Test Bank for International Finance Theory And Policy 12th Global Edition Paul Krugman, Maurice Obst

TEST BANK FOR International Finance Theory And Policy 12th Global Edition Paul Krugman, Maurice Obstfeld, Marc Melitz Chapter 1-11 Chapter 1 1.1

Introduction

What Is International Economics About?

1) Historians of economic thought often describe written by as the first real exposition of an economic model.

A) "Of the Balance of Trade"; David Hume; 1776 B) "Wealth of Nations"; David Hume; 1758 C) "Wealth of Nations"; Adam Smith; 1758 D) "Wealth of Nations"; Adam Smith; 1776 E) "Of the Balance of Trade"; David Hume; 1758 Answer: E Difficulty: Easy AACSB: Application of knowledge

and published in

2) From 1960 to 2019 A) the U.S. economy roughly tripled in size.

B) U.S. imports roughly tripled in size.

C) the share of U.S. trade in the global economy roughly tripled in size compared with the economy as a whole.

D) U.S. imports roughly tripled as compared to U.S. exports.

E) U.S. exports roughly tripled in size.

Answer: C Difficulty: Easy AACSB: Application of knowledge 3) From 1960 to 2019, both U.S. imports and exports have increased, leading to a large excess of .

A) imports; imports over exports B) exports; exports over imports C) imports; exports over imports D) exports; imports over exports Answer: A Difficulty: Easy AACSB: Application of knowledge

have grown more,

4) The facts that U.S. imports and exports plunged in 2009 during the global economic crisis and in 2020 during the Covid-19 pandemic demonstrated the close links between A) world trade and the overall state of the world economy.

B) crisis and unemployment.

C) the pandemic and shortage of goods and services.

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D) the business cycle and trade policies.

Answer: A Difficulty: Easy AACSB: Application of knowledge 5) The United States is less dependent on trade than most other countries because A) the United States is a relatively large country with diverse resources.

B) the United States is a "Superpower."

C) the military power of the United States makes it less dependent on anything.

D) the United States invests in many other countries.

E) many countries invest in the United States.

Answer: A Difficulty: Easy AACSB: Application of knowledge 6) Theories of international economics from the 18th and 19th centuries are A) not relevant to current policy analysis.

B) only of moderate relevance in today's modern international economy.

C) highly relevant in today's modern international economy.

D) the only theories that are actually relevant to modern international economy.

E) not well understood by modern mathematically oriented theorists.

Answer: C Difficulty: Easy AACSB: Application of knowledge 7) International economics use the same fundamental methods of analysis as other branches of economics, because .

A) does not; the level of complexity of international issues is unique B) does not; the interactions associated with international economic relations is highly mathematical C) does not; international economics takes a different perspective on economic issues D) does; international economists must reach an agreement with other economists on every economic issue E) does; the motives and behavior of individuals are the same in international trade as they are in domestic transactions Answer: E Difficulty: Easy AACSB: Application of knowledge 8) Because the Constitution forbids restraints on interstate trade A) the U.S. may not impose tariffs on imports from NAFTA countries.

B) the U.S. may not affect the international value of the $ U.S. C) the U.S. may not put restraints on foreign investments in California if it involves a financial intermediary in New York State.

D) the U.S. may not impose export duties.

E) the U.S. may not disrupt commerce between Florida and Hawaii.

Answer: E 2 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Easy AACSB: Application of knowledge 9) An important insight of international economics is that when countries sell goods and services to each other, A) the exchange is almost always mutually beneficial.

B) one country always benefits at the expense of the other.

C) it only benefits the low wage country.

D) it only benefits the high wage country.

E) it is almost never beneficial to both countries.

Answer: A Difficulty: Easy AACSB: Application of knowledge 10) "Trade is generally harmful if there are large disparities between countries in wages."

A) This is generally true.

B) This is generally false.

C) Trade theory has nothing to say about this issue.

D) This is true if the trade partner ignores child labor laws.

E) This is true if the trade partner uses prison labor.

Answer: B Difficulty: Easy AACSB: Application of knowledge 11) If there are large disparities in wage levels between countries, then A) trade is likely to be harmful to both countries.

B) trade is likely to be harmful to the country with the high wages.

C) trade is likely to be harmful to the country with the low wages.

D) trade is likely to be harmful to neither country.

E) trade is likely to have no effect on either country.

Answer: D Difficulty: Easy AACSB: Application of knowledge 12) If there are large disparities in productivity between countries, then A) trade is likely to be harmful to neither country.

B) trade is likely to be harmful to the country with the high wages.

C) trade is likely to be harmful to the country with the low wages.

D) trade is likely to be harmful to both countries.

E) trade is likely to have no effect on either country.

Answer: A Difficulty: Easy AACSB: Application of knowledge

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13) Which of the following statements is TRUE? A) Trade is mutually beneficial when countries exchange goods and services.

B) Trade is harmful if large disparities exist between countries in productivity.

C) Trade is harmful if large disparities exist between countries in wages.

D) Trading with less-advanced, lower-wage countries will drag down a country's standard of living.

Answer: A Difficulty: Easy AACSB: Application of knowledge 14) The benefits of international trade are derived from trade in A) tangible goods only.

B) intangible goods only.

C) goods but not services.

D) services but not goods.

E) anything of value.

Answer: E Difficulty: Easy AACSB: Application of knowledge 15) Which of the following statements is NOT TRUE? A) International trade will have no effects on income distribution.

B) International trade may hurt particular groups within nations.

C) International trade can adversely impact owners of resources that are specific to industries that compete with imports.

D) International trade can alter the distribution of income between broad groups, such as workers and the owners of capital.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 16) Who sells what to whom A) has been a major preoccupation of international economics.

B) is not a valid concern of international economics.

C) is not considered important for government foreign trade policy since such decisions are made in the private competitive market.

D) is determined by political rather than economic factors.

E) is less important than international economic theory.

Answer: A Difficulty: Easy AACSB: Application of knowledge

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17) The insight that patterns of trade are primarily determined by international differences in labor productivity was first proposed by A) David Ricardo.

B) David Hume.

C) Adam Smith.

D) Eli Heckscher.

E) Lerner and Samuelson.

Answer: A Difficulty: Easy AACSB: Application of knowledge 18) International economists cannot discuss the effects of international trade or recommend changes in government policies toward trade with any confidence unless they know A) their theory is the best available.

B) their theory is internally consistent.

C) their theory passes the "reasonable person" legal criteria.

D) their theory is good enough to explain the international trade that is actually observed.

E) their theory accounts for China's unique position in international trade.

Answer: D Difficulty: Easy AACSB: Application of knowledge 19) Which of the following is NOT a major concern of international economic theory?

A) protectionism B) the balance of payments C) exchange rate determination D) bilateral trade relations with China E) the international capital market Answer: D Difficulty: Easy AACSB: Application of knowledge 20) Which of the following does NOT belong?

A) NAFTA B) Uruguay Round C) World Trade Organization D) non-tariff barriers E) major free trade agreements of the 1990s Answer: D Difficulty: Easy AACSB: Application of knowledge

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21) In 1998 an economic and financial crisis in South Korea caused it to experience A) a surplus in their balance of payments.

B) a deficit in their balance of payments.

C) a balanced balance of payments.

D) an unbalanced balance of payments.

E) a lull in international trade.

Answer: A Difficulty: Easy AACSB: Application of knowledge 22) In 1998, countries that ran large trade surpluses include A) China and South Korea.

B) U.S. and Japan.

C) China and U.S. D) U.S. and South Korea.

Answer: A Difficulty: Easy AACSB: Application of knowledge 23) After World War II, the United States has pursued a broad policy of A) strengthening "Fortress America" protectionism.

B) removing barriers to international trade.

C) isolating Iran and other members of the "axis of evil."

D) protecting the U.S. from the economic impact of oil producers.

E) restricting trade of manufactured goods.

Answer: B Difficulty: Easy AACSB: Application of knowledge 24) Cost-benefit analysis of international trade A) is basically useless.

B) is empirically intractable.

C) focuses attention primarily on conflicts of interest within nations.

D) focuses attention on conflicts of interest between nations.

E) never leads to government intervention in international trade.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 25) An improvement in a country's balance of payments means a decrease in its balance of payments deficit, or an increase in its surplus. In fact, we know that a surplus in a balance of payments A) is always beneficial.

B) is usually beneficial.

C) is never harmful.

D) is sometimes harmful.

E) is always harmful.

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Answer: D Difficulty: Moderate AACSB: Application of knowledge 26) The GATT is A) an international agreement.

B) an international U.N. agency.

C) an international IMF agency.

D) a U.S. government agency.

E) a collection of tariffs.

Answer: A Difficulty: Easy AACSB: Application of knowledge 27) The balance of payments has become a central issue for the United States because A) when the balance of payments is not balanced, society is unbalanced.

B) the U.S. economy cannot grow when the balance of payments is in deficit.

C) the U.S. has run huge trade deficits in every year since 1982.

D) the U.S. never experienced a surplus in its balance of payments.

E) the U.S. once ran a large trade surplus of about $40 billion.

Answer: C Difficulty: Easy AACSB: Application of knowledge 28) In September 2010, the finance minister of declared that the world was "in the midst of an international currency war" because of rapid appreciation in the value of the country's currency, the .

A) England; pound sterling B) Germany; euro C) Japan; yen D) China; renminbi E) Brazil; Real Answer: E Difficulty: Easy AACSB: Application of knowledge

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29) The study of exchange rate determination is a relatively new part of international economics, since A) for much of the past century, exchange rates were fixed by government action.

B) the calculations required for this were not possible before modern computers became available.

C) economic theory developed by David Hume demonstrated that real exchange rates remain fixed over time.

D) dynamic overshooting asset pricing models are a recent theoretical development.

E) the exchange rate never fluctuates.

Answer: A Difficulty: Easy AACSB: Application of knowledge 30) A fundamental problem in international economics is how to produce A) a perfect degree of monetary harmony.

B) an acceptable degree of harmony among the international trade policies of different countries.

C) a world government that can harmonize trade and monetary policies.

D) a counter-cyclical monetary policy so that all countries will not be adversely affected by a financial crisis in one country.

E) a worldwide form of currency.

Answer: B Difficulty: Easy AACSB: Application of knowledge 31) For almost 70 years international trade policies have been governed A) by the World Trade Organization.

B) by the International Monetary Fund.

C) by the World Bank.

D) by an international treaty known as the General Agreement on Tariffs and Trade (GATT).

E) by the North American Free Trade Agreement (NAFTA).

Answer: D Difficulty: Easy AACSB: Application of knowledge 32) International capital markets experience a kind of risk not faced in domestic capital markets, namely A) "economic meltdown" risk.

B) Flood and hurricane crisis risk.

C) the risk of unexpected downgrading of assets by Standard and Poor.

D) the risk of currency fluctuations.

E) the risk of political upheaval.

Answer: D Difficulty: Moderate AACSB: Application of knowledge

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33) Since 1994, trade rules have been enforced by A) the WTO. B) the G10.

C) the GATT. D) The U.S. Congress.

E) the European Union.

Answer: A Difficulty: Easy AACSB: Application of knowledge 34) The international capital market is A) the place where you can rent earth moving equipment anywhere in the world.

B) a set of arrangements by which individuals and firms exchange money now for promises to pay in the future.

C) the arrangement where banks build up their capital by borrowing from the Central Bank.

D) the place where emerging economies accept capital invested by banks.

E) exclusively concerned with the debt crisis that ended in the 1990s.

Answer: B Difficulty: Easy AACSB: Application of knowledge 35) The international financial crisis of 2007 was the result of A) failure of the Euro currency.

B) runaway inflation in the U.S. C) a deep global recession.

D) the collapse of global currency markets.

E) defaults on U.S. mortgage-backed securities.

Answer: E Difficulty: Easy AACSB: Application of knowledge 36) It is argued that global trade tends to be more important to countries with smaller economies than the U.S. Is this empirically verified?

Answer: Yes. Figure 1-2 shows exports and imports as a percentage of national income in the U.S. and five other countries and notes that "International trade is even more important to most other countries than it is to the U.S." Difficulty: Moderate AACSB: Application of knowledge 37) It is argued that if a rich high wage country such as the United States were to expand trade with a relatively poor and low wage country such as Mexico, then U.S. industry would migrate south, and U.S. wages would fall to the level of Mexico's. What do you think about this argument?

Answer: The student may think anything. The purpose of the question is to set up a discussion, which will lead to the models in the following chapters.

Difficulty: Moderate AACSB: Reflective thinking 38) How are the patterns of international trade, that is the pattern of what different countries export 9 Copyright © 2023 Pearson Education, Ltd.

and import, explained?

Answer: Climate explains why Brazil exports coffee. Natural resources explains why Saudi Arabia exports oil. More generally, differences in labor productivity and in the availability of land, labor, and capital within different countries explain patterns of trade. More recent research suggests that there is a significant random component involved, as well.

Difficulty: Moderate AACSB: Application of knowledge 39) International trade theory implies that international trade is beneficial to all trading countries.

However, casual observation leads to the conclusion that official obstruction of international trade flows is widespread. How might you reconcile these two facts?

Answer: This question is meant to allow students to offer preliminary discussions of issues, which will be explored in depth later in the book.

Difficulty: Moderate AACSB: Application of knowledge 1.2

International Economics: Trade and Money

1) International economics can be divided into two broad sub-fields A) macro and micro.

B) developed and less developed.

C) monetary and barter.

D) international trade and international money.

E) static and dynamic.

Answer: D Difficulty: Easy AACSB: Application of knowledge 2) International trade analysis focuses on A) the real transactions that involve a physical movement of goods or a tangible commitment of economic resources in the international economy.

B) the monetary side of the international economy.

C) the financial transactions such as foreign purchases of U.S. dollars.

D) the devaluation of currencies of the international economy.

Answer: A Difficulty: Easy AACSB: Application of knowledge

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3) International monetary analysis focuses on A) the real side of the international economy.

B) the international trade side of the international economy.

C) the international investment side of the international economy.

D) the issues of international cooperation between Central Banks.

E) the monetary side of the international economy, such as currency exchange.

Answer: E Difficulty: Easy AACSB: Application of knowledge 4) The distinction between international trade and international money is NOT entirely clear because A) real developments in the trade accounts do not have monetary implications.

B) the balance of payments includes only real measures.

C) developments caused by purely monetary changes have no real effects.

D) trade models focus on real, or barter relationships.

E) most international trade involves monetary transactions.

Answer: E Difficulty: Easy AACSB: Application of knowledge 5) The distinction between international trade and international money is NOT entirely clear because A) many monetary events have important consequences for trade.

B) real developments in the trade accounts do not have monetary implications.

C) the balance of payments includes only real measures.

D) developments caused by purely monetary changes have no real effects.

E) trade models focus on real, or barter relationships.

Answer: A Difficulty: Easy AACSB: Application of knowledge

International Finance: Theory & Policy, 12/e, Global Edition Chapter 2 National Income Accounting and the Balance of Payments 2.1

The National Income Accounts

1) Between 2014 and 2019, the world's economy total real product grew at an annual average rate of nearly percent per year.

A) 3.5 B) 3.9 C) 2.9 D) 2.5 Answer: A Difficulty: Easy AACSB: Application of knowledge 11 Copyright © 2023 Pearson Education, Ltd.

2) Macroeconomic analysis emphasizes four aspects of economic life which are A) unemployment, saving, trade imbalances, money and the price level.

B) market structures, social inequality, inflation, balance of payments.

C) firms' competition, growth, trade imbalances, inflation.

D) happiness and utilities, trade imbalances, equality, GDP growth.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) Two related and essential tools to get a complete picture of the macroeconomic linkages among economies that engage in international trade include A) national income accounting and balance of payment accounting.

B) public accounting and government accounting.

C) foreign currency accounting and balance of payment accounting.

D) corporate accounting and foreign exchange accounting.

Answer: A Difficulty: Easy AACSB: Application of knowledge 4) A country's gross national product (GNP) is A) the value of all final goods and services produced by its factors of production and sold on the market in a given time period.

B) the value of all intermediate goods and services produced by its factors of production and sold on the market in a given time period.

C) the value of all final goods produced by its factors of production and sold on the market in a given time period.

D) the value of all final goods and services produced by its factors of production and sold on the market.

E) the value of all final goods and services produced by its factors of production, excluding land, and sold on the market in a given time period.

Answer: A Difficulty: Easy AACSB: Application of knowledge 5) For most macroeconomists A) national income accounts is much more important than national output accounts.

B) it is impossible to tell whether national income accounts equal to national output accounts.

C) national output accounts exceed national income accounts.

D) national income accounts exceed national output accounts.

E) national income accounts, rather than national output accounts are used to describe types of expenditure that make up a country's GNP. Answer: E Difficulty: Easy AACSB: Application of knowledge 6) GNP is divided into four possible uses for which a country's final output is purchased: 12 Copyright © 2023 Pearson Education, Ltd.

A) consumption, investment, government purchases, and the current account balance.

B) salaries and wages, rent, interest, and profits.

C) total national income, sales taxes, depreciation, and net foreign factor income.

D) government purchases, corporate investment, exports, imports.

Answer: A Difficulty: Easy AACSB: Application of knowledge 7) For most macroeconomists A) gross national income exceeds gross national product.

B) it is hard to tell whether gross national income equals gross national product.

C) gross national product exceeds gross national income.

D) gross national product is much more important than gross national income.

E) gross national income and gross national product are used interchangeably.

Answer: E Difficulty: Easy AACSB: Application of knowledge 8) The sale of A) a used textbook does enter GNP. B) a used textbook does not enter GNP, but the sale of a used house does.

C) both a used textbook and a used house do not enter GNP. D) a used house does not enter GNP, but the sale of a used book does.

E) the GNP does not include sale of used items priced below $1000.

Answer: C Difficulty: Easy AACSB: Application of knowledge 9) Which one of the following statements is the MOST accurate?

A) The sale of a used textbook does generate income for factors of production.

B) The sale of a used textbook does not generate income for any factor of production.

C) The sale of a used textbook sometimes does and sometimes does not generate income for factors of production.

D) It is hard to tell whether a sale of a used textbook does or does not generate income for factors of production.

E) The sale of a used textbook is a part of the GNP. Answer: B Difficulty: Easy AACSB: Application of knowledge 10) Which one of the following statements is the MOST accurate?

A) GNP plus depreciation is called net national product (NNP).

B) GNP less depreciation is called net national product (NNP).

C) GNP less depreciation is called net factor product (NFP).

D) GDP plus depreciation is called net national product (NNP).

E) GDP less depreciation is called net national product (NNP).

Answer: B 13 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Easy AACSB: Application of knowledge 11) Net unilateral transfers A) are part of a national income.

B) are part of a country's product.

C) must be added to NNP in calculations of national income.

D) are part of a country's GNP. E) Only A and C. Answer: E Difficulty: Easy AACSB: Application of knowledge 12) National income equals GNP A) less depreciation, less net unilateral transfers.

B) less depreciation or net unilateral transfers.

C) plus depreciation, less net unilateral transfers.

D) plus depreciation, plus net unilateral transfers.

E) less depreciation, plus net unilateral transfers.

Answer: E Difficulty: Easy AACSB: Application of knowledge 13) The United States began to report its gross domestic product (GDP) only since A) 1900.

B) 1921.

C) 1931.

D) 1941.

E) 1991.

Answer: E Difficulty: Easy AACSB: Application of knowledge 14) GDP is supposed to measure A) the volume of production within a country's borders.

B) the volume of services generated within a country's borders.

C) the volume of production of a country's output.

D) GNP plus depreciation.

E) net unilateral transfers from foreigners.

Answer: A Difficulty: Easy AACSB: Application of knowledge 15) GNP equals GDP A) minus net receipts of factor income from the rest of the world.

B) plus receipts of factor income from the rest of the world.

C) minus receipts of factor income from the rest of the world.

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D) plus net receipts of factor income from the rest of the world.

E) minus depreciation.

Answer: D Difficulty: Easy AACSB: Application of knowledge 16) GDP is different than GNP in that A) it accounts for net unilateral transfers.

B) it does not account for indirect business taxes.

C) it does not account for a country's production using services with foreign-owned capital.

D) it accounts for depreciation.

E) it is unhelpful when tracking national income.

Answer: C Difficulty: Easy AACSB: Application of knowledge 17) An example of how GNP accounts for services provided by foreign-owned capital (and GDP does not) is A) earnings of a Spanish factory with British owners counts only in Spain's GDP. B) earnings of a Spanish factory with British owners counts only in Britain's GNP. C) earnings of a Spanish factory with British owners counts in Spain's GNP but are part of Britain's GDP. D) earnings of a Spanish factory with British owners counts in Spain's GDP but are part of Britain's GNP. E) earnings of a Spanish factory with British owners counts in Spain's GNP but not in Britain's GDP or GNP. Answer: D Difficulty: Moderate AACSB: Application of knowledge 18) The profits of a Spanish factory with British owners are A) counted in Spain's GNP. B) not part of Britain's GDP. C) counted in Britain's GDP. D) part of Spain's GNP. E) counted in Spain's GDP and are a part of Britain's GNP. Answer: E Difficulty: Moderate AACSB: Application of knowledge 19) The services British capital provides in Spain are a service export from Britain A) therefore they are subtracted from British GDP in calculating British GNP. B) therefore they are added to Spanish GDP in calculating Spanish GDP. C) therefore they are added to British GDP in calculating British GNP. D) therefore they are added to Spanish GNP in calculating Spanish GDP. E) therefore they are subtracted from Spanish GNP. Answer: C 15 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Difficult AACSB: Application of knowledge 20) Movements in GDP A) differ greatly from movements in GNP. B) do not differ greatly from movements in GNP. C) are not allowed to differ at all from movements in GNP by definition.

D) need to be inflation adjusted in order to match movements in GNP. E) are not relevant to an examination of national income.

Answer: B Difficulty: Easy AACSB: Application of knowledge 21) What are the main aspects of economic life that macroeconomics analysis is most concerned with?

Answer: There are four main aspects: unemployment, saving, trade imbalances, and money and the price level.

Difficulty: Easy AACSB: Application of knowledge 22) What can you learn from the figure below (Figure 2.1 from the text) which depicts the U.S. GNP and its components for the 1st quarter of 2020?

Answer: The largest component of GNP is consumption and the U.S. has a negative current account balance.

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Difficulty: Easy AACSB: Application of knowledge 2.2

National Income Accounting for an Open Economy

1) The largest component of GNP is A) the current account.

B) investment.

C) government purchases.

D) consumption.

E) trade.

Answer: D Difficulty: Easy AACSB: Application of knowledge 2) In the United States over the past seventy years, the fraction of GNP devoted to consumption has fluctuated in a range of about A) 42 to 49 percent.

B) 32 to 39 percent.

C) 22 to 29 percent.

D) 82 to 89 percent.

E) 62 to 70 percent.

Answer: E Difficulty: Easy AACSB: Application of knowledge 3) Purchases of inventories by A) firms are not counted in investment spending.

B) firms are also counted in investment spending.

C) households are also counted in investment spending.

D) households and Firms are also counted in investment spending.

E) foreign consumers are counter in investment spending.

Answer: B Difficulty: Easy AACSB: Application of knowledge 4) Investment is usually A) more variable than consumption.

B) less variable than consumption.

C) as variable as consumption.

D) a larger component of the GNP than consumption.

E) It is hard to tell from the data whether investment is more or less variable than consumption.

Answer: A Difficulty: Easy AACSB: Application of knowledge 5) In the United States, (gross) investment has fluctuated between 17 Copyright © 2023 Pearson Education, Ltd.

of GNP in recent

years.

A) 2 and 12 percent B) 11 and 22 percent C) 22 and 32 percent D) 32 and 42 percent E) 42 and 52 percent Answer: B Difficulty: Easy AACSB: Application of knowledge 6) Government purchases are defined as A) only goods purchased by federal, state, or local governments.

B) all goods and services purchased by the federal government.

C) all goods and services purchased by the federal or state government.

D) all goods and services purchased by the federal, state, or local government.

E) goods and services purchased from the government.

Answer: D Difficulty: Easy AACSB: Application of knowledge 7) Government transfer payments like social security and unemployment benefits are A) included in government purchases.

B) not included in government purchases.

C) not included in government purchases, but they are included in the consumption component of GNP. D) not included in government purchases, but they are part of the investment component of GNP. E) included in government purchases but not in the GNP. Answer: B Difficulty: Moderate AACSB: Application of knowledge 8) Government purchases currently take up about A) 18 percent of U.S. GNP, and this share has not changed much since the late 1950s.

B) 38 percent of U.S. GNP, and this share has not changed much since the late 1950s.

C) 18 percent of U.S. GNP, and this share has been increasing since the late 1950s.

D) 18 percent of U.S. GNP, and this share has been decreasing since the late 1950s.

E) 25 percent of U.S. GNP, and this share has been decreasing since the late 1950s.

Answer: A Difficulty: Easy AACSB: Application of knowledge 9) In 1929, government purchases accounted for A) only 18.5 percent of U.S. GNP. B) only 8.5 percent of U.S. GNP. C) 28.5 percent of U.S. GNP. D) 38.5 percent of U.S. GNP. E) 48.5 percent of U.S. GNP. 18 Copyright © 2023 Pearson Education, Ltd.

Answer: B Difficulty: Easy AACSB: Application of knowledge 10) In 1959, government purchases accounted for A) 22 percent of U.S. GNP. B) 8.5 percent of U.S. GNP. C) 18 percent of U.S. GNP. D) 38.5 percent of U.S. GNP. E) 48.5 percent of U.S. GNP. Answer: A Difficulty: Easy AACSB: Application of knowledge 11) Which one of the following expressions is the MOST accurate?

A) CA = EX - IM B) CA = IM - EX C) CA = EX = IM D) CA = EX + IM E) CA - IM = EX Answer: A Difficulty: Easy AACSB: Application of knowledge 12) A country's current account A) balance equals the change in its net foreign wealth.

B) balance equals the change in its foreign wealth.

C) surplus equals the change in its foreign wealth.

D) deficit equals the change in its foreign wealth.

E) balance equals its GNP. Answer: A Difficulty: Easy AACSB: Application of knowledge 13) In an open economy, the CA is equal to A) Y - (C + I + G).

B) Y + (C + I + G).

C) Y - (C - I + G).

D) Y - (C + I - G).

E) Y + (C - I - G).

Answer: A Difficulty: Easy AACSB: Application of knowledge 14) In 2019, the United States had A) a surplus in the current account.

B) a balance in the current account.

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C) a deficit in the current account.

D) a positive balance of net financial flows.

Answer: C Difficulty: Easy AACSB: Application of knowledge 15) The position of the United States current account balance in 2019 was A) lent roughly 6 percent of its GNP, resulting in a large current account surplus.

B) borrowed roughly 2.3 percent of its GNP, leading to a large current account deficit.

C) achieved a current account balance of zero.

D) borrowed roughly 10 percent of its GNP, leading to a large current account deficit.

E) borrowed less then 5 percent of its GNP, leading to a large current account surplus.

Answer: B Difficulty: Easy AACSB: Application of knowledge 16) Which of the following is TRUE? A) A country with a current account surplus is earning more from its exports than it spends on imports.

B) A country could finance a current account deficit by using previously accumulated foreign wealth to pay for its imports.

C) A country with a current account deficit must be increasing its net foreign debts by the amount of the deficit.

D) We can describe the current account surplus as the difference between income and absorption.

E) All of the above are true of current account balances.

Answer: E Difficulty: Moderate AACSB: Application of knowledge 17) Over the 1980s A) there is no question that a large increase in U.S. foreign assets did occur.

B) there is a question whether a large decrease in U.S. foreign assets did occur.

C) there is no question that a large decrease in U.S. foreign assets did occur.

D) there is no question that there was almost no change in U.S. foreign assets.

E) there is no question that rising exports exceeded U.S. foreign debt.

Answer: C Difficulty: Easy AACSB: Application of knowledge 18) Which one of the following statements is FALSE? A) The United States had accumulated substantial foreign wealth by the early 1980s.

B) The 1980s witnessed a sustained current account deficit of proportions unprecedented in the twentieth century.

C) In 1989, the country became a net debtor to foreigners for the first time since World War I. D) U.S. foreign debt has continued to grow and now stands at 50 percent of GNP at the start of 2020.

E) The U.S. foreign debt was paid off in the 1990s, allowing the U.S. to attain a current account 20 Copyright © 2023 Pearson Education, Ltd.

surplus. However, the deficit has returned in recent years.

Answer: E Difficulty: Moderate AACSB: Application of knowledge 19) In a closed economy, national saving A) sometimes equals investment.

B) always equals investment.

C) is always less than investment.

D) is always more than investment.

E) is never equal to investment.

Answer: B Difficulty: Easy AACSB: Application of knowledge 20) In open economies A) saving and investment are necessarily equal.

B) as in a closed economy, saving and investment are not necessarily equal.

C) saving and investment are not necessarily equal as they are in a closed economy.

D) saving and investment are necessarily equal contrary to the case of a closed economy.

E) investment always refers to the domestic stock market.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 21) For open economies, A) S = I. B) S = I + CA. C) S = I - CA. D) S > I + CA. E) S < I + CA. Answer: B Difficulty: Easy AACSB: Application of knowledge 22) An open economy A) can save only by building up its capital stock.

B) can save only by acquiring foreign wealth.

C) cannot save either by building up its capital stock or by acquiring foreign wealth.

D) can save either by building up its capital stock or by acquiring foreign wealth.

E) can save by avoiding excessive imports.

Answer: D Difficulty: Easy AACSB: Application of knowledge 23) A closed economy A) can save either by building up its capital stock or by acquiring foreign wealth.

21 Copyright © 2023 Pearson Education, Ltd.

B) can save only by building up its capital stock.

C) can save only by acquiring foreign wealth.

D) cannot save either by building up its capital stock or by acquiring foreign wealth.

E) can save by avoiding excessive imports.

Answer: B Difficulty: Easy AACSB: Application of knowledge 24) Disposable income is national income A) less taxes collected from households and firms by the government.

B) plus net taxes collected from households and firms by the government.

C) less net taxes collected from firms by the government.

D) less net taxes collected from households by the government.

E) less net taxes collected from households and firms by the government.

Answer: E Difficulty: Easy AACSB: Application of knowledge 25) Government savings, , is equal to A) T - G. B) T + G. C) T = G. D) T + G - I. E) T - G = I. Answer: A Difficulty: Easy AACSB: Application of knowledge 26) Which of the following is FALSE about private savings and government savings?

A) SP = Y - T - C B) Unlike private saving decisions, government saving decisions are often made with an eye toward their effect on output and employment.

C) Total savings (S) = SP + D) The national income identity can help us to analyze the channels through which government saving decisions influence macroeconomic conditions.

E) None of the above; all statements are true.

Answer: E Difficulty: Moderate AACSB: Application of knowledge 27) In a closed economy, private saving, A) I - (G - T).

B) I + (G - T).

C) I + (G + T).

D) I - (G + T).

E) I + (G - T) + C.

, is equal to

22 Copyright © 2023 Pearson Education, Ltd.

Answer: B Difficulty: Moderate AACSB: Application of knowledge 28) In an open economy, private saving, A) I - CA + (G - T).

B) I + CA - (G - T).

C) I + CA + (G - T).

D) I - CA - (G - T).

E) I + CA + (G + T).

Answer: C Difficulty: Moderate AACSB: Application of knowledge

, is equal to

29) What is the national income identity for a closed economy?

Answer: Y = C + I + G Difficulty: Easy AACSB: Application of knowledge 30) What is the national income identity for an open economy?

Answer: Y = C + I + G + EX - IM Difficulty: Easy AACSB: Application of knowledge 31) Discuss the values of private saving in closed and open economies.

Answer: In a closed economy, private saving, , is equals to, I + (G - T). In a open economy, private saving, , is equals to I + CA + (G - T). Open economy helps in extending the opportunities for private saving or dis-saving, or borrowing.

Difficulty: Moderate AACSB: Application of knowledge 32) Assume in a closed economy: C = 40 + 0.8(Y - T) G = 10 I = 20 T = 0, where T are taxes. (a) Calculate Y at equilibrium. (b) Calculate C, I, and G at equilibrium. (c) Now assume the economy is open with exports and imports activities, EX = 5 + 4EP /P IM = 10 + 0.1 (Y - T) - 3EP /P E=3 P = 1.5 P=2 Find equilibrium Y. Answer: (a) Y = C + I + G 23 Copyright © 2023 Pearson Education, Ltd.

Y = 350 (b) C = 40 + 0.8 Y = 320 I = 20 G = 10 (c) Y = 269.1667 Difficulty: Moderate AACSB: Analytical thinking 33) Fill in the following table.

Answer:

Difficulty: Moderate AACSB: Analytical thinking 34) Assume in a closed economy: C = 50 + 0.6 (Y - T) G = 15 I = 15 T=2 (a) Calculate Y at equilibrium (b) Calculate C (c) Assume the economy is open EX = 4 + 3EP /P 24 Copyright © 2023 Pearson Education, Ltd.

IM = 8 + 0.1 (Y - T) - 2EP /P E=3 P =1 P = 1.5 Find equilibrium Y. Answer: (a) Y = C + I + G Y = 50 + 0.6(Y - 2 + 15 + 15) Y = 197 (b) C = 50 + 0.6 (197 - 2) = 50 + 117 = 167 (c) Y = 170 Difficulty: Moderate AACSB: Analytical thinking 35) Fill in the following table.

Answer:

Difficulty: Moderate AACSB: Analytical thinking 36) What can one learn from the following figure 2.2?

25 Copyright © 2023 Pearson Education, Ltd.

Answer: The figure shows the U.S. current account and net foreign wealth from 1976 until 2019.

It shows that a string of current account deficits in the 1980s reduced America's net foreign wealth until, by the early 21st century, the country had accumulated a substantial net foreign debt. In 1989 the country became a net debtor to foreigners for the first time since World War I. Difficulty: Moderate AACSB: Analytical thinking 37) Fill in the following table.

Answer:

26 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Moderate AACSB: Analytical thinking 2.3

The Balance of Payments Accounts

1) Every international transaction automatically enters the balance of payments A) once either as a credit or as a debit.

B) twice, once as a credit and once as a debit.

C) once as a credit.

D) twice, both times as debit.

E) three times, once as a credit, once as a debit, and once as an exchange.

Answer: B Difficulty: Easy AACSB: Application of knowledge 2) You travel to Paris and pay for a $100 dinner with your credit card. How is this accounted for in the balance of payments?

A) current account, French service import B) current account, U.S. good export C) financial account, U.S. asset export D) financial account, U.S. asset import E) financial account, French asset export Answer: C Difficulty: Moderate AACSB: Application of knowledge 3) The German government carries out an official foreign exchange intervention in which it uses dollars held in an American bank to buy French currency from its citizens. How is this accounted for in the balance of payments?

A) current account, French good export B) current account, German good import C) financial account, French asset export D) financial account, German asset export E) financial account, German asset import Answer: C Difficulty: Difficult AACSB: Application of knowledge 27 Copyright © 2023 Pearson Education, Ltd.

4) The United States issues a $10,000 debt forgiveness to Argentina. How is this accounted for in the balance of payments?

A) financial account, U.S. asset import B) current account, Argentina transfer payment C) current account, U.S. service export D) capital account, U.S. transfer payment E) current account, Argentina good import Answer: D Difficulty: Moderate AACSB: Application of knowledge 5) A U.S. citizen buys a newly issued share of stock in England, paying for his order with a check, which the British company deposits in its own U.S. bank account in New York. How is this transaction accounted for in the balance of payments?

A) financial account, U.S. asset import B) current account, U.S. service import C) current account, British good export D) financial account, British asset import E) financial account, U.S. asset export Answer: A Difficulty: Difficult AACSB: Application of knowledge 6) Unilateral transfers between countries are A) long-term loans.

B) part of national income, but not part of the current account C) part of the current account, but not a part of national income.

D) known for reducing the income of capital owners.

E) international gifts or payments that do not correspond to the purchase of any good, service, or asset.

Answer: E Difficulty: Moderate AACSB: Application of knowledge 7) How do we allocate statistical discrepancy among the current, capital, and financial accounts?

A) We have no way of knowing exactly how to allocate this discrepancy.

B) Depend on the degree of certainty which we attribute to these accounts.

C) Divide it evenly amongst the three accounts.

D) Depend on the convention adopted by the specific financial institution.

E) Statistical discrepancy signals human errors made when dealing with financial accounts.

Answer: A Difficulty: Easy AACSB: Application of knowledge 8) Which of the following statements was announced by Ireland's Central Statistics Office on July 12, 2016?

A) Ireland's real GDP had risen by 26.3 percent between 2014 and 2015.

28 Copyright © 2023 Pearson Education, Ltd.

B) Ireland's real GDP had risen by 7.8 percent between 2014 and 2015.

C) Ireland's real GDP had risen by 5.8 percent between 2014 and 2015.

D) Ireland's real GDP had risen by 2.3 percent between 2014 and 2015.

Answer: A Difficulty: Easy AACSB: Application of knowledge 9) Ireland's remarkable spurt of GDP growth between 2014 and 2015 was A) in large part an accounting phenomenon reflecting tax avoidance by large multinationals from other countries.

B) because of a sudden upsurge in Ireland's available supplies of factories, land, and labor.

C) due to massive increase in factors of production.

D) thanks to innovation and job creation.

Answer: A Difficulty: Easy AACSB: Application of knowledge 10) Which of the following statements is TRUE? A) Ireland's low tax on corporate profits set up an incentive for large multinationals to relocate their intellectual property assets to subsidiaries in Ireland.

B) Ireland's high tax on corporate profits set up an incentive for large multinationals to relocate their intellectual property assets to the United States of America.

C) Ireland's high tax on corporate profits set up an incentive for Irish firms to relocate their intellectual property assets to other countries.

D) Ireland's high tax on corporate profits make the Irish businesses very unhappy.

Answer: A Difficulty: Easy AACSB: Application of knowledge 11) The practice used by multinational corporations to relocate their intellectual property assets to subsidiaries in low-tax havens so that global profits are booked and taxed there is called A) profit shifting.

B) offshore taxing.

C) profit sharing.

D) offshore relocating.

Answer: A Difficulty: Easy AACSB: Application of knowledge 12) U.S. multinationals are estimated to shift roughly percent of their total annual profit to low-tax jurisdictions, whereas the global average profit share that multinationals shift from their home countries is about percent.

A) 60; 40 B) 40; 60 C) 80; 20 D) 20; 80 Answer: A 29 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Easy AACSB: Application of knowledge 13) Facing the problem of multinational profit sharing, the United States and other large economies in 2021 agreed to establish a common minimum corporate tax rate of percent.

A) 15 B) 20 C) 25 D) 30 Answer: A Difficulty: Easy AACSB: Application of knowledge 14) Which of the following statements about the central bank is TRUE? A) Only the central bank may hold foreign reserves and intervene officially in exchange markets.

B) Central banks have little power to affect macroeconomic conditions.

C) Today, central banks' reserves consist largely of gold.

D) The Federal Reserve holds only a small level of official reserve assets other than gold.

E) Central banks never inject money into the economy.

Answer: D Difficulty: Moderate AACSB: Application of knowledge 15) An American buys a Japanese car, paying by writing a check on an account with a bank in New York. How would this be accounted for in the balance of payments?

A) current account, a Japanese good import B) current account, a U.S. good import C) financial account, a U.S. asset import D) financial account, a U.S. asset export E) a current account as a U.S. good import and a financial account, a U.S. asset export Answer: E Difficulty: Moderate AACSB: Application of knowledge 16) The official settlements balance or balance of payments is the sum of A) the current account balance, and the capital account balance, less the non-reserve portion of the financial account balance.

B) the current account balance and the capital account balance.

C) the current account balance, the capital account balance, the non-reserve portion of the financial account balance, the statistical discrepancy.

D) the current account balance and the non-reserve portion of the financial account balance.

E) the current account balance and the interest in all investments.

Answer: A Difficulty: Easy AACSB: Application of knowledge 30 Copyright © 2023 Pearson Education, Ltd.

17) Which of the following is TRUE about current cost method and market value method?

A) They are used by the BEA to place current values on foreign indirect investments.

B) These methods lead to the same valuations.

C) Based on the current cost method, the BEA's 2019 estimate of U.S. net foreign wealth was -$11,050.5 billion.

D) The market value cost method is preferred by the BEA. E) Foreign direct investments of the U.S. are valued at their original purchase price.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 18) What types of international transactions are recorded in the balance of payment accounts?

Answer: Three types: (1) transactions that involve exports and imports of goods and services; (2) transactions that involve the purchase or sale of financial assets; (3) other activities resulting in transfer of wealth between countries which are recorded in the capital account.

Difficulty: Moderate AACSB: Application of knowledge 19) "If the simple rule of double-entry bookkeeping holds true, the Balance of payments is always in balance." Discuss.

Answer: True. Every international transaction automatically enters the balance of payments twice, once as a credit and once as a debit.

Current account + financial account + capital account = 0 Difficulty: Moderate AACSB: Application of knowledge 20) Consider how the United States balance of payments accounts are affected when U.S. banks forgive two billion in debt owed to them by the government of Argentina.

Answer: In this case, the United States makes a two billion dollar capital transfer to Argentina, which should appear as a negative two billion entry in the capital account. The associated credit is in the financial account, in the form of a two billion dollars reduction in U.S. assets held abroad, i.e., a net asset "export," and therefore a positive balance of payments entry.

Difficulty: Moderate AACSB: Application of knowledge 21) "The balance of payments is seldom in balance in practice." Discuss.

Answer: True. The main reasons are due to the fact that data collected or received from different sources may differ in coverage, accuracy, and timing. In addition, data on services are not reliable as well as data from the financial account. Moreover, accurate measurements of international interest and dividend receipts are particularly difficult.

Difficulty: Moderate AACSB: Application of knowledge 22) What is profit shifting? How can governments including the U.S. solve this problem?

Answer: Profit shifting is the practice used by multinational corporations to pay less profit tax by relocating operations from higher-tax jurisdictions to lower-tax jurisdictions. Governments can solve this problem only through substantial coordination of tax policies as well as detailed 31 Copyright © 2023 Pearson Education, Ltd.

information sharing. Efforts to date had only limited success until 2021, when the United States (under President Joseph R. Biden, Jr.) and other large economies agreed to establish a common minimum corporate tax rate of 15 percent. Although that agreement was a major breakthrough, implementation faces political as well as technical obstacles.

Difficulty: Easy AACSB: Application of knowledge 23) Explain the huge jump in Ireland's 2015 real GDP. Answer: The huge jump in Ireland's 2015 real GDP was mostly an artifact of creative accounting.

The increase in GDP was in large part an accounting phenomenon reflecting tax avoidance by large multinationals form other countries. Ireland has a statutory tax on corporate profits of 12.5 percent, which is lower than other countries including the United States. This discrepancy sets up an incentive for large multinationals, notably in fields such as high tech and pharma, to relocate their intellectual property assets to subsidiaries in Ireland so that global profits are booked and taxed there and not at home.

Difficulty: Easy AACSB: Application of knowledge 24) How does an economy's central bank manage the supply of money through official reserve transactions?

Answer: Official foreign exchange interventions are a way for the central bank to inject money into the economy or withdraw it from circulation. They can buy or sell international reserves in private asset markets in order to affect macroeconomic conditions without noticeably impacting the money supply. When a central bank purchases or sells a foreign asset, the transaction appears in its country's financial account as if a private citizen had carried out the same transaction.

Difficulty: Moderate AACSB: Application of knowledge 25) How can changes in the market price of wealth previously acquired alter a country's net foreign wealth?

Answer: When Japan's stock market lost value in the 1990s, American and European owners of Japanese assets lost value in their claims, while Japan's net foreign wealth increased. Similarly, exchange rate changes can have this effect. When the dollar depreciates against foreign currency, foreigners who hold dollar assets will see their wealth fall when measured in their home currencies.

Difficulty: Moderate AACSB: Application of knowledge 26) Discuss the two different methods the Bureau of Economic Analysis (BEA) uses to place current values on foreign direct investments.

Answer: The current cost method values direct investments at the cost of buying them today. The market value method is meant to measure the price at which the investments could be sold. These two methods can lead to different valuations because the cost of replacing a particular direct investment and the price it would command if sold on the market may be hard to measure.

Difficulty: Moderate AACSB: Application of knowledge 32 Copyright © 2023 Pearson Education, Ltd.

International Finance: Theory & Policy, 12/e, Global Edition Chapter 3 Exchange Rates and the Foreign Exchange Market: An Asset Approach 3.1

Exchange Rates and International Transactions

1) The price of one currency in terms of another is called a(n) A) exchange rate B) forward rate C) effective rate D) interest rate E) trading rate Answer: A Difficulty: Easy AACSB: Application of knowledge

.

2) How many dollars would it cost to buy an Edinburgh Woolen Mill sweater costing 50 British pounds if the exchange rate is 1.25 dollars per one British pound?

A) 50 dollars B) 60 dollars C) 70 dollars D) 62.5 dollars E) 40 British pounds Answer: D Difficulty: Easy AACSB: Application of knowledge 3) How many dollars would it cost to buy an Edinburgh Woolen Mill sweater costing 50 British pounds if the exchange rate is 1.50 dollars per one British pound?

A) 50 dollars B) 60 dollars C) 70 dollars D) 80 dollars E) 75 dollars Answer: E Difficulty: Easy AACSB: Application of knowledge 4) How many dollars would it cost to buy an Edinburgh Woolen Mill sweater costing 50 British pounds if the exchange rate is 1.80 dollars per one British pound?

A) 40 dollars B) 90 dollars C) 50 dollars D) 100 dollars E) 95 dollars Answer: B Difficulty: Easy AACSB: Application of knowledge 33 Copyright © 2023 Pearson Education, Ltd.

5) The Japanese currency is called the A) DM. B) Yen. C) Euro.

D) Dollar.

E) Pound.

Answer: B Difficulty: Easy AACSB: Application of knowledge 6) How many British pounds would it cost to buy a pair of American designer jeans costing $45 if the exchange rate is 1.50 dollars per British pound?

A) 440 British pounds B) 20 British pounds C) 30 British pounds D) 35 British pounds E) 25 British pounds Answer: C Difficulty: Easy AACSB: Application of knowledge 7) How many British pounds would it cost to buy a pair of American designer jeans costing $45 if the exchange rate is 1.80 dollars per British pound?

A) 10 British pounds B) 25 British pounds C) 20 British pounds D) 30 British pounds E) 40 British pounds Answer: B Difficulty: Easy AACSB: Application of knowledge 8) How many British pounds would it cost to buy a pair of American designer jeans costing $45 if the exchange rate is 2.00 dollars per British pound?

A) 22.5 British pounds B) 32.5 British pounds C) 12.5 British pounds D) 40 British pounds E) 30 British pounds Answer: A Difficulty: Easy AACSB: Application of knowledge 9) How many British pounds would it cost to buy a pair of American designer jeans costing $45 if the exchange rate is 1.60 dollars per British pound?

A) 38.125 British pounds 34 Copyright © 2023 Pearson Education, Ltd.

B) 28.125 British pounds C) 48.125 British pounds D) 58.125 British pounds E) 18.125 British pounds Answer: B Difficulty: Easy AACSB: Application of knowledge 10) Exxon Mobil wants to pay €160,000 to a German supplier. They get an exchange rate quotation from its own commercial bank and instruct it to debit their dollar account and pay €160,000 to the supplier's German account. If the exchange rate quoted is $1.2 per euro, how much is debited to Exxon Mobil's account?

A) $192,000 B) $160,000 C) $172,000 D) $180,000 E) $150,000 Answer: A Difficulty: Easy AACSB: Application of knowledge 11) Total Wine & More wants to pay ¥500,000 to a Japanese supplier of sake and plum wine. They get an exchange rate quotation from its own commercial bank and instruct it to debit their dollar account and pay ¥500,000 to the supplier's Japanese account. If the exchange rate quoted is $0.0092 per Japanese yen, how much is debited to Total Wine & More's account?

A) $4,600 B) $1,150 C) $2,300 D) $9,200 E) $50,000 Answer: A Difficulty: Easy AACSB: Application of knowledge 12) What is the exchange rate between the dollar and the British pound if a pair of American jeans costs 50 dollars in New York and 100 Pounds in London?

A) 1.5 dollars per British pound B) 0.5 dollars per British pound C) 2.5 dollars per British pound D) 3.5 dollars per British pound E) 2 dollars per British pound Answer: B Difficulty: Easy AACSB: Application of knowledge 13) What is the exchange rate between the dollar and the British pound if a pair of American jeans costs 60 dollars in New York and 30 Pounds in London?

A) 1.5 dollars per British pound 35 Copyright © 2023 Pearson Education, Ltd.

B) 0.5 dollars per British pound C) 2.5 dollars per British pound D) 3.5 dollars per British pound E) 2 dollars per British pound Answer: E Difficulty: Easy AACSB: Application of knowledge 14) What is the exchange rate between the British pound and the dollar if a pair of American jeans costs 40 dollars in New York and 20 Pounds in London?

A) 0.5 British pounds per U.S. dollar B) 1.5 British pounds per U.S. dollar C) 2.5 British pounds per U.S. dollar D) 3.5 British pounds per U.S. dollar E) 2 British pounds per U.S. dollar Answer: A Difficulty: Easy AACSB: Application of knowledge 15) When a country's currency depreciates A) foreigners find that its exports are more expensive, and domestic residents find that imports from abroad are more expensive.

B) foreigners find that its exports are more expensive, and domestic residents find that imports from abroad are cheaper.

C) foreigners find that its exports are cheaper; however, domestic residents are not affected.

D) foreigners are not affected, but domestic residents find that imports from abroad are more expensive.

E) foreigners find that its exports are cheaper and domestic residents find that imports from abroad are more expensive.

Answer: E Difficulty: Easy AACSB: Application of knowledge 16) When a country's currency appreciates A) foreigners find that its exports are more expensive, and domestic residents find that imports from abroad are cheaper.

B) foreigners find that its exports are more expensive, and domestic residents find that imports from abroad are more expensive.

C) foreigners find that its exports are cheaper; however, domestic residents are not affected.

D) foreigners are not affected, but domestic residents find that imports from abroad are more expensive.

E) foreigners find that its exports are cheaper and domestic residents find that imports from abroad are more expensive.

Answer: A Difficulty: Easy AACSB: Application of knowledge 36 Copyright © 2023 Pearson Education, Ltd.

17) A depreciation of a country's currency A) lowers the relative price of its exports and raises the relative price of its imports.

B) decreases the relative price of its exports and lowers the relative price of its imports.

C) raises the relative price of its exports and raises the relative price of its imports.

D) raises the relative price of its exports and lowers the relative price of its imports.

E) raises the relative price of its exports and does not affect the relative price of its imports.

Answer: A Difficulty: Easy AACSB: Application of knowledge 18) An appreciation of a country's currency A) decreases the relative price of its exports and lowers the relative price of its imports.

B) raises the relative price of its exports and raises the relative price of its imports.

C) lowers the relative price of its exports and raises the relative price of its imports.

D) raises the relative price of its exports and lowers the relative price of its imports.

E) raises the relative price of its exports and does not affect the relative price of its imports.

Answer: D Difficulty: Easy AACSB: Application of knowledge 19) Which one of the following statements is the MOST accurate?

A) A depreciation of a country's currency makes its goods cheaper for foreigners.

B) A depreciation of a country's currency makes its goods more expensive for foreigners.

C) A depreciation of a country's currency makes its goods cheaper for its own residents.

D) A depreciation of a country's currency makes its goods cheaper.

E) An appreciation of a country's currency makes its goods more expensive.

Answer: A Difficulty: Easy AACSB: Application of knowledge 20) A(n)

of a nation's currency will cause imports to , all other things held constant.

A) depreciation; increase; decrease B) appreciation; decrease; increase C) depreciation; decrease; increase D) appreciation; increase; increase E) depreciation; decrease; decrease Answer: C Difficulty: Moderate AACSB: Application of knowledge

and exports to

21) A(n)

and exports to

of a nation's currency will cause imports to , all other things held constant.

A) appreciation; increase; decrease B) depreciation; decrease; decrease C) depreciation; increase; decrease D) appreciation; decrease; increase 37 Copyright © 2023 Pearson Education, Ltd.

E) depreciation; increase; increase Answer: A Difficulty: Moderate AACSB: Application of knowledge 22) If the goods' money prices do NOT change, an appreciation of the dollar against the pound A) makes British sweaters cheaper in terms of American jeans.

B) makes British sweaters more expensive in terms of American jeans.

C) doesn't change the relative price of sweaters and jeans.

D) makes American jeans cheaper in terms of British sweaters.

E) makes British jeans more expensive in Britain.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 23) If the goods' money prices do NOT change, a depreciation of the dollar against the pound A) makes British sweaters cheaper in terms of American jeans.

B) makes British sweaters more expensive in terms of American jeans.

C) makes American jeans more expensive in terms of British sweaters.

D) doesn't change the relative price of sweaters and jeans.

E) makes British jeans more expensive in Britain.

Answer: B Difficulty: Moderate AACSB: Application of knowledge 24) Compute how many dollars it would cost to buy an Edinburgh Woolen Mill sweater costing 50 British pounds for the following exchange rates.

Answer:

38 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Easy AACSB: Application of knowledge 25) Compute how many British pounds it would cost to buy a pair of American designer jeans costing $45.

Answer:

39 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Easy AACSB: Application of knowledge 26) Find the exchange rate between the dollar and the British pounds for the following cases.

Answer:

40 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Easy AACSB: Application of knowledge 3.2

The Foreign Exchange Market

1) The market in which households, firms, and financial institutions buy and sell foreign currencies to make international payments is called the A) foreign exchange market.

B) currency market.

C) money market.

D) international market .

E) trading market.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) Which major actor is at the center of the foreign exchange market?

A) corporations B) central banks C) commercial banks D) non-bank financial institutions E) individual firms Answer: C Difficulty: Easy AACSB: Application of knowledge 3) Which of the following is NOT a major actor in the foreign exchange market?

A) corporations B) central banks C) commercial banks 41 Copyright © 2023 Pearson Education, Ltd.

D) non-bank financial institutions E) tourists Answer: E Difficulty: Easy AACSB: Application of knowledge 4) Which of the following type of funds cater to wealthy individuals, are NOT bound by government regulations, and are actively traded in foreign exchange markets?

A) pension funds B) mutual funds C) hedge funds D) exchange funds Answer: C Difficulty: Easy AACSB: Application of knowledge 5) The largest trading of foreign exchange occurs in A) New York.

B) London.

C) Tokyo.

D) Frankfurt.

E) Singapore.

Answer: B Difficulty: Easy AACSB: Application of knowledge 6) The action of arbitrage is A) the process of buying a currency cheap and selling it dear.

B) the process of buying a currency dear and selling it cheap.

C) the process of buying and selling currency at the same price.

D) the process of selling currency at different prices in different markets.

E) the process of buying a currency and holding onto it to take it off the market.

Answer: A Difficulty: Easy AACSB: Application of knowledge 7) In 2019, about A) 4.3 percent of foreign exchange transactions involved exchanges of foreign currencies for U.S. dollars.

B) 16.8 percent of foreign exchange transactions involved exchanges of foreign currencies for U.S. dollars.

C) 32.3 percent of foreign exchange transactions involved exchanges of foreign currencies for U.S. dollars.

D) 39 percent of foreign exchange transactions involved exchanges of foreign currencies for U.S. dollars.

E) 88.3 percent of foreign exchange transactions involved exchanges of foreign currencies for U.S. dollars.

42 Copyright © 2023 Pearson Education, Ltd.

Answer: E Difficulty: Easy AACSB: Application of knowledge 8) By April 2019 A) only about 0.9 percent of foreign exchange trades were against euros.

B) only about 4.3 percent of foreign exchange trades were against euros.

C) only about 32.3 percent of foreign exchange trades were against euros.

D) only about 39 percent of foreign exchange trades were against euros.

E) only about 88.3 percent of foreign exchange trades were against euros.

Answer: C Difficulty: Easy AACSB: Application of knowledge 9) Which of the following statements is TRUE about a vehicle currency?

A) It is widely used to denominate contracts made by parties who reside in the country that issues the vehicle currency.

B) The dollar is sometimes called a vehicle currency because of its pivotal role in many foreign exchange deals.

C) There is much skepticism that the euro will ever evolve into a vehicle currency on par with the dollar.

D) The pound sterling, once second only to the dollar as a key international currency, is beginning to rise in importance.

E) Vehicle currencies include nondeliverable currencies like the renminbi.

Answer: B Difficulty: Easy AACSB: Application of knowledge 10) The future date on which the currencies are actually exchanged is called what?

A) the value date B) the spot exchange date C) the two-day window D) the commitment date E) the forward exchange rate Answer: A Difficulty: Easy AACSB: Application of knowledge 11) Which one of the following statements is the MOST accurate?

A) Spot exchange rates are always higher than forward exchange rates.

B) Spot exchange rates are always lower than forward exchange rates.

C) Spot exchange rates and forward exchange rates are always equal.

D) Spot exchange rates and forward exchange rates are equal when the value date and the date of the spot transaction are the same.

E) Spot exchange rates and forward exchange rates never move closely together.

Answer: D Difficulty: Moderate 43 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 12) Forward and spot exchange rates A) are necessarily equal.

B) do not move closely together.

C) are always such that the forward exchange rate is higher.

D) move closely together and are equal on the value date when the value date and the date of the spot transaction are the same.

E) are unrelated to the value date.

Answer: D Difficulty: Moderate AACSB: Application of knowledge 13) The following is an example of Radio Shack hedging its foreign currency risk: A) needing to pay 9,000 yen per radio to its suppliers in a month, Radio Shack makes a forward-exchange deal to buy yen.

B) needing to pay 9,000 yen per radio to its suppliers in a month, Radio Shack makes a forward-exchange deal to sell yen.

C) needing to pay 9,000 yen per radio to its suppliers in a month, Radio Shack buys yen at a spot-exchange 1 month from now.

D) needing to pay 9,000 yen per radio to its suppliers in a month, Radio Shack sells yen at a spot-exchange 1 month from now.

E) needing to pay 9,000 yen per radio to its suppliers in a month, Radio Shack sells yen in a forward-exchange deal.

Answer: A Difficulty: Easy AACSB: Application of knowledge 14) A foreign exchange swap A) is a spot sale of a currency.

B) is a forward repurchase of the currency.

C) is a spot sale of a currency combined with a forward repurchase of the currency.

D) is a spot sale of a currency combined with a forward sale of the currency.

E) make up a negligible proportion of all foreign exchange trading.

Answer: C Difficulty: Easy AACSB: Application of knowledge 15) Which of the following is NOT an example of a financial derivative?

A) forwards B) bonds C) swaps D) futures E) options Answer: B Difficulty: Easy AACSB: Application of knowledge 44 Copyright © 2023 Pearson Education, Ltd.

16) Futures contracts differ from forward contracts in that A) future contracts ensures you will receive a certain amount of foreign currency at a specified future date.

B) future contracts bind you into your end of the deal.

C) future contracts allow you to sell your contract on an organized futures exchange.

D) future contracts are a disadvantage if your views about the future spot exchange rate are to change.

E) futures contracts don't allow you to realize a profit or a loss right away.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 17) Who are the major participants in the foreign exchange market?

Answer: (1) Commercial banks (2) Corporations (3) Nonbank financial institutions (4) Central banks Difficulty: Easy AACSB: Application of knowledge 18) Explain what is a "vehicle currency." Why is the U.S. dollar considered a vehicle currency?

Answer: A vehicle currency is one that is widely used to denominate international contracts made by parties who do not reside in the country that issues the vehicle currency. Since in 2004, nearly 90 percent of foreign exchange transactions involve exchanges of foreign currencies for U.S. dollars; therefore, it is considered a vehicle currency.

Difficulty: Moderate AACSB: Application of knowledge 19) Explain the purpose of the following figure.

45 Copyright © 2023 Pearson Education, Ltd.

Answer: To show that spot and forward exchange rates move closely together.

Difficulty: Moderate AACSB: Application of knowledge 3.3

The Demand for Foreign Currency Assets

1) What is the expected dollar rate of return on euro deposits if today's exchange rate is $1.10 per euro, next year's expected exchange rate is $1.165 per euro, the dollar interest rate is 10%, and the euro interest rate is 5%?

A) 10% B) 11% C) -1% D) 0% E) 15% Answer: B Difficulty: Moderate AACSB: Application of knowledge 2) What is the expected dollar rate of return on dollar deposits if today's exchange rate is $1.10 per euro, next year's expected exchange rate is $1.165 per euro, the dollar interest rate is 10%, and the euro interest rate is 5%?

A) 10% B) 11% C) -1% D) 0% E) 15% Answer: A Difficulty: Easy AACSB: Application of knowledge 46 Copyright © 2023 Pearson Education, Ltd.

3) What is the expected dollar rate of return on euro deposits if today's exchange rate is $1.167 per euro, next year's expected exchange rate is $1.10 per euro, the dollar interest rate is 10%, and the euro interest rate is 5%?

A) 10% B) 11% C) -1% D) 0% Answer: C Difficulty: Moderate AACSB: Application of knowledge 4) Which one of the following statements is the MOST accurate?

A) Since dollar and yen interest rates are measured in comparable terms, they can move quite differently over time.

B) Since dollar and yen interest rates are not measured in comparable terms, they can move quite differently over time.

C) Since dollar and yen interest rates are measured in comparable terms, they move quite the same over time.

D) Since dollar and yen interest rates are measured in comparable terms, they still move quite differently over time.

E) Since dollar and yen interest rates are so similar, they move quite the same way over time.

Answer: B Difficulty: Easy AACSB: Application of knowledge 5) The dollar rate of return on euro deposits is A) approximately the euro interest rate plus the rate of depreciation of the dollar against the euro.

B) approximately the euro interest rate minus the rate of depreciation of the dollar against the euro.

C) the euro interest rate minus the rate of inflation against the euro.

D) the rate of appreciation of the dollar against the euro.

E) the euro interest rate plus the rate of inflation against the euro.

Answer: A Difficulty: Easy AACSB: Application of knowledge 6) If the dollar interest rate is 10 percent and the euro interest rate is 6 percent, then an investor should A) invest only in dollars.

B) invest only in euros.

C) be indifferent between dollars and euros.

D) invest only in dollars if the exchange rate is expected to remain constant.

E) invest only in euros if the exchange rate is expected to remain constant.

Answer: D Difficulty: Easy AACSB: Application of knowledge 47 Copyright © 2023 Pearson Education, Ltd.

7) If the dollar interest rate is 5 percent and the euro interest rate is 3 percent, then an investor should A) invest only in dollars if the exchange rate is expected to remain constant.

B) invest only in dollars.

C) invest only in euros.

D) be indifferent between dollars and euros.

E) invest only in euros if the exchange rate is expected to remain constant.

Answer: A Difficulty: Easy AACSB: Application of knowledge 8) If the dollar interest rate is 4 percent, the euro interest rate is 6 percent, then A) an investor should invest only in dollars.

B) an investor should invest only in euros.

C) an investor should be indifferent between dollars and euros.

D) invest only in dollars if the exchange rate is expected to remain constant.

E) invest only in euros if the exchange rate is expected to remain constant.

Answer: E Difficulty: Easy AACSB: Application of knowledge 9) If the dollar interest rate is 5 percent, the euro interest rate is 10 percent, then A) invest only in euros if the exchange rate is expected to remain constant.

B) an investor should invest only in dollars.

C) an investor should invest only in euros.

D) an investor should be indifferent between dollars and euros.

E) invest only in dollars if the exchange rate is expected to remain constant.

Answer: A Difficulty: Easy AACSB: Application of knowledge 10) If the dollar interest rate is 10 percent, the euro interest rate is 6 percent, then A) an investor should invest only in dollars if the expected dollar depreciation against the euro is 4 percent.

B) an investor should invest only in euros if the expected dollar depreciation against the euro is 4 percent.

C) an investor should be indifferent between dollars and euros if the expected dollar depreciation against the euro is 4 percent.

D) an investor should invest only in dollars.

E) an investor should invest only in euros.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 11) If the dollar interest rate is 10 percent and the euro interest rate is 6 percent, then A) an investor should invest only in dollars if the expected dollar depreciation against the euro is 8 percent.

48 Copyright © 2023 Pearson Education, Ltd.

B) an investor should invest only in euros if the expected dollar depreciation against the euro is 8 percent.

C) an investor should be indifferent between dollars and euros if the expected dollar depreciation against the euro is 8 percent.

D) an investor should invest only in dollars.

E) an investor should invest only in euros.

Answer: B Difficulty: Moderate AACSB: Application of knowledge 12) If the dollar interest rate is 10 percent, the euro interest rate is 12 percent, then A) an investor should invest only in dollars if the expected dollar appreciation against the euro is 4 percent.

B) an investor should invest only in euros if the expected dollar appreciation against the euro is 4 percent.

C) an investor should be indifferent between dollars and euros if the expected dollar appreciation against the euro is 4 percent.

D) an investor should invest only in dollars.

E) an investor should invest only in euros.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 13) What are the three factors that affect the demand for foreign currency?

Answer: The three factors that affect the demand for foreign currency are expected return, risk and liquidity.

Difficulty: Moderate AACSB: Application of knowledge 14) Explain risk and liquidity of assets.

Answer: Risk is the variability an asset contributes to a savers' wealth. An asset's real return can be unpredictable and savers dislike this uncertainty if the return fluctuates widely. Liquidity refers to the ease with which an asset can be sold or exchanged for goods. Cash is the most liquid of assets because it is always acceptable at face value as payment for goods or other assets. Thus, savers consider an asset's liquidity and its expected return and risk in deciding how much of it to hold.

Difficulty: Moderate AACSB: Application of knowledge 15) Explain the purpose of the following figure 3-2 from the text in the context of the interest rates on the dollar and the Japanese Yen between 1978 and 2020.

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Answer: Since the dollar and the Yen interest rates are not measured in comparable terms, they can move quite differently over time. Except for a period from 1990 to 1993 when the Yen interest rate was higher than the dollar and the period between 2009 and 2011 when the interest rates were pretty close, dollar interest rates have been higher than the Yen, indicating depreciation of the dollar against the Yen. Difficulty: Moderate AACSB: Application of knowledge 16) What is the expected dollar rate of return on euro deposits if today's exchange rate is $1.10 per euro, next year's expected exchange rate is $1.20 per euro, the dollar interest rate is 10%, and the euro interest rate is 5%?

A) Calculate the expected dollar rate of return on euro deposits.

B) Given the result above, if you were an investor, would you hold wealth in the form of euro or dollar deposits? Explain why.

Answer: A) If today's exchange rate is $1.10 per euro, the dollar price of a euro is $1.10 If you purchase 1 euro deposit today, with interest rate of 5% a year, your deposit will be worth 1.05 euro at the end of the year.

Since the dollar is expected to depreciate against the euro over the coming year, the exchange rate 12 months from today is $1.20 per euro, you expect the dollar value of your euro deposit after a year to be $1.05 Euro x $1.20 per euro = $1.26 After you know the dollar price of 1 euro deport today ($1.10) and can forecast its value in a year ($1.26), you can calculate the expected dollar rate of return on a euro deposit as ($1.26-$1.10)/$1.10 = 0.15 or 15% a year.

B) Since the dollar interest rate is only 10% per year and the expected rate of return on a euro deposits is 15% per year, you expect to do better by holding your wealth in the form of euro deposits. Despite the fact that dollar interest rate exceeds the euro interest rate by 5% a year, the euro's expected appreciation against the dollar gives euro holders a prospective capital gain that is large enough to make the euro deposits the higher-yield asset.

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Difficulty: Difficult AACSB: Application of knowledge 17) For the following 15 cases, compare the dollar rates of return on dollar and euro deposits.

Answer:

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Difficulty: Moderate AACSB: Application of knowledge 18) For the table below calculate the EXACT relationship (i.e., EXACT calculated result of the rate of return difference between dollar and euro deposits, up to 4 digits after the decimal point).

Answer: Using Figure (3-1) and Table 3-3 from the textbook as example, students can calculate the rate of return difference between dollar and euro deposits with up to 4 digits after the decimal point.

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Difficulty: Moderate AACSB: Application of knowledge 3.4

Equilibrium in the Foreign Exchange Market

1) Which one of the following statements is the MOST accurate?

A) A rise in the interest rate offered by dollar deposits causes the dollar to appreciate.

B) A rise in the interest rate offered by dollar deposits causes the dollar to depreciate.

C) A rise in the interest rate offered by dollar deposits does not affect the U.S. dollar.

D) For a given euro interest rate and constant expected exchange rate, a rise in the interest rate offered by dollar deposits causes the dollar to appreciate.

E) A rise in the interest rate offered by the dollar causes the euro to appreciate.

Answer: D Difficulty: Easy AACSB: Application of knowledge 2) Which one of the following statements is the MOST accurate?

A) For a fixed interest rate, a rise in the expected future exchange rate causes a rise in the current exchange rate.

B) For a fixed interest rate, a rise in the expected future exchange rate causes a fall in the current exchange rate.

C) For a fixed interest rate, a rise in the expected future exchange rate does not cause a change in the current exchange rate.

D) For a given dollar interest rate and a constant expected exchange rate, a rise in the interest rate of the euro causes the dollar to depreciate.

E) For a fixed interest rate, a fall in the expected future exchange rate causes a rise in the current 53 Copyright © 2023 Pearson Education, Ltd.

exchange rate.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) A carry trade can be defined as A) a trading strategy that involves borrowing low-interest currencies and buying high-interest currencies.

B) a trading strategy that involves borrowing high-interest currencies and buying low-interest currencies.

C) a trading strategy that involves borrowing and investing in only low-interest currencies.

D) a trading strategy that involves borrowing and investing in only high-interest currencies.

Answer: A Difficulty: Easy AACSB: Application of knowledge 4) A trade activity where international investors borrow low interest currencies and invest in high-interest currencies to seek profits is called A) carry trade.

