Exchange
Rates

Correct: B. When £ appreciates, each pound buys more dollars. A UK good priced at £100 now costs US buyers $140 instead of $125 — more expensive. A US good priced at $125 now costs UK buyers £89 instead of £100 — cheaper. So appreciation: makes exports less competitive (volume falls) and makes imports cheaper (volume rises). The opposite of depreciation.

Correct: B. The Marshall-Lerner condition: |PEDx| + |PEDm| > 1. Depreciation makes exports cheaper and imports dearer. Whether this improves the trade balance depends on how much volumes change. If demand is very inelastic (people keep buying the same quantities), price changes dominate and the trade balance may worsen. If demand is elastic, volume changes outweigh price changes and the balance improves. In the short run, elasticities tend to be low (contracts fixed) — hence the J-curve.

Correct: C. The J-curve: in the short run, existing contracts mean trade volumes don't change quickly — but import prices rise immediately (more expensive in domestic currency). So import bill rises before export volumes respond → trade balance worsens. Over 6–18 months, exporters gain new contracts at competitive prices, importers switch to domestic alternatives → volumes adjust → trade balance improves. The time path traces a J shape.

Correct: B. Black Wednesday showed the fundamental weakness of fixed exchange rate systems: if the fixed rate is incompatible with domestic needs (UK needed low rates for recession; ERM required high rates to match Germany), speculative pressure is irresistible. George Soros recognised the inconsistency and bet $10bn against sterling — the UK government raised rates from 10% to 15% in one day but couldn't hold. After exiting the ERM, sterling depreciated, monetary policy could focus on the UK cycle, and recovery was strong.

Correct: C. Higher UK inflation → UK goods become relatively more expensive → export demand falls (less demand for £) → import demand rises (more UK residents selling £ for foreign goods) → supply of £ increases → pound depreciates. A is wrong — higher UK rates attract hot money inflows → demand for £ rises → appreciation. B is wrong — more service exports → more demand for £ → appreciation. D is wrong — foreign investment in UK gilts → demand for £ → appreciation.

Correct: B. PPP: if a basket of goods costs £100 in UK and $130 in US, the exchange rate should converge toward £1 = $1.30 through arbitrage. If UK inflation is persistently higher than US, sterling should depreciate to maintain PPP. Works as a long-run anchor but poorly predicts short-run movements (dominated by capital flows and speculation). The Big Mac Index is The Economist's informal PPP measure.

Correct: B. A managed float (also called "dirty float") is the most common system in practice. The exchange rate primarily reflects supply and demand, but the central bank intervenes (buying/selling foreign reserves, or adjusting interest rates) to prevent disorderly markets or excessive misalignment. China operated this for decades, keeping the yuan artificially weak. Singapore's MAS manages its exchange rate band actively as its primary monetary policy tool.

Correct: B. The fundamental contradiction: UK was in deep recession (high unemployment, housing crash) and needed interest rate cuts. But German reunification pushed up German inflation → Bundesbank raised rates → to maintain the DM peg, UK also had to keep rates high (10%+). This was perverse — contractionary monetary policy during a UK recession. Speculators (Soros) recognised the government would eventually have to choose between its citizens' economic welfare and the peg. They bet on the peg breaking, and won. This is the core lesson: fixed exchange rates eliminate monetary policy flexibility.