International Economics, 11th Edition Test Bank

TEST BANK Leonie L. Stone, Ph.D. State University of New York at Geneseo

to accompany

International Economics Eleventh Edition Dominick Salvatore Fordham University

Salvatore’s International Economics – 11th Edition

Test Bank

File: Ch01; Chapter 1: Introduction

Multiple Choice

1. Which of the following products are not produced at all in the United States? a. Coffee, tea, cocoa b. steel, copper, aluminum c. petroleum, coal, natural gas d. typewriters, computers, airplanes Ans: a Level: Easy Heading: The Globalization of the World Economy

2. International trade is most important to the standard of living of: a. the United States b. Switzerland c. Germany d. England Ans: b Level: Easy Heading: International Trade and a Nation’s Standard of Living

3. Over time, the economic interdependence of nations has: a. grown b. diminished c. remained unchanged d. cannot say Ans: a Level: Easy Heading: International Trade and a Nation’s Standard of Living

4. A rough measure of the degree of economic interdependence of a nation is given by:

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a. the size of the nations' population b. the percentage of its population to its GDP c. the percentage of a nation's imports and exports to its GDP d. all of the above Ans: c Level: Easy Heading: International Trade and a Nation’s Standard of Living

5. Economic interdependence is greater for: a. small nations b. large nations c. developed nations d. developing nations Ans: a Level: Easy Heading: International Trade and a Nation’s Standard of Living

6. The gravity model of international trade predicts that trade between two nations is larger a. the larger the two nations b. the closer the nations c. the more open are the two nations d. all of the above Ans: d Level: Medium Heading: The International Flow of Goods, Services, Labor and Capital

7. International economics deals with: a. the flow of goods, services, and payments among nations b. policies directed at regulating the flow of goods, services, and payments c. the effects of policies on the welfare of the nation d. all of the above Ans: d Level: Easy Heading: International Economic Theories and Policies

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8. International trade theory refers to: a. the microeconomic aspects of international trade b. the macroeconomic aspects of international trade c. open economy macroeconomics or international finance d. all of the above Ans: a Level: Easy Heading: International Economic Theories and Policies

9. Which of the following is not the subject matter of international finance? a. foreign exchange markets b. the balance of payments c. the basis and the gains from trade d. policies to adjust balance of payments disequilibria Ans: c Level: Easy Heading: International Economic Theories and Policies

10. Economic theory: a. seeks to explain economic events b. seeks to predict economic events c. abstracts from the many detail that surrounds an economic event d. all of the above Ans: d Level: Medium Heading: International Economic Theories and Policies

11. Which of the following is not an assumption generally made in the study of international economics? a. two nations b. two commodities c. perfect international mobility of factors d. two factors of production Ans: c Level: Medium

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Heading: International Economic Theories and Policies

12. In the study of international economics: a. international trade policies are examined before the bases for trade b. adjustment policies are discussed before the balance of payments c. the case of many nations is discussed before the two-nations case d. none of the above Ans: d Level: Medium Heading: International Economic Theories and Policies

13. International trade is similar to interregional trade in that both must overcome: a. distance and space b. trade restrictions c. differences in currencies d. differences in monetary systems Ans: a Level: Easy Heading: International Economic Theories and Policies

14. The opening or expansion of international trade usually affects all members of society: a. positively b. negatively c. most positively but some negatively d. most negatively but some positively Ans: c Level: Easy Heading: International Economic Theories and Policies

15. An increase in the dollar price of a foreign currency usually: a. benefit U.S. importers b. benefits U.S. exporters c. benefit both U.S. importers and U.S. exporters d. harms both U.S. importers and U.S. exporters

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Ans: b Level: Medium Heading: International Economic Theories and Policies

16. Which of the following statements with regard to international economics is true? a. It is a relatively new field b. it is a relatively old field c. most of its contributors were not economists d. none of the above Ans: b Level: Easy Heading: International Economic Theories and Policies

17. Today roughly _____ million people live in countries other than the one in which they were born. a. 500 b. 100 c. 50 d. 200 Ans: d Level: Easy Heading: The International Flow of Goods, Services, Labor and Capital

18. Today the largest net exporter of capital in terms of the total world percentage is a. Japan b. The United States c. Russia d. China Ans: d Level: Easy Heading: The International Flow of Goods, Services, Labor and Capital

19. The 2008 and 2009 financial and economic crisis began in a. U.S. subprime housing mortgage markets

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b. Chinese export markets c. The Japanese stock market d. Russian foreign exchange markets Ans: a Level: Easy Heading: Current International Economic Problems

20. Today, how many people live on less that $1 a day across the globe. a. Roughly 1 billion b. Roughly 1 million c. Roughly 1 trillion d. Roughly 100 million Ans: a Level: Easy Heading: Current International Economic Problems

Short Answer

21. What does the term “globalized world” mean?

Ans: It means we can connect instantly with any corner of the world, that we consume good from around the world, that tastes are converging, that worker can increasingly migrate for work, and that people can invest in companies anywhere in the world.

Level: Easy Heading: The Globalization of the World Economy

22. What does the gravity model suggest?

Ans: That bilateral trade is positively related to the product of two countries GDP’s and is smaller the greater distance between the two nations.

Level: Hard Heading: The International Flow of Goods, Services, Labor and Capital

23. Identify at least three of the major international problems facing the world today.

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Ans: Rising protectionism, excessive volatility in exchange rates, structural imbalances in the United States, poverty in many developing nations, environmental degradation and climate change Level: Medium Heading: Current International Economic Problems

24. Identify some of the criticisms of the anti-globalization movement.

Ans: Increased world income inequality, child labor, environmental pollution.

Level: Easy Heading: The globalization of the world Economy

25. Identify some of the topics that international economics studies Ans: The basis and gains from trade, the reasons and effects of protectionism, the flow of international payments, exchange rate systems and determination, macroeconomic policy in an open economy.

Level: Easy Heading: International Economic Theories and Policies

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File: Ch02; Chapter 2: The Law of Comparative Advantage

Multiple Choice 1. The Mercantilists did not advocate: a. free trade b. stimulating the nation's exports c. restricting the nations' imports d. the accumulation of gold by the nation Ans: a Level: Easy Heading: The Mercantilists Views on Trade 2. According to Adam Smith, international trade is based on: a. absolute advantage b. comparative advantage c. both absolute and comparative advantage d. neither absolute nor comparative advantage Ans: a Level: Easy Heading: Trade Based on Absolute Advantage: Adam Smith 3. What proportion of international trade is based on absolute advantage? a. All b. most c. some d. none Ans: c Level: Easy Heading: Trade Based on Absolute Advantage: Adam Smith 4. The commodity in which the nation has the smallest absolute disadvantage is the commodity of its: a. absolute disadvantage b. absolute advantage c. comparative disadvantage d. comparative advantage Ans: d Level: Easy Heading: Trade Based on Comparative Advantage: David Ricardo

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5. If in a two-nation (A and B), two-commodity (X and Y) world, it is established that nation A has a comparative advantage in commodity X, then nation B must have: a. an absolute advantage in commodity Y b. an absolute disadvantage in commodity Y c. a comparative disadvantage in commodity Y d. a comparative advantage in commodity Y Ans: d Level: Medium Heading: Trade Based on Comparative Advantage: David Ricardo

6. If with one hour of labor time nation A can produce either 3X or 3Y while nation B can produce either 1X or 3Y (and labor is the only input): a. nation A has a comparative disadvantage in commodity X b. nation B has a comparative disadvantage in commodity Y c. nation A has a comparative advantage in commodity X d. nation A has a comparative advantage in neither commodity Ans: c Level: Medium Heading: Trade Based on Comparative Advantage: David Ricardo 7. If with one hour of labor time nation A can produce either 3X or 3Y while nation B can produce either 1X or 3Y (and labor is the only input): a. Px/Py=1 in nation A b. Px/Py=3 in nation B c. Py/Px=1/3 in nation B d. Px/Py=3 in nation A Ans: d Level: Hard Heading: Trade Based on Comparative Advantage: David Ricardo

8. With one hour of labor time nation A can produce either 3X or 3Y, while nation B can produce either 1X or 3Y (and labor is the only input). If 3X is exchanged for 3Y: a. nation A gains 2X b. nation B gains 6Y c. nation A gains 3Y d. nation B gains 3Y Ans: b Level: Hard Heading: Trade Based on Comparative Advantage: David Ricardo