B) surplus trade.

C) deficit trade.

D) terms of trade.

Answer: A Difficulty: Easy AACSB: Application of knowledge 5) In a carry trade, the low interest currencies are called currencies are called currencies.

A) funding; investment B) borrowing; lending C) lending; borrowing D) investment; funding Answer: A Difficulty: Easy AACSB: Application of knowledge

currencies, and the high-interest

6) What is the interest parity condition?

Answer: The condition that the expected returns on deposits of any two currencies are equal when measured in the same currency is called the interest parity condition. It implies that potential holders of foreign currency deposits view them as equally desirable assets, i.e. risk is assumed away.

In notational forms: R$ = RE + (

- E$/E)/E$/E

Difficulty: Easy AACSB: Application of knowledge 54 Copyright © 2023 Pearson Education, Ltd.

7) Explain why the interest parity condition must hold if the foreign exchange market is in equilibrium.

Answer: The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return. Potential holders of foreign currency deposits view them all as equally desirable assets. If expected rate of return on any currency deposit is higher or lower than the other, there will exist an excess supply or demand for that currency because one will yield a higher return than the other.

Difficulty: Moderate AACSB: Application of knowledge 8) Calculate the interest rate in the United States, if interest parity condition holds, for the following 15 cases.

Answer:

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Difficulty: Moderate AACSB: Application of knowledge 9) Calculate the interest rate in the euro zone if interest parity condition holds, for the following 15 cases.

Answer:

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Difficulty: Moderate AACSB: Application of knowledge 10) Determine for each, whether the interest parity condition holds or not, if

Answer:

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= 1.10

Difficulty: Moderate AACSB: Application of knowledge 11) Assume that the euro interest rate is constant at 5 percent, and that the expected exchange rate is 1.05 dollars per one euro. Find the expected dollar return on euro deposits for the following cases.

Answer:

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Difficulty: Moderate AACSB: Application of knowledge 12) Using the data in the table above, plot today's dollar/euro exchange rate against the expected dollar return on euro deposits.

Answer:

Difficulty: Moderate AACSB: Application of knowledge 13) Calculate the Expected Dollar Depreciation Rate against the euro and the expected dollar return on euro deposits if the expected exchange rate is $1.10 per euro.

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Answer:

Difficulty: Moderate AACSB: Application of knowledge 14) Discuss the effects of a rise in the dollar interest rate on the exchange rate.

Answer: There are two effects to consider. A rise in the interest rate offered by dollar deposits combined with a constant expected exchange rate will cause the dollar to appreciate (see Figure 3-5 from the text). However, the expected exchange rate will likely change. As Figure 3-6 from the text shows, if the expected exchange rate increases, the dollar will depreciate.

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Figure 3-5

Figure 3-6 Difficulty: Moderate 61 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 15) Discuss the effects of a rise in the interest rate paid by euro deposits on the exchange rate.

Answer: There are two effects to consider. If we make the unrealistic assumption that the expected exchange rate will not change, then a rise in the interest rate paid by euro deposits causes the dollar to depreciate. However, if the expected exchange rate were to rise, then the current exchange rate would also rise. (See Figure 3-6 from the text.)

Difficulty: Moderate AACSB: Application of knowledge 16) Explain why (holding interest rates constant), a rise in the expected depreciation in a country's currency leads to depreciation of that currency today.

Answer: A rise in the expected depreciation rate of the dollar raises the expected dollar return on euro deposits. Now, there are excess supply of dollar deposits (euro deposits offer higher expected rate of return than do dollar deposits). The dollar must depreciate to remove this excess supply.

Difficulty: Moderate AACSB: Application of knowledge 17) Show graphically a drop in the interest rate paid by euro deposits. What is the effect on the dollar?

Answer: A drop in the interest rate from R1$ to R2$ causes the dollar to depreciate from

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(point 2) to

(point 1). (See Figure 3-5 from the text.)

Difficulty: Difficult AACSB: Application of knowledge 18) Show graphically a drop in the interest rate offered by dollar deposits, R$, and the effect on the exchange rate, .

Answer: A drop in the interest rate paid by euro deposits causes the dollar to appreciate from (point 2) to

(point 1). The expected future exchange rate also drops. (See Figure 3-6

from the text.)

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Difficulty: Difficult AACSB: Application of knowledge 19) What is a carry trade?

Answer: A carry trade is a trading strategy that involves borrowing a currency that has a low interest rate, then use that money to buy another currency that pays a higher interest rate. low-interest currencies and re-investing in high-interest currencies. A carry trader may gain profits on the difference between the interest rates.

Difficulty: Easy AACSB: Application of knowledge 20) Explain why carry trade should not be systematically profitable and is a highly risky business.

Answer: Carry trade involves high risks and liquidity factors. Investment currencies (the high-interest currencies that carry traders target) may experience abrupt crashes and funding currencies (the low interest currencies that carry traders borrow) may be subject to abrupt appreciation. Big carry trade positions emergence can result in great exchange volatility as well as the possibility of big trader losses with negative repercussions in stock markets, bond markets, and markets for interbank loans.

Difficulty: Moderate AACSB: Application of knowledge 3.5

Forward Exchange Rates and Covered Interest Parity

1) The covered interest rate parity condition can be stated as follows: The interest rate on dollar deposits equals the interest rate on euro deposits the forward on euros against 64 Copyright © 2023 Pearson Education, Ltd.

dollars.

A) plus; premium B) minus; premium C) plus; discount D) minus; discount E) times; premium Answer: A Difficulty: Easy AACSB: Application of knowledge 2) The covered interest rate parity condition can be stated as follows: The interest rate on dollar deposits equals the interest rate on euro deposits the forward on dollars against euros.

A) plus; premium B) plus; discount C) times; premium D) minus; premium E) minus; discount Answer: B Difficulty: Easy AACSB: Application of knowledge 3) Suppose that the one-year forward price of euros in terms of dollars is equal to $1.113 per euro.

Further, assume that the spot exchange rate is $1.05 per euro, and the interest rate on dollar deposits is 10 percent and on euro it is 4 percent. Under these assumptions A) covered interest parity does hold.

B) covered interest parity does not hold.

C) it is hard to tell whether covered interest parity does or does not hold.

D) covered interest parity fluctuates.

E) Not enough information is given to answer the question.

Answer: B Difficulty: Moderate AACSB: Application of knowledge 4) Assume the U.S. interest rate is 10 percent, and the interest rate on euro deposits is 5 percent.

For the following exchange rates, find the forward exchange rates.

Answer: Using the covered interest rate parity will yield the second column in the table: 65 Copyright © 2023 Pearson Education, Ltd.

F$/E = (R$ - RE) E$/E + E$/E

Difficulty: Moderate AACSB: Application of knowledge International Finance: Theory & Policy, 12/e, Global Edition Chapter 4 Money, Interest Rates, and Exchange Rates 4.1

Money Defined: A Brief Review

1) The exchange rate between currencies depends on A) the interest rate that can be earned on deposits of those currencies.

B) the interest rate that can be earned on deposits of those currencies and the expected future exchange rate.

C) the expected future exchange rate.

D) national output.

E) the interest rate that can be earned on deposits of those countries and the national output.

Answer: B Difficulty: Easy AACSB: Application of knowledge 2) Which of the following statements is TRUE? A) Because exchange rates are the relative prices of national monies, factors that affect a country's money supply or demand are among the most powerful determinants of its currency's exchange rate against foreign currencies.

B) Because exchange rates are the relative prices of national monies, factors that affect a country's imports and exports are among the most powerful determinants of its currency's exchange rate against foreign currencies.

C) Because exchange rates are the relative prices of imports and exports, factors that affect a country's trade barriers are among the most powerful determinants of its currency's exchange rate against foreign currencies.

D) Because exchange rates are the relative prices of imports and exports, factors that affect a country's trade openness are among the most powerful determinants of its currency's exchange rate against foreign currencies.

Answer: A Difficulty: Easy AACSB: Application of knowledge 66 Copyright © 2023 Pearson Education, Ltd.

3) Expectations about future exchange rates are closely connected with A) expectations about the future money prices of countries' products; which, in turn, depend on changes in money supply and demand.

B) expectations about the future unemployment rate; which, in turn, depends on changes in labor supply and demand.

C) expectations about the future inflation rate; which, in turn, depends on changes in money supply.

D) expectations about the future discount rate; which, in turn, depends on central bank's decisions.

Answer: A Difficulty: Easy AACSB: Application of knowledge 4) Money serves as all of the following EXCEPT A) a medium of exchange.

B) a unit of account.

C) a store of value.

D) a symbol that is made of or can be redeemed for a fixed amount of precious metal.

E) a highly liquid asset.

Answer: D Difficulty: Easy AACSB: Application of knowledge 5) Money includes A) currency.

B) checking deposits held by households and firms.

C) deposits in the foreign exchange markets.

D) currency and checking deposits held by households and firms.

E) futures and deposits in the foreign exchange market.

Answer: D Difficulty: Easy AACSB: Application of knowledge 6) In the United States in the last quarter of 2019, the total money supply, M1, amounted to approximately A) 19 percent of that year's GNP. B) 20 percent of that year's GNP. C) 30 percent of that year's GNP. D) 40 percent of that year's GNP. E) 50 percent of that year's GNP. Answer: A Difficulty: Easy AACSB: Application of knowledge 7) M1 is a measure of money supply that includes A) the total amount of currency and checking deposits held by households and firms.

B) the large deposits traded by participants in the foreign exchange market.

C) the total amount of savings deposits and certificates of deposit.

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D) the large time deposits, institutional money market funds, short-term repurchase agreements, and larger liquid funds.

Answer: A Difficulty: Easy AACSB: Application of knowledge 8) The money supply is A) controlled by central bank.

B) controlled by the money market.

C) regulated by demand and supply in the goods and service market.

D) regulated by the U.S. Treasury.

Answer: A Difficulty: Easy AACSB: Application of knowledge 9) What are the main functions of money?

Answer: Money serves, in general, three important functions: a medium of exchange; a unit of account; and a store of value. As a medium of exchange, money avoids going back to a barter economy, with the enormous search costs connected with it. As a unit of account, the use of money economizes on the number of prices an individual faces. Consider an economy with N goods, then one needs only (N - 1) prices. As a store of value, the use of money in general ensures that you can transfer wealth between periods.

Difficulty: Moderate AACSB: Application of knowledge 10) What are the factors that determine the amount of money an individual desires to hold?

Answer: Three main factors: first, the expected return the asset offers compared with the returns offered by other assets; second, the riskiness of the asset's expected return; and third, the asset's liquidity.

Difficulty: Moderate AACSB: Application of knowledge 4.2

The Demand for Money by Individuals

1) Individuals base their demand for an asset on A) the expected return the asset offers compared with the returns offered by other assets.

B) the riskiness of the asset's expected return.

C) the asset's liquidity.

D) the expected return, the riskiness of the asset's expected return, and the asset's liquidity.

E) the aesthetic qualities of the asset.

Answer: D Difficulty: Easy AACSB: Application of knowledge 2) A family's summer house on Cape Cod pays a return in the form of A) interest rate.

B) capital gains.

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C) the pleasure of vacations at the beach.

D) stock options.

E) capital gains and pleasure.

Answer: E Difficulty: Easy AACSB: Application of knowledge 3) Which of the following statements is TRUE? A) All else equal, a rise in interest rate causes the demand for money to fall.

B) All else equal, a rise in interest rate causes the demand for money to rise.

C) All else equal, a rise in interest rate has no effect on the demand for money.

D) All else equal, a rise in interest rate causes people to hold more wealth in the form of money.

Answer: A Difficulty: Easy AACSB: Application of knowledge 4) In a world with money and bonds, A) it is not risky to hold money.

B) any change in the riskiness of money causes an equal change in the riskiness of bonds.

C) risk is an important factor in the demand for money.

D) there is no relationship between risk and holding money.

E) it is not risky to hold bonds.

Answer: B Difficulty: Easy AACSB: Application of knowledge 5) Opportunity cost is NOT A) the value of benefit you receive when you choose to take an action.

B) the amount you sacrifice by taking one course of action rather than another.

C) the value of the next best alternative forgone when a decision is made.

D) the forgone benefit that would have been derived by an option not chosen.

Answer: A Difficulty: Easy AACSB: Application of knowledge 6) It is risky to hold money because of the following reasons EXCEPT A) the government can confiscate individuals' money whenever it wants to.

B) an unexpected increase in the prices of goods and services could reduce the value of the money in terms of the commodities to be consumed.

C) money can be stolen, burnt, or lost.

D) unexpected inflation can reduce the value of money any time.

Answer: A Difficulty: Easy AACSB: Application of knowledge 7) Households and firms hold money because A) it is the easiest way of financing their everyday purchases.

B) it is essential to hold money in a bartering economy.

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C) it is the safest way to save for the future generations.

D) it is now the era of bitcoin and digital currency's popularity.

Answer: A Difficulty: Easy AACSB: Application of knowledge 8) Which one of the following statements is the MOST accurate?

A) A rise in the average value of transactions carried out by a household or a firm causes its demand for money to fall.

B) A reduction in the average value of transactions carried out by a household or a firm causes its demand for money to rise.

C) A rise in the average value of transactions carried out by a household or a firm causes its demand for money to rise.

D) A rise in the average value of transactions carried out by a household or a firm causes its demand for real money to rise.

E) A decrease in the average value of transactions carried out by a household or a firm causes its demand for real money to rise.

Answer: D Difficulty: Easy AACSB: Application of knowledge 9) An individual's need for liquidity would increase if A) the average value of transactions carried out by the individual fell.

B) the average value of transactions carried out by the individual rose.

C) the individual got a raise.

D) the individual received a new ATM card.

E) the individual wanted to avoid risks.

Answer: B Difficulty: Easy AACSB: Application of knowledge 10) Explain how changes in the rate of interest affect the demand for money.

Answer: Because an increase in the interest rate is a rise in the rate of return on less liquid assets relative to the rate of return on money, individuals will want to hold more of their wealth in nonmoney assets that pay the market interest rate and less of their wealth in the form of money if the interest rate rises.

Difficulty: Easy AACSB: Application of knowledge 11) Why is risk not an important factor in money demand?

Answer: People face the same risk whether holding money or bonds, whose real value may change. Because any change in the riskiness of money causes an equal change in the riskiness of bonds, changes in the risk of holding money need not cause individuals to reduce their demand for money and increase their demand for interest-paying assets.

Difficulty: Easy AACSB: Application of knowledge 70 Copyright © 2023 Pearson Education, Ltd.

12) What is the main benefit of holding money?

Answer: The main benefit of holding money comes from its liquidity. Households and firms hold money because it is the easiest way of financing their everyday purchases.

Difficulty: Easy AACSB: Application of knowledge 4.3

Aggregate Money Demand

1) The aggregate money demand depends on A) the interest rate.

B) the price level.

C) real national income.

D) the interest rate, price level, and real national income.

E) the price level and the liquidity of the asset.

Answer: D Difficulty: Easy AACSB: Application of knowledge 2) All else equal, aggregate money demand A) falls; rises B) rises; rises C) stays the same; rises D) falls; falls E) stays the same; falls Answer: A Difficulty: Easy AACSB: Application of knowledge

when interest rate

.

3) All else equal, if the price level , aggregate money demand will because individual households and firms must spend more money than before to purchase their usual weekly baskets of goods and services.

A) rises; rise B) rises; fall C) falls; rise D) rises; stay the same E) falls; stay the same Answer: A Difficulty: Easy AACSB: Application of knowledge 4) All else equal, when real national income (GNP) the economy and therefore aggregate money demand will A) rises; rise B) rises; fall C) falls; rise D) rises; stay the same E) falls; stay the same

, more goods and services are sold in .

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Answer: A Difficulty: Easy AACSB: Application of knowledge 5) The aggregate demand for money can be expressed by A) Md = P × L(R,Y).

B) Md = L × P(R,Y).

C) Md = P × Y(R, L).

D) Md = R × L(P,Y).

E) Md = R × L(R, P).

Answer: A Difficulty: Easy AACSB: Application of knowledge 6) The aggregate real money demand schedule L(R,Y) A) slopes upward because a fall in the interest rate raises the desired real money holdings of each household and firm in the economy.

B) slopes downward because a fall in the interest rate reduces the desired real money holdings of each household and firm in the economy.

C) has a zero slope because a fall in the interest rate keeps constant the desired real money holdings of each household and firm in the economy.

D) slopes downward because a fall in the interest rate raises the desired real money holdings of each household and firm in the economy.

E) slopes downward because a rise in the interest rate makes consumers less focused on the liquidity of their assets.

Answer: D Difficulty: Easy AACSB: Application of knowledge 7) For a given level of A) nominal GNP, changes in interest rates cause movements along the L(R,Y) schedule.

B) real GNP, changes in interest rates cause a decrease of the L(R,Y) schedule.

C) real GNP, changes in interest rates cause an increase of the L(R,Y) schedule.

D) nominal GNP, changes in interest rates cause an increase in the L(R,Y) schedule.

E) real GNP, changes in interest rates cause movements along the L(R,Y) schedule.

Answer: E Difficulty: Easy AACSB: Application of knowledge 8) All else equal, A) changes in real GNP cause the L(R,Y) schedule to shift.

B) changes in real GNP cause movements along the L(R,Y) schedule.

C) changes in interest rates cause an increase of the L(R,Y) schedule.

D) changes in interest rates cause a decrease in the L(R,Y) schedule.

Answer: A Difficulty: Easy AACSB: Application of knowledge 72 Copyright © 2023 Pearson Education, Ltd.

9) What are the main factors that determine aggregate money demand?

Answer: The three main factors are interest rate, the price level and real national income. A rise in the interest rate causes individuals in the economy to reduce their demand for money. If the price level rises, individual households and firms will spend more money than before. When real national income (GNP) rises the demand for money will also rise.

Difficulty: Moderate AACSB: Application of knowledge 10) Explain why one can write the demand for money as the price level times a function of the interest rate and real income as follows: = PxL (R, Y) Answer: The aggregate money demand is proportional to the price level. Imagine that all prices in an economy doubled, but the interest rate and everyone's real incomes remained unchanged.

Then, the money value of each individual's average daily transactions would simply double, as would the amount of money each wishes to hold.

Difficulty: Moderate AACSB: Application of knowledge 4.4

The Equilibrium Interest Rate: The Interaction of Money Supply and Demand

1) Which of the following statements is the MOST accurate?

A) The money market is in equilibrium when the money supply set by the central bank equals aggregate money demand.

B) The money market is in equilibrium when the aggregate money demand is sloping upward.

C) The money market is in equilibrium when the money supply is set by the central bank.

D) The money market is in equilibrium when the aggregate money demand is the sum of all the economy's individual money demands.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) The money supply schedule is A) horizontal because is set by the central bank while P is taken as given.

B) horizontal because is set by the central bank.

C) vertical because is set by the households and firms while P is taken as given.

D) vertical because and P are set by the central bank.

E) vertical because is set by the central bank while P is taken as given.

Answer: E Difficulty: Easy AACSB: Application of knowledge 3) If individuals are holding more money than they desire A) they will attempt to reduce their liquidity by using money to purchase goods.

B) they will attempt to reduce their liquidity by using money to purchase interest-bearing assets.

C) they will attempt to reduce their liquidity by converting real money holdings into nominal 73 Copyright © 2023 Pearson Education, Ltd.

money holdings.

D) they will keep their holdings constant.

Answer: B Difficulty: Easy AACSB: Application of knowledge 4) If there is an excess supply of money A) the interest rate falls.

B) the interest rate rises.

C) the real money supply shifts left to make an equilibrium.

D) the real money supply shifts right to make an equilibrium.

E) the interest rate stays constant, but consumer confidence falters.

Answer: A Difficulty: Easy AACSB: Application of knowledge 5) Which of the following statements is the most ACCURATE? A) The market always moves toward an interest rate at which the real money supply equals aggregate real money demand.

B) The market never moves toward an interest rate at which the real money supply equals aggregate real money demand.

C) The market sometimes moves toward an interest rate at which the real money supply equals aggregate real money demand.

D) The market rarely moves toward an interest rate at which the real money supply equals aggregate real money demand.

Answer: A Difficulty: Easy AACSB: Application of knowledge 6) If there is initially an A) excess demand for money, the interest rate will fall, and the supply of money will rise.

B) excess supply of money, the interest rate will fall, and if there is initially an excess demand, it will rise.

C) excess supply of money, the interest rate will rise, and if there is initially an excess demand, it will fall.

D) excess supply of money, the interest rate will fall, and if there is also an excess demand, it will fall rapidly.

E) excess supply of money, the interest rate will rise, and if there is also an excess demand, it will rise rapidly.

Answer: B Difficulty: Easy AACSB: Application of knowledge 7) Which one of the following statements is the MOST accurate?

A) A decrease in the money supply lowers the interest rate while an increase in the money supply raises the interest rate, given the price level and output.

B) An increase in the money supply lowers the interest rate while a fall in the money supply raises 74 Copyright © 2023 Pearson Education, Ltd.

the interest rate, given the price level.

C) An increase in the money supply lowers the interest rate while a fall in the money supply raises the interest rate, given the output level.

D) An increase in the money supply lowers the interest rate while a fall in the money supply raises the interest rate, given the price level and output.

E) An increase in the money supply does not usually affect the interest rate.

Answer: D Difficulty: Easy AACSB: Application of knowledge 8) An increase in A) nominal output raises the interest rate while a fall in real output lowers the interest rate, given the price level and the money supply.

B) real output decreases the interest rate while a fall in real output increases the interest rate, given the price level.

C) real output raises the interest rate while a fall in real output lowers the interest rate, given the money supply.

D) nominal output raises the interest rate while a fall in real output lowers the interest rate, given the price level.

E) real output increase raises the interest rate while a fall in real output lowers the interest rate, given the price level and the money supply.

Answer: E Difficulty: Easy AACSB: Application of knowledge 9) What will be the effects of an increase in the money supply on the interest rate?

Answer: An increase in the money supply will cause interest rates to decrease. This should increase investment and possibly consumption of durable goods. The reduction in the interest rate will cause a depreciation of the dollar.

Difficulty: Moderate AACSB: Application of knowledge 10) What will be the effects of an increase in real output on the interest rate?

Answer: An increase in real output will increase the interest rate. If investment depends only on interest rate, this will cause investment to go down. The increased interest rate will cause an appreciation of the dollar.

Difficulty: Moderate AACSB: Application of knowledge 4.5

The Money Supply and the Exchange Rate in the Short Run

1) An increase in a country's money supply causes A) its currency to appreciate in the foreign exchange market while a reduction in the money supply causes its currency to depreciate.

B) its currency to depreciate in the foreign exchange market while a reduction in the money supply causes its currency to appreciate.

C) no effect on the values of it currency in international markets.

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D) its currency to depreciate in the foreign exchange market while a reduction in the money supply causes its currency to further depreciate.

E) its currency to depreciate in the domestic market and appreciate in the foreign market.

Answer: B Difficulty: Easy AACSB: Application of knowledge 2) A decrease in a country's money supply causes A) its currency to appreciate in the foreign exchange market.

B) its currency to depreciate in the foreign exchange market.

C) no effect on the values of it currency in international markets.

D) its currency to depreciate in the foreign exchange market while an increase in the money supply causes its currency to further depreciate.

E) its currency to depreciate in the domestic market and appreciate in the foreign market.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) Different from the short run, the long-run analysis of an economic event allows for A) adjustment of the price level and for full employment of all factors of production.

B) no adjustment of the price level.

C) no adjustment of factors of production.

D) no adjustment of price levels and exchange rate expectations.

Answer: A Difficulty: Easy AACSB: Application of knowledge 4) Which one of the following statements is the MOST accurate?

A) Given PUS, when the money supply rises, the dollar interest rate declines and the dollar depreciates against the euro.

B) Given YUS, when the money supply rises, the dollar interest rate declines and the dollar depreciates against the euro.

C) Given PUS and YUS, when the money supply decreases, the dollar interest rate declines and the dollar depreciates against the euro.

D) Given PUS and YUS, when the money supply rises, the dollar interest rate declines and the dollar appreciates against the euro.

E) Given PUS and YUS, when the money supply rises, the dollar interest rate declines and the dollar depreciates against the euro.

Answer: E Difficulty: Moderate AACSB: Application of knowledge 5) Given PUS and YUS A) an increase in the European money supply causes the euro to appreciate against the dollar, but it does not disturb the U.S. money market equilibrium.

B) an increase in the European money supply causes the euro to appreciate against the dollar, and 76 Copyright © 2023 Pearson Education, Ltd.

it creates excess demand for dollars in the U.S. money market.

C) an increase in the European money supply causes the euro to depreciate against the dollar, and it creates excess demand for dollars in the U.S. money market.

D) an increase in the European money supply causes the euro to depreciate against the dollar, but it does not disturb the U.S. money market equilibrium.

E) an increase in the European money supply causes the euro to depreciate against the dollar, and disturbing the U.S. money market equilibrium.

Answer: D Difficulty: Moderate AACSB: Application of knowledge 6) Explain how the money markets of two countries are linked through the foreign exchange market.

Answer: The monetary policy actions by the Fed affect the U.S. interest rate, changing the dollar/euro exchange rate that clears the foreign exchange market. The European System of Central Banks (ECB) can affect the exchange rate by changing the European money supply and interest rate.

Difficulty: Moderate AACSB: Application of knowledge 7) Explain the following figure.

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Answer: The figure explains how the money markets of two countries are linked through the foreign exchange market. The monetary policy actions by the Fed affect the U.S. interest rate, changing the dollar/euro exchange rate that clears the foreign exchange market. The European System of Central Banks (ESCB) can affect the exchange rate by changing the European money supply and interest rate.

Difficulty: Moderate AACSB: Application of knowledge 8) Using a figure describing both the U.S. money market and the foreign exchange market, analyze the effects of a temporary increase in the European money supply on the dollar/euro exchange rate.

Answer: An increase in the European money supply will reduce the interest rate on the euro and thus will cause the schedule of the expected euro return expressed in dollars to shift down, causing a reduction in the dollar/euro exchange rate, i.e., an appreciation of the U.S. Dollar. The euro depreciates against the dollar. The U.S. money demand and money supply are not going to be affected, and thus the interest rate in the U.S. will remain the same.

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Difficulty: Difficult AACSB: Application of knowledge 9) Combine a graph showing the interest parity condition and one showing money demand and supply to demonstrate simultaneous equilibrium in the money market and the foreign exchange market.

How would an increase in the U.S. money supply affect the dollar/euro exchange rate and the U.S. interest rate? Illustrate your answer graphically and explain.

Answer: Above the axis is depicted the foreign exchange market, where changes in the rate of return on the dollar are mapped into changes in the exchange rate. Below the axis is depicted the U.S. money market and shows the relation between the rate of return on the dollar and U.S. real money holdings. The mechanism works as follows. Consider an increase in the U.S. real money holdings. Supply and demand dictate that the demand for money must increase, so the rate of return must lower to equilibrate at point 2. The lower rate of return on the dollar will cause the dollar to depreciate (exchange rate moves to point ).

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Difficulty: Difficult AACSB: Application of knowledge 10) Analyze the effects of an increase in the European money supply on the dollar/euro exchange rate.

Answer: The main points are: An increase in the European money supply will reduce the interest rate on the euro, and thus causes the euro to depreciate against the dollar. The U.S. money demand and money supply are not going to be affected, and thus the interest rate in the U.S. will remain the same.

Difficulty: Moderate AACSB: Application of knowledge 11) What would be the effect of an increase in the European money supply in the dollar /euro exchange rate?

Answer: An increase in the European money supply lowers the dollar return on euro deposits, i.e. the dollar appreciates against the euro. There is no change in the U.S. money market.

Difficulty: Moderate 80 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 12) Using a figure describing both the U.S. money market and the foreign exchange market, analyze the effects of an increase in the U.S. money supply on the dollar/euro exchange rate.

Answer: An increase in the U.S. money supply will cause interest rates to decrease. This should increase investment and possibly consumption of durable goods. The reduction in the interest rate will cause a movement to the left along the schedule depicting the expected euro return expressed in dollars. The result is an increase in E or a depreciation of the dollar.

Difficulty: Difficult AACSB: Application of knowledge 4.6

Money, the Price Level, and the Exchange Rate in the Long Run

1) An economy's long-run equilibrium is A) the equilibrium that would occur if prices were perfectly flexible.

B) the equilibrium that would occur if prices were perfectly flexible and always adjusted 81 Copyright © 2023 Pearson Education, Ltd.

immediately.

C) the equilibrium that would occur if prices were perfectly flexible and always adjusted immediately to preserve full employment.

D) the equilibrium that would occur if prices were perfectly fixed to preserve full employment.

E) the equilibrium that would occur if prices were perfectly fixed at the full employment point.

Answer: C Difficulty: Easy AACSB: Application of knowledge 2) Which one of the following statements is the MOST accurate?

A) All else equal, an increase in a country's money supply causes a proportional increase in its price level.

B) All else equal, an increase in a country's money supply causes a proportional decrease in its price level.

C) All else equal, an increase in a country's money supply has no effect on its price level.

D) All else equal, an increase in a country's money supply may cause an increase or decrease in its price level.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) A change in the level of the supply of money A) increases the long-run values of the interest rate and real output.

B) decreases the long-run values of the interest rate and real output.

C) has no effect on the long-run values of the interest rate, but may affect real output.

D) has no effect on the long-run values of real output, but may affect the interest rate.

E) has no effect on the long-run values of the interest rate or real output.

Answer: E Difficulty: Easy AACSB: Application of knowledge 4) The long run effects of money supply change has A) an ambiguous effect on the long-run values of the interest rate or real output, a proportional change in the price level's long-run value in the opposite direction.

B) a proportional effect on the long-run values of the interest rate or real output, a proportional change in the price level's long-run value in the same direction.

C) no effect on the long-run values of the interest rate or real output, a proportional change in the price level's long-run value in the same direction.

D) no effect on the long-run values of the interest rate or real output, no change in the price level's long-run value.

E) an ambiguous effect on the long-run values of the interest rate or real output, a disproportional change in the price level's long-run value in the same direction.

Answer: C Difficulty: Easy AACSB: Application of knowledge 5) Changes in the money supply growth rate 82 Copyright © 2023 Pearson Education, Ltd.

A) are neutral in the short run.

B) need not be neutral in the short run.

C) are neutral in the long run.

D) need not be neutral in the long run.

E) affect the real output of the economy.

Answer: D Difficulty: Easy AACSB: Application of knowledge 6) A sustained change in the monetary growth rate will A) immediately affect equilibrium real money balances by raising the money interest rate.

B) eventually affect equilibrium nominal money balances by raising the money interest rate.

C) eventually affect equilibrium real money balances by reducing the money interest rate.

D) eventually affect equilibrium real money balances by raising the real interest rate.

E) eventually affect equilibrium real money balances by raising the money interest rate.

Answer: E Difficulty: Easy AACSB: Application of knowledge 7) A permanent increase in a country's money supply A) causes a more than proportional increase in its price level.

B) causes a less than proportional increase in its price level.

C) causes a proportional increase in its price level.

D) leaves its price level constant in long-run equilibrium.

E) causes an inversely proportional fall in its price level.

Answer: C Difficulty: Easy AACSB: Application of knowledge 8) Money demand behavior may A) change as a result of demographic trends or financial innovations such as electronic cash-transfer facilities.

B) change only as a result of demographic trends.

C) change only as a result of financial innovations such as electronic cash-transfer facilities.

D) not change as a result of demographic trends or financial innovations such as electronic cash-transfer facilities.

E) change as a result of demographic trends but not as a result of financial innovations such as electronic cash-transfer facilities.

Answer: A Difficulty: Easy AACSB: Application of knowledge 9) Using year-by-year data from 1980-2014 shows that A) there is a strong positive relation between average Latin American money-supply growth and inflation.

B) there is a strong negative relation between average Latin American money-supply growth and inflation.

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C) there is a strong positive relation between average Latin American money-supply growth and deflation.

D) it is difficult to find a strong positive relation between average Latin American money-supply growth and inflation.

E) there is a weak positive relation between average Latin American money-supply growth and inflation.

Answer: A Difficulty: Easy AACSB: Application of knowledge 10) Which one of the following statements is the MOST accurate?

A) A permanent increase in a country's money supply causes a proportional long-run depreciation of its currency against foreign currencies.

B) A temporary increase in a country's money supply causes a proportional long-run depreciation of its currency against foreign currencies.

C) A permanent increase in a country's money supply causes a proportional long-run appreciation of its currency against foreign currencies.

D) A permanent increase in a country's money supply causes a proportional short-run depreciation of its currency against foreign currencies.

E) A permanent increase in a country's money supply causes a proportional short-run appreciation of its currency against foreign currencies.

Answer: A Difficulty: Easy AACSB: Application of knowledge 11) Which one of the following statements is the MOST accurate?

A) A permanent decrease in a country's money supply causes a proportional long-run appreciation of its currency against foreign currencies.

B) A temporary increase in a country's money supply causes a proportional long-run depreciation of its currency against foreign currencies.

C) A permanent decrease in a country's money supply causes a proportional long-run depreciation of its currency against foreign currencies.

D) A permanent increase in a country's money supply causes a proportional short-run depreciation of its currency against foreign currencies.

Answer: A Difficulty: Easy AACSB: Application of knowledge 12) Describe the effects of an increase in a country's long-run money supply on: (a) price level (b) values of interest rate and real output (c) exchange rates Answer: All else equal, an increase in a country's long-run money supply (a) causes a proportional increase in its price level. (b) has no effect on the long-run values of the interest rate or real output, a proportional change in the price level's long-run value in the same direction. (c) causes a proportional long-run depreciation of its currency against foreign currencies.

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Difficulty: Easy AACSB: Application of knowledge 13) Describe the effects of a decrease in a country's long-run money supply on (a) price level (b) values of interest rate and real output (c) exchange rate Answer: All else equal, a decrease in a country's long-run money supply (a) causes a proportional decrease in its price level. (b) has no effect on the long-run values of the interest rate or real output, a proportional change in the price level's long-run value in the same direction. (c) causes a proportional long-run appreciation of its currency against foreign currencies.

Difficulty: Easy AACSB: Application of knowledge 14) Use Figure 4-10 below to describe the link between average money growth and inflation in Western Hemisphere Developing Countries from 1980 to 2014.

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Answer: Even year by year, there is a strong positive relation between average Latin American money supply growth and inflation. On average, years with higher money growth also tended to be years with higher inflation. In addition, the data points cluster around the 45-degree line, along which money supplies and price levels increase in proportion. The data confirm the strong long-run link between national money supplies and national price levels predicted by economic theory.

Difficulty: Moderate AACSB: Application of knowledge 4.7

Inflation and Exchange Rate Dynamics

1) For main industrial countries such as Japan and the U.S. A) there is much less month-to-month variability of the exchange rate, suggesting that price levels are relatively sticky in the short run.

B) there is much more month-to-month variability of the exchange rate, suggesting that price 86 Copyright © 2023 Pearson Education, Ltd.

levels are relatively sticky in the short run.

C) there is almost the same month-to-month variability of the exchange rate and price levels.

D) it is hard to tell whether month-to-month variability of the exchange rate is similar to changes in price levels.

E) there is much more month-to-month variability of the exchange rate, suggesting that price levels are relatively sticky in the long run.

Answer: B Difficulty: Easy AACSB: Application of knowledge 2) What term means an explosive and seemingly uncontrollable inflation in which money loses value rapidly and may even go out of use?

A) superinflation B) stagflation C) hyperinflation D) maginflation E) deflation Answer: C Difficulty: Easy AACSB: Application of knowledge 3) Which one of the following statements is the MOST accurate?

A) There is a lively academic debate over the possibility that seemingly sticky wages and prices are in reality quite fixed.

B) There is a lively academic debate over the possibility that seemingly sticky wages and prices are in reality much more sticky than theory assumes.

C) There is a lively academic debate over the possibility that seemingly sticky wages and prices are in reality quite flexible.

D) There is no debate over the possibility that wages and prices are sticky in the long run.

E) There is no debate over the possibility that wages and prices are sticky in the short run.

Answer: C Difficulty: Easy AACSB: Application of knowledge 4) During hyperinflation, exploding inflation causes real money demand to A) fall over time, and this additional monetary change makes money prices rise even more quickly than the money supply itself rises.

B) increase over time, and this additional monetary change makes money prices rise even more quickly than the money supply itself rises.

C) fall over time, and this additional monetary change makes money prices decrease even more quickly than the money supply itself rises.

D) increase over time, and this additional monetary change makes money prices decrease even more quickly than the money supply itself rises.

E) fall over time, and this additional monetary change makes money prices decrease even less quickly than the money supply itself rises.

Answer: A Difficulty: Easy 87 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 5) A change in the money supply creates demand and cost pressures that lead to future increases in the price level from which main sources?

I. Excess demand for output and labor II. Inflationary expectations III. Raw materials prices A) I B) II C) II and III D) I and II E) I, II, and III Answer: E Difficulty: Easy AACSB: Application of knowledge 6) The most extreme inflationary conditions occurred A) in Zimbabwe between 2007 and 2009.

B) in Chile in 2012.

C) in Eastern Europe in the 1990s.

D) in Western Europe in the 1980s.

E) in Germany in 2013.

Answer: A Difficulty: Easy AACSB: Application of knowledge 7) In a classic paper, Columbia University economist Phillip Cagan drew the line between inflation and hyperinflation at an inflation rate of A) 50 percent per month.

B) 10 percent per month.

C) 20 percent per month.

D) 5 percent per month.

E) 25 percent per month.

Answer: A Difficulty: Easy AACSB: Application of knowledge 8) In a classic paper, Columbia University economist Phillip Cagan drew the line between inflation and hyperinflation at an inflation rate of A) more than 120 percent per year.

B) more than 100 percent per year.

C) more than 200 percent per year.

D) more than 12,000 percent per year.

E) more than 1,000 percent per year.

Answer: D 88 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Easy AACSB: Application of knowledge 9) In Zimbabwe, the government stopped the country's hyperinflation by A) reducing domestic monetary growth drastically.

B) returning to a gold/silver currency standard.

C) switching to foreign currencies that are relatively stable.

D) passing a law making price increases illegal.

E) implementing a new currency based on diamonds.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 10) "Although the price levels appear to display short-run stickiness in many countries, a change in the money supply creates immediate demand and cost pressures that eventually lead to future increase in the price level." Discuss.

Answer: The statement is true. The pressures come from three main sources: excess demand for output and labor; inflationary expectations; and, raw material prices.

Difficulty: Moderate AACSB: Application of knowledge 11) Explain the effects of a permanent increase in the U.S. money supply in the short run and in the long run. Assume that the U.S. real national income is constant.

Answer: An increase in the nominal money supply raises the real money supply, lowering the interest rate in the short run. The money supply increase is considered to continue in the future; thus, it will affect the exchange rate expectations. This will make the expected return on the euro more desirable and thus the dollar depreciates. In the case of a permanent increase in the U.S. money supply, the dollar depreciates more than under a temporary increase in the money supply.

Now, in the long run, prices will rise until the real money balances are the same as before the permanent increase in the money supply. Since the output level is given, the U.S. interest rate, which decreased before, will start to increase, until it will move back to its original level. The equilibrium interest rate must be the same as its original long run value. This increase in the interest rate must cause the dollar to appreciate against the euro after its sharp depreciation as a result of the permanent increase in the money supply. So a large depreciation is followed by an appreciation of the dollar. Eventually, the dollar depreciates in proportion to the increase in the price level, which in turn increases by the same proportion as the permanent increase in the money supply. Thus, money is neutral, in the sense that it cannot affect, in the long run, real variables, such as output, investment, etc.

Difficulty: Difficult AACSB: Application of knowledge 4.8

Permanent Money Supply Changes and the Exchange Rate

1) In a world where the price level could adjust immediately to its new long-run level after a money supply increase A) the dollar interest rate would increase because prices would adjust immediately and prevent the money supply from rising.

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B) the dollar interest rate would not fall because prices would adjust immediately and prevent the money supply from rising.

C) the dollar interest rate would fall because prices would adjust immediately and prevent the money supply from decreasing.

D) the dollar interest rate would decrease because prices would adjust immediately and prevent the money supply from decreasing.

E) the dollar interest rate would fall because prices would not be able to prevent the money supply from rising.

Answer: B Difficulty: Easy AACSB: Application of knowledge 2) The exchange rate is said to overshoot when A) its immediate response to a disturbance is greater than its long-run response.

B) its immediate response to a disturbance is less than its long-run response.

C) its immediate response to a disturbance is the same as its long-run response.

D) its immediate response to a disturbance is not related to its long-run response.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) After a permanent increase in the money supply A) the exchange rate overshoots in the short run.

B) the exchange rate overshoots in the long run.

C) the exchange rate smoothly depreciates in the short run.

D) the exchange rate smoothly appreciates in the short run.

E) the exchange rate remains the same.

Answer: A Difficulty: Easy AACSB: Application of knowledge 4) Michael Woodford says the following is an advantage of interest-rate instruments for central banks.

A) Conduct monetary policy without inflation.

B) Conduct monetary policy even if checking deposits pay interest at competitive rates.

C) Conduct monetary policy without government approval.

D) Conduct monetary policy with consumers in mind.

E) Conduct monetary policy with workers in mind.

Answer: B Difficulty: Easy AACSB: Analytical thinking 5) Inflation targeting was initiated by which central bank in 1989?

A) U.S. B) Japan C) Canada D) New Zealand 90 Copyright © 2023 Pearson Education, Ltd.

E) U.K. Answer: D Difficulty: Easy AACSB: Application of knowledge 6) Which of the following can help to explain why higher inflation may lead to currency appreciations?

A) The interest rate is not the prime target of monetary policy.

B) Most central banks adjust their policy interest rates expressly so as to keep inflation in check.

C) Central banks increase the money supply leading to overshooting of the exchange rate.

D) Inflation will increase the purchasing power of a currency.

E) The world market does not adjust their currency trade to reflect inflation.

Answer: B Difficulty: Easy AACSB: Application of knowledge 7) Which one of the countries below announces inflation targets?

A) Japan B) U.S. C) Canada D) Mexico E) Nicaragua Answer: C Difficulty: Easy AACSB: Application of knowledge 8) Using figures for both the short run and the long run, show the effects of a permanent increase in the U.S. money supply. Try to line up your figures to the short and long run equilibria side by side.

Assume that the U.S. real national income is constant.

Answer:

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An increase in the nominal money supply raises the real money supply, lowering the interest rate in the short run (the movement from 1 to 2 on the lower left figure). The money supply increase is considered to continue in the future, and thus it will affect the exchange rate expectations. This will make the expected return on the euro more desirable and thus the dollar depreciates. In the case of a permanent increase in the U.S. money supply, the dollar depreciates more than under a temporary increase in the money supply (from point to point in the upper left figure).

Now, in the long run, (the right hand side figure), prices will rise until the real money balances are the same as before the permanent increase in the money supply (from point 2 to point 4, in the lower right figure). Since the output level is given, the U.S. interest rate which decreased before, will start to increase, until it will move back to its original level (from Point 2 to 4 in the lower left figure). The equilibrium interest rate must be the same as its original long run value (at point 4 in the lower right figure). This increase in the interest rate must cause the dollar to appreciate against the euro after its sharp depreciation as a result of the permanent increase in the money supply (this process is depicted in the upper right figure from point to ). So a large depreciation (from Point in the left upper figure to pint in both the left and right upper figures) is followed by an appreciation of the dollar (the movement from to point in the upper right hand side figure).

Eventually, the dollar depreciates in proportion to the increase in the price level, which in turn increases by the same proportion as the permanent increase in the money supply. Thus, money is neutral, in the sense that it cannot affect, in the long run, real variables, such as output, investment, etc. Note that points and represent the same exchange rate.

92 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Difficult AACSB: Application of knowledge 9) Explain the exchange rate over-shooting hypothesis.

Answer: Many prices in the economy are written into long-term contracts and cannot be changed immediately when changes in the money supply occur. A permanent increase in M, holding P constant, increases the real money supply (M/P) and lowers the nominal interest rate (R). This shifts the dollar return schedule left. A permanent increase in M also creates the expectation that in the long run all prices, including the exchange rate, would rise. A rise in the expected exchange rate shifts the ERR(DM) schedule right. Therefore, in the short run equilibrium is established at point 2 In the long run the price level adjusts and rises proportionately with the money supply.

Therefore, M/P and R return to their initial levels in the long run and the equilibrium exchange rate is determined at point 3. In other words, the exchange rate first overshoots and then returns to its long run level. Therefore, the fluctuations in E are much stronger than those of P. Difficulty: Difficult AACSB: Application of knowledge 10) Using 4 different figures, plot the time paths showing the effects of a permanent increase in the United States money supply on: (a) U.S. Money supply (b) The dollar interest rate. (c) The U.S. price level (d) The dollar/euro exchange rate Answer: See below.

Difficulty: Difficult AACSB: Application of knowledge 93 Copyright © 2023 Pearson Education, Ltd.

11) What is inflation targeting?

Answer: A central bank can keep inflation from getting too high or too low by raising the interest rate when it learns that inflation is running higher than expected, and lowering it when inflation is running lower. Many central banks now follow formal strategies of inflation targeting, under which they announce a target (or target range) for the inflation rate and adjust the interest rate to keep inflation on target.

Difficulty: Moderate AACSB: Application of knowledge 12) Can higher inflation lead to currency appreciation? Explain the "paradox" case of Canada when inflation drove Canadian dollar higher.

Answer: Yes. Suppose market participants unexpectedly push up prices and borrow to enlarge the money supply. Thus, when the Canadian government releases new price data, the data show a price level higher than what market participants had previously predicted. If the Bank of Canada is expected to raise interest rates quickly so as to push the price level and money supply back on course, there is no reason for the future expected exchange rate to change. But with higher Canadian interest rates, interest parity requires an expected future depreciation of the Canadian dollar, which is consistent with an unchanged future exchange rate only if the Canadian dollar appreciates immediately.

Difficulty: Moderate AACSB: Application of knowledge International Finance: Theory & Policy, 12/e, Global Edition Chapter 5 Price Levels and the Exchange Rate in the Long Run 5.1

The Law of One Price

1) Which of the following statements is the MOST accurate?

A) In the long run, national price levels play a minor role in determining both interest rates and the relative prices at which countries' products are traded.

B) In the long run, national price levels play a key role only in determining interest rates.

C) In the long run, national price levels play a key role only in determining the relative prices at which countries' products are traded.

D) In the long run, national price levels play a key role in determining both interest rates and the relative prices at which countries' products are traded.

E) In the long run, national price levels play no role in determining interest rates and the relative prices at which countries' products are traded.

Answer: D Difficulty: Easy AACSB: Application of knowledge 2) Which of the following statements is the MOST accurate? The law of one price states A) in competitive markets free of transportation costs and official barriers to trade, identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency.

B) in competitive markets free of transportation costs and official barriers to trade, identical goods 94 Copyright © 2023 Pearson Education, Ltd.

sold in the same country must sell for the same price when their prices are expressed in terms of the same currency.

C) in competitive markets free of transportation costs and official barriers to trade, identical goods sold in different countries must sell for the same price.

D) identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency.

E) in competitive markets free of official barriers to trade, identical goods are sold at the same price regardless of transportation costs.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) The law of one price states that when trade is open and costless, identical goods must trade at prices regardless of where they are sold.

A) the same relative B) higher C) lower D) different Answer: A Difficulty: Easy AACSB: Application of knowledge 4) Using the law of one price, if the dollar/pound exchange rate is $1.50 per pound and a sweater sells for $45 in New York must sell for per sweater in London, the same as its price in New York.

A) ₤30.00 B) ₤45.00 C) ₤67.50 D) ₤15.00 Answer: A Difficulty: Easy AACSB: Application of knowledge 5) Using the law of one price, if the dollar/euro exchange rate is $1.25 per euro, a Tesla Model 3 car sells for $35,000 in the U.S. market must sell for in Europe.

A) ₤28,000 B) ₤43,750 C) ₤35,714 D) ₤52,490 E) ₤54,990 Answer: A Difficulty: Easy AACSB: Application of knowledge 6) Under the law of one price, if the price for one particular good is PUS in the US and PE in Europe, then A) E$/P = PUS/PE. 95 Copyright © 2023 Pearson Education, Ltd.

B) E$/€ = PUS/PE C) E$/€ = PUS - PE. D) E$/€ = PE/PES. E) E$/€ = PUS + PE. Answer: B Difficulty: Easy AACSB: Application of knowledge 7) Explain the Law of One Price. Give an example.

Answer: The law of one price states that in competitive markets free of transportation costs and trade barriers, identical goods sold in different countries must sell for the same price when expressed in terms of the same currency. = (E$/£) × ( E$/£ =

) for good i.

/

If, for example, the price of the same sweater was cheaper in London than in New York, U.S. importers and British exporters would have an incentive to buy sweaters in London and ship them to New York, pushing the London price up and the New York price down, until both were equal.

Difficulty: Moderate AACSB: Application of knowledge 8) Fill in the following table, assuming the law of one price prevails.

Answer:

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Difficulty: Moderate AACSB: Analytical thinking 5.2

Purchasing Power Parity

1) The theory of purchasing power parity states that the exchange rate between two countries' currencies the ratio of the countries' price levels.

A) equals B) is higher than C) is lower than D) is different from Answer: A Difficulty: Easy AACSB: Application of knowledge 2) The purchasing power parity theory predicts that a in a currency's domestic purchasing power will be associated with a proportional currency in the foreign exchange market.

A) fall; depreciation B) fall; appreciation C) rise; depreciation D) rise; floating Answer: A Difficulty: Easy AACSB: Application of knowledge 3) Under Purchasing Power Parity A) E$/€ = PiUS/PiE. B) E$/€ = PiE/PiUS. C) E$/€ = PUS/PE. D) E$/€ = PE/PES. E) E$/€ = PiE + PiUS/PiE. Answer: C Difficulty: Easy 97 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 4) If the reference commodity basket costs $200 in the United States and €160 in Europe, Purchasing Power Parity (PPP) theory predicts a dollar/euro exchange rate of per euro.

If the U.S. price level were to triple to $600/basket, PPP would imply an exchange rate of per euro.

A) $1.25; $3.75 B) $1.25; $0.42 C) $0.80; $2.40 D) $0.80; $0.27 Answer: A Difficulty: Easy AACSB: Application of knowledge 5) Which of the following statements is the MOST accurate?

A) The law of one price applies only to the general price level.

B) The law of one price applies to the general price level while PPP applies to individual commodities.

C) The law of one price applies to individual commodities while PPP applies to both the general price level and to individual commodities.

D) PPP applies only to individual commodities.

E) The law of one price applies to individual commodities while PPP applies to the general price level.

Answer: E Difficulty: Easy AACSB: Application of knowledge 6) Which of the following statements is the MOST accurate?

A) If PPP holds true, then the law of one price holds true for every commodity as long as the reference baskets used to reckon different countries' price levels are the same.

B) If the law of one price holds true for every commodity, PPP must hold automatically.

C) If the law of one price holds true for every commodity, PPP must automatically hold as long as the reference baskets used to reckon different countries' price levels are the same.

D) If the law of one price does not hold true for every commodity, PPP cannot be true as long as the reference baskets used to reckon different countries' price levels are the same.

E) If PPP holds true, then the law of one price must hold true automatically.

Answer: C Difficulty: Easy AACSB: Application of knowledge 7) Which of the following statements is the MOST accurate?

A) Absolute PPP does not imply relative PPP. B) Relative PPP implies absolute PPP. C) There is no causality relation between the two.

D) Absolute PPP implies relative PPP. E) Absolute PPP is inversely related to relative PPP. Answer: D 98 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Easy AACSB: Application of knowledge 8) Which of the following statements is the MOST accurate?

A) Relative PPP may be valid even when absolute PPP is not, provided the factors causing deviations from absolute PPP are more or less stable over different commodities space.

B) Absolute PPP may be valid even when relative PPP is not, provided the factors causing deviations from relative PPP are more or less stable over time.

C) Relative PPP may be valid even when absolute PPP is not, provided the factors causing deviations from absolute PPP are more or less stable over time.

D) Relative PPP is not valid when absolute PPP is not.

E) Relative PPP is only valid when absolute PPP is valid, providing the factors causing deviations from relative PPP are more or less stable over time.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 9) Explain Purchasing Power Parity.

Answer: PPP states that the exchange rate between two countries' currencies equals the ratio of the countries' price levels.

A fall in a currency's domestic purchasing power (i.e. an increase in the domestic price level) will be associated with a proportional currency depreciation in the foreign exchange market and vice versa. = PUS/PE where P is the price of a reference commodity basket.

Rearrange: PUS = × (PE) Thus, PPP asserts that all countries' price levels are equal when measured in terms of the same currency.

Difficulty: Moderate AACSB: Application of knowledge 10) Discuss the relationship between PPP and the Law of One Price.

Answer: The law of one price applies to individual commodities while PPP applies to the general price level.

Proponents of PPP argue that its validity in the long run doesn't require the law of one price to hold exactly. When goods and services temporarily become more expensive in one country than in others, the demands for its currency and its products falls, pushing the exchange rate and domestic prices back in line with PPP and vice versa.

Difficulty: Moderate AACSB: Application of knowledge 11) Discuss the differences between Absolute PPP and Relative PPP. Answer: Absolute PPP states that the exchange rate between two currencies equals the ratio of their price levels. Relative PPP states that the percentage change in the exchange rate between two currencies over a given period equals the difference between the inflation rates of those two currencies.

Difficulty: Moderate 99 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 12) Explain why Relative PPP is useful when comparing countries that base their price levels on different product baskets.

Answer: For Example: If the U.S. price level rises by 10% over a year while Europe's rises by only 5%, relative PPP predicts a 5% depreciation of the dollar against the euro. This just cancels the 5% by which U.S. inflation exceeds European, leaving the relative domestic and foreign purchasing powers of both currencies unchanged. ( )/ = ( )US,t - ( )E,t between dates t and t - 1.

Relative PPP is useful when comparing countries that base their price levels on different product baskets. Relative PPP may be valid even when absolute PPP is not.

Difficulty: Moderate AACSB: Application of knowledge 13) Suppose Russia's inflation rate is 200% over one year but the inflation rate in Switzerland is only 2%. According to relative PPP, what should happen over the year to the Swiss franc's exchange rate against the Russian ruble?

Answer: (Eruble/franc, t - Eruble/franc, t-1)/Eruble/franc, t-1 = 2 - 0.02 = 1.98 So there will be a 198% depreciation of the ruble against the franc or, conversely, a 198% appreciation of the franc against the ruble.

Difficulty: Moderate AACSB: Application of knowledge 14) Assuming relative PPP, fill in the table below:

Answer: Using (

-

)/

= ΠUS, t - ΠE, t one gets:

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Difficulty: Moderate AACSB: Analytical thinking 5.3

A Long-Run Exchange Rate Model Based on PPP

1) Which of the following statements is the MOST accurate? In general A) the monetary approach to the exchange rate is a long run theory.

B) the monetary approach to the exchange rate is a short run theory.

C) the monetary approach to the exchange rate is both a short and long run theory.

D) the monetary approach to the exchange rate neither long run nor short run theory.

E) the monetary approach to the exchange rate is considered less practical than the law of one price.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) The monetary approach makes the general prediction that A) the exchange rate, which is the relative price of American and European money, is fully determined in the long run by the relative supplies of those monies.

B) the exchange rate, which is the relative price of American and European money, is fully determined in the short run by the relative supplies of those monies and the relative demands for them.

C) the exchange rate, which is the relative price of American and European money, is fully determined in the short run and long run by the relative supplies of those monies and the relative demands for them.

D) the exchange rate, which is the relative price of American and European money, is fully determined in the long run by the relative supplies of those monies and the relative demands for them.

E) the money supply in the U.S. will adjust to European monetary equilibrium.

Answer: D Difficulty: Easy AACSB: Application of knowledge 3) Under the monetary approach to exchange rate theory, money supply growth at a constant rate A) eventually results in ongoing price level deflation at the same rate, but changes in this long-run deflation rate do not affect the full-employment output level or the long-run relative prices of 101 Copyright © 2023 Pearson Education, Ltd.

goods and services.

B) eventually results in ongoing price level inflation at the same rate, but changes in this long-run inflation rate do affect the full-employment output level and the long-run relative prices of goods and services.

C) eventually results in ongoing price level inflation at the same rate, but changes in this long-run inflation rate do not affect the full-employment output level or the long-run relative prices of goods and services.

D) eventually results in ongoing price level inflation at the same rate, but changes in this long-run inflation rate do not affect the full-employment output level, only the long-run relative prices of goods and services.

E) eventually results in ongoing price level deflation at the same rate, but changes in this long-run deflation rate do not affect the full-employment output level, only the long-run relative prices of goods and services.

Answer: C Difficulty: Easy AACSB: Application of knowledge 4) Which of the following statements is the MOST accurate? In general, under the monetary approach to the exchange rate A) the interest rate is not independent of the money supply growth rate in the short run.

B) the interest rate is independent of the money supply growth rate in the long run.

C) the interest rate is not independent of the money supply growth rate in the long run, but independent in the short run.

D) the interest rate is not independent of the money supply growth rate in the long run.

E) the interest rate is a factor of the money supply growth rate only in the short term.

Answer: D Difficulty: Easy AACSB: Application of knowledge 5) Which of the following statements is the MOST accurate? In general, under the monetary approach to the exchange rate A) while the short-run interest rate does not depend on the absolute level of the money supply, continuing growth in the money supply eventually will affect the interest rate.

B) while the long-run interest rate does depend on the absolute level of the money supply, continuing growth in the money supply does not affect the interest rate.

C) while the long-run interest rate does not depend on the absolute level of the money supply, continuing growth in the money supply eventually will affect the interest rate.

D) the long-run interest rate does not depend on the absolute level of the money supply, and thus continuing growth in the money supply will not affect the interest rate.

E) while the short-run interest rate does not depend on the absolute level of the money supply, continuing decline in the money supply eventually will not affect the interest rate.

Answer: C Difficulty: Easy AACSB: Application of knowledge 6) If people expect relative PPP to hold A) the difference between the interest rates offered by dollar and euro deposits will equal the difference between the inflation rates expected, in the United States and Europe, respectively, over 102 Copyright © 2023 Pearson Education, Ltd.

the relevant horizon.

B) the difference between the interest rates offered by dollar and euro deposits will equal the difference between the inflation rates expected in Europe and the United States, respectively.

C) the difference between the interest rates offered by dollar and euro deposits will equal the difference between the inflation rates expected, over the relevant horizon, in the United States and Europe, respectively, in the short run.

D) the difference between the interest rates offered by dollar and euro deposits will be above the difference between the inflation rates expected, over the relevant horizon, in the United States and Europe, respectively.

E) the difference between the interest rates offered by dollar and euro deposits will be below the difference between the inflation rates expected, over the relevant horizon, in the United States and Europe, respectively.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 7) Who among the following list of people is an early 20th century economist from Yale University who wrote the book The Theory of Interest?

A) Gustav Cassel B) Irving Fisher C) David Ricardo D) Paul Krugman E) Israel Kirzner Answer: B Difficulty: Easy AACSB: Application of knowledge 8) Under PPP (and by the Fisher Effect), all else equal A) a rise in a country's expected inflation rate will eventually cause a more-than proportional rise in the interest rate that deposits of its currency offer in order to accommodate for the higher inflation.

B) a fall in a country's expected inflation rate will eventually cause an equal rise in the interest rate that deposits of its currency offer.

C) a rise in a country's expected inflation rate will eventually cause an equal rise in the interest rate that deposits of its currency offer.

D) a rise in a country's expected inflation rate will eventually cause a less than proportional rise in the interest rate that deposits of its currency offer to accommodate the rise in expected inflation.

E) a fall in a country's expected inflation rate will eventually cause an inversely proportional rise in the interest rate that deposits of its currency offer to accommodate the rise in expected inflation.

Answer: C Difficulty: Easy AACSB: Application of knowledge 9) In the short run A) the interest rate can rise when the domestic money supply falls.

B) the interest rate can decrease when the domestic money supply falls.

C) the interest rate stays constant when the domestic money supply falls.

D) the interest rate rises in the same proportion as the domestic money supply falls.

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E) the interest rate never rises when the domestic money supply falls.

Answer: A Difficulty: Easy AACSB: Application of knowledge 10) Under a flexible-price monetary approach to the exchange rate A) when the domestic money supply falls, the price level would eventually fall, increasing the interest rate.

B) when the domestic money supply falls, the price level would fall right away, causing a reduction in the interest rate.

C) when the domestic money supply falls, the price level would fall right away, causing an increase in the interest rate.

D) when the domestic money supply falls, the price level would eventually fall, keeping the interest rate constant.

E) when the domestic money supply falls, the price level would fall right away, keeping the interest rate constant.

Answer: E Difficulty: Easy AACSB: Application of knowledge 11) Under sticky prices A) a fall in the money supply raises the interest rate to preserve money market equilibrium.

B) a fall in the money supply reduces the interest rate to preserve money market equilibrium.

C) a fall in the money supply keeps the interest rate intact to preserve money market equilibrium.

D) a fall in the money supply does not affect the interest rate in the short run, only in the long run.

E) a fall in the money supply raises the interest rate to preserve money market equilibrium in the long run.

Answer: A Difficulty: Easy AACSB: Application of knowledge 12) Under sticky prices A) an interest rate rise is associated with lower expected deflation and a long-run currency appreciation, so the currency appreciates immediately.

B) an interest rate rise is associated with higher expected inflation and a long-run currency appreciation, so the currency appreciates immediately.

C) an interest rate rise is associated with lower expected inflation and a long-run currency depreciation, so the currency appreciates immediately.

D) an interest rate rise is associated with lower expected inflation and a long-run currency depreciation, so the currency depreciates immediately.

E) an interest rate rise is associated with lower expected inflation and a long-run currency appreciation, so the currency appreciates immediately.

Answer: E Difficulty: Easy AACSB: Application of knowledge 13) Under the monetary approach to the exchange rate 104 Copyright © 2023 Pearson Education, Ltd.

A) an interest rate decrease is associated with higher expected inflation and a currency that will be weaker on all future dates.

B) an interest rate increase is associated with higher expected deflation and a currency that will be weaker on all future dates.

C) an interest rate increase is associated with higher expected inflation and a currency that will be strengthened on all future dates.

D) an interest rate increase is associated with higher expected deflation and a currency that will be strengthened on all future dates.

E) an interest rate increase is associated with higher expected inflation and a currency that will be weaker on all future dates.

Answer: E Difficulty: Moderate AACSB: Application of knowledge 14) Under the monetary approach to the exchange rate A) a reduction in the money supply will cause immediate currency depreciation.

B) a rise in the money supply will cause currency depreciation.

C) a rise in the money supply will cause immediate currency appreciation.

D) a rise in the money supply will cause depreciation.

E) a rise in the money supply will cause immediate currency depreciation.

Answer: E Difficulty: Moderate AACSB: Application of knowledge 15) Explain why an exchange rate model based on PPP is a long run theory.

Answer: PPP theory is a monetary approach to the exchange rate. It is a long-run theory because it does not allow for price rigidities. It assumes that prices can adjust right away to maintain full employment as well as PPP. Difficulty: Moderate AACSB: Application of knowledge 16) Present and explain the Fundamental Equation of the Monetary Approach.

Answer: Assume = PUS/PE and that domestic price levels depend on domestic money demands and supplies: PUS = MUSS/L(R$, YUS) PE = MES/L( , YE) Therefore, the exchange rate is fully determined in the long run by the relative supplies of those monies and the relative real demands for them. Shifts in interest rates and output levels affect the exchange rate only through their influence on money demand.

Difficulty: Moderate AACSB: Application of knowledge 17) What are the predictions for the long-run equilibrium of the Monetary Approach?

Answer: Money supplies: Given the equations, = PUS/PE 105 Copyright © 2023 Pearson Education, Ltd.

PUS = MUSS/L(R$, YUS) PE = MES/L( , YE) one can show that an increase in the U.S. money supply MUSS causes a proportional increase in the U.S. price level PUS, which in turn causes a proportional increase in . Thus, an increase in U.S. money supply causes a proportional long-run depreciation of the dollar against the euro and vice versa.

Interest rates: A rise in the interest rate R$ lowers U.S. money demand L(R$, YUS) thereby causing a rise in the U.S. price level and a proportional depreciation of the dollar against the euro.

Output levels: A rise in U.S. output YUS raises real U.S. money demand leading to a fall in the long-run U.S. price level and an appreciation of the dollar against the euro.

Difficulty: Moderate AACSB: Application of knowledge 18) Discuss the effects of ongoing inflation based on the PPP theory.

Answer: Other things equal, money supply growth at a constant rate eventually results in ongoing price level inflation at the same rate as the money supply growth, but changes in this long-run inflation rate do not affect the full-employment output level or the long-run relative prices of goods and services.

The interest rate, however, is affected by continuing growth in the money supply (inflation). This can be shown by combining PPP with the interest parity condition. To show it analytically, recall that the condition of parity between dollar and euro assets is: R$ =

+(

-

)/

And according to relative PPP: ( )/ = ΠUS,t - ΠE,t If people expect relative PPP to hold, the difference between interest rates offered by dollar and euro deposits will equal the difference between the expected inflation rates, over the relative horizon, in the U.S. and Europe.

Difficulty: Moderate AACSB: Application of knowledge 19) Describe and explain the relationship between expected inflation rates in two countries and their interest rate differential according to the PPP theory.

Answer: Expected inflation is given by the following equation: Πe = (Pe - P)/P where Pe is the expected price level in a country a year from today.

If relative PPP is expected to hold then: (

-

)/

-

Combine the expected version of relative PPP with the interest parity condition: R$ =

+(

-

)/

Rearrange: 106 Copyright © 2023 Pearson Education, Ltd.

R$ -

=

-

If, as PPP predicts, currency depreciation is expected to offset international inflation difference, the interest rate difference must equal the expected inflation difference.

Difficulty: Difficult AACSB: Application of knowledge 20) What is the Fisher Effect? Provide an example.

Answer: All else equal, a rise in a country's expected inflation rate will eventually cause an equal rise in the interest rate that deposits of its currency offer. Similarly, a fall in the expected inflation rate will eventually cause a fall in the interest rate.

Ex: If the expected U.S. inflation were to rise permanently from Π to Π + ΔΠ, current dollar interest rates R$ would eventually catch up to the higher inflation, rising by a value ΔR$ = ΔΠ in accordance with the Monetary Approach that in the long run purely monetary developments should have no effect on an economy's relative prices since the real rate of return on dollar assets would remain unchanged.

Difficulty: Moderate AACSB: Application of knowledge 21) Discuss the different effects on the domestic interest rates when prices are assumed flexible and when they are assumed to be sticky.

Answer: When prices are flexible, a decrease in the domestic money supply has no effect on the interest rate, because of the immediate decrease in the price level. However, when prices are assumed to be sticky, a decrease in the domestic money supply will cause the interest rate to rise, because the sticky domestic price level leads to an excess demand for real money balances at the initial interest rate.

Difficulty: Moderate AACSB: Application of knowledge 5.4

Empirical Evidence on PPP and the Law of One Price

1) Which of the following statements is the MOST accurate?

A) All versions of the Purchasing Power Parity theory do badly in explaining the actual data on exchange rates and national price levels.

B) Only the absolute Purchasing Power Parity explains well the actual data on exchange rates and national price levels.

C) Only the relative Purchasing Power Parity explains well the actual data on exchange rates and national price levels.

D) All versions of the Purchasing Power Parity theory explain well the actual data on exchange rates and national price levels.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) In practice A) changes in national price levels often tell us relatively little about exchange rate movements.

B) changes in national price levels raise the exchange rate.

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C) changes in national price levels lower the exchange rate.

D) changes in national price levels often tell us about exchange rate movements.

E) changes in national price levels match identical changes in the exchange rate.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) Which of the following statements is the MOST accurate?

A) The prices of identical commodity baskets, when converted to a single currency, are the same across countries.

B) The prices of identical commodity baskets, when converted to a single currency, differ substantially across countries.

C) The prices of identical commodity baskets, when converted to a single currency, do not differ substantially across countries.

D) The prices of identical commodity baskets, when converted to a single currency, are often the same across countries.

E) The prices of identical commodity baskets, when converted to a single currency, are the same across countries more than 50% of the time.

Answer: B Difficulty: Easy AACSB: Application of knowledge 4) Which of the following statements is the MOST accurate?

A) The law of one price does fare well in all recent studies.

B) The law of one price does fare well in many recent studies.

C) The law of one price sometimes fares well in recent studies.

D) The law of one price does not fare well in recent studies.

E) The law of one price has not been studied recently.

Answer: D Difficulty: Easy AACSB: Application of knowledge 5) Which of the following statements is the MOST accurate?

A) Relative PPP is not a reasonable approximation to the data.

B) Relative PPP is sometimes a reasonable approximation to the data but often performs poorly.

C) Relative PPP is sometimes a reasonable approximation to the data.

D) PPP is sometimes a reasonable approximation to the data.

E) PPP is sometimes a reasonable approximation to the data but usually performs poorly.

Answer: B Difficulty: Easy AACSB: Application of knowledge 6) Relative PPP predicts that the yen/dollar exchange rate and the relative Japan-U.S. price levels will move in proportion. In the 1980s, when Japan's price level consistently fell relative to that in the United States, A) there was a steep appreciation of the dollar against the yen, against what relative PPP predicted.

B) there was a steep depreciation of the dollar against the yen, same as what relative PPP 108 Copyright © 2023 Pearson Education, Ltd.

predicted.

C) there was a steep appreciation of the yen against the dollar, against what relative PPP predicted.

D) there was a steep appreciation of the yen against the dollar, same as what relative PPP predicted.

Answer: A Difficulty: Easy AACSB: Application of knowledge 7) What can explain the failure of relative PPP to hold in reality?

