Exchange Rates worksheet
The answer key prints on its own page, so hand out everything before it.
Exchange Rates: practice worksheet
1. If the exchange rate changes from 1 USD = 0.90 EUR to 1 USD = 1.05 EUR, the US dollar has:
- (A) Depreciated against the euro
- (B) Appreciated against the euro
- (C) Remained at parity with the euro
- (D) Become overvalued compared to PPP
2. If the Federal Reserve raises interest rates while the European Central Bank holds rates steady, what is the most likely effect on the USD/EUR exchange rate?
- (A) USD depreciates as investors flee
- (B) USD appreciates as foreign capital flows in seeking higher returns
- (C) EUR appreciates due to weaker US economic growth
- (D) No change because interest rates do not affect exchange rates
3. A country experiences higher inflation than its trading partners. According to exchange rate theory, what will likely happen to its currency in the long run?
- (A) The currency will appreciate due to more money in circulation
- (B) The currency will depreciate as foreign buyers find its exports more expensive
- (C) The currency's value will be unaffected by inflation differentials
- (D) The currency will become more volatile but maintain its value
4. The demand for US dollars in the foreign exchange market comes primarily from:
- (A) Americans buying foreign goods and services
- (B) Foreign individuals and businesses wanting to purchase US goods, services, or assets
- (C) The Federal Reserve printing new currency
- (D) Tourists converting dollars before international travel
5. A depreciation of the US dollar will most likely:
- (A) Make US exports more expensive and reduce net exports
- (B) Make US imports cheaper and increase net exports
- (C) Make US exports cheaper and increase net exports
- (D) Have no effect on the trade balance
6. If American tourists suddenly increase their travel to Europe, what happens in the USD/EUR exchange rate market?
- (A) Demand for USD increases, dollar appreciates
- (B) Supply of USD increases, dollar depreciates against the euro
- (C) Both supply and demand for USD decrease equally
- (D) Only the euro market is affected
7. Which of the following would cause the US dollar to appreciate?
- (A) A decrease in US interest rates relative to other countries
- (B) An increase in the US inflation rate above other countries
- (C) An increase in foreign demand for US exports
- (D) An increase in US imports
8. An inflow of foreign direct investment into the United States would most likely cause:
- (A) The US dollar to depreciate
- (B) The US dollar to appreciate as foreign investors demand dollars to purchase US assets
- (C) No change in the exchange rate
- (D) A decrease in US net exports only
9. Which of the following factors does NOT directly affect the exchange rate between two currencies?
- (A) Relative interest rates between countries
- (B) Relative inflation rates between countries
- (C) Relative levels of GDP and economic growth
- (D) The geographical size of each country
10. A major US corporation announces it will build a large manufacturing plant in Mexico, requiring payment in pesos. This will:
- (A) Increase the demand for pesos in the forex market
- (B) Increase the supply of dollars in the forex market
- (C) Both A and B, leading to dollar depreciation against the peso
- (D) Neither A nor B; company investments don't affect forex markets
Exchange Rates: answer key
1. (B) Appreciation means each dollar now buys more of the foreign currency. At 0.90 EUR per dollar, $1 gets you 90 euro cents. At 1.05 EUR per dollar, the same dollar gets you 1.05 euros, which is more foreign currency. That's what dollar appreciation looks like in practice. Option A describes the opposite movement. Option D confuses nominal exchange rate moves with purchasing power parity analysis, which is a separate long-run concept.
2. (B) Higher US rates on dollar-denominated bonds attract foreign capital chasing the yield differential. Foreign investors sell euros to buy dollars, which shifts dollar demand right on the forex graph. Dollar appreciates, euro depreciates. This is exactly what happened from March 2022 through September 2022: the Fed raised rates aggressively while the ECB moved more slowly, and the euro fell below parity with the dollar for the first time in two decades.
3. (B) Higher domestic inflation makes the country's exports more expensive abroad, which cuts export demand and reduces demand for the currency. Simultaneously, domestic consumers shift toward cheaper imports, which increases the supply of the currency. Both effects push the currency's value down. The 1970s US experience fits: persistent high US inflation caused the dollar to lose about half its value against the German mark between 1971 and 1979.
4. (B) Dollar demand comes from foreigners who need dollars to pay for US goods, services, or investments. A BMW factory in Munich needs dollars to buy American microchips. A Japanese pension fund needs dollars to buy US Treasury bonds. All of these create dollar demand. Option A describes dollar supply because Americans buying imports supply dollars to the forex market in exchange for foreign currency. Option C refers to the money supply domestically, not the forex market. Option D is actually dollar supply, not demand.
5. (C) A weaker dollar makes American goods cheaper for foreign buyers (exports rise) and makes imports more expensive for Americans (imports fall). Net exports increase. This is why countries sometimes pursue competitive devaluation to boost their export competitiveness, though it typically triggers retaliation and is discouraged by both the IMF and WTO. Option A reverses the mechanism for exports. Option B has imports moving the wrong direction.
6. (B) American tourists need euros to spend in Europe, so they exchange dollars for euros in the forex market. That supplies more dollars and demands more euros. Higher dollar supply shifts the USD supply curve right, which pushes the dollar's value down against the euro. Option A describes the effect of European tourists visiting the US, which is the opposite scenario.
7. (C) Higher foreign demand for US exports means foreigners need more dollars to pay for those goods, which shifts dollar demand right and pushes the exchange rate up. This is straightforward supply-and-demand reasoning applied to the currency market. Option A would cause depreciation because lower US rates make dollar assets less attractive. Option B would also cause depreciation since higher US inflation makes US exports less competitive. Option D increases dollar supply as Americans sell dollars to buy imports, which pushes the dollar down.
8. (B) Foreign investors buying US assets (factories, real estate, businesses) must first convert their currency into dollars. That increase in dollar demand pushes the exchange rate up. The dollar appreciates, which secondarily reduces net exports by making US exports more expensive abroad. So the effect runs through the exchange rate, not directly on trade. Option D captures only part of the chain of effects.
9. (D) Geographical area doesn't affect currency values. Exchange rates respond to economic variables that affect the supply and demand for each currency. Relative interest rates drive capital flows. Relative inflation rates affect export competitiveness. Relative GDP growth drives trade flows. All three are standard determinants of exchange rate movements. Geography plays no direct role.
10. (C) The corporation must acquire pesos to pay for construction, labor, and supplies in Mexico. It does this by selling dollars (which increases dollar supply) and buying pesos (which increases peso demand). Both forces push in the same direction: dollar down, peso up. This is a straightforward application of forex supply-demand analysis to a real corporate transaction.