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9. With one hour of labor time nation A can produce either 3X or 3Y while nation B can produce either 1X or 3Y (and labor is the only input). The range of mutually beneficial trade between nation A and B is: a. 3Y < 3X < 5Y b. 5Y < 3X < 9Y c. 3Y < 3X < 9Y d. 1Y < 3X < 3Y Ans: c Level: Hard Heading: Trade Based on Comparative Advantage: David Ricardo

10. If domestically 3X=3Y in nation A, while 1X=1Y domestically in nation B: a. there will be no trade between the two nations b. the relative price of X is the same in both nations c. the relative price of Y is the same in both nations d. all of the above Ans: d Level: Medium Heading: Comparative Advantage and Opportunity Costs

11. Ricardo explained the law of comparative advantage on the basis of: a. the labor theory of value b. the opportunity cost theory c. the law of diminishing returns d. all of the above Ans: a Level: Easy Heading: Comparative Advantage and Opportunity Costs 12. Which of the following statements is true? a. The combined demand for each commodity by the two nations is negatively sloped b. the combined supply for each commodity by the two nations is rising stepwise c. the equilibrium relative commodity price for each commodity with trade is given by the intersection of the demand and supply of each commodity by the two nations d. All of the above statements are true.

Ans: d

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Level: Medium Heading: The Basis for and the Gains from Trade under Constant Costs

13. A difference in relative commodity prices between two nations can be based upon a difference in: a. factor endowments b. technology c. tastes d. all of the above Ans: d Level: Easy Heading: The Basis for and the Gains from Trade under Constant Costs

14. In trade between a small and a large nation: a. the large nation is likely to receive all of the gains from trade b. the small nation is likely to receive all of the gains from trade c. the gains from trade are likely to be equally shared d. we cannot say Ans: b Level: Medium Heading: The Basis for and the Gains from Trade under Constant Costs 15. “The importance of being unimportant” refers to which of the following? a. Small countries are likely to gain a great deal from trade since they have little impact on world prices. b. Small countries are likely to gain a great deal from trade because they will be able to sell large amounts on world markets. c. Large countries are likely to gain a great deal from trade since they have a large impact on world prices. d. All countries are will gain from trade because every country will have a comparative advantage in at least one good.

Ans: a Level: Hard Heading: The Basis for and the Gains from Trade under Constant Costs

16. The Ricardian trade model has been empirically a. verified b. rejected c. not tested

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d. tested but the results were inconclusive Ans: a Level: Easy Heading: Empirical Tests of the Ricardian Model

17. The first empirical test of the comparative advantage trade model was conducted by a. MacDougall b. Marshall c. Jevons d. Friedman Ans: a Level: Easy Heading: Empirical Tests of the Ricardian Model

18. If nation A can produce 5 units of good X or 10 units of good Y and nation B can produce 4 units of good X or 12 units of good Y we can conclude that nation A has a a. Comparative advantage in X and an absolute advantage in Y b. Comparative advantage in X and an absolute advantage in X c. Comparative advantage in Y and an absolute advantage in X d. Comparative advantage in Y and an absolute advantage in Y Ans: a Level: Medium Heading: Trade Based on Comparative Advantage: David Ricardo 19. If nation A can produce 5 units of good X or 10 units of good Y and nation B can produce 4 units of good X or 12 units of good Y we can conclude that both nations would gain from trade if nation A sold _____ units of good _____ for one unit of good _____ a. 0.4; Y; X b. 2.5; Y; X c. 2.5; X; Y d. 0.4; X; Y Ans: c Level: Hard Heading: Comparative Advantage and Opportunity Cost 20. The Mercantilists believed in a. running trade surpluses b. balanced trade c. the logic of Adam Smith

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d. no government intervention in markets.

Ans: a Level: Easy Heading: The Mercantilists Views on Trade 21. The theory of comparative advantage was first proposed by a. Adam Smith b. David Ricardo c. J.M. Keynes d. Paul Krugman Ans: b Level: Easy Heading: Trade Based on Comparative Advantage: David Ricardo Short Answer 22. Explain the mercantilist view on trade.

Ans: The mercantilists believed trade was a zero-sum game – that one nation’s gain was another’s loss. They advocated export promotion and import restriction.

Level: Easy Heading: The Mercantilists Views on Trade 23. Explain why Ricardo’s model of trade was superior to Adam Smith’s.

Ans: Smith’s model was based on absolute advantage, which required each nation to have an absolute productivity advantage in order for mutually beneficial trade to occur. Ricardo’s model considered relative productivity, showing that even if a nation had an absolute advantage in everything it could still benefit from trade.

Level: Medium Heading: Trade Based on Comparative Advantage: David Ricardo 24. Who was the first to test the theory of comparative advantage and what were to results?

Ans: MacDougall tested comparative advantage in the 1950’s using data from the 1930’s. He compared the productivities and export ratios of various industries in the United Kingdom against the United States. The results showed support for the theory of comparative advantage.

Level: Medium Heading: Empirical Tests of the Ricardian Model 25. How can the production possibilities frontier be used to determine opportunity cost?

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Ans: An production possibility frontier (ppf) shows the trade off between two goods. The slope of the ppf is the opportunity cost of the good on the x axis. The reciprocal of the slope is the opportunity cost of the good on the y axis.

Level: Medium Heading: Comparative Advantage and Opportunity Cost 27. Explain the benefits and risks of being a small country relative to the size of international markets.

Ans: A small country is one that is a price taker in world markets. Since the country is a price taker, it will have no effect on world prices, and thus can potentially gain a great deal from trade because its export supply and import demand have no effect on world prices. However, it is also vulnerable to changes in world prices due to factors over which it can have no control.

Level: Hard Heading: Comparative Advantage and Opportunity Cost

Problem 28. Assume that both the United States and Germany produce beef and computer chips with the following costs: United Germany States (marks) (dollars) Unit cost of beef (B) 2 8 Unit cost of computer chips (C) 1 2 a) What is the opportunity cost of beef (B) and computer chips (C) in each country? b) In which commodity does the United States have a comparative cost advantage? What about Germany? c) What is the range for mutually beneficial trade between the United States and Germany for each computer chip traded? d) How much would the United States and Germany gain if 1 unit of beef is exchanged for 3 chips?

Ans: a) In the United States: the opportunity cost of one unit of beef is 2 chips; the opportunity cost of one chip is 1/2 unit of beef. In Germany: the opportunity cost of one unit of beef is 4 chips; the opportunity cost of one chip is 1/4 unit of beef. b) The United States has a comparative cost advantage in beef with respect to Germany, while Germany has a comparative cost advantage in computer chips. c) The range for mutually beneficial trade between the United States and Germany for each unit of beef that the United States exports is: 2C < 1B < 4C d) Both the United States and Germany would gain 1 chip for each unit of beef traded.

Level: Medium Heading: Comparative Advantage and Opportunity Costs

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29. Assume a Ricardian, constant-cost world. There are two countries, the United States and Canada. Each country can produce cameras and milk. The table below shows production per man-hour for each country.

United Canada States Cameras 6 2 Milk 1 2 The United States has a labor force of 1,000 workers, and Canada has a labor force of 500 workers. a) Use this information to graph production possibilities frontiers for both countries. Put cameras on the horizontal axis. b) Assuming that a world price is established at which both countries can gain from trade, show possible consumption frontiers for each country.

Ans: a) The United States PPF should have horizontal intercept (6000, 0) and vertical intercept (0, 1000). The Canadian PPF should have horizontal intercept (1000, 0) and vertical intercept (0, 1000). b) The slope of the U.S. PPF is -1/6, and the slope of the Canadian PPF is -1. The U.S. has a comparative advantage in cameras, and Canada has a comparative advantage in milk. For mutually beneficial trade, a unit of milk must trade for between 1 camera and 1/6 camera. The consumption frontier for the U.S. must begin at the horizontal intercept and have a slope greater than -1/6, and Canada’s consumption frontier must begin at the vertical intercept and have a slope less than -1. The slopes of the two consumption frontiers must be identical.

Level: Hard Heading: Comparative Advantage and Opportunity Costs 30. Assume a Ricardian, constant-cost world. There are two countries, the United States and Canada. Each country can produce cameras and milk. The table below shows production per man-hour for each country.