Answer: Government measures of the price level differ from country to country.

One reason for these differences is that people living in different countries spend their income in different ways.

Because of this inherent difference among countries, certain baskets will be affected more by price changes given their consumptions basket. For example, consumers in country, X, eats more fish relative to another country. More than likely, the government, upon determining a commodity basket to reflect preference, will have an overwhelming representation of fish in their basket. Any price level change in the fish market will be felt particularly by country X, and their overall price level will reflect this. Thus, changes in the relative prices of basket components can cause relative PPP to become distorted.

Difficulty: Difficult AACSB: Application of knowledge 5.5

Explaining the Problems with PPP

1) In order for the condition E$/HK$ = PUS/PHK to hold, what assumptions does the principle of purchasing power parity make?

A) Only that there are no transportation costs and restrictions on trade.

B) Only that the markets are perfectly competitive, i.e., P = MC. C) The factors of production are identical between countries.

D) No arbitrage exists.

E) HK and the U.S. are perfectly competitive and there are no transportation costs or restrictions on trade.

Answer: E Difficulty: Easy AACSB: Application of knowledge 2) The PPP theory fails in reality for all of the following reasons EXCEPT A) transport costs.

B) monopolistic or oligopolistic practices in goods markets.

C) the inflation data reported in different countries are based on different commodity baskets.

D) restrictions on trade.

E) inflation rates are unrelated to money supply growth.

Answer: E Difficulty: Easy AACSB: Application of knowledge 3) Which one of the following statements is the MOST accurate?

109 Copyright © 2023 Pearson Education, Ltd.

A) The purchasing power of any given country's currency will increase in countries where the prices of non-tradable goods rise.

B) The purchasing power of any given country's currency will fall in countries where the prices of non-tradable goods fall.

C) The purchasing power of any given country's currency will fall in countries where the prices of non-tradable goods rise.

D) The purchasing power of any given country's currency will remain constant in countries where the prices of non-tradable goods rise.

E) The purchasing power of any given country's currency will fall in countries where the prices of non-tradable goods remain constant.

Answer: C Difficulty: Easy AACSB: Application of knowledge 4) Which one of the following statements is the MOST accurate?

A) Relative price changes could not lead to PPP violations even if trade were free and costless.

B) Relative price changes could lead to PPP violations only if trade were free and costless.

C) Relative price changes could lead to PPP violations even if trade were free and costless.

D) Price changes could lead to PPP violations even if trade were free and costless.

E) Price changes could not lead to PPP violations even if trade were free and costless.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 5) Which one of the following statements is the MOST accurate?

A) Departures from PPP are similar in both the short run and long run.

B) Departures from PPP are even greater in the long run than in the short run.

C) Departures from PPP are always greater in the short run than in the long run.

D) It is hard to tell whether departures from PPP are greater in the short run than in the long run.

E) Departures from PPP may often be greater in the short run than in the long run.

Answer: E Difficulty: Easy AACSB: Application of knowledge 6) Floating exchange rates A) systematically lead to much larger but less frequent short-run deviations from the absolute PPP. B) systematically lead to much larger and more frequent short-run deviations from the relative PPP. C) systematically lead to much smaller and less frequent short-run deviations from the relative PPP. D) systematically lead to much smaller but more frequent short-run deviations from the relative PPP. E) systematically lead to much smaller and less frequent short-run deviations from the absolute PPP. Answer: B Difficulty: Easy AACSB: Application of knowledge 110 Copyright © 2023 Pearson Education, Ltd.

7) Which of the following are theories meant to explain "Why price levels are lower in poorer countries"?

A) only Bhagwati-Kravis-Lipsey B) only Balassa-Samuelson C) only Goldberg-Knetter D) Bhagwati-Kravis-Lipsey and Balassa-Samuelson E) Bhagwati-Kravis-Lipsey and Goldberg-Knetter Answer: D Difficulty: Easy AACSB: Application of knowledge 8) Does the existence of non-tradable goods allow for deviations from Purchasing power Parity?

Answer: Yes, the existence of nontradables allows deviations from PPP. This is because the price of a nontradable is determined entirely by its domestic supply and demand curves, and in turn fluctuations in demand and supply for these good will affect the price level. Examples include housing, haircut, services etc.

Difficulty: Moderate AACSB: Application of knowledge 9) What effect do non-tradable goods have on PPP? Answer: The effect is quite substantial.

In 2006, the services accounted for about 75% of the value of U.S. output. Along with haircuts, non-tradable goods include routine medical treatment, housing etc. For the most part, non-tradable goods are comprised of services, and the output of the construction industry. Non-tradable help explain much of the wide departure from PPP that is present in empirical data.

Difficulty: Moderate AACSB: Application of knowledge 10) Discuss why the empirical support for PPP and the law of one price is weak in recent data.

Answer: The failure of these propositions in the real world is related to trade barriers and departures from free competition, factors that can result in pricing to market by exporters. In addition, different definitions of price levels in different countries bedevil attempts to test PPP using the price indexes governments publish. For some products, including many services, international transport costs are so steep that these products become non-tradable (see page 425).

Difficulty: Moderate AACSB: Application of knowledge 11) Explain why price levels are lower in poorer countries.

Answer: One theory explains the difference in prices on different endowments of capital and labor (Bhagwati, Kravis, and Lipsey). The explanation is as follows: ∙ Rich countries have high capital-labor ratios while poor countries have much more labor relative to capital. ∙ Because rich countries have high capital labor ratios, the MPL is greater and thus they have a higher wage. ∙ Higher wages lead to higher disposable income, and citizens' demand for goods will increase. ∙ Because labor is cheaper in poor countries and is used intensively in producing non-tradable 111 Copyright © 2023 Pearson Education, Ltd.

goods; non-tradable goods will be cheaper in the poor countries than in the rich. ∙ The price of non-tradable goods will move with the increase in wage, thus increasing the price level of the good.

Rich Countries: Expensive Non-tradable goods vs. Poor Countries: Cheap Non-tradable goods.

Difficulty: Moderate AACSB: Application of knowledge 5.6

Beyond Purchasing Power Parity: A General Model of Long-Run Exchange Rates

1) Which of the following statements is MOST accurate?

A) The United States price level will place a relatively light weight on commodities produced and consumed in America, while the European price level will place a relatively heavy weight on commodities produced and consumed in Europe.

B) The United States price level will place a relatively light weight on commodities produced and consumed in America, and the European price level will place a relatively light weight on commodities produced and consumed in Europe.

C) The United States price level will place a relatively heavy weight on commodities produced and consumed in America, and the European price level will place a relatively heavy weight on commodities produced and consumed in Europe.

D) The United States price level will place a relatively heavy weight on commodities produced and consumed in Europe, and the European price level will place a relatively heavy weight on commodities produced and consumed in America.

E) The United States price level will place a relatively light weight on commodities produced and consumed in Europe, and the European price level will place a relatively heavy weight on commodities produced and consumed in America.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 2) When the domestic money prices of goods are held constant A) a nominal dollar appreciation makes U.S. goods cheaper compared with foreign goods.

B) a nominal dollar depreciation makes U.S. goods less appealing in foreign markets.

C) a nominal dollar appreciation does not affect the prices of U.S. goods.

D) a nominal dollar depreciation makes U.S. goods more expensive compared with foreign goods.

E) a nominal dollar depreciation makes U.S. goods cheaper compared with foreign goods and a nominal dollar appreciation makes U.S. goods more expensive compared with foreign goods.

Answer: E Difficulty: Easy AACSB: Application of knowledge 3) An increase in the world relative demand for U.S. output causes A) a short-run real depreciation of the dollar against the euro.

B) a long-run real appreciation of the dollar against the euro.

C) a long-run real depreciation of the dollar against the euro.

D) a short-run real appreciation of the euro against the dollar.

E) a long-run real appreciation of the euro against the dollar.

Answer: B 112 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Easy AACSB: Application of knowledge 4) A decrease in the world relative demand for U.S. output causes A) a long-run real depreciation of the dollar against the euro.

B) a short-run real appreciation of the euro against the dollar.

C) a short-run real depreciation of the dollar against the euro.

D) a long-run real appreciation of the euro against the dollar.

Answer: A Difficulty: Easy AACSB: Application of knowledge 5) Which of the following statements is MOST accurate?

A) A relative expansion of U.S. output causes a long-run depreciation of the dollar against the euro, while a relative expansion of European output causes a long-run real appreciation of the dollar against the euro.

B) A relative decline of U.S. output causes a long-run depreciation of the dollar against the euro, while a relative expansion of European output causes a long-run real appreciation of the dollar against the euro.

C) A relative expansion of U.S. output causes a long-run appreciation of the dollar against the euro, while a relative expansion of European output causes a long-run real depreciation of the dollar against the euro.

D) A relative expansion of U.S. output causes a long-run depreciation of the dollar against the euro, while a relative decline of European output causes a long-run real appreciation of the dollar against the euro.

E) A relative decline of U.S. output causes a long-run depreciation of the dollar against the euro, while a relative decline of European output causes a long-run real appreciation of the dollar against the euro.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 6) When all variables start out at their long-run equilibrium levels, the most important determinants of long-run swings in nominal exchange rates do NOT include A) a shift in relative money supply levels.

B) a shift in relative money supply growth rates.

C) a change in relative output demand.

D) a change in relative output supply.

E) a change in relative inflation rates.

Answer: E Difficulty: Difficult AACSB: Application of knowledge 7) Which of the following statements is MOST accurate?

A) In the output market, an increase in demand for U.S. output leads to an increase in the long-run nominal dollar/euro exchange rate.

B) In the output market, an increase in the demand for European output leads to an increase in the 113 Copyright © 2023 Pearson Education, Ltd.

long-run nominal dollar/euro exchange rate.

C) In the output market, a decrease in demand for U.S. output leads to a decrease in the long-run nominal dollar/euro exchange rate.

D) In the output market, an increase in the demand for European output leads to a decrease in the long-run nominal dollar/euro exchange rate.

E) In the output market, an increase in the demand for European output leads to an increase in the long-run nominal euro/dollar exchange rate.

Answer: B Difficulty: Moderate AACSB: Application of knowledge 8) Which of the following statements is MOST accurate?

A) In the money market, an increase in U.S. money supply level leads to a proportional increase in the long-run nominal dollar/euro exchange rate.

B) In the money market, an increase in European money supply level leads to a proportional increase in the long-run nominal dollar/euro exchange rate.

C) In the money market, an increase in U.S. money supply growth rate leads to a decrease in the long-run nominal dollar/euro exchange rate.

D) In the money market, an increase in European money supply growth leads to an increase in the long-run nominal dollar/euro exchange rate.

E) In the money market, an increase in U.S. money supply level leads to a proportional decrease in the long-run nominal dollar/euro exchange rate.

Answer: A Difficulty: Easy AACSB: Application of knowledge 9) In the long run A) exchange rates obey relative PPP when all disturbances occur in the output markets.

B) exchange rates obey absolute PPP when all disturbances occur in the output markets.

C) exchange rates are unlikely to obey relative PPP when all disturbances occur in the output markets.

D) exchange rates are unlikely to obey relative PPP when all disturbances are monetary in nature.

E) exchange rates obey absolute PPP when all disturbances are monetary in nature.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 10) In the long run A) exchange rates obey absolute PPP when all disturbances are monetary in nature.

B) exchange rates obey relative PPP when all disturbances occur in the output markets.

C) exchange rates obey absolute PPP when all disturbances occur in the output markets.

D) exchange rates are unlikely to obey relative PPP when all disturbances occur in the output markets.

E) exchange rates are unlikely to obey relative PPP when all disturbances are monetary in nature.

Answer: A Difficulty: Easy AACSB: Application of knowledge 114 Copyright © 2023 Pearson Education, Ltd.

11) Which of the following statements is the MOST accurate about the Law of One Price on Scandinavian ferry lines?

A) Due to menu costs, the Law of One Price does not hold.

B) To avoid arbitrage opportunities, the Law of One Price must hold.

C) Transaction costs of exchanging currency causes the Law of One Price to fail.

D) Transportation costs between ferry lines leads to a violation of the Law of One Price.

E) The physical distance allowed the Law of One Price to hold.

Answer: C Difficulty: Easy AACSB: Application of knowledge 12) What are the predictions of the PPP theory with regards to the real exchange rates?

Answer: The real exchange rate between two countries is a broad summary measure of the prices of one country's goods and services relative to the other's. PPP predicts that the real exchange rate never permanently changes, which is different from nominal exchange rates that deals with the relative price of two currencies.

Difficulty: Moderate AACSB: Application of knowledge 13) What is the real exchange rate between the dollar and the euro equal to?

Answer: Let ∙ Real dollar/euro exchange rate = ∙ Nominal exchange rate = ∙ Price of an unchanging basket in US = Pus ∙ Price of an unchanging basket in Europe = PE Then, =( × PE)/PUS A rise in the real dollar/euro exchange rate is called a real depreciation of the dollar against the euro, a fall in purchasing power of the dollar.

A fall in the real dollar/euro exchange rate is called a real appreciation of the dollar against the euro, a rise in purchasing power of the dollar.

Difficulty: Difficult AACSB: Application of knowledge 14) Define the concept of the real exchange rate and explain how it differs from the nominal exchange rate.

Answer: In general, the real exchange rate between two countries' currencies is the price of the second country's commodity basket (in terms of the first country's currency) relative to the price of the first country's commodity basket. For example, in the case of U.S. and Europe, the real dollar/euro exchange rate is the dollar value of Europe's price level divided by the U.S. price level.

We can thus denote the real dollar/euro exchange rate ( =(

) as:

× PE)/PUS 115 Copyright © 2023 Pearson Education, Ltd.

where is the nominal dollar/euro exchange rate, PE is Europe's price level, and PUS is the U.S. price level. Unlike the real exchange rate, which is the relative price of two output baskets, the nominal exchange rate is the relative price of two currencies. However, as we can see from the equation above, real exchange rates are defined in terms of nominal exchange rates.

Difficulty: Difficult AACSB: Application of knowledge 15) Describe the chain of events leading to exchange rate determination for the following cases: (a) An increase in U.S. money supply (d) Increase in growth rate of U.S. money supply (c) Increase in world relative demand for U.S. products (d) Increase in relative U.S. output supply Answer: Chain of events leading to exchange rate determination: = × (Pus/PE) Increase in U.S. money supply: Pus rises in proportion to the money supply; q remains the same.

All dollar prices will rise (including dollar price of euro).

Increase in growth rate of U.S. money supply: Inflation rate, dollar interest rate, Pus, E, rises in proportion to Pus. Increase in world relative demand for U.S. products: E falls, and q does as well.

Increase in relative U.S. output supply: Dollar depreciates, lowers relative price of U.S. output, rise in q, effect on E is not clear since q and Pus work in opposite directions.

Difficulty: Difficult AACSB: Application of knowledge 16) Construct a table that will summarize the effects of money market and output market changes on the long-run nominal dollar/euro exchange rate Answer:

Difficulty: Difficult AACSB: Application of knowledge 5.7

International Interest Rate Differences and the Real Exchange Rate

1) Interest rate differences between countries depend on A) differences in expected inflation, but not on expected changes in the real exchange rate.

B) differences in expected changes in the real exchange rate, but not on expected inflation.

C) neither differences in expected inflation, nor on expected changes in the real exchange rate.

116 Copyright © 2023 Pearson Education, Ltd.

D) differences in expected inflation and nothing else.

E) differences in expected inflation, and on expected changes in the real exchange rate.

Answer: E Difficulty: Easy AACSB: Application of knowledge 2) The expected rate of change in the nominal dollar/euro exchange rate is best described as A) the expected rate of change in the real dollar/euro exchange rate minus the U.S.-Europe expected inflation difference.

B) the expected rate of change in the real dollar/euro exchange rate plus the U.S.-Europe real interest rate difference.

C) the expected rate of change in the real dollar/euro exchange rate plus the U.S.-Europe expected inflation difference.

D) the expected rate of change in the real dollar/euro exchange rate minus the U.S.-Europe real interest rate difference.

E) the expected rate of change in the real dollar/euro exchange rate plus the European expected inflation.

Answer: C Difficulty: Easy AACSB: Application of knowledge 3) The expected change in the real dollar/euro exchange rate is A) the expected change in the nominal dollar/euro exchange rate minus the U.S.-Europe expected inflation difference.

B) the expected change in the nominal dollar/euro exchange rate plus the U.S.-Europe expected inflation difference.

C) the expected change in the nominal dollar/euro exchange rate minus the real interest rate difference.

D) the expected change in the nominal dollar/euro exchange rate plus the real interest rate difference.

Answer: A Difficulty: Easy AACSB: Application of knowledge 4) If the expected rate of real dollar depreciation against the euro is 1 percent per year, and the expected inflation difference between the United States and Europe is 5 percent per year, the dollar/euro interest difference will be percent.

A) 6 B) 4 C) 3 D) 2 E) 1 Answer: A Difficulty: Easy AACSB: Application of knowledge 5.8

Real Interest Parity 117 Copyright © 2023 Pearson Education, Ltd.

1) Nominal interest rates are A) rates of return measured in monetary terms.

B) rates of return measured in terms of a country's output.

C) rates of return measured in PPP terms.

D) rates of return after taking inflation into account.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) Real interest rates are A) rates of return measured in terms of a country's output.

B) rates of return measured in monetary terms.

C) rates of return measured in PPP terms.

D) rates of return before taking inflation into account.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) The expected real interest rate (re) in terms of the nominal interest rate (R) and the expected inflation rate (πe) is given by A) re = πe + R. B) re = 2πe + R2.

C) re = πe + R2.

D) re = R - πe.

E) re = R2 - πe.

Answer: D Difficulty: Easy AACSB: Application of knowledge 4) The difference between nominal and real interest rates is that A) nominal interest rates are measured in terms of a country's output, while real interest rates are measured in monetary terms.

B) nominal interest rates are measured in monetary terms, while real interest rates are measured in terms of a country's output.

C) nominal interest rates can fluctuate, while real interest rates always remain fixed.

D) real interest rates can fluctuate, while nominal interest rates always remain fixed.

E) real interest rates are the same in every country, while nominal interest rates are different for every country.

Answer: B Difficulty: Easy AACSB: Application of knowledge 5) What is the real interest rate parity condition?

Answer: Real Interest Parity Condition: (

-

)=(

-

118 Copyright © 2023 Pearson Education, Ltd.

)/

Difficulty: Moderate AACSB: Application of knowledge 6) Is a depreciation of the dollar/euro exchange rate correlated with a decrease in the dollar return on U.S. deposits? Explain your answer.

Answer: No. Assume that the Interest Parity is maintained, i.e., R$ =

+(

-

)/

Holding constant, one would expect a depreciation of the dollar/euro exchange rate (i.e. increase in ) to be correlated with a decrease in R$, dollar returns on euro deposits. However, the higher expected inflation in the U.S. implies an increase in the to euro exchange rate. Thus, the quantity (

-

)/

, the expected future dollar

goes up and, increases despite a

depreciation in the current dollar to euro exchange rate, .

Difficulty: Difficult AACSB: Application of knowledge 5.9 Appendix to Chapter 5: The Fisher Effect, the Interest Rate, and the Exchange Rate Under the Flexible-Price Monetary Approach 1) The monetary approach to interest rates assumes that the prices of goods are implies that a country's currency will , when nominal interest rates expected future inflation.

A) perfectly flexible; depreciate; increase; higher B) perfectly flexible; appreciate; increase; higher C) immutable; depreciate; increase; higher D) immutable; appreciate; decrease; higher E) absolutely inflexible; depreciate; decrease; higher Answer: A Difficulty: Moderate AACSB: Application of knowledge 2) When the nominal dollar interest rate price level will .

A) increases; decrease; increase B) increases; increase; increase C) increases; decrease; decrease D) increases; increase; decrease E) decreases; increase; increase Answer: A Difficulty: Easy AACSB: Application of knowledge

, money demand will

, which because of

, and the general

3) To answer the following question, please refer to the figure below. Concentrating only at the lower right quadrant, discuss the effects of a change in U.S. expected inflation.

119 Copyright © 2023 Pearson Education, Ltd.

Answer: The lower right quadrant shows the equilibrium in the U.S. Money Market, where =

/

A given interest rate

corresponds with a given U.S. real money supply,

/

.

Consider a rise of ΔΠ in the future rate of U.S money supply growth (i.e. an increase in the expected rate of inflation).

The Key point: The rise in expected future inflation generates expectations of more rapid currency depreciation in the future.

Under PPP the dollar now depreciates at a rate of Π+ΔΠ. Interest parity therefore requires the dollar interest rate to rise where = Note: R$ -

+ ΔΠ (Point 2 in the figure.) =

-

120 Copyright © 2023 Pearson Education, Ltd.

This relation shows a change in the U.S. interest rate due to an increase in expected U.S. inflation has no effect on the euro interest rate.

The rise in the interest rate from

to

creates a monetary excess supply of real U.S. money

balances at the prevailing price level P1. However, since under this Monetary Approach, prices are assumed to be flexible, prices will immediately adjust from P1 to P2, thus causing the following two effects: One, reducing real money supply and two, bringing U.S. money market back into equilibrium.

Difficulty: Difficult AACSB: Application of knowledge 4) To answer the following question, please refer to the figure below. Concentrating only at the lower left quadrant, discuss the relationship between the U.S. real money supply and the dollar/euro exchange rate, E$/E.

Answer: The lower left quadrant in the figure described the Purchasing Power Parity (PPP) relationship. The relationship between the U.S. real money supply and the dollar/euro exchange 121 Copyright © 2023 Pearson Education, Ltd.

rate, E$/E is negative. is equal to the price level ratio, PUS/ .

In this derivation of the relationship, the following variables are assumed constants: and So,

,

,

. =

/PUS PUS ↑ →

↑

→ Thus, the purchasing power of the dollar decreases due to the increase in the price level. → i.e., dollar depreciates due to PPP Difficulty: Difficult AACSB: Application of knowledge 5) To answer the following question, please refer to the figure below. Concentrating only at the upper right quadrant, discuss the foreign exchange market equilibrium.

122 Copyright © 2023 Pearson Education, Ltd.

Answer: The upper right quadrant describes the equilibrium in the foreign exchange market.

We begin with the Interest Parity Condition.

R$ =

+(

-

)/

In general, two effects are present: →

and

→

A rise in the interest rate normally creates an excess demand for dollar deposits and appreciation in the currency market.

However, in this case the increase is due to higher expected inflation or higher expected monetary growth in the U.S. which implies a faster expected depreciation of the dollar against the euro, , thus,

goes up and thus reduced the attractiveness of U.S. deposits.

Difficulty: Difficult AACSB: Application of knowledge International Finance: Theory & Policy, 12/e, Global Edition Chapter 6 Output and the Exchange Rate in the Short Run 123 Copyright © 2023 Pearson Education, Ltd.

6.1

Determinants of Aggregate Demand in an Open Economy

1) What is the best way to describe aggregate demand?

A) quantity required to satisfy equilibrium B) net export demand C) amount of a country's goods and services demanded by households and firms throughout the world D) individual's demand E) domestic demand of foreign imports Answer: C Difficulty: Easy AACSB: Application of knowledge 2) In the short-run, a country's overall output level depends on ; in the long-run, domestic output depends only on .

A) aggregate demand for its products; the available domestic supplies of factors of production such as labor and capital B) the available domestic supplies of factors of production such as labor and capital; aggregate demand for its products C) aggregate supply for its products; aggregate demand for its products D) the available domestic supplies of factors of production such as labor and capital; aggregate supply for its products Answer: A Difficulty: Easy AACSB: Application of knowledge 3) Aggregate demand for an open economy's output is the sum of A) consumption demand, investment demand, government demand, net export demand.

B) investment demand, government demand, the current account.

C) consumption demand, government demand, investment demand.

D) current account, government demand, investment demand.

Answer: A Difficulty: Easy AACSB: Application of knowledge 4) Disposable income is defined as A) Y - C. B) Y - T. C) C - T. D) I - C. E) Y - I. Answer: B Difficulty: Easy AACSB: Application of knowledge 5) Disposable income equals 124 Copyright © 2023 Pearson Education, Ltd.

A) national income minus taxes.

B) present income plus expected future income.

C) national income minus consumption.

D) investment minus consumption.

E) consumption minus taxes.

Answer: A Difficulty: Easy AACSB: Application of knowledge 6) Which one of the following statements is MOST accurate?

A) Factors of production can only be over-employed in the short run.

B) Factors of production can only be under-employed in the short run.

C) Factors of production can be over- or under-employed in the long run.

D) Factors of production can be over- or under-employed in the short run.

E) Factors of production are fully employed in the short run.

Answer: D Difficulty: Easy AACSB: Application of knowledge 7) Why is the economy at full employment in the long run?

A) Only wages have the ability to adjust.

B) Only price can adjust.

C) Prices don't adjust.

D) Wages and the price level eventually adjust to full employment equilibrium levels.

E) Government policies eventually converge on the full employment strategy.

Answer: D Difficulty: Easy AACSB: Application of knowledge 8) Which one of the following statements is MOST accurate?

A) In the long run, foreign output depends only on the available domestic supplies of factors of production.

B) In the short run, domestic output depends only on the available domestic supplies of factors of production.

C) In the long run, domestic output depends only on the available domestic supplies of factors of production.

D) In the long run and in the short run, domestic output depends only on the available domestic supplies of factors of production.

E) In the long run, domestic output depends only on the real exchange rate.

Answer: C Difficulty: Easy AACSB: Application of knowledge 9) Consumption level can be written as a function of A) disposable income.

B) investment income.

C) government income.

125 Copyright © 2023 Pearson Education, Ltd.

D) exports income.

Answer: A Difficulty: Easy AACSB: Application of knowledge 10) Consumption and disposable income are A) positively related.

B) negatively related.

C) completely unrelated.

D) randomly related.

Answer: A Difficulty: Easy AACSB: Application of knowledge 11) Because each consumer demands , consumption will A) more; rises; increase; increases B) less; rises; decrease; increases C) more; lowers; increase; decreases D) more; lowers; decrease; increases Answer: A Difficulty: Easy AACSB: Application of knowledge

goods and services as his or her real income as disposable income at the aggregate level.

12) The current account balance is A) the supply of a country's exports less the country's own demand for imports.

B) the demand for a country's exports plus the country's own demand for imports.

C) the country's own demand for imports less the demand for a country's exports.

D) the demand for a country's exports less the country's own demand for imports.

E) the country's federal reserves minus the national debt.

Answer: D Difficulty: Easy AACSB: Application of knowledge 13) The domestic currency price of a representative foreign expenditure basket is A) P, the domestic price level.

B) E, the nominal exchange rate.

C) P times E, the domestic price level times the domestic price level.

D) P , the foreign price level.

E) P times E, the foreign price level times the nominal exchange rate.

Answer: E Difficulty: Moderate AACSB: Application of knowledge 14) The domestic currency price of a representative domestic expenditure basket is A) P, the domestic price level.

B) E, the nominal exchange rate.

C) P times E, the domestic price level times the domestic price level.

126 Copyright © 2023 Pearson Education, Ltd.

D) P , the foreign price level.

E) P times E, the foreign price level times the nominal exchange rate.

Answer: A Difficulty: Easy AACSB: Application of knowledge 15) The real exchange rate, q, is defined as A) the price of the foreign basket in terms of the domestic one.

B) the price of the domestic basket in terms of the foreign one.

C) the price of the foreign basket.

D) the price of the domestic basket.

E) the nominal exchange rate in terms of the domestic basket.

Answer: A Difficulty: Easy AACSB: Application of knowledge 16) The real exchange rate is A) how much of a foreign currency you can buy with the domestic currency.

B) foreign CPI divided by the domestic CPI. C) the price of foreign goods in terms of domestic goods.

D) the price of foreign goods in dollars.

E) the domestic currency divided by the price level.

Answer: C Difficulty: Easy AACSB: Application of knowledge 17) A country's domestic currency's real exchange rate, q, is best described by A) the price of similar goods in the same market.

B) the price of the domestic basket in terms of the foreign one.

C) the price of a domestic basket.

D) the price of the foreign basket in terms of the domestic basket.

E) the price of different goods baskets in the same market.

Answer: D Difficulty: Easy AACSB: Application of knowledge 18) A country's domestic currency's real exchange rate, q, is defined as A) E. B) E times P. C) E times P .

D) (E times P )/P. E) P/(E times P ).

Answer: D Difficulty: Easy AACSB: Application of knowledge 19) If the representative basket of European goods and services costs 40 euros, the representative 127 Copyright © 2023 Pearson Education, Ltd.

U.S. basket costs $50, and the dollar/euro exchange rate is $0.90 per euro, then the price of the European basket in terms of U.S. basket is A) [(0.9 $/euro) (40 euro per a European basket)]/[(50 $/U.S. basket)].

B) [(0.9 $/euro) (50 $/U.S. basket)]/[(40 euro per a European basket)].

C) [(40 euro per a European basket)]/[(50 $/U.S. basket) (0.9 $/euro)].

D) [(50 $/U.S. basket)].

E) [(0.9 $/euro) (40 euro per a European basket) (50 $ U.S. basket)].

Answer: A Difficulty: Moderate AACSB: Application of knowledge 20) If the representative basket of European goods and services costs 40 euros, the representative U.S. basket costs $50, and the dollar/euro exchange rate is $1.10 per euro, then the price of the European basket in terms of U.S. basket is A) 0.88.

B) 0.80.

C) 1.38.

D) 1.25.

Answer: A Difficulty: Easy AACSB: Application of knowledge 21) Current account is given by the equation: A) CA = IM - EX (measured in terms of domestic output).

B) CA = IM - EX (measured in terms of foreign output).

C) CA = EX - IM (measured in terms of domestic output).

D) CA = EX - IM (measured in terms of foreign output).

E) CA = EX + IM (measured in terms of domestic output).

Answer: C Difficulty: Easy AACSB: Application of knowledge 22) A in the price of the foreign basket in terms of domestic baskets will be associated with a in the relative price of foreign output in general relative to domestic output.

A) rise; rise B) rise; fall C) fall; rise D) fall; no change E) rise; no change Answer: A Difficulty: Easy AACSB: Application of knowledge 23) How does an increase in the real exchange rate affect exports and imports?

A) exports increase; imports decrease B) exports decrease; imports increase C) exports increase; imports change ambiguously 128 Copyright © 2023 Pearson Education, Ltd.

D) exports change ambiguously; imports decrease E) exports increase; imports are constant Answer: C Difficulty: Easy AACSB: Application of knowledge 24) When EP /P rises A) IM will rise.

B) IM will fall.

C) IM may rise or fall.

D) IM is not affected.

E) IM and P* will both rise.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 25) When the real exchange rate rises A) imports measured in terms of domestic output will rise.

B) imports measured in terms of domestic output will fall.

C) imports measured in terms of domestic output will never be affected.

D) imports measured in terms of domestic output may rise or fall.

E) imports measured in terms of foreign output will rise.

Answer: D Difficulty: Moderate AACSB: Application of knowledge 26) An increase in the real exchange rate A) makes imports more expensive.

B) makes imports less expensive.

C) does not affect import values.

D) always makes the number of imports rise.

E) makes domestic consumers spend more on only foreign imports.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 27) Which of the following compete to determine whether the current account improves or worsens following a rise in the real exchange rate?

A) appreciation and depreciation B) crowding out effect and producers effect C) volume effect and value effect D) volume effect and inflation E) producers effect and value effect Answer: C Difficulty: Easy AACSB: Application of knowledge 129 Copyright © 2023 Pearson Education, Ltd.

28) Assuming that the volume effect outweighs the value, the current account will increase if A) the real exchange rate decreases.

B) the real exchange rate increases.

C) disposable income increases.

D) exports fall.

E) domestic prices fall.

Answer: B Difficulty: Easy AACSB: Application of knowledge 29) What have we assumed when we conclude that a real depreciation of the currency improves the current account?

A) The volume effect outweighs the value effect.

B) The value effect outweighs the volume effect.

C) All else equal and the volume effect outweighs the value effect.

D) All else equal and the value effect outweighs the volume effect.

E) All else equal and the volume effect equals the value effect.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 30) What have we assumed when we conclude that a real appreciation of the currency worsens the current account?

A) All else equal and the volume effect outweighs the value effect.

B) The value effect outweighs the volume effect.

C) The volume effect outweighs the value effect.

D) All else equal and the value effect outweighs the volume effect.

E) All else equal and the volume effect equals the value effect.

Answer: A Difficulty: Easy AACSB: Application of knowledge 31) If a dollar depreciation lowers the relative cost of producing in the United States, A) the German auto manufacturer BMW can shift production from Germany to its Spartanburg, South Carolina.

B) the German auto manufacturer BMW can shift production from Spartanburg, South Carolina to Germany.

C) the German auto manufacturer BMW can shift production from Spartanburg, South Carolina to outside the U.S. D) the German auto manufacturer BMW can shift production from Germany to non-U.S. locations.

Answer: A Difficulty: Easy AACSB: Application of knowledge 32) Which one of the following statements is the MOST accurate?

A) An increase in disposable income improves the current account.

130 Copyright © 2023 Pearson Education, Ltd.

B) An increase in disposable income does not affect the current account.

C) An increase in disposable income worsens the current account.

D) An increase in income worsens the current account.

E) An increase in income improves the current account.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 33) Which one of the following statements is the MOST accurate?

A) An increase in the real exchange rate and an increase in disposable income improve the current account.

B) A decrease in the real exchange rate and a decrease in disposable income improve the current account.

C) A decrease in the real exchange rate and an increase in disposable income improve the current account.

D) An increase in the real exchange rate and a decrease in disposable income improve the current account.

E) An increase in the real exchange rate and a decrease in disposable income lowers the current account.

Answer: D Difficulty: Moderate AACSB: Application of knowledge 34) Which of the following would cause the current account to decrease?

A) an increase in the nominal exchange rate, E B) an appreciation of the home currency C) an increase in disposable income D) an increase in foreign prices, P E) a decrease in domestic prices, P Answer: C Difficulty: Easy AACSB: Application of knowledge 35) Find the real exchange rate for the following case: Assume that the representative basket of European goods and services costs 40 euros and the representative U.S. basket costs $50, and the dollar/euro exchange rate is $0.90 per euro, then the price of the European basket in terms of U.S. basket is .

Answer: [(0.9 $/euro) (40 euro per a European basket)]/[(50 $/U.S. basket)] = 0.72 U.S. basket/European basket.

Difficulty: Moderate AACSB: Application of knowledge 36) Find the real exchange rate for the following case: Assume that the representative basket of European goods costs 150 euros and the representative U.S. basket costs $90, and the dollar/euro exchange rate is $0.80 per euro, then the price of the European basket in terms of U.S. basket is .

Answer: [(0.80 $/euro) (150 euro per a European basket)]/[(90 $/U.S. basket)] = 1.33 U.S. 131 Copyright © 2023 Pearson Education, Ltd.

baskets/European basket.

Difficulty: Moderate AACSB: Application of knowledge 37) Find the real exchange rate for the following case: Assume that the representative basket of European goods costs 150 euros and the representative U.S. basket costs $200, and the dollar/euro exchange rate is $1.20 per euro, then the price of the European basket in terms of U.S. basket is .

Answer: [(1.20 $/euro) (150 euro per a European basket)]/[(200 $/U.S. basket)] = 0.9 U.S. baskets/European basket.

Difficulty: Moderate AACSB: Application of knowledge 38) Find the real exchange rate for the following case: Assume that the representative basket of European goods costs 100 euros and the representative U.S. basket costs $125, and the dollar/euro exchange rate is $0.75 per euro, then the price of the European basket in terms of U.S. basket is .

Answer: [(0.75 $/euro) (100 euro per a European basket)]/[(125 $/U.S. basket)] = 0.60 U.S. baskets/European basket.

Difficulty: Moderate AACSB: Application of knowledge 39) Fill in the following table.

Answer:

132 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Moderate AACSB: Application of knowledge 40) Fill in the following table.

Answer:

Difficulty: Moderate AACSB: Application of knowledge 41) What is the real exchange rate? What is its relationship to the current account?

Answer: Defined as: EP /P (the exchange rate multiplied by foreign prices, divided by domestic prices).

While the nominal exchange rate measures how much of a foreign currency one can buy with a unit of domestic currency, the real exchange rate measures how many goods and services one could buy.

A rise in the real exchange rate (a depreciation of domestic currency) means that domestic goods are cheaper compared to foreign goods, so exports increase and imports may increase or decrease.

Difficulty: Moderate AACSB: Application of knowledge 42) Explain how does an increase in the real exchange rate affect exports and imports?

Answer: When the real exchange rate increases, domestic products are cheaper relative to foreign products. Due to this, exports increase as foreigners demand more of our exports. The change in 133 Copyright © 2023 Pearson Education, Ltd.

imports is ambiguous because fewer units of imports are purchased (the volume effect), but each foreign unit is now more expensive (the value effect). Remember: exports and imports are measured in terms of domestic output, i.e. dollar value, not volume of units.

Difficulty: Moderate AACSB: Application of knowledge 43) Please discuss the volume effect and the value effect in regards to how the current account will move given a change in the real exchange rate.

Answer: The volume effect takes place when consumer spending shifts on export and import quantities, while the value effect results when the domestic output worth of a given amount of foreign imports is changed. It is assumed that the volume effect outweighs the value effect, so that, other things equal, a real depreciation of the currency improves the current account.

Difficulty: Difficult AACSB: Application of knowledge 6.2

The Equation of Aggregate Demand

1) Aggregate demand for home output can be written as a function of A) the real exchange rate, disposable income, investment demand, and government spending.

B) the nominal exchange rate, disposable income, investment demand, and government spending.

C) the real exchange rate, before tax income, investment demand, and government spending.

D) the nominal exchange rate, disposable income, consumer demand, and government spending.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) Which of the following statements is TRUE? A) A rise in EP*/P makes domestic goods and services cheaper relative to foreign goods and services and shifts both domestic and foreign spending from foreign goods to domestic goods.

B) A fall in EP*/P makes domestic goods and services cheaper relative to foreign goods and services and shifts both domestic and foreign spending from foreign goods to domestic goods.

C) A rise in EP*/P makes domestic goods and services more expensive relative to foreign goods and services and shifts both domestic and foreign spending from domestic goods to foreign goods.

D) A fall in EP*/P makes domestic goods and services more expensive relative to foreign goods and services and shifts both domestic and foreign spending from domestic goods to foreign goods.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) A real of the home currency raises aggregate demand for home output, other things equal; a real lowers aggregate demand for home output.

A) depreciation; appreciation B) appreciation; depreciation C) appreciation; appreciation D) depreciation; depreciation Answer: A Difficulty: Easy 134 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 4) A real depreciation of the home currency aggregate demand for home output, other things equal; a real appreciation aggregate demand for home output.

A) raises; lowers B) lowers; raises C) raises; raises D) lowers; lowers Answer: A Difficulty: Easy AACSB: Application of knowledge 5) With no trade and finance exchange barriers, which of the following statements is TRUE? A) A real depreciation of the home currency raises aggregate demand for home output, other things equal; a real appreciation lowers aggregate demand for home output.

B) A real depreciation of the home currency lowers aggregate demand for home output, other things equal; a real appreciation raises aggregate demand for home output.

C) A real appreciation of the home currency raises aggregate demand for home output, other things equal; a real depreciation lowers aggregate demand for home output.

D) A real appreciation or depreciation of the home currency has no effect on aggregate demand for home output.

Answer: A Difficulty: Easy AACSB: Application of knowledge 6) How does a rise in real income affect aggregate demand?

A) Y ↑ implies Yd ↑ implies IM ↑ implies CA ↓ implies AD ↓, but Y ↑ implies Yd ↑ implies C ↑ implies AD ↑ by more.

B) Y ↑ implies Yd ↑ implies IM ↓ implies CA ↓ implies AD ↓, but Y ↑ implies Yd ↑ implies C ↑ implies AD ↑ by more.

C) Y ↑ implies Yd ↑ implies IM ↑ implies CA ↑ implies AD ↑, and Y ↑ implies Yd ↑ implies C ↑ implies AD ↑.

D) Y ↑ implies Yd ↑ implies IM ↑ implies CA ↓ implies AD ↓, but Y ↑ implies Yd ↑ implies C ↑ implies AD ↑ by less.

E) Y ↑ implies Yd ↑ implies IM ↓ implies CA ↓ implies AD ↓, but Y ↑ implies Yd ↑ implies C ↑ implies AD ↑ by less.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 7) Which one of the following statements is the MOST accurate?

A) A rise in domestic real income raises aggregate demand for home output.

B) A rise in domestic real income decreases aggregate demand for home output because of the increase demand for import.

C) A rise in domestic real income keeps aggregate demand for home output at the same level.

D) It is difficult to tell whether a rise in domestic real income affects positively or negatively aggregate demand for home output.

E) A rise in domestic real income decreases aggregate demand for home output because the CA is 135 Copyright © 2023 Pearson Education, Ltd.

raised.

Answer: A Difficulty: Easy AACSB: Application of knowledge 8) What is an accurate implication resulting from an increase in income?

A) an increase in exchange rate B) a decrease in exchange rate C) a decrease in consumption D) a decrease in output E) an increase in consumption Answer: E Difficulty: Easy AACSB: Application of knowledge 9) Which one of the following statements is MOST accurate?

A) In general, consumption demand rises by less than disposable income.

B) In general, consumption demand rises by more than disposable income.

C) In general, consumption demand rises by more than income.

D) In general, consumption demand rises by the same amount as disposable income rises.

E) In general, consumption demand rises are unrelated to disposable income rises.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 10) Explain the difference between the following two expressions: Y = C(Yd) + I + G + CA(EP /P, Yd) and Y = C + I +G + CA Answer: The first one represents a behavioral equation and thus may express equilibrium condition for the output market or the aggregate desired demand for output. The second equation is only an identity that is always true.

Difficulty: Moderate AACSB: Application of knowledge 11) Explain how a rise in real exchange rate affects aggregate demand.

Answer: A rise in EP*/P makes domestic goods and services cheaper relative to foreign goods and services and shifts both domestic and foreign spending from foreign goods to domestic goods.

As a result, CA rises and aggregate demand, D, therefore goes up.

Difficulty: Easy AACSB: Application of knowledge 12) Explain how does a rise in real income affect aggregate demand?

Answer: A rise in domestic real income, Y, leads to a rise in disposable income, Yd. This raises the spending on imports, IM, thus lowering the current account, CA, and reducing aggregate demand, AD. However, the rise in Yd also causes a rise in consumption, C, and raises aggregate demand, AD, by more than the corresponding decrease.

Difficulty: Moderate 136 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 13) Refer to Figure 6-1, explain why the slope of the aggregate demand function is less than 1.

Answer: Aggregate demand is a function of the real exchange rate (EP*/P), disposable income (Y — T), investment demand (I), and government spending (G). If all other factors remain unchanged, a rise in output (real income), Y, increases aggregate demand. As Y rises, consumption rises by a fraction of the increase in income. Part of this increase in consumption, moreover, goes into import spending. The effect of an increase in Y on the aggregate demand for home output is therefore smaller than the accompanying rise in consumption demand, which is smaller, in turn, than the increase in Y. Therefore, the slope of the aggregate demand function is less than 1 (as indicated by its position within the 45-degree angle).

Difficulty: Moderate AACSB: Application of knowledge 6.3

How Output Is Determined in the Short Run

1) Which of the following equations does NOT state a condition required for equilibrium output?

A) Y = C(Yd) + I + G + CA(EP*/P,Yd) B) Y = C(Y - T) + I + G + CA(EP*/P,Y - T) C) Y = D(EP*/P,Y - T,I,G) D) R = R* + (EP/E) E) Y = D(EP*/P,Yd,I,G) Answer: D Difficulty: Difficult AACSB: Application of knowledge 2) The unique equilibrium output level in the short run is found at the intersection of the following curves.

A) aggregate demand and aggregate supply B) aggregate demand and 45 degree line C) aggregate supply and 45 degree line D) aggregate demand and short-run aggregate supply E) aggregate supply and long-run demand Answer: B Difficulty: Easy AACSB: Application of knowledge 3) In the short run, we assume that the money prices of goods and services are A) temporarily fixed.

B) permanently fixed.

C) allowed to fluctuate.

D) equal to long-run prices.

E) fully employed.

Answer: A Difficulty: Easy AACSB: Application of knowledge 137 Copyright © 2023 Pearson Education, Ltd.

4) What would be the best description of what we assume about money prices in the short run?

A) Money prices of goods and services vary.

B) Money prices of goods and services are not related to each other.

C) Money prices of goods are fixed.

D) Money prices of services are fixed.

E) Money prices of goods and services are only temporarily fixed.

Answer: E Difficulty: Easy AACSB: Application of knowledge 5) Assume money prices of goods and services are temporarily fixed, explain how national output is determined in the short-run.

Answer: The output market is in equilibrium when real domestic output, Y, equals the aggregate demand for domestic output. In Figure 6-2, it is the intersection (at point 1) of the aggregate demand schedule and a 45-degree line drawn from the origin (the equation D = Y) gives us the unique output level Y1 at which aggregate demand equals domestic output.

Difficulty: Easy AACSB: Application of knowledge 6.4

Output Market Equilibrium in the Short Run: The DD Schedule

1) The economy as a whole is in equilibrium only A) when both the output market and the asset markets are in equilibrium.

B) when the asset markets are in equilibrium.

C) when the output market is in equilibrium.

D) when neither the output market nor the asset markets are in equilibrium.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) The DD schedule shows all combinations of which 2 variables so that the output market is in equilibrium?

A) imports and exports B) exports and the exchange rate C) foreign prices and the exchange rate D) output and the exchange rate E) output and exports Answer: D Difficulty: Easy AACSB: Application of knowledge 3) How would you define a DD schedule?

A) the combinations of output and the exchange rate that must hold when the home money market and the foreign exchange market are in equilibrium B) the combinations of output and the exchange rate that must hold when the output market is in short-run equilibrium C) factors of production in the long run 138 Copyright © 2023 Pearson Education, Ltd.

D) the aggregate demand in relation to the foreign market value E) the currency depreciation in relation to the exchange rate Answer: B Difficulty: Easy AACSB: Application of knowledge 4) In the short run, any rise in the real exchange rate, EP /P, will cause A) an upward shift in the aggregate demand function and a reduction in output.

B) an upward shift in the aggregate demand function and an expansion of output.

C) a downward shift in the aggregate demand function and an expansion of output.

D) an downward shift in the aggregate demand function and a reduction in output.

E) an upward shift in the aggregate demand function but leaves output intact.

Answer: B Difficulty: Easy AACSB: Application of knowledge 5) In the short run, any fall in EP /P, regardless of its causes, will cause A) an upward shift in the aggregate demand function and an expansion of output.

B) an upward shift in the aggregate demand function and a reduction in output.

C) a downward shift in the aggregate demand function and an expansion of output.

D) an downward shift in the aggregate demand function and a reduction in output.

E) an upward shift in the aggregate demand function but leaves output intact.

Answer: D Difficulty: Easy AACSB: Application of knowledge 6) Which of the following does NOT affect the position of the DD curve?

A) monetary policy B) government spending C) taxes D) export demand E) price levels Answer: A Difficulty: Easy AACSB: Application of knowledge 7) Temporary tax cuts would cause A) the AA-curve to shift downward.

B) the AA-curve to shift upward.

C) the DD-curve to shift to the left.

D) the DD-curve to shift to the right.

E) a shift in the AA-curve, although the direction is ambiguous.

Answer: D Difficulty: Easy AACSB: Application of knowledge 8) A rise in government demand would cause 139 Copyright © 2023 Pearson Education, Ltd.

A) the DD-curve to shift to the right.

B) the AA-curve to shift downward.

C) the AA-curve to shift upward.

D) the DD-curve to shift to the left.

E) a shift in the AA-curve, although the direction is ambiguous.

Answer: A Difficulty: Easy AACSB: Application of knowledge 9) A fall in government demand would cause A) the DD-curve to shift to the left.

B) the AA-curve to shift downward.

C) the AA-curve to shift upward.

D) the DD-curve to shift to the right.

Answer: A Difficulty: Easy AACSB: Application of knowledge 10) An increase in taxes would cause A) the DD-curve to shift to the left.

B) the AA-curve to shift downward.

C) the AA-curve to shift upward.

D) the DD-curve to shift to the right.

Answer: A Difficulty: Easy AACSB: Application of knowledge 11) An increase in investment demand would cause A) the DD-curve to shift to the right.

B) the AA-curve to shift downward.

C) the AA-curve to shift upward.

D) the DD-curve to shift to the left.

Answer: A Difficulty: Easy AACSB: Application of knowledge 12) An increase in domestic price level makes domestic output more expensive relative to foreign output and lowers net export demand, therefore this will shift A) the DD-curve to the left.

B) the AA-curve downward.

C) the AA-curve upward.

D) the DD-curve to the right.

Answer: A Difficulty: Easy AACSB: Application of knowledge 13) An increase in foreign price P* makes foreign goods and services relatively more expensive, 140 Copyright © 2023 Pearson Education, Ltd.

therefore this will shift A) the DD-curve to the right.

B) the AA-curve downward.

C) the AA-curve upward.

D) the DD-curve to the left.

Answer: A Difficulty: Easy AACSB: Application of knowledge 14) An autonomous fall in domestic consumption, if it is not entirely due to a fall in import demand, will shift A) the DD-curve to the left.

B) the AA-curve downward.

C) the AA-curve upward.

D) the DD-curve to the right.

Answer: A Difficulty: Easy AACSB: Application of knowledge 15) A shift in world demand away from domestic products and toward foreign products causes A) the DD-curve to shift to the left.

B) the AA-curve to shift downward.

C) the AA-curve to shift upward.

D) the DD-curve to shift to the right.

Answer: A Difficulty: Easy AACSB: Application of knowledge 16) Which of the following is the MOST accurate?

A) Any disturbance that lowers aggregate demand for domestic output shifts the DD schedule to the right.

B) Any disturbance that lowers aggregate demand for foreign output shifts the DD schedule to the left.

C) Any disturbance that raises aggregate demand for domestic output shifts the DD schedule to the right.

D) Any disturbance that raises aggregate demand for domestic output shifts the DD schedule to the left.

E) Any disturbance that lowers aggregate demand for domestic output shifts the DD schedule downward.

Answer: C Difficulty: Easy AACSB: Application of knowledge 17) Which of the following is the MOST accurate?

A) Any disturbance that lowers aggregate demand for domestic output shifts the DD schedule to the right.

B) Any disturbance that lowers aggregate demand for domestic output shifts the DD schedule to 141 Copyright © 2023 Pearson Education, Ltd.

the left.

C) Any disturbance that raises aggregate demand for domestic output shifts the DD schedule to the left.

D) Any disturbance that lowers aggregate demand for domestic output shifts the DD schedule downward.

Answer: B Difficulty: Easy AACSB: Application of knowledge 18) List the main factors affecting the position of the DD schedule.

Answer: The level of government demand, taxes, and investment; the domestic and foreign price levels; variations in domestic consumption behavior; and the foreign demand for home output.

Difficulty: Easy AACSB: Application of knowledge 19) Give 4 examples of situations that would cause the DD-curve to shift to the left.

Answer: Correct answers include any situations that involve: (1) a decrease in government spending (e.g., decrease in military spending) (2) an increase in taxes (3) a fall in Investment demand (4) a price increase, which would lower net export demand (assuming E and P stay constant) (5) a fall in foreign prices (assuming E and P stay constant) (6) an autonomous fall in consumption demand (as long as it is not entirely a change in import demand) (7) a shift to demanding more foreign goods at the expense of domestic good demand Difficulty: Moderate AACSB: Application of knowledge 20) Explain what are the factors that shift the DD Schedule.

Answer: A change in government demand, change in taxes, a change in investment, change in domestic prices, change in foreign prices, changes in the consumption function and a demand shift between foreign and domestic goods.

Difficulty: Moderate AACSB: Application of knowledge 6.5

Asset Market Equilibrium in the Short Run: The AA Schedule

1) The interest parity condition states that the foreign exchange market is in equilibrium only when A) the expected rates of return on domestic and foreign currency deposits are equal.

B) the expected rates of return on domestic and foreign currency deposits are different.

C) the expected rates of return on domestic currency deposits are higher than those on foreign currency deposits.

D) the expected rates of return on foreign currency deposits are higher than those on domestic currency deposits.

Answer: A Difficulty: Easy AACSB: Application of knowledge 142 Copyright © 2023 Pearson Education, Ltd.

2) What best describes the slope of the AA schedule?

A) It is derived by the schedule of interest rate and output combinations that are consistent with equilibrium in the domestic money market and the foreign exchange market.

B) It is derived by the schedule of exchange rate and output combinations that are consistent with equilibrium in the foreign money market and the domestic exchange market.

C) It is derived by the schedule of exchange rate and output combinations that are consistent with equilibrium in the domestic money market and the foreign exchange market.

D) It is derived by the schedule of exchange rate and output combinations that are consistent with equilibrium in the domestic bond market and the foreign asset market.

E) It is derived by the schedule of exchange rate and output combinations that are greater than equilibrium in the foreign money market and the domestic exchange market.

Answer: C Difficulty: Easy AACSB: Application of knowledge 3) What best describes the slope of the AA schedule?

A) The AA schedule has a positive slope because an increase in output leads to a depreciation of the currency.

B) The AA schedule has a negative slope because an increase in output leads to a decrease in the domestic interest rate.

C) The AA schedule has a negative slope because an increase in output leads to an increase in the domestic interest rate and a domestic currency appreciation.

D) The AA schedule has a positive slope because an increase in the money supply leads to an increase in the domestic interest rate.

E) The AA schedule has a positive slope because a decrease in output leads to a depreciation of the currency.

Answer: C Difficulty: Easy AACSB: Application of knowledge 4) The interest parity condition requires that A) all countries have the same interest rate.

B) there is a unique exchange rate for every output level.

C) purchasing power parity hold.

D) interest rates are fixed in the short run.

E) the money supply is held constant.

Answer: B Difficulty: Easy AACSB: Application of knowledge 5) Which one of the following statements is the MOST accurate?

A) For asset markets to remain in equilibrium, a rise in domestic output must be accompanied by a depreciation of domestic currency, all else equal.

B) For asset markets to remain in equilibrium, a fall in domestic output must be accompanied by a depreciation of foreign currency, all else equal.

C) For asset markets to remain in equilibrium, a rise in domestic output must be accompanied by 143 Copyright © 2023 Pearson Education, Ltd.

an appreciation of domestic currency, all else equal.

D) For asset markets to remain in equilibrium, a fall in domestic output must be accompanied by an appreciation of domestic currency, all else equal.

E) For asset markets to remain in equilibrium, a fall in domestic output must be accompanied by an appreciation of foreign currency, all else equal.

Answer: C Difficulty: Easy AACSB: Application of knowledge 6) Assume the asset market is always in equilibrium. Therefore, a rise in Y would result in A) an appreciation of the home currency.

B) higher inflation abroad.

C) a decreased demand for domestic products.

D) a contraction of the money supply.

E) a depreciation of the home currency.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 7) Assume the asset market is always in equilibrium. Therefore, a fall in Y would result in A) an depreciation of the home currency.

B) higher inflation abroad.

C) a decreased demand for domestic products.

D) a contraction of the money supply.

E) an appreciation of the home currency.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 8) Assume the asset market is always in equilibrium. An increase in domestic money supply Ms causes A) the AA-curve to shift upward.

B) the DD-curve to the right.

C) the AA-curve to shift downward.

D) the DD-curve to the left.

Answer: A Difficulty: Easy AACSB: Application of knowledge 9) Assume the asset market is always in equilibrium. An increase in P causes A) the AA-curve to shift downward.

B) the DD-curve to the right.

C) the AA-curve to shift upward.

D) the DD-curve to the left.

Answer: A Difficulty: Easy AACSB: Application of knowledge 144 Copyright © 2023 Pearson Education, Ltd.

10) Assume the asset market is always in equilibrium. A rise in the expected future exchange rate causes A) the AA-curve to shift upward.

B) the DD-curve to the right.

C) the AA-curve to shift downward.

D) the DD-curve to the left.

Answer: A Difficulty: Easy AACSB: Application of knowledge 11) Assume the asset market is always in equilibrium. A fall in R* causes A) the AA-curve to shift downward.

B) the DD-curve to the right.

C) the AA-curve to shift upward.

D) the DD-curve to the left.

Answer: A Difficulty: Easy AACSB: Application of knowledge 12) Assume the asset market is always in equilibrium. An increase in money demand causes A) the AA-curve to shift upward.

B) the DD-curve to the right.

C) the AA-curve to shift downward.

D) the DD-curve to the left.

Answer: A Difficulty: Easy AACSB: Application of knowledge 13) Explain how the AA schedule is derived.

Answer: For a fixed real money supply, an increase in output leads to an increase in the domestic interest rate. In the foreign exchange market, an increase in the domestic interest rate leads to a lower nominal exchange rate, thus appreciating the currency. Therefore, the relationship between nominal exchange rate and output is negative; this leads to a negative slope of the AA schedule, which has the nominal exchange rate and output on its axes.

Difficulty: Moderate AACSB: Application of knowledge 14) List the main factors affecting the position of the AA schedule.

Answer: Changes in the domestic money supply; changes in the domestic price level; changes in the expected future exchange rate; changes in the foreign interest rate; and shifts in the aggregate real money demand schedule.

Difficulty: Easy AACSB: Application of knowledge 15) What is the AA-curve? Why does it have a negative slope? What factors cause it to shift?

Answer: The AA-curve is the specific levels of E and Y under which the money and foreign 145 Copyright © 2023 Pearson Education, Ltd.

exchange markets are in equilibrium.

The AA-curve has a negative slope because an increase in Y will cause E to fall (a domestic currency appreciation).

The factors that affect it are: the money supply, price level, expected exchange rate, foreign interest rates, and the level of real money demand.

Difficulty: Moderate AACSB: Application of knowledge 16) Explain what are the factors that shift the AA Schedule?

Answer: Changes in the domestic money supply; changes in the domestic price level; changes in the expected future exchange rates; changes in the foreign interest rate and shifts in the aggregate real money demand.

Difficulty: Moderate AACSB: Application of knowledge 6.6

Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together

1) Which of the following have to be in equilibrium for the economy to be in equilibrium?

A) the money market only B) the goods market only C) the output and asset markets D) the savings and investment markets E) the goods and output markets Answer: C Difficulty: Easy AACSB: Application of knowledge 2) Imagine that the economy is at a point that is above both AA and DD, where both the output and asset markets are out of equilibrium. Which first action is TRUE? A) The economy will stay at this level in the short run.

B) The exchange rate will first drop to a point on the AA schedule.

C) The exchange rate will first move to a point on the DD schedule.

D) The AA-DD equilibrium will shift to the position of the economy.

E) The exchange rate will first move left to a position on the AA schedule.

Answer: B Difficulty: Moderate AACSB: Application of knowledge 3) Why does an exchange rate-output combination lying above both DD and AA jump first to AA in equilibrium?

A) Asset prices can adjust immediately.

B) Production plans can adjust immediately.

C) to preserve full employment D) Prices are nominal and demand is real.

E) Aggregate demand adjusts faster than output.

Answer: A Difficulty: Moderate 146 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 4) Imagine that the economy is at a point that is below both AA and DD, where both the output and asset markets are out of equilibrium. Which first action is TRUE? A) The economy will stay at this level in the short run.

B) The exchange rate will first rise to a point on the AA schedule.

C) The exchange rate will first rise to a point on the DD schedule.

D) The AA-DD equilibrium will shift to the position of the economy.

E) The output level will first increase to a position on the DD schedule.

Answer: B Difficulty: Difficult AACSB: Application of knowledge 5) Assume the output market adjusts more rapidly than the asset market. A point of disequilibrium that is below both AA and DD will therefore initially result in A) an increase in output.

B) a decrease in output.

C) a contraction of the money supply.

D) a depreciation of the home currency.

E) an appreciation of the home currency.

Answer: B Difficulty: Difficult AACSB: Application of knowledge 6) Explain how an increase in government spending would affect the DD-AA schedule in the short run.

Answer: An increase in government spending will increase aggregate demand, which will shift the DD to the right. If AA remains unchanged, the new equilibrium will be at a higher Y and lower E. Since E is the nominal exchange rate, a lower E is an appreciation of the currency.

Difficulty: Moderate AACSB: Application of knowledge 7) Imagine that the economy is at a point on the DD-AA schedule that is above both AA and DD and where both the output and asset markets are out of equilibrium. Explain what will happen next?

Answer: Since the asset market adjusts very quickly, the exchange rate drops immediately to a point on the AA schedule. There will be excess demand for the domestic currency because the high expected future appreciation rate of the domestic currency implies that the expected domestic currency return on foreign deposits is below that on domestic deposits. This excess demand leads to an immediate fall in the exchange rate.

Difficulty: Moderate AACSB: Application of knowledge 8) Use a figure to study the following question: Imagine that the economy is at a point on the DD-AA schedule that is above both AA and DD, where both the output and asset markets are out of equilibrium. Explain what will happen next.

Answer: Since the asset market adjusts very quickly, the exchange rate drops immediately to a 147 Copyright © 2023 Pearson Education, Ltd.

point on the AA schedule. There will be excess demand for the domestic currency because the high expected future appreciation rate of the domestic currency implies that the expected domestic currency return on foreign deposits is below that on domestic deposits. This excess demand leads to an immediate fall in the exchange rate.

The figure:

Difficulty: Moderate AACSB: Application of knowledge 6.7

Temporary Changes in Monetary and Fiscal Policy

1) In the short run, a temporary increase in money supply A) shifts the DD curve to the right, increases output and appreciates the currency.

B) shifts the AA curve downward, increases output and depreciates the currency.

C) shifts the AA curve downward, decreases output and depreciates the currency.

D) shifts the AA curve downward, increases output and appreciates the currency.

E) shifts the AA curve upward, increases output and depreciates the currency.

Answer: E Difficulty: Moderate AACSB: Application of knowledge 2) In the short run, a temporary decrease in money supply A) shifts the AA curve downward, decreases output and appreciates the currency.

B) shifts the AA curve downward, increases output and depreciates the currency.

C) shifts the DD curve to the right, increases output and appreciates the currency.

D) shifts the AA curve downward, increases output and appreciates the currency.

E) shifts the AA curve upward, increases output and depreciates the currency.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 3) In the short run, with prices fixed, how would an increase in government spending affect the DD-AA equilibrium?

A) It will increase output and appreciate the currency.

B) It will increase output and depreciate the currency.

148 Copyright © 2023 Pearson Education, Ltd.

C) It will decrease output and appreciate the currency.

D) It will decrease output and depreciate the currency.

E) It will increase output and have no effect on the currency.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 4) In the short run, an increase in government purchases will cause A) a shift of the DD curve to the left and an increase in output.

B) a shift of the DD curve to the right and a decrease in output.

C) a shift of the DD curve to the left and a decrease in output.

D) a shift of the DD curve to the right and an increase in output.

E) a shift of the DD curve the left and an appreciation of the currency.

Answer: D Difficulty: Moderate AACSB: Application of knowledge 5) In the short run, a decrease in government purchases will cause A) a shift of the DD curve to the left and a decrease in output.

B) a shift of the DD curve to the right and a decrease in output.

C) a shift of the DD curve to the left and an increase in output.

D) a shift of the DD curve to the right and an increase in output.

E) a shift of the DD curve the left and an appreciation of the currency.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 6) In the short run, a tax increase A) shifts the DD curve to the right, increases output and appreciates the currency.

B) shifts the AA curve downward, increases output and depreciates the currency.

C) shifts the AA curve downward, decreases output and depreciates the currency.

D) shifts the AA curve downward, increases output and appreciates the currency.

E) shifts the DD curve to the left, decreases output and depreciates the currency.

Answer: E Difficulty: Moderate AACSB: Application of knowledge 7) In the short run, a tax decrease A) shifts the DD curve to the right, increases output and appreciates the currency.

B) shifts the AA curve downward, increases output and depreciates the currency.

C) shifts the AA curve downward, decreases output and depreciates the currency.

D) shifts the AA curve downward, increases output and appreciates the currency.

E) shifts the DD curve to the left, decreases output and depreciates the currency.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 149 Copyright © 2023 Pearson Education, Ltd.

8) Using the DD-AA framework, which one of the following statements is the MOST accurate?

A) Only monetary policy can bring the economy to full employment.

B) Only fiscal policy can bring the economy to full employment.

C) Only both monetary and fiscal policies can bring the economy to full employment.

D) Both policies are capable of bringing the economy to full employment and low inflation.

E) Monetary policy by itself or fiscal policy by itself can bring the economy to full employment.

Answer: E Difficulty: Moderate AACSB: Application of knowledge 9) Monetary expansion causes the current account balance to increase in the short run. Discuss. Is the same the case for fiscal expansion?

Answer: An increase in the money supply leads to an increase in Y and E (output increases and the currency depreciates, respectively). Because of the currency depreciation, domestic goods are now cheaper compared to foreign goods. Exports increase and imports decrease, therefore the CAB increases.

An expansion of fiscal policy actually reduces the CAB: the DD curve is shifted right. Therefore Y rises, but E falls (output rises but the currency appreciates.) Domestic goods are more expensive, and the CAB falls.

Difficulty: Difficult AACSB: Application of knowledge 10) What are two ways the government can maintain full employment in an open economy? Also give an example for each.

Answer: There are two types of government policy, monetary and fiscal policy. Examples of monetary policy are changes in the money supply. Examples of fiscal policy are changes in government spending or taxes.

Difficulty: Moderate AACSB: Application of knowledge 11) Using a figure show that under full employment, a temporary fiscal expansion would increase output (over-employment) but cannot increase output in the long run.

Answer: A temporarily fiscal expansion will move the economy from DD1 to DD2, and output increases. A permanent fiscal expansion will also shift the AA curve downward. The nominal exchange rate appreciates, i.e. E decreases.

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Difficulty: Moderate AACSB: Application of knowledge 6.8

Inflation Bias and Other Problems of Policy Formulation

1) The outcome of the government's expansionary monetary policy that leads to high inflation without average gain in output is called A) inflation bias.

B) over inflation.

C) hyper inflation.

D) discrete inflation.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) A government concerned about the exchange rate effect of its policy response needs to know before it can choose between monetary and fiscal policy.

A) the source of the disturbance B) the output market equilibrium C) the asset market equilibrium D) inflation bias Answer: A Difficulty: Easy AACSB: Application of knowledge 3) Real-world policy choices are frequently determined by rather than by detailed consideration of whether shocks to the economy originate in the output or asset markets.

A) bureaucratic necessities B) political bias C) public consensus D) voting process 151 Copyright © 2023 Pearson Education, Ltd.

Answer: A Difficulty: Easy AACSB: Application of knowledge 4) To avoid procedural delays, governments are likely to respond to disturbances by changing even when a shift in would be more appropriate.

A) monetary policy; fiscal policy B) fiscal policy; monetary policy C) trade policy; investment policy D) tax policy; trade policy Answer: A Difficulty: Easy AACSB: Application of knowledge 5) What is inflation bias? What measures have governments taken to avoid it?

Answer: Inflation bias is caused when a government is expected to use policy tools to create an economic expansion (such as before an election). Because it is expected, wages and therefore prices are increased. If the government did not pursue the expansionary policy then, there would be a recession! Inflation is increased without the advantage of an increase in output.

Making the central bank independent of the political government is one answer to avoid inflation bias.

Difficulty: Moderate AACSB: Application of knowledge 6) Explain and give some examples of governmental policy problems.

Answer: Steady nominal prices give government the power to raise output when it is low. It can also cause them to create a tool that can be used for an economic boom. An example is just before an election. The temptation can be a problem when workers and companies expect it in advance.

This will cause a rise in wage demand and prices in the expected expansionary policies. An inflation bias causing high inflation but no average gains in output is also a problem. Others are the difficulty in showing the sources or time of economic changes, and time lags in implementing policies. Impact on the government budget by fiscal policy also causes problems by the way of a tax cut; increase in spending may lead to a government budget deficit that must sooner or later be closed by a fiscal reversal. Policy problems that seem to act quickly have actually a lag time with varying lengths.

Difficulty: Moderate AACSB: Application of knowledge 7) Discuss the impact of fiscal policy on government budget.

Answer: Tax cut or spending increase may lead to a larger government budget deficit, which must sooner or later be closed by a fiscal reversal, as happened following the multibillion-dollar fiscal stimulus package sponsored by the Obama administration in the United States in 2009.

Unfortunately, there is no guarantee the government will have the political will to synchronize these actions with the state of the business cycle.

Difficulty: Easy AACSB: Application of knowledge 152 Copyright © 2023 Pearson Education, Ltd.

8) Compared with monetary policy, what are the disadvantages of using fiscal policy?

Answer: Shifts in fiscal policy often can be made only after lengthy legislative deliberation, while monetary policy is usually exercised expeditiously by the central bank. Another problem with fiscal policy is its impact on the government budget. A tax cut or spending increase may lead to a larger government budget deficit, which must sooner or later be closed by a fiscal reversal.

Difficulty: Moderate AACSB: Application of knowledge 9) A naive implication of the DD-AA framework is that either fiscal or monetary policy can lead to full employment. Discuss why this view is naive.

Answer: (1) Inflation may arise without any gain in output if the government misuses its power to print money.

(2) In practice, it is sometimes hard to be sure whether a disturbance to the economy originates in the output or assets markets.

(3) Shifts in fiscal policy often can be made only after lengthy legislative deliberations.

Governments are likely to respond to disturbances by changing the monetary policy even when a shift in fiscal policy would be more appropriate.

(4) Fiscal policy impacts the government budget and may lead to government budget deficit that must sooner or later be closed by a fiscal reversal. The state of the electoral cycle may be more important.

(5) Policies operate in reality with lags of varying length.

