad. Both create benefits and costs.
- Ignoring the SRAS channel. Imported-input prices matter.
- Assuming exports and imports respond immediately and fully. Use elasticity, contracts and time.
- Confusing demand for exports with demand for currency. Export purchases usually generate currency demand, but explain the link.
- Confusing a movement along a curve with a shift. The currency’s own price causes movement along; another determinant shifts the curve.
- Claiming AD and SRAS imply a certain output result when they shift in opposite directions. State ambiguity and conditions.
Revise it first
If any of the above is unfamiliar, work through the notes before practising: Exchange Rates revision notes.