United Canada States Cameras 6 2 Milk 1 2 The United States has a labor force of 1,000 workers, and Canada has a labor force of 500 workers. a) Graph the world supply curve for cameras. b) Show a possible world demand curve and price (assuming that both countries completely specialize).

Ans: a) The world supply of cameras begins at a relative price of 1/6 and is horizontal up to a quantity of 6,000. At that point, the supply curve becomes vertical until the relative price is 1.

At a price of 1, the world supply is horizontal from 6,000 to 7,000. After this point, the world supply of cameras is vertical. b) Students should draw world demand such that the relative price of cameras falls between 1/6 and 1.

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Level: Hard Heading: Comparative Advantage and Opportunity Costs

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File: Ch03; Chapter 3: The Standard Theory of International Trade

Multiple Choice

1. A production frontier that is concave from the origin indicates that the nation incurs increasing opportunity costs in the production of: a. commodity X only b. commodity Y only c. both commodities d. neither commodity Ans: c Level: Easy Heading: The Production Frontier with Increasing Costs

2. The marginal rate of transformation (MRT) of X for Y refers to: a. the amount of Y that a nation must give up to produce each additional unit of X b. the opportunity cost of X c. the absolute slope of the production frontier at the point of production d. all of the above Ans: d Level: Medium Heading: The Production Frontier with Increasing Costs

3. Which of the following is not a reason for increasing opportunity costs? a. technology differs among nations b. factors of production are not homogeneous c. factors of production are not used in the same fixed proportion in the production of all commodities d. for the nation to produce more of a commodity, it must use resources that are less and less suited in the production of the commodity Ans: a Level: Medium Heading: The Production Frontier with Increasing Costs

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4. Community indifference curves: a. are negatively sloped b. are convex to the origin c. should not cross d. all of the above Ans: d Level: Easy Heading: Community Indifference Curves

5. The marginal rate of substitution (MRS) of X for Y in consumption refers to the: a. amount of X that a nation must give up for one extra unit of Y and still remain on the same indifference curve b. amount of Y that a nation must give up for one extra unit of X and still remain on the same indifference curve c. amount of X that a nation must give up for one extra unit of Y to reach a higher indifference curve d. amount of Y that a nation must give up for one extra unit of X to reach a higher indifference curve Ans: b Level: Medium Heading: Community Indifference Curves

6. Which of the following statements is true with respect to the MRS of X for Y? a. It is given by the absolute slope of the indifference curve b. declines as the nation moves down an indifference curve c. rises as the nation moves up an indifference curve d. all of the above Ans: d Level: Medium Heading: Community Indifference Curves

7. Which of the following statements about community indifference curves is true? a. They are entirely unrelated to individuals' community indifference curves b. they cross, they cannot be used in the analysis c. the problems arising from intersecting community indifference curves can be overcome by the application of the compensation principle

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d. all of the above.

Ans: c Level: Medium Heading: Community Indifference Curves

8. Which of the following is not true for a nation that is in equilibrium in isolation? a. It consumes inside its production frontier b. it reaches the highest indifference curve possible with its production frontier c. the indifference curve is tangent to the nation's production frontier d. MRT of X for Y equals MRS of X for Y, and they are equal to Px/Py Ans: a Level: Medium Heading: Equilibrium in Isolation

9. If the internal Px/Py is lower in nation 1 than in nation 2 without trade: a. nation 1 has a comparative advantage in commodity Y b. nation 2 has a comparative advantage in commodity X c. nation 2 has a comparative advantage in commodity Y d. none of the above Ans: c Level: Easy Heading: Equilibrium in Isolation

10. Nation 1's share of the gains from trade will be greater: a. the greater is nation 1's demand for nation 2's exports b. the closer Px/Py with trade settles to nation 2's pretrade Px/Py c. the weaker is nation 2's demand for nation 1's exports d. the closer Px/Py with trade settles to nation 1's pretrade Px/Py Ans: b Level: Medium Heading: The Basis for and the Gains from Trade with Increasing Costs

11. If Px/Py exceeds the equilibrium relative Px/Py with trade a. the nation exporting commodity X will want to export more of X than at equilibrium

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b. the nation importing commodity X will want to import less of X than at equilibrium c. Px/Py will fall toward the equilibrium Px/Py d. all of the above Ans: d Level: Hard Heading: The Basis for and the Gains from Trade with Increasing Costs

12. With free trade under increasing costs: a. neither nation will specialize completely in production b. at least one nation will consume above its production frontier c. a small nation will always gain from trade d. all of the above Ans: d Level: Meduim Heading: The Basis for and the Gains from Trade with Increasing Costs

13. Which of the following statements is false? a. The gains from trade can be broken down into the gains from exchange and the gains from specialization b. gains from exchange result even without specialization c. gains from specialization result even without exchange d. none of the above Ans: c Level: Heading: The Basis for and the Gains from Trade with Increasing Costs

14. The gains from exchange with respect to the gains from specialization are always: a. greater b. smaller c. equal d. we cannot say without additional information Ans: d Level: Medium Heading: The Basis for and the Gains from Trade with Increasing Costs

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15. Mutually beneficial trade cannot occur if production frontiers are: a. equal but tastes are not b. different but tastes are the same c. different and tastes are also different d. the same and tastes are also the same.

Ans: d Level: Medium Heading: Trade Based on Differences in Tastes

16. If nations have identical production possibilities frontiers it is possible for them to experience gains from trade if a. they have the same tastes and preference b. they have different tastes and preferences c. they have different natural resources d. they have constant opportunity costs Ans: b Level: Easy Heading: Trade Based on Differences in Tastes

17. Under which circumstance is it not possible for nations to gain from trade? a. identical production possibilities and identical tastes and preferences b. different production possibilities and identical tastes and preferences c. identical production possibilities and different tastes and preferences d. different production possibilities and different tastes and preferences Ans: a Level: Easy Heading: Trade Based on Differences in Tastes

18. If a nation has a steeper indifference curve relative to that of another nation it means that a. it has stronger tastes and preferences for good Y b. it has stronger tastes and preferences for good X c. it has a higher opportunity costs for good Y d. it has a higher opportunity costs for good X

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Ans: b Level: Medium Heading: Community Indifference Curves

19. Trade allows nations to attain and indifference curve that is a. beyond the indifference curve it could attain without trade b. inside the indifference curve it could attain without trade c. is positively sloped d. is negatively sloped Ans: a Level: Easy Heading: The Basis for and the Gains from Trade with Increasing Costs 20. The primary factor for the loss in manufacturing employment in developed nations is a. Trade b. Investment c. Productivity growth d. Outsourcing Ans: c Level: Easy Heading: The Basis for and the Gains from Trade with Increasing Costs 21. In 2010, international trade statistics showed that the United States has a comparative advantage in which of the following goods? a. Textiles b. Automobiles c. Chemicals d. Agricultural goods Ans: c Level: Easy Heading: The Basis for and the Gains from Trade with Increasing Costs 22. Which of the following is a correct statement about deindustrialization in the United States? a. Most job loss in manufacturing has been due to changes in productivity. b. Most job loss in manufacturing has been due to competition from other countries. c. Most job loss in manufacturing has been due to changes in the legal structure of trade. d. Most job loss in manufacturing has been due to unfair trade practices.

Ans: a Level: Medium Heading: The Basis for and the Gains from Trade with Increasing Costs

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Short Answer

23. Carefully explain what an indifference curve is.

Ans: An indifference curve show various combinations of commodity consumption that yield the same level of satisfaction. It is convex to the origin due to the diminishing returns associated with the consumption of more of one commodity relative to another.

Level: Medium Heading: Community Indifference Curves

24. What is the marginal rate of transformation (MRT)?

Ans: The MRT of X for Y refers to the amount of Y that a nation must give up to produce each additional unit of X. MRT is another name for opportunity cost. The MRT increases as additional units of X are produced in an environment with increasing opportunity costs.

Level: Medium Heading: The Production Function with Increasing Costs

25. What is the reason for increasing opportunity cost?

Ans: Heterogeneous inputs. Not all inputs are equally well suited at producing different commodities. As a nation begins to produce more of one commodity it increases the scarcity of the resource that is good producing that commodity resulting in higher production costs as less productive resources are employed.

Level: Medium Heading: The Production Function with Increasing Costs

26. What is meant by gains from exchange? How is this shown in the context of production possibilities (ppf) and indifference curves?