Difficulty: Difficult AACSB: Application of knowledge 6.9

Permanent Shifts in Monetary and Fiscal Policy

1) In long-run equilibrium after a permanent money-supply increase there follows A) an increase in exchange rate, E. B) a decrease in exchange rate, E. C) an increase in output, Y. D) a decrease in output, Y. E) an unchanged exchange rate, E. Answer: A Difficulty: Moderate AACSB: Application of knowledge 2) A permanent increase in the domestic money supply A) must ultimately lead to a proportional decrease in E, and, therefore, the expected future exchange rate must rise proportionally.

B) must ultimately lead to a proportional decrease in E, and, therefore, the expected future exchange rate must decrease proportionally.

C) must ultimately lead to a proportional rise in E, and, therefore, the expected future exchange rate must rise proportionally.

D) must ultimately lead to a proportional rise in E, and, therefore, the expected future exchange rate must rise more than proportionally.

E) must ultimately lead to a proportional rise in E, and, therefore, the expected future exchange 153 Copyright © 2023 Pearson Education, Ltd.

rate must rise less than proportionally.

Answer: C Difficulty: Difficult AACSB: Application of knowledge 3) In the short run, a permanent increase in the domestic money supply causes A) a greater rightward shift in the DD curve than that caused by an equal, but transitory, increase.

B) a greater downward shift in the AA curve than that caused by an equal, but transitory, increase.

C) a smaller upward shift in the AA curve than that caused by an equal, but transitory, increase.

D) a smaller downward shift in the AA curve than that caused by an equal, but transitory, increase.

E) a greater upward shift in the AA curve than that caused by an equal, but transitory, increase.

Answer: E Difficulty: Difficult AACSB: Application of knowledge 4) In the short run, a permanent increase in the domestic money supply A) has stronger effects on the exchange rate and output than an equal temporary increase.

B) has stronger effects only on the exchange rate but not on output than an equal temporary increase.

C) has weaker effects on the exchange rate and output than an equal temporary increase.

D) has stronger effects on output, but lower effect on the exchange rate than an equal temporary increase.

E) has weaker effects only on the exchange rate than an equal temporary increase.

Answer: A Difficulty: Difficult AACSB: Application of knowledge 5) Which one of the following statements is the MOST accurate?

A) Over time, the inflationary pressure that follows a temporary money supply expansion pushes the price level to its long-run value and returns the economy to full employment.

B) Over time, the inflationary pressure that follows a permanent money supply expansion pushes the price level to its long-run value and returns the economy to full employment.

C) Over time, the inflationary pressure that follows a temporary money supply expansion pushes the price level to its long-run value, but leaves the economy in a state of artificially low employment.

D) Over time, the inflationary pressure that follows a permanent money supply expansion pushes the price level to its long-run value, but leaves the economy in a state of artificially low employment.

E) Over time, the inflationary pressure that follows a permanent money supply expansion pushes the price level beyond its long-run value and lower the level of employment.

Answer: B Difficulty: Moderate AACSB: Application of knowledge 6) Which one of the following statements is the MOST accurate?

A) A permanent increase in the money supply cannot have any short-run effects.

B) A permanent increase in taxes cannot have any short-run effects.

154 Copyright © 2023 Pearson Education, Ltd.

C) A permanent decrease in the money supply cannot have short-run effects.

D) A permanent decrease in taxes cannot have short-run effects.

E) A permanent increase in money demand can be offset with a permanent increase in the money supply of equal magnitude.

Answer: E Difficulty: Moderate AACSB: Application of knowledge 7) If the economy starts in long-run equilibrium, a permanent fiscal expansion will cause A) an increase in exchange rate, E. B) a decrease in exchange rate, E. C) an increase in output, Y. D) a decrease in output, Y. E) shifting of the AA curve up and to the right.

Answer: B Difficulty: Moderate AACSB: Application of knowledge 8) A permanent fiscal expansion A) shifts the DD to the right and the AA schedule upward, increasing output.

B) shifts the DD to the left and the AA schedule upward, decreasing output.

C) shifts the DD to the right and the AA schedule downward, leaving output the same.

D) shifts the DD to the left and the AA schedule downward, decreasing output.

E) shifts the DD to the left and the AA schedule downward, leaving output the same.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 9) Show the effects of a permanent increase in the money supply.

Answer: (1) AA-shifts upward-increase in Y and E both higher than if money supply change was temporary, rising price level makes AD decrease, DD shifts left (2) rising prices also reduce real money supply, so AA shifts downward (although not all the way back to original position) (3) AA and DD reach short-run equilibrium at an E that is higher than initially, but lower than the short-run effects of the shift.

(4) Output returns to initial level because higher prices reversed the effect of the initial depreciation on Aggregate Demand.

Difficulty: Moderate AACSB: Application of knowledge 10) Explain the following figure:

155 Copyright © 2023 Pearson Education, Ltd.

Answer: The figure depicts the effect of a permanent increase in the money supply starting from full employment equilibrium. After the initial increase in the money supply and the move of the AA curve upward from AA1 to AA2, a steadily increasing price level shifts the AA downward and the DD schedule to the left until a new long-run equilibrium is reached. Note that point 3 is above point 1, because Ee is permanently higher after a permanent increase in the money supply. The expected exchange rate, Ee, has risen by the same percentage as Ms. Notice that along the adjustment path between the initial short-run equilibrium (point 2) and the long-run equilibrium (point 3) the domestic currency actually appreciates (from E2 to E3) following its initial sharp depreciation (from E1 to E2).

Difficulty: Difficult AACSB: Application of knowledge 11) Using the DD-AA framework, show the phenomenon of overshooting. Use a figure to explain when it is taking place.

Answer: The figure below shows the phenomenon of overshooting. A permanent increase in the money supply starting from full employment equilibrium will shift the AA curve upward from AA1 to AA2. Now, a steadily increasing price level shifts the AA downward and the DD schedule to the left until a new long-run equilibrium is reached. Note that point 3 is above point 1, because Ee is permanently higher after a permanent increase in the money supply. The expected exchange rate, Ee, has risen by the same percentage as Ms. Notice that along the adjustment path between the initial short-run equilibrium (point 2) and the long-run equilibrium (point 3) the domestic currency actually appreciates (from E2 to E3) following its initial sharp depreciation (from E1 to E2). This exchange rate behavior is an example of overshooting, in which the exchange rate's initial response to some change is greater than its long-run response.

156 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Difficult AACSB: Application of knowledge 12) Demonstrate how a permanent fiscal expansion will not increase output in the long run.

Answer: (1) E on Y-axis, Y on X-axis (2) DD shifts right (3) temporary equilibrium where E lower and Y increased (4) permanent increase in demand caused by increase in G causes currency to appreciate: AA shifts downward (5) therefore Y returns to original levels, E decreases even more RESULT of permanent fiscal expansion: currency appreciation, output does not change. This effect is called "crowding out."

Difficulty: Difficult AACSB: Application of knowledge 13) Using the DD model, explain what happens to output when Government demands increase.

Use a figure to explain when it is taking place.

Answer: The figure below shows the G1 to G2 raises output at every level of the exchange rate.

The change shifts the DD to the right, which, in turn, increases output to Y2.

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Difficulty: Difficult AACSB: Application of knowledge 6.10

Macroeconomic Policies and the Current Account

1) Policy makers are often concerned about the level of the current account. An excessive imbalance in the current account—either a surplus or a deficit— A) may have undesirable long-run effects on national welfare.

B) will have no effects on national welfare C) may turn a country into a developed or less developed one D) will have no effects on aggregate demand Answer: A Difficulty: Easy AACSB: Application of knowledge 2) What can large external imbalances generate?

A) Political pressures for governments to impose restrictions on trade.

B) Political pressures for governments to remove restrictions on trade.

C) Political pressures for governments to make the country more open to trade.

D) Political pressures for governments to switch to a self-sufficient economy without trade.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) Which of the following is TRUE of the current account balance?

A) Monetary expansion has no effect on the current account balance.

B) Monetary expansion decreases the current account balance.

C) Fiscal expansion increases the current account balance.

D) Fiscal expansion has no effect on the current account balance.

E) Monetary expansion increases the current account balance.

Answer: E Difficulty: Moderate AACSB: Application of knowledge 158 Copyright © 2023 Pearson Education, Ltd.

4) Which statement best describes the current account balance in the short run?

A) Monetary expansion lowers the current account balance.

B) Monetary expansion keeps the current account balance the same.

C) Fiscal expansion increases the current account balance.

D) Fiscal expansion keeps the current account balance the same.

E) Monetary expansion increases the current account balance.

Answer: E Difficulty: Moderate AACSB: Application of knowledge 5) In the short run A) monetary expansion causes the CA to increase and fiscal expansion causes the CA to decrease.

B) monetary expansion causes the CA to decrease and fiscal expansion causes the CA to decrease.

C) monetary expansion causes the CA to increase and fiscal expansion causes the CA to increase.

D) monetary expansion causes the CA to decrease and fiscal expansion causes the CA to increase.

E) monetary expansion causes the CA to increase and the effects of fiscal expansion are ambiguous.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 6) Which statement describes most accurately how fiscal policies affect current account?

A) Expansionary fiscal policy reduces the current account balance.

B) Expansionary fiscal policy expands the current account balance.

C) Expansionary fiscal policy has no effect on the current account balance.

D) Expansionary fiscal policy either reduces or expands the current account balance.

Answer: A Difficulty: Easy AACSB: Application of knowledge 6.11

Gradual Trade Flow Adjustment and Current Account Dynamics

1) The J-curve illustrates which of the following?

A) the effects of depreciation on the home country's economy B) the immediate increase in current account caused by a currency depreciation C) the gradual adjustment of home prices to a currency depreciation D) the short-term effects of depreciation on the current account E) the Keynesian view of international trade dynamics Answer: D Difficulty: Easy AACSB: Application of knowledge 2) The J-curve illustrates which of the following?

A) the time lag with which a real currency depreciation improves the current account B) the effects of depreciation on the home country's economy C) the immediate increase in current account caused by a currency depreciation 159 Copyright © 2023 Pearson Education, Ltd.

D) the gradual adjustment of home prices to a currency depreciation E) the Keynesian view of international trade dynamics Answer: A Difficulty: Easy AACSB: Application of knowledge 3) Empirical evidence indicates for most industrial countries a J-curve lasting more than but less than . Then the current account continues to improve afterward.

A) six months; a year B) a year; two years C) two years; five years D) three months; six months Answer: A Difficulty: Easy AACSB: Application of knowledge 4) The percent by which import prices rise when the home currency depreciates by 1% is the degree of A) pass-forward from exchange rates to import prices.

B) pass-through from exchange rates to import prices.

C) pass-on from exchange rates to import prices.

D) roll-forward from exchange rates to import prices.

E) pass-beyond from exchange rates to import prices.

Answer: B Difficulty: Easy AACSB: Application of knowledge 5) In practice, many U.S. import prices tend to rise by only around A) 1/4 of a typical dollar depreciation over the following year.

B) 1/3 of a typical dollar depreciation over the following year.

C) 1/2 of a typical dollar depreciation over the following year.

D) 2/3 of a typical dollar depreciation over the following year.

E) 2/5 of a typical dollar depreciation over the following year.

Answer: C Difficulty: Easy AACSB: Application of knowledge 6) A phenomenon in which different countries produce a portion of the value added in a final product is called A) global value chains.

B) international production sharing.

C) multinational outsourcing chains.

D) intermediation production offshoring.

Answer: A Difficulty: Easy AACSB: Application of knowledge 160 Copyright © 2023 Pearson Education, Ltd.

7) Imported value that accounts for a significant portion of the gross value of exports is called linkages.

A) backward B) forward C) value added D) intermediate Answer: A Difficulty: Easy AACSB: Application of knowledge 8) A country's exports may go on to be incorporated as inputs into several rounds of exports from other countries, this key aspect of global value chains is called A) forward linkages.

B) backward linkages.

C) value linkages.

D) intermediate linkages.

Answer: A Difficulty: Easy AACSB: Application of knowledge 9) Which of the following statements is TRUE? A) There is strong evidence that more complex global value chains go hand in hand with larger volumes of both imports and exports.

B) There is no evidence that more complex global value chains go hand in hand with larger volumes of both imports and exports.

C) There is strong evidence that more complex global value chains go hand in hand with smaller volumes of both imports and exports.

D) There is strong evidence that less complex global value chains go hand in hand with larger volumes of both imports and exports.

Answer: A Difficulty: Easy AACSB: Application of knowledge 10) A permanent fiscal expansion would cause A) an appreciation of currency and a current account deficit.

B) an appreciation of currency and a current account surplus.

C) a depreciation of currency and a current account surplus.

D) a depreciation of currency and a current account deficit.

Answer: A Difficulty: Easy AACSB: Application of knowledge 11) The net foreign wealth of an economy with a A) deficit; falling B) surplus; falling C) deficit; rising D) surplus; unchanged

is

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over time.

Answer: A Difficulty: Easy AACSB: Application of knowledge 12) Which currency is not only the key vehicle currency in the global foreign exchange market but also the dominant invoice currency?

A) the U.S. dollar B) the Euro C) the Japanese Yen D) the British Pound Answer: A Difficulty: Easy AACSB: Application of knowledge 13) Because a country with a current account deficit is transferring wealth to foreigners, domestic consumption is over time and foreign consumption is .

A) falling; rising B) falling; falling C) rising; falling D) rising; rising Answer: A Difficulty: Easy AACSB: Application of knowledge 14) Describe a J Curve.

Answer: The time lag with which real currency depreciation improves the current account. The current account is measured in terms of domestic output, and can drop quickly right after real currency depreciation because most import and export orders are placed several months in advance. In the first few months after the depreciation, export and import volumes therefore may reflect buying decisions that were made on the basis of the old real exchange rate.

Difficulty: Moderate AACSB: Application of knowledge 15) Define global value chains and describe its key aspects.

Answer: A web of complex global value chains is something in which different countries produce portions of the value added in a final product. Under these arrangements, one country's value added may cross borders many times at successive production stages before reaching its ultimate buyer. Two key aspects of global value chains include backward linkages and forward linkages.

Difficulty: Easy AACSB: Application of knowledge 16) What are forward and backward linkages? Discuss their implications for the effects of exchange rate changes on export and import prices?

Answer: When imported value accounts for a significant portion of the gross value of exports, it is called backward linkages. When a country's exports may go on to be incorporated as inputs into several rounds of exports from other countries, it is called forward linkages.

162 Copyright © 2023 Pearson Education, Ltd.

Assume that the pass-through of an exchange rate change to import prices is complete, that is, when a country's currency depreciates, its import prices rise immediately in proportion to the depreciation. If the country has strong backward linkages, however, that assumption means that the price of the intermediate imports used to produce its exports will rise. As a result, the depreciation will have only a partial effect in lowering the export prices it charges to its trading partners.

Forward linkages work in the same direction on the import side, though the effect is more roundabout. Because a currency depreciation lowers a country's export prices, it will also lower the prices of imports that incorporate those exports as inputs. Even if the domestic-currency prices of imports rise fully in response to a home currency depreciation, given the foreign-currency prices of imports, the currency depreciation can lower the foreign-currency import prices themselves in the presence of global value chains. This effect will reduce the exchange rate's impact in shifting demand away from imports and raising net exports.

Difficulty: Easy AACSB: Application of knowledge 17) What is the implication of the immediate pass-through to importers of U.S. goods, in terms of their own currencies, close to 1?

Answer: The implication is that dollar depreciation may boost U.S. exports immediately but have little impact on U.S. imports. Of course, foreign firms selling into the United States and invoicing in dollars will earn lower profits in terms of their own currencies (can you see why?) and as a result will desire to raise their goods' U.S. prices over time to recoup their losses.

Difficulty: Easy AACSB: Application of knowledge 6.12

The Liquidity Trap

1) If a country's nominal interest rate is zero, then A) the country's economy is in a liquidity trap.

B) exchange rates with other countries are likely to decline.

C) exchange rates with other countries are likely to increase.

D) monetary policy is likely to be very effective in stimulating the economy.

E) the country's economy has achieved monetary equilibrium.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) When an economy is in a liquidity trap A) monetary policy cannot be used to influence the exchange rate.

B) monetary policy can be used to drive interest rates down, but not to drive them up.

C) there is an excess demand for bonds.

D) people and institutions avoid holding cash balances.

E) it can escape only by introducing a hard, or illiquid, currency.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 163 Copyright © 2023 Pearson Education, Ltd.

3) Which of the following is an example of an "unconventional monetary policy" by a central bank?

A) the purchase of specific categories of assets with new money B) the sale of long-term government bonds for foreign exchange C) the purchase of long-term government bonds using foreign exchange D) raising reserve requirements by commercial banks E) selling gold reserves Answer: A Difficulty: Moderate AACSB: Application of knowledge 4) If an economy is in a liquidity trap, then the nominal interest rate is effective policy that can be used to stimulate the economy is .

A) zero or negative; expansionary fiscal policy B) zero or negative; expansionary monetary policy C) high and rising; contractionary monetary policy D) high and rising; expansionary monetary policy E) high and rising; expansionary fiscal policy Answer: A Difficulty: Moderate AACSB: Application of knowledge

and the only

5) A government spending multiplier A) measures the size of the increase in output caused by an increase in government spending.

B) measures the size of the increase in output caused by a decrease in taxes.

C) measures the size of the increase in output caused by a decrease in interest rate.

D) measures the size of the increase in output caused by an increase in investment.

Answer: A Difficulty: Easy AACSB: Application of knowledge 6) Robert E. Hall of Stanford University suggests that most studies find a multiplier A) between 0.5 and 1.0.

B) between 1.0 and 2.0.

C) between 2.0 and 3.0.

D) between 3.0 and 4.0.

Answer: A Difficulty: Easy AACSB: Application of knowledge 7) Alan Auerbach and Yuriy Gorodnichenko of the University of California, Berkeley, analyze data from the mostly wealthy OECD member countries and find that for economies in recession, the multiplier is about A) 2 B) 3.7 C) 1 D) 0 164 Copyright © 2023 Pearson Education, Ltd.

Answer: A Difficulty: Easy AACSB: Application of knowledge 8) What is a liquidity trap? Why economists recommend banks to avoid the zero lower bound (ZLB)?

Answer: A liquidity trap is when an economy's nominal interest rate falls to zero and the central bank will face great difficulty in reducing it further by increasing the money supply. While a zero interest rate may please borrowers who can borrow for free, it worries makers of macroeconomic policy, who are trapped in a situation where they may no longer be able to steer the economy through conventional monetary expansion. Economists therefore recommend that if possible, central banks avoid the zero lower bound (ZLB) on the nominal interest rate.

Difficulty: Easy AACSB: Application of knowledge 9) What does it mean when the government spending multiplier is equal to 1?

Answer: When the government raises its consumption by $1, the resulting increase in output will be at most $1–smaller than the big multipliers of the simplest closed-economy models, but still an effect likely to have a substantial positive impact on employment.

Difficulty: Easy AACSB: Application of knowledge 6.13

Appendix 1 to Chapter 6: Intertemporal Trade and Consumption Demand

1) If present consumption demand is and future consumption demand , present income is and future income is , and r is the real rate of interest. The intertemporal budget constraint can be written as A) + /(1 + r) = + /(1 + r) B) /(1 + r) = /(1 + r) C) + /(1 - r) = + /(1 + r) D) + = + Answer: A Difficulty: Easy AACSB: Application of knowledge 2) A in lifetime income that is concentrated in present will indeed lead to a current consumption less than the in current income.

A) rise; rise; rise B) rise; fall; rise C) fall; rise; fall D) fall; rise; rise Answer: A Difficulty: Easy AACSB: Application of knowledge

165 Copyright © 2023 Pearson Education, Ltd.

in

3) An intertemporal budget constraint A) requires the present value of consumption to be equal to the present value of production.

B) requires total spending in each period to be equal to total consumption in each period.

C) does not take into account the ability to borrow or loan goods domestically.

D) categorizes income into permanent and temporary income.

E) limits consumption to the amount produced in each time period.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 4) If consumers experience an increase in lifetime income, current spending will current saving will , and future spending will .

A) increase; increase; increase B) increase; decrease; decrease C) increase; decrease; increase D) increase; increase; decrease E) decrease; increase; increase Answer: A Difficulty: Moderate AACSB: Application of knowledge

,

5) If consumers experience an decrease in lifetime income, current spending will current saving will , and future spending will .

A) decrease; decrease; decrease B) increase; decrease; decrease C) increase; decrease; increase D) increase; increase; decrease E) decrease; increase; increase Answer: A Difficulty: Moderate AACSB: Application of knowledge

,

6.14 Appendix 2 to Chapter 6: The Marshall-Lerner Condition and Empirical Estimates of Trade Elasticities 1) The Marshall-Lerner Condition states that, all else equal A) nominal appreciation improves the current account if export and import volumes are sufficiently elastic with respect to the real exchange rate.

B) real depreciation improves the current account if export and import volumes are sufficiently inelastic with respect to the real exchange rate.

C) real appreciation improves the current account if export and import volumes are sufficiently elastic with respect to the real exchange rate.

D) real depreciation improves the current account if export and import volumes are sufficiently elastic with respect to the real exchange rate.

E) the sum of import and export elasticities must be equal to one in order for depreciation to occur.

Answer: D Difficulty: Easy 166 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 2) The Marshall-Lerner condition holds that a country's current account balance will in response to a real in a nation's currency if the .

A) improve; depreciation; sum of the price elasticities of export and import demand exceeds 1 B) worsen; depreciation; sum of the price elasticities of export and import demand exceeds 1 C) improve; appreciation; sum of the price elasticities of export and import demand exceeds 1 D) improve; appreciation; sum of the price elasticities of export and import demand exceeds 0 E) worsen; depreciation; sum of the price elasticities of export and import demand exceeds 0 Answer: A Difficulty: Moderate AACSB: Application of knowledge 3) A real depreciation of a nation's currency gives rise to the effect on the current account.

A) volume; value B) depletion; expansion C) surplus; deficit D) output; trade E) price; profit Answer: A Difficulty: Moderate AACSB: Application of knowledge

effect and the

4) One implication of an empirical investigation of the Marshall-Lerner condition is that, in the , a real in a nation's currency is likely to the country's current account balance.

A) long run; depreciation; improve B) short run; depreciation; improve C) long run; appreciation; improve D) short run; appreciation; improve E) short run but not the long run; appreciation; improve Answer: A Difficulty: Easy AACSB: Application of knowledge 6.15

Appendix 3 to Chapter 6: The IS-LM Model and the DD-AA Model

1) The IS-LM model assumes that A) investment is negatively related to the expected real interest rate.

B) investment is positively related to the expected real interest rate.

C) investment is not directly related to the expected real interest rate.

D) investment is not related to consumer purchases of durable goods.

Answer: A Difficulty: Easy AACSB: Application of knowledge 167 Copyright © 2023 Pearson Education, Ltd.

2) Which of the following statements is TRUE? A) Consumption response to the interest rate is weaker than the investment response.

B) Consumption response to the interest rate is stronger than the investment response.

C) Consumption response to the interest rate is the same as the investment response.

D) Consumption response to the interest rate is always the opposite of the investment response.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) The IS-LM model can be used to analyze which of the following?

A) the effects of monetary and fiscal policies B) the effects of inflation and unemployment C) the effects of trade barriers and trade wars D) the Keynesian view of international trade dynamics Answer: A Difficulty: Easy AACSB: Application of knowledge 4) A temporary increase in money supply A) shifts LM to the right, lowering the interest rate and expanding output.

B) shifts LM to the left, lowering the interest rate and expanding output.

C) shifts LM to the right, raising the interest rate and lowering output.

D) shifts LM to the left, raising the interest rate and expanding output.

Answer: A Difficulty: Easy AACSB: Application of knowledge 5) A permanent increase in money supply A) shifts both LM and IS to the right.

B) shifts LM to the right and IS to the left.

C) shifts LM to the right and has no effect on IS. D) shifts IS to the left and has no effect on LM. Answer: A Difficulty: Easy AACSB: Application of knowledge 6) A temporary increase in government spending A) shifts IS to the right but has no effect on LM. B) shifts LM to the right and IS to the left.

C) shifts LM to the right and does not shift IS. D) shifts IS to the left and does not shift LM. Answer: A Difficulty: Easy AACSB: Application of knowledge 7) A permanent fiscal expansion A) has no effect on output or the home interest rate.

168 Copyright © 2023 Pearson Education, Ltd.

B) has positive effect on output.

C) has positive effect on interest rate.

D) has positive effect on both output and home interest rate.

Answer: A Difficulty: Easy AACSB: Application of knowledge 8) Explain how a fall in the nominal interest rate R raises aggregate demand.

Answer: A fall in the nominal interest rate R raises aggregate demand through two channels: (1) Given the expected future exchange rate, a fall in R causes a domestic currency depreciation that improves the current account. (2) Given expected inflation, a fall in R directly encourages consumption and investment spending that falls only partly on imports.

Difficulty: Moderate AACSB: Application of knowledge International Finance: Theory & Policy, 12/e, Global Edition Chapter 7 Fixed Exchange Rates and Foreign Exchange Intervention 7.1

Why Study Fixed Exchange Rates?

1) Central banks often intervene in currency markets. This activity is called A) super-pegging.

B) flexible floating.

C) currency warfare.

D) fixing exchange rates.

E) managed floating.

Answer: E Difficulty: Easy AACSB: Application of knowledge 2) A system of managed floating exchange rates is A) a system in which governments may attempt to moderate exchange rate movements without keeping exchange rates rigidly fixed.

B) a system in which governments use flexible exchange rates.

C) a system in which governments are forbidden from attempts to moderate exchange rate movements without keeping exchange rates rigidly fixed.

D) a system in which governments need to reach a prior agreement among them before they may attempt to moderate exchange rate movements without keeping exchange rates rigidly fixed.

E) a system in which governments use extensive fiscal policy to discourage exchange rate movements.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) Which of the following is an example of a regional currency arrangement?

A) most-favored nation status B) free-trade zones 169 Copyright © 2023 Pearson Education, Ltd.

C) exchange rate union D) currency cartel associations E) agreement on commercial trade Answer: C Difficulty: Easy AACSB: Application of knowledge 4) Organizations whose members agree to fix their mutual exchange rates while allowing their currencies to fluctuate in value against the currencies of nonmember countries are called A) exchange rate unions.

B) mutual rate unions.

C) pegging rate unions.

D) common rate unions.

Answer: A Difficulty: Easy AACSB: Application of knowledge 5) Industrialized countries typically their floating exchange rates. Developing countries often their floating exchange rates.

A) fix; allow markets to determine B) manage; peg C) allow markets to determine; fix D) fix; manage E) peg; manage Answer: B Difficulty: Easy AACSB: Application of knowledge 6) Why is it important to understand fixed exchange rates in the modern global economy?

Answer: Fixed rates continue to be important for four reasons: 1. Managed floating: Central banks intervene in foreign exchange markets.

2. Regional currency arrangements: Some countries peg their currency to another currency.

3. Developing countries and countries in transition: These countries often attempt to peg their currency to another currency.

4. Lessons of the past: Fixed exchange rates could have a resurgence.

Difficulty: Moderate AACSB: Application of knowledge 7) What is the difference between clean and dirty float exchange rates?

Answer: The system of partially floating dollar exchange rates is sometimes referred to as a dirty float, to distinguish it from a clean float in which governments make no direct attempts to influence foreign currency values.

Difficulty: Easy AACSB: Application of knowledge 7.2

Central Bank Intervention and the Money Supply 170 Copyright © 2023 Pearson Education, Ltd.

1) The central bank balance sheet records A) the assets held by the central bank and its liabilities.

B) the purchase and sale of goods and services.

C) the imports and exports payments.

D) the key transactions among big banks.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) A central bank's international reserves consist of its holdings of A) gold.

B) silver and gold.

C) foreign assets and gold.

D) domestic assets and precious metals.

E) foreign and domestic currency holdings.

Answer: C Difficulty: Easy AACSB: Application of knowledge 3) The liabilities side of a central bank's accounts consists of A) deposits held by private banks.

B) currency in circulation.

C) deposits held by private banks and currency in circulation.

D) deposits held by foreign banks, domestic assets, and currency in circulation.

E) foreign assets and domestic assets.

Answer: C Difficulty: Easy AACSB: Application of knowledge 4) When the central bank buys an asset from the public, in central bank liabilities associated with the asset purchase causes the money supply to . When the central bank sells an asset to the public, in central bank liabilities causes the money supply to .

A) an increase; expand; a decrease; shrink B) a decrease; shrink; an increase; expand C) an increase; shrink; a decrease; expand D) a decrease; expand; an increase; shrink Answer: A Difficulty: Easy AACSB: Application of knowledge 5) Which one of the following statements is most correct?

A) Any central bank purchase of assets automatically results in an increase in the domestic money supply, while any central bank sale of assets automatically causes the money supply to decline.

B) Any central bank purchase of assets results in an increase in the domestic money supply, while any central bank sale of assets causes the money supply to decline.

C) Any central bank purchase of assets automatically results in a decrease in the domestic money 171 Copyright © 2023 Pearson Education, Ltd.

supply, while any central bank sale of assets automatically causes the money supply to decline.

D) Any central bank purchase of assets automatically results in a decrease in the domestic money supply, while any central bank sale of assets automatically causes the money supply to increase.

E) Any central bank purchase of assets automatically results in an increase in the domestic money supply, while any central bank sale of assets does not necessarily affect the money supply.

Answer: A Difficulty: Easy AACSB: Application of knowledge 6) Central banks sometimes carry out equal foreign and domestic asset transactions in opposite directions to nullify the impact of their foreign exchange operations on the domestic money supply. This type of policy is called A) sterilized foreign exchange intervention.

B) nullified foreign exchange intervention.

C) balancing foreign exchange intervention.

D) offsetting foreign exchange intervention.

Answer: A Difficulty: Easy AACSB: Application of knowledge 7) Which one of the following statements is the most correct?

A) If central banks are not sterilizing and the home country has a balance of payments surplus, any associated increase in the home central bank's foreign assets implies an increased home money supply.

B) If central banks are not sterilizing and the home country has a balance of payments surplus, any associated increase in the home central bank's foreign assets implies a decreased home money supply.

C) If central banks are not sterilizing and the home country has a balance of payments surplus, any associated increase in the home central bank's foreign assets implies an increased home money demand.

D) If central banks are not sterilizing and the home country has a balance of payments surplus, any associated decrease in the home central bank's foreign assets implies an increased home money supply.

E) If central banks are not sterilizing and the home country has a balance of payments shortage, any associated decrease in the home central bank's foreign assets implies an increased home money supply.

Answer: A Difficulty: Easy AACSB: Application of knowledge 8) Which one of the following statements is most correct?

A) If central banks are not sterilizing and the home country has a balance of payments surplus, any associated increase in a foreign central bank's claims on the home country implies a decreased foreign money supply.

B) If central banks are not sterilizing and the home country has a balance of payments surplus, any associated decrease in a foreign central bank's claims on the home country implies a decreased foreign money demand.

172 Copyright © 2023 Pearson Education, Ltd.

C) If central banks are not sterilizing and the home country has a balance of payments surplus, any associated decrease in a foreign central bank's claims on the home country implies a decreased foreign money supply.

D) If central banks are not sterilizing and the home country has a balance of payments shortage, any associated decrease in a foreign central bank's claims on the home country implies a decreased foreign money supply.

E) If central banks are not sterilizing and the home country has a balance of payments shortage, any associated decrease in a foreign central bank's claims on the home country implies an increased domestic money supply.

Answer: C Difficulty: Easy AACSB: Application of knowledge 9) What do a central bank' foreign and domestic assets consist of?

Answer: Foreign assets consist mainly of foreign currency bonds owned by the central bank.

These foreign assets make up the central bank's official international reserves, and their level changes when the central bank intervenes in the foreign exchange market by buying or selling foreign exchange. A central bank's international reserves also include any gold that it owns.

Domestic assets are central bank holdings of claims to future payments by its own citizens and domestic institutions. These claims usually take the form of domestic government bonds and loans to domestic private banks.

Difficulty: Easy AACSB: Application of knowledge 10) A balance sheet for the central bank of Pecunia is shown below: Central Bank Balance Sheet Assets Foreign assets $1,000 Domestic assets $1,500

Liabilities Deposits held by private banks Currency in circulation

$500 $2,000

Please write the new balance sheet if the bank sells $100 worth of foreign bonds for domestic currency.

Answer: Central Bank Balance Sheet Assets Liabilities Foreign assets $900 Deposits held by private banks $500 Domestic assets $1,500 Currency in circulation $1,900 Difficulty: Moderate AACSB: Application of knowledge 11) A balance sheet for the central bank of Pecunia is shown below: Central Bank Balance Sheet Assets Foreign assets $1,000 Domestic assets $1,500

Liabilities Deposits held by private banks Currency in circulation

$500 $2,000

Please write the new balance sheet if the bank purchased $100 in foreign bonds by writing a check 173 Copyright © 2023 Pearson Education, Ltd.

on itself.

Answer: Central Bank Balance Sheet Assets Liabilities Foreign assets $1,100 Deposits held by private banks Domestic assets $1,500 Currency in circulation Difficulty: Moderate AACSB: Application of knowledge

$600 $2,000

12) A balance sheet for the central bank of Pecunia is shown below: Central Bank Balance Sheet Assets Foreign assets $1,000 Domestic assets $1,500

Liabilities Deposits held by private banks Currency in circulation

$500 $2,000

Please write the new balance sheet if the bank makes a sterilized transaction by selling $100 of foreign assets for domestic currency and then purchasing $100 of domestic assets by writing a check on itself.

Answer: Central Bank Balance Sheet Assets Liabilities Foreign assets $900 Deposits held by private banks $600 Domestic assets $1,600 Currency in circulation $1,900 Difficulty: Moderate AACSB: Application of knowledge 13) Please define and give an example of sterilized foreign exchange intervention.

Answer: Sterilized foreign exchange intervention occurs when a central bank carries out equal foreign and domestic asset transactions in opposite directions to nullify the impact on the domestic money supply. An example is a central bank purchasing $100 of domestic assets but selling $100 of foreign bonds.

Difficulty: Moderate AACSB: Application of knowledge 7.3

How the Central Bank Fixes the Exchange Rate

1) To hold the exchange rate constant, A) a central bank must always be willing to trade currencies at the fixed exchange rate with the private actors in the foreign exchange market.

B) a central bank cannot trade currencies at the fixed exchange rate with the private actors in the foreign exchange market.

C) a central bank does not intervene to remove excess supplies or demands in the foreign exchange market.

D) a central bank lets the foreign exchange and asset markets adjust itself to equilibrium.

Answer: A Difficulty: Easy AACSB: Application of knowledge 174 Copyright © 2023 Pearson Education, Ltd.

2) Under fixed exchange rate, the foreign exchange market is in equilibrium when the interest parity condition holds, that is A) the domestic and foreign interest rates are equal, R = R .

B) R = R + (Ee - E)/E. C) the foreign and domestic interest rates are unequal.

D) the expected rate of domestic currency depreciation is high.

E) the expected rate of currency depreciation is one.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) Under fixed exchange rate, in general which one of the following statements is the MOST accurate?

A) The following condition should hold for domestic money market equilibrium: Ms/P = L(R , Y).

B) The following condition should hold for domestic money market equilibrium: Md/P = L(R , Y).

C) The following condition should hold for domestic money market equilibrium: Ms = L(R , Y).

D) The following condition should hold for domestic money market equilibrium: P = L(R , Y).

E) The following condition should hold for domestic money market equilibrium: R*Md/P = L(Y).

Answer: A Difficulty: Easy AACSB: Application of knowledge 4) What are the factors affecting the demand for foreign currency?

Answer: Three factors affect the demand for foreign currency. They are expected return, risk, and liquidity.

Difficulty: Moderate AACSB: Application of knowledge 5) If the central bank does not purchase foreign assets when output increases but instead holds the money stock constant, can it still keep the exchange rate fixed at ? Please explain.

Answer: No, the rise in output leads to an excess demand for money. If the central bank does not increase supply to meet this demand, the domestic interest rate would rise above the foreign rate, R*. This higher rate of return (and given expectations in the foreign exchange market) would cause the exchange rate to fall below .

Difficulty: Difficult AACSB: Application of knowledge 6) If the central bank does not purchase foreign assets when output increases but instead holds the money stock constant, can it still keep the exchange rate fixed at ? Please explain with the aid of a figure.

Answer: 175 Copyright © 2023 Pearson Education, Ltd.

No, the rise in output leads to an excess demand for money. If the central bank does not increase supply to meet this demand, the domestic interest rate would rise above the foreign rate, R*. This higher rate of return (and given expectations in the foreign exchange market) would cause the exchange rate to fall below .

Difficulty: Moderate AACSB: Application of knowledge 7) Please draw a figure illustrating the actions the central bank must take to maintain a fixed exchange rate following an increase in output.

Answer:

176 Copyright © 2023 Pearson Education, Ltd.

A rise in output from to will increase the real money demand, so the central bank must purchase foreign assets and raise the money supply from to , in order to maintain a fixed exchange rate .

Difficulty: Difficult AACSB: Application of knowledge 7.4

Stabilization Policies with a Fixed Exchange Rate

1) By fixing the exchange rate, the central bank gives up its ability to A) adjust taxes.

B) increase government spending.

C) influence the economy through fiscal policy.

D) depreciate the domestic currency.

E) influence the economy through monetary policy.

Answer: E Difficulty: Easy AACSB: Application of knowledge 2) Which one of the following statements is the MOST accurate?

A) Under a fixed exchange rate, central bank monetary tools are powerless to affect the economy's 177 Copyright © 2023 Pearson Education, Ltd.

money supply.

B) Under a flexible exchange rate, central bank monetary tools are powerless to affect the economy's money supply or its output.

C) Under a fixed exchange rate, fiscal policy tools are powerless to affect the economy's money supply or its output.

D) Under a fixed exchange rate, central bank monetary tools are powerless to affect the economy's money supply or its output.

E) Under a dirty float exchange rate, central bank monetary tools are powerless to affect the economy's money supply or its output.

Answer: D Difficulty: Easy AACSB: Application of knowledge 3) Under fixed rates, which one of the following statements is the MOST accurate?

A) Monetary policy can affect only output.

B) Monetary policy can affect only employment.

C) Monetary policy can affect only international reserves.

D) Monetary policy can not affect international reserves.

E) Monetary policy can only affect money supply.

Answer: C Difficulty: Easy AACSB: Application of knowledge 4) Fiscal expansion under fixed exchange rates will have what temporary effect?

A) the money supply will decrease B) output will decrease C) the exchange rate will increase D) the exchange rate will decrease E) there will be no effect Answer: D Difficulty: Easy AACSB: Application of knowledge 5) Under fixed rates, which one of the following statements is the MOST accurate?

A) Fiscal policy can affect output, employment and international reserves at the same time.

B) Fiscal policy can affect only employment.

C) Fiscal policy can affect only international reserves.

D) Fiscal policy can affect only output and employment.

E) Fiscal employment can affect only output and international reserves.

Answer: A Difficulty: Easy AACSB: Application of knowledge 6) Which one of the following statements is the MOST accurate?

A) Fiscal policy has the same effect on employment under fixed and flexible exchange rate regimes.

B) Fiscal policy affects employment less under fixed than under flexible exchange rate regimes.

178 Copyright © 2023 Pearson Education, Ltd.

C) Fiscal policy affects employment more under fixed than under flexible exchange rate regimes.

D) Fiscal policy cannot affect employment under fixed exchange rate but does affect output under flexible exchange rate regimes.

E) Fiscal policy can affect employment under fixed exchange rate regimes, but does not affect output under flexible exchange rate regimes.

Answer: C Difficulty: Easy AACSB: Application of knowledge 7) Which one of the following statements is the MOST accurate?

A) Fiscal policy has the same effect on output under fixed and flexible exchange rate regimes.

B) Fiscal policy affects output more under fixed than under flexible exchange rate regimes.

C) Fiscal policy affects output less under fixed than under flexible exchange rate regimes.

D) Fiscal policy cannot affect output under fixed exchange rate but does affect output under flexible exchange rate regimes.

E) Fiscal policy can affect output under fixed exchange rate but does not affect output under flexible exchange rate regimes.

Answer: B Difficulty: Easy AACSB: Application of knowledge 8) Which one of the following statements is the MOST accurate?

A) A devaluation occurs when the central bank lowers the domestic currency price of foreign currency, E, and a revaluation occurs when the central bank raises E. B) A devaluation occurs when the central bank raises the domestic currency price of foreign currency, E, and a revaluation occurs when the central bank lowers E. C) Devaluation occurs when the domestic currency price of foreign currency, E, raises and a revaluation occurs when E is lowered.

D) A devaluation occurs when the central bank of the foreign country raises the domestic currency price of foreign currency, E, and a revaluation occurs when the central bank of the foreign country lowers E. E) A devaluation occurs when the central bank raises the foreign currency price of domestic currency, E, and a revaluation occurs when the central bank lowers E. Answer: B Difficulty: Easy AACSB: Application of knowledge 9) Which one of the following statements is the MOST accurate?

A) Depreciation is a rise in E when the exchange rate is fixed while devaluation is a rise in E when the exchange rate floats.

B) Depreciation is a decrease in E when the exchange rate floats while devaluation is a rise in E when the exchange rate is fixed.

C) Depreciation is a rise in E when the exchange rate floats while devaluation is a rise in E when the exchange rate is fixed.

D) Depreciation is a rise in E when the exchange rate floats while devaluation is a decrease in E when the exchange rate is fixed.

E) Depreciation is a fall in E when the exchange rate is fixed while devaluation is a fall in E when 179 Copyright © 2023 Pearson Education, Ltd.

the exchange rate floats.

Answer: C Difficulty: Easy AACSB: Application of knowledge 10) Which one of the following statements is the MOST accurate?

A) Appreciation is a rise in E when the exchange rate floats while revaluation is a fall in E when the exchange rate is fixed.

B) Appreciation is a fall in E when the exchange rate floats while revaluation is a fall in E when the exchange rate is fixed.

C) Appreciation is a fall in E when the exchange rate is fixed while revaluation is a fall in E when the exchange rate is flexible.

D) Appreciation is a fall in E when the exchange rate floats while revaluation is a rise in E when the exchange rate is fixed.

E) Appreciation is a rise in E when the exchange rate floats while revaluation is a rise in E when the exchange rate is fixed.

Answer: B Difficulty: Easy AACSB: Application of knowledge 11) Which one of the following statements is the MOST accurate?

A) Devaluation reflects a deliberate government decision.

B) Depreciation reflects a deliberate government decision.

C) Devaluation reflects a deliberate government decision while depreciation is an outcome of government actions and market forces acting together.

D) Depreciation reflects a deliberate government decision while devaluation is an outcome of government actions and market forces acting together.

E) Devaluation and depreciation have the same meaning and the same causes.

Answer: C Difficulty: Easy AACSB: Application of knowledge 12) Which one of the following statements is the MOST accurate?

A) Revaluation reflects an outcome of government actions and market forces acting together while appreciation reflects a deliberate government decision.

B) Revaluation reflects a deliberate government decision while appreciation is an outcome of government actions and market forces acting together.

C) Revaluation reflects a deliberate government decision while appreciation is an outcome of government actions.

D) Revaluation and appreciation have the same meaning and the same causes.

E) Appreciation reflects a deliberate government decision while revaluation is an outcome of government actions and market forces acting together.

Answer: B Difficulty: Easy AACSB: Application of knowledge 13) Under fixed exchange rates, which one of the following statements is the MOST accurate?

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A) Keeping other things constant, devaluation causes a decrease in output, a decrease in official reserves, and a contraction of the money supply.

B) Keeping other things constant, devaluation causes a rise in output, a rise in official reserves, and an expansion of the money supply.

C) Keeping other things constant, devaluation causes a rise in output and a rise in official reserves.

D) Keeping other things constant, devaluation causes a rise in output and an expansion of the money supply.

E) Keeping other things constant, devaluation causes a rise in official reserves, and an expansion of the money supply.

Answer: B Difficulty: Easy AACSB: Application of knowledge 14) Under fixed exchange rates, which one of the following statements is the MOST accurate?

A) Devaluation causes a rise in output.

B) Devaluation causes a decrease in output.

C) Devaluation has no effect on output.

D) Devaluation causes a rise in output and a decrease in official reserves.

E) Devaluation causes a decrease in output and in official reserves.

Answer: A Difficulty: Easy AACSB: Application of knowledge 15) Under fixed exchange rates, which one of the following statements is the MOST accurate?

A) Devaluation causes a reduction of the money supply.

B) Devaluation has no effect on the stock of money.

C) Devaluation causes an expansion of the money supply.

D) Devaluation causes a reduction in output.

E) Devaluation causes a reduction in official reserves.

Answer: C Difficulty: Easy AACSB: Application of knowledge 16) Which of the following best describes a deliberate government decision to lower the exchange rate, E? A) appreciation B) depreciation C) revaluation D) devaluation E) accumulation Answer: C Difficulty: Easy AACSB: Application of knowledge 17) When a country's currency is devalued A) output decreases.

B) output increases and the money supply decreases.

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C) the money supply decreases.

D) output decreases and the money supply increases.

E) both the output and the money supply increases.

Answer: E Difficulty: Easy AACSB: Application of knowledge 18) The main reason(s) why governments sometimes choose to devalue their currencies is (are) A) devaluation makes domestic goods more expensive in relation to foreign goods.

B) devaluation makes domestic services more expensive in relation to foreign services.

C) devaluation increases foreign reserves held by the central bank.

D) devaluation improves the current account and increases foreign reserves held by the central bank.

E) devaluation hurts foreign currencies.

Answer: D Difficulty: Easy AACSB: Application of knowledge 19) Which of the following statements is TRUE? A) A devaluation under a fixed rate has the same long-run effect as a proportional increase in the money supply under a floating rate.

B) A devaluation under a fixed rate has a stronger long-run effect in the money supply than under a floating rate.

C) A devaluation under a fixed rate has a weaker long-run effect in the money supply than under a floating rate.

D) A devaluation under a fixed rate has no long-run effect in the money supply.

Answer: A Difficulty: Easy AACSB: Application of knowledge 20) Use a figure to illustrate the ineffectiveness of monetary policy to spur on an economy under a fixed exchange rate.

Answer:

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The initial equilibrium rests at point 1. If the central bank wishes to use monetary policy to increase output from to , then they might buy domestic assets and shift the AA curve outward. However, the central bank must maintain a fixed exchange rate , so would have to sell foreign assets for domestic currency, returning the economy to point 1.

Difficulty: Difficult AACSB: Application of knowledge 21) Use a figure to explain the potential effectiveness of fiscal policy to spur on the economy under a fixed exchange rate.

Answer:

183 Copyright © 2023 Pearson Education, Ltd.

With an aim toward increasing output, the government could use fiscal policy to shift the DD curve outward. The central bank will have to take steps to maintain a fixed exchange rate , among the options is buying foreign assets with money, to shift the AA schedule outward until the equilibrium at point 3 is reached.

Difficulty: Difficult AACSB: Application of knowledge 22) Please discuss the difference between devaluation and depreciation.

Answer: Depreciation is a rise in the exchange rate E when the exchange rate floats, while devaluation is a rise in E when the exchange rate is fixed. Devaluation reflects a deliberate government decision, while depreciation is an outcome of government actions and market forces ("the invisible hand") acting together.

Difficulty: Moderate AACSB: Application of knowledge 23) Define devaluation and use a figure to show the effect of a currency devaluation on the economy.

Answer:

A devaluation occurs when the central bank raises the domestic currency price of foreign currency.

In the figure, the domestic currency is devalued from to . Since nothing in the DD schedule has changed, the new equilibrium at point 2 must be reached by an expansion of the money supply (AA curve shifts outward). Notice also that output has increased from to .

Difficulty: Difficult AACSB: Application of knowledge 24) Why do governments sometimes choose to devalue their currencies?

Answer: First, devaluation allows the government to fight domestic unemployment despite the lack of effective monetary policy. If government spending and budget deficits are politically 184 Copyright © 2023 Pearson Education, Ltd.

unpopular, for example, or if the legislative process is slow, a government may opt for devaluation as the most convenient way of boosting aggregate demand.

A second reason for devaluing is the resulting improvement in the current account, a development the government may believe to be desirable.

The third motive behind devaluations, one we mentioned at the start of this subsection, is their effect on the central bank's foreign reserves. If the central bank is running low on reserves, a sudden, one-time devaluation (one that nobody expects to be repeated) can be used to draw in more reserves.

Difficulty: Easy AACSB: Application of knowledge 25) Please use a figure to discuss whether or not a devaluation under a fixed exchange rate has the same long-run effect as a proportional increase in the money supply under a floating rate.

Answer:

A currency devaluation shifts the AA schedule outward from equilibrium point 1 to equilibrium point 2. The devaluation does not change long-run demand or supply conditions in the output market. Thus, the increase in the long-run price level will exactly offset the increase in exchange rate. Thus, a devaluation is neutral in the long run and this is the exact same scenario as for an increase in the money supply under a floating exchange rate.

Difficulty: Difficult AACSB: Application of knowledge 7.5

Balance of Payments Crises and Capital Flight

1) A balance of payments crisis is best described as A) a sharp change in interest rates sparked by a change in expectations about the level of imports.

B) a sharp change in foreign reserves sparked by a change in expectations about the future exchange rate.

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C) a sharp change in interest rates sparked by a change in expectations about the level of exports.

D) a sharp change in foreign reserves sparked by a change in expectations about the level of imports.

E) a sharp change in foreign reserves sparked by a change in expectations about domestic production.

Answer: B Difficulty: Easy AACSB: Application of knowledge 2) The expectation of future devaluation causes a balance of payments crisis marked by A) a sharp rise in reserves and a fall in the home interest rate below the world interest rate.

B) a sharp fall in reserves and an even bigger fall in the home interest rate below the world interest rate.

C) a sharp fall in reserves and a rise in the home interest rate above the world interest rate.

D) a sharp rise in reserves and an even greater rise in the home interest rate above the world interest.

E) a sharp rise in reserves and a rise in the home interest rate to the level of the world interest.

Answer: C Difficulty: Easy AACSB: Application of knowledge 3) The expectation of future revaluation causes a balance of payments crisis marked by A) a sharp rise in reserves and a fall in the home interest rate below the world interest rate.

B) a sharp fall in reserves and an even bigger fall in the home interest rate below the world interest rate.

C) a sharp fall in reserves and a rise in the home interest rate above the world interest rate.

D) a sharp rise in reserves and an even greater rise in the home interest rate above the world interest.

E) a sharp fall in reserves and an unchanged home interest rate.

Answer: A Difficulty: Easy AACSB: Application of knowledge 4) Capital flight A) increases reserves.

B) is never associated with the expectation of devaluation.

C) may undo expected devaluation.

D) reduces losses during a devaluation scare.

E) decreases reserves and may induce devaluation.

Answer: E Difficulty: Easy AACSB: Application of knowledge 5) The reserve loss accompanying a devaluation scare is often labeled A) capital flight.

B) reserve scarcity.

C) capital flee.

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D) devaluation fear.

Answer: A Difficulty: Easy AACSB: Application of knowledge 6) Currency crises may result from A) central bank balance sheets with higher liabilities than assets.

B) political upheaval leading to lowering exports.

C) a reconfiguration of central bank balance sheets.

D) speculative attacks on the currency or central banks purchasing excessive amounts of government bonds.

E) depreciation of foreign reserves.

Answer: D Difficulty: Easy AACSB: Application of knowledge 7) is a situation when an economy can be vulnerable to currency speculation not directly caused by the unhealthy economic fundamental conditions or improper government policies.

A) Self-fulfilling currency crisis B) Self-fulfilling debt crisis C) Self-fulfilling financial crisis D) Self-fulfilling prophecy crisis Answer: A Difficulty: Easy AACSB: Application of knowledge 8) What is capital flight?

Answer: The reserve loss accompanying a devaluation scare is often labeled capital flight.

Residents flee the domestic currency by selling it to the central bank for foreign exchange; they then invest the foreign currency abroad. At the same time, foreigners convert holdings of home assets into their own currencies and repatriate the proceeds.

When fears of devaluation arise because the central bank's reserves are low to begin with, capital flight is of particular concern to the government. By pushing reserves even lower, capital flight may force the central bank to devalue sooner and by a larger amount than planned.

Difficulty: Easy AACSB: Application of knowledge 9) What causes currency crises? How can they be prevented?

Answer: A government is following policies that are not consistent with maintaining a fixed exchange rate over the longer term. Once market expectations take those policies into account, the country's interest rates inevitably are forced up. A country's central bank may be buying bonds from the domestic government to allow the government to run continuing fiscal deficits. Since these central bank purchases of domestic assets cause ongoing losses of central bank foreign exchange reserves, reserves will fall toward a point at which the central bank may find itself without the means to support the exchange rate. As the possibility of a collapse rises over time, so will domestic interest rates, until the central bank indeed runs out of foreign reserves and the fixed exchange rate is abandoned. The only way for the central bank to avoid this fate is to stop 187 Copyright © 2023 Pearson Education, Ltd.

bankrolling the government deficit, hopefully forcing the government to live within its means.

Difficulty: Moderate AACSB: Application of knowledge 7.6

Managed Floating and Sterilized Intervention

1) Which of the following statements is TRUE? A) Under managed floating, monetary policy is influenced by exchange rate changes without being completely subordinate to the requirements of a fixed rate.

B) Under managed floating, monetary policy cannot be influenced by exchange rate changes due to the requirements of a fixed rate.

C) Under managed floating, the central bank manages to keep a fixed foreign exchange rate all the time.

D) Under managed floating, the central bank does not intervene with foreign exchange rate at all.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) An action taken by a country's central bank to counter the effects on the money supply with opposite domestic asset transactions is called A) sterilized foreign exchange intervention.

B) unsterilized foreign exchange intervention.

C) counter foreign exchange intervention.

D) balancing foreign exchange intervention.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) Perfect asset substitutability is the assumption that A) the foreign exchange market is in equilibrium only when expected returns on domestic assets are greater than returns on foreign currency bonds.

B) the foreign exchange market is in equilibrium only when expected returns on foreign currency bonds are greater than returns on domestic assets.

C) the foreign exchange market is in equilibrium only when expected returns on all assets are negative.

D) the foreign exchange market is in equilibrium only when expected returns on domestic assets are equal to returns on foreign currency bonds.

E) the foreign exchange market is in equilibrium only when domestic assets are risk-free.

Answer: D Difficulty: Easy AACSB: Application of knowledge 4) Imperfect asset substitutability assumes A) the returns on foreign and domestic currency bonds are identical.

B) the returns on foreign and domestic currency are unrelated.

C) the risks of holding foreign and domestic currency are identical.

D) the risks of holding foreign and domestic currency are unrelated to returns.

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E) the returns on foreign and domestic currency differ and are influenced by risk.

Answer: E Difficulty: Easy AACSB: Application of knowledge 5) The global financial crisis of 2007-2008 resulted in a(n) of the Swiss franc as foreign currency flowed the country. As a result, Swiss products became competitive in world markets.

A) depreciation; out of; more B) depreciation; into; more C) appreciation; out of; less D) depreciation; out of; less E) appreciation; into; less Answer: E Difficulty: Easy AACSB: Application of knowledge 6) The global financial crisis of 2007-2008 resulted in a(n) the Swiss central bank intervened in order to cause a(n) A) appreciation; appreciation B) depreciation; depreciation C) appreciation; revaluation D) depreciation; appreciation E) appreciation; depreciation Answer: E Difficulty: Easy AACSB: Application of knowledge

of the Swiss franc. In 2011, of the franc.

7) Imperfect asset substitutability exists A) when it is possible for the expected returns on two assets to be different.

B) when the expected returns on two assets are the same.

C) only when one asset is foreign and the other is domestic.

D) when there is risk in the foreign exchange market.

E) when assets are liquid.

Answer: D Difficulty: Easy AACSB: Application of knowledge 8) The interest parity condition can be written as A) R = R - (Ee - E)/E. B) R = R + (Ee - E)/E. C) R = R2 - (Ee - E)/E. D) R = R /(Ee - E).

E) R = R + (Ee + E)/E. Answer: B Difficulty: Easy AACSB: Application of knowledge 189 Copyright © 2023 Pearson Education, Ltd.

9) When domestic and foreign currency bonds are imperfect substitutes, the domestic interest rate (R) can be written as A) R = R - (Ee - E)/E + ρ.

B) R = R - (Ee - E)/E. C) R = R + (Ee - E)/E + ρ.

D) R = R - (Ee + E)/E + ρ.

E) R = R - (Ee - E)ρ.

Answer: C Difficulty: Easy AACSB: Application of knowledge 10) In the interest rate parity condition with imperfect substitutes and a risk premium of ρ A) an increased stock of domestic government debt will raise the difference between the expected returns on domestic and foreign currency bonds.

B) a decreased stock of domestic government debt will raise the difference between the expected returns on domestic and foreign currency bonds.

C) an increased stock of domestic government debt will reduce the difference between the expected returns on domestic and foreign currency bonds.

D) an increased stock of domestic government debt will have no effect on the difference between the expected returns on domestic and foreign currency bonds.

E) a decreased stock of domestic government debt will have no effect on the difference between the expected returns on domestic and foreign currency bonds.

Answer: A Difficulty: Easy AACSB: Application of knowledge 11) With imperfect asset substitutability, sterilized purchases of foreign exchange can cause the home currency to , and sterilized sales of foreign exchange cause the home currency to .

A) depreciate; appreciate B) appreciate; depreciate C) depreciate; depreciate D) appreciate; appreciate Answer: A Difficulty: Easy AACSB: Application of knowledge 12) The signaling effect of foreign exchange intervention A) never has any effect on exchange rates.

B) can alter the market's view of exchange rates independent from the stance of monetary and fiscal policies.

C) cannot cause an immediate exchange rate change when bonds denominated in different currencies are perfect substitutes.

D) never leads to actual changes in monetary or fiscal policy.

E) can alter the market's view of future monetary policies and cause an immediate exchange rate 190 Copyright © 2023 Pearson Education, Ltd.

change.

Answer: E Difficulty: Easy AACSB: Application of knowledge 13) Please describe in detail a self-fulfilling currency crisis.

Answer: Consider an economy in which domestic commercial banks' liabilities are mainly short-term deposits, and in which many of the banks' loans to businesses are likely to go unpaid in the event of a recession. If the market suspects there will be devaluation, interest rates will rise, banks' borrowing costs go up, and a banks' assets have lower value if a recession hits. To prevent financial collapse, the central bank will lend money to banks and no longer be able to keep the exchange rate from rising. Thus, the emergence of devaluation expectations eventually leads to a devaluation of currency (self-fulfilling).

Difficulty: Moderate AACSB: Application of knowledge 14) Sterilization will be fruitless under a fixed exchange rate. Explain.

Answer: To hold the exchange rate constant when fiscal policy becomes more expansive, the central bank must buy foreign assets and expand the home money supply. The policy raises output, but it eventually also causes inflation, which the central bank may try to avoid by sterilizing the increase in the money supply that its fiscal policy has induced. As quickly as the central bank sells domestic assets to reduce the money supply, however, it will have to buy more foreign assets to keep the exchange rate fixed. The ineffectiveness of monetary policy under a fixed exchange rate implies that sterilization is a self-defeating policy.

Difficulty: Moderate AACSB: Application of knowledge 15) Describe the effect of the 2008-2009 global financial crisis on the Swiss franc and the central bank's efforts to respond to the resulting problems.

Answer: The 2008-2009 global financial crisis resulted in appreciation of the franc as currency traders purchased the franc as a safe haven currency. The Swiss economy consequently suffered as its products became less competitive with imports. The Swiss responded by committing to currency intervention designed to control appreciation of the franc and restore the country's competitiveness in global markets.

Difficulty: Moderate AACSB: Application of knowledge 16) Use a figure to explain how a balance of payments crisis occurs and its hand in capital flight.

Answer:

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Suppose the foreign exchange market expects the government to devalue the currency in the future and adopt a new fixed exchange rate > . This leads to a rightward shift in the curve that measures the expected domestic currency return on foreign currency deposits. Since the exchange rate remains fixed at , the domestic interest rate must rise to R* + ( - )/ . The central bank must sell foreign reserves and shrink the money supply in response. This reserve loss accompanying a devaluation scare is labeled capital flight.

Difficulty: Difficult AACSB: Application of knowledge 17) Assuming perfect asset substitutability, can sterilized intervention by the central bank be effective? Please discuss.

Answer: No, a sterilized foreign exchange intervention by the central bank leaves the domestic money supply unchanged. Under floating exchange rates, a change in the interest rate is needed to affect the exchange rate, but the interest rate won't change if the money supply does not. Under a fixed exchange rate, an expansive policy needs to be offset by an increase in the domestic money supply. To avoid inflation, the central bank sterilizes this increase in the money supply by selling domestic assets. However, with a fixed exchange rate, this means buying foreign assets. If foreign assets are perfect substitutes for domestic assets, this sterilization is not effective.

Difficulty: Moderate AACSB: Application of knowledge 192 Copyright © 2023 Pearson Education, Ltd.

18) Use a figure to show the effect of a sterilized central bank purchase of foreign assets under the imperfect asset substitutability assumption.

Answer:

The interest parity condition is given by R = R* + ( - E)/E + Suppose that the domestic assets of the central bank fall from to through a sterilized purchase of foreign assets. Then the risk-adjusted return increases and the exchange rate increases.

Difficulty: Difficult AACSB: Application of knowledge 19) Assume that initially, the risk premium, ρ = 0 and that the domestic and foreign interest rates are given by R = .06, R* = .05. Suppose that the risk premium depends linearly on the difference between domestic government debt, B, and domestic assets of the central bank, A, i.e., ρ= Find the new domestic interest rate if a sterilized purchase of foreign assets adjusts A s.t. (a) B - A = -.01/ (b) B - A = .01/ (c) B - A = .03/ Answer: (a) R = .05 + .01 + (-.01) = .05 (b) R = .05 + .01 + (.01) = .07 (c) R = .05 + .01 + (.03) = .09 Difficulty: Difficult 193 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 20) Assume that initially, the risk premium, ρ = 0 and that the domestic and foreign interest rates are given by R = .06, R* = .05. Suppose that the risk premium depends linearly on the difference between domestic government debt, B, and domestic assets of the central bank, A, i.e., ρ= How much will the central bank have to reduce domestic assets A s.t. the domestic interest rate will increase by (a) 1% (b) 4%?

Answer: (a) ρ = .01 = ΔA =

- (B -

)

- (B -

)

(b) ρ = .04 = ΔA =

Difficulty: Difficult AACSB: Application of knowledge 21) Does the signaling effect of foreign exchange intervention support or refute the claim that assets cannot be perfect substitutes if sterilized intervention is going to have any effect? Please explain.

Answer: The signaling effect refutes the claim. Even with the assumption of perfect asset substitutability, if the market is unsure of the future direction of policy, then sterilized intervention can fix a market's expectations about the exchange rate in the future. From post discussion, a change in the expected exchange rate will lead to a change in the exchange rate today.

Difficulty: Moderate AACSB: Application of knowledge 7.7

Reserve Currencies in the World Monetary System

1) What is a reverse currency?

A) the currency central banks hold in their international reserves B) the currency central banks use for invoices C) the currency central banks use for investment D) the currency central banks hold to pay public debt Answer: A Difficulty: Easy AACSB: Application of knowledge 2) Between the end of World War II and 1973, the main reverse currency that almost every country pegged the exchange rate of its money was the A) U.S. dollar.

B) Euro.

C) British pound.

D) Japanese yen.

E) Swiss franc.

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Answer: A Difficulty: Easy AACSB: Application of knowledge 3) What is the gold standard?

Answer: Under a gold standard, central banks peg the prices of their currencies in terms of gold and hold gold as official international reserves.

Difficulty: Easy AACSB: Application of knowledge 4) Briefly describe two systems for fixing the exchange rates of all currencies against each other and the time periods in which they were used.

Answer: The first is to single cut one country's currency as the reserve currency. The other countries hold this reserve currency and fix their interest rate to it by standing ready to exchange domestic currency for the reserve currency. The U.S. dollar was the reserve currency from 1945 to 1973. The second is the gold standard in which central banks peg the prices of their currencies in terms of gold and hold gold as official international reserves. This was used between 1870 and 1914.

Difficulty: Moderate AACSB: Application of knowledge 5) This question concerns the mechanism of a reserve currency standard.

Two countries, X and Y, have two currencies, x and y, fixed to the reserve currency, the U.S. dollar. Suppose the exchange rate between x and the U.S. dollar is 3x per dollar. Suppose the exchange rate between y and the U.S. dollar is 5y per dollar. Explain (using numbers) the mechanism if the x-y exchange rate was 0.5 x per y.

Answer: At this exchange rate, an investor can make an arbitrage profit by selling $100 to the central bank of X (receiving 300 x), then selling your 300 x to the foreign exchange market for 300 x/(0.5 x per y) = 600 y, then buying U.S. dollars in the amount of $120 from the central bank of Y. Thus the foreign exchange market will bid the x-y exchange rate up to 0.6 x per y.

Difficulty: Difficult AACSB: Application of knowledge 6) This question concerns the mechanism of a reserve currency standard.

Two countries, X and Y, have two currencies, x and y, fixed to the reserve currency, the U.S. dollar. Suppose the exchange rate between x and the U.S. dollar is 3x per dollar. Suppose the exchange rate between y and the U.S. dollar is 5y per dollar. Explain (using numbers) the mechanism if the x-y exchange rate was 0.8 x per y.

Answer: At this exchange rate, an investor can make an arbitrage profit by selling $100 to the central bank of Y (receiving 500 y), then selling this 500 y to the foreign exchange market for 500 y/(0.8 x per y) = 400 x, then buying $133.33 U.S. dollars from the central bank of X with this 400 x. Thus the foreign exchange market will bid the x-y exchange rate down to 0.6.

Difficulty: Difficult AACSB: Application of knowledge 7) Explain how a country whose currency is the reserve currency can use monetary policy for macroeconomic stabilization. In particular, explain the result if that country doubled its domestic 195 Copyright © 2023 Pearson Education, Ltd.

money supply.

Answer: The immediate result of the doubling of the money supply in the reserve currency's country will be able to increase the exchange rate between the reserve currency and all other currencies. However, all other countries must fix their exchange rate to the reserve currency, so they will purchase the reserve currency and hold it as official international reserves (thus increase their own money supply) until the exchange rate has returned to normal. Thus, the reserve country has the power to affect its own economy and all other countries must adjust in response.

Difficulty: Moderate AACSB: Application of knowledge 7.8

The Gold Standard

1) Which of the following statements is TRUE? A) Under a gold standard, each country fixes the price of its currency in terms of gold by standing ready to trade domestic currency for gold whenever necessary to defend the official price.

B) Under a gold standard, each country is not responsible for pegging its currency's price in terms of the official international reserve asset, gold.

C) Under a gold standard, countries with limited gold reserves cannot participate.

D) Under a gold standard, all countries sets the same price of its currency in terms of gold.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 2) The gold standard, like a reserve currency system, results in A) fixed exchange rates between all currencies.

B) volatile exchange rates between all currencies.

C) unpredictable exchange rates between all currencies.

D) variable exchange rates between all currencies.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) If the dollar price of gold is pegged at $35 per ounce by the Federal Reserve while the pound price of gold is pegged at £14.58 per ounce by the Bank of England, the dollar/pound exchange rate must be constant at A) $2.40 per pound.

B) $0.42 per pound.

C) $0.24 per pound.

D) $4.20 per pound.

Answer: A Difficulty: Easy AACSB: Application of knowledge 4) Under a gold standard, whenever a country is losing reserves and seeing its money supply as a consequence, foreign countries are gaining reserves and seeing their money supplies .

A) shrink; expand 196 Copyright © 2023 Pearson Education, Ltd.

B) expand; shrink C) shrink; shrink D) expand; expand Answer: A Difficulty: Easy AACSB: Application of knowledge 5) The gold standard offers many potential benefits EXCEPT A) more influence on world macroeconomic conditions by countries with potentially large gold production.

B) symmetric nature of international monetary adjustment.

C) automatic limit on central banks' money creation.

D) certainty with a fixed pattern of exchanged rates.

Answer: A Difficulty: Easy AACSB: Application of knowledge 6) The gold standard has some drawbacks EXCEPT A) symmetric nature of international monetary adjustment.

B) overall price level stability depends on whether the relative price of gold and all other goods and services is stable.

C) central bank cannot increase holdings of international reserves as its economy grows unless new gold is discovered.

D) gold-producing nations gain unfair advantage.

Answer: A Difficulty: Easy AACSB: Application of knowledge 7) From 1837 and up until the Civil War, the United States adhered to a A) gold standard.

B) silver standard.

C) bimetallic standard.

D) bronze standard.

E) copper standard.

Answer: C Difficulty: Easy AACSB: Application of knowledge 8) From the Civil War up to 1914, the United States adhered to a A) gold standard.

B) silver standard.

C) bimetallic standard.

D) bronze standard.

E) copper standard.

Answer: A Difficulty: Easy AACSB: Application of knowledge 197 Copyright © 2023 Pearson Education, Ltd.

9) From 1837 until the Civil War, the U.S. adhered to a bimetallic standard, in which the currency was based on both A) silver and gold.

B) silver and platinum.

C) gold and palladium.

D) platinum and palladium.

Answer: A Difficulty: Easy AACSB: Application of knowledge 10) Halfway between the gold standard and a pure reserve currency standard where central banks' reserves consist of gold and currencies whose prices in terms of gold are fixed, is the A) gold exchange standard.

B) mixed exchange standard.

C) currency exchange standard.

D) reserve currency standard.

Answer: A Difficulty: Easy AACSB: Application of knowledge 11) The top four major currencies in countries' international reserve holdings include A) U.S. dollar, euro, British pound, and Japanese yen.

B) U.S. dollar, euro, Chinese renminbi, and Japanese yen.

C) U.S. dollar, euro, Japanese yen, and Swiss franc.

D) U.S. dollar, euro, Chinese renminbi, and British pound.

Answer: A Difficulty: Easy AACSB: Application of knowledge 12) Under the gold standard, if the dollar price of gold is pegged at $35 per ounce and the euro price of gold is pegged at 12 euro per ounce, what is the dollar/euro exchange rate?

Answer: The dollar/euro exchange rate must be constant and equal to ($35 per ounce) / (12 euro per ounce) = $2.92 per euro.

Difficulty: Moderate AACSB: Application of knowledge 13) Under the gold standard, if the dollar price of gold is pegged at $35 per ounce and the dollar/euro exchange rate is set at $2.40 per euro, what must the euro price of gold be pegged at?

Answer: The euro price of gold is constant and equal to ($35 per ounce) / ($2.40 per euro) = 14.58 euro per ounce.

Difficulty: Moderate AACSB: Application of knowledge 14) Describe the mechanism which would take place if the Bank of England decides to increase its money supply by purchasing domestic assets under the gold standard.

Answer: The increase in Britain's money supply would push interest rates down and make 198 Copyright © 2023 Pearson Education, Ltd.

foreign currency assets more attractive than domestic ones. Holders of pound deposits will attempt to sell them for foreign deposits. To accomplish this, they sell pound deposits to the Bank of England for gold and then use this gold to purchase foreign deposits. England loses foreign reserves since it is selling gold and foreign countries are gaining reserves. Equilibrium is re-established after Britain's money supply has fallen enough to force the British interest rate up until it is equally as attractive as the interest rate on foreign currency.

Difficulty: Difficult AACSB: Application of knowledge 15) List the drawbacks of the gold standard.

Answer: 1. Undesirable constraints on the use of monetary policy to fight unemployment.

2. A stable overall price level is achieved only if the relative price of gold and all other goods and services is stable.

3. A central bank cannot increase holdings of international reserves as its economy grows unless new gold is discovered.

4. Unfair advantage to gold-producing nations.

Difficulty: Moderate AACSB: Application of knowledge 16) Briefly discuss the main advantage of the bimetallic standard over the gold standard.

Answer: The advantage of bimetallism was that it might reduce the price level instability resulting from the use of gold alone. Were gold to become scarce and expensive, cheaper and relatively abundant silver would become the predominant form of money, thereby mitigating the deflation that a pure gold standard would imply.

Difficulty: Moderate AACSB: Application of knowledge 17) Please briefly describe what is meant by a gold exchange standard.

Answer: Under a gold exchange standard, central banks' reserves consist of gold and currencies whose price in terms of gold are fixed, and each central bank fixes its exchange rate to a currency with a fixed gold price. The post-WWII currency system was supposed to be a gold exchange standard with the U.S. responsible for fixing the price of gold at $35 per ounce.

Difficulty: Moderate AACSB: Application of knowledge 18) From the figure below, please provide an explanation for the slower pace of accumulation of international reserves held by developing countries starting with the crisis years of 2008-2009.

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Answer: The growth of global capital markets has increased the potential variability of financial flaws across borders, and especially across the borders of developing countries. The sharp decline in developing country reserve growth started from 2008-2009 due to an international debt crisis.

Difficulty: Difficult AACSB: Application of knowledge 7.9 Appendix 1 to Chapter 7: Equilibrium in the Foreign Exchange Market with Imperfect Asset Substitutability 1) If assets are imperfect substitutes, then an increase in the amount of domestic currency bonds held by the public will the risk premium and the amount of domestic currency bonds held by the central bank.

A) increase; leave unchanged B) increase; decrease C) increase; increase D) decrease; decrease E) leave unchanged; decrease Answer: A Difficulty: Moderate AACSB: Application of knowledge 2) If assets are imperfect substitutes, then a decrease in the amount of domestic currency bonds held by the public will the risk premium and the amount of domestic currency bonds held by the central bank.

A) decrease; leave unchanged B) increase; decrease C) increase; increase 200 Copyright © 2023 Pearson Education, Ltd.

D) decrease; decrease E) leave unchanged; decrease Answer: A Difficulty: Moderate AACSB: Application of knowledge 7.10

Appendix 2 to Chapter 7: The Timing of Balance of Payments Crises

1) Balance of payments crises under fixed exchange rates occur because of A) government policies that are inconsistent with fixed exchange rates.

B) punitive currency wars.

C) global inflation and trade imbalances due to war.

D) excessive exports and imports that overload the global system.

E) monotonic expansion in global currency volume.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) A balance of payments crises under fixed exchange rates occurs when A) marginal returns on foreign exchange investments approach zero.

B) a country runs out of foreign reserves.

C) a country is in a liquidity trap.

D) forward currency markets undergo high volatility.

E) exports and imports expand beyond some point.

Answer: B Difficulty: Easy AACSB: Application of knowledge 7.11

Appendix 3 to Chapter 7: The Monetary Approach to the Balance of Payments

1) The fluctuations in central bank reserves can be thought of as the result of changes in the money market. This method of analyzing the balance of payments is called the A) monetary approach to the balance of payments.

B) fiscal approach to the balance of payments.

C) fluctuation approach to the balance of payments.

D) reserve approach to the balance of payments.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) The monetary approach was developed in the 1950s and 1960s by A) IMF researchers Polak, Johnson, Mundell, and their students at the University of Chicago.

B) Polak, Johnson, and Mundell.

C) students at the University of Chicago.

D) Krugman, Obstfeld, and Melitz.

Answer: A Difficulty: Easy 201 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge International Finance: Theory & Policy, 12/e, Global Edition Chapter 8 International Monetary Systems: A Historical Overview 8.1

Macroeconomic Policy Goals in an Open Economy

1) What made it sometimes more difficult for governments to achieve such policy goals as full employment and price level stability?

A) The interdependence of open national economies.

B) The independence of closed national economies.

C) The independence of open national economies.

D) The interdependence of closed national economies.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) In an open economy, macroeconomic policy has two basic goals: A) internal and external balance.

B) internal and foreign balance.

C) external and domestic balance.

D) domestic and foreign balance.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) By internal balance, most economists mean A) full employment.

B) price stability.

C) full employment and domestic price level stability.

D) full employment and moderate increase in prices.

E) full employment and high disposable income.

Answer: C Difficulty: Easy AACSB: Application of knowledge 4) By external balance, most economists mean A) avoiding excessive imbalances in international payments.

B) balance between exports and imports.

C) balance between the trade and service accounts.

D) what amounts to fixed exchange rates.

E) imbalance in internal transactions.

Answer: A Difficulty: Easy AACSB: Application of knowledge 5)

can lead to general price level movements that reduce the economy's efficiency by 202 Copyright © 2023 Pearson Education, Ltd.

making the real value of the monetary unit less certain and thus a less useful guide for economic decisions.

A) Under- and overemployment B) Full employment C) Cyclical employment D) Seasonal employment Answer: A Difficulty: Easy AACSB: Application of knowledge 6) Which one of the following statements is TRUE? A) Inflation but not deflation can occur even under conditions of full employment.

B) Deflation but not inflation can occur even under conditions of full employment.

C) Inflation or deflation can occur even under conditions of full employment.

D) Inflation can occur even under conditions of full employment only in the long run.

E) Inflation does not coincide with periods of high unemployment levels.

Answer: C Difficulty: Easy AACSB: Application of knowledge 7) A country seeking to maintain internal balance would be concerned A) only with attaining low levels of unemployment.

B) primarily with ensuring that saving is weighted more towards domestic investment than the current account.

C) with large fluctuations in output or wage prices.

D) with maintaining an adequate stock of gold reserves.

E) with stabilizing employment levels globally.

Answer: C Difficulty: Easy AACSB: Application of knowledge 8) Inflation can occur under conditions of full employment A) only if the central bank continues to inject money into the economy and the agents' expectations of inflation are supported by the bank's activities.

B) only if the central bank continues to inject money into the economy.

C) only if the central bank continues to withdraw money from the economy.

D) only if the central bank continues to inject money into the economy and all agents expect that inflation will not occur.

E) only if the central bank fails to inject money into the economy.

Answer: A Difficulty: Easy AACSB: Application of knowledge 9) A sudden increase in the U.S. price level A) makes those with dollar debts worse off.

B) makes those with dollar debts better off.

C) does not affect those with dollar debts.

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D) makes those with foreign debts better off.

E) increases all dollar debts.

Answer: B Difficulty: Easy AACSB: Application of knowledge 10) A sudden increase in the U.S. price level A) makes creditors in dollars better off.

B) makes creditors in dollars worse off.

C) does not affect creditors in dollars.

D) makes creditors in DM worse off.

E) makes lenders worse off.

Answer: B Difficulty: Easy AACSB: Application of knowledge 11) A sudden decrease in the U.S. price level A) makes those with dollar debts worse off.

B) makes those with dollar debts better off.

C) does not affect those with dollar debts.

D) makes those with DM worse off.

E) makes creditors worse off.

Answer: A Difficulty: Easy AACSB: Application of knowledge 12) A sudden decrease in the U.S. price level A) makes creditors in dollars better off.

B) makes creditors in dollars worse off.

C) does not affect creditors in dollars.

D) makes creditors in DM better off.

E) makes those with dollar debts better off.

Answer: A Difficulty: Easy AACSB: Application of knowledge 13) The costs of inflation have been most apparent in the post-war period in countries like A) Argentina.

B) Belgium.

C) the United States.

D) Canada.

E) Japan.

Answer: A Difficulty: Easy AACSB: Application of knowledge 14) The costs of inflation have been most apparent in the post-war period in countries like 204 Copyright © 2023 Pearson Education, Ltd.

A) Brazil.

B) Belgium.

C) the United States.

D) Canada.

E) Japan.

Answer: A Difficulty: Easy AACSB: Application of knowledge 15) The costs of inflation have been most apparent in the post-war period in countries like A) Serbia.

B) Belgium.

C) the United States.

D) Canada.

E) Japan.

Answer: A Difficulty: Easy AACSB: Application of knowledge 16) The costs of inflation have been most apparent in the post-war period in countries like A) Zimbabwe.

B) Belgium.

C) the United States.

D) Canada.

E) Japan.

Answer: A Difficulty: Easy AACSB: Application of knowledge 17) External balance as the balance in a country's current account A) is appropriate in some circumstances, and not appropriate as a general rule.

B) is always appropriate as a general rule.

C) is inappropriate in all circumstances.

D) is appropriate in all circumstances.

Answer: A Difficulty: Easy AACSB: Application of knowledge 18) Trade of consumption over time is called A) intertemporal trade.

B) future trade.

C) consumption trade.

D) time trade.

Answer: A Difficulty: Easy AACSB: Application of knowledge 205 Copyright © 2023 Pearson Education, Ltd.

19) A current account surplus A) poses a problem if domestic savings are being invested more profitably abroad than they would be at home.

B) may pose no problem if domestic savings are being invested more profitably abroad than they would be at home.

C) may pose no problem if domestic savings are being invested less profitably abroad than they would be at home.

D) there is no relation between current account surplus and between savings and investment.

E) poses a problem if domestic savings are being invested less profitably abroad than they would be at home.

Answer: B Difficulty: Easy AACSB: Application of knowledge 20) A current account deficit A) will not pose a problem, especially if it is accompanied by an expansionary fiscal policy.

B) may pose no problem if the borrowed funds are channeled into productive domestic investment projects that pay for themselves with the revenue they generate in the future.

C) may still pose a problem, even if the borrowed funds are channeled into productive domestic investment projects.

D) there is no relation between current account surplus and between savings and investment.

E) will pose a problem because the country is borrowing funds from the rest of the world that it won't be able to pay back later.

Answer: B Difficulty: Easy AACSB: Application of knowledge 21) Which one of the following statements is TRUE? A) Countries with strong investment opportunities should invest little at home and channel their savings into more productive investment activity abroad.

B) Countries with weak investment opportunities should invest little at home and channel their savings into more productive investment activity abroad.

C) Countries with weak investment opportunities should invest more at home.

D) Countries with weak investment opportunities should invest little abroad.

E) Countries with weak investment opportunities should invest little abroad and channel their savings into more productive investment activity domestically.

Answer: B Difficulty: Easy AACSB: Application of knowledge 22) Countries with A) strong investment opportunities should invest little at home and channel their savings into more productive investment activity abroad.

B) strong investment opportunities should invest more at home and less abroad.

C) weak investment opportunities should invest more at home.

D) weak investment opportunities should invest little abroad.

E) countries with productive investment should invest exclusively at home.

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Answer: B Difficulty: Easy AACSB: Application of knowledge 23) Countries where investment is relatively A) productive should be net exporters of currently available output.

B) unproductive should be net importers of currently available output.

C) unproductive should be net exporters of currently available output.

D) unproductive should be net exporters of future available output.

E) unproductive should focus on their internal balance.

Answer: C Difficulty: Easy AACSB: Application of knowledge 24) Countries where investment is relatively A) unproductive should have current account deficits.

B) unproductive should have current account surpluses.

C) productive should have current account surpluses.

D) productive should have low outputs.

Answer: B Difficulty: Easy AACSB: Application of knowledge 25) Which one of the following statements is TRUE? A) Countries where investment is relatively productive should be net importers of current output.

B) Countries where investment is relatively unproductive should be net importers of current output.

C) Countries where investment is relatively productive should be net exporters of current output.

D) Countries where investment is relatively productive should not export or import current output.

E) Countries where investment is relatively unproductive should invest at home.

Answer: A Difficulty: Easy AACSB: Application of knowledge 26) Countries where investment is A) relatively unproductive should have current account deficits.

B) relatively productive should have current account surpluses.

C) relatively productive should have current account deficits.

D) relatively productive should have balanced current accounts.

E) relatively unproductive should have balanced current accounts.

Answer: C Difficulty: Easy AACSB: Application of knowledge 27) A large current account deficit caused by an expansionary fiscal policy that does not simultaneously make domestic investment opportunities more profitable may signal a need for the government to 207 Copyright © 2023 Pearson Education, Ltd.

A) restore external balance by changing its economic course.

B) restore internal balance by lowering taxes even more.

C) restore internal balance by increasing government spending even more.

D) restore external balance by promoting more imports.

Answer: A Difficulty: Easy AACSB: Application of knowledge 28) Every open economy faces that limits its spending over time to levels that allow it to pay the interest and principal on its foreign debts.

A) an intertemporal budget constraint B) no budget constraint C) no international or national regulation D) an international annual budget agreement Answer: A Difficulty: Easy AACSB: Application of knowledge 29) When countries begin to have trouble meeting their payments on past foreign loans, foreign creditors become reluctant to lend them new funds and may even demand immediate repayment of the earlier loans. Economists refer to such an event as a sudden in foreign lending.

A) stop B) penalty C) punishment D) pause Answer: A Difficulty: Easy AACSB: Application of knowledge 30) Governments prefer to avoid excessive current account surpluses because A) the returns to domestic savings are more difficult to tax than those on assets abroad.

B) an addition to the home capital stock may increase domestic unemployment and therefore lead to higher national income.

C) foreign investment in one firm may have beneficial technological spillover effects on other foreign producers that the investing firm does not capture.

D) an addition to the home capital stock may reduce domestic unemployment and therefore lead to higher national income.

E) domestic savings increase with more investment abroad.

Answer: D Difficulty: Easy AACSB: Application of knowledge 31) Governments prefer to avoid excessive current account surpluses because A) the returns to domestic savings are easier to tax than those on assets abroad.

B) the returns to domestic savings are more difficult to tax than those on assets abroad.

C) an addition to the home capital stock may increase domestic unemployment and therefore lead to higher national income.

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D) foreign investment in one firm may have beneficial technological spillover effects on other foreign producers that the investing firm does not capture.

E) domestic savings increase with more investment abroad.

Answer: A Difficulty: Easy AACSB: Application of knowledge 32) The case of New Zealand, described in the text, is concerned with the country's A) prospects for long term growth.

B) ability to sustain current account deficits.

C) unproductive industrial sector and its prospects for long-run growth.

D) labor productivity.

E) exchange rate volatility relative to other currencies.

Answer: B Difficulty: Easy AACSB: Application of knowledge 33) New Zealand's net debt to foreign lenders stands at around output.

A) 50 B) 40 C) 30 D) 20 E) 10 Answer: A Difficulty: Easy AACSB: Application of knowledge

percent of its national

34) "The line distinguishing external from internal goals can be fuzzy." Discuss.

Answer: This statement is true. For example, employment target for export industries when export growth influences the ability of the economy to repay its foreign debts.

Difficulty: Moderate AACSB: Application of knowledge 35) Why do governments prefer to avoid current account deficits that are too large?

Answer: A current account deficit may pose no problem if the borrowed funds are channeled into productive domestic investment projects that pay for themselves with the revenue they generate in the future. However, sometimes, large current account deficits represent temporarily high consumption resulting from misguided government policies or some other malfunctioning of the economy. Sometimes the investment projects that draw on foreign funds may be badly planned and based on overoptimistic expectations about future profitability. In such cases, the government might wish to reduce the current account deficit immediately rather than face problems in repaying its foreign debt in the future. A large current account deficit can undermine foreign investors' confidence and contribute to a sudden stop. In the event of a sudden stop, moreover, the larger the initial deficit, the larger and more painful the fall in domestic spending that is needed to make the economy live strictly within its means.

Difficulty: Moderate 209 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 36) What is a sudden stop in foreign lending and its purpose?

Answer: A sudden stop in foreign lending happens when countries begin to have trouble meeting their payments on past foreign loans, foreign creditors become reluctant to lend them new funds and may demand immediate repayment of the earlier loans. In such cases, the purpose is for home government to take severe action to reduce the country's desired borrowing from foreigners to feasible levels as well as to repay maturing loans that foreigners are unwilling to renew.

Difficulty: Easy AACSB: Application of knowledge 37) Why do governments prefer to avoid excessive current account surpluses? Or, why are growing domestic claims to foreign wealth ever a problem?

Answer: For a given level of national saving, an increased current account surplus implies lower investment in domestic plant and equipment. A few reasons why: first, the returns to domestic savings may be easier to tax than those on assets abroad; second, an addition to the home capital stock may reduce domestic unemployment and therefore lead to higher national income; third, domestic investment by one firm may have beneficial technological spillover effects on other domestic producers that the investing firm does not capture. In addition, the country may in the future find itself unable to collect the money it is owed. Furthermore, countries with large surpluses can become targets for discriminatory protectionist measures by trading partners with external deficits.

Difficulty: Moderate AACSB: Application of knowledge 38) Using an equation, explain why governments prefer to avoid excessive current account surpluses?

Answer: This follows from the national income identity, S = CA + I, which says that total domestic savings, S, is divided between foreign asset accumulation, CA, and domestic investment, I. Difficulty: Moderate AACSB: Application of knowledge 39) The case of New Zealand, described in the text, asks what question about the country's international debt position?

Answer: Fundamentally, the question is whether or not a country can sustain a current account deficit indefinitely. The answer is that, under certain conditions, yes it can.

Difficulty: Moderate AACSB: Reflective thinking 40) The case of New Zealand, as described in the text, draws what simple conclusion regarding the country's international debt position?

Answer: Fundamentally, the question is whether or not a country can sustain a current account deficit indefinitely. The conclusion is that, under certain conditions, yes it can.

Difficulty: Moderate AACSB: Reflective thinking 210 Copyright © 2023 Pearson Education, Ltd.

41) The case of New Zealand, described in the text, draws what technical conclusion regarding the country's international debt position?

Answer: Fundamentally, the question is whether or not a country can sustain a current account deficit indefinitely. The conclusion depends upon the country's future prospects. If net exports are expected to rise at a rate sufficient to counteract the effects of debt (including interest payments) over the relevant time period, then deficits could go on for an extended period.

Difficulty: Moderate AACSB: Reflective thinking 8.2

Classifying Monetary Systems: The Open-Economy Monetary Trilemma

1) Which of the following is one component of the "trilemma" that is faced by policy makers in choosing monetary arrangements?

A) exchange rate stability B) restrictions on international capital movements C) tariffs and subsidies D) restrictions on the migration of labor E) global inflation Answer: A Difficulty: Easy AACSB: Application of knowledge 2) Which of the following is one component of the "trilemma" that is faced by policy makers in choosing monetary arrangements?

A) freedom of international capital movements B) exchange rate instability C) tariffs and subsidies D) restrictions on the migration of labor E) global inflation Answer: A Difficulty: Easy AACSB: Application of knowledge 3) Which of the following is one component of the "trilemma" that is faced by policy makers in choosing monetary arrangements?

A) monetary policy oriented towards domestic goals B) exchange rate instability C) tariffs and subsidies D) restrictions on the migration of labor E) global inflation Answer: A Difficulty: Easy AACSB: Application of knowledge 4) What is the nature of the trilemma that is encountered when choosing monetary arrangements?

A) Only two of the three aspects of internal and external balance can be accommodated simultaneously.

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B) Only three of the four aspects of internal and external balance can be accommodated simultaneously.

C) Only one of the three aspects of internal and external balance can be accommodated simultaneously.

D) Only two of the four aspects of internal and external balance can be accommodated simultaneously.

E) Only one of the four aspects of internal and external balance can be accommodated simultaneously.

Answer: A Difficulty: Easy AACSB: Application of knowledge 5) What are the components of the trilemma that is encountered when a country chooses its monetary policy and what is the meaning of the term?

Answer: The components are (1) exchange rates, (2) domestic goals, and (3) international capital movements. The monetary trilemma (a three-part dilemma) exists because only two of the three components can be influenced by monetary policy.

Difficulty: Moderate AACSB: Application of knowledge 8.3

International Macroeconomic Policy under the Gold Standard, 1870-1914

1) The gold standard had its origin in the use of gold coins as A) a medium of exchange, unit of account, and store of value.

B) an input for fine jewelry.

C) a medium of exchange.

D) unit of account.

E) store of value.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) In which country was the gold standard established as a legal institution in 1819?

A) Great Britain B) India C) China D) Australia Answer: A Difficulty: Easy AACSB: Application of knowledge 3) When did the United States, Germany, and Japan adopt the gold standard?

A) later in the 19th century B) later in the 18th century C) later in the 20th century D) later in the 21st century Answer: A 212 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Easy AACSB: Application of knowledge 4) Under the gold standard era of 1870-1914 A) Tokyo was the center of the international monetary system.

B) Paris was the center of the international monetary system.

C) Berlin was the center of the international monetary system.

D) New York was the center of the international monetary system.

E) London was the center of the international monetary system.

Answer: E Difficulty: Easy AACSB: Application of knowledge 5) Under the gold standard, the primary responsibility of a central bank was to A) fix the exchange rate between its currency and gold.

B) manage the flow of gold in and out of the country.

C) float the exchange rate between its currency and gold.

D) keep gold in national reserves safe.

Answer: A Difficulty: Easy AACSB: Application of knowledge 6) Under the gold standard era of 1870-1914 A) central banks tried to have sharp fluctuations in the balance of payments.

B) central banks tried to avoid sharp fluctuations in the current account of the balance of payments.

C) central banks tried to avoid sharp fluctuations in the trade account of the balance of payments.

D) central banks tried to avoid sharp fluctuations in the capital account of the balance of payments.

E) central banks tried to avoid sharp fluctuations in the balance of payments.

Answer: E Difficulty: Easy AACSB: Application of knowledge 7) A country's balance of payment is A) the difference between the current plus capital account balances and the balance of net non-reserved financial flows abroad.

B) the difference between export and import payments.

C) the difference between a country's domestic assets and foreign liabilities.

D) the difference between the outflow and inflow of gold shipments between the central banks.

Answer: A Difficulty: Easy AACSB: Application of knowledge 8) A country is said to be in balance of payments equilibrium, when the sum of its current and its A) non-reserved capital accounts equals zero.

B) reserved capital accounts equals zero.

C) non-reserved capital accounts equals to the surplus in the capital account.

D) non-reserved capital accounts equals to the deficit in the capital account.

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E) non-reserved capital accounts' balance is higher than the total capital account balance.

Answer: A Difficulty: Easy AACSB: Application of knowledge 9) Under the Gold standard, a country is said to be in balance of payments equilibrium when the current account balance is A) financed entirely by international lending without reserve movements.

B) financed by international lending and with reserve movements.

C) equal to zero.

D) financed entirely by international lending and past gold reserves.

E) financed entirely by gold reserves.

Answer: A Difficulty: Easy AACSB: Application of knowledge 10) The price-specie-flow mechanism A) is an automatic mechanism for assuring external balance under floating exchange rates.

B) is an automatic mechanism for assuring external balance under the gold standard.

C) is an automatic mechanism for assuring internal balance under floating exchange rates.

D) is an automatic mechanism for assuring internal balance under the gold standard.

E) is an automatic mechanism for assuring internal balance under mercantilism.

Answer: B Difficulty: Moderate AACSB: Application of knowledge 11) The price-specie-flow mechanism is a model developed by to recognize the powerful automatic mechanism that contributes to the simultaneous achievement of balance of payment by all countries.

A) David Hume B) Keynes C) Frank Baum D) Jeffrey Frieden Answer: A Difficulty: Easy AACSB: Application of knowledge 12) Under the price-specie-flow mechanism, what happens when, say, Great Britain's current plus capital account surplus is greater than its non-reserve financial account balance?

A) Great Britain's loans will finance all foreign net imports.

B) An automatic drop in Great Britain's domestic prices and rise in foreign prices.

C) Gold reserves will flow into Great Britain.

D) Gold reserves will flow out of Great Britain.

E) Great Britain will experience a deficit.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 214 Copyright © 2023 Pearson Education, Ltd.

13) The "rules of the game" under the gold standard can best be described as which of the following?

A) selling domestic assets in a deficit and buying assets in a surplus B) slowing down the automatic adjustments processes inherent in the gold standard C) selling domestic assets in order to accumulate gold D) selling foreign assets in a deficit and buying foreign assets in a surplus E) selling domestic assets in a surplus Answer: A Difficulty: Easy AACSB: Application of knowledge 14) Until the United States Civil War, The Unites States had a A) gold-based monetary standard.

B) silver-based monetary standard.

C) bimetallic monetary standard consisting of silver and gold.

D) bimetallic monetary standard consisting of copper and silver.

E) bimetallic monetary standard consisting of copper and gold.

Answer: C Difficulty: Easy AACSB: Application of knowledge 15) Which of the following statements is TRUE? A) The gold standard allowed high degrees of exchange rate stability and international financial capital mobility but did not allow monetary policy to pursue internal policy goals.

B) The gold standard allowed high degrees of exchange rate stability, international financial capital mobility and monetary policy to pursue internal policy goals.

C) The gold did not allow high degrees of exchange rate stability, international financial capital mobility, and monetary policy to pursue internal policy goals.

D) The gold standard allowed monetary policy to pursue internal policy goals, but did not allow high degrees of exchange rate stability and international financial capital mobility.

Answer: A Difficulty: Easy AACSB: Application of knowledge 16) Until the Civil War, the United States had A) bimetallic monetary standard consisting of silver and gold.

B) gold standard.

C) silver standard.

D) paper currency, called the "greenback."

Answer: A Difficulty: Easy AACSB: Application of knowledge 17) Once the United States Civil War broke out, the United States moved to a A) gold standard.

B) silver standard.

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C) bimetallic monetary standard consisting of silver and gold.

D) bimetallic monetary standard consisting of copper and gold.

E) paper currency, called the "greenback."

Answer: E Difficulty: Easy AACSB: Application of knowledge 18) L. Frank Baum's classic 1900 children's book, The Wonderful Wizard of Oz, is A) an allegorical rendition of the U.S. political struggle over silver.

B) an allegorical rendition of the U.S. political struggle over copper.

C) an allegorical rendition of the U.S. political struggle over both silver and gold.

D) an allegorical rendition of the U.S. political struggle over indebted farmers.

E) an allegorical rendition of the U.S. political struggle over gold.

Answer: E Difficulty: Easy AACSB: Application of knowledge 19) In L. Frank Baum's classic 1900 children's book, The Wonderful Wizard of Oz, the name "oz" is a reference to A) an ounce (oz.) of gold.

B) an ounce (oz.) of silver.

C) an ounce (oz.) of copper.

D) an ounce (oz.) of gold or silver.

E) an ounce (oz.) of wheat.

Answer: A Difficulty: Easy AACSB: Application of knowledge 20) How did the international monetary system influence macroeconomic policy-making and performance during the gold standard era (1870-1914)?

Answer: London was the center of the international monetary system. The primary responsibility of the central bank was to preserve the official parity between its currency and gold. To maintain this price, the central bank needed an adequate stock of gold reserves. Central banks tried to avoid sharp fluctuations in the balance of payments.

Difficulty: Moderate AACSB: Application of knowledge 21) It is claimed that L. Frank Baum's classic 1900 children's book, The Wonderful Wizard of Oz, is an allegorical rendition of the U.S. political struggle over gold.

Answer: This statement is true. In L. Frank Baum's classic 1900 children's book, The Wonderful Wizard of Oz, the name "oz" is a reference to an ounce (oz.) of gold, and the yellow brick road represents the false promise of gold. The story represents the struggle of farmers in the western U.S. who were heavily indebted.

Difficulty: Easy AACSB: Application of knowledge 22) Explain how the price-specie-flow mechanism works under the gold standard.

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Answer: When a country with a gold standard had a positive balance of trade, gold would flow into the country in the amount that the value of exports exceeds the value of imports. Conversely, when such a country had a negative balance of trade, gold would flow out of the country in the amount that the value of imports exceeds the value of exports. These gold flows automatically influence the domestic and foreign money supply, change domestic and foreign price of goods and services, therefore reducing the domestic trade surplus/deficit so that all countries reach balance of payment equilibrium.

Difficulty: Moderate AACSB: Application of knowledge 23) Why "the rules of the game" of the gold standard were frequently violated before 1914?

Answer: The incentives to obey the rules applied with greater force to deficit than to surplus countries, so in practice it was the deficit countries that bore the burden of bringing the payments balances of all countries into equilibrium. By not always taking action to reduce gold inflows, the surplus countries worsened a problem of international policy coordination inherent in the system: Deficit countries competing for a limited supply of gold reserves might adopt overly contractionary monetary policies that harmed employment while doing little to improve their reserve positions.

Difficulty: Moderate AACSB: Application of knowledge 8.4

The Interwar Years, 1918-1939

1) The gold standard period was A) up until the first world war.

B) between the first and second world wars.

C) following the second world war until 1970.

D) between 1954 and 1970.

E) between 1814 and 1865.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) Which of the following statements is TRUE? A) Governments effectively suspended the gold standard during World War I and financed part of their massive military expenditures by printing money.

B) Governments continued with the gold standard during World War I and used gold to finance their massive military expenditures.

C) Governments effectively suspended the gold standard during World War I and financed part of their massive military expenditures by borrowing money from other countries.

D) Governments continued with the gold standard during World War I and increased gold reserves to finance reconstruction process.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) Britain returned to the gold standard in

then left again in 217

Copyright © 2023 Pearson Education, Ltd.

when foreign

holders of sterling lost confidence in Brian's promise to maintain its currency's value and began converting their sterling to gold.

A) 1925; 1931 B) 1919; 1922 C) 1922; 1925 D) 1925; 1929 Answer: A Difficulty: Easy AACSB: Application of knowledge 4) The U.S. left the gold standard in A) 1933; 1934 B) 1925; 1931 C) 1919; 1933 D) 1925; 1929 Answer: A Difficulty: Easy AACSB: Application of knowledge

then returned in

.

5) A policy of "beggar-thy-neighbor" is a policy that A) often benefits the home country in the long run.

B) often benefits the foreign country in the long run.

C) often benefits the foreign country in the short run.

D) does not often benefit any country in the long run.

E) benefits the home country's neighbors in the long run.

Answer: D Difficulty: Easy AACSB: Application of knowledge 6) A measure that raises domestic welfare is called a at the cost of worsening economic conditions abroad.

A) beggar-thy-neighbor policy B) price-specie-flow mechanism C) prosper-thy-neighbor policy D) the wizard of oz mechanism Answer: A Difficulty: Easy AACSB: Application of knowledge

when it benefits the home country

7) The world economy into increasingly A) disintegrated; autarkic B) integrated; interdependent C) disintegrated; dependent D) integrated; self-sufficient Answer: A Difficulty: Easy AACSB: Application of knowledge

national units in the early 1930s.

218 Copyright © 2023 Pearson Education, Ltd.

8) Which of the following statements is TRUE? A) All countries would have been better off in a world with freer international trade, provided international cooperation had helped each country preserve its external balance and financial stability without sacrificing internal policy goals.

B) All countries would have been worse off in a world with freer international trade, provided international cooperation had helped each country preserve its external balance and financial stability without sacrificing internal policy goals.

C) All countries would have been better off in a world with higher trade barriers and less international cooperation.

D) All countries would have been worse off in a world with freer international trade and more international cooperation.

Answer: A Difficulty: Easy AACSB: Application of knowledge 9) The Great Depression that started in 1929 was A) confined only to the United States.

B) confined only to the United States and Britain.

C) confined only to the United States and Europe.

D) a global phenomenon.

E) confined only to the Americas.

Answer: D Difficulty: Easy AACSB: Application of knowledge 10) Which one of the following statements is the MOST accurate? By the year 1932, the United States A) and Canada alone held more than 70 percent of the world's monetary gold.

B) and Germany alone held more than 70 percent of the world's monetary gold.

C) and Britain alone held more than 70 percent of the world's monetary gold.

D) Britain, and France alone held more than 70 percent of the world's monetary gold.

E) and France alone held more than 70 percent of the world's monetary gold.

Answer: E Difficulty: Easy AACSB: Application of knowledge 11) Countries that abandoned the gold standard freed themselves to adopt more expansionary monetary policies that limited (or prevented) both A) domestic deflation and output contraction.

B) domestic inflation and output expansion.

C) domestic deflation and output expansion.

D) domestic inflation and output contraction.

Answer: A Difficulty: Easy AACSB: Application of knowledge 219 Copyright © 2023 Pearson Education, Ltd.

12) Countries with the A) biggest deflations and output contractions are countries which were never on the gold standard until 1936.

B) biggest inflations and output contractions are countries which were on the gold standard until 1936.

C) lowest deflations and output contractions are countries which were on the gold standard until 1936.

D) biggest deflations and output increases are countries which were on the gold standard until 1936.

E) biggest deflations and output contractions are countries which stayed on the gold standard until 1936.

Answer: E Difficulty: Easy AACSB: Application of knowledge 13) How did the international monetary system influence macroeconomic policy-making and performance during the interwar period (1918-1939)?

Answer: Governments effectively suspended the gold standard during World War I and financed part of their massive military expenditures by printing money. Further, labor forces and productivity capacity had been reduced sharply through war losses. As a result, price levels were higher everywhere at the conclusion of the war in 1918. Of special note is the German hyperinflation that occurred when prices in Germany increased by a factor of 481.5 billion!

The United States returned to gold in 1919. In 1922, at a conference in Genoa, Italy, a group of countries including Britain, France, Italy and Japan agreed on a program of a partial gold exchange standard in which smaller countries could hold as reserves the currencies of several large countries whose own international reserves would consist entirely of gold.

In 1925, Britain returned to the gold standard by pegging the pound to gold at the prewar price.

Thus, the Bank of England was therefore forced to follow contractionary monetary policies that contributed to severe unemployment and to the decline of London as the leading financial center.

The world economy disintegrated into increasingly autarkic (self-sufficient) national units in the early 1930s.

Difficulty: Difficult AACSB: Application of knowledge 14) Describe the effects of the Smoot-Hawley tariff imposed by the United States in 1930.

Answer: It had a damaging effect on employment abroad. The foreign response involved retaliatory trade restrictions and preferential trading arrangements among a group of countries.

This is an example of "beggar-thy-neighbor" policy, meaning a policy that benefits the home country only because it worsens economic conditions abroad.

Difficulty: Moderate AACSB: Application of knowledge 15) What explains the nearly universal scope of the Great Depression?

Answer: The international gold standard played a central role in starting, deepening, and spreading the Great Depression.

Difficulty: Moderate AACSB: Application of knowledge 220 Copyright © 2023 Pearson Education, Ltd.

8.5

The Bretton Woods System and the International Monetary Fund

1) What was signed by representatives of 44 countries in Bretton Woods, New Hampshire in July 1944?

A) the Articles of Agreement of the International Monetary Fund (IMF) B) the Articles of Agreement of the World Bank (WB) C) the Articles of Agreement of the World Trade Organization (WTO) D) the General Agreement on Tariffs and Trade (GATT) Answer: A Difficulty: Easy AACSB: Application of knowledge 2) Countries singed the Articles of Agreement in Bretton Woods with a hope to A) design an international monetary system that would foster full employment and price stability while allowing individual countries to attain external balance without restrictions on international trade.

B) design an international system that would enforce stricter restrictions on international trade.

C) design an international tax system that would increase taxes on imports and exports.

D) design an international monetary system that would allow floating exchange rates.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) The IMF's Articles of Agreement forced the U.S. to exchange gold for dollars at what price?

A) $25/ ounce B) $35/ ounce C) $45/ ounce D) $55/ ounce E) $20/ ounce Answer: B Difficulty: Easy AACSB: Application of knowledge 4) Which of the two features of the IMF Articles of Agreement helped promote flexibility in external adjustment?

A) IMF members helped countries maintain full employment.

B) IMF allowed countries to attain internal balance.

C) New countries would enter the agreement if they fixed their exchange rate.

D) IMF members contributed their currency to form a pool of resources that IMF could lend to countries in need and parities in the exchange rate against the dollar could be adjusted with agreement of IMF. E) IMF members argued against the use of floating exchange rates.

Answer: D Difficulty: Easy AACSB: Application of knowledge 5) The IMF Articles of Agreement, through a mixture of discipline and flexibility, hoped to 221 Copyright © 2023 Pearson Education, Ltd.

A) avoid a repetition of the turbulent interwar experience.

B) enforce stricter restrictions on international trade.

C) increase taxes on imports and exports.

D) promote floating exchange rates.

Answer: A Difficulty: Easy AACSB: Application of knowledge 6) A convertible currency is a currency that may be freely exchanged for A) domestic assets.

B) only silver.

C) only copper.

D) national currency.

E) foreign currencies.

Answer: E Difficulty: Easy AACSB: Application of knowledge 7) The dollar of the United States became the postwar world's key currency because of all EXCEPT A) the early convertibility of the U.S. dollar in 1945.

B) the special position of the dollar under the Bretton Woods system.

C) the strength of the American economy relative to the devastated economies of Europe and Japan.

D) central banks naturally found it advantageous to hold their international reserves in the form of interest-bearing dollar assets.

E) the ease of transporting U.S. dollars compared with other currencies.

Answer: E Difficulty: Moderate AACSB: Application of knowledge 8) With growing opportunities to move funds across borders after the restoration of the convertibility, national interest rates became more A) linked.

B) isolated.

C) disconnected.

D) independent.

Answer: A Difficulty: Easy AACSB: Application of knowledge 9) A person holding dollar deposits during the devaluation of the dollar would A) enjoy a monetary gain.

B) see the foreign currency value of dollar assets increase by the amount of the exchange rate change.

C) shift their wealth into domestic investments.

D) suffer a monetary loss and see the foreign currency value of dollar assets decrease by the 222 Copyright © 2023 Pearson Education, Ltd.

amount of the exchange rate change.

E) see no change in their investments.

Answer: D Difficulty: Moderate AACSB: Application of knowledge 10) Countries with large current account surpluses might be viewed by the market as candidates for A) devaluation.

B) revaluation.

C) bankruptcy.

D) depreciation.

E) investment.

Answer: B Difficulty: Easy AACSB: Application of knowledge 11) Countries with large and persistent current account deficits might be viewed by the market as candidates for A) devaluation.

B) revaluation.

C) bankruptcy.

D) depreciation.

E) investment.

Answer: A Difficulty: Easy AACSB: Application of knowledge 12) The Bretton Woods structure of fixed exchange rates was brought down eventually because of A) the balance of payments crises.

B) the border crises.

C) the financial crisis.

D) The debt crisis.

Answer: A Difficulty: Easy AACSB: Application of knowledge 13) How did the international monetary system influence macroeconomic policy-making and performance during the post-World War II years during which exchange rates were fixed under the Bretton Woods agreement (1946-1973)?

Answer: In July 1944, representatives of 44 countries met in Bretton Woods, New Hampshire, and drafted and signed the Articles of Agreement of the International Monetary Fund (IMF) and of the World Bank. The agreement established fixed exchange rates against the U.S. dollar and an unvarying dollar price of gold-$35 an ounce.

The dollar of the United States became the postwar world's key currency because of a few factors: (1) The early convertibility of the U.S. dollar in 1945 (2) The special position of the dollar under the Bretton Woods system 223 Copyright © 2023 Pearson Education, Ltd.

(3) The strength of the American economy relative to the devastated economies of Europe and Japan (4) Central banks naturally found it advantageous to hold their international reserves in the form of interest-bearing dollar assets.

The Marshall Plan, a program of dollar grants from the United States to European countries, was initiated in 1948.

Most countries in Europe did not restore convertibility until the end of 1958, with Japan following in 1964.

Difficulty: Easy AACSB: Application of knowledge 14) How did the Bretton Woods system resolve the trilemma?

Answer: The system was based on the presumption that movements of private financial capital could be restricted, allowing some degree of independence for domestically oriented monetary policies. The new system thus was diametrically opposed to the gold standard's subordination of monetary policy to external considerations such as freedom of financial flows. After the experience of high interwar unemployment, the architects of the Bretton Woods system hoped to ensure that countries would not be forced to adopt contractionary monetary policies for balance of payments reasons in the face of an economic downturn.

Difficulty: Moderate AACSB: Application of knowledge 15) What is a convertible currency?

Answer: A convertible currency is a currency that may be freely exchanged for foreign currencies.

Difficulty: Easy AACSB: Application of knowledge 16) Explain why the United States dollar became the postwar world's key currency.

Answer: (1) The early convertibility of the U.S. dollar in 1945.

(2) The special position of the dollar under the Bretton Woods system.

(3) The strength of the American economy relative to the devastated economies of Europe and Japan.

(4) Central banks naturally found it advantageous to hold their international reserves in the form of interest-bearing dollar assets.

Difficulty: Easy AACSB: Application of knowledge 17) How did the international monetary system created at Bretton Woods in 1944 allow its members to reconcile their external commitments with their internal goals of full employment and price stability?

Answer: The system set up by the Bretton Woods Agreement called for fixed exchange rates against the U.S. dollar and an unvarying dollar price of gold–$35 an ounce. Member countries held their official international reserves largely in the form of gold or dollar assets and had the right to sell dollars to the Federal Reserve for gold at the official price.Therefore, it provided a stable exchange rate environment that nurtured the reconstruction of the world economy and the growth 224 Copyright © 2023 Pearson Education, Ltd.

of international trade and finance.

Difficulty: Moderate AACSB: Application of knowledge 18) Discuss the impact of the restoration of convertibility in 1958.

Answer: As foreign exchange trading expanded, financial markets in different countries became more tightly integrated, an important step towards the creation of today's worldwide foreign exchange market. With growing opportunities to move funds across borders, national interest rates became more closely linked and the speed with which policy changes might cause a country to lose or gain international reserves increased.

Difficulty: Moderate AACSB: Application of knowledge 19) Explain how a country with a current account deficit is a ripe candidate for currency devaluation.

Answer: If, for example, Great Britain had a current account deficit, the holders of pounds would become nervous and shift their wealth into other currencies. In order to hold the pound's exchange rate against the dollar pegged, the Bank of England would have to buy pounds and supply the foreign assets that market participants wished to hold. This resulting loss in foreign reserves, if large enough, would most likely force a devaluation by leaving the Bank of England without enough reserves to prop up the exchange rate.

Difficulty: Moderate AACSB: Application of knowledge 20) Explain how a country with a current account surplus is a ripe candidate for currency revaluation.

Answer: If a country like Germany had a current account surplus, it would sell its currency in the foreign exchange market in order to keep it from appreciating. The German central banks would thus find themselves swamped with official reserves, and Germany would face the problem of having its money supply grow uncontrollably, a trend that would most likely drive up the domestic price levels and upset internal balance. Revaluation of the currency would thus be a viable solution to this problem.

Difficulty: Moderate AACSB: Application of knowledge 8.6

Analyzing Policy Options for Reaching Internal and External Balance

1) Internal balance requires that A) aggregate demand equal the full employment output level.

B) aggregate demand equal aggregate supply.

C) domestic interest rate equal foreign interest rate.

D) import supply equal export demand.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) When the exchange rate, E, and the foreign price level, P*, is fixed, domestic inflation depends 225 Copyright © 2023 Pearson Education, Ltd.

primarily on A) amount of aggregate demand.

B) home price level set by IMF. C) current account balance.

D) government tax policy.

E) foreign interest rates.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 3) The current account surplus is A) an increasing function of disposable income and an increasing function of the real exchange rate.

B) a decreasing function of disposable income and a decreasing function of the real exchange rate.

C) a decreasing function of disposable income and an increasing function of the real exchange rate.

D) only a decreasing function of disposable income.

E) only an increasing function of the real exchange rate.

Answer: C Difficulty: Easy AACSB: Application of knowledge 4) Under fixed exchange rates A) monetary policy is not an effective policy.

B) fiscal policy is not an effective policy.

C) monetary policy and fiscal policy are not effective.

D) both monetary and fiscal policies are effective.

E) monetary policy has an unpredictable effect on the domestic money supply.

Answer: A Difficulty: Easy AACSB: Application of knowledge 5) Fiscal expansion A) stimulates aggregate demand and causes output to decline.

B) decreases aggregate demand and causes output to decline.

C) stimulates aggregate demand and causes output to rise.

D) decreases aggregate demand and causes output to rise.

E) decreases government expenditures.

Answer: C Difficulty: Easy AACSB: Application of knowledge 6) A devaluation of the home currency A) makes foreign goods and services cheaper relative to those sold at home.

B) makes domestic goods and services more expensive relative to those sold abroad.

C) decreases demand and output.

D) increases demand for domestic goods and services.

E) increases output and makes domestic goods and services cheaper relative to those sold abroad.

226 Copyright © 2023 Pearson Education, Ltd.

Answer: E Difficulty: Easy AACSB: Application of knowledge 7) An attempt by a central bank to alter the money supply by buying or selling domestic assets A) will leave both domestic money supply and foreign reserves unchanged.

B) will cause an offsetting change in aggregate demand.

C) will lead to a rise in domestic employment and output.

D) will lead to a decrease in domestic employment and output.

E) will cause an offsetting change in foreign reserves and leave the domestic money supply unchanged.

Answer: E Difficulty: Easy AACSB: Application of knowledge 8) The condition of internal balance (full-employment output equals aggregate demand) can NOT be written as A) Yf = C + I + G. B) Yf = C + I + G + CA(EP*/P, A).

C) Yf = A + CA(EP*/P, A).

D) Yf = A + CA. Answer: A Difficulty: Moderate AACSB: Application of knowledge 9) Given P and P*, a rise in E makes A) domestic goods cheaper and improves the current account.

B) domestic goods more expensive and worsens the current account.

C) domestic goods cheaper and worsens the current account.

D) foreign goods cheaper and improves the current account.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 10) Given P and P*, a rise in E A) raises; improves B) raises; worsens C) lowers; improves D) lowers; worsens Answer: A Difficulty: Moderate AACSB: Application of knowledge

net exports and

11) Given P and P*, a fall in E makes A) domestic goods more expensive and worsens the current account.

B) domestic goods cheaper and improves the current account.

C) domestic goods cheaper and worsens the current account.

227 Copyright © 2023 Pearson Education, Ltd.

the current account.

D) foreign goods more expensive and worsens the current account.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 12) Given P and P*, a fall in E A) lowers; worsens B) raises; improves C) raises; worsens D) lowers; improves Answer: A Difficulty: Moderate AACSB: Application of knowledge

net exports and

the current account.

13) The XX schedule shows how much A) fiscal expansion is needed to hold the current account surplus at X as the currency is devalued by a given amount.

B) monetary expansion is needed to hold the current account surplus at X as the currency is devalued by a given amount.

C) fiscal expansion is needed to hold the current account surplus at X as the currency is evaluated by a given amount.

D) fiscal and monetary expansions are needed to hold the current account surplus at X as the currency is devalued by a given amount.

E) foreign funding is needed to hold the current account surplus at X as the currency is devalued by a given amount.

Answer: A Difficulty: Easy AACSB: Application of knowledge 14) Under fixed exchange rates, domestic asset transactions by the central bank A) can be used to alter the level of foreign reserves but not to affect the state of employment and output.

B) cannot be used to alter the level of foreign reserves but only to affect the state of employment and output.

C) can be used to alter the level of foreign reserves and to affect the state of employment and output.

D) can be used to alter the domestic money supply and the level of foreign reserves.

E) can raise output to full-employment level.

Answer: A Difficulty: Easy AACSB: Application of knowledge 15) An expenditure-changing policy A) alters the direction of the economy's total demand for goods and services.

B) alters the level of the economy's total demand for goods and services.

C) has no effect on aggregate demand.

D) is the same thing as an expenditure-switching policy.

228 Copyright © 2023 Pearson Education, Ltd.

E) affects aggregate supply but not aggregate demand.

Answer: B Difficulty: Easy AACSB: Application of knowledge 16) An expenditure-switching policy A) changes the direction of demand, shifting it between domestic output and imports with exchange rate adjustment.

B) changes the level of the economy's total demand for goods and services.

C) has no effect on aggregate demand.

D) is the same thing as an expenditure-changing policy.

E) affects aggregate supply but not aggregate demand.

Answer: A Difficulty: Easy AACSB: Application of knowledge 17) By raising the real exchange rate EP*/P, A) devaluation improves the current account and aggregate demand.

B) devaluation worsens the current account and aggregate demand.

C) revaluation improves the current account and aggregate demand.

D) devaluation has no effect on current account and aggregate demand.

Answer: A Difficulty: Easy AACSB: Application of knowledge 18) The alteration of exchange rates to move the economy to internal and external balance may lead to all EXCEPT A) a balance of payments crisis.

B) changes in the terms of trade.

C) changes in the level of imports or exports.

D) changes in interest rates.

E) a guaranteed unilateral improvement in economic wealth.

Answer: E Difficulty: Moderate AACSB: Application of knowledge 19) "A monetary policy is not a policy tool under fixed exchange rates." Discuss.

Answer: True, under fixed exchange rates, domestic asset transactions by the central bank can be used to alter the level of foreign reserves but not to affect the state of employment and output.

Difficulty: Moderate AACSB: Application of knowledge 20) "Fiscal policy, is generally insufficient to attain the two goals of internal and external balance."

Discuss.

Answer: Only if the economy had been displaced horizontally from point 1 would fiscal policy be able to do the job alone. In addition, fiscal policy is an unwieldy tool, since it often cannot be implemented without legislative approval. Another drawback is that a fiscal expansion, for 229 Copyright © 2023 Pearson Education, Ltd.

example, might have to be reversed after some time if it leads to chronic government budget deficits.

Difficulty: Easy AACSB: Application of knowledge 21) What is the difference between an expenditure-changing policy and an expenditure-switching policy?

Answer: An expenditure-changing policy alters the level of the economy's total demand for goods and services. An expenditure-switching policy, on the other hand, induces an exchange rate adjustment and thus changes the direction of demand, shifting it between domestic output and imports.

Difficulty: Moderate AACSB: Application of knowledge 22) (a) Assume that R denotes the domestic interest rate and R denotes the foreign interest rate.

Under a fixed exchange rate what is the relation between R and R (b) Assume E denotes the domestic currency price of the dollar for a country which is not the United States. If one wants to analyze only the short-run effects of a policy, what does one assume about the Home and Foreign price levels, P and P , respectively. (c) Assume that there is no ongoing balance of payment crisis. What does this assumption really assume? (d) Assume a fixed exchange rate system. What does this tell you about E? (e) Under the above assumptions what are the conditions for internal balance? (f) How would your answer to Part D above change if P is unstable due to foreign inflation. (g) Given the definitions above, how would one define the real exchange rate? (h) Write the condition for internal balance. (i) Define the variable not defined before in Part G above. (j) Using the equation for internal balance derived above, given our assumptions analyze the effects of a fiscal expansion. (k) What would happen if the government of that country, which is not the United States under Bretton Woods, decides to devaluate its currency? (l) What would happen if the government of that country, which is not the United States under Bretton Woods, decides to use monetary policy rather than fiscal policy? (m) Given all of the above, what is the relation between the exchange rate, E, and fiscal ease, i.e., an increase in G or a reduction in T? (n) Assume that the economy is at internal balance. What will happen if G goes up for a given level of E? (o) Assume that the economy is at internal balance. What will happen if G goes down for a given level of E? Answer: (a) R = R (b) Constant prices. (c) That Ee, the expected exchange rate, is equal to the exchange rate today, E. In other words, E = Ee. (d) E is constant, i.e., E = E0. (e) Since P and E are fixed, the expected price is fixed; thus, no inflation is expected. Then, 230 Copyright © 2023 Pearson Education, Ltd.

internal balance will require only full employment, aggregate demand equaling the full-employment level, Yf. (f) In this case, full employment alone will not guarantee price stability under a fixed exchange rate. (g) The real exchange rate is equal to EP /P. (h) Yf = C(Yf - T) + I + G + CA(EP /P, Yf - T) (i) C = consumption, I = Investment, (Yf - T) = disposable income, T = taxes. (j) An increase in G or a reduction in T will increase aggregate demand and will cause output to rise in the short run. (k) A rise in E makes domestic goods and services cheaper relative to those sold abroad and thus increases demand for output. (l) A monetary policy is not a policy tool under fixed exchange rates. Under fixed exchange rates, domestic asset transactions by the central bank can be used to alter the level of foreign reserves but not to affect the state of employment and output. (m) Negative relation. (n) Over-employment. (o) Under employment.

Difficulty: Moderate AACSB: Application of knowledge 23) Assume that the government has a target value, X, for the current account surplus. (a) What is the goal of external balance? (b) Assume that we are dealing with only the short run, what are the values of P and P∗ ? (c) Given fixed P and P , what would happen if E rises? (d) Given P and P , what would happen if T decreases, i.e., an expansionary fiscal policy? (e) Given P and P , what would happen if G increases, i.e., an expansionary fiscal policy? (f) Given all of the above, what is the relation between the exchange rate, E, and fiscal ease, i.e., an increase in G or a reduction in T? (g) Assume that the economy is in external balance. What will happen if the government maintains its current account at X, but devaluates the domestic currency? (h) Assume that the economy is at external balance. What will happen if the government raises E? (i) Assume that the economy is at external balance. What will happen if the government lowers E? Answer: (a) The goal of external balance requires the government to manage fiscal policy and the exchange rate so that the following equation is satisfied: CA(EP /P, Y - T) = X. (b) Constant prices. (c) An increase in E makes domestic goods cheaper, thus improving the current account. (d) A fall in T raises output, Y. The resulting increase in output increases disposable income and thus leads to increased home spending on foreign goods, worsening the current account. (e) Similar to the answer above. A rise in G causes CA to fall by increasing Y. (f) Positive relationship. (g) The government raises E; thus, either G should go up or T should go down to maintain the external balance. (h) An increase in E raises net exports and thus leads to a surplus in the current account higher than the target level of X. This will represent a point above the XX schedule. (i) A decrease in E reduces net exports and thus leads to a deficit in the current account lower than 231 Copyright © 2023 Pearson Education, Ltd.

the target level of X. This will represent a point below the XX schedule.

Difficulty: Moderate AACSB: Application of knowledge 24) Use a figure below to describe the four zones of economic discomfort.

Answer: The answer is given in the following figure.

Difficulty: Moderate AACSB: Application of knowledge 232 Copyright © 2023 Pearson Education, Ltd.

25) Using the II-XX framework, show using a figure that fiscal policies by themselves cannot bring the economy to both internal and external balances.

Answer: Starting at point 2, fiscal policy is shown as only horizontal movements. This means that the economy can reach either point 3 (internal balance) or point 4 (external balance) in the figure, but not both internal and external balances. Only a devaluation of the currency accompanied with an increase in fiscal ease, namely increasing government expenditures or decreasing taxes, will move the economy to both internal and external balances at point 1 in the figure.

Difficulty: Moderate AACSB: Application of knowledge 8.7

The External Balance Problem of the United States Under Bretton Woods

1) The confidence problem of the Bretton Woods systems articulated by Robert Triffin refers to A) the unwillingness of central banks to accumulate currency for fear of not being able to convert it to gold in case a run on the banks occurs.

B) consumer fear of stock market instability.

C) producer fear of rising wages.

D) the lack of convertibility of gold into silver.

E) low consumer spending because of balance of payment crises.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) The acceleration of American inflation in the late 1960s was A) a worldwide phenomenon.

B) a national problem of the US alone.

C) a regional problem.

D) a good problem to have.

233 Copyright © 2023 Pearson Education, Ltd.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) In order to bring about a real depreciation of the dollar, the U.S. can hope for A) a rise in the U.S. price level.

B) a fall in foreign price levels.

C) a rise in the dollar's nominal value in terms of foreign currencies.

D) a rise in foreign price levels or a fall in the dollar's nominal value in terms of foreign currencies.

E) increased output and full employment.

Answer: D Difficulty: Easy AACSB: Application of knowledge 4) The collapse of the Bretton Woods system marked A) the end of floating exchange rates and a move to fixed exchange rates.

B) the end of fixed exchange rates and a move to floating exchange rates.

C) the beginning of the gold standard.

D) a plunge in the price of gold.

E) the elimination of paper currencies.

Answer: B Difficulty: Easy AACSB: Application of knowledge 5) Which of the following statements is MOST accurate?

A) A revaluation restores internal and external balance immediately, without causing domestic inflation.

B) A devaluation restores internal and external balance immediately, without causing domestic inflation.

C) A revaluation restores internal and external balance immediately, but also causes domestic inflation.

D) A devaluation restores internal and external balance immediately, but also causes domestic inflation.

E) A devaluation restores external balance in the long run, without causing immediate domestic inflation.

Answer: A Difficulty: Easy AACSB: Application of knowledge 6) Which of the following is the MOST accurate?

A) U.S. macroeconomic policies in the late 1960s helped cause the breakdown of the Bretton Woods system by early 1973.

B) U.S. macroeconomic policies in the late 1970s helped cause the breakdown of the Bretton Woods system by early 1983.

C) U.S. macroeconomic policies in the late 1980s helped cause the breakdown of the Bretton Woods system by early 1993.

D) U.S. macroeconomic policies in the late 1950s helped cause the breakdown of the Bretton 234 Copyright © 2023 Pearson Education, Ltd.

Woods system by early 1963.

E) U.S. macroeconomic policies in the late 1960s delayed the breakdown of the Bretton Woods system to early 1973.

Answer: A Difficulty: Easy AACSB: Application of knowledge 7) Refer to the graph below, which shows the effect of

on the home economy.

A) foreign inflation B) domestic inflation C) foreign deflation D) domestic recession E) foreign recession Answer: A Difficulty: Moderate AACSB: Application of knowledge 8) Refer to the graph below. The movement from point 1 to point 2 is stimulated by a disequilibrium in which there is domestic and .

235 Copyright © 2023 Pearson Education, Ltd.

A) overemployment; trade surplus B) unemployment; trade surplus C) overemployment; trade deficit D) unemployment; trade deficit E) inflation; unemployment Answer: A Difficulty: Moderate AACSB: Application of knowledge 9) Explain the confidence problem under Bretton Woods system. Is there any possible solution?

Answer: As central banks' international reserve needs grew over time, their holdings of dollars would necessarily grow until they exceeded the U.S. gold stock. Since the United States had promised to redeem these dollars at $35 an ounce, it would no longer have the ability to meet its obligations should all dollar holders simultaneously try to convert their dollars into gold. Central banks, knowing that their dollars were no longer "as good as gold," might become unwilling to accumulate more dollars and might even bring down the system by attempting to cash in the dollars they already held.

One possible solution was an increase in the official price of gold in terms of the dollar and all other currencies. But such an increase would have been inflationary and would have had the politically unattractive consequence of enriching the main gold-supplying countries. Further, an increase in gold's price would have caused central banks to expect further decreases in the gold value of their dollar reserve holdings in the future, thereby possibly worsening the confidence problem rather than solving it!

Difficulty: Moderate AACSB: Application of knowledge 236 Copyright © 2023 Pearson Education, Ltd.

10) How can inflation be imported from abroad under Bretton Woods system?

Answer: A country faced with a rise in the foreign price level will be thrown out of balance and ultimately will import the foreign inflation if it holds its exchange rate fixed.

Difficulty: Moderate AACSB: Application of knowledge 8.8

The Case for Floating Exchange Rates

1) In a system of floating exchange rates, A) central banks do not intervene in the foreign exchange market to fix rates.

B) central banks always intervene in the foreign exchange market to fix rates.

C) central banks sometimes intervene in the foreign exchange market to fix rates.

D) central banks may intervene in the foreign exchange market to fix rates.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) Advocates of floating rate suggested it is favorable for economies for all of the following reasons EXCEPT A) it automatically matches the domestic inflation with ongoing foreign inflation.

B) it would deliver necessary exchange rate flexibility.

C) it would produce benefits for the world economy.

D) it is a healthy development in the evolution of the world monetary.

E) it would put markets at center stage in determining exchange rates.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) Advocates of floating rate suggested it is favorable for economies for all of the following reasons EXCEPT A) it discourages attack from foreign exchange speculators because of the fact that exchange rate adjustment is immediate.

B) it helps stabilize the shock effect on unemployment in case of economic changes such as a fall in export demand.

C) it automatically matches the domestic inflation with ongoing foreign inflation.

D) it gives every country the opportunity to guide its own monetary conditions at home.

E) it brings the LR exchange rate to the level predicted by PPP without government policy decisions.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 4) If central banks were no longer obliged to intervene in currency markets to fix exchange rates, governments would be able to use monetary policy to reach A) internal balance.

B) external balance.

237 Copyright © 2023 Pearson Education, Ltd.

C) internal and external balance.

D) internal but not external balance.

E) external but not internal balance.

Answer: C Difficulty: Easy AACSB: Application of knowledge 5) Advocates of flexible exchange rates claim that under flexible exchange rates A) no country would be forced to import only inflation from abroad.

B) no country would be forced to import only deflation from abroad.

C) no country would be forced to import inflation and deflation from abroad.

D) flexible exchange rates are not able to halt importing inflation from abroad.

E) flexible exchange rates are not able to halt importing deflation from abroad.

Answer: C Difficulty: Easy AACSB: Application of knowledge 6) Advocates of flexible exchange rates claim that under flexible exchange rates A) the United States would now be able to set world monetary conditions all by itself.

B) Germany would no longer be able to set world monetary conditions all by itself.

C) the United Kingdom would no longer be able to set world monetary conditions all by itself.

D) the United States would no longer be able to set world monetary conditions all by itself.

E) Germany would now be able set world monetary conditions all by itself.

Answer: D Difficulty: Easy AACSB: Application of knowledge 7) Advocates of flexible exchange rates claim that under flexible exchange rates A) the United States would no longer have the same opportunity as other countries to influence its exchange rate against foreign currencies.

B) the United States would have the same opportunity as other countries to influence its exchange rate against foreign currencies.

C) the United Kingdom would not have the same opportunity as other countries to influence its exchange rate against foreign currencies.

D) Germany would not have the same opportunity as other countries to influence its exchange rate against foreign currencies.

E) China would have the same opportunity as other countries to influence its exchange rate against foreign currencies.

Answer: B Difficulty: Easy AACSB: Application of knowledge 8) Some claim that the long and agonizing periods of speculation preceding exchange rate realignments would A) not occur under a fixed exchange rate regime.

B) not occur under floating.

C) become more severe under currency board.

238 Copyright © 2023 Pearson Education, Ltd.

D) become less severe under floating.

E) be prolonged under floating.

Answer: D Difficulty: Easy AACSB: Application of knowledge 9) Advocates of flexible exchange rates claim that under flexible exchange rates, market-determined exchange rates would move automatically so as A) to prevent the emergence of big current account deficits and surpluses.

B) countries have little scope to use monetary policy to attain internal and external balance.

C) countries keep domestic interest rate in line with that of the United States.

D) to solve the problem of monetary trilemma.

Answer: A Difficulty: Easy AACSB: Application of knowledge 10) Under the fixed rate regime foreign countries could hold their dollar exchange rates constant by A) using tight monetary policy.

B) using expansionary fiscal policy.

C) negotiating with the central bank of the United States.

D) setting their domestic interest rate equal to the U.S. interest rate.

E) holding their exchange rates constantly pegged to the euro and yen.

Answer: D Difficulty: Moderate AACSB: Application of knowledge 11) Advocates of floating rates pointed out that A) removal of the obligation to peg currency values would restore monetary control to central banks.

B) imposing of the obligation to peg currency values would restore monetary control to central banks.

C) removing of the obligation to peg currency values would restore fiscal control.

D) imposing of the obligation to peg currency values would restore fiscal control.

E) imposing of the obligation to peg currency would restore monetary control to the consumer.

Answer: A Difficulty: Easy AACSB: Application of knowledge 12) Advocates of flexible exchange rates claim that under flexible exchange rates, if the central bank faced unemployment A) and thus wished to decrease its money supply, there would no longer be any legal barrier to the currency depreciation this would cause.

B) and thus wished to expand its money supply, there would no longer be any legal barrier to the currency depreciation this would cause.

C) and wished to expand its money supply, there would no longer be any legal barrier to the currency appreciation this would cause.

D) and wished to decrease its money supply, there now would be a legal barrier to the currency 239 Copyright © 2023 Pearson Education, Ltd.

depreciation this would cause.

E) and wished to increase output, there would no longer be a legal barrier to the currency appreciation this would cause.

Answer: B Difficulty: Easy AACSB: Application of knowledge 13) Advocates of flexible exchange rates claim that under flexible exchange rates, a currency A) appreciation caused by increasing the money supply would reduce unemployment by lowering the relative price of domestic products.

B) depreciation caused by increasing the money supply would increase unemployment by lowering the relative price of domestic products.

C) depreciation caused by increasing the money supply would reduce unemployment by lowering the relative price of domestic products.

D) depreciation caused by increasing the money supply would reduce unemployment by increasing the relative price of domestic products.

E) depreciation cause by decreasing the money supply would not effect unemployment, but would increase the relative price of domestic products.

Answer: C Difficulty: Easy AACSB: Application of knowledge 14) Advocates of flexible exchange rates claim that under flexible exchange rates, a currency A) depreciation caused by increasing the money supply would reduce unemployment by increasing world demand for them.

B) appreciation caused by increasing the money supply would reduce unemployment by increasing world demand for them.

C) appreciation caused by decreasing the money supply would reduce unemployment by increasing world demand for them.

D) appreciation caused by increasing the money supply would increase unemployment by increasing world demand for them.

E) appreciation caused by increasing the money supply would increase unemployment by decreasing world demand for them.

Answer: A Difficulty: Easy AACSB: Application of knowledge 15) Advocates of flexible exchange rates claim that under flexible exchange rates, a currency A) depreciation caused by increasing the money supply would reduce unemployment by lowering the relative price of domestic products and increasing the world demand for them.

B) appreciation caused by increasing the money supply would reduce unemployment by lowering the relative price of domestic products and increasing world demand for them.

C) appreciation caused by decreasing the money supply would reduce unemployment by lowering the relative price of domestic products and increasing world demand for them.

D) appreciation caused by increasing the money supply would increase unemployment by lowering the relative price of domestic products and increasing world demand for them.

E) appreciation caused by increasing the money supply would increase unemployment by 240 Copyright © 2023 Pearson Education, Ltd.

lowering the relative price of domestic products and by decreasing world demand for them.

Answer: A Difficulty: Easy AACSB: Application of knowledge 16) Advocates of flexible exchange rates claim that under flexible exchange rates, the central bank of A) an overheated economy could cool down activity by increasing the money supply without worrying that undesired reserve inflow would undermine its stabilization effort.

B) a cooled economy could cool down activity by contracting the money supply without worrying that undesired reserve inflow would undermine its stabilization effort.

C) an overheated economy could cool down activity by contracting the money supply without worrying that undesired reserve inflow would undermine its stabilization effort.

D) an overheated economy could cool down activity by contracting the money supply without worrying that undesired reserve outflow would undermine its stabilization effort.

E) an overheated economy could cool down activity by decreasing employment and increasing output without worrying that this would undermine its stabilization effort.

Answer: C Difficulty: Easy AACSB: Application of knowledge 17) Advocates of flexible exchange rates claim that under flexible exchange rates A) enhanced control over fiscal policy would allow countries to dismantle their distorting barriers to international payments.

B) reduced control over monetary policy would allow countries to dismantle their distorting barriers to international payments.

C) enhanced control over monetary policy would allow countries to increase their distorting barriers to international payments.

D) enhanced control over monetary policy would allow countries to dismantle their distorting barriers to international payments.

E) enhanced control over monetary policy would destabilize exchange rates.

Answer: D Difficulty: Easy AACSB: Application of knowledge 18) By the end of the 1960s, many countries felt that they were importing inflation from A) the United States.

B) Germany.

C) France.

D) Japan.

E) the United Kingdom.

Answer: A Difficulty: Easy AACSB: Application of knowledge 19) Which one of the following statements is TRUE? A) By devaluing its currency, that is, by lowering the domestic currency price of foreign currency, 241 Copyright © 2023 Pearson Education, Ltd.

a country can insulate itself completely from an inflationary increase in foreign prices.

B) By revaluing its currency, that is, by increasing the domestic currency price of foreign currency, a country can insulate itself completely from an inflationary increase in foreign prices.

C) By revaluing its currency, that is, by lowering the domestic currency price of foreign currency, a country cannot insulate itself completely from an inflationary increase in foreign prices.

D) By revaluing its currency, that is, by lowering the domestic currency price of foreign currency, a country can insulate itself completely from an inflationary increase in foreign prices.