Ans: Gains from exchange in the context of production possibilities and indifference curves is shown by a nation’s ability to achieve a higher level of satisfaction (on an indifference curve beyond the ppf) than would be possible without exchange. In equilibrium both nations benefit by trading common quantities and a common price, resulting in consumption beyond their respective ppf’s.

Level: Medium Heading: The Basis for and the Gains from Trade with Increasing Costs

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27. What is meant by gains from specialization? How is this shown in the context of production possibilities (ppf) and indifference curves?

Ans: Gains from specialization in the context of production possibilities and indifference curves is shown by a nation’s ability to achieve a higher level of satisfaction (on an indifference curve beyond the ppf) than would be possible without the change in the composition of national production caused by trade.

Level: Medium Heading: The Basis for and the Gains from Trade with Increasing Costs

Essay

28. Given: (1) two nations (1 and 2) which have the same technology but different factor endowments and tastes, (2) two commodities (X and Y) produced under increasing costs conditions, and (3) no transportation costs, tariffs, or other obstructions to trade. Prove geometrically that mutually advantageous trade between the two nations is possible. Note: Your answer should show the autarky (no-trade) and free-trade points of production and consumption for each nation, the gains from trade of each nation, and express the equilibrium condition that should prevail when trade stops expanding.)

Ans: See Figure 1.

Nations 1 and 2 have different production possibilities curves and different community indifference maps. With these, they will usually end up with different relative commodity prices in autarky, thus making mutually beneficial trade possible.

In the figure, Nation 1 produces and consumes at point A and Px/Py=PA in autarky, while Nation 2 produces and consumes at point A' and Px/Py=PA'. Since PA < PA', Nation 1 has a comparative advantage in X and Nation 2 in Y. Specialization in production proceeds until point B in Nation 1 and point B' in Nation 2, at which PB=PB' and the quantity supplied for export of each commodity exactly equals the quantity demanded for import. Thus, Nation 1 starts at point A in production and consumption in autarky, moves to point B in production, and by exchanging BC of X for CE of Y reaches point E in consumption. E > A since it involves more of both X and Y and lies on a higher community indifference curve. Nation 2 starts at A' in production and consumption in autarky,

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moves to point B' in production, and by exchanging B'C' of Y for C'E' of X reaches point E'in consumption (which exceeds A').

At Px/Py=PB=PB', Nation 1 wants to export BC of X for CE of Y, while Nation 2 wants to export B'C' (=CE) of Y for C'E' (=BC) of X. Thus, PB=PB' is the equilibrium relative commodity price because it clears both (the X and Y) markets.

Level: Hard Heading: The Basis for and the Gains from Trade with Increasing Costs 29. The graph below shows an autarky point for a nation that is assumed to have a comparative advantage in good Y. Suppose that international trade begins, and thus the relative price of X falls (relative price of Y rises). On the graph, show the new equilibrium point and then show the gains from exchange, specialization, and trade, as based on your graph. <graph here> Ans: Answers will vary slightly as based on graphing, but should identify all points and label the breakdown of gains. U2 is the new indifference curves, so U2 – U0 represents the utility gain from trade. U2 – U1 is the gain from specialization, and U1 – U0 represents the gain from exchange.

Level: Hard Heading: The Basis for and the Gains from Trade with Increasing Costs 30. In a concise and organized essay, explain how and why the manufacturing production of industrialized countries has decreased, even though these countries have a comparative advantage in some manufactured goods. Be sure to include all relevant factors.

Ans: Answers will vary, but should include the following factors: 1) productivity and capital stock growth (investment), which reduces the demand for labor, 2) comparative advantage of other countries in labor-intensive manufactures. The conclusion should explain that capital stock and productivity growth have been more significant than international trade.

Level: Medium Heading: The Basis for and the Gains from Trade with Increasing Costs

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File: Ch04; Chapter 4: Demand and Supply, Offer Curves, and the Terms of Trade

Multiple Choice

1. Which of the following statements is not correct? a. The demand for imports is given by the excess demand for the commodity b. the supply of exports is given by the excess supply of the commodity c. the supply curve of exports is flatter than the total domestic supply curve of the commodity d. the supply curve for exports is more inelastic than the total domestic supply curve of the commodity.

Ans: d Level: Easy Heading: The Equilibrium-Relative Commodity Price with Trade – Partial Equilibrium Analysis

2. At a relative commodity price above equilibrium a. the excess demand for a commodity exceeds the excess supply of the commodity b. the quantity demanded of imports exceeds the quantity supplied of exports c. the world price of the commodity will fall d. the excess demand for the commodity will increase.

Ans: c Level: Easy Heading: The Equilibrium-Relative Commodity Price with Trade – Partial Equilibrium Analysis

3. The offer curve of a nation shows: a. the supply of a nation's imports b. the demand for a nation's exports c. the trade partner's demand for imports and supply of exports d. the nation's demand for imports and supply of exports Ans: d Level: Easy Heading: Offer Curves

4. The offer curve of a nation curves toward the axis measuring the nation’s

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a. import commodity b. export commodity c. export or import commodity d. nontraded commodity Ans: b Level: Easy Heading: Offer Curves

5. Export prices must rise for a nation to increase its exports because the nation: a. incurs increasing opportunity costs in export production b. faces decreasing opportunity costs in producing import substitutes c. faces decreasing marginal rate of substitution in consumption d. all of the above Ans: d Level: Medium Heading: Offer Curves

6. Which of the following statements regarding partial equilibrium analysis is false? a. It relies on traditional demand and supply curves b. It studies a single market. c. it can be used to determine the equilibrium relative commodity price but not the equilibrium quantity with trade. d. It can be used to show changes in prices when demand or supply changes in another country.

Ans: c Level: Medium Heading: The Equilibrium-Relative Commodity Price with Trade – Partial Equilibrium Analysis

7. Which of the following statements regarding general equilibrium analysis is not true? a. The demand and supply curve are derived from the nation's production frontier and indifference map b. It shows the same basic information as offer curves c. It shows the same equilibrium relative commodity prices as with offer curves d. It shows the same equilibrium relative commodity prices as partial equilibrium analysis.

Ans: d Level: Easy Heading: The Equilibrium-Relative Commodity Price with Trade – Partial Equilibrium Analysis

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8. In what way does partial equilibrium analysis differ from general equilibrium analysis? a. The former but not the latter can be used to determine the equilibrium price with trade b. the former but not the latter can be used to determine the equilibrium quantity with trade c. the former but not the latter takes into consideration the interaction among all markets in the economy d. the former gives only an approximation to the answer sought.

Ans: d Level: Medium Heading: Relationship between General and Partial Equilibrium Analysis

9. If the terms of trade of a nation are 1.5 in a two-nation world, those of the trade partner are: a. 3/4 b. 2/3 c. 3/2 d. 4/3 Ans: b Level: Medium Heading: Relationship between General and Partial Equilibrium Analysis

10. If the terms of trade increase in a two-nation world, those of the trade partner: a. deteriorate b. improve c. remain unchanged d. any of the above Ans: a Level: Medium Heading: The Terms of Trade

11. If a nation does not affect world prices by its trading, its offer curve: a. is a straight line b. bulges toward the axis measuring the import commodity c. intersects the straight-line segment of the world's offer curve d. intersects the positively-sloped portion of the world's offer curve

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Ans: c Level: Hard Heading: The Terms of Trade

12. If the nation's tastes for its import commodity increases: a. the nation's offer curve rotates toward the axis measuring its import commodity b. the partner's offer curve rotates toward the axis measuring its import commodity c. the partner's offer curve rotates toward the axis measuring its export commodity d. the nation's offer curve rotates toward the axis measuring its export commodity Ans: d Level: Hard Heading: The Terms of Trade

13. If the nation's taste for its import commodity increases: a. the nation's terms of trade remain unchanged. b. the nation's terms of trade deteriorate. c. the partner's terms of trade deteriorate. d. the partner’s terms of trade improve.

Ans: b Level: Hard Heading: The Terms of Trade

14. If the tastes for a nation import commodity increases, trade volume: a. increases b. declines c. remains unchanged d. cannot be determined.

Ans: a Level: Medium Heading: The Terms of Trade

15. If a nation’s terms of trade improve, the nation’s social welfare a. will deteriorate. b. will improve. c. will remain unchanged.

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d. might improve, deteriorate, or remain unchanged.