E) By revaluing its currency, that is, by lowering the domestic currency price of foreign currency, a country cannot insulate itself completely from a harmful decrease in foreign prices.

Answer: D Difficulty: Easy AACSB: Application of knowledge 20) When all changes in the world are due to A) fiscal policy, purchasing power parity holds true in the long run.

B) monetary policy, purchasing power parity does not hold true in the long run.

C) monetary policy, purchasing power parity holds true in the long run.

D) monetary policy, purchasing power parity holds true even in the short run.

E) fiscal and monetary policy, purchasing power parity holds true in the long run.

Answer: C Difficulty: Easy AACSB: Application of knowledge 21) Under purchasing power parity (PPP), if U.S. monetary growth leads to a long run doubling of the U.S. price level, while Europe's price level remains constant, PPP predicts that the A) long-run euro price of the dollar will be doubled.

B) long-run euro price of the dollar will be halved.

C) long-run euro price of the dollar will remain the same.

D) short-run euro price of the dollar will be halved.

E) short-run euro price of the dollar will be doubled.

Answer: B Difficulty: Easy AACSB: Application of knowledge 22) Under flexible exchange rate regime, a money-induced A) decrease in U.S. prices causes an immediate appreciation of the foreign currencies against the dollar.

B) increase in U.S. prices causes an immediate appreciation of the foreign currencies against the dollar.

C) increase in U.S. prices causes an eventual appreciation of the foreign currencies against the dollar.

D) increase in U.S. prices causes an eventual depreciation of the foreign currencies against the dollar.

E) decrease in U.S. prices causes no change in foreign exchange rate.

Answer: B Difficulty: Easy AACSB: Application of knowledge 242 Copyright © 2023 Pearson Education, Ltd.

23) Under Bretton Woods, A) any foreign country cannot devalue its currency against the dollar in conditions of "fundamental disequilibrium."

B) any foreign country could devalue its currency against the dollar in conditions of "fundamental disequilibrium," but the system's rules did not give the United States the option of devaluing against foreign currencies.

C) any foreign country could devalue its currency against the dollar in conditions of "fundamental disequilibrium," and the system's rules did give the United States the same option of devaluing against foreign currencies.

D) the U.S. could devalue its currency against the foreign currencies in conditions of "fundamental disequilibrium."

E) any foreign country can revalue its currency against the dollar in conditions of "fundamental disequilibrium."

Answer: B Difficulty: Easy AACSB: Application of knowledge 24) The DD schedule shows A) interest rate and output pairs for which aggregate demand equals aggregate output.

B) exchange rate and output pairs for which aggregate demand equals aggregate output.

C) exchange rate and output pairs for which aggregate supply equals aggregate output.

D) interest rate and output pairs for which aggregate supply equals aggregate output.

E) exchange rate and output pairs for which aggregate demand is greater than aggregate output.

Answer: B Difficulty: Easy AACSB: Application of knowledge 25) The AA schedule shows A) interest rate and output pairs at which the foreign exchange market and the domestic money market are in equilibrium.

B) exchange rate and output pairs at which the foreign exchange market and the domestic money market are in equilibrium.

C) interest rate and output pairs at which only the foreign exchange market is in equilibrium.

D) exchange rate and output pairs at which only the foreign exchange market is in equilibrium.

E) exchange rate and output pairs at which only the domestic money market are in equilibrium.

Answer: B Difficulty: Easy AACSB: Application of knowledge 26) Under flexible exchange rate, the response of an economy to a temporary fall in foreign demand for its exports is A) the currency appreciates, and output falls.

B) the currency depreciates, and output falls.

C) the currency depreciates, and output increases.

D) the currency depreciates, and output remains constant.

E) the currency appreciates, and output increases.

243 Copyright © 2023 Pearson Education, Ltd.

Answer: B Difficulty: Moderate AACSB: Application of knowledge 27) Under fixed exchange rate, the response of an economy to a temporary fall in foreign demand for its exports is A) the currency appreciates, and output falls.

B) the currency depreciates, and output falls.

C) the currency remains the same, and output decreases.

D) the currency depreciates, and output remains constant.

E) the currency appreciates, and output remains the same.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 28) Which of the following is NOT a result of a temporary fall in foreign demand on one country's exports under floating exchange rate?

A) The DD curve shifts to the left due to reduction of aggregate demand.

B) The AA curve shifts downwards due to reduction of money supply.

C) a fall in aggregate output D) depreciation in home country's currency E) a fall in the home interest rate Answer: B Difficulty: Moderate AACSB: Application of knowledge 29) Which of the following is NOT a result of a permanent fall in foreign demand on one country's exports under floating exchange rate?

A) The DD curve shifts to the left due to reduction of aggregate demand.

B) The AA curve shifts upwards due to the increased expected long-run exchange rate.

C) a reduction in output by a smaller degree compared to temporary fall in demand D) depreciation in home country's currency E) a raised level of unemployment Answer: E Difficulty: Moderate AACSB: Application of knowledge 30) Comparing fixed to flexible exchange rate, the response of an economy to a temporary fall in foreign demand for its exports is A) output actually falls less under fixed rate than under floating rate.

B) output actually falls more under fixed rate than under floating rate.

C) output actually remains the same under fixed rate than under floating rate.

D) the currency value grows in a fixed rate system and falls in a flexible system.

E) output grows in a fixed rate system and falls in a flexible system.

Answer: B Difficulty: Moderate AACSB: Application of knowledge 244 Copyright © 2023 Pearson Education, Ltd.

31) The effects of a decrease in export demand A) is a powerful argument in favor of fixed rates.

B) is a powerful argument in favor of flexible rates.

C) shows the difficulties in determining which exchange rate is better.

D) is a powerful argument in favor of fixed rates only in the short run.

E) is a powerful argument in favor of fixed rates only in the long run.

Answer: B Difficulty: Moderate AACSB: Application of knowledge 32) The reason that the claim that floating exchange rates result in greater economic autonomy for individual countries may not be entirely accurate is that A) empirical research finds no supporting data.

B) policy makers are influenced by the effect of domestic policies on the exchange rate.

C) there is no generally satisfactory method for measuring economic autonomy.

D) it is based on the assumption of a gold standard.

E) countries that run large trade deficits must increase exports to balance trade.

Answer: B Difficulty: Moderate AACSB: Application of knowledge 33) Under a flexible exchange rate regime, an increase in real money demand A) moves the AA curve upward.

B) moves the AA curve downward.

C) leaves the AA curve unchanged.

D) moves the DD curve to the right.

E) moves the DD curve to the left.

Answer: B Difficulty: Easy AACSB: Application of knowledge 34) Under the flexible exchange rate, lowering the price of a foreign currency will A) allow the expansion of monetary policy without causing inflation.

B) decrease the foreign country's output.

C) prevent a foreign price increase from causing deflation at home.

D) cause a home price increase to be exported to the foreign markets.

E) cause a "beggar-thy-neighbor" effect.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 35) What caused inflation to accelerate in most countries in 1974?

A) the oil shock B) the real estate market shock C) the climate change shock D) the floating exchange rate shock 245 Copyright © 2023 Pearson Education, Ltd.

Answer: A Difficulty: Easy AACSB: Application of knowledge 36) A combination of stagnating output and high inflation is called A) stagflation.

B) hyperinflation.

C) stagnation.

D) inflagnation.

Answer: A Difficulty: Easy AACSB: Application of knowledge 37) Federal Reserve Chairman Volcker's policy to fight inflation A) led to the 1981-1983 recession, but was ultimately successful.

B) led to the 1981-1983 recession, but did not end high inflation due to beggar-thy-neighbor effects.

C) was perfectly complemented by Reagan's decrease in fiscal spending.

D) led to the 1981-1983 recession and foretold the economic downturn in the mid-1990s.

E) led to an immediate depreciation of the dollar.

Answer: A Difficulty: Easy AACSB: Application of knowledge 38) The Plaza Accord of 1985 announces that the A) G-5 countries will intervene in the foreign exchange market to bring about a dollar appreciation.

B) G-7 countries will intervene in the foreign exchange market to bring about a dollar depreciation.

C) G-5 countries will intervene in the foreign exchange market to bring about a dollar depreciation.

D) G-7 countries will intervene in the foreign exchange market to bring about a euro depreciation.

E) G-5 countries will not intervene in the foreign exchange market unless the dollar needs to appreciate.

Answer: C Difficulty: Easy AACSB: Application of knowledge 39) Supporters of a floating exchange rate cited all of the following as advantages over the Bretton Woods system EXCEPT A) each country would be able to choose its own long-run inflation rate.

B) parity changes and speculative attacks would no longer be possible.

C) countries would be forced to work cooperatively in deciding monetary policy.

D) exchange rates would be set symmetrically in foreign markets rather than by government decision.

E) governments would not need to export inflation to decrease domestic unemployment.

Answer: C 246 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Easy AACSB: Application of knowledge 40) If the demand for Home exports decreased abroad, the Home fall in output would be greatest A) if the decrease was temporary and the exchange rate was fixed.

B) if the decrease was temporary and the exchange rate was floating.

C) if the decrease was permanent and the exchange rate was fixed.

D) if the decrease was permanent and the exchange rate was floating.

E) if the decrease was permanent and the exchange rate was high.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 41) If most of the shocks that buffet the economy come from the output market shocks, then A) fixed exchange rates are better than flexible exchange rates.

B) flexible exchange rates are better than fixed exchange rates.

C) which system is chosen is not important.

D) fixed exchange rates are better than flexible exchange rates only in the short run.

E) flexible exchange rates are better than fixed exchange rates only in the short-run.

Answer: B Difficulty: Moderate AACSB: Application of knowledge 42) Present the case for floating exchange rates.

Answer: (1) Monetary policy autonomy — Governments would be able to use monetary policy to reach internal and external balance. No country would be forced to import inflation and deflation from abroad.

(2) Symmetry — The United States would no longer be able to set world monetary conditions all by itself. The United States would have the same opportunity as other countries to influence its exchange rate against foreign currencies.

(3) Exchange rates as automatic stabilizers — The long and agonizing periods of speculation preceding exchange rate realignments would not occur under floating.

Difficulty: Moderate AACSB: Application of knowledge 43) "No central bank can be indifferent to its currency's value in the foreign exchange market."

Discuss.

Answer: — despite the "Monetary Policy Autonomy" theory of the original supporters of floating exchange rates — exchange rate's role in inflation — prices are sticky in the short run, so foreign developments can affect real interest rates and real exchange rates at home — don't want their exchange rate to be too volatile as it affects the demand for their domestic products — appreciation or depreciation can cause inflation that is difficult to counter 247 Copyright © 2023 Pearson Education, Ltd.

— banks intervene on a discretionary basis so it is still necessary for them to continue to hold foreign reserves — "dirty floats" stabilize output and price level after shocks that affect exchange rates — empirically: after 1973 countries have continued to intervene to affect exchange rates Difficulty: Moderate AACSB: Application of knowledge

44) Refer to the above figure. Use the DD-AA model to examine and compare the response of an economy under fixed and floating exchange rate to a temporary fall in foreign demand for its exports.

Answer: The DD curve shifts to the left. When the exchange rate floats, because the demand shift is assumed to be temporary, it does not change the long-run expected exchange rate and so does not move the asset market equilibrium schedule AA. Thus, E rises, i.e. the currency depreciates and output falls.

Under fixed exchange rate, the central bank must prevent the currency depreciation that occurs 248 Copyright © 2023 Pearson Education, Ltd.

under a floating rate; thus, it buys domestic money with foreign currency, reducing the domestic money supply and shifting the AA to the left and down. E will remain constant and output will fall.

Difficulty: Moderate AACSB: Application of knowledge 45) Refer to the above figure. Use the DD-AA model to examine and compare the response of an economy under fixed and floating exchange rate to a permanent fall in foreign demand for its exports.

Answer: The DD curve shifts to the left. Under flexible exchange rate, the expected exchange rate Ee also rises and AA shifts upward and to the right. Thus, a permanent shock causes a greater depreciation than a temporary one.

Under fixed exchange rate, the central bank must prevent the currency depreciation that occurs under a floating rate; thus, it buys domestic money with foreign currency, reducing the domestic money supply and shifting the AA to the left and down. E will remain constant and output will fall.

Under fixed exchange rate, a fall in export demand, if permanent, has led to a situation of "fundamental disequilibrium" calling for a devaluation of the currency or a long period of domestic unemployment as export prices fell. Uncertainty about the government's intention would have encouraged speculative capital outflows, further worsening the situation by depleting central bank reserves and contracting the domestic money supply at a time of unemployment.

Difficulty: Moderate AACSB: Application of knowledge 46) Use the DD-AA model to compare the domestic economic response under flexible and fixed exchange rate regimes to a temporary rise in export demand from foreign countries.

Answer: Under floating rate: The DD curve shifts right. AA does not change because the temporary increase will not affect the long run expected exchange rate. Output rises and E falls (depreciates).

Under fixed rate: The DD curve shifts right. The central bank intervenes to prevent a change in the exchange rate. By selling domestic currency they expand the domestic supply and the AA curve shifts right, keeping E constant. Output, however, will rise due to the new equilibrium of the DD and AA curves to the right of its former location.

Difficulty: Moderate AACSB: Application of knowledge 8.9

Macroeconomic Interdependence under a Floating Rate

1) Due to macroeconomics interdependence between large countries, the effect of a permanent monetary policy expansion by Home is as follows: Home output A) rises, Home's currency depreciates, and Foreign output may rise or fall.

B) falls, Home's currency depreciates, and Foreign output may rise or fall.

C) rises, Home's currency appreciates, and Foreign output may rise or fall.

D) rises, Home's currency depreciates, and Foreign output rises.

E) falls, Home's currency appreciates, and Foreign output may rise or fall.

Answer: A Difficulty: Easy AACSB: Application of knowledge 249 Copyright © 2023 Pearson Education, Ltd.

2) Due to macroeconomics interdependence between large countries, the effect of a permanent fiscal expansion by Home is as follows: Home output A) falls, Home's currency appreciates, Foreign output rises.

B) rises, Home's currency appreciates, Foreign output rises.

C) rises, Home's currency depreciates, Foreign output rises.

D) rises, Home's currency appreciates, Foreign output decreases.

E) falls, Homes currency depreciates, Foreign output rises.

Answer: B Difficulty: Easy AACSB: Application of knowledge 3) Which of the following does NOT occur if Home starts a policy of permanent fiscal expansion?

A) Home's exchange rate increases.

B) Foreign's interest rate rises.

C) Home output rises.

D) Foreign output rises.

E) Current Account Balance increases.

Answer: E Difficulty: Moderate AACSB: Application of knowledge 4) Where did crisis happen between 1990 and 1999?

A) Europe and Asia B) America and Australia C) Africa and Europe D) Australia and Asia Answer: A Difficulty: Easy AACSB: Application of knowledge 5) What happened to Germany's general price level after the reunification of West and East Germany on July 1, 1990?

A) rising inflation B) rising deflation C) volatile price fluctuation D) stable price level Answer: A Difficulty: Easy AACSB: Application of knowledge 6) Japan's loose monetary policy from 1986 to 1988 did NOT lead to A) loss in Japan's stock price index value.

B) skyrocketing prices for Japanese real estate.

C) rising stock prices.

D) rising inflation.

Answer: A Difficulty: Easy 250 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 7) Problems of the Japanese economy in 1997-1998 spilled over to A) East Asia.

B) Europe.

C) Sub-Saharan Africa.

D) Latin America.

Answer: A Difficulty: Easy AACSB: Application of knowledge 8) The U.S. stock market soared in the late 1990s as money flooded into high-tech, "dot-com" stocks and then began to collapse in 2000, creating the so-called A) dot-com crash.

B) high-tech crumble.

C) dot-com failure.

D) Internet downfall.

Answer: A Difficulty: Easy AACSB: Application of knowledge 9) During the first half of the 2000s, the large increase in the U.S. current account deficit was matched by increases in the A) surpluses of other countries, notably Asian countries including China.

B) deficits of other countries, notably Asian countries including China.

C) deficits of other countries, notably newly industrialized countries such as Singapore and Taiwan.

D) surpluses of other countries, notably South American countries.

Answer: A Difficulty: Easy AACSB: Application of knowledge 10) The global financial crisis in 2007 started as a result of A) the U.S. subprime mortgage crisis.

B) the long-term high mortgage interest rate.

C) the U.S. government's budget deficit.

D) the significant barriers in world trade.

Answer: A Difficulty: Easy AACSB: Application of knowledge 11) The election of Donald Trump as U.S. President had A) mixed consequences for global economy.

B) no impacts on the global economy.

C) promoted global rate of real GDP growth between 2018 and 2019.

D) decreased protectionist actions against a range of U.S. trade partners, notably China and the European Union.

251 Copyright © 2023 Pearson Education, Ltd.

Answer: A Difficulty: Easy AACSB: Application of knowledge 12) Early in 2020, global output level declined sharply because of A) the global pandemic crisis.

B) the aggressive protectionism actions around the world.

C) the high global public debt and deficits.

D) the lack of global cooperation.

Answer: A Difficulty: Easy AACSB: Application of knowledge 13) Which of the following is NOT among the quantitative indicators for the U.S. Department of the Treasury to judge whether it should name a country a currency manipulator?

A) having inflation rate of more than 10% a year B) having a bilateral trade surplus of more than $20 billion with the United States C) having an overall (multilateral) current account surplus of more than 2 percent of GDP D) official net intervention purchases of foreign currency totaling more than 2 percent of GDP, taking place in at least six of the past twelve months Answer: A Difficulty: Easy AACSB: Application of knowledge 14) Dangers of deflation do NOT include A) increased purchasing power.

B) debt deflation.

C) decreased economic resilience.

D) more frequent liquidity traps.

E) loss of inflation-target-credibility.

Answer: A Difficulty: Easy AACSB: Analytical thinking 15) Imagine a world with two large countries, Home and Foreign. Evaluate how Home's macroeconomic policies affect Foreign. Compare the small and the large country cases; consider both permanent monetary and fiscal policies.

Answer: Note that since the two countries are large, neither country can be thought of any longer as facing a fixed external interest rate or a fixed level of foreign export demand. Consider only permanent shifts.

A permanent monetary expansion by Home, in the small country's case, would lead to currency depreciation and increase in output, interest rates also falling. When the Home economy is large, the same would happen, but now the rest of the world is affected too. Because Home is facing real currency depreciation, Foreign must be experiencing a real currency appreciation. This makes foreign goods relatively expensive and thus reduces its output. However, this increases Homes output, since Home's imports will rise. Thus, it is not clear what will happen to Foreign output.

Note that Foreign output can rise only if the Foreign nominal interest rate rises too and can fall 252 Copyright © 2023 Pearson Education, Ltd.

only if Foreign nominal interest rate falls. This is because the foreign market equilibrium is: M /P = L(R , Y ). Because in this exercise M is not changing and P is sticky by assumption and thus fixed in the short run.

Consider now, a permanent expansionary fiscal policy in Home.

In the small country case, a permanent fiscal expansion would cause a real currency appreciation and a current account deterioration that would fully nullify any positive effect on aggregate demand. In effect, the expansionary impact of the Home fiscal ease would leak entirely abroad.

This is because the counterpart of Home's lower current account balance must be higher current account balance abroad.

In the large country case, Foreign output still rises since Foreign's exports become relatively cheaper when Home's currency appreciates. In addition, now some of Foreign's increased spending increases Home exports, so Home's output actually increases along with the output of Foreign. Home's nominal interest rate must rise and Foreign's interest rate rises at the same time as well.

Difficulty: Difficult AACSB: Application of knowledge 16) "Even under flexible exchange rate regime, governments could not be indifferent to the behavior of exchange rates and inevitably surrendered some of their policy autonomy in other areas to prevent exchange rate movements they viewed as harmful to their economies." Discuss.

Answer: True. One example is Volcker in October 1979 decreasing the U.S. money supply to halt further weakening the dollar.

Difficulty: Moderate AACSB: Application of knowledge 17) Which system of interest rates is theoretically worst for policy coordination among the industrial countries of the world? How has this played out since the 1980s?

Answer: — pro-fixed rate theorists predicted that with floating rates, countries would only make policies that helped themselves at the expense of the world economy (although it has been empirically proven that in the short run policy decisions are exported, requiring the "dirty float") — pro-floaters rebutted that the fixed rate system provided coordination only by giving the U.S. a dominant position — during the 1980s industrial countries could have collectively reduced the effects of recession by coordinating their policies much more effectively, that is floating rates have not provided more coordination as predicted.

Difficulty: Moderate AACSB: Application of knowledge 8.10

What Has Been Learned Since 1973?

1) Economic theory and experience since 1973 indicate that, under floating exchange rates, a country's fiscal and monetary policies in the short run and the long run can A) have both domestic and foreign economic impact.

B) have domestic or foreign economic impact, but not both.

C) have domestic but not foreign economic impact.

D) have foreign but not domestic economic impact.

E) have neither domestic nor foreign economic impact.

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Answer: A Difficulty: Moderate AACSB: Application of knowledge 2) Economic theory and experience since 1973 indicate that floating exchange rates allow A) a much larger international divergence in inflation.

B) a smaller international divergence in inflation.

C) proportional exchange rate and relative price level changes.

D) central banks with less control of their money supplies.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) The mechanism behind the inflation insulation provided by a floating exchange rate is A) Purchasing Power Parity.

B) a fixed AA curve.

C) market speculation.

D) tight monetary policy.

E) symmetry.

Answer: A Difficulty: Easy AACSB: Application of knowledge 4) Economic experience since 1973 indicates that, under floating exchange rates, symmetry A) was not attained.

B) was attained almost immediately.

C) was attained over time as central banks held more U.S. dollars as a reserve currency.

D) has been difficult to measure and no consensus has emerged.

E) has been attained in foreign countries, but not domestically.

Answer: A Difficulty: Easy AACSB: Application of knowledge 5) Economic experience since 1973 indicates that, under floating exchange rates, A) many countries were able to relax the capital controls, which spurred the rapid growth of a global financial industry and allowed greater gains from intertemporal trade and from trade in assets.

B) all economic sectors can be cushioned from real disturbances such as shifts in aggregate demand.

C) countries always become less vulnerable to shocks arising from the foreign exchange market itself, such as fluctuations in the currency risk premium.

D) many countries were still not able to relax the capital controls.

Answer: A Difficulty: Easy AACSB: Application of knowledge 6) Economic experience since 1973 indicates that, under floating exchange rates 254 Copyright © 2023 Pearson Education, Ltd.

A) large and persistent departures from external balance were not prevented.

B) large and persistent departures from external balance were prevented.

C) changes in exchange rates failed to act as automatic stabilizers.

D) reduced monetary policy autonomy.

E) monetary policy autonomy was protected.

Answer: A Difficulty: Easy AACSB: Application of knowledge 7) Economic experience since 1973 indicates that, under floating exchange rates, A) problems of international policy coordination clearly have not disappeared.

B) problems of international policy coordination have disappeared.

C) countries experienced more convergent rates of recovery after the 2007-2009 crisis.

D) policy coordination has become increasingly easy.

Answer: A Difficulty: Easy AACSB: Application of knowledge 8) What has been learned since 1973 with regards to the experience with floating exchange rate regime?

Answer: (1) Monetary policy autonomy: Yes, however, floating rate did not insulate countries completely from foreign policy shock. In addition, no central bank can be indifferent to its currency's value in the foreign exchange market, thus the name "dirty float" rather than "clean float."

(2) Symmetry: No, the dollar remains an important currency; the DM and the yen have gained importance; the British pound declines in importance.

(3) The exchange rate as an automatic stabilizer: Good performance of the flexible regimes; many believe that, otherwise, major realignments of exchange rates should have taken place. However, some sectors suffered, such as agriculture.

(4) Discipline: Did countries abuse the autonomy afforded by floating rates? Inflation rates did accelerate after 1973.

(5) Destabilizing Speculation: Floating exchange rates have exhibited much more day-to-day volatility than the early advocates of floating would have predicted. However, exchange rates are assets prices and so considerable volatility is to be expected. Over the long run, they do not seem to support the notion of destabilizing speculation.

(6) International trade and investment: Critics of floating claimed that international trade and investment would suffer as a result of the increased uncertainty. This prediction was certainly wrong. The use of forward markets and other derivatives expanded dramatically. Still, some economists disagree about the benefit to international trade.

(7) Policy coordination: Floating exchange rates have not promoted policy coordination.

Difficulty: Moderate AACSB: Application of knowledge 8.11

Are Fixed Exchange Rates Even an Option for Most Countries?

1) Maintaining a fixed exchange rate over the long run is today A) virtually impossible.

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B) more vulnerable to speculative attacks than in the past.

C) preferable.

D) possible only in special cases when countries are willing to maintain controls over capital movements.

E) aided by technology which allows instant movement of money between financial markets in different countries.

Answer: D Difficulty: Easy AACSB: Application of knowledge 2) A country following prudent monetary and fiscal policies A) is not safe from speculative attacks on its fixed exchange rate.

B) is safe from speculative attacks on its fixed exchange rate.

C) is able to peg currency values for long while maintaining open capital markets and national policy sovereignty.

D) is able to solve the monetary trilemma.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) "Fixed exchange rates are not even an option for most countries." Discuss.

Answer: Durable fixed exchange rate arrangements may not even be possible unless countries are willing to maintain strict controls over capital movements (as China does), or, at the other extreme, move to a shared single currency with their monetary partners (as in Europe). Even a country following prudent monetary and fiscal policies is not safe from speculative attacks on its fixed exchange rate.

Difficulty: Moderate AACSB: Application of knowledge 8.12

Appendix to Chapter 8: International Policy Coordination Failures

1) Coordination of economic policies among nations is a prisoner's will be better off if they .

A) dilemma; cooperate B) conundrum; cooperate C) sentence; compete D) screed; compete E) quandary; collude Answer: A Difficulty: Easy AACSB: Application of knowledge

because all countries

2) Coordination of economic policies among nations is a prisoner's countries go it alone, they will choose to .

A) dilemma; compete B) conundrum; cooperate C) sentence; compete

because if all

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D) dilemma; cooperate E) quandary; collude Answer: A Difficulty: Easy AACSB: Application of knowledge 3) Refer to the payoff matrix below, which is a prisoner's dilemma. If both countries go it alone, Home will choose Policy and Foreign will choose Policy .

A) 1; A B) 2; B C) 1; B D) 2; A Answer: A Difficulty: Moderate AACSB: Application of knowledge 4) Refer to the payoff matrix below, which is a prisoner's dilemma. If both countries cooperate, Home will choose Policy and Foreign will choose Policy .

A) 1; A B) 2; B C) 1; B D) 2; A Answer: B Difficulty: Moderate AACSB: Application of knowledge 257 Copyright © 2023 Pearson Education, Ltd.

5) Use the following table to illustrate the importance of macroeconomic policy coordination.

Show that the two governments would have been happier if the two of them had adopted looser monetary policies, but given the policies that the other government did adopt, it is not in the interest of any individual government to change its course. Assume that each country wishes to get the biggest reduction in inflation rate at the lowest cost in terms of unemployment. This means that each country maximizes-ΔΠ/ΔU, the inflation reduction per point of increased unemployment.

Answer: One needs to translate the outcomes of the table above into policy payoffs. Assume that each country wishes to get the biggest reduction in inflation rate at the lowest cost in terms of unemployment. This means that each country maximizes -ΔΠ/ΔU, the inflation reduction per point of increased unemployment. This leads to the following table.

Home finds itself better off with a very restrictive policy regardless of what Foreign does. In a symmetric position, Foreign finds itself better off with a very restrictive policy regardless of what Home does. The result is that both countries will choose very restrictive monetary policies, and 258 Copyright © 2023 Pearson Education, Ltd.

each will get a payoff of

. However, both countries are actually better off if they simultaneously

adopt the somewhat restrictive policies. The resulting payoff for each is 1, which is greater than . Under this last policy configuration, inflation falls less in the two countries, but the rise in unemployment is less than under very restrictive policies.

Difficulty: Moderate AACSB: Application of knowledge 6) Assume that each country wishes to get the biggest reduction in inflation rate at the lowest cost in terms of unemployment. This means that each country maximizes-ΔΠ/ΔU, the inflation reduction per point of increased unemployment. What are the outcomes of the following games, assuming the max-min criteria is used?

Answer: There are two equilibria in this game, in which one regime uses a "somewhat restrictive" policy, while the other uses a "very restrictive" policy.

Difficulty: Difficult AACSB: Application of knowledge International Finance: Theory & Policy, 12/e, Global Edition Chapter 9 Financial Globalization: Opportunity and Crisis 9.1

The International Capital Market and the Gains from Trade

1) What would best describe the international capital markets?

A) the market of exchange of bonds B) the market of exchange of stocks C) the market of exchange of real estate D) the market in which residents of different countries trade assets E) the currency market Answer: D Difficulty: Easy AACSB: Application of knowledge 259 Copyright © 2023 Pearson Education, Ltd.

2) The international capital market is A) the international currency exchange.

B) a market in which capital assets are exchanged for services.

C) the market that is subject to intense regulation and must file a report to the Basel committee on a biannual basis.

D) not really a single market, but a group of closely interconnected markets in which asset exchanges with some international dimension take place.

E) an organization of fiscal policies that dictate international trade.

Answer: D Difficulty: Easy AACSB: Application of knowledge 3) Main actors in the international capital markets do NOT include A) casinos and gamblers.

B) commercial banks.

C) corporations.

D) nonbank financial institutions.

E) central banks and other government agencies.

Answer: A Difficulty: Easy AACSB: Application of knowledge 4) International currency trades take place in the the international market.

A) foreign exchange B) money C) stock D) financial Answer: A Difficulty: Easy AACSB: Application of knowledge

market, which is an important part of

5) International capital market's activities take place in A) a network of world financial centers linked by sophisticated communication systems.

B) the stock exchange worldwide.

C) only online platforms that allow lenders and borrowers to meet.

D) governments' regulated financial centers.

Answer: A Difficulty: Easy AACSB: Application of knowledge 6) The assets traded in the capital market do NOT include A) durable goods and non-tradable services.

B) stocks.

C) bonds.

D) bank deposits denominated in different currencies.

Answer: A 260 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Easy AACSB: Application of knowledge 7) Describe three types of gains from trades?

A) trades of exchange rates for goods or services, trades of goods or services for property, and trades of gold for textiles B) trades of goods or services for goods or services, trades of goods or services for assets, and trades of assets for assets C) trades of imports for exports, trades of exports for imports, and trades of natural resources for financial assets D) trades of services for goods, trades of currency for services, and trades of one type of currency for another E) trades of current goods for future services, trades of currency for gold, and trades of one type of currency for another Answer: B Difficulty: Easy AACSB: Application of knowledge 8) Which of the following statements is the MOST accurate?

A) By providing a worldwide payments system that lowers transaction costs, banks active in the international capital market enlarge the trade gains that result from such exchanges.

B) By providing a worldwide payments system that raises transaction costs, banks active in the international capital market enlarge the trade losses that result from such costs.

C) By providing a worldwide cryptocurrency payments system, banks active in the international capital market maximize customers' gains from trade exchanges.

D) By providing a worldwide risk-free payments system of digital currencies, banks active in the international capital market minimize customers' losses from trade exchanges.

Answer: A Difficulty: Easy AACSB: Application of knowledge 9) Intertemporal trade is A) the exchange of goods but not services for claims to future goods.

B) the exchange of services but not goods for claims to future services.

C) the exchange of goods and services for claims to future goods and services.

D) the exchange of domestic goods and services for foreign goods and services.

E) the type of trade that the U.S. government focuses most upon.

Answer: C Difficulty: Easy AACSB: Application of knowledge 10) The importers' ability to obtain foreign goods today in return for a promise to repay soon after they have sold the goods to domestic customers is an example of A) intertemporal trade.

B) trade of assets for assets.

C) risk-free trade.

D) pure asset swap.

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Answer: A Difficulty: Easy AACSB: Application of knowledge 11) Trade in assets between countries, like trades involving goods and services, A) can yield benefits to all the countries involved.

B) will always make all countries worse off.

C) usually benefits one country and harms the other.

D) never bring benefits to any country involved.

Answer: A Difficulty: Easy AACSB: Application of knowledge 12) When selecting assets, people make decisions based on the riskiness of each asset's return.

People dislike risk and economists call this property of people's preferences A) risk averse.

B) risk dislike.

C) risk neutral.

D) risk loving.

Answer: A Difficulty: Easy AACSB: Application of knowledge 13) What is the basic motive for asset trade?

A) the belief that large risks will lead to large returns B) restoration of the balance of payments C) portfolio unification D) economic stability E) increase expected returns and reduced risk Answer: E Difficulty: Easy AACSB: Application of knowledge 14) Using international asset trade, countries can A) never really eliminate all risk.

B) eliminate all risk.

C) actually increase their risk in some cases.

D) eliminate all their risk except for emerging markets.

E) never really diversify their holdings.

Answer: A Difficulty: Easy AACSB: Application of knowledge 15) If you are offered a gamble in which you win 500 dollars 3/8 of the time and you lose 500 dollars 5/8 of the time, what is your expected payoff and your behavior given that you are a risk-lover?

A) $500, take the gamble 262 Copyright © 2023 Pearson Education, Ltd.

B) -$125, take the gamble C) -$125, it is unclear what you would do without further information D) $500, decline the gamble E) -$125, decline the gamble Answer: C Difficulty: Easy AACSB: Application of knowledge 16) Suppose one is offered a gamble in which you win $1,000 half the time but lose $1,000 half the time. Since in this case one is as likely to win as to lose the $1,000, the average payoff on this gamble—its expected value—is: 0.5 ∗ $1,000 + 0.5 ∗ (-$1,000) = 0.

Under such circumstances A) no one will take the gamble.

B) risk averse individuals will take the gamble.

C) risk lovers individuals will not take the gamble.

D) risk neutral individuals will not take the gamble.

E) risk lovers and risk neutral individuals may take the gamble.

Answer: E Difficulty: Easy AACSB: Application of knowledge 17) For most practical matters, economists assume that A) individuals are risk neutral.

B) individuals are risk lovers.

C) individuals are risk averse.

D) most individuals are risk lovers.

E) most individuals are risk neutral.

Answer: C Difficulty: Easy AACSB: Application of knowledge 18) People who are risk averse A) value a collection of assets only on the basis of its expected returns.

B) value a collection of assets only on the basis of the risk of that return.

C) value a collection of assets not only on the basis of its expected returns but also on the basis of the risk of that return.

D) are less likely to invest in life insurance.

E) are less likely to have a diverse portfolio.

Answer: C Difficulty: Easy AACSB: Application of knowledge 19) The idea of risk aversion A) is at odds with the idea of insurance.

B) helps explain the profitability of insurance companies.

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C) has nothing to do with insurance companies.

D) helps explain the losses suffered by the insurance industry.

E) helps explain why insurance companies in the long run are zero profit companies.

Answer: B Difficulty: Moderate AACSB: Application of knowledge 20) Risk averse people A) will never hold bonds denominated in several different currencies because of transaction costs.

B) will always hold bonds denominated in several different currencies because of transaction costs.

C) may hold bonds denominated in several different currencies.

D) may hold bonds denominated in several different currencies only if satisfying the well known interest party condition.

E) will hold only domestic bonds because of the home bias effect.

Answer: C Difficulty: Easy AACSB: Application of knowledge 21) Which of the following statements is the MOST accurate?

A) International trade in assets can make both parties to the trade better off by allowing them to reduce the riskiness of return by portfolio diversification.

B) International trade in assets can make both parties to the trade worse off by allowing them to increase the riskiness of return by portfolio diversification.

C) International trade in assets can make both parties to the trade worse off by allowing them to eliminate all risk by portfolio unification.

D) International trade in assets can make both parties to the trade better off by allowing them to eliminate all risk by portfolio unification.

Answer: A Difficulty: Easy AACSB: Application of knowledge 22) International trade reduces the risk by allowing both parties to trade to divide their wealth among a wide spectrum of assets. This is described as A) portfolio diversification.

B) portfolio unification.

C) risk aversion.

D) asset swap.

Answer: A Difficulty: Easy AACSB: Application of knowledge 23) Imagine that there are two countries, Home and Far Far Away, and that residents of each own only one asset, domestic land yielding an annual harvest of mangoes. Assume that the yield on the land is uncertain. Half the time, Home's land yields a harvest of 5,000 tons of mangoes at the same time as Far Far Away's land yields a harvest of 2,500 tons. The other half of the time the outcomes are reversed. The average for each country mango harvest is 264 Copyright © 2023 Pearson Education, Ltd.

A) 2500.

B) 2750.

C) 3500.

D) 3750.

E) 3000.

Answer: D Difficulty: Easy AACSB: Application of knowledge 24) The two types of trade, intertemporal and pure asset swap perfect substitutes, because .

A) are; they both offer considerable payoff and are equal in the long run B) are; they both involve the smoothing out of now and future consumption C) are not; asset swapping is immediate and involves only assets, while intertemporal trade takes two time periods and involves both assets and goods/services D) could possibly be; different economic states occur at different points in time E) are not; asset swapping never relates to intertemporal trade Answer: D Difficulty: Easy AACSB: Application of knowledge 25) Equity Instruments include A) stocks.

B) bonds.

C) banks deposits.

D) receipts.

E) bank statements.

Answer: A Difficulty: Easy AACSB: Application of knowledge 26) Asset trades that deal with debt instruments are best described as A) share of stock.

B) exchange rate.

C) receipts.

D) factors.

E) bonds or bank deposits.

Answer: E Difficulty: Easy AACSB: Application of knowledge 27) Asset trades that deal with equity instruments are best described as A) share of stock.

B) exchange rate.

C) bonds.

D) bank deposits.

E) factors.

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Answer: A Difficulty: Easy AACSB: Application of knowledge 28) Who are the main actors in the international capital market?

Answer: (1) Commercial banks (2) Corporations (3) Non-bank financial institutions, such as insurance companies, pension funds, and mutual funds. This includes investment banks, which specialize in underwriting sales of stocks and bonds by corporations and in some cases governments.

(4) Central banks and other government agencies Difficulty: Moderate AACSB: Application of knowledge 29) Why is the foreign exchange market an important part of the international capital market?

Answer: The foreign exchange market is the central component of the international capital market. The exchange rates it sets help determine the profitability of international transactions of all types. The exchange rates show valuable economic signals to households and firms involved in international trade and investment.

Difficulty: Moderate AACSB: Application of knowledge 30) What are the three types of transactions between the residents of different countries?

Answer: The three types are: (1) Trades of goods and services for goods or services (2) Trades of goods and services for assets, and (3) Trades of assets for assets.

Difficulty: Easy AACSB: Application of knowledge 31) How can international trade in assets make both countries better off?

Answer: By allowing them to reduce the riskiness of the return on their wealth and by allowing the two parties to diversify their portfolios, i.e., to divide their wealth among a wider spectrum of assets, and thus reduce the amount of money placed on one specific asset.

Difficulty: Moderate AACSB: Application of knowledge 32) Explain Tobin's idea of "Don't put all your eggs in one basket."

Answer: Trade in assets can make both parties better off by allowing them to reduce the riskiness of the return on their wealth. Portfolio diversification occurs when the wealth is divided among a wide spectrum of assets, so the amount of money riding on each individual asset is reduced.

Obviously, this diversification needs to be contrasted against the expected returns of the new assets that you are acquiring.

Difficulty: Moderate AACSB: Application of knowledge 266 Copyright © 2023 Pearson Education, Ltd.

33) Why is it useful to make a distinction between debt and equity instruments?

Answer: Debt instruments such as bonds and bank deposits are repaid regardless of economic circumstances. Equity instruments, like a share of stock, have a payoff that is linked to economic performances. However, remember the possibility of bankruptcy and the real return, which is subject to domestic currency fluctuations.

Difficulty: Moderate AACSB: Application of knowledge 34) Suppose you are offered a gamble in which you win $1,000 half the time but lose $1,000 half the time. If you are risk averter will you take the gamble?

Answer: Since you are as likely to win as to lose the $1,000, the average payoff on this gamble— its expected value— is: 0.5 ∗ $1,000 + 0.5 ∗ (-$1,000) = 0. If you are risk averse, you will not take the gamble because, for you, the possibility of losing $1000 outweighs the possibility that you will win, although both outcomes are equally likely.

Difficulty: Moderate AACSB: Application of knowledge 35) Suppose you are offered a gamble in which you win $1,000 1/3 of the time but lose $800 2/3 of the time. If you are risk lover will you take the gamble? What will your expected payoff be?

Answer: The expected payoff would be: 1/3 (+$1,000) + 2/3 (-$800) = -$200.

From this calculation, we know that risk-neutral individuals would not take the gamble, but it is not clear what a risk-loving individual would do.

Difficulty: Moderate AACSB: Application of knowledge 36) Calculate the expected payoff for the following cases, where q1 and q2 are the probabilities of state 1 and 2, respectively.

Answer:

Difficulty: Easy AACSB: Analytical thinking 37) Calculate the expected payoff for the following cases, where q1 and q2 are the probabilities of state 1 and 2, respectively.

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Answer:

Difficulty: Easy AACSB: Analytical thinking 38) Complete the following table.

Answer:

Difficulty: Moderate AACSB: Analytical thinking 39) Complete the following table.

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Answer:

Difficulty: Moderate AACSB: Analytical thinking 40) Calculate the expected payoff for the following cases with the formula: (P1) * (payoff if state 1) + (P2) * (payoff if state 2), where P1 and P2 are the probabilities of state 1 and 2, respectively.

Answer:

Difficulty: Easy AACSB: Analytical thinking 269 Copyright © 2023 Pearson Education, Ltd.

41) Complete the following table with the formula (P1) * (payoff if state 1) + (P2)* (payoff if state 2), where P1 and P2 are the probabilities of state 1 and 2, respectively.

Answer:

Difficulty: Moderate AACSB: Analytical thinking 42) Define risk aversion and give an example of a risk-averse person?

Answer: Risk aversion is a characteristic of a person that dislikes risk. An example of this is someone who takes out rental or home insurance to reduce the risk of some kind of catastrophe from happening.

Difficulty: Moderate AACSB: Application of knowledge The following simple two-country question illustrates how countries are made better off by trade in assets. Imagine that there are two countries, Home and Foreign, and that residents of each own only one asset, domestic land yielding an annual harvest of kiwi fruit. Assume that the yield on the land is uncertain. Half the time, Home's land yields a harvest of 100 tons of kiwi fruit at the same time as Foreign's land yields a harvest of 50 tons. The other half of the time the outcomes are reversed. The Foreign's harvest is 100 tons, but the Home harvest is only 50.

43) Calculate the average, for each country of kiwi harvest.

Answer: The average for each country of kiwi harvest is: 0.5 ∗ 100 + 0.5 ∗ 50 = 75 tons of kiwi fruit. However, note that the inhabitants of the two countries never know in advance whether the next year will bring feast or famine.

Difficulty: Moderate AACSB: Application of knowledge 270 Copyright © 2023 Pearson Education, Ltd.

44) Suppose the two countries can trade shares in the ownership of their perspective assets.

Further, assume that a Home owner owns a 10 percent share in Foreign land. He will receive 10 percent share in Foreign land, and thus receives 10 percent of the annual Foreign kiwi fruit harvest.

Further assume that a Foreign owner of a 10 percent share in Home land is permitted. In this case, a Foreigner is entitled to 10 percent of the Home harvest. Calculate the expected value of kiwi fruit for each investor. Is the investor better off?

Answer: Good year at Home: the farmer will get 90 toms of kiwi from home and 5 tons of kiwi from Foreign. Bad years at home: he will get 45 tons of kiwi from his Home and 10 tons from the Foreign country, namely 55 tons. The probability for a good or a bad year is 0.5. Thus the expected returns will now be: 0.5 ∗ 95 + 0.5 ∗ 55 = 75 It is not clear whether the investor is better off or not. If he likes to smooth his consumption, he may be better off. Otherwise, it is impossible to tell without a particular utility function.

Difficulty: Difficult AACSB: Application of knowledge 45) Suppose the two countries can trade shares in the ownership of their perspective assets. Further assume that a Home owner owns a 25 percent share in Foreign land. He will receive 25 percent share in Foreign land and thus receives 25 percent of the annual Foreign kiwi fruit harvest. Further assume also that a Foreign owner of a 25 percent share in Home land is permitted. In this case, a Foreigner is entitled to 25 percent of the Home harvest. Calculate the expected value of kiwi fruit for each investor.

Answer: Good year at Home: 75 + 12.5 = 87.5 tons with probability 0.5 Bad year at Home: 37.5 from Home and 25 from Foreign = 62.5 with probability 0.5.

The expected return is: 0.5 ∗ 87.5 + 0.5 ∗ 62.5 = 75.

Difficulty: Difficult AACSB: Application of knowledge 46) Suppose the two countries can trade shares in the ownership of their perspective assets without any restrictions. Assume that the consumers in both countries would like to totally smooth their consumption. Describe the outcomes.

Answer: In this case, Home residents will buy a 50 percent share of the land in Foreign, and they will pay for it by giving Foreign residents a 50 percent share in Home land. Explain why. To understand why, think about the returns to the Home and Foreign portfolios when both are equally divided between titles to Home and Foreign land. When times are good at Home (and therefore bad in Foreign), each country earns the same return harvest, which is 75 every year with certainty.

Half of the Home harvest (100 ton of kiwi fruit) plus half of the Foreign harvest (50 tons of kiwi fruit) or 75 tons of fruit.

0.5 ∗ 100 + 0.5 ∗ 500 = 75.

In the opposite case-bad times in Home, good time in Foreign-each country still earns 75 tons of fruit.

Thus, we have shown that if the countries hold portfolios equally divided between the two assets, each country earns a certain return of 75 tons of kiwi fruit. This certain return is exactly the same as the average harvest each faced before international asset trade was allowed. This trade completely eliminates the risk faced by both countries without changing average returns.

Assuming risk-averse individuals in both countries, the two countries are better off as a result of 271 Copyright © 2023 Pearson Education, Ltd.

asset trade.

Difficulty: Difficult AACSB: Application of knowledge 47) Suppose that trade in asset is not allowed but the two countries sign a treaty that guarantees the sending of 25 tons of kiwi in good time by the high output country in that season. What will the outcome be of such a treaty? Explain why.

Answer: The outcomes will be exactly the same as in Case D above. In other words, rather than signing a treaty, just leaving the financial markets to function will lead us to the desirable results.

Difficulty: Difficult AACSB: Application of knowledge 48) Why is portfolio diversification so important in international trade?

Answer: Portfolio diversification is important in international trade because parties of the trade are better off by allowing themselves to reduce the risk of the return on their wealth. Traders can divide their wealth among wider amounts of assets in turn reducing the amount of money they have riding on each individual asset.

Difficulty: Moderate AACSB: Application of knowledge 49) What is the difference between equity instruments and debt instruments?

Answer: Equity instruments are shares of stocks. It is defined as a claim to the firm's profit. Debt instruments are bonds and bank deposits. They specify that the issuer of the instrument must repay a fixed value.

Difficulty: Moderate AACSB: Application of knowledge 9.2

International Banking and the International Capital Market

1) As a country begins to liberalize its capital account, what would you expect to happen to the difference between the interest rates for similar assets in this country and another country with open capital markets?

A) get larger B) get smaller C) stay the same D) It depends on the existing exchange rate.

E) exponential divergence Answer: B Difficulty: Moderate AACSB: Application of knowledge 2) What structures make up the international capital markets?

A) stock market, IFM, and the World bank B) bond market, foreign exchange rates, IFM, and the World bank C) commercial banks, corporations, non-bank financial institutions, the central banks, and other government agencies D) commercial banks and corporations 272 Copyright © 2023 Pearson Education, Ltd.

E) the central banks and non-bank financial institutions Answer: C Difficulty: Easy AACSB: Application of knowledge 3) are at the center of the international capital market. They run international payments mechanism and a broad range of financial activities.

A) Commercial banks B) Corporations C) Nonbank financial institutions D) Central banks E) Government agencies Answer: A Difficulty: Easy AACSB: Application of knowledge 4) Corporations routinely finance their investments to obtain foreign sources of funds in the international capital market including A) selling shares of stocks and debt financing.

B) opening subsidiaries in foreign countries.

C) increasing the domestic and foreign market shares.

D) hiring more foreign employees.

Answer: A Difficulty: Easy AACSB: Application of knowledge 5) Investment banks in the U.S. are A) regular banks specializing in investment projects.

B) not banks at all but institutions which specialize in underwriting sales of stocks and bonds.

C) special arm of the U.S. government for U.S. banks operating outside the U.S. D) regular banks specializing in investment projects, but allowed to offer limited domestic transactions.

E) international banks that are heavily invested in the U.S. Answer: B Difficulty: Easy AACSB: Application of knowledge 6) Credit Suisse, Goldman Sachs, and Lazard Freres are examples of A) commercial banks.

B) corporations.

C) non-bank financial institutions, such as insurance companies, pension funds, and mutual funds.

D) central banks and other government agencies.

E) non-profit organizations.

Answer: C Difficulty: Easy AACSB: Application of knowledge 7) Which type of main institution in the international capital market most often is involved in 273 Copyright © 2023 Pearson Education, Ltd.

foreign exchange intervention?

A) central banks B) non-bank financial institutions C) insurance companies D) corporations E) commercial banks Answer: A Difficulty: Easy AACSB: Application of knowledge 8) The scale of transactions in the international capital market has A) grown more quickly than world GDP since the early 1970s.

B) grown less quickly than world GDP since the early 1970s.

C) grown about the same rate as the world GDP since the early 1970s.

D) been fixed by international regulations.

E) decreased more quickly than world GDP since the early 1970s.

Answer: A Difficulty: Easy AACSB: Application of knowledge 9) A business's use of a bank located outside of the home country is called A) offshore banking.

B) international banking.

C) domestic banking.

D) international swapping.

Answer: A Difficulty: Easy AACSB: Application of knowledge 10) What are the types of institution banks used to conduct foreign business?

A) corporations B) central banks C) commercial banks D) agency offices, subsidiary banks, and foreign branches E) state-owned enterprises Answer: D Difficulty: Easy AACSB: Application of knowledge 11) Offshore banking can take place at which institution?

A) agency office only B) subsidiary bank only C) foreign bank only D) subsidiary bank and foreign bank E) agency office, subsidiary bank, and foreign branch Answer: E Difficulty: Easy 274 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 12) The difference between an agency office located abroad and a subsidiary bank located abroad is A) an agency office is just a home bank in another country, while a subsidiary bank is controlled by a foreign bank and subject to the same regulations as local banks.

B) an agency office is just a home bank in another country, while a subsidiary bank arranges loans and transfers funds but does not accept deposits.

C) an agency office arranges loans and transfers funds but does not accept deposits, while a subsidiary bank is controlled by a foreign bank and subject to the same regulations as local banks.

D) an agency office arranges loans and transfers funds but does not accept deposits, while a subsidiary bank is just a home bank in a foreign country.

E) an agency office is controlled by a foreign bank and subject to the same regulations as local banks, while a subsidiary bank arranges loans and transfers funds but does not accept deposits.

Answer: C Difficulty: Easy AACSB: Application of knowledge 13) A bank deposit denominated in a currency other than that of the country in which the bank resides is called A) an offshore deposit.

B) an onshore deposit.

C) an overseas deposit.

D) a foreign deposit.

Answer: A Difficulty: Easy AACSB: Application of knowledge 14) Which one of the following possibilities is TRUE? A) Much of eurocurrency trading occurs in Europe.

B) Much of eurocurrency trading occurs in the United States.

C) Eurocurrencies trading occurs everywhere except the United States.

D) Eurocurrencies trading occurs everywhere except Europe.

E) Eurocurrencies trading occurs everywhere except China.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 15) Eurodollars are A) dollar deposits located in the United States.

B) dollar deposits located in Europe.

C) dollar deposits located outside Europe.

D) dollar deposits located outside the United States.

E) dollar deposits located outside both Europe and the United States.

Answer: D Difficulty: Easy AACSB: Application of knowledge 275 Copyright © 2023 Pearson Education, Ltd.

16) Eurobanks are A) all European Banks.

B) all non American banks.

C) banks that accept deposits denominated in Eurocurrencies excluding Eurodollars.

D) banks that accept deposits denominated in Eurocurrencies including Eurodollars.

E) banks that do not take U.S. dollars.

Answer: D Difficulty: Easy AACSB: Application of knowledge 17) The leading center of Eurocurrency trading is A) New York City.

B) Chicago.

C) London.

D) Paris.

E) Frankfurt.

Answer: C Difficulty: Easy AACSB: Application of knowledge 18) Besides world trade growth, what can explain the growth of international banking since the 1960s?

A) war in the Middle East B) government focus on banking regulation C) an increase in world travel D) the emergence of developing countries like China E) desire of depositors to hold currencies outside the jurisdiction of the countries that issue them Answer: E Difficulty: Easy AACSB: Application of knowledge 19) Regulatory asymmetries can explain why the following places have become main Eurocurrency centers A) the United States.

B) Germany.

C) Zurich, Somalia, and Mozambique.

D) London, Luxembourg, and The United States.

E) London, Luxembourg, and Hong Kong.

Answer: E Difficulty: Moderate AACSB: Application of knowledge 20) Discuss why commercial banks are at the center of the international capital market.

Answer: Commercial banks are at the center of the international capital market, not only because they run the international payments mechanism but also because of the broad range of financial activities they undertake. Bank liabilities consist chiefly of deposits of various maturities, as well 276 Copyright © 2023 Pearson Education, Ltd.

as debt and short-term borrowing from other financial institutions, while their assets consist largely of loans (to corporations and governments), deposits at other banks (interbank deposits), and various securities including bonds. Multinational banks are also heavily involved in other types of asset transaction. For example, banks may underwrite issues of corporate stocks and bonds by agreeing, for a fee, to find buyers for those securities at a guaranteed price.

Difficulty: Moderate AACSB: Application of knowledge 21) Give an example of regulatory asymmetry in international banking? How did it affect the growth of international banking over the past 50 years?

Answer: Commercial banks are often free to pursue activities abroad that they could not legally pursue in their home countries. This type of regulatory asymmetry has spurred the growth of international banking over the past 50 years.

Another example of regulatory asymmetry is the shadow banking system (money market mutual funds, investment banks, etc). The shadow banking system has grown dramatically and taken up many of the same functions as traditional banking. They have been minimally regulated compared to banks.

Difficulty: Easy AACSB: Application of knowledge 22) Describe the role of offshore banking and of offshore currency (eurocurrencies) trading.

Answer: Both have mushroomed due to increased international trade, increased multinational corporations and globalization. Students should also emphasize banks' desire to escape domestic government regulations and taxes on financial activities and political concerns from holding deposits in the country that issued them, which increases default concerns on the part of the foreign investors, etc.

Difficulty: Moderate AACSB: Application of knowledge 23) Describe at least one major factor that contributed to the growth of international capital market since the early 1970s.

Answer: In the industrial world, countries have progressively dismantled barriers to private capital flows across their borders. The widespread adoption of flexible exchange rates since the early 1970s has allowed countries to reconcile open capital markets with domestic monetary autonomy.

Difficulty: Easy AACSB: Application of knowledge 24) Explain the growth of international banking since the 1960s.

Answer: Besides world trade growth, another factor is the banks' desire to escape domestic government regulations on financial activity (and sometimes taxes) by shifting some of their operations abroad and into foreign currencies. A further factor is in part political: the desire by some depositors to hold currencies outside the jurisdictions of the countries that issue them.

Difficulty: Easy AACSB: Application of knowledge 25) Explain why a London Eurobank has a competitive advantage over a bank in New York in 277 Copyright © 2023 Pearson Education, Ltd.

attracting dollar deposits.

Answer: It can pay more because the London bank is not subject to any reserve requirements (neither American nor British), whereas the New York bank is subject to U.S. reserve requirements.

Difficulty: Moderate AACSB: Application of knowledge 26) Explain what Eurocurrencies are and why they are significant.

Answer: Eurocurrencies are offshore currency deposits denominated in a currency other than that of the country in which the bank resides. This currency is significant because of the rapid expansion of international trade and increased multinational nature of corporations' activities.

Difficulty: Moderate AACSB: Application of knowledge 9.3

Banking and Financial Fragility

1) Which of the following statements is NOT true regarding a bank failure?

A) A bank fails when its profit is much lower and it is unable to compete with other local banks.

B) A bank fails when it is unable to meet its obligations to its depositors and other creditors.

C) A bank fails when it is unable to repay its short-term liabilities, including demand deposits without notice.

D) A bank fails when some of the bank's borrowers are unable to repay their loans or the bank's assets decline in value for some other reason.

E) A bank fails when faced with a large and sudden loss of deposits — a bank run.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) A bank faced with a large and sudden loss of deposits is likely to shut down despite a fundamentally sound balance sheet. Why could this be?

A) Banks have accountants that are too optimistic.

B) Banks purposely lie about their balance sheets in order to attract more clients.

C) Many bank assets are illiquid and cannot be sold quickly to meet deposit obligations without substantial loss to the bank.

D) Many banks operate on a budget that exceeds their actual reserves.

E) Many banks will shut down to preserve their interest profits.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 3) Which of the following statements is TRUE? A) Bank failure is limited to banks that have mismanaged their assets.

B) Bank failure is limited to banks that have invested in real estate.

C) Bank failure is limited to banks that have invested in government bonds.

D) Bank failure is limited to a few banks.

E) Bank failure is NOT limited to banks that have mismanaged their assets.

Answer: E 278 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Easy AACSB: Application of knowledge 4) The difference between assets and liabilities or the amount the bank could lose on its assets before it becomes unable to pay off its debts by selling its assets is called A) bank capital.

B) bank failure.

C) bank run.

D) bank balance.

Answer: A Difficulty: Easy AACSB: Application of knowledge 5) The a bank's capital, the values.

A) lower; higher B) lower; lower C) higher; higher D) higher; same Answer: A Difficulty: Easy AACSB: Application of knowledge

chance it becomes insolvent due to losses in asset

6) Which of the following statements is TRUE? A) Bank failures inflict serious financial harm on individual depositors.

B) Bank failures do not inflict serious financial harm on individual depositors.

C) Bank failures inflict not only serious financial harm on individual depositors, but also harm the macroeconomic stability of the economy.

D) Bank failures inflict serious financial harm on individual depositors, but fortunately do not harm the macroeconomic stability of the economy.

E) Bank failures only inflict serious financial harm on the macroeconomic stability of the economy.

Answer: C Difficulty: Easy AACSB: Application of knowledge 7) In the United States, which of the following safety precautions has the government NOT taken to reduce Bank failures?

A) implemented deposits insurance B) bank reserve requirements C) capital requirements and asset restrictions D) required bank examination E) forcibly closing poorly run banks Answer: E Difficulty: Moderate AACSB: Application of knowledge 279 Copyright © 2023 Pearson Education, Ltd.

8) Which of the following statements is TRUE for the U.S.?

A) The Federal Deposit Insurance Corporation (FDIC) insures bank deposits against losses up to $250,000.

B) The Federal Deposit Insurance Corporation (FDIC) insures bank deposits against losses up to $100,000.

C) The Federal Deposit Insurance Corporation (FDIC) insures bank deposits against losses up to $10,000.

D) The Federal Deposit Insurance Corporation (FDIC) insures bank deposits against natural disaster up to $100,000.

E) The Federal Deposit Insurance Corporation (FDIC) insures bank deposits against floods up to $100,000.

Answer: A Difficulty: Easy AACSB: Application of knowledge 9) Which of the following statements is TRUE for the U.S.?

A) The FDIC does not provide insurance for deposits for Savings and Loans (S&L) associations.

B) The FDIC does provide insurance for deposits for Savings and Loans (S&L) associations, but only up to $50,000.

C) The FDIC does provide insurance for deposits for Savings and Loans (S&L) associations up to $250,000.

D) The FDIC does provide insurance for deposits for Savings and Loans (S&L) associations up to $150,000.

E) The FDIC does provide insurance for deposits for Savings and Loans (S&L) associations up to $100,000.

Answer: C Difficulty: Easy AACSB: Application of knowledge 10) Banks in the U.S. A) face rules against lending too large a fraction of their assets to a single private customer only.

B) face rules against lending too large a fraction of their assets to a single private customer or to a single foreign government borrower.

C) face rules against lending too large a fraction of their assets to a single foreign government borrower only.

D) face rules against lending to too many foreign organizations and corporations.

E) face rules against lending to other banks.

Answer: B Difficulty: Easy AACSB: Application of knowledge 11) Banks in the U.S. A) cannot hold common stocks.

B) can hold common stocks.

C) cannot hold common stocks of companies they do business with.

D) cannot hold common stocks of companies that have their headquarters in the same state.

E) can hold risky assets.

280 Copyright © 2023 Pearson Education, Ltd.

Answer: A Difficulty: Easy AACSB: Application of knowledge 12) Banks in the U.S. A) are prevented from holding assets that are "too risky."

B) are not prevented from holding assets that are "too risky."

C) are encouraged not to hold assets that are "too risky."

D) are not encouraged not to hold assets that are "too risky."

E) are encouraged to lend to a single private customer.

Answer: A Difficulty: Easy AACSB: Application of knowledge 13) Government supervisors such as a central bank or a separate financial supervision authority A) have the right to examine a bank's books to ensure compliance with bank capital standards and other regulations.

B) pay off loans that banks are unable to pay.

C) help manage bank over the crisis.

D) insure bank depositors against losses.

Answer: A Difficulty: Easy AACSB: Application of knowledge 14) In the U.S., banks A) cannot be forced to sell assets that the bank examiner deems too risky.

B) can be forced to sell assets that the bank examiner deems too risky.

C) can be forced to sell assets that the bank examiner deems too risky only after a court order.

D) can be forced to sell assets that the bank examiner deems too risky only after both examiners from the Fed and from the FDIC agree.

E) can be forced to trade assets that the bank examiner deems too risky.

Answer: B Difficulty: Easy AACSB: Application of knowledge 15) In the U.S., banks A) may not be forced by bank examiner to adjust their balance sheets by writing off loans the examiner thinks will not be repaid.

B) may be forced by bank examiner to adjust their balance sheets by writing off loans the examiner thinks will not be repaid.

C) may be forced by bank examiner to adjust their balance sheets by writing off loans the examiner thinks will not be repaid only if the Fed and the FDIC examiners agree.

D) may be forced by bank examiner to adjust their balance sheets by writing off loans the examiner thinks will not be repaid only if the Fed and the Office of the Comptroller of the Currency examiners agree.

E) may be forced by bank examiner to adjust their balance sheets by paying off loans the examiner thinks will not be repaid.

281 Copyright © 2023 Pearson Education, Ltd.

Answer: B Difficulty: Easy AACSB: Application of knowledge 16) U.S. reserve requirements A) are rejected by half the banks operating in the United States.

B) show how regulatory asymmetries can operate to enhance the profitability of Eurocurrency trading.

C) tend to harm the bank's business and decrease monetary aggregates.

D) force banks to hold a portion of its assets in a liquid form easily mobilized to meet sudden deposit outflows.

E) remain in place, but capital requirements have begun defaulting.

Answer: D Difficulty: Easy AACSB: Application of knowledge 17) When a central bank lends to banks facing massive deposit outflows as much as they need to satisfy their depositors' claims, it is acting as a to safeguard against financial panic conditional on the bank's sound management.

A) lender of last resort B) life saver C) problem solver D) risk taker Answer: A Difficulty: Easy AACSB: Application of knowledge 18) The case where people purposely act in a careless way, for example, driving recklessly because they are insured, is called A) asymmetric information.

B) risk aversion.

C) moral hazard.

D) bounded rationality.

E) thrill-seeking.

Answer: C Difficulty: Easy AACSB: Application of knowledge 19) The that results from a combination of perceived government guarantees and weak regulations of the guaranteed institutions has helped fuel excessively speculative investment in many economies.

A) moral hazard B) risk aversion C) asymmetric information D) bounded rationality E) thrill-seeking Answer: A 282 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Easy AACSB: Application of knowledge 20) What is "too big to fail" policy?

A) It is a government's policy to protect big banks when they get into trouble because their failures may set off a chain reaction that throws the entire financial system into crisis.

B) It is a government's policy to prevent small and medium sized banks from becoming too big to get into trouble.

C) It is a government's policy to make banks become more interconnected so that their creditors can be fully protected.

D) It is a government's policy to avoid a vicious circle of moral hazard to stabilize the financial system.

Answer: A Difficulty: Easy AACSB: Application of knowledge 21) Many observers believe that the largely unregulated nature of global banking activity leaves the world financial system vulnerable to bank failure on a massive scale. Is this a real threat? If so, what measures have governments taken to reduce it?

Answer: Yes, this is a real threat. A high level of inter-bank depositing implies that problems affecting a single bank could be highly contagious and could spread quickly to banks with which it is thought to do business. In response to this threat, the Basel Committee was created in 1974 to coordinate the surveillance and regulation among bank regulators from different countries.

Difficulty: Moderate AACSB: Application of knowledge 22) "Bank failure may not be limited to banks that have mismanaged their assets." Explain why?

Answer: A sound bank faced with the wholesale loss of deposits is likely to close its door even if the asset side of its balance sheet is fundamentally sound because many bank assets are illiquid and cannot be sold quickly to meet deposit obligations without substantial loss to the bank. Students should stress the atmosphere of financial panic, which will lead to self-fulfilling expectations.

Difficulty: Moderate AACSB: Application of knowledge 23) "It is in the interest of each depositor to withdraw her money from a bank if all other depositors are doing the same, even when the bank's assets are sound." Discuss. As part of your answer clearly state whether the statement is true or false.

Answer: True. Students should elaborate on bank run and stress the atmosphere of financial panic, which will lead to self-fulfilling expectations.

Difficulty: Moderate AACSB: Application of knowledge 24) "There is evidence that the string of U.S. bank closings in the early 1930s helped start and worsen the Great Depression." Discuss.

Answer: Bank failure can harm the economy's macroeconomic stability (keep in mind that safeguards intended to reduce the risk of bank failure were put in place after the Great Depression).

One bank's problems may spread to sounder banks if they are suspected of having lent to the bank 283 Copyright © 2023 Pearson Education, Ltd.

in trouble. This leads to a drastic reduction in the banking system's ability to finance investment and consumer-durable expenditure, so the economy slips into recession (or worse in the case of the Great Depression).

Difficulty: Moderate AACSB: Application of knowledge 25) Describe the extensive "safety net" that has been set up in the United States in order to reduce the risk of bank failure.

Answer: (1) Deposit insurance (2) Reserve requirements (3) Capital requirements and asset restrictions (4) Bank examination (5) Lender of last resort facilities Difficulty: Moderate AACSB: Application of knowledge 26) What is moral hazard and how to avoid it?

Answer: The possibility that someone who is insured against an accident will take less care to prevent it is called moral hazard. Domestic bank supervision and balance-sheet restrictions are necessary to limit the moral hazard resulting from deposit insurance and access to the lender of last resort, which otherwise would lead banks to make excessively risky loans and inadequate provision for their possible failure.

Difficulty: Easy AACSB: Application of knowledge 27) Explain why the FDIC is following a "too-big-to-fail" policy of fully protecting all depositors at the largest banks.

Answer: A tricky question. The FDIC does that although, officially, it still applies only to the $250,000 limit. Probably, the idea is that the cost to one depositor is unbearable relative to the small cost we all need to pay as a collective. Also, there are the issues of political pressure and avoiding blaming the government for mismanaging the safeguards.

Difficulty: Moderate AACSB: Application of knowledge 28) Why are economists increasingly in favor of curbs on the size of financial firms instead of "too big to fail" policy?

Answer: When a financial institution is "too big to fail" or "too interconnected to fail"–its managers and creditors expect that the government will have no choice but to support it in case it gets into trouble. The resulting moral hazard sets off a vicious circle of firms getting bigger, more profit, more growth, and more moral hazard; therefore makes the entire financial system becomes less stable. For this reason, economists are increasingly in favor of curbs on the size of financial firms despite the possible sacrifice of scale efficiencies. They favor forcing large complex banks and shadow banks to be closed and wound down, in case of insolvency, with minimal disruption and minimal cost to taxpayers. The credible threat of bank closure is necessary for limiting moral hazard–bank managers need to know they can be put out of business if they misbehave–but devising concrete procedures is not easy, especially in an international context.

Difficulty: Easy 284 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 9.4

How Well Have International Financial Markets Allocated Capital and Risk?

1) What is a difficulty encountered in regulating international banking?

A) excessive deposit insurance rates on international banks B) absence of overseas reserve requirements C) oppressive regulatory controls that reduce competitiveness D) lack of funds and incentive to secure payments E) variability in exchange rates Answer: B Difficulty: Moderate AACSB: Application of knowledge 2) The process of banks shifting risky business that home regulators might question to regulatory jurisdictions where fewer questions are asked is called A) regulatory arbitrage.

B) regulatory asymmetry.

C) regulatory shifting.

D) regulatory capture.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) A financial trilemma constrains what policy makers in an open economy can achieve. At most two goals from the following list of three are simultaneously feasible A) financial stability, national control over financial safeguard policy, freedom of international capital movements.

B) financial security, fiscal decentralization, system scalability.

C) national sovereignty, democracy, and globalization economic integration.

D) independent monetary policy, fixed exchange rate, freedom of international capital movements.

Answer: A Difficulty: Easy AACSB: Application of knowledge 4) The purpose of the Basel Committee was to A) achieve a better coordination of the surveillance exercised by national authorities over the international banking system.

B) achieve a better coordination of domestic banking systems.

C) achieve a better coordination between brokers and investment bankers.

D) achieve a better coordination between bond holder and bond issuers.

E) manipulate bank rates for more leverage profits.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 5) The Basel Committee was set up in 1974 to 285 Copyright © 2023 Pearson Education, Ltd.

A) strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability.

B) achieve a better coordination of domestic banking systems.

C) strengthen coordination between brokers and investment bankers.

D) achieve a better coordination between bond holder and bond issuers.

E) manipulate bank rates for more leverage profits.