Ans: d Level: Medium Heading: The Terms of Trade

16. Suppose Nation 1 has a comparative advantage in good X over Nation 2 and the two nations are currently engaged in equilibrium trade for good X. A decrease in the cost of producing good X in Nation 2 would cause the international price of good X to _______ and the quantity of good X traded to ______. a. increase; increase b. increase; decrease c. decrease; increase d. decrease; decrease Ans: d Level: Medium Heading: The Equilibrium-Relative Commodity Price with Trade – Partial Equilibrium Analysis

17. The index of relative U.S. export prices fell during the first few years of the 21st century. The primary cause of this was a. the growing U.S. trade deficit b. the rising price of commodities, such as oil c. the persistent appreciation of the U.S. dollar d. the introduction of the Euro as a major world currency Ans: b Level: Easy Heading: The Terms of Trade

18. The equilibrium price and quantity for a commodity traded between two nations occurs where a. the slopes of the two offer curves are the same. b. the two offer curves intersect c. the slopes of the two offer curves is equal to zero d. the price ratio of good X for good Y is equals one.

Ans: b Level: Medium

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Heading: The Equilibrium-Relative Commodity Price with Trade – General Equilibrium Analysis

19. Suppose nation 1 is an importer of good X. In a general equilibrium framework, an increase in the demand for good Y will a. decreased the price of good X and increase the volume of imports of good X b. decreased the price of good X and decrease the volume of imports of good X c. increase the price of good X and increase the volume of imports of good X d. increase the price of good X and decrease the volume of imports of good X Ans: a Level: Medium Heading: The Equilibrium-Relative Commodity Price with Trade – General Equilibrium Analysis

20. Suppose nation 1 is an importer of good X. In a general equilibrium framework, an increase in the cost of producing good X in nation 2 will a. decreased the price of good X and increase the volume of imports of good X b. decreased the price of good X and decrease the volume of imports of good X c. increase the price of good X and increase the volume of imports of good X d. increase the price of good X and decrease the volume of imports of good X

Ans: d Level: Medium Heading: The Equilibrium-Relative Commodity Price with Trade – General Equilibrium Analysis 21. During the last decade, the nominal price of petroleum has __________, while the real price of petroleum has _________. a. increased, increased by less than nominal prices. b. increased, increased by more than nominal prices. c. decreased, decreased by less than nominal prices. d. decreased, increased.

Ans: a Level: Medium Heading: The Equilibrium-Relative Commodity Price with Trade – Partial Equilibrium Analysis

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22. All other things equal, if a nation’s terms of trade deteriorate, to maintain the same quantity of imports, the nation a. will have to export a greater quantity of goods. b. will have to export a smaller quantity of goods. c. could increase or decrease its exports. d. will have to accept a lower standard of living.

Ans: a Level: Medium Heading: The Equilibrium-Relative Commodity Price with Trade – Partial Equilibrium Analysis

Short Answer 23. Carefully define an offer curve and explain how it is derived.

Ans: An offer curve of a nation shows how much its import commodity the nation demands to be willing to supply various quantities of its export commodity. The offer curve is derived from a nations production function and its utility maximizing production and consumption levels at alternative prices. The offer curve bends towards the axis of the nation’s comparative advantage due to rising opportunity cost of specialization.

Level: Medium Heading: Offer Curves

24. Carefully define and explain the meaning of “equilibrium terms of trade” Ans: The equilibrium terms of trade occurs at a price ratio where the desired quantity of exports of good X and desired quantity of imports of commodity of good by one nation equals the desired quantity of imports by another nation for .

Level: Medium Heading: The Equilibrium-Relative Commodity Price with Trade – Partial Equilibrium Analysis

25. Explain the effect of changes in petroleum prices on the terms of trade and relative export prices for the United States in recent years.

Ans: In recent years the nominal price of petroleum has risen dramatically. Because petroleum is a significant import for the United States it has negatively impacted the terms of trade and, since real prices have risen as well, relative export prices for the United States.

Level: Medium Heading: The Terms of Trade

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26. Suppose the terms of trade for nation X rises from 100 to 110. Explain how this will impact the terms of trade for nation Y. Ans: Nation Y’s terms of trade are the reciprocal of Nation X’s terms of trade. Nation Y’s terms of trade will deteriorate from 100 to (100/110)*100=91 Level: Medium Heading: The Terms of Trade

Essay

27. Draw a figure showing: (1) in Panel A a nation's demand and supply curve for A traded commodity and the nation's excess supply of the commodity, (2) in Panel C the trade partner's demand and supply curve for the same traded commodity and its excess demand for the commodity, and (3) in Panel B the supply and demand for the quantity traded of the commodity, its equilibrium price, and why a price above or below the equilibrium price will not persist. At any other price, QD  QS, and P will change to P2.

Ans: See Figure 2.

The equilibrium relative commodity price for commodity X (the traded commodity exported by Nation 1 and imported by Nation 2) is P2 and the equilibrium quantity of commodity X traded is Q2.

Level: Hard Heading: The Equilibrium-Relative Commodity Price with Trade – Partial Equilibrium Analysis 28. Using a graph of offer curves, for each of the following, identify the effect of the change listed on the relative price of good X and on exports of good X by Nation 1. a. The supply of Y increases in Nation 2. b. The demand for X decreases in Nation 1. (ch04(1))

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Ans: a. Nation 2’s offer curve shifts towards the Y axis, raising the relative price of X (Nation 2 is now willing to offer more Y for the same amount of X) and thus decreasing the relative price of Y. The volume of trade is likely to increase. b. Nation 1’s offer curve will shift towards the Y axis, lowering the relative price of X and thus increasing the relative price of Y. Since Nation 1 is now willing to trade more of its export good for the same amount of Y, the volume of trade is likely to increase.

Level: Hard Heading: Offer Curves 29, Using a graph of offer curves, for each of the following, identify the effect of the change listed on the relative price of good Y and on exports of good Y by Nation 2. a. The demand for X increases in Nation 2. b. The supply of Y increases in Nation 2.

Ans: a. Nation 2’s offer curve shifts towards the Y axis, raising the relative price of X (Nation 2 is now willing to offer more Y for the same amount of X). The volume of trade is likely to increase. b. Since there is more domestic demand, Nation 1 is now willing to supply less X for a given amount of Y. Thus Nation 1’s offer curve shifts toward the Y axis, and the relative price of X will increase. The volume of trade is likely to fall.

Level: Hard Heading: Offer Curves 30. Carefully explain the importance of the terms of trade to a nation. Your answer should include an explanation of how changes in the terms of trade are likely to impact social welfare.

Ans: Answers will vary, but should include (1) a definition of the terms of trade as the price of exports divided by the price of imports, and (2) a discussion of how a change in terms of trade might have a positive or negative effect on social welfare. For example, an improvement in the terms of trade means that the nation is receiving a higher relative price for its exports, which will tend to increase social welfare. However, if the world demand for the good is elastic, the quantity that is exported may decreased, which might actually decrease social welfare.

Level: Medium Heading: The Equilibrium-Relative Commodity Price with Trade – Partial Equilibrium Analysis

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File: Ch05; Chapter 5: Factor Endowments and the Heckscher-Ohlin Theory

Multiple Choice

1. Which of the following situations would violate the assumptions of the H-O model? a. Doubling all inputs doubled the production of all outputs. b. Nation 1 has technology that is different from Nation 2. c. Nation 1’s trade is balanced. d. Nation 2 does not completely specialize in either good.

Ans: b Level: Easy Heading: Assumptions of the Theory

2. Which is not an assumption of the H-O model? a. the same technology in both nations b. constant returns to scale c. complete specialization d. equal tastes in both nations Ans: c Level: Easy Heading: Assumptions of the Theory

3. With equal technology nations will have equal K/L in production if: a. factor prices are the same b. tastes are the same c. production functions are the same d. all of the above Ans: a Level: Medium Heading: Factor Intensity, Factor Abundance, and the Shape of the Production Frontier

4. We say that commodity Y is K-intensive with respect to X when: a. more K is used in the production of Y than X

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b. less L is used in the production of Y than X c. a lower L/K ratio is used in the production of Y than X d. a higher K/L is used in the production of X than Y Ans: c Level: Medium Heading: Factor Intensity, Factor Abundance, and the Shape of the Production Frontier

5. When w/r falls, L/K a. falls in the production of both commodities b. rises in the production of both commodities c. can rise or fall d. is not affected Ans: b Level: Medium Heading: Factor Intensity, Factor Abundance, and the Shape of the Production Frontier

6. A nation is said to have a relative abundance of K if it has a: a. greater absolute amount of K b. smaller absolute amount of L c. higher L/K ratio d. lower r/w Ans: d Level: Medium Heading: Factor Intensity, Factor Abundance, and the Shape of the Production Frontier

7. A difference in relative commodity prices between nations can be based on a difference in: a. technology b. factor endowments c. tastes d. all of the above Ans: d Level: Easy Heading: Factor Intensity, Factor Abundance, and the Shape of the Production Frontier

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8. In the H-O model, international trade is based mostly on a difference in: a. technology b. factor endowments c. economies of scale d. tastes Ans: b Level: Easy Heading: Factor Endowments and the Heckscher-Ohlin Theory

9. According to the H-O model, trade reduces international differences in: a. relative but not absolute factor prices b. absolute but not relative factor prices c. both relative and absolute factor prices d. neither relative nor absolute factor prices Ans: c Level: Medium Heading: Factor Endowments and the Heckscher-Ohlin Theory

10. According to the H-O model, international trade will: a. reduce international differences in per capita incomes b. increases international differences in per capita incomes c. may increase or reduce international differences in per capita incomes d. lead to complete specialization Ans: c Level: Medium Heading: Factor Endowments and the Heckscher-Ohlin Theory

11. The H-O model is a general equilibrium model because it deals with: a. production in both nations b. consumption in both nations c. trade between the two nations d. all of the above Ans: d Level: Medium Heading: Factor Endowments and the Heckscher-Ohlin Theory

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12. The H-O model is a simplification of a truly general equilibrium model because it deals with: a. two nations b. two commodities c. two factors of production d. all of the above Ans: d Level:Medium Heading: Factor Endowments and the Heckscher-Ohlin Theory

13. The Leontief paradox refers to the empirical finding that U.S. a. import substitutes are more K-intensive than exports b. imports are more K-intensive than exports c. exports are more L-intensive than imports d. exports are more K-intensive than import substitutes Ans: a Level: Easy Heading: Empirical Test of the Heckscher-Ohlin Model

14. From empirical studies, we conclude that the H-O theory: a. must be rejected b. must be accepted without reservations c. can be accepted while awaiting further testing d. explains all international trade Ans: c Level: Medium Heading: Empirical Test of the Heckscher-Ohlin Model

15. For factor reversal to occur, two commodities must be produced with: a. sufficiently different elasticity of substitution of factors b. the same K/L ratio c. technologically-fixed factor proportions d. equal elasticity of substitution of factors Ans: a Level: Medium

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Heading: Empirical Test of the Heckscher-Ohlin Model

16. The economist who rigorously proved the factor-price equalization theorem was a. David Ricardo b. Adam Smith c. Paul Samuelson d. Wassily Leontief Ans: c Level: Easy Heading: Factor Price Equalization and Income Distribution

17. The factor price equalization theorem states that international trade will bring about equalization in a. relative returns only b. absolute returns only c. both relative and absolute returns d. neither absolute nor relative returns Ans: c Level: Medium Heading: Factor Price Equalization and Income Distribution

18. International trade will ______ the price of a nation’s abundant resources and _____ the price of a nation’s scarce resources a. increase; increase b. decrease; decrease c. decrease; increase d. increase; decrease Ans: d Level: Medium Heading: Factor Price Equalization and Income Distribution

19. One potential reasonable explanation for the Leontief paradox is that a. The U.S. exports capital intensive goods b. U.S. labor is more productive than its foreign counterpart c. U.S. tastes were biased strongly in favor of capital intensive goods

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d. The two factor model that was used was incomplete Ans: d Level: Medium Heading: Empirical Test of the Heckscher-Ohlin Model

20. According to the factor price equalization theorem, a nation that has a relative capital abundance should specialize in goods that are ______ intensive resulting in an increase in the price of ______. a. capital; capital b. capital; labor c. labor; capital d. labor; labor Ans: a Level: Medium Heading: Factor Price Equalization and Income Distribution 21. The United States can be characterized as relatively capital abundant and labor scarce. Thus, according to the H-O model, a. social welfare in the United States will be reduced by trade. b. wages in the United States will be reduced by trade. c. the return on capital in the United States will be reduced by trade. d. capital-labor ratios in will be changed by trade.

Ans: b Level: Medium Heading: Factor Endowments and the Heckscher-Ohlin Theory

22. If the assumptions of the H-O hold, a country that is relatively capital abundant will have a production possibilities frontier that is a. relatively flat, with a constant slope. b. relatively steep, with a constant slope. c. relatively flat, with an increasing slope (in absolute value). d. relatively steep, with an increasing slope (in absolute value).

Ans: d Level: Medium Heading: Factor Intensity, Factor Abundance, and the Shape of the Production Frontier 23. Over the last five decades, relative to the United States, real wages among industrialized countries have a. become equal. b. moved farther away.

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c. moved closer together. d. increased, then decreased.

Ans: c Level: Medium Heading: Factor Price Equalization and Income Distribution

Short Answer

24. List at least four of the assumptions of the Heckscher-Ohlin theory Ans: Two nations, two goods, two inputs; the same technology; commodities are the same input intensity; constant returns to scale; incomplete specialization; equal tastes; perfect internal and no external factor mobility; no transportation costs, or protectionism; full employment.

Level: Medium Heading: Assumptions of the Theory

25. List three possible explanations for the Leontief paradox Ans: The data from 1947 was a non-representative year; The use of a two factor model that omitted other production inputs; U.S. protectionism was biased towards labor intensive industries; the omission of human capital from the calculations.

Level: Hard Heading: Empirical Test of the Heckscher-Ohlin Model

26. Define and explain factor intensity reversal Ans: Factor intensity reversal occurs when, for example, what is a labor intensive commodity in one nation is a capital intensive commodity in another nation. For example, in the U.S. agriculture may have a capital intensive production process, while in a developing nation it may have a labor intensive process. Such reversals cause the factor price equalization theorems to fail.

Level: Medium Heading: Empirical Test of the Heckscher-Ohlin Model 27. In the United States, labor unions consistently oppose international trade and support trade barriers. Use the H-O model to explain why.

Ans: The United States is a capital-abundant nation. Thus, international trade should reduce the absolute and relative return to labor and increase the absolute and relative return to capital.

Therefore, labor unions, interested in preserving wages of their membership, oppose expansion of international trade.

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Essay

28. a) Identify the conditions that may give rise to trade between two nations. b) What are some of the assumptions on which the Heckscher-Ohlin theory is based? c) What does this theory say about the pattern of trade and effect of trade on factor prices?

Ans: a) Trade can be based on a difference in factor endowments, technology, or tastes between two nations. A difference either in factor endowments or technology results in a different production possibilities frontier for each nation, which, unless neutralized by a difference in tastes, leads to a difference in relative commodity price and mutually beneficial trade. If two nations face increasing costs and have identical production possibilities frontiers but different tastes, there will also be a difference in relative commodity prices and the basis for mutually beneficial trade between the two nations. The difference in relative commodity prices is then translated into a difference in absolute commodity prices between the two nations, which is the immediate cause of trade. b) The Heckscher-Ohlin theory (sometimes referred to as the modern theory – as opposed to the classical theory - of international trade) assumes that nations have the same tastes, use the same technology, face constant returns to scale (i.e., a given percentage increase in all inputs increases output by the same percentage) but differ widely in factor endowments. It also says that in the face of identical tastes or demand conditions, this difference in factor endowments will result in a difference in relative factor prices between nations, which in turn leads to a difference in relative commodity prices and trade. Thus, in the Heckscher-Ohlin theory, the international difference in supply conditions alone determines the pattern of trade. To be noted is that the two nations need not be identical in other respects in order for international trade to be based primarily on the difference in their factor endowments. c) The Heckscher-Ohlin theorem postulates that each nation will export the commodity intensive in its relatively abundant and cheap factor and import the commodity intensive in its relatively scarce and expensive factor. As an important corollary, it adds that under highly restrictive assumptions, trade will completely eliminate the pretrade relative and absolute differences in the price of homogeneous factors among nations. Under less restrictive and more usual conditions, however, trade will reduce, but not eliminate, the pretrade differences in relative and absolute factor prices among nations. In any event, the Heckscher-Ohlin theory does say something very useful on how trade affects factor prices and the distribution of income in each nation. Classical economists were practically silent on this point.