Answer: A Difficulty: Easy AACSB: Application of knowledge 6) The Basel committee A) takes advantages of loopholes in multinational banks.

B) does not support regulatory agencies that monitor the assets of banks' foreign subsidiaries.

C) submitted its Concordat in 1975 and was then disbanded.

D) continues to be the major forum for cooperation in the regulation of international banking.

E) met for the first time in 1975.

Answer: D Difficulty: Easy AACSB: Application of knowledge 7) Capital markets of poor developing countries that liberalized their financial systems to allow private asset trade with foreigners are called A) direct foreign markets.

B) foreign exchange markets.

C) stock & bond markets.

D) emerging markets.

E) fledgling financial markets.

Answer: D Difficulty: Easy AACSB: Application of knowledge 8) Which statement is NOT true regarding emerging markets?

A) Emerging market financial institutions have generally proven to be weaker than those in industrialized countries.

B) Emerging markets are the capital markets of poorer, developing countries that have liberalized their financial system to allow private asset trade with foreigners.

C) Countries with emerging markets include Brazil, Mexico, and Thailand.

D) Countries with emerging markets have been unable to liberalize their financial systems to allow private trade with foreigners.

E) Emerging market financial institutions contributed to the financial crisis of 1997-1999.

Answer: D Difficulty: Easy AACSB: Application of knowledge 9) What is an appropriate definition for "securitization"?

A) the repackaging of bank assets into readily marketable forms B) the promise of a secure return on deposits in FDIC banks 286 Copyright © 2023 Pearson Education, Ltd.

C) the simplification of interest-bearing assets into their simplest derivative form D) the unloading of derivative securities in response to a bank run E) the reinforcement of an asset's worth through official certification Answer: A Difficulty: Easy AACSB: Application of knowledge 10) What caused a major economic shock in August 2007?

A) U.S. mortgage market B) war in Iraq C) U.S. bond market D) technology stocks E) misreporting from Asian markets Answer: A Difficulty: Easy AACSB: Application of knowledge 11) The severity and breadth of the 2007—2009 crisis have led to initiatives to reform both national financial systems and the international system in order to A) fill gaps in existing regulatory frameworks while also paying more attention to the macroeconomic causes and consequences of banking problems.

B) avoid financial crisis permanently in the future.

C) make it easy for banks to get around capital requirements.

D) to set up an omniscient global financial authority responsible for monitoring and regulating the systems.

Answer: A Difficulty: Easy AACSB: Application of knowledge 12) was proposed in 2010 as a tougher set of capital standards and regulatory safeguards for international banks.

A) Basel III B) Basel II C) Basel I D) FSB Answer: A Difficulty: Easy AACSB: Application of knowledge 13) In April 2009, Financial Stability Board was established to A) monitor the global financial system and make recommendations for global policy coordination and reform.

B) implement Base III recommendations.

C) regulate systemically important nonbank financial institutions.

D) eliminate the problem of "too big to fail."

Answer: A Difficulty: Easy 287 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 14) The macroprudential perspective on financial regulation seeks A) to ensure the financial system as a whole is sound.

B) to ensure that each individual financial institution is sound and that is enough.

C) to make each individual institution more resilient without worrying about the whole system.

D) to reduce moral hazard in the financial markets.

Answer: A Difficulty: Easy AACSB: Application of knowledge 15) National financial regulators often face fierce lobbying from their home financial institutions, which argue that A) stricter rules would put them at a disadvantage relative to foreign rivals.

B) stricter rules would give them an advantage relative to foreign rivals.

C) stricter rules would have no effect on their disadvantage relative to foreign rivals.

D) stricter rules would put home institutions and foreign rivals on an equal and fair playing field.

Answer: A Difficulty: Easy AACSB: Application of knowledge 16) Describe the financial trilemma for international policy makers.

Answer: The difficulties in regulating international financial institutions show that a financial trilemma constrains what policy makers in an open economy can achieve. At most two goals from the following list of three are simultaneously feasible: 1. Financial stability.

2. National control over financial safeguard policy.

3. Freedom of international capital movements.

Difficulty: Easy AACSB: Application of knowledge 17) Explain why an international banking system is harder to regulate than a national system.

Answer: Students can look at how the effectiveness of the U.S. safeguards is reduced owing to offshore banking activities covered in the textbook and during the lecture.

(1) No deposit insurance, in particular, inter-bank deposits are unprotected (2) Absence of reserve requirements (3) Bank examination more difficult to enforce (4) Not clear which group of regulators has responsibility for monitoring a given bank's assets (5) Not clear which central bank, if any, is responsible for providing Lender of Last Resort assistance.

Difficulty: Moderate AACSB: Application of knowledge 18) "The internationalization of banking has weakened national safeguards against banking collapse, but at the same time it has made the need for effective safeguards more urgent." Discuss.

Answer: True. Students should elaborate on: (1) No deposit insurance, in particular, inter-bank deposits are unprotected 288 Copyright © 2023 Pearson Education, Ltd.

(2) Absence of reserve requirements (3) Bank examination more difficult to enforce (4) Not clear which group of regulators has responsibility for monitoring a given bank's assets (5) Not clear which central bank, if any, is responsible for providing Lender of Last Resort assistance.

Difficulty: Moderate AACSB: Application of knowledge 19) Explain the difficulties in regulating international banking.

Answer: (1) No deposit insurance, in particular, inter-bank deposits are unprotected (2) Absence of reserve requirements (3) bank examination more difficult to enforce (4) not clear which group of regulators has responsibility for monitoring a given bank's assets (5) not clear which central bank, if any, is responsible for providing Lender of Last Resort assistance.

Difficulty: Moderate AACSB: Application of knowledge 20) Explain the issues involved with the Fed acting as a Lender of Last Resort (LLR).

Answer: On the one hand, LLR enables the Fed to avoid panic and disturbance to proper functioning of financial markets. On the other hand, using the policy may cause problems of moral hazard.

Difficulty: Moderate AACSB: Application of knowledge 21) Who is the Basel Committee? Discuss both their involvement in the Concordat as well as the role of the Concordat in international banking.

Answer: In 1975, the Basel Committee reached an agreement, called the Concordat, which allocated responsibility for supervising multinational banking establishments. In addition, the Concordat called for the sharing of information about banks and the granting of permission to inspect any such banks.

Difficulty: Moderate AACSB: Application of knowledge 22) What is securitization?

Answer: The term refers to financial instrument in which bank assets are repackaged in readily marketable forms. This kind of "derivatives," although useful for the international investors and the banks that underwrite them, causes huge problems in government abilities to monitor bank assets and independently assess their risk to the soundness of the international banking system.

Difficulty: Moderate AACSB: Application of knowledge 23) Explain the source of the global financial crisis of 2007-2009?

Answer: Students can answer based on the case study covered in the textbook and during the lecture.

Difficulty: Easy 289 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 9.5

Metrics for International Capital Market Performance

1) The present structure of the international capital market involves risks of financial instability that can be reduced through all of the following EXCEPT A) enhancement of trade barriers.

B) close cooperation of bank and financial supervisors in many countries.

C) portfolio diversification when residents of different countries trade risky assets.

D) innovative way around national regulations that also provide important gains for customers.

E) rapid flow of information about investment opportunities.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) What are three things to measure for in evaluating the performance of the capital markets?

A) level of intertemporal trade, international trade, portfolio diversification B) level of portfolio diversification, balanced capital accounts, global inflation C) level of portfolio diversification, intertemporal trade, efficiency of foreign exchange D) onshore-offshore interest rate parity, level of portfolio diversification, stability of eurocurrency market E) onshore-offshore interest rate parity, interest parity and foreign exchange, balanced capital accounts Answer: C Difficulty: Easy AACSB: Application of knowledge 3) Investors much prefer to invest in domestic stocks rather than diversifying abroad. This situation is called A) home bias.

B) foreign bias.

C) domestic bias.

D) national bias.

Answer: A Difficulty: Easy AACSB: Application of knowledge 4) Why might a country's savings rate have a high positive correlation to its investment rate?

A) A country's gains from intertemporal trade may have been large.

B) governments' regulation to avoid inflation C) A country's savings rate and investment rate are generally not positively correlated but rather have negative correlation.

D) governments' regulation to avoid large current account balances E) A government has not practiced sufficient fiscal regulation.

Answer: D Difficulty: Easy AACSB: Application of knowledge 290 Copyright © 2023 Pearson Education, Ltd.

5) From 1990 to 2019, OECD countries' saving and investment ratios to output tend to be A) positively related.

B) negatively related.

C) completely unrelated.

D) randomly related.

Answer: A Difficulty: Easy AACSB: Application of knowledge 6) Large differences in interest rates between countries would indicate that A) the global market is thriving.

B) there is good communication between countries about potential global investment opportunities.

C) there are unrealized gains from trade.

D) the market is in danger of collapse.

E) the supply growth exceeds the aggregate demand.

Answer: C Difficulty: Easy AACSB: Application of knowledge 7) Statistical studies of the relationship between interest rates and later depreciation rates show that A) the interest difference has been a very bad predictor in the large swings of exchange rates.

B) the interest difference has been an accurate predictor in the large swings of exchange rates.

C) the interest difference has correctly predicted the direction in which exchange rates would change.

D) the interest difference has not yet been studied as a predictor in the large swings of exchange rates.

E) the interest difference is unrelated to the large swings of exchange rates.

Answer: A Difficulty: Easy AACSB: Application of knowledge 8) In the Interest Parity Condition, Rt - R t = ( differential and (

- Et)/Et + xt, where Rt - R t is the interest rate

- Et)/Et is the expected change in the exchange rate, what does xt stand for

if it potentially is a market efficient difference between the two?

A) market inefficiency B) risk premium C) forecast error D) tracking error E) excessive volatility Answer: B Difficulty: Easy AACSB: Application of knowledge 291 Copyright © 2023 Pearson Education, Ltd.

9) Departures from interest parity A) can be explained using theories of risk premium.

B) cannot be explained using theories of risk premium.

C) may or may not be able to be explained using theories of risk premium, more research is needed.

D) are completely unrelated to risk premium.

E) occur when risk premium is over calculated.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 10) A random walk model can more accurately predict exchange rates as compared to a sophisticated forecast A) always.

B) for forecasts up to a year away.

C) for forecasts longer than a year away.

D) never.

E) because of the predictability of exchange rates.

Answer: B Difficulty: Easy AACSB: Application of knowledge 11) The exchange rate disconnect puzzle refers to A) the remarkable weak short-term relationship between the exchange rate and the rest of the economy.

B) the remarkable strong short-term relationship between the exchange rate and the rest of the economy.

C) the remarkable weak long-term relationship between the exchange rate and the rest of the economy.

D) the remarkable strong long-term relationship between the exchange rate and the rest of the economy.

Answer: A Difficulty: Easy AACSB: Application of knowledge 12) Which of the following is TRUE about exchange rates?

A) They should not be volatile because they will determine the economic climate.

B) They are generally more volatile than stock prices.

C) They are more volatile than several underlying factors that move them such as money supplies and fiscal variables.

D) They should be volatile because to correct price signals they adjust quickly in response to economic news, but they are generally less volatile than stock prices.

E) They never overreact to economic news.

Answer: D Difficulty: Moderate AACSB: Application of knowledge 292 Copyright © 2023 Pearson Education, Ltd.

13) Explain why, according to Feldstein and Horioka, one should expect that domestic investment rates diverge widely from saving rates.

Answer: The decisions of corporations to invest and for households to save are different. Thus globalization means more and different ways to save and invest and increasing the differences between the two ratios.

Difficulty: Moderate AACSB: Application of knowledge 14) Explain why large interest rate differences would be strong evidence of unrealized gains from trade.

Answer: The difference between onshore and offshore interest rates on similar assets denominated in the same currency should be small if information about global investment opportunities is transmitted efficiently. Data show that this is the case for the U.S., Germany, Japan and the Netherlands.

Difficulty: Moderate AACSB: Application of knowledge 15) Discuss studies based on the interest parity conditions.

Answer: In general, the formula does not hold and is not a good predictor of future devaluations.

Even worse, it failed to predict correctly even the direction in which the spot exchange rate would change.

Difficulty: Moderate AACSB: Application of knowledge 16) Explain the forecast error, ut+1, in terms of: (1) Its equation (what it is equal to) (2) How it is used (3) Its accuracy Answer: (Et+1 - Et)/Et - (

- Et)/Et this equation represents actual minus expected

depreciation, where ut+1 is the forecast error made in predicting future depreciation.

Under interest parity the equation ((Et+1 - Et)/Et - (Rt - Rt ) would also be correct, this equation represents the actual currency depreciation minus the interest difference.

Statistical methods have been used to see if the forecast error is predictable through the use of past information. Indeed, a number of researchers have found that ut+1 CAN be predicted.

Difficulty: Difficult AACSB: Application of knowledge 17) Does the interest rate parity hold in each of the following cases? In case it does not hold, calculate the risk premium.

A. Rt = 5,

= 3, Et = 5,

=7

B. Rt = 6,

= 3, Et = 5,

=7

293 Copyright © 2023 Pearson Education, Ltd.

C. Rt = 7,

= 3, Et = 5,

=7

D. Rt = 8,

= 3, Et = 5,

=7

E. Rt = 5,

= 4, Et = 5,

=7

F. Rt = 5,

= 5, Et = 5,

=7

G. Rt = 5,

= 6, Et = 5,

=7

H. Rt = 5,

= 3, Et = 6,

=7

I.

Rt = 5,

= 3, Et = 7,

=7

J.

Rt = 5,

= 3, Et = 8,

=7

K. Rt = 5,

= 3, Et = 5,

=8

L. Rt = 5,

= 3, Et = 5,

=9

M. Rt = 5,

= 3, Et = 5,

= 10

Answer:

Difficulty: Moderate AACSB: Application of knowledge 18) Does the interest rate parity hold in each of the following cases? In case it does not hold, calculate the risk premium.

294 Copyright © 2023 Pearson Education, Ltd.

N. Rt = 8,

= 3, Et = 5,

=7

O. Rt = 7,

= 4, Et = 6,

=8

P. Rt = 6,

= 5, Et = 5,

=7

Q. Rt = 5,

= 4, Et = 6,

=8

R. Rt = 8,

= 6, Et = 5,

=7

S. Rt = 7,

= 5, Et = 6,

=8

T. Rt = 6,

= 4, Et = 5,

=7

U. Rt = 5,

= 3, Et = 6,

=8

V. Rt = 8,

= 5, Et = 6,

=8

W. Rt = 7,

= 3, Et = 8,

=9

X. Rt = 6,

= 7, Et = 7,

=8

Y. Rt = 5,

= 6, Et = 5,

=9

Z. Rt = 4,

= 3, Et = 5,

= 10

Answer:

Difficulty: Difficult 295 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 19) Assume interest parity holds. Calculate

for each of the following cases.

Answer:

Difficulty: Moderate AACSB: Application of knowledge 20) Assume interest parity holds. Calculate

for each of the following cases.

Answer:

296 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Moderate AACSB: Application of knowledge 21) Does the interest rate parity hold in each of the following cases by using the formula Rt - Rt = (Ee+1 - Et)/Et ? In case it does not hold, calculate the risk premium.

1. Rt = 5,

= 3, Et = 5,

= 17

2. Rt = 6,

= 4, Et = 5,

=5

3. Rt = 7,

= 5, Et = 5,

=8

4. Rt = 8,

= 3, Et = 5,

= 15

5. Rt = 5,

= 4, Et = 6,

=6

6. Rt = 5,

= 5, Et = 3,

= 10

7. Rt = 5,

= 6, Et = 2,

=8

8. Rt = 5,

= 3, Et = 0,

= 20

9. Rt = 5,

= 9, Et = 7,

=3

10. Rt = 5,

= 10, Et = 8,

=7

Answer:

297 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Difficult AACSB: Application of knowledge 22) How well has the international capital market performed?

Answer: International portfolio diversification has increased.

Difficulty: Moderate AACSB: Application of knowledge 23) What does the ambiguous evidence on the foreign exchange market's performance suggest?

Answer: The ambiguous evidence on the foreign exchange market's performance suggests an open-minded view. A judgment that the market is doing its job well would support a laissez-faire attitude by governments and a continuation of the present trend toward increased cross-border financial integration in the industrial world. A judgment of market failure, on the other hand, might imply a need for increased foreign exchange intervention by central banks and a reversal of the global trend toward external financial liberalization. The stakes are high, and we need more research and experience before reaching a firm conclusion.

Difficulty: Easy AACSB: Application of knowledge International Finance: Theory & Policy, 12/e, Global Edition Chapter 10 Optimum Currency Areas and the Euro 10.1

How the European Single Currency Evolved

1) On January 1, 1999, member countries of the European Union (EU) adopted a common currency, the euro.

A) 11 B) 8 C) 19 D) 20 Answer: A Difficulty: Easy AACSB: Application of knowledge 2) The EMU created a currency area with more than 298 Copyright © 2023 Pearson Education, Ltd.

A) 200 million consumers.

B) 250 million consumers.

C) about a billion.

D) 500 million consumers.

E) 340 million consumers.

Answer: E Difficulty: Easy AACSB: Application of knowledge 3) Which of the following is TRUE? A) All European countries are part of the EMU. B) All Western European countries are part of the EMU. C) Originally, 20 countries joined the EMU on January 1999.

D) No Western European countries are part of the EMU. E) Not all Western European countries are part of the EMU. Answer: E Difficulty: Easy AACSB: Application of knowledge 4) The birth of the Euro A) resulted in fixed exchange rates between all EMU member countries.

B) resulted in flexible exchange rates between all EMU member countries.

C) resulted in crawling-peg exchange rates between all EMU member countries.

D) resulted in non currency board exchange rates between all EMU member countries.

E) resulted in floating exchange rates between all EMU member countries.

Answer: A Difficulty: Easy AACSB: Application of knowledge 5) How many countries are in the EMU as of January 1, 2019?

A) 9 B) 15 C) 17 D) 19 E) 25 Answer: D Difficulty: Easy AACSB: Application of knowledge 6) The EU countries were prompted to seek closer coordination of monetary policies and greater exchange rate stability in order A) to enhance Europe's role in the world monetary system.

B) to turn the European Union into a truly unified market.

C) both to enhance Europe's role in the world monetary system and to turn the European Union into a truly unified market.

D) both to turn the European Union into a truly unified market and to counter the rise of Japan in international financial markets.

299 Copyright © 2023 Pearson Education, Ltd.

E) to homogenize all European cultures.

Answer: C Difficulty: Easy AACSB: Application of knowledge 7) Which of the following statements is TRUE? A) The 1957 Treaty of Rome founded the EU and created a custom union.

B) The 1957 Treaty of Rome founded the EU. C) The 1957 Treaty of Rome founded the euro.

D) The 1957 Treaty of Rome founded the European Central Bank.

E) The 1957 Treaty of Rome founded the Stability and Growth Pact known as SGP. Answer: A Difficulty: Easy AACSB: Application of knowledge 8) Did the 1957 Treaty of Rome turn the EU into a truly unified market?

A) Yes, it paved the way for the current EMU. B) No, although it established a customs union, it failed to remove barriers to the movement of goods and factors within Europe.

C) No, it was only after the German unification and locating the ECB in Frankfurt that unity was achieved.

D) No, since the Northern members of the EU had larger endowments of capital and skilled labor.

E) No, the Treaty of Rome created more trade barriers between European countries.

Answer: B Difficulty: Easy AACSB: Application of knowledge 9) Many European leaders agreed with the following EXCEPT A) raising official barriers to the movements of goods and services among its member countries will turn EU into a unified market on the model of the United States.

B) economic cooperation and integration among the former belligerents would be the best guarantee against a repetition of the 20th century's two devastating wars.

C) by speaking with a single voice on monetary issues, EU countries can defend more effectively their own economic interests in the face of an increasingly self-absorbed United States.

D) exchange rate uncertainty, like official trade barriers, was a major factor reducing trade within Europe.

Answer: A Difficulty: Easy AACSB: Application of knowledge 10) On June 23, 2016, nearly percent of British voters chose "Leave" on the referendum question "Should the United Kingdom remain a member of the European Union or leave the European Union?"

A) 52 B) 45 C) 42 D) 35 300 Copyright © 2023 Pearson Education, Ltd.

E) 12 Answer: A Difficulty: Easy AACSB: Application of knowledge 11) Which of the following statements is TRUE? A) After more than four decades of membership, Brexit caused many by surprise.

B) After more than four decades of membership, Brexit was not a surprise.

C) After more than four decades of membership, 70 percent of firms had contingency plan in the event of Brexit.

D) After more than four decades of membership, Britain's political leaders were prepared for Brexit.

Answer: A Difficulty: Easy AACSB: Application of knowledge 12) EMS stands for A) European Monetary System.

B) European Mechanism of Stability.

C) European Marketing Supervision.

D) European Management System.

Answer: A Difficulty: Easy AACSB: Application of knowledge 13) In March 1979, original participants in the EMS's exchange rate mechanism does NOT include A) Portugal.

B) France.

C) Germany.

D) Italy.

E) Belgium.

Answer: A Difficulty: Easy AACSB: Application of knowledge 14) The result of the reunification of eastern and western Germany in 1990 A) was a boom in Germany and higher inflation, with no effect on nearby countries.

B) was a recession in Germany and lower inflation, with no effect on nearby countries.

C) was a boom in Germany and higher inflation, and, with other EMS countries' commitment to fixed exchange rates, a deep recession in nearby countries.

D) was a recession in Germany and lower inflation, and, with other EMS countries' commitment to fixed exchange rates, a deep recession in nearby countries.

E) was a recession in Germany and lower inflation, causing a boom in nearby countries.

Answer: C Difficulty: Easy AACSB: Application of knowledge 301 Copyright © 2023 Pearson Education, Ltd.

15) The German central bank in the European Monetary System, 1979-1998 A) was very inflation-averse.

B) was moderately inflation-averse.

C) was willing to accept inflation.

D) lacked control over inflation since it had fixed its exchange rate.

E) lacked sufficient reserves.

Answer: A Difficulty: Easy AACSB: Application of knowledge 16) The credibility theory of the EMS implies in effect that the political costs of violating international exchange rate agreements A) cannot restrain governments from depreciating their currency.

B) can restrain governments from depreciating their currency.

C) cannot restrain governments from depreciating their currency in the short run.

D) cannot restrain governments from depreciating their currency in the long run.

E) can control the political policies of member nations.

Answer: B Difficulty: Easy AACSB: Application of knowledge 17) The credibility theory of the EMS implies in effect that the political costs of violating international exchange rate agreements A) cannot restrain governments from depreciating their currency to gain the short-term advantage of an economic boom at the long-term cost of higher inflation.

B) can restrain governments from depreciating their currency to gain the short-term advantage of an economic boom at the long-term cost of higher inflation.

C) cannot restrain governments from depreciating their currency in the short run.

D) cannot restrain governments from depreciating their currency in the long run.

E) cannot restrain governments from depreciating their currency to gain the long-term advantage of an economic boom.

Answer: B Difficulty: Easy AACSB: Application of knowledge 18) Under the EMS, Germany set the system's A) monetary policy while the other European countries pegged their currencies to the DM. B) fiscal policy while the other European countries pegged their currencies to the DM. C) monetary policy while the other European countries kept their currencies fluctuating relative to the DM. D) fiscal policy while the other European countries kept their currencies fluctuating relative to the DM. E) monetary policy, while other European countries maintained their traditional policies.

Answer: A Difficulty: Easy AACSB: Application of knowledge 302 Copyright © 2023 Pearson Education, Ltd.

19) During the period from 1978-2019, the difference between annual inflation rates of EU countries and the German inflation rate A) grew at an accelerating rate.

B) remained fairly constant.

C) largely disappeared.

D) went through periods of hyperinflation.

E) trended upward at a declining rate.

Answer: C Difficulty: Easy AACSB: Application of knowledge 20) The credibility theory of EMS had as an effect A) the inflation rates of member countries converging to the low German levels, a result that was not matched by similar countries who did not fix their exchange rates.

B) the inflation rates of member countries failing to converge to the low German levels.

C) the inflation rates of member countries converging to the low German levels, but other countries including U.S. and Britain also reduced inflation in this time period without fixing exchange rates.

D) the inflation rate in Germany rose to match the inflation rates of other member countries.

E) the inflation rate in the U.S. dropped to the low German levels.

Answer: C Difficulty: Easy AACSB: Application of knowledge 21) An inflation-prone country A) gains from vesting its monetary policy decisions with a "conservative" central bank.

B) loses from vesting its monetary policy decisions with a "conservative" central bank.

C) gains from vesting its fiscal policy decisions with a "conservative" central bank.

D) loses from vesting its fiscal policy decisions with a "conservative" central bank.

E) remains constant when vesting its fiscal policy decisions with a "conservative" central bank.

Answer: A Difficulty: Easy AACSB: Application of knowledge 22) The EU countries have tried to achieve greater internal economic unity through direct measures to A) encourage the free flow of goods, services, and factors of production.

B) discourage the free flow of goods, services, and factors of production.

C) raise trade barriers within the European Union.

D) discourage the free flow of financial capital within the European Union and between the European Union and outside jurisdictions.

Answer: A Difficulty: Easy AACSB: Application of knowledge 23) The most important feature of the Single European Act of 1986, which amended the founding Treaty of Rome, was dropping the requirement of 303 Copyright © 2023 Pearson Education, Ltd.

A) unanimous consent for measures related to market completion and making it a decision that only Germany and France agreed about.

B) unanimous consent for measures related to market completion.

C) majority consent for measures related to market completion and making it a decision that only Germany and France agreed about.

D) unanimous consent for measures related to agricultural policies only.

E) unanimous consent for measures related only to fiscal policies.

Answer: B Difficulty: Easy AACSB: Application of knowledge 24) The European Economic and Monetary Union (EMU) A) set up a single currency and sole bank for European economic monetary policy.

B) eliminated all barriers to trade such as tax differentials between borders.

C) produced a single government for handling European affairs.

D) created the Common Agricultural Pact.

E) eliminated all local currencies in Western Europe.

Answer: A Difficulty: Easy AACSB: Application of knowledge 25) The 1991 Maastricht Treaty can be best described as A) a peace treaty between Europe and the United States.

B) an agreement for the accession of the Netherlands into the EU. C) an agreement for the creation of a free trade area.

D) a provision for the introduction of a single European currency and European central bank.

E) the beginning of a floating exchange rate European monetary system.

Answer: D Difficulty: Easy AACSB: Application of knowledge 26) Why did British voters decide to leave the EU? Answer: The reasons are complex, but a number of factors stand out. First was the desire to limit immigration from Eastern Europe and the benefits, such as medical care, the U.K. government must provide to immigrants under EU law. Another factor was the panoply of regulations from EU headquarters in Brussels, felt by many to be intrusive, overly detailed, and unnecessary to promote intra-EU trade.

Difficulty: Easy AACSB: Application of knowledge 27) How and why did Europe set up its single currency?

Answer: The why part is because large fluctuations in the exchange rates among the European countries disturbed trade. Also, one of the main reasons was to design a way to prevent future world war. The how part of the question is related to the collapse of Bretton Woods and the European Currency reform of 1969-1978. The Werner Report of 1971 establishes a three-phase program to lead to the EMU. Difficulty: Moderate 304 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 28) How did the European single currency evolve?

Answer: The answer is related to the collapse of Bretton Woods and the European Currency reform of 1969-1978. The Werner Report of 1971 establishes three-phase program to lead to the EMU. Difficulty: Moderate AACSB: Application of knowledge 29) What prompted the EU countries to seek closer coordination of monetary policies and greater exchange rate stability in the late 1960s?

Answer: (1) To enhance Europe's role in the world monetary system (2) To turn the European Union into a truly unified market Difficulty: Moderate AACSB: Application of knowledge 30) Discuss the effects of the reunification of eastern and western Germany in 1990 on both Germany and its neighboring European countries.

Answer: Germany: boom, high interest rates to fight inflation. Other European countries: France, Italy and UK in recession, trying to match the high German interest rates to hold their currencies fixed against Germany's, thereby pushing their economies into deep recession. Other European countries tried to continue the fixed exchange rate in order not to lose the credibility they had built up since 1985. The policy conflict between Germany and the other European countries led to a series of fierce speculative attacks on the EMS exchange parities starting in September 1992. By august 1993, the EMS was forced to retreat to very wide (± 10 percent) bands, which is kept in force until the introduction of the euro in 1993.

Difficulty: Difficult AACSB: Application of knowledge 31) Explain why the EMS countries decided to fix their exchange rates against the German DM. Answer: In this way, the other EMS countries in effect imported the credibility of the German central bank in fighting inflation, thus discouraging the development of inflationary pressures at home.

Difficulty: Moderate AACSB: Application of knowledge 32) Explain the credibility theory of the EMS. Answer: In this way, the other EMS countries in effect imported the credibility of the German central bank in fighting inflation, thus discouraging the development of inflationary pressures at home. This is known as the credibility theory of the EMS. Difficulty: Moderate AACSB: Application of knowledge 33) Explain how the German Bundesbank gained its low-inflation reputation.

Answer: Mainly, Germany's experience with hyperinflation in the 1920s and again after World War II left the German electorate with a deeply rooted fear of inflation. The law establishing the Bundesbank singled out the defense of the DM's real value as the primary goal of the German 305 Copyright © 2023 Pearson Education, Ltd.

central bank.

Difficulty: Moderate AACSB: Application of knowledge 34) Describe the effects of the reunification of eastern and western Germany in 1990 on both Germany and its neighboring European countries using the AA-DD framework.

Answer: As for Germany a period of boom with high interest rates to fight inflation.

Other European countries: France, Italy and UK in recession, trying to match the high German interest rates to hold their currencies fixed against Germany's, thereby pushing their economies into deep recession. Other European countries tried to continue the fixed exchange rate in order not to lose the credibility they had build up since 1985. The policy conflict between Germany and the other European countries led to a series of fierce speculative attacks on the EMS exchange parities starting in September 1992. By August 1993, the EMS was forced to retreat to very wide (± 10 percent) bands, which was kept in force until the introduction of the euro in 1993.

Difficulty: Moderate AACSB: Application of knowledge 35) What is the purpose of the following figure?

Answer: The purpose of the figure is to show the inflation convergence within the six original EMS members. The figure shows the difference between domestic inflation and German inflation for six of the original EMS members. As of 2019 all national inflation rates were very close to the 306 Copyright © 2023 Pearson Education, Ltd.

German levels.

Difficulty: Moderate AACSB: Application of knowledge 36) Describe the main provisions of the Maastricht Treaty of 1991.

Answer: Called for a single currency by January 1, 1999, harmonizing social security policy within the European Union, and centralizing foreign and defense policy decisions.

Difficulty: Easy AACSB: Application of knowledge 37) Why did the EU countries move away from the EMS toward the goal of a single shared currency?

Answer: (1) To produce a greater degree of European market integration by removing the threat of EMS currency realignments.

(2) Reduce German dominance of the EMS monetary policy.

(3) Given the move to complete freedom of capital movements within the EU, fixed but adjustable currency parities, may lead to ferociously speculative attacks, as in 1992-1993.

(4) To guarantee the political stability of Europe.

Difficulty: Moderate AACSB: Application of knowledge 10.2

The Euro and Economic Policy in the Euro Zone

1) To join the EMU, a country should have no more than A) 1.5 percent inflation rate above the average of the three EU member states with the highest inflation.

B) 3 percent inflation rate above the average of the three EU member states with the lowest inflation.

C) 4 percent inflation rate above the average of the three EU member states with the lowest inflation.

D) 1.5 percent inflation rate above the average of the three EU member states with the lowest inflation.

E) 2 percent inflation rate above the average of the three EU member states with the lowest inflation.

Answer: D Difficulty: Easy AACSB: Application of knowledge 2) To join the EMU, a country must have A) maintained a stable exchange rate within the ERM without devaluing on its own initiative.

B) devalued its currency on its own initiative.

C) a volatile exchange rate within the ERM. D) an unstable exchange rate within the ERM with devaluations on its own initiative.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) To join the EMU, a country must have 307 Copyright © 2023 Pearson Education, Ltd.

A) a public-sector deficit no higher than 3 percent of its GDP in general.

B) a public-sector deficit no higher than 2 percent of its GDP in general.

C) a public-sector deficit no higher than 1 percent of its GDP in general.

D) a zero public-sector deficit.

E) a public-sector deficit no higher than 4 percent of its GDP in general.

Answer: A Difficulty: Easy AACSB: Application of knowledge 4) To join the EMU, a country must have a public debt below or approaching a reference level of A) 50 percent of its GDP. B) 10 percent of its GDP. C) 60 percent of its GDP. D) 100 percent of its GDP. E) 5 percent of its GDP. Answer: C Difficulty: Easy AACSB: Application of knowledge 5) The main function of the 1997 Stability and Growth Pact (SGP) was to A) exclude a highly indebted EMU country.

B) enhance cooperation between France and Germany.

C) tighten the fiscal constraints.

D) distribute the Euro banknote among European central banks and to create a timetable for the imposition of financial penalties on countries that fail to correct situations of "excessive" deficits and debt promptly enough.

E) determine specialized penalties for each member nation.

Answer: C Difficulty: Easy AACSB: Application of knowledge 6) The European Central Bank has its headquarter in A) London.

B) Berlin.

C) Frankfurt.

D) Paris.

E) Brussels.

Answer: C Difficulty: Easy AACSB: Application of knowledge 7) The Eurosystem makes decisions by A) votes of the governing council of the European Central Bank (ECB).

B) the President of the European Central Bank.

C) votes approved by legislatures or voters in every member country of the EU. D) the governors of central banks of non-euro area countries.

Answer: A 308 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Easy AACSB: Application of knowledge 8) Euro and non-euro central banks in the European System of Central Banks (ESCB) are committed to A) pursue domestic price stability as well as various forms of cooperation with the Eurosystem.

B) pursue low inflation under political influences.

C) pursue various forms of cooperation with the Eurosystem.

D) pursue peace without conflict among member countries.

Answer: A Difficulty: Easy AACSB: Application of knowledge 9) Unlike any other central bank in the world, the European Central Bank (ECB) operates A) beyond the reach of any single national government.

B) under complete control by the European Parliament.

C) by approval from voters in every member country of the EU. D) under control by legislatures in all member countries.

Answer: A Difficulty: Easy AACSB: Application of knowledge 10) A revised exchange rate mechanism, referred to as ERM 2, defines broad exchange rate zones against the euro of ± percent.

A) 15 B) 10 C) 5 D) 3 E) 1.5 Answer: A Difficulty: Easy AACSB: Application of knowledge 11) Under ERM 2 rules, the national central bank of an EU member with its own currency can suspend euro intervention operations A) if there is a civil war.

B) if they result in money supply changes that threaten to destabilize the domestic price level.

C) if there is a current account deficit.

D) if there is a current account surplus.

E) if they result in a weakened current account.

Answer: B Difficulty: Easy AACSB: Application of knowledge 12) How were the initial members of EMU chosen? How will new members be admitted? What is the structure of the complex of financial and political institutions that govern economic policy in the euro zone?

309 Copyright © 2023 Pearson Education, Ltd.

Answer: EU countries should satisfy: (1) Low inflation rate (no more than 1.5 percent above the average of the three EU member states with the lowest inflation).

(2) A stable exchange rate within the ERM. (3) Public-sector deficit no higher than 3 percent of its GDP in general.

(4) A public debt below or approaching a reference level of 60 percent of its GDP. Difficulty: Difficult AACSB: Application of knowledge 13) What is the purpose of the Stability and Growth Pact (SGP) negotiated by European leaders in 1997?

Answer: It tightened the fiscal constraints. The SGP set out "the medium-term budgetary objective of positions close to balance or in surplus." It also set a timetable for the imposition of financial penalties on countries that fail to correct situations of "excessive" deficits and debt promptly enough.

Difficulty: Easy AACSB: Application of knowledge 14) What does the Eurosystem do and how are decisions made?

Answer: The Eurosystem conducts monetary policy for the euro zone and consists of the European Central Bank (ECB) in Frankfurt plus the 19 national central banks of the euro area. The Eurosystem makes decisions by votes of the governing council of the ECB, consisting of the six-member ECB executive board (including the president of the ECB) and the heads of the national central banks of the euro area.

Difficulty: Easy AACSB: Application of knowledge 15) What is the revised exchange rate mechanism?

Answer: For EU countries that are not yet members of EMU, a revised exchange rate mechanism–referred to as ERM 2–defines broad exchange rate zones against the euro (±15 percent) and specifies reciprocal intervention arrangements to support these target zones. The EU viewed ERM 2 as necessary to discourage competitive devaluations against the euro by EU members outside the euro zone and to give would-be EMU entrants a way of satisfying the Maastricht Treaty's exchange rate stability convergence criterion.

Difficulty: Easy AACSB: Application of knowledge 10.3

The Theory of Optimum Currency Areas

1) The European monetary integration process has helped advance the political goals of its founders by giving the European Union A) a stronger position in international affairs.

B) a weaker position in international affairs.

C) a consensus agreement in all economic and monetary policies.

D) full protection from financial and monetary crisis.

Answer: A Difficulty: Easy 310 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 2) The survival and future development of the European monetary experiment depend on its ability to A) help countries reach their economic goals.

B) help non-euro countries to converge in terms of economic growth.

C) make its all citizens happy and prosperous.

D) cope with economic shocks including Covid-19 pandemic.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) Exchange rate flexibility can have potentially harmful effects EXCEPT A) stabilizing domestic price level.

B) making prices less predictable.

C) undermining the government's resolve to keep inflation in check.

D) cushioning the disruptive impact of various economic shocks.

Answer: A Difficulty: Easy AACSB: Application of knowledge 4) The theory of optimum currency areas predicts that A) floating exchange rates are most appropriate for areas closely integrated through international trade and factor movements.

B) fixed exchange rates are most appropriate for areas that are loosely integrated through international trade and factor movements.

C) fixed exchange rates are most appropriate for areas closely integrated through international trade and factor movements.

D) floating exchange rates are most appropriate for all countries in Europe.

E) fixed exchange rates are most appropriate for all countries in Europe.

Answer: C Difficulty: Easy AACSB: Application of knowledge 5) A major economic A) benefit of fixed exchange rates is that they simplify economic calculations and provide a more predictable basis for decisions that involve international transactions than do floating rates.

B) benefit of floating exchange rates is that they simplify economic calculations and provide a more predictable basis for decisions that involve international transactions than do fixed rates.

C) cost of fixed exchange rates is that they simplify economic calculations and provide a more predictable basis for decisions that involve international transactions than do currency board rates.

D) benefit of flexible exchange rates is that they simplify economic calculations and provide a more predictable basis for decisions that involve international transactions than do crawling peg rates.

E) benefit of fixed exchange rates is that the value of goods will remain constant across a large region of consumers.

Answer: A 311 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Moderate AACSB: Application of knowledge 6) The monetary efficiency A) gain from joining the fixed exchange rate system equals the joiner's savings from avoiding the uncertainty, confusion, and calculation and transaction costs that arise when exchange rates float.

B) gain from joining the fixed exchange rate system equals the joiner's savings from estimated costs of future predicted exchange rate fluctuation.

C) loss from joining the fixed exchange rate system equals the joiner's savings from transaction costs that arise when exchange rates float.

D) loss from joining the fixed exchange rate system equals the joiner's savings from uncertainty and confusion when exchange rates float.

Answer: A Difficulty: Easy AACSB: Application of knowledge 7) The efficiency A) gain from a fixed exchange rate with the euro is smaller when trade between say, Norway and the euro zone, is extensive than when it is small.

B) gain from a fixed exchange rate with euro is greater when trade between say, Norway and the euro zone, is extensive than when it is small.

C) loss from a fixed exchange rate with the euro is smaller when trade between say, Norway and the euro zone, is extensive than when it is small.

D) gain from a fixed exchange rate with euro is the same as when trade between say, Norway and the euro zone, is extensive than when it is small.

E) gain from a fixed exchange rate with euro is the same as when trade between say, Norway and the euro zone, is small than when it is small.

Answer: B Difficulty: Moderate AACSB: Application of knowledge 8) Other things equal, if Norway's trade with the euro zone amounts to 50 percent of its GNP while its trade with the United States amounts to only 5 percent of GNP, A) a fixed krone/euro exchange rate yields a greater monetary efficiency gain to Norwegian traders than a fixed krone/dollar rate.

B) a fixed krone/dollar exchange rate yields a greater monetary efficiency gain to Norwegian traders than a fixed krone/euro rate.

C) a fixed krone/euro exchange rate yields a smaller monetary efficiency gain to Norwegian traders than a fixed krone/dollar rate.

D) a fixed krone/euro exchange rate yields the same monetary efficiency gain to Norwegian traders as a fixed krone/dollar rate.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 9) The monetary efficiency A) loss from pegging the Norwegian krone to the euro (for example) will be higher if factors of 312 Copyright © 2023 Pearson Education, Ltd.

production can migrate freely between Norway and the euro area.

B) gain from pegging the Norwegian krone to the euro (for example) will be lower if factors of production can migrate freely between Norway and the euro area.

C) gain from pegging the Norwegian krone to the euro (for example) will be higher if factors of production can not migrate freely between Norway and the euro area.

D) gain from pegging say the Norwegian krone to the euro (for example) will be higher if factors of production can migrate freely between Norway and the euro area.

E) gain or loss from pegging the Norwegian krone to the Euro cannot be predicted using the available information.

Answer: D Difficulty: Moderate AACSB: Application of knowledge 10) A high degree of economic integration between a country and a fixed exchange rate area A) magnifies the monetary efficiency gain the country reaps when it fixes its exchange rate against the area's currencies.

B) reduces the monetary efficiency gain the country reaps when it fixes its exchange rate against the area's currencies.

C) has no effect on the monetary efficiency gain the country reaps when it fixes its exchange rate against the area's currencies.

D) magnifies the monetary efficiency loss the country incurs when it fixes its exchange rate against the area's currencies.

Answer: A Difficulty: Easy AACSB: Application of knowledge 11) Which of the following statements is MOST accurate?

A) A high degree of economic integration between a country and a fixed exchange rate area that it joins magnifies the monetary efficiency gain the country reaps when it fixes its exchange rate against the area's currencies.

B) A low degree of economic integration between a country and a fixed exchange rate area that it joins magnifies the monetary efficiency gain the country reaps when it fixes its exchange rate against the area's currencies.

C) A high degree of economic integration between a country and a fixed exchange rate area that it joins reduces the monetary efficiency gain the country reaps when it fixes its exchange rate against the area's currencies.

D) A low degree of economic integration between a country and a fixed exchange rate area that it joins has no effect on the monetary efficiency gain the country reaps when it fixes its exchange rate against the area's currencies.

Answer: A Difficulty: Easy AACSB: Application of knowledge 12) Which one of the following statements is TRUE? A) The less extensive are cross-border trade and factor movements, the greater is the gain from a fixed cross-border exchange rate.

B) The more extensive are cross-border trade and factor movements, the greater is the loss from a 313 Copyright © 2023 Pearson Education, Ltd.

fixed cross-border exchange rate.

C) The more extensive are cross-border trade and factor movements, the greater is the gain from a fixed cross-border exchange rate.

D) The more extensive are cross-border trade, the greater is the loss from a fixed cross-border exchange rate.

E) The more extensive are factor movements, the greater is the loss from a fixed cross-border exchange rate.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 13) The GG schedule shows the relationship between A) a country's degree of economic integration with a fixed exchange rate area and the monetary efficiency gain to the country from joining the area.

B) a country's degree of economic integration with a fixed exchange rate area and the monetary efficiency loss to the country from joining the area.

C) a country's degree of economic integration with a floating exchange rate area and the monetary efficiency gain to the country from joining the area.

D) a country's degree of economic integration with a floating exchange rate area and the monetary efficiency loss to the country from joining the area.

Answer: A Difficulty: Easy AACSB: Application of knowledge 14) Why does the GG schedule have a positive slope?

A) The monetary efficiency gain a country gets by joining a fixed exchange rate area falls as its economic integration with the area increases.

B) The monetary efficiency gain a country gets by joining a fixed exchange rate area rises as its economic integration with the area decreases.

C) The monetary efficiency gain a country gets by joining a fixed exchange rate area rises as its economic integration with the area increases.

D) The monetary efficiency gain a country gets by joining a floating exchange rate area rises as its economic integration with the area increases.

E) The monetary efficiency gain a country gets by joining a fixed exchange rate area is constant after their integration into the area.

Answer: C Difficulty: Easy AACSB: Application of knowledge 15) If the euro zone's price level is stable and Norway's exchange rate commitment is firm, A) when Norway pegs to the euro, its efficiency gain from the stability of its currency against the euro is greater the more closely tied are Norway's markets with euro zone markets.

B) when Norway pegs to the euro, its efficiency gain from the stability of its currency against the euro is reduced the more closely tied are Norway's markets with euro zone markets.

C) when Norway pegs to the euro, there is no impact on its monetary efficiency gain.

D) when Norway pegs to the euro, its efficiency loss is greater the more closely tied are Norway's markets with euro zone markets.

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Answer: A Difficulty: Easy AACSB: Application of knowledge 16) When the economy of the pegging country is well integrated with that of the low-inflation area, low domestic inflation is A) easier to achieve.

B) harder to achieve.

C) impossible to achieve.

D) highly uncertain.

Answer: A Difficulty: Easy AACSB: Application of knowledge 17) A country that joins an exchange rate area A) gives up its ability to use the exchange rate for the purpose of stabilizing output and employment.

B) does not give up its ability to use the exchange rate and monetary policy for the purpose of stabilizing output and employment.

C) gives up its ability to use the exchange rate and monetary policy for the purpose of stabilizing output and employment.

D) gives up its ability to use only monetary policy for the purpose of stabilizing output and employment.

E) does not gives up its ability to use only monetary policy for the purpose of stabilizing output and employment.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 18) The LL schedule shows the relationship between A) a country's degree of economic integration with a fixed exchange rate area and the economic stability loss to the country from joining the area.

B) a country's degree of economic integration with a fixed exchange rate area and the economic stability gain to the country from joining the area.

C) a country's degree of economic integration with a floating exchange rate area and the economic stability loss to the country from joining the area.

D) a country's degree of economic integration with a floating exchange rate area and the economic stability gain to the country from joining the area.

Answer: A Difficulty: Easy AACSB: Application of knowledge 19) When the economy is disturbed by a change in the output market A) a fixed exchange rate has an advantage over a flexible rate.

B) a floating exchange rate has an advantage over a fixed rate.

C) a crawling peg exchange rate has an advantage over a flexible rate.

D) a floating exchange rate has the same effect as a fixed rate.

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E) a flexible exchange rate is not as effective as a fixed exchange rate.

Answer: B Difficulty: Moderate AACSB: Application of knowledge 20) Which one of the following statements is TRUE? A) A fixed exchange rate automatically cushions the economy's output and employment by allowing an immediate change in the relative price of domestic and foreign goods.

B) A flexible exchange rate does not automatically cushion the economy's output and employment by allowing an immediate change in the relative price of domestic and foreign goods.

C) A flexible exchange rate automatically cushions the economy's output and employment by allowing an immediate change in the relative price of domestic and foreign goods.

D) A flexible exchange rate automatically cushions the economy's output and employment by allowing an immediate change in the absolute price of domestic and foreign goods.

E) A fixed exchange rate automatically cushions the economy's output and employment by allowing an immediate change in the absolute price of domestic and foreign goods.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 21) When the exchange rate is A) flexible, purposeful stabilization is more difficult because monetary policy has no power at all to affect domestic output and employment.

B) fixed, purposeful stabilization is less difficult because monetary policy has no power at all to affect domestic output and employment.

C) fixed, purposeful stabilization is more difficult because monetary policy has no power at all to affect domestic output and employment.

D) a crawling peg, rather than fixed, purposeful stabilization is more difficult because monetary policy has no power at all to affect domestic output and employment.

E) fixed rather than crawling peg purposeful stabilization is more difficult because fiscal policy has no power at all to affect domestic output and employment.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 22) Economic stability loss is A) the extra instability caused by a country's joining a fixed exchange rate area.

B) the extra instability caused by a country's joining a floating exchange rate area.

C) the extra instability caused by the monetary authority.

D) the extra instability caused by the change in prices of domestic and foreign goods.

Answer: A Difficulty: Easy AACSB: Application of knowledge 23) When Norway unilaterally fixes its exchange rate against the euro and leaves the krone A) free to float against the non-euro currencies, it is able to keep at least some monetary independence.

B) free to float against the non-euro currencies, it is unable to keep at least some monetary 316 Copyright © 2023 Pearson Education, Ltd.

independence.

C) free to float against the non-euro currencies, it is able to keep its monetary independence.

D) run by crawling peg against the non-euro currencies, it is able to keep at least some monetary independence.

E) fixed against the non-euro currencies, it is unable to keep its monetary independence.

Answer: B Difficulty: Moderate AACSB: Application of knowledge 24) After Norway unilaterally pegs the krone to the euro, domestic money market disturbances will A) no longer affect domestic output despite the continuation of float-rate regime against non-euro currencies.

B) now have major effect on domestic output despite the continuation of float-rate regime against non-euro currencies.

C) have some effect on domestic output despite the continuation of float-rate regime against non-euro currencies.

D) have major effect on domestic employment despite the continuation of float-rate regime against non-euro currencies.

E) no longer affect foreign imports despite the continuation of float-rate regime against non-euro currencies.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 25) A krone/euro peg alone is A) not enough to provide automatic stability in the face of any monetary shocks that shift the AA schedule.

B) enough to provide automatic stability in the face of any monetary shocks that shift the AA schedule.

C) not enough to provide automatic stability in the face of any monetary shocks that shift the AA schedule, provided fiscal policy will be used as well.

D) enough to provide automatic stability in the face of any monetary shocks that shift the AA schedule, provided the government runs a budget deficit.

E) enough to provide partial stability in the face of smaller monetary shocks that shift the AA schedule.

Answer: B Difficulty: Moderate AACSB: Application of knowledge 26) Since Norway has close trading links with the euro zone A) a small reduction in its price will lead to an increase in euro zone demand for Norwegian goods that is large relative to Norway's output. Thus, full employment can be restored fairly quickly.

B) a small reduction in its price will lead to a decrease in euro zone demand for Norwegian goods that is large relative to Norway's output. Thus, full employment can be restored fairly quickly.

C) a small reduction in its price will lead to an increase in euro zone demand for Norwegian goods that is small relative to Norway's output. Thus, full employment can be restored fairly quickly.

317 Copyright © 2023 Pearson Education, Ltd.

D) a big reduction in its price will lead to an increase in euro zone demand for Norwegian goods that is large relative to Norway's output. Thus, full employment can be restored fairly quickly.

E) a big reduction in its price will lead to a decrease in euro zone demand for Norwegian goods that is small relative to Norway's output. Thus, full employment can be restored fairly quickly.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 27) If Norway's labor and capital markets are highly correlated with those of its euro zone neighbors A) unemployed workers can easily move abroad to find work and domestic capital can be shifted to more profitable uses in other countries.

B) unemployed workers cannot easily move abroad to find work and domestic capital cannot be shifted to more profitable uses in other countries.

C) while unemployed workers can easily move abroad to find work, domestic capital cannot be shifted to more profitable uses in other countries.

D) while capital can easily move abroad to be put to a more profitable use, unemployed workers cannot easily move abroad to find work.

E) unemployment will rise, thanks to competition from foreign labor.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 28) The ability of factors to migrate abroad A) reduces the severity of unemployment and the fall in the rate of return available to investors.

B) increases the severity of unemployment and the fall in the rate of return available to investors.

C) reduces the severity of unemployment but increases the fall in the rate of return available to investors.

D) cannot change the severity of unemployment and the constant rate of return available to investors.

E) reduces the migration of highly-skilled workers.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 29) Which one of the following statements is TRUE for Norway, a non-euro country?

A) Of course, owners of capital that cannot be moved cannot avoid more of the economic stability loss due to fixed exchange rates when Norway's economy is open to capital flows.

B) Even owners of capital that cannot be moved can avoid more of the economic stability loss due to fixed exchange rates when Norway's economy is open to capital flows.

C) Owners of capital that cannot be moved can avoid more of the economic stability loss due to fixed exchange rates when Norway's economy is closed to capital flows.

D) Even owners of capital that can be moved can avoid more of the economic stability loss due to fixed exchange rates when Norway's economy is closed to capital flows.

E) Only owners of capital that can be moved can avoid more of the economic stability loss due to fixed exchange rates when Norway's economy is open to capital flows.

Answer: B 318 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Moderate AACSB: Application of knowledge 30) Which of the following statements is MOST accurate?

A) A low degree of economic integration between a country and the fixed exchange rate area that it joins reduces the resulting economic stability loss due to output market disturbances.

B) A high degree of economic integration between a country and the fixed exchange rate area that it joins reduces the resulting economic stability loss due to output market disturbances.

C) A high degree of economic integration between a country and the fixed exchange rate area that it joins increases the resulting economic stability loss due to output market disturbances.

D) A complete lack of economic integration between a country and the fixed exchange rate area that it joins reduces the resulting economic stability loss due to output market disturbances.

E) A low degree of economic integration between a country and the fixed exchange rate area that it joins increases the resulting economic stability loss due to output market disturbances.

Answer: B Difficulty: Easy AACSB: Application of knowledge 31) Why does the LL schedule have a negative slope?

A) The economic stability loss from pegging to the area's currencies rises as the degree of economic interdependence rises.

B) The economic stability loss from pegging to the area's currencies falls as the degree of economic interdependence rises.

C) The economic stability loss from pegging to the area's currencies falls as the degree of economic interdependence falls.

D) The economic stability loss from pegging to the area's currencies rises as the degree of economic activity increases.

E) The economic stability loss from pegging to the area's currencies is constant, even as the degree of economic activity increases.

Answer: B Difficulty: Easy AACSB: Application of knowledge 32) The intersection of GG and LL determines A) the optimal level of integration desired by Norway.

B) the maximum integration level desired by Norway.

C) the minimum level of integration that will cause Norway to join the fixed exchange rate regime.

D) the maximum level of integration that will cause Norway to join the fixed exchange rate regime.

E) the maximum level of integration that can aid Norway if it joins the fixed exchange rate regime.

Answer: C Difficulty: Easy AACSB: Application of knowledge 33) The GG-LL framework has important implications about A) how changes in a country's economic environment affect its willingness to peg its currency to an outside currency area.

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B) how changes in a country's economic environment have no effect on its willingness to peg its currency to an outside currency area.

C) how changes in a country's economic environment always decrease its willingness to peg its currency to an outside currency area.

D) how changes in a country's economic environment always increase its willingness to peg its currency to an outside currency area.

Answer: A Difficulty: Easy AACSB: Application of knowledge 34) Which of the following best defines an optimum currency area?

A) a group of nations sharing the same currency B) a group of regions in close proximity to each other C) a group of regions who operate under similar economic policies D) a group of regions with economies closely linked by factor mobility and by trade in goods and services E) a group of nations that engage in free trade with each other Answer: D Difficulty: Easy AACSB: Application of knowledge 35) A fixed exchange rate area will best serve the economic interests of each of its members if A) the degree of output and factor trade among the included economies is high.

B) the degree of output and factor trade among the included economies is low.

C) the degree of output and factor trade among the included economies is volatile.

D) the degree of output and factor trade among the included economies is uncertain.

Answer: A Difficulty: Easy AACSB: Application of knowledge 36) Which of the following statements is MOST accurate?

A) A rise in the size and frequency of country-specific disturbances to the joining country's product markets raises the critical level of economic integration at which the exchange rate area is joined.

B) A rise in the size and frequency of country-specific disturbances to the joining country's product markets lowers the critical level of economic integration at which the exchange rate area is joined.

C) A decline in the size and frequency of country-specific disturbances to the joining country's product markets raises the critical level of economic integration at which the exchange rate area is joined.

D) A rise in the size and frequency of country-specific disturbances to the joining country's product markets has no effect on the critical level of economic integration at which the exchange rate area is joined.

E) A decline in the size and frequency of country-specific disturbances to the joining country's product markets does not affect the level of economic integration at which the exchange rate area is joined.

Answer: A 320 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Easy AACSB: Application of knowledge 37) Which of the following statements is MOST accurate?

A) The countries of southern Europe are better endowed with capital and skilled labor than the countries of northern Europe.

B) The countries of northern Europe are better endowed with capital and skilled labor than the countries of southern Europe.

C) EU products that make intensive use of high-skill labor are most likely to come from Portugal.

D) EU products that make intensive use of low-skill labor are most likely to come from Great Britain.

E) The countries of eastern Europe are better endowed with capital and skilled labor than the countries of western Europe.

Answer: B Difficulty: Easy AACSB: Application of knowledge 38) Fiscal federalism in the EU refers to A) one nation's control of the monetary policy of all the other nations.

B) freedom of member countries to leave the EU at any time.

C) the transfer of economic resources from members with healthy economies to those suffering economic setbacks.

D) one nation's freedom to abandon the Euro and use its own currency.

E) the transfer of economic resources between members with healthy economies.

Answer: C Difficulty: Easy AACSB: Application of knowledge 39) The level of fiscal federalism in the European Union is A) too big to cushion member countries from adverse economic events.

B) too small to cushion member countries from adverse economic events.

C) appropriate to cushion member countries from adverse economic events.

D) too big relative to the one in the U.S. E) similar in its level to that of the U.S. Answer: B Difficulty: Easy AACSB: Application of knowledge 40) A good measure of a country's level of economic integration with a currency area is A) the intersection of DD and GG. B) the country's price level.

C) the compatibility of economic policies.

D) the intersection of AA and GG. E) the extent of trade between the joining country and the currency area and the ease with which labor and capital can migrate between the joining country and the currency area.

Answer: E Difficulty: Moderate 321 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 41) Which of the following statements is the MOST accurate?

A) Trade of EU countries with other EU countries has increased since the euro was introduced.

B) Trade of EU countries with other EU countries has decreased since the euro was introduced.

C) Trade of EU countries with other EU countries has increased in some years and decreased in other years since the euro was introduced.

D) Trade of EU countries with other EU countries can no longer be measured since both trading parties have the same currency.

E) Trade of EU countries with North American countries has decreased since the euro was introduced.

Answer: A Difficulty: Easy AACSB: Application of knowledge 42) Compared with inter-regional trade in the he United States, intra-EU trade A) is far greater.

B) is greater.

C) is about the same.

D) is less.

E) is far less.

Answer: D Difficulty: Easy AACSB: Application of knowledge 43) Richard Baldwin's estimate was that the euro increased the trade level of its users by A) only 5 percent.

B) only 9 percent.

C) over 30 percent.

D) over 50 percent.

E) only 12 percent.

Answer: B Difficulty: Easy AACSB: Application of knowledge 44) A recent study by Andrew Rose of the University of California showed that, on average, two countries that are members of the same currency union A) trade three times as much with each other as countries that do not share a currency.

B) trade twenty times as much with each other as countries that do not share a currency.

C) trade ten times as much with each other as countries that do not share a currency.

D) trade six times as much with each other as countries that do not share a currency.

E) trade twice as much with each other as countries that do not share a currency.

Answer: A Difficulty: Easy AACSB: Application of knowledge 45) When did the UK decide to adopt the Euro?

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A) 1999 B) 2001 C) 2008 D) The UK never adopted the Euro.

E) 2010 Answer: D Difficulty: Easy AACSB: Application of knowledge 46) A key barrier to labor mobility within Europe is A) the laziness of workers.

B) full employment in most European countries.

C) differences in language and culture.

D) lack of transportation.

E) the physical barriers in the landscape.

Answer: C Difficulty: Moderate AACSB: Application of knowledge 47) What are the biggest advantages the U.S. has over the EU in terms of being an Optimum Currency Area?

A) low mobility of labor, higher labor productivity, lower level of intra-regional trade B) high unionization of U.S. labor force C) high mobility of labor force, more transfer payments between regions D) higher uniformity of population's taste in consumption E) more specialized labor force and natural resource advantages Answer: C Difficulty: Moderate AACSB: Application of knowledge 48) "The costs and benefits for a country from joining a fixed-exchange rate area such as the EMS depend on how well-integrated its economy is with those of its potential partners." Discuss.

Answer: We will expand on this idea, which is roughly the theory of an optimum currency area as developed by Mundell. A major economic benefit of fixed exchange rates is that they simplify economic calculations and provide a more predictable basis for decisions that involve international transactions than do floating rates. This gain in monetary efficiency would be even higher if the factors of production could migrate freely. The costs of joining a fixed-exchange rate area is that a country gives up the ability to use the exchange rate and monetary policy to stabilize the domestic economy. So, if a country has a well-integrated economy with those in the fixed-exchange rate area, then the benefits would likely outweigh the costs.

Difficulty: Moderate AACSB: Application of knowledge 49) Discuss the benefits and costs of joining a fixed-exchange area.

Answer: Benefits: In general, gains from the stability of the area and reduced uncertainty. The efficiency gain from a fixed exchange rate with euro is greater when trade between, say Norway and the euro zone, is extensive than when it is small. A major economic benefit of fixed exchange 323 Copyright © 2023 Pearson Education, Ltd.

rates it that they simplify economic calculations and provide a more predictable basis for decisions that involve international transactions than do floating rates. The monetary efficiency gain from pegging, say the Norwegian krone to the euro, will be higher if factors of production can migrate freely between Norway and the euro area. The more extensive are cross-border trade and factor movements, the greater is the gain from a fixed cross-border exchange rate.

Costs: A country that joins an exchange rate area gives up its ability to use the exchange rate and monetary policy for the purpose of stabilizing output and employment. When the economy is disturbed by a change in the output market, a floating exchange rate has an advantage over a fixed rate. A flexible exchange rate automatically cushions the economy's output and employment by allowing an immediate change in the relative price of domestic and foreign goods. When the exchange rate is fixed, purposeful stabilization is more difficult because monetary policy has no power at all to affect domestic output and employment.

Difficulty: Difficult AACSB: Application of knowledge 50) Explain what the GG-LL model tells us about the benefits of extensive trade between EU member states and comment on the significance of similarity of economic structure in this framework.

Answer: The GG-LL model shows that extensive trade with the rest of the euro zone makes it easier for a member to adjust to output market disturbances that affect it and its currency partners differently. A key element in minimizing such disturbances is similarity in economic structure, especially in the types of products produced. Euro zone countries are, in fact, not entirely dissimilar in the manufacturing structure, as evidenced by the very high volume of intraindustry trade. The hope is that any difference in EU member country factor endowments will be minimized by the completion of a single European market and the redistribution of capital and labor across Europe. This will bring about the desired similarity of economic structure.

Difficulty: Difficult AACSB: Application of knowledge 51) Explain the theory of optimum currency areas.

Answer: The theory implies that countries will wish to join fixed exchange rate areas closely linked to their own economies through trade and factor mobility. This decision to join is, in turn, determined by the difference between the monetary efficiency gain from joining and the economic stability loss from joining. These factors are both related to the degree of economic integration between the joining country and the larger fixed exchange rate zone. Only when economic integration passes a critical level is it beneficial to join.

Difficulty: Difficult AACSB: Application of knowledge 52) Explain why when Norway unilaterally fixes its exchange rate against the euro but leaves the krone free to float against the non-euro currencies, it is unable to keep at least some monetary independence.

Answer: Any independent money supply change in Norway would put pressure on krone interest rates and thus on the krone/euro exchange rate. So by pegging the krone even to a single foreign currency, Norway completely surrenders its domestic monetary control.

Difficulty: Moderate AACSB: Application of knowledge 324 Copyright © 2023 Pearson Education, Ltd.

53) Explain why after, say Norway unilaterally pegs the krone to the euro, domestic money market disturbances will no longer affect domestic output despite the continuation of float-rate regime against non-euro currencies.

Answer: Because Norway's interest rate must equal the euro interest rate, any pure shifts in the AA curve (see chapter 8) will result in immediate reserve inflows or outflows that leave Norway's interest rate unchanged.

Difficulty: Moderate AACSB: Application of knowledge 54) Explain why even owners of capital that cannot be moved can avoid more of the economic stability loss due to fixed exchange rates when Norway's economy is open to capital flows.

Answer: The main reason is through diversification. If Norway's capital market is integrated with those of the EMU neighbors, Norwegians will invest some of their wealth in other countries while at the same time part of Norway's capital stock will be owned by foreigners.

Difficulty: Moderate AACSB: Application of knowledge 55) Explain why the oil price shocks after 1973 made countries unwilling to revive the Bretton Woods system of fixed exchange rates. See also Chapter 8.

Answer: Using the GG-LL framework will help solve this question. The oil price shock of 1973 pushes the LL curve upward and to the right. Thus, the level of economic integration at which it becomes worthwhile to join the currency rises. In general, increased variability in the product markets makes countries less willing to enter fixed exchange rate areas. This prediction helps explain why the oil price shocks after 1973 made countries unwilling to revive the Bretton Woods system of fixed exchange rates.

Difficulty: Moderate AACSB: Application of knowledge 56) Explain why it may make sense for the United States, Japan, and Europe to allow their mutual exchange rate to float?

Answer: Even though these regions trade with each other, the extent of that trade is modest compared with regional GDPs and interregional labor mobility is low.

Difficulty: Moderate AACSB: Application of knowledge 57) What is one way to offset the economic stability loss due to fixed exchange rates?

Answer: Fiscal federalism is one solution in which the EU transfers economic resources from members with healthy economies to those suffering economic setbacks. These transfer payments come in the form of welfare benefits, and they are usually financed by the taxes that other member states pay. Ultimately, the extent of fiscal federalism is limited by the EU's restricted taxation powers.

Difficulty: Moderate AACSB: Application of knowledge 58) Using the GG-LL framework, analyze the effect of an increase in the size and frequency of sudden shifts in the demand for a country's exports.

325 Copyright © 2023 Pearson Education, Ltd.

Answer: Such a change pushes LL upward and to the right. Thus, the level of economic integration at which it becomes worthwhile to join the currency rises. In general, increased variability in the product markets makes countries less willing to enter fixed exchange rate areas.

This prediction helps explain why the oil price shocks after 1973 made countries unwilling to revive the Bretton Woods system of fixed exchange rates. See also Chapter 8.

Difficulty: Difficult AACSB: Application of knowledge 59) Is Europe an optimum currency area?

Answer: An open question. I think yes, the area's economy is closely integrated with its own: most EU members export from 10 to 20 percent of their output to other EU members. But still, the law of one price does not apply to many products such as the auto market. In 1998, prices for the BMW 520i varied by as much as 29.5 percent between the United Kingdom and the Netherlands.

Prices for the Ford Fiesta varied as much as 43.5 percent between the United Kingdom and Portugal!

The text is more critical, claiming: "The extent of intra-European trade is not large enough, however, to give us an overwhelming reason for believing the European Union itself is an optimum currency area." Also, the text cites the fact that maybe price convergence has more to do with Internet marketing than optimum currency area. The book concludes that on balance, it seems doubtful that the 1992 measures have yet pushed Europe dramatically closer to being an optimum currency area.

Difficulty: Difficult AACSB: Application of knowledge 60) How mobile is Europe's labor force?

Answer: Differences in language and culture discourage labor movements between European countries. Differences in regional unemployment rates are smaller and less persistent in the United States than are differences between national unemployment rates in the European Union. Even, within European countries, labor mobility appears limited, partly because of government regulations. For example, the requirement in some countries that workers establish residence before receiving unemployment benefits makes it harder for unemployed workers to seek jobs in regions that are far from their current homes.

Difficulty: Moderate AACSB: Application of knowledge 61) How much trade do currency unions create?

Answer: The main result is that currency unions promote trade. One study found that on average, two countries that are members of the same currency union trade three times as much with each other as countries that do not share a currency. Even if the euro were to raise trade within the euro zone by 50 percent, the positive effect on people's welfare could be immense, as another study has shown. However, some challenge the conclusion. Some claim the results would not be duplicated when applied to large countries such as the members of the EU; another study found out that leaving a common currency area as Ireland did has not caused reduction in UK-Ireland trade.

Difficulty: Moderate AACSB: Application of knowledge 62) Draw the graph of the GG and LL schedules and explain the logic behind the slopes of each of 326 Copyright © 2023 Pearson Education, Ltd.

the schedules.

Answer: The correct graph has "degree of economic integration between the joining country and the exchange rate area" on the x-axis, and "gains and losses for the joining country" on the y-axis.

The GG curve has a positive slope since the monetary efficiency gain a country gets by joining a fixed exchange rate area rises as its economic integration with the area increases. The LL curve has a negative slope because the economic stability loss from pegging to the area's currencies falls as the degree of economic interdependence rises. The two curves cross at a point that determines the critical level of economic integration (1 between the fixed exchange rate area and the country considering joining). In other words, it is the minimum integration level at which the country will join. (See Figure 10-5 in the text.)

Difficulty: Difficult AACSB: Application of knowledge 10.4

The Euro Crisis and the Future of EMU

1) Which one of the following countries was the "spark" that ignited the 2009 euro crisis?

A) China B) Greece C) England D) Spain E) Germany Answer: B Difficulty: Easy AACSB: Application of knowledge 2) Which one of the following unexpected events ignited the 2009 euro crisis?

A) accelerating hyperinflation and political upheaval 327 Copyright © 2023 Pearson Education, Ltd.

B) the prospect of a sovereign default by one or more euro zone countries C) rising oil prices D) revolutions in Switzerland and Belgium E) a Chinese boycott of European products Answer: B Difficulty: Easy AACSB: Application of knowledge 3) A sovereign default occurs when A) the debtor, a country's government, does not make the debt payments it has promised to creditors.

B) the debtor, a country's government, makes the debt payments it has promised to creditors.

C) the debtor pays off its debts and can still keep the country's sovereignty.

D) the debtor negotiates debt payments with its creditors.

Answer: A Difficulty: Easy AACSB: Application of knowledge 4) After entry into the euro, real appreciation set in for peripheral euro zone countries, most noticeably the two with massive housing booms, A) Ireland and Spain.