Level: Medium Heading: Factor Endowments and the Heckscher-Ohlin Theory

29. Consumers demand more of commodity X (the L-intensive commodity) and less of commodity Y (the K-intensive commodity). Suppose that Nation 1 is India, commodity X is textiles, and commodity Y is food. Starting from the no-trade equilibrium position and using the HeckscherOhlin model, trace the effect of this change in tastes on India's

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a) relative commodity prices and demand for food and textiles, b) production of both commodities and factor prices, c) comparative advantage and volume of trade. d) Do you expect international trade to lead to the complete equalization of relative commodity and factor prices between India and the United States? Why? Ans: a) The change in tastes can be visualized by a shift toward the textile axis in India's indifference map in such a way that an indifference curve is tangent to the steeper segment of India's production frontier (because of increasing opportunity costs) after the increase in demand for textiles. This will cause the pretrade relative commodity price of textiles to rise in India. b) The increase in the relative price of textiles will lead domestic producers in India to shift labor and capital from the production of food to the production of textiles. Since textiles are Lintensive in relation to food, the demand for labor and therefore the wage rate will rise in India.

At the same time, as the demand for food falls, the demand for and thus the price of capital will fall. With labor becoming relative more expensive, producers in India will substitute capital for labor in the production of both textiles and food. c) Even with the rise in relative wages and in the relative price of textiles, India still remains the L-abundant and low-wage nation with respect to a nation such as the United States. However, the pretrade difference in the relative price of textiles between India and the United States is now somewhat smaller than before the change in tastes in India. As a result the volume of trade required to equalize relative commodity prices and hence factor prices is smaller than before.

That is, India need now export a smaller quantity of textiles and import less food than before for the relative price of textiles in India and the United States to be equalized. Similarly, the gap between real wages and between India and the United States is now smaller and can be more quickly and easily closed (i.e., with a smaller volume of trade). d) Since many of the assumptions required for the complete equalization of relative commodity and factor prices do not hold in the real world, great differences can be expected and do in fact remain between real wages in India and the United States. Nevertheless, trade would tend to reduce these differences, and the H-O model does identify the forces that must be considered to analyze the effect of trade on the differences in the relative and absolute commodity and factor prices between India and the United States.

Level: Medium Heading: Factor Endowments and the Heckscher-Ohlin Theory 30. The H-O model assumes a world in which factors of production cannot move but goods can.

In terms of output prices and factor prices, explain what (if anything) would be different about a world in which there was complete factor mobility but no trade versus a world in which there was absolutely free trade but no factor mobility.

Ans: In the H-O model, output prices equalize through trade, which in turn causes factor price equalization. If factors of production could move but output does not, capital and labor would move to seek the highest return. Thus, for example, as labor moved to seek the highest wages,

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wages in the new country would fall as supply (of labor) increased, and would rise in the original country as labor became more scarce. This would continue until factor prices equalized among countries. With identical factor prices, there would be identical output prices, even without trade in outputs.

Level: Hard Heading: Factor Endowments and the Heckscher-Ohlin Theory

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File: Ch06; Chapter 6: Economies of Scale, Imperfect Competition, and International Trade

Multiple Choice

1. Relaxing the assumptions on which the Heckscher-Ohlin theory rests: a. leads to rejection of the theory b. leaves the theory unaffected c. requires complementary trade theories d. cannot be done.

Ans: c Level: Easy Heading: The Heckscher-Ohlin Model and New Trade Theories

2. Which of the following is an example of intra-industry trade? a. Japan and the United States both import and export cars. b. The United States sends high technology goods to China and imports textiles and clothing. c. The United States produces lettuce in the summer and imports lettuce from Chile in the winter. d. The United States ships wheat to Africa.

Ans: a Level: Easy Heading: Economies of Scale and International Trade

3. Which of the following assumptions of the Heckscher-Ohlin theory, when relaxed, require new trade theories? a. Economies of scale b. incomplete specialization c. similar tastes in both nations d. the existence of transportation costs Ans: a Level: Medium Heading: The Heckscher-Ohlin Model and New Trade Theories

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4. International trade can be based on economies of scale even if both nations have identical: a. factor endowments b. tastes c. technology d. all of the above Ans: d Level: Easy Heading: Economies of Scale and International Trade

5. Increasing returns to scale means that a. doubling all inputs leads to a more than proportional increase in output. b. doubling all inputs leads to a proportional increase in output. c. doubling all inputs leads to a less than proportional increase in output. d. doubling all inputs leads to a decrease in output.

Ans: a Level: Easy Heading: Imperfect Competition and International Trade

6. External economies refers to a. an increase in inputs that leads to a more than proportional increase in outputs. b. a reduction in the average cost of production as the firm expands. c. a reduction in firm’s average cost of production as the industry expands. d. a reduction in the world cost of production as international trade increases.

Ans: c Level: Medium Heading: The Heckscher-Ohlin Model and New Trade Theories

7. The theory that a nation exports those products for which a large domestic market exists was advanced by: a. Linder b. Vernon c. Leontief d. Ohlin Ans: a Level: Easy Heading: Economies of Scale and International Trade

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8. Intra-industry trade takes place: a. because products are homogeneous b. in order to take advantage of economies of scale c. because perfect competition is the prevalent form of market organization d. because there is technological change.

Ans: b Level: Medium Heading: Imperfect Competition and International Trade

9. If a nation exports twice as much of a differentiated product that it imports, its intra-industry (T) index is equal to: a. 1.00 b. 0.75 c. 0.50 d. 0.25 Ans: c Level: Hard Heading: Imperfect Competition and International Trade

10. Trade based on technological gaps is closely related to: a. the H-O theory b. the product-cycle theory c. Linder's theory d. the factor price equalization theorem.

Ans: b Level: Easy Heading: Trade Based on Dynamic Technology Differences

11. Which of the following statements is not true with regard to the product-cycle theory? a. It depends on differences in technological changes over time among countries b. It depends on the opening and the closing of technological gaps among countries c. It postulates that industrial countries export more advanced products to less advanced countries d. It corresponds with the predictions of the Hecksher-Ohlin theorem.

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Ans: d Level: Medium Heading: Trade Based on Dynamic Technology Differences

12. Transport costs: a. increase the price in the importing country. b. increase the price in the exporting country. c. prevent international trade. d. increase international trade.

Ans: a Level: Medium Heading: Costs of Transportation, Environmental Standards, and International Trade

13. Outsourcing refers to a. the purchase of parts and components from overseas to reduce production costs. b. a firm producing parts in its own plants abroad. c. importing final consumer goods instead of purchasing them domestically. d. technology transfer from one country to another.

Ans: a Level: Easy Heading: Economies of Scale and International Trade

14. The share of transport costs will fall less heavily on the nation: a. with the more elastic demand and supply of the traded commodity b. with the less elastic demand and supply of the traded commodity c. exporting agricultural products d. with the largest domestic market Ans: a Level: Hard Heading: Costs of Transportation, Environmental Standards, and International Trade

15. A footloose industry is one in which the product: a. gains weight in processing b. loses weight in processing c. does not change weight in processing d. could increase, decrease, or have no change in weight in processing.

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Ans: c Level: Medium Heading: Costs of Transportation, Environmental Standards, and International Trade

16. When a nation has increasing returns to scale, the shape of its production possibility frontier is a. linear b. concave to the origin c. convex to the origin d. discontinuous Ans: c Level: Medium Heading: Economies of Scale and International Trade

17. Two developed nations are most likely to engage in a. inter-industry trade based on economies of scale b. intra-industry trade based on economies of scale c. inter-industry trade based on comparative advantage d. intra-industry trade based on comparative advantage Ans: b Level: Medium Heading: Economies of Scale and International Trade

18. A developed and developing nation are most likely to engage in a. inter-industry trade based on economies of scale b. intra-industry trade based on economies of scale c. inter-industry trade based on comparative advantage d. intra-industry trade based on comparative advantage Ans: c Level: Medium Heading: Economies of Scale and International Trade

19. The Grubel and Lloyd index measures the magnitude of a nation’s a. product life cycle

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b. comparative advantage c. economies of scale d. intra-industry trade Ans: d Level: Easy Heading: Economies of Scale and International Trade

20. If transportation costs are imposed on an exporting nation the ultimate burden of paying for those costs will fall on a. only the exporting nation b. only the importing nation c. the cost will be split 50/50 between the importing and exporting nation d. the costs will be split between the importing and exporting nation based on their supply and demand elasticity Ans: d Level: Medium Heading: Costs of Transportation, Environmental Standards, and International Trade 21. Offshoring refers to a. the purchase of parts and components from overseas to reduce production costs. b. a firm producing parts in its own plants abroad. c. importing final consumer goods instead of purchasing them domestically. d. technology transfer from one country to another.