B) Germany and France.

C) Italy and Portugal.

D) Finland and the Netherlands.

Answer: A Difficulty: Easy AACSB: Application of knowledge 5) As the 1999 launch date for the euro approached, nominal long-term bond rates in prospective member countries converged, leading to real interest rates in those countries with relatively inflation.

A) lower; high B) higher; low C) lower; low D) higher; high Answer: A Difficulty: Easy AACSB: Application of knowledge 6) What was the spark that ignited the tinder of overextended banks and uncompetitive, indebted EU economies?

A) Greece's intractable fiscal problems B) Germany's low inflation rate C) U.S. real estate market D) European housing market booms Answer: A Difficulty: Easy 328 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 7) In mid-April 2010, euro zone countries, working with IMF, agreed on a for Greece.

A) €110 billion B) €78 billion C) €67 billion D) €5 billion Answer: A Difficulty: Easy AACSB: Application of knowledge

loan package

8) Late in 2010, Ireland negotiated a European Financial Stability Facility (EFSF) troika loan package. In May 2011, Portugal negotiated a troika loan.

A) €67.5 billion; €78 billion B) €27.5 billion; €38 billion C) €15 billion; €18 billion D) €7.5 billion; €8 billion Answer: A Difficulty: Easy AACSB: Application of knowledge 9) The term troika which came into widespread use during the euro crisis, refers to the loan package to bailout member states since 2010 from A) the European Commission, the European Central Bank, and the IMF. B) the U.S. Treasury.

C) the World Bank.

D) the Bank of Russia.

Answer: A Difficulty: Easy AACSB: Application of knowledge 10) What is a doom loop?

A) It is a two-way feedback loop in which each action makes the situation worse, from bank distress to government borrowing problems.

B) It is a phenomenon in which each action makes the situation slightly better for banks and the government.

C) It is a situation where banks and government can take actions without any impacts on one another.

D) It is a loop in which government support banks and banks help to stabilize the government.

Answer: A Difficulty: Easy AACSB: Application of knowledge 11) Public debts in the euro area support their weak banks.

A) increased rapidly

after 2007, in part due to the need for governments to

329 Copyright © 2023 Pearson Education, Ltd.

B) decreased rapidly C) remained constant D) fluctuated slightly Answer: A Difficulty: Easy AACSB: Application of knowledge 12) During the euro crisis, due to fiscal cutbacks and the credit squeeze in troubling countries, output and unemployment .

A) plummeted; soared B) soared; plummeted C) stayed the same; stayed the same D) plummeted; plummeted E) soared; soared Answer: A Difficulty: Easy AACSB: Application of knowledge 13) In June 2012, euro area finance ministers extended to Spain an ESM loan potentially as big as to cover recapitalization of its ailing banks. But the country remained in turmoil.

A) €100 billion B) €10 billion C) €110 billion D) €1 billion Answer: A Difficulty: Easy AACSB: Application of knowledge 14) In 2012, two key initiatives launched by euro zone leaders during the euro crisis included A) Fiscal Stability Treaty and Single Supervisory Mechanism.

B) Stability Pact And Growth Pact.

C) European Financial Stability Facility and Troika.

D) European Recovery Program and Single Resolution Mechanism.

Answer: A Difficulty: Easy AACSB: Application of knowledge 15) What does OMT stand for?

A) Outright Monetary Transactions B) Overseas Money Transitions C) Overspending Monetary Transactions D) Occupancy Management Training Answer: A Difficulty: Easy AACSB: Application of knowledge 16) A program under which ECB would purchase sovereign bonds, potentially without limit, to 330 Copyright © 2023 Pearson Education, Ltd.

prevent their interest rates from rising too far is called A) Outright Monetary Transactions.

B) European Recovery Program.

C) Stability and Growth Program.

D) Open Market Operations.

Answer: A Difficulty: Easy AACSB: Application of knowledge 17) EU countries went into lockdowns to halt the spread of the COVID-19 virus in the first quarter of 2020, A) resulting in sharp falls in economic activity across the continent.

B) resulting in sharp increases in economic activity across the continent.

C) resulting in no change in economic activity across the continent.

D) resulting in a halt in joint economic activity across the continent.

Answer: A Difficulty: Easy AACSB: Application of knowledge 18) A European Commission initiative supported EU members' short time work programs A) in which businesses reduce workers' hours rather than fire them, but continue to pay them normal or near-normal wages.

B) in which businesses hire more workers to work on additional short-term projects for income.

C) in which businesses fire workers and offer them loans while they are searching for short term temporary jobs.

D) in which businesses pay workers above normal wages to cope with the inflation.

Answer: A Difficulty: Easy AACSB: Application of knowledge 19) In response to Covid 19 pandemic, the ECB rolled out a Pandemic Emergency Purchase Program (PEPP) worth to purchase euro area assets.

A) €750 billion B) €75 billion C) €50 billion D) €7 billion Answer: A Difficulty: Easy AACSB: Application of knowledge 20) Which of the following statement is NOT true?

A) Europe is an optimum currency area.

B) If EMU succeeds, it will promote European political as well as economic integration, fostering peace and prosperity in a region.

C) If the euro project fails, its driving force, the goal of European political unification, will be set back.

D) EMU must overcome difficult challenges, if it is to survive its current crisis and prosper.

Answer: A 331 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Easy AACSB: Application of knowledge 21) Which of the following statements is TRUE? A) Asymmetric economic developments within different countries of the euro zone will remain hard to handle through monetary policy.

B) Asymmetric economic developments within different countries of the euro zone will make it easy to handle through monetary policy.

C) Symmetric economic developments within different countries of the euro zone will make it easy to handle through monetary policy.

D) Symmetric economic developments within different countries of the euro zone will no longer remain a problem to handle through monetary policy.

Answer: A Difficulty: Easy AACSB: Application of knowledge 22) In most EU countries, A) labor markets remain rigid and subject to employment taxes and regulations that impede labor mobility between industries and regions.

B) labor markets are open and flexible, promoting labor mobility between industries and regions.

C) labor markets are not subject to employment taxes and regulations.

D) labor markets subject to employment taxes and regulations that promote labor mobility between industries and regions.

Answer: A Difficulty: Easy AACSB: Application of knowledge 23) For the euro zone to achieve comparable economic success, it will have to make progress in various areas EXCEPT A) raising taxes and tightening regulations in each member country.

B) creating more flexible labor and product markets.

C) reforming its fiscal and financial regulatory systems.

D) deepening its political union.

Answer: A Difficulty: Easy AACSB: Application of knowledge 24) Discuss the problems that the EMU will continue to experience in the coming years.

Answer: (1) Europe is not an optimum currency area; therefore asymmetric economic developments within different countries of the euro zone that call for different interest rates cannot be implemented. (2) The political part of the unification is much weaker and may limit the political legitimacy of the economic unification. (3) On the one hand, labor markets remain highly unionized and subject to high government unemployment taxes and other regulations impeding labor mobility. On the other hand, capital has high incentive to migrate to the EMU countries with the lowest wages. (4) Constraints on national fiscal policy are likely to be painful due to the absence of substantial fiscal federalism (fiscal transfer of resources from the rich to the less rich countries within the European Union) within the EU. (5) The EU is considering a large-scale 332 Copyright © 2023 Pearson Education, Ltd.

expansion of its membership into Eastern Europe and the Mediterranean. This will cause many coordination costs and also the issue of representation of small and big countries.

Difficulty: Difficult AACSB: Application of knowledge 25) What behavior by central and private banks in euro zone countries created the conditions for the 2009 euro crisis?

Answer: Assets were accumulated by the banks through the purchase of U.S. financial products and through lending to other euro zone countries. Easy credit led to a European housing boom.

Following the global financial crisis and the consequent recession, some European countries such as Greece, Ireland, Portugal, Italy and Spain were found to have unsustainable levels of debt relative to national GDP. This raised the specter of a sovereign default by one or more euro zone countries and the crisis was on.

Difficulty: Moderate AACSB: Application of knowledge 26) During the 2009 euro crisis, a number of countries had private banks that had become too "big to save." Explain.

Answer: A private bank is too big to save if the resources available to the home government through the central bank are insufficient to prevent bank failure. Essentially, saving the private bank would lead to a sovereign default by a countries' government and so was not feasible.

Difficulty: Moderate AACSB: Application of knowledge 27) What led to the over-extension of credit by some private banks and central banks in the euro zone prior to the 2009 euro crisis?

Answer: Differences in interest rates in euro zone countries did not accurately represent differences in risk and inflation. Consequently banks were able to borrow at very low real interest rates while assuming relatively high levels of default risk. Once it became apparent that sovereign default and private bank failures were not only possible but likely in some countries, borrowing costs skyrocketed in those countries. In some cases, credit was cut off entirely.

Difficulty: Moderate AACSB: Application of knowledge 28) What event in 2009 ignited the euro crisis?

Answer: Greece elected a new government in 2009 which found that the previous government had been misreporting economic statistics for years and the public debt amounted to more than 100% of GDP. It became apparent that Greece would experience a sovereign default unless bailed out by the European Central Bank or some other source of credit.

Difficulty: Moderate AACSB: Application of knowledge 29) Is the United States in danger of a sovereign default because, like countries in the euro zone, it has high current account deficits and levels of public debt?

Answer: No. The United States has a central bank that can print money as needed to service its debt. It is in no danger of default. Euro zone countries, on the other hand, do not have individual central banks capable of printing money to pay off debt. Instead the European Central Bank and all 333 Copyright © 2023 Pearson Education, Ltd.

member countries must collectively agree on monetary policy. Countries that have managed their affairs prudently are understandably unwilling to support the profligate behavior of other countries.

Difficulty: Easy AACSB: Application of knowledge 30) How do constraints on monetary policy in the United States differ from those experienced by euro zone countries?

Answer: United States monetary policy constraints are quite different from those encountered by countries in the euro zone. The U.S. can print dollars to pay off debts as necessary and, while the result might be a higher rate of inflation, it makes it virtually impossible for the U.S. to default on its public debts. Euro countries have a European Central Bank that must make decisions regarding monetary policy that will affect all of the euro zone countries. One possibility that has been discussed is to make it possible to conditionally remove countries from the euro zone to prevent the destruction of the monetary union. Note that this would be equivalent to the United States deciding to remove a state from the union if the state threatened bankruptcy.

Difficulty: Moderate AACSB: Application of knowledge 31) What is the "doom loop" responsible for the rapid development and severity of the 2009 euro crisis?

Answer: The "doom loop" refers to the feedback loop that runs from private bank distress to central bank distress to further private bank distress and so on, increasing in magnitude as it goes.

During the euro crisis this process was evident in several euro zone countries.

Difficulty: Moderate AACSB: Application of knowledge 32) What is the "three-pronged approach" to organizing a banking union?

Answer: Centralize financial supervision, create a deposit insurance fund, and provide mechanisms for the resolution of insolvent banks within the euro area.

Difficulty: Moderate AACSB: Application of knowledge 33) What is fiscal federalism?

Answer: Fiscal federalism in the euro zone involves establishing a larger centralized budget managed by a central fiscal authority with the capability to tax, spend, and issue euro bonds.

Difficulty: Moderate AACSB: Application of knowledge 34) Describe the single supervisory mechanism or SSM proposed by EU leaders in June of 2012.

Answer: The SSM involved granting the European Central Bank the power to police banks throughout the euro zone and the ability to re-capitalize banks directly if needed.

Difficulty: Moderate AACSB: Application of knowledge 35) Describe the policy of "outright monetary transactions" or 0MT presented by the president of the European Central Bank in 2012.

334 Copyright © 2023 Pearson Education, Ltd.

Answer: The ECB is now committed to purchase sovereign bonds of euro zone countries, potentially without limit, in order to control interest rates in the euro zone.

Difficulty: Moderate AACSB: Application of knowledge 36) Is the EU an optimum currency area? Why or why not?

Answer: Europe is not an optimum currency area. Labor mobility is highly limited. Economic and political conflicts within the euro zone have been persistent and they continue to result in questions regarding the ability of the euro zone to survive going forward.

Difficulty: Moderate AACSB: Application of knowledge International Finance: Theory & Policy, 12/e, Global Edition Chapter 11 Developing Countries: Growth, Crisis, and Reform 11.1

Income, Wealth, and Growth in the World Economy

1) Industrialized market economies is characterized by the following EXCEPT A) strict direct government control.

B) rich endowment of capital and skilled labor.

C) political stability.

D) high level of income for their residents.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) Over the decades following World War II, A) trade between developing and industrial nations has expanded.

B) trade between developing and industrial nations has decreased.

C) trade between developing and industrial nations has been up and down all the time.

D) trade between developing and industrial nations has been non-existent.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) Which of the following statements is TRUE? A) Events in developing countries have a significant impact on welfare and policies in more advanced economies.

B) Events in developing countries have an insignificant impact on welfare and policies in more advanced economies.

C) Events in developing countries have no impact on welfare and policies in more advanced economies.

D) Events in developing countries have a global impact on welfare and policies in all countries including closed economies.

Answer: A Difficulty: Easy AACSB: Application of knowledge 335 Copyright © 2023 Pearson Education, Ltd.

4) Lower income levels of developing areas can have A) consequences that can threaten political and social cohesion.

B) no consequences that can threaten political and social cohesion.

C) consequences that can threaten democracy and voting rights in developed areas.

D) no consequences that can threaten national security and social equality.

Answer: A Difficulty: Easy AACSB: Application of knowledge 5) What is the basic problem of developing countries?

A) corruption B) murder C) poverty D) stock market E) natural resources Answer: C Difficulty: Easy AACSB: Application of knowledge 6) Compared with industrialized economies, most developing countries are poor in the factors of production essential to modern industry. These factors are A) capital and skilled labor.

B) capital and unskilled labor.

C) fertile land and unskilled labor.

D) fertile land and skilled labor.

E) water and capital.

Answer: A Difficulty: Easy AACSB: Application of knowledge 7) The relative scarcity of capital and skilled labor contributes to levels of per capita income in developing countries and often prevents them from realizing the .

A) low; economies of scale B) high; economies of scale C) low; diseconomies of scale D) high; economies of scope Answer: A Difficulty: Easy AACSB: Application of knowledge 8) The main factors that discourage investment in capital and skills in developing countries are A) political stability, secure property rights.

B) political instability, insecure property rights, misguided economic policies.

C) political stability, well-guided economic policies.

D) secure property rights, well-guided economic policies.

Answer: B 336 Copyright © 2023 Pearson Education, Ltd.

Difficulty: Easy AACSB: Application of knowledge 9) The world's economies can be divided into four main categories according to their annual per-capita income levels. Which one of the following is NOT one of the categories?

A) low-income B) upper middle-income C) high-income D) lower middle-income E) middle-income Answer: E Difficulty: Easy AACSB: Application of knowledge 10) Average national income per-capita in the riches economies is average in the poorest developing economies.

A) 115 B) 95 C) 73 D) 44 E) 57 Answer: E Difficulty: Easy AACSB: Application of knowledge

times that of the

11) The upper middle-income countries enjoy about industrial group.

A) one-fifth B) one-third C) one-half D) one-fourth Answer: A Difficulty: Easy AACSB: Application of knowledge

of the per capita income of the

12) The per-capita GNP of the industrial group is about middle-income countries.

A) 5 B) 10 C) 15 D) 19 E) 2 Answer: A Difficulty: Easy AACSB: Application of knowledge

times that of the upper

13) In general, one would expect that life expectancies reflect international differences in income 337 Copyright © 2023 Pearson Education, Ltd.

levels. Do the data support such a claim?

A) Average life span falls as relative poverty falls.

B) Average life span increases as relative poverty falls.

C) There is no statistically significant relationship between the two.

D) The relation is not very strong.

E) The relationship looks more like a U-shape.

Answer: B Difficulty: Easy AACSB: Application of knowledge 14) How would you define convergence?

A) tendency for gaps between industrial countries' per-capital incomes to narrow B) tendency for gaps between all countries' per-capital incomes to narrow C) the theory that a crisis in a low-income country will spread to all countries, regardless of debt structure D) the theory that a crisis in a low-income country will spread to only those countries which had lent money to the original country E) tendency for the world distribution of income to be persistently unequal Answer: A Difficulty: Easy AACSB: Application of knowledge 15) How would you describe the world distribution of income?

A) persistently unequal B) temporarily unequal C) converging D) fairly equal E) completely unpredictable Answer: A Difficulty: Easy AACSB: Application of knowledge 16) When one compares per-capital output growth rates among countries A) one needs to correct the data to account for departures from purchasing power parity.

B) corrections are not often necessary.

C) corrections are sometimes necessary.

D) the evidence whether such corrections are necessary are vague.

E) corrections are never necessary.

Answer: A Difficulty: Easy AACSB: Application of knowledge 17) Over the period 1960-2017, the United States economy grew at roughly A) 2 percent.

B) 3 percent.

C) 4 percent.

D) one percent.

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E) 3.5 percent.

Answer: A Difficulty: Easy AACSB: Application of knowledge 18) Japan had been percent poorer than the United States in 1960, was only around percent poorer in 2017 - thereby having narrowed the earlier income gap significantly.

A) 63; 28 B) 28; 63 C) 37; 28 D) 72; 37 Answer: A Difficulty: Easy AACSB: Application of knowledge 19) Spain had been percent poorer than the United States in 1960, was only around percent poorer in 2017 - thereby having narrowed the earlier income gap.

A) 58; 38 B) 38; 28 C) 58; 28 D) 62; 38 Answer: A Difficulty: Easy AACSB: Application of knowledge 20) Over the period 1960-2017, in terms of annual average growth rate, France grew than the United States economy.

A) 2 % slower B) 2% faster C) more than 0.2% slower D) 0.2% faster E) more than 2% faster Answer: D Difficulty: Easy AACSB: Application of knowledge 21) Over the post-war era, the gaps between industrial countries' living standards A) disappeared.

B) stayed the same.

C) increased.

D) decreased.

E) fluctuated.

Answer: D Difficulty: Easy AACSB: Application of knowledge 22) Between 1960 and 2017, the annual growth rate in percent per year was the highest in 339 Copyright © 2023 Pearson Education, Ltd.

A) South Korea.

B) United States.

C) Brazil.

D) Singapore.

E) China.

Answer: A Difficulty: Easy AACSB: Application of knowledge 23) Which of the following countries had a larger growth rate since 1960?

A) U.S. B) Senegal C) South Korea D) Mexico E) Colombia Answer: C Difficulty: Easy AACSB: Application of knowledge 24) Over the post-war era, the gaps between countries' living standards A) disappeared.

B) stayed the same.

C) increased.

D) decreased.

E) changed inconsistently.

Answer: E Difficulty: Easy AACSB: Application of knowledge 25) Over the post-war era, poorer countries grew A) faster.

B) slower.

C) stayed the same.

D) grew faster, then grew slower.

E) No general tendency can be found.

Answer: E Difficulty: Easy AACSB: Application of knowledge 26) Since 1960, countries in sub-Saharan Africa have grown at rates industrial countries.

A) far below B) far above C) about the same D) slightly below E) slightly above Answer: A 340 Copyright © 2023 Pearson Education, Ltd.

those of the main

Difficulty: Easy AACSB: Application of knowledge 27) Since 1960, South Korea and Singapore enjoyed average per-capita growth rates average industrialized world.

A) far below B) far above C) about the same D) slightly below E) slightly above Answer: B Difficulty: Easy AACSB: Application of knowledge

the

28) Until recently, per-capita income increased in East Asian countries such as Hong Kong, Singapore, South Korea, and Taiwan by -fold every generation A) 2 B) 3 C) 4 D) 5 E) 1 Answer: D Difficulty: Easy AACSB: Application of knowledge 29) Three key macroeconomic goals to achieve in developing countries' success stories include A) low inflation, low unemployment, and financial-sector stability.

B) high employment, stable exchange rate, and capital inflows.

C) low inflation, high economic growth rate, and balanced budget.

D) high employment, low taxes, and current account surplus.

Answer: A Difficulty: Easy AACSB: Application of knowledge 30) Over the past half century, poorer economies now account for a much share of global income than in the past - more than measured on a PPP basis–and account for a share of global economic growth.

A) bigger; half; bigger B) smaller; half; smaller C) bigger; half; smaller D) smaller; half; bigger Answer: A Difficulty: Easy AACSB: Application of knowledge 31) Explain what the four main categories of world economies are and give examples?

Answer: The four main categories of the world economies are categorized by annual per-capita 341 Copyright © 2023 Pearson Education, Ltd.

income levels. Low-income economies which include India, Pakistan, and much of the sub-Saharan Africa. Lower middle income includes most Middle Eastern Countries, Latin American, Caribbean countries, the former Soviet countries and most of the African countries. The upper middle income economies which are Latin American countries, Saudi Arabia, Malaysia, South Africa, Poland, Hungary, Czech and the Slovak Republic. The last category is the high-income economies such as Korea, Israel, Kuwait, Singapore and the United states.

Difficulty: Easy AACSB: Application of knowledge 32) Explain the theory behind convergence and why it is a "deceptively simple" theory.

Answer: Convergence is the tendency for gaps between industrialized countries' living standards (i.e. per capita income) to narrow. If trade is free, if capital can move to countries offering the highest returns, and if knowledge itself moves across political borders so that countries always have access to new production technologies, then there is no reason for international income differences to persist for long. Some differences, however, do exist because of policy differences across industrial countries.

Difficulty: Moderate AACSB: Application of knowledge 33) What explains the sharply divergent long-run growth patterns in general?

Answer: The answer lies in the economic and political features of developing countries and the way these have changed over time in response to both world events and internal pressures.

Difficulty: Moderate AACSB: Application of knowledge 34) How have rich countries become less important for global GDP growth?

Answer: As many developing economies have grown more quickly and come to account for larger shares of world output, their GDP growth rates have become more important in determining overall world growth. At the same time, growth in the richer economies has tended to slow over time.

Difficulty: Easy AACSB: Application of knowledge 35) Please consider Table 11-2 below.

342 Copyright © 2023 Pearson Education, Ltd.

Assuming constant Annual Average Growth Rate in the future, calculate the output per capita for the United States and South Korea for the year 2074.

Answer: Since 2074 - 2017 = 2017 - 1960, then 343 Copyright © 2023 Pearson Education, Ltd.

output per capita for U.S. = 54586 * (54586 / 17319) = 172,044 output per capita for South Korea = 36999 * (36999 / 1573) = 870,264 Difficulty: Moderate AACSB: Application of knowledge 36) Please consider Table 11-2 below.

344 Copyright © 2023 Pearson Education, Ltd.

At that Annual Average Growth Rate, how many years does it take for the output per capita to double in both the United States and South Korea.

Answer: United States 345 Copyright © 2023 Pearson Education, Ltd.

(1 + 0.02 = 2 t = ln(2) / ln(1.02) ≈ 35 years South Korea (1 + 0.06 = 2 t = ln(2) / ln(1.06) = 12 years (short-cut-rule of 69) United States t = 69/2 ≈ 35 years South Korea t = 69/6 ≈ 12 years Difficulty: Moderate AACSB: Application of knowledge 11.2

Structural Features of Developing Countries

1) Which of the following are characteristic of a developing country?

A) extensive direct government control of the economy B) low inflation C) high national savings D) a current account surplus and high national savings E) strong credit institutions Answer: A Difficulty: Easy AACSB: Application of knowledge 2) Which of the following is NOT a common characteristic of a developing country?

A) extensive direct government control of the economy B) history of low inflation C) many weak credit institutions D) "pegged" exchange rates E) agricultural commodities make up a large share of its exports Answer: B Difficulty: Easy AACSB: Application of knowledge 3) Which of the following are characteristic of a developing country?

A) extensive embrace of free trade policies B) low inflation C) high national savings D) rampant tax evasion and underground economic activity E) strong credit institutions Answer: D Difficulty: Easy AACSB: Application of knowledge 346 Copyright © 2023 Pearson Education, Ltd.

4) The real resource a government earns when it prints money and spends it on goods and services is called A) seigniorage.

B) control of capital movements by limiting foreign exchange transactions.

C) pure profits.

D) inflation profits.

E) greenback.

Answer: A Difficulty: Easy AACSB: Application of knowledge 5) Seigniorage refers to A) real resources a government earns when it prints money to use for spending on goods and services.

B) nominal resources a government earns when it prints money to use for spending on goods and services.

C) real resources a government earns when it prints money.

D) nominal resources a government earns when it prints money.

E) real resources a government earns when it issues bonds to use for spending on goods and services.

Answer: A Difficulty: Easy AACSB: Application of knowledge 6) Which of the following is NOT a common characteristic of a developing country?

A) strong credit institutions B) extensive direct government control of the economy C) history of high inflation D) "pegged" exchange rate E) agricultural commodities make up a large share of its exports Answer: A Difficulty: Easy AACSB: Application of knowledge 7) In developing countries, exchange rates tend to be A) floating with some government intervention.

B) managed heavily by developing-country governments.

C) hard to tell from the data.

D) run by currency boards.

E) flexible.

Answer: B Difficulty: Easy AACSB: Application of knowledge 8) How would you define exchange control?

A) The government allocates foreign exchange through decree rather than through the market.

347 Copyright © 2023 Pearson Education, Ltd.

B) a country NOT pegging its exchange rate C) a country pegging its exchange rate D) a country buying up excess current account so that CA=0 E) a country restricting all foreign exchange Answer: A Difficulty: Easy AACSB: Application of knowledge 9) Most developing countries have tried to A) liberalize capital movement.

B) control capital movements.

C) Hard to tell from the data.

D) in the 1960s and 1970s control, now to liberalize.

E) in the 1960s and 1970s liberalize, now to control.

Answer: B Difficulty: Easy AACSB: Application of knowledge 10) For many developing countries, natural resources or agricultural commodities make up a share of exports.

A) large B) moderate C) nonexistent D) small E) insubstantial Answer: A Difficulty: Easy AACSB: Application of knowledge 11) For many developing countries, natural resources or agricultural commodities make up share of exports A) close to no B) an unimportant C) an important D) close a to 5 percent E) close to a 10 percent Answer: C Difficulty: Easy AACSB: Application of knowledge 12) While many developing countries have reformed their economies in order to imitate the success of the successful industrial economies, the process remains incomplete and most developing countries tend to be characterized by all of the following EXCEPT A) seigniorage.

B) control of capital movements by limiting foreign exchange transactions connected with trade in assets.

C) use of natural resources or agricultural commodities as an important share of exports.

348 Copyright © 2023 Pearson Education, Ltd.

D) a worse job of directing savings toward their most efficient investment uses.

E) reduced corruption and poverty due to limited underground markets.

Answer: E Difficulty: Easy AACSB: Application of knowledge 13) In general, the development of underground economic activity A) hinders B) has no effect C) aides D) hard to tell, sometime hinders, sometimes aides E) spikes Answer: A Difficulty: Easy AACSB: Application of knowledge

economic efficiency

14) One should expect relationship between annual per-capita GDP and an inverse index of corruption.

A) a weak and negative B) a weak and positive C) a strong and negative D) a strong and positive E) an unpredictable Answer: D Difficulty: Easy AACSB: Application of knowledge 15) The relationship between annual real per-capita GDP and corruption across countries has been found to be A) negative.

B) positive.

C) The relationship was negative in the late 1960s but is now positive.

D) The relationship was in the late 1960s but is now negative.

E) There is no relationship between these two variables.

Answer: A Difficulty: Easy AACSB: Application of knowledge 16) Which of the following does NOT explain why developing countries encouraged new manufacturing industries of their own in the mid 20th century?

A) They were cut off from traditional suppliers of manufactures during WWII. B) They wanted to attain the same income levels as their former rulers.

C) Leaders of these countries feared that their efforts to escape poverty would be doomed if they continue to specialize in primary commodity exports.

D) There was political pressure to protect these industries.

E) Developing countries ran out of the natural resources that traditionally made up the majority of their trade.

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Answer: E Difficulty: Easy AACSB: Application of knowledge 17) Over the past two decades, aggregate commodity prices have experienced a boom-bust cycle, rising by more than percent between 1998 and 2020 with a sharp but brief interruption during the Great Recession that began in 2007 and then falling by more than percent between 2011 and 2016.

A) 400; 50 B) 50; 400 C) 30; 40 D) 40; 30 Answer: A Difficulty: Easy AACSB: Application of knowledge 18) Each commodity super cycle since the 19th century usually lasted A) about 30 to 40 years.

B) about 20 to 30 years.

C) about 10 to 20 years.

D) about 5 to 10 years.

Answer: A Difficulty: Easy AACSB: Application of knowledge 19) Major factors contributing to the commodity price run-up between 1999 and 2011 include A) rapid growth of emerging economies, supply constraints, and low global real interest rates.

B) slow growth of emerging economies, supply surplus, and high global real interest rates.

C) rapid growth of emerging economies, supply surplus, and high global real interest rates.

D) slow growth of emerging economies, supply constraints, and low global real interest rates.

Answer: A Difficulty: Easy AACSB: Application of knowledge 20) Describe some of the features hindering developing countries from growing faster.

Answer: One of the features that can be holding developing countries from growing faster is corruption. The way governments control the economy by developing restrictions that would not allow international trade among other countries; knowing that by having the doors open for international trading the country can be better off. Moreover, governments also owning or controlling the largest industries, that produce more in the countries, and controlling international transactions, they do not let new opportunities to come into their society.

These governments also do tax evasion, which most of the time in some countries it's been out of control. Basically, developing countries have been managed by corrupt and inexperienced people that just want to disrupt instead of encouraging new opportunities for a better future.

Difficulty: Moderate AACSB: Application of knowledge 350 Copyright © 2023 Pearson Education, Ltd.

21) Explain the extensive economic role of government within a developing country.

Answer: An open question. Students should include two of the following in their answer along with discussion: (1) Restrictions on international trade (2) Government control over large industrial firms (3) High level of government consumption as a share of GNP (4) Strict management of exchange rates; limit exchange rate flexibility Difficulty: Moderate AACSB: Application of knowledge 22) List major factors that contributed to the commodity price run-up between 1999 and 2011.

Answer: Rapid growth of emerging economies, supply constraints, and low global real interest rates.

Difficulty: Easy AACSB: Application of knowledge 23) What caused the Chinese economic growth to slow since 2011 and how it impacted the global commodity prices?

Answer: Since 2011, China has attempted to shift its economy away from investment and manufacturing, including construction, in the direction of more domestic consumption, especially of services. This reorientation, however, led the overall pace of Chinese economic growth to slow considerably, from double digits to somewhere around 6 percent per year before the COVID-19 pandemic. As a result, as the world price of oil plummeted in 2014—2015, driven by slowing world growth as well as a price war among oil producers.

Difficulty: Easy AACSB: Application of knowledge 24) According to Prebisch and Singer's hypothesis, what would happen to commodity exporters?

Answer: Developing commodity exporters were doomed to a secular process of terms of trade decline and therefore would have a hard time converging to advanced-country income levels. They argued that global commodity demand is income inelastic while demand for manufactured goods and services rises strongly with incomes, so that as the world economy grew, the terms of trade would inevitably fall for primary exporters.

Difficulty: Easy AACSB: Application of knowledge 11.3

Developing-Country Borrowing and Debt

1) As of 2020, how large is the debt of developing countries to the rest of the world?

A) $350 million B) $350 billion C) $11 trillion D) $35 trillion E) $3.5 trillion Answer: C Difficulty: Easy AACSB: Application of knowledge 351 Copyright © 2023 Pearson Education, Ltd.

2) If national saving falls short of domestic investment, the difference equals A) the current account deficit.

B) the current account surplus.

C) the current account positive.

D) the current account shortage.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) In developing economies, national saving is often relative to developed economies.

A) high B) the same C) hard to tell D) low E) low for the very poor countries and high for the more developed Answer: D Difficulty: Easy AACSB: Application of knowledge 4) Which of the following is a reason that developing countries are running large surpluses?

A) They are required to do so by IMF. B) They have defaulted on international loans.

C) They have pegged exchange rates and thus the growth of exports must drive surplus up.

D) They have to accumulate international reserves to protect against a sudden stop of capital inflows.

E) They don't know how to manage their surpluses.

Answer: D Difficulty: Easy AACSB: Application of knowledge 5) What does it mean for a loan to be in default?

A) when the borrower of the a loan fails to repay on schedule according to a loan contract, without the agreement of the lender B) when the borrower of a loan fails to repay on schedule according to a loan contract, with the agreement of the lender C) when the lender of a loan fails to supply the full amount of a loan to the borrower D) when the lender of a loan supplies the full amount of a loan to a borrower without any promise of being repaid E) when the lender of a loan fails to offer the promised sum Answer: A Difficulty: Easy AACSB: Application of knowledge 6) In the instances where a loan has been issued under certain terms and has to be repaid, what happens when the borrower does not uphold these stipulations?

A) call 352 Copyright © 2023 Pearson Education, Ltd.

B) option C) payment D) default E) fraud Answer: D Difficulty: Easy AACSB: Application of knowledge 7) When a government defaults on its obligations, the event is called a A) sovereign default.

B) magisterial default.

C) private default.

D) sudden stop default.

E) national default.

Answer: A Difficulty: Easy AACSB: Application of knowledge 8) There are many ways developing countries finance their external deficits EXCEPT A) bank finance.

B) portfolio investment in ownership of firms.

C) bond finance.

D) official lending.

E) foreign exchange rates.

Answer: E Difficulty: Easy AACSB: Application of knowledge 9) Which of the following are all the forms of debt finance?

A) bond, bank, and official finance B) bond and bank finance C) bond, bank, and portfolio finance D) foreign direct and portfolio investment E) direct investment, stock, and dividends Answer: A Difficulty: Easy AACSB: Application of knowledge 10) Why may equity finance be preferred to debt finance for developing countries?

A) A fall in domestic income automatically reduces the earnings of foreign shareholders without violating any loan agreement.

B) There are laws insuring against any default with equity finance.

C) The risk is shared between debtor and creditor with debt finance.

D) The tax structure leaves equity finance unconstrained.

E) Repayments are unaffected by falls in real income.

Answer: A Difficulty: Easy 353 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 11) A trend that has been reinforced by many developing countries is privatization. Privatization refers to A) purchasing large companies and turning them into state-owned enterprises.

B) investing government money in large, privately-owned companies.

C) exchanging bonds for shares in state-owned enterprises.

D) selling large state-owned enterprises to private owners in the financial sector.

E) selling large state-owned enterprises to private owners in key areas such as electricity, telecommunications, or petroleum.

Answer: E Difficulty: Easy AACSB: Application of knowledge 12) When developing countries incur debts to foreigners, those debts are often denominated in currencies. In contrast, richer countries almost always borrow in terms of currencies.

A) foreign; their own B) their own; foreign C) foreign; foreign D) their own; their own Answer: A Difficulty: Easy AACSB: Application of knowledge 13) A considerable advantage that richer countries have over poorer ones is exemplified by the fact that A) richer countries do not have to denominate their foreign debts in their own currencies.

B) richer countries have the ability to denominate their foreign debts in foreign currencies.

C) when demand falls for a poorer country's goods, this leads to a significant wealth transfer from foreigners to the poorer country, a kind of international insurance payment.

D) richer countries have the ability to denominate their foreign debts in their own currencies.

E) richer countries can extract trade advantages by using military power.

Answer: D Difficulty: Easy AACSB: Application of knowledge 14) The term Original Sin by two economists Barry Eichengreen and Ricardo Hausmann is used to describe what?

A) low-income economy B) developing countries' inability to borrow in their own currencies C) borrows not able to receive loans D) not diversifying economies portfolios Answer: B Difficulty: Easy AACSB: Application of knowledge 354 Copyright © 2023 Pearson Education, Ltd.

15) During the time period of 1981-1983 what dramatic world issue happened?

A) political instability, insecure property rights B) stock market crashed C) world wide hyperinflation D) the collapse of the U.S. mortgages market E) A world economic recession caused developing countries to not be able to make payments on foreign loans, in turn causing a universal default.

Answer: E Difficulty: Easy AACSB: Application of knowledge 16) In 1981-1983, the world economy suffered a steep recession. Naturally, the fall in industrial countries' aggregate demand had a direct negative impact on the developing countries. What other mechanism was an even more important contributor to this event?

A) the immediate steep inflation that followed the recession B) the dollar's sharp depreciation in the foreign exchange market C) the increase in primary commodity prices, increasing terms of trade in many poor countries D) the collapse in primary commodity prices and the immediate, large rise in the interest burden that debtors had to pay E) the influx of defaulting credit Answer: D Difficulty: Easy AACSB: Application of knowledge 17) With which country did the Debt Crisis of the early 1980s begin?

A) France B) Mexico C) Argentina D) Japan E) Germany Answer: B Difficulty: Easy AACSB: Application of knowledge 18) In 1991, Argentina established a radical institutional reform after experiencing a decade marked by financial instability. This program was called the new Convertibility Law. What did this law do?

A) made Argentina's currency fully convertible into Eurocurrency at a fixed rate B) required that the monetary base be backed completely by U.S. dollars C) placed limits on exports of commodities D) made Argentina's currency fully convertible into U.S. dollars at a fixed rate and required that the monetary base be backed completely by gold or foreign currency E) restricted risky international trade activity Answer: D Difficulty: Easy AACSB: Application of knowledge 355 Copyright © 2023 Pearson Education, Ltd.

19) The Convertibility Law of April 1991 in Argentina A) pegged the Argentinean currency to the U.S. dollar at a ratio of one to one.

B) pegged the Argentinean currency to the U.S. dollar at a ratio of one to two.

C) pegged the Argentinean currency to the U.S. dollar at a ratio of one to 0.5.

D) represents an era of floating exchange rate in Argentina.

E) pegged the Argentinean currency to the British pound at a ratio of one to one.

Answer: A Difficulty: Easy AACSB: Application of knowledge 20) How would you define a currency board?

A) the process by which non-pegged interest rates are allowed to fluctuate B) the stockpiling of international reserves by developing countries C) using the dollar to carry out all domestic transactions, making the domestic currency a currency in name alone D) a constraint placed on monetary policy E) The monetary base is backed entirely by foreign currency and the central bank holds no domestic assets.

Answer: E Difficulty: Easy AACSB: Application of knowledge 21) If a developing country institutes a currency board, it relinquishes control over having A) monetary policy autonomy.

B) exchange rate stability.

C) freedom of capital movement.

D) freedom of labor movement.

E) all of its funds.

Answer: A Difficulty: Moderate AACSB: Application of knowledge 22) A currency board can a country's ability to act as a lender of last resort.

A) aggrandize B) limit C) enhance D) offset E) not affect Answer: B Difficulty: Easy AACSB: Application of knowledge 23) Which Latin American country defaulted on its foreign debts in December 2001 and output fell by nearly 11 percent in 2002?

A) Argentina B) Brazil C) Chile 356 Copyright © 2023 Pearson Education, Ltd.

D) Colombia E) Mexico Answer: A Difficulty: Easy AACSB: Application of knowledge 24) Brazil's 1999 crisis was relatively short lived because A) Brazil's financial institutions had avoided borrowing all together.

B) Brazil's financial institutions had avoided heavy borrowing in local currency.

C) Brazil's financial institutions had avoided heavy borrowing in dollars.

D) Brazil's financial institutions had extended low-interest loans.

E) Brazil's financial institutions had extended high-interest loans.

Answer: C Difficulty: Easy AACSB: Application of knowledge 25) The $50 billion emergency loan orchestrated by the U.S. Treasury and the IMF to Mexico in 1994 A) was a disastrous policy for Mexico.

B) avoided a disaster to the Mexican economy.

C) did not affect Mexico in the short run.

D) did not affect Mexico in the long run.

E) was ineffective both in the short and long runs.

Answer: B Difficulty: Easy AACSB: Application of knowledge 26) What factors lie behind capital inflows to the developing world?

Answer: Many developing countries have received a lot of capital inflows that lead them to a huge debt to foreigners. These debts are being produced because the economy of the developing world is very small compared to the economy of the industrial world. Since developing countries face a lot of poverty and poor financial institutions, national savings is often low and because of that, they are always facing current account deficit. Even though these countries are very poor in capital, there are opportunities for profitable introduction or expansion of firms and equipment, and these opportunities give good reason for a high level of investment. However, because these countries always have deficits in their current account, a country can obtain resources from abroad to invest even if its domestic savings level is low. This means that the country is going to have to borrow money from a foreign country. These ways of production are the ones that lie behind capital inflows because by helping these countries to grow and expand, the price to be paid is a big debt which they know based on their circumstances is going to be hard to repay.

Difficulty: Moderate AACSB: Application of knowledge 27) "Sharp contractions in a country's output and employment invariably result from a crisis in which the country suddenly loses access to all foreign sources of funds." Explain how the current account identity necessitates these contractions.

Answer: S - I = CA (Current Account Identity) Imagine that a country is running a current account deficit (i.e. borrowing from abroad) a certain 357 Copyright © 2023 Pearson Education, Ltd.

amount of its GNP when foreign lenders suddenly become scared of default and cut off all new loans. This action causes the current account balance to be at least 0 due to either a rise in saving or a fall in investment (or a combination of both). The required sharp fall in aggregate demand necessarily depresses the country's output dramatically.

Difficulty: Moderate AACSB: Application of knowledge 28) List and explain 3 major channels through which developing countries have financed their external deficits.

Answer: Any of the 3 below along with clear explanation will suffice: (1) Bond Finance (2) Bank Finance (3) Official Lending (4) Foreign Direct Investment (5) Portfolio investment in ownership of firms Difficulty: Moderate AACSB: Application of knowledge 29) What are the five major channels, which developing countries use to finance their external deficit?

Answer: The five major channels are bonds finance, bank finance, official lending, foreign investment, and portfolio investment.

Difficulty: Moderate AACSB: Application of knowledge 30) Describe alternative forms of capital inflow to finance external deficits and explain why these methods were used in different times?

Answer: The capital inflows that finance developing countries' deficits are: Bond finance in which developing countries sell bonds to private foreign citizens to finance their deficits. At that time bond finance is a key to get money to solve the deficit of the country. Bank finance, which help developing countries to borrow widely from commercial banks. At that time banks provide more or less a quarter of a developing country's external finance. Official lending, this is used because developing countries sometimes borrow from official foreign agencies such as the World Bank or Inter American Development Bank. They like to take advantage of these banks because they lend at interest rates below market level or on a market basis that allows the lender to earn the market rate of return. Direct foreign investment, which allows a foreign largest firm owned by foreigner's residents, acquires or expands a subsidiary firm or factory domestically. Since WWII, direct investment has been a consistently important source of developing country's capital.

Difficulty: Moderate AACSB: Application of knowledge 31) Explain why the distinction between debt and equity finance is useful in analyzing the response of developing countries to unforeseen events such as recession or terms of trade change?

Answer: When a country's liabilities are in the form of debt, its fixed scheduled payments to creditors do not fall when its real income falls. This makes it difficult to honor the developing country's foreign obligations and may lead to default.

Difficulty: Moderate 358 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 32) Economists Eichengreen and Hausmann coined the phrase original sin to describe developing countries inability to borrow in their own currencies. Where do they believe that this inability comes from? What are other beliefs on this topic?

Answer: Eichengreen and Hausmann believe that this inability is a structural problem of poor countries caused by features of the global capital market such as limited additional diversification potential.

For the second part of the question, students' discussion may include but is not limited to the following: (1) Bad history of economic policies (2) Problems arise with debt finance in international markets for developing countries Difficulty: Moderate AACSB: Application of knowledge 33) Explain why despite enormous natural resources, much of Latin America's population remains in poverty and the region has been repeatedly experiencing financial crises.

Answer: Most Latin America population remains in poverty because of bad advice and inefficient proliferated about investment decisions having taken. At the same time, the revenues available to those able to exploit limited domestic markets inspired lobbying for imports licenses and expanding the market as well as corruption. Discrimination in the import that alternates financial system and poverty at the lowest income levels grew over time. Government corruption and bad administration of money have been one of the factors that enable Latin America population from growing. Since the 1950s and 1960s many of the Latin America countries in the region were able to attain amazing growth rates by exploiting the initially high returns from moving resources in to industrial uses from inefficient agricultural activities. Instead of using the growth to get rid of debts and decrease the deficit of the country, governments along with corrupt people wasted for getting about the debt that the country was facing.

Difficulty: Moderate AACSB: Application of knowledge 34) The 1980s are considered as the "lost decade" of Latin American growth. Explain why?

Answer: Just as the Great Depression made it hard for developing countries to make payments on their foreign loans, the great recession of the 1980s also sparked a crisis over developing country debt. The fall in the industrial countries' aggregate demand had a direct negative impact on the developing countries. The problem was made worse by the dollar's sharp appreciation in the foreign exchange market, which raised the real value of the dollar debt burden substantially. The crisis began in August 1982 when Mexico announced that its central bank had run out of foreign reserves and that it could no longer meet payments on its $80 billion in foreign debt. Seeing potential similarities between Mexico and other large Latin American debtors such as Argentina, Brazil, and Chile, banks in the industrial countries, the largest private lenders to Latin America scrambled to reduce their risks by cutting off new credits and demanding repayment on earlier loans. The result was a widespread inability of developing countries to meet prior debt obligations, and a rapid move to the edge of a generalized default. Latin America was perhaps hardest hit, but so were Soviet bloc countries like Poland that had borrowed from the European banks.

Nonetheless, by the end of 1986 more than 40 countries had encountered severe financing problems. Growth had slowed sharply in much of the developing countries because they had to 359 Copyright © 2023 Pearson Education, Ltd.

stop producing in order to pay the debtors.

Difficulty: Moderate AACSB: Application of knowledge 35) What is Argentina's Convertibility Law of April 1991? Explain.

Answer: The convertibility law is the law that made Argentina currency fully convertible into U.S. dollars at a fixed rate of exactly one peso per dollar. The law also required that the monetary base be backed entirely by gold or foreign currency.

Difficulty: Moderate AACSB: Application of knowledge 36) Evaluate the Argentinean Convertibility Law of April, 1991.

Answer: Good idea in the short run, catastrophic idea in the long run. The law was abandoned only in January 2002.

Difficulty: Moderate AACSB: Application of knowledge 37) During 1991, Argentina's monetary law had a currency board. Explain and give an example.

Answer: The currency board is monetary base backed entirely by foreign currency and the central bank therefore held no domestic assets. An example of currency board is 100% foreign exchange backing for monetary base.

Difficulty: Moderate AACSB: Application of knowledge 38) Does it appear that currency boards make fixed exchange rates credible?

Answer: No, because is prohibited by law from acquiring any domestic assets, so all the currency it issues automatically is fully backed by foreign reserves. Also, countries that adopt currency board do it because one of the major advantages, aside from the constraint it places on fiscal policy, is that the central bank can never run out of foreign exchange reserves in the face of a speculative attack on the exchange rate. So the currency board cannot fix exchange rates.

Difficulty: Moderate AACSB: Application of knowledge 39) Does it appear that currency boards make low-inflation policies credible?

Answer: Currency boards have the power to bring in anti-inflation credibility from the country to which the domestic currency is hooked. Currency boards typically may not acquire government debt, but it can discourage fiscal deficits leading to reduce a major cause of inflation and devaluation. In order for a currency board to be successful is by increasing the banking sector and that can get the government under pressure to abandon the currency board. Moreover, if the markets anticipate that the government is leaving the currency board, the country may not benefit from the potential of a currency board.

Difficulty: Moderate AACSB: Application of knowledge 40) Compare currency board to conventional fixed exchange rate.

Answer: Currency board may not acquire domestic assets and thus cannot lend currency freely to domestic banks in time of financial crisis. Also, limit government ability to "surprise" the market 360 Copyright © 2023 Pearson Education, Ltd.

and have real devaluation.

Difficulty: Moderate AACSB: Application of knowledge 41) What do you think about dollarization?

Answer: This is an open question. The answer is probably a bad idea unless in the very short run.

Students should talk about the loss of seigniorage and the gain in credibility against devaluation, which should lead to lower domestic interest rates. Students should mention the importance of political will to repair the fundamental economic weaknesses of the country.

Difficulty: Moderate AACSB: Application of knowledge 42) Explain why Argentina, one of the world's richest countries at the start of the twentieth century, has become progressively poorer relative to the industrial countries. [An alternative question: What explains Argentina's regress from riches to rags?]

Answer: As usual, the answer is complex, but the country's inward orientation and macroeconomic instability appear to be the major culprits.

Difficulty: Moderate AACSB: Application of knowledge 43) The main reason for the crisis in Argentina in 2001 and 2002, has to do with exchange rate policy, i.e., the continued peg of the exchange rate to the dollar. Discuss.

Answer: Student should emphasize that the quote is mainly true. Students should compare Argentina in those years with the better experience of Chile and Mexico with flexible exchange rates and emphasize the appreciation of the dollar.

Difficulty: Moderate AACSB: Application of knowledge 44) Explain how Brazil was able to reduce the rate of inflation from 2,669 percent in 1994 to less than 10 percent in 1997?

Answer: By introducing a new currency and initially pegging it to the dollar. At the cost of widespread bank failures, high interest rates in 1995 and the shift to a fixed upwardly crawling peg and a substantial real appreciation of the local currency.

Difficulty: Moderate AACSB: Application of knowledge 45) Write an essay on the importance of a sound banking system in developing countries.

Answer: See for example the vivid example of Chile in 1981-1982 experience. Students should explain the phenomena of moral hazard as a part of their answer.

Difficulty: Moderate AACSB: Application of knowledge 46) Some economists claim that the Chilean experience during the 1990s was much more successful than its Latin American neighbors. Evaluate the Chilean policies during that decade.

Answer: Students should refer to the democratic nature of the regime, and the fact that the policies specifically targeted corruption.

Difficulty: Moderate 361 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 47) What were Mexico's major achievements to help the country to lower inflation by 1996 and regain access to private capital markets?

Answer: Democratic institutions and moving away from the virtual one-party rule are among major achievements of Mexico.

Difficulty: Easy AACSB: Application of knowledge 11.4

East Asia: Success and Crisis

1) In the early 1960s South Korea was an extremely poor country. However, in 1963, the country began a remarkable economic ascent. What was a direct cause of this?

A) a shift in strategy that emphasized exports rather than imports B) an increase in wages C) an increase in the labor force D) an increase in the money supply E) an emphasis on education, leading to a highly productive labor force Answer: A Difficulty: Easy AACSB: Application of knowledge 2) Over 50 years since the country launched a series if sweeping economic reforms in 1963, South Korea increased its real per capita GDP by a factor of about , more than the increase that the United States has achieved over the past century.

A) 16 B) 10 C) 6 D) 20 Answer: A Difficulty: Easy AACSB: Application of knowledge 3) The high-growth East Asian economies shared something in common EXCEPT A) low rates of saving and investment.

B) rapidly moving educational levels among the workforce.

C) relatively moderate inflation rates.

D) a high degree of openness to and integration with world markets.

Answer: A Difficulty: Easy AACSB: Application of knowledge 4) Since foreign credit dries up in crises when it is most needed, developing countries can protect themselves from default by A) cutting off imports of goods.

B) allowing the exchange rate to float.

C) using equity finance only.

362 Copyright © 2023 Pearson Education, Ltd.

D) accumulating high levels of international reserves.

E) avoiding the international capital market.

Answer: D Difficulty: Moderate AACSB: Application of knowledge 5) What weakness in the economic structures of Asian countries contributed to the severe financial crisis that Asian economies experienced in 1997?

A) Productivity: There had been relatively little increase in productivity.

B) Banking regulation: Banks were excessively regulated, which reduced profits.

C) Legal Framework: The system dealt successfully with companies in financial trouble.

D) Natural Resources: Countries' lack of natural resources and failure to explore developing industries accumulated and led to the crisis.

E) High Taxes: High rates of taxation resulted in a reliance on imports.

Answer: A Difficulty: Easy AACSB: Application of knowledge 6) What weakness in the economic structures of Asian countries contributed to the severe financial crisis that Asian economies experienced in 1997?

A) Poor state of banking regulation B) There had been much increase in productivity.

C) Countries' lack of natural resources and failure to explore developing industries accumulated and led to the crisis.

D) High rates of taxation resulted in a reliance on imports.

Answer: A Difficulty: Easy AACSB: Application of knowledge 7) The problem of moral hazard has led A) the governments of many developing countries to guarantee repayment of all loans.

B) to higher growth rates in Latin America.

C) to excessively speculative investment.

D) to both privilege and responsibility of creditors.

E) to stable investments with small and steady expected gains.

Answer: C Difficulty: Easy AACSB: Application of knowledge 8) What weakness in the economic structures of Asian countries contributed to the severe financial crisis that Asian economies experienced in 1997?

A) Productivity: It increased rapidly and the countries were victims of their own success.

B) Banking regulation: Banks were excessively regulated, which reduced profits.

C) Legal Framework: The system dealt unsuccessfully with companies in financial trouble.

D) Natural Resources: Countries' lack of natural resources and failure to explore developing industries accumulated and led to the crisis.

E) High Taxes: High rates of taxation resulted in a reliance on imports.

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Answer: C Difficulty: Easy AACSB: Application of knowledge 9) Important ingredients for success among the high-performing Asian economies include the following EXCEPT A) high taxes.

B) high saving rate.

C) strong emphasis on education.

D) stable macroeconomic environment.

E) high share of trade in GDP. Answer: A Difficulty: Easy AACSB: Application of knowledge 10) What event started the Asian financial crisis in 1997?

A) Indonesia's inability to pay its debts B) devaluation of Indonesia's currency C) Thailand's inability to pay its debts D) devaluation of Thailand's currency E) devaluation of Malaysia's currency Answer: D Difficulty: Easy AACSB: Application of knowledge 11) The Asian financial crisis started in Thailand in 1997, and next spread to other countries including A) Malaysia, Indonesia, South Korea.

B) India, Singapore, Iran.

C) Cambodia, Taiwan, Vietnam.

D) China, Vietnam, Brunei.

Answer: A Difficulty: Easy AACSB: Application of knowledge 12) By the summer of 1998, the Indonesian rupiah had lost A) 85 B) 55 C) 35 D) 15 Answer: A Difficulty: Easy AACSB: Application of knowledge

percent of its original value.

13) Explain why East Asian countries have done so well relative to South American countries.

Answer: Mainly, the reasons are: less moral hazard, less government debt to foreigners and smaller budget deficits in East Asian countries.

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Difficulty: Moderate AACSB: Application of knowledge 14) Explain the reasons for the economic "miracle" of the East Asian countries between 1960 and 1997. Is it only because of the common Asian practice of industrial policy and business-government cooperation?

Answer: Students should emphasize high rates of savings and investment, rapidly improving educational levels among the work force, and a high degree of openness to and integration with world markets.

Difficulty: Moderate AACSB: Application of knowledge 15) Based on the 1997 Crisis and your own experience, what are the main weaknesses of the East Asian economies?

Answer: The textbook raised mainly three issues. The first weakness is little productivity increase, most of the growth due to capital and labor inputs increase, eventually leading to diminishing returns. The second weakness is the poor state of banking regulation in most of the Asian economies. The third reason is inadequate legal framework for dealing with companies in trouble.

Difficulty: Moderate AACSB: Application of knowledge 16) Describe the Asian financial crisis as it unfolds beginning with the devaluation of the Thai currency in July 1997, followed by the Malaysian, Indonesian and South Korean crises. As part of your answer, elaborate on the Malaysian response to the crisis versus its troubled neighbors' responses.

Answer: Students should emphasize the relation to the slowdown in their largest industrial neighbor, Japan, and the reliability on large debts denominated in dollars. Malaysia did not turn to the IMF with its austerity plans. Malaysia imposed extensive foreign exchange controls on capital movements.

Difficulty: Moderate AACSB: Application of knowledge 17) How was South Korea able to become one of the East Asian Economic Miracles?

Answer: South Korea was able to become one of the East Asian Economic Miracles by launching a series of economic reforms, shifting from an inward-looking, import-substitution development strategy to one that emphasized exports.

Difficulty: Moderate AACSB: Application of knowledge 11.5

Lessons of Developing-Country Crises

1) Crony capitalism is A) an economic system characterized by excessively cozy relationships between businesspeople and government officials.

B) an economic system characterized by unfriendly relationships between businesspeople and government officials.

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C) an economic system characterized by rival relationships between businesspeople and government officials.

D) an economic system characterized by excessively hostile relationships between businesspeople and government officials.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) Which of the following economic lessons should we take from developing country crises in Latin America (and elsewhere)?

A) only that it is important to choose the right exchange rate regime B) only that banking is of central importance in any government C) the order in which reform measures are implemented are irrelevant D) It is important to choose the right exchange rate regime and banking is of central importance in any government.

E) The order in which reform measures are implemented are irrelevant and banking is of central importance in any government.

Answer: D Difficulty: Easy AACSB: Application of knowledge 3) The term contagion refers to A) a government's complete control over it's banking system.

B) a drop in interest rates across industrialized countries.

C) the vulnerability of healthy economies to crises generated by events elsewhere.

D) a directed attack on one market by a foreign market.

E) a side effect of international trade.

Answer: C Difficulty: Easy AACSB: Application of knowledge 4) What are the three main lessons on crisis learned from early developing countries in Latin America?

A) choosing the right exchange rate regime, the importance of contagion and the importance of the banking system B) choosing the right real rate, the importance of following exchange rates, and keeping prices high to make the most profit C) pegging exchange rates with Euros, keeping labor cost and wages low D) maintaining money supply, avoiding tariffs, and increasing output E) maintaining money supply, avoiding inflation, and increasing production Answer: A Difficulty: Easy AACSB: Application of knowledge 5) What are the main lessons economists learned from the developing country crisis?

Answer: (1) Choosing the right exchange rate regime (2) The central importance of sound banking system 366 Copyright © 2023 Pearson Education, Ltd.

(3) The proper sequence of reform measures (4) The importance of contagion Difficulty: Moderate AACSB: Application of knowledge 6) Choosing the right exchange rate regime is important. Give examples.

Answer: The experiences of Brazil, Chile, Mexico, and other Latin American countries shows that larger developing countries can manage quite well with a floating exchange rate. Students can give other examples based on the reading and lecture.

Difficulty: Moderate AACSB: Application of knowledge 7) What role does banking play in financial crisis? Give examples.

Answer: The collapse of many banks disrupted the economy by cutting off channels of credit, which made it difficult for even profitable companies to stay in business. Banking fragility had earlier played roles in the crises of Argentina, Chile, and Uruguay in the 1980s; of Mexico in 1994—1995; and even of industrial countries like Sweden during the 1992 attacks on the EMS. It caused the Asian crisis when governments were faced with the conflict between restricting the money supply to support the currency and the need to print large quantities of money to deal with bank runs. The advanced country banking crises of 2007—2009 were another example.

Difficulty: Moderate AACSB: Application of knowledge 8) What is the theory of Second Best?

Answer: The principal of the second best tells us that when an economy suffers from multiple distortions, the removal of only a few may make matters worse, not better.

Difficulty: Moderate AACSB: Application of knowledge 9) "Developing countries should delay opening the capital account until the domestic financial system is strong enough to withstand the sometimes violent ebb and flow of world capital."

Discuss.

Answer: Probably true. The issue is related to the theory of second best and the proper sequence of reform measures. Of course, students may argue against such step-by-step measures.

Difficulty: Moderate AACSB: Application of knowledge 10) "Trade liberalization should precede capital account liberalization." Discuss.

Answer: The answer is probably true. The issue is related to the theory of second best and the proper sequence of reform measures. Of course, students may argue against such step-by-step measures.

Difficulty: Moderate AACSB: Application of knowledge 11) What is the domino effect or contagion?

Answer: The definition is the vulnerability of even seemingly healthy economies to crisis of confidence generated by events elsewhere in the world. Students should provide examples like the 367 Copyright © 2023 Pearson Education, Ltd.

Thai crisis, which provoked another crisis in South Korea, a much larger economy some 7,000 miles away. Or the Russian crisis sparking massive speculation against the Brazil's real.

Difficulty: Moderate AACSB: Application of knowledge 11.6

Reforming the World's Financial "Architecture"

1) The Asian crisis demonstrated that A) a country can be vulnerable to a currency crisis even if its own position looks healthy by normal measures.

B) a country can never be vulnerable to a currency crisis if its own position looks healthy by normal measures.

C) a country can avoid a currency crisis if it is closely connected with the world capital market.

D) a country can take preventive measures to protect itself from contagious market disturbances.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) The widespread developing-country practice of borrowing in dollars or other major currencies (both externally and internally) means that A) currency depreciations can sharply increase the real burden of debts.

B) currency appreciations can sharply increase the real burden of debts.

C) currency depreciations can sharply decrease the real burden of debts.

D) currency depreciations have no effects on the real burden of debts.

E) currency appreciations have no effects on the real burden of debts.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) Increased transparency, that is better provision of financial information, hopefully will A) reduce both the tendency of too much money rushing into a country when things are going well, and the rush for the exits when the risks are larger than expected.

B) promote too much money rushing into a country.

C) promote too much money from rushing out of a country.

D) encourage foreign banks and other investors to lend money to enterprises without any clear idea of what the risks are.

Answer: A Difficulty: Easy AACSB: Application of knowledge 4) Prophylactic measures to reduce the risk of financial crisis include the following EXCEPT A) less transparency.

B) stronger banking systems.

C) enhanced credit lines.

D) increased equity capital inflows relative to debt inflows.

Answer: A Difficulty: Easy 368 Copyright © 2023 Pearson Education, Ltd.

AACSB: Application of knowledge 5) served as a forum for developing country dept restructuring.

A) The Paris Club B) The IMF C) The WB D) The WTO Answer: A Difficulty: Easy AACSB: Application of knowledge 6) The COVID-19 pandemic sparked massive private capital poorer countries, bringing back into focus the prospect of widespread debt defaults and the absence of dependable orderly restructuring procedures.

A) outflows from B) inflows into C) paradoxes among D) accumulation in Answer: A Difficulty: Easy AACSB: Application of knowledge 7) Although emerging and developing countries make up a measured by GDP, their financial markets are much economies.

A) large; smaller B) small; larger C) large; larger D) small; smaller Answer: A Difficulty: Easy AACSB: Application of knowledge 8) The GDP growth rate of poorer countries A) moves closely in tandem with B) moves in opposite direction with C) has no relation with D) has a negative relationship with Answer: A Difficulty: Easy AACSB: Application of knowledge

share of the global economy than those of the advanced

the global financial cycle.

9) Contractionary Federal Reserve monetary policy economic activity in developing countries.

A) reduces; reduces B) increases; increases C) reduces; increases

global asset prices, therefore

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D) increases; reduces Answer: A Difficulty: Easy AACSB: Application of knowledge 10) To navigate an increasingly complex global financial environment, emerging markets will need to use an array of tools EXCEPT A) trade embargo.

B) foreign exchange intervention.

C) monetary policy.

D) macroprudential policy.

E) capital control measures.

Answer: A Difficulty: Easy AACSB: Application of knowledge 11) Explain the basic macroeconomic policy trilemma for open economies.

Answer: Of three goals most countries share—independence in monetary policy, stability in the exchange rate, and the free movement of capital—only two can be reached simultaneously.

Difficulty: Moderate AACSB: Application of knowledge 12) Explain the macroprudential motive for emerging markets to impose limited controls on financial inflows.

Answer: Limits on financial inflows could limit excessive bank lending during booms and thereby temper the resulting contraction in case of a sudden stop or financial-flow reversal later.

Equally (if not more) important as a motivation has been the desire to limit real currency appreciation, and the resulting harm to exports, without resorting to inflationary monetary policies.

Difficulty: Easy AACSB: Application of knowledge 13) Discuss the role of more "transparency" in reducing the risk of financial crisis.

Answer: Students should discuss the Asian crisis where foreign banks lent money to Asian enterprises without any clear idea of what the risks were, and then pulled their money out equally blindly when it became clear those risks were larger than they anticipated.

Difficulty: Moderate AACSB: Application of knowledge 14) List the prophylactic measures to reduce the risk of financial crisis.

Answer: More "transparency," stronger banking systems, enhanced credit lines, increased equity capital inflows relative to debt inflows.

Difficulty: Easy AACSB: Application of knowledge 15) Should the IMF be abolished? Discuss.

Answer: An open answer. Arguments for abolishing the IMF should mention moral hazard, insistence on high interest rates, hasty structural reforms, etc. Arguments against abolishing will 370 Copyright © 2023 Pearson Education, Ltd.

stress more coordination, more credit lines, transparency, etc.

Difficulty: Moderate AACSB: Application of knowledge 16) How do the booms and busts in global asset prices and capital flows affect the emerging economies?

Answer: Booms in global asset prices and capital flows lift emerging economies, whereas busts lead to slowdowns, notwithstanding countercyclical monetary and fiscal responses.

Difficulty: Easy AACSB: Application of knowledge 17) Compare the macroeconomic performances in the 1990s of the following countries under the following exchange-rate regimes: floating exchange rates, Mexico and Brazil; capital control, China and Malaysia; and currency boards, Estonia and Hong Kong; dollarization, Argentina.

Answer: An open question. Students should use the IMF web site to discuss the issue, and to obtain data.

Difficulty: Moderate AACSB: Application of knowledge 11.7 Understanding Global Capital Flows and the Global Distribution of Income: Is Geography Destiny?

1) Which of the following statements is TRUE? A) There is no systematic tendency for poorer countries' income levels to converge, even slowly, to those of richer countries.

B) There is systematic tendency for poorer countries' income levels to converge to those of richer countries.

C) The theory of convergence applies to today's world.

D) Poor countries grow more quickly than the rich ones as the standard models predict.

Answer: A Difficulty: Easy AACSB: Application of knowledge 2) Which of the following statements is the MOST accurate since the late 1990s?

A) Relatively little capital flows to developing countries.

B) Relatively little capital flows to developed countries.

C) Developing countries suck most of the world's available current account surpluses.

D) The scale of capital flows between advanced countries is dwarfed by the capital flow to the developing countries.

Answer: A Difficulty: Easy AACSB: Application of knowledge 3) Which theory best explains the wealth inequalities amongst nations?

A) weather B) government institutions C) natural selection 371 Copyright © 2023 Pearson Education, Ltd.

D) factors outside of any human control E) levels of corruption Answer: B Difficulty: Easy AACSB: Application of knowledge 4) Why did China run huge current account surpluses in the 2000s?

A) China's spending failed to keep up with rapid growth and China intervened in the foreign exchange market to keep its currency artificially weak.

B) China intervened in the foreign exchange market to keep its currency strong.

C) China's imports exceeded exports in many years.

D) China imports a lot of oil from OPEC countries.

Answer: A Difficulty: Easy AACSB: Application of knowledge 5) Two main schools of thought to explain the fact that some countries have grown very rich while some attract little or no foreign investment and remain in extreme poverty include A) geographical features and institutions of government.

B) religions and institutions of government.

C) colonial history and economic planning.

D) culture and institutions of government.

Answer: A Difficulty: Easy AACSB: Application of knowledge 6) According to Jared Diamond's Guns Germs, and Steel: The Fates of Human Societies book, what determines a country's long-run economic performance?

A) Aspects of a country's physical environment such as climate, soil type, diseases, and geographical accessibility.

B) Aspects of a country's political environment such as political regime and stability.

C) Aspects of a country's social environment such as race relations, and social inequality.

D) Aspects of a country's cultural environment such as religions, family, and educational systems.

Answer: A Difficulty: Easy AACSB: Application of knowledge 7) Which of the following statements is NOT true?

A) Countries with a high corruption level are associated with higher per capita income for the majority of their population.

B) Countries that are landlocked and mountainous trade less with the outside world than those countries blessed with good ocean harbors, navigable internal waterways, and easily traveled roadways.

C) Countries that favor the institutions of government in protecting private property rights encourage private enterprise, investment, innovation, and ultimately economic growth.

D) Countries with a low corruption level promotes productive economic activity by ensuring investors that the fruits of their labors will not be arbitrarily seized.

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Answer: A Difficulty: Easy AACSB: Application of knowledge 8) Explain the vicious circle of slow growth of developing countries that attract little or no foreign investment and remain in extreme poverty.

Answer: Developing countries' poor economic growth performances are closely related to high risks of investing that limit their attractiveness for investors. When governments are unwilling or unable to protect property rights, investors will be unwilling to invest in either physical or human capital, so growth will be nonexistent or low. The circle continues.

Difficulty: Easy AACSB: Application of knowledge 9) What are the "capital paradoxes"?

Answer: Capital was flowing uphill, from poorer to richer countries, contrary to what simple economic theory would predict.

Difficulty: Easy AACSB: Application of knowledge 10) Give Luca's and other scholars' explanation on why the big income disparities between rich and poor countries.

Answer: Scarcity in poor countries of human capital–in the form of a highly educated work force and managerial know-how. Other scholars put more weight on the greater fragility of property rights and government stability in poorer countries, a position that was partially borne out by the crises of the 1990s.

Difficulty: Easy AACSB: Application of knowledge 11) What is the allocation puzzle?

Answer: Countries with lower growth in the productivity of labor and capital actually attract relatively more foreign financial inflows than countries with high productivity growth.

Difficulty: Easy AACSB: Application of knowledge 12) Give Gourincha and Jeanne's explanation on the allocation puzzle.

Answer: Gourincha and Jeanne suggest that the allocation puzzle is related to accumulation of international reserves by some fast-growing economies (such as China's). These economies often do receive substantial inflows of foreign direct investment, but their saving is so high that they still run overall surpluses in their current accounts.

Difficulty: Easy AACSB: Application of knowledge 13) Why do some critics suggest that Acemoglu, Johnson, and Robinson's measures of institutional quality are inadequate?

Answer: Acemoglu, Johnson, and Robinson show that the effect of early European-settler mortality rates on current per capita income, operating through the influence of mortality on later institutions, is large. Some argue that their mortality data are faulty or even that historical mortality 373 Copyright © 2023 Pearson Education, Ltd.

rates could be related directly to productivity today.

Difficulty: Moderate AACSB: Application of knowledge

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