Ans: b Level: Easy Heading: Economies of Scale and International Trade 22. According to the Environmental Performance Index, the highest ranking country is a. New Zealand. b. Switzerland. c. the United States. d. Germany.

Ans: b Level: Easy Heading: Costs of Transportation, Environmental Standards, and International Trade 23. With intra-industry trade, the gains from trade a. decrease. b. come from reductions in cost due to comparative advantage and exchange. c. come from increases in the variety of goods available.

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d. come from the reduction of tariffs and trade.

Ans: b Level: Medium Heading: Economies of Scale and International Trade Short Answer

24. How is intra-industry trade measured? Does the degree of intra-industry trade depend on how an industry is defined?

Ans: Intra-industry trade can be measure by the Grubel Lloyd index. Generally, the more broadly an industry is defined the greater the degree of intra-industry trade. For example, there is likely to be less intra-industry trade in the category “light trucks” than in the category “transportation vehicles.”

Level: Medium Heading: Imperfect Competition and International Competition

25. Discuss the stages of the product cycle model.

Ans: Stage 1 the product is produced and consumed only in the innovating country. Stage 2 the innovating country begins to export the product. Stage 3 the product becomes standardized and the product begins to be produced in the imitating country. Stage 4 the imitating country begins to export the product. Stage 5 the innovating country becomes a net importer of the product.

Level: Medium Heading: Trade Based on Dynamic Technological Differences

26. Define and explain economies of scale.

Ans: Economies of scale is falling average costs as output of a particular commodity increases.

Such scale is often the results of large fixed costs being spread over larger output levels.

Level: Easy Heading: Economies of Scale and International Trade

27. Define and discuss the differences between intra-industry trade and inter-industry trade.

Ans: Intra-industry trade is trade with in the same industry. Intra-industry trade is usually driven by product differentiation and economies of scale. Inter-industry trade is trade across differing industries and is usually a results of comparative advantage based on differences in relative factors of production.

Level: Medium Heading: Imperfect Competition and International Trade

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28. How do differing environmental standards between countries affect international trade, and why can this create problems?

Ans: Since countries may have different levels of environmental protection, costs of production may vary. For example, a country with less environmental protection will, in general, have lower costs of production. When there are negative externalities, the cost of production does not reflect the marginal social cost of production, and thus countries with less protection will overproduce goods relative to their true social cost. (Additional problems might include the distortion of comparative advantage due to the failure to include external costs.)

Level: Hard Heading: Costs of Transportation, Environmental Standards, and International Trade

Essay

29. a) Explain why the Heckscher-Ohlin trade model needs to be extended. b) Indicate in what important ways the Heckscher-Ohlin trade model can be extended. c) Explain what is meant by differentiated products and intra-industry trade.

Ans: a) The Heckscher-Ohlin trade model needs to be extended because, while generally correct, it fails to explain a significant portion of international trade, particularly the trade in manufactured products among industrial nations. b) The international trade left unexplained by the basic Heckscher-Ohlin trade mode can be explained by (1) economies of scale; (2) intra-industry trade; and (3) trade based on imitation gaps and product differentiation. c) Differentiated products refer to similar, but not identical, products (such as cars, typewriters, cigarettes, soaps, and so on) produced by the same industry or broad product group. Intra-industry trade refers to the international trade in differentiated products.

Level: Medium Heading: The Heckscher-Ohlin Model and New Trade Theories

30. Carefully explain how and why the share of intra-industry trade has changed for countries.

Ans: In general, as countries develop, the share of intra-industry trade increases between countries of similar levels of economic development. This is because such countries both produce and exchange differentiated goods. Trade in these goods is based on the development of many varieties of goods rather than on comparative advantage. Case Study 6-5 shows the change in intra-industry trade shares for a variety of countries; in general shares of intra-industry trade have increased for nearly all of the (mostly developed) countries in the study. (Further discussion could include patterns of trade will countries at different levels of development.)

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Level: Medium Heading: Economies of Scale and International Trade

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File: Ch07; Chapter 7: Economic Growth and International Trade

Multiple Choice

1. Dynamic factors in trade theory refer to changes in all of the above except: a. factor endowments b. technology c. tastes d. tariff structure Ans: d Level: Easy Heading: Introduction

2. Doubling the amount of L and K under constant returns to scale does all of the following except: a. doubles the output of the L-intensive commodity b. doubles the output of the K-intensive commodity c. leaves output unchanged. d. leaves the shape of the production frontier unchanged Ans: d Level: Medium Heading: Growth of Factors of Production 3. Doubling only the amount of L available under constant returns to scale: a. less than doubles the output of the L-intensive commodity b. more than doubles the output of the L-intensive commodity c. doubles the output of the K-intensive commodity d. leaves the output of the K-intensive commodity unchanged Ans: b Level: Medium Heading: Growth of Factors of Production

4. The Rybczynski theorem postulates that doubling L at constant relative commodity prices: a. doubles the output of the L-intensive commodity b. reduces the output of the K-intensive commodity c. increases the output of both commodities d. reduces the output of both commodities Ans: b

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Level: Medium Heading: Growth of Factors of Production

5. Doubling L is likely to: a. increases the relative price of the L-intensive commodity b. reduces the relative price of the K-intensive commodity c. reduces the relative price of the L-intensive commodity d. any of the above Ans: c Level: Medium Heading: Growth of Factors of Production

6. Technical progress that increases the productivity of L proportionately more than the productivity of K is called: a. capital saving b. labor saving c. neutral d. any of the above Ans: a Level: Easy Heading: Technical Progress

7. In the absence of trade, technical progress a. tends to increase the nation’s welfare. b. increases the nation’s welfare only if it is labor-saving. c. increases the nation’s welfare only if it is capital-saving. d. tends to decrease the nation’s welfare.

Ans: a Level: Medium Heading: Technical Progress

8. Doubling L with trade in a small L-abundant nation: a. reduces the welfare of representative citizens. b. reduces the nation's terms of trade c. reduces the volume of trade

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d. reduces national consumption.

Ans: a Level: Medium Heading: Growth and Trade: The Small Country Case

9. Doubling L with trade in a large L-abundant nation is most likely to: a. increase the nation's social welfare b. reduces the nation's terms of trade c. reduces the volume of trade d. increase the welfare of individual citizens.

Ans: b Level: Medium Heading: Growth and Trade: The Large Country Case

10. If, at unchanged terms of trade, a nation wants to trade more after growth, then for a large country, the nation's terms of trade can be expected to: a. deteriorate b. improve c. remain unchanged d. any of the above Ans: a Level: Medium Heading: Growth and Trade: The Large Country Case

11. A proportionately greater increase in the nation's supply of labor than of capital is likely to result in a deterioration in the nation's terms of trade if the nation exports: a. the K-intensive commodity b. the L-intensive commodity c. either commodity d. both commodities Ans: b Level: Hard Heading: Growth and Trade: The Large Country Case

12. Technical progress in the nation's export commodity: a. may reduce the nation's welfare b. will reduce the nation's welfare

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c. will increase the nation's welfare d. leaves the nation's welfare unchanged Ans: a Level: Easy Heading: Technical Progress

13. Doubling K with trade in a large L-abundant nation: a. increases the nation's welfare b. improves the nation's terms of trade c. reduces the volume of trade d. all of the above Ans: d Level: Medium Heading: Growth and Trade: The Large Country Case

14. An increase in tastes for the import commodity in both nations: a. reduces the volume of trade b. increases the volume of trade c. leaves the volume of trade unchanged d. any of the above Ans: b Level: Medium Heading: Growth, Changes in Tastes, and Trade in Both Nations

15. An increase in tastes of the import commodity of Nation A and export in B: a. will reduce the terms of trade of Nation A b. will increase the terms of trade of Nation A c. will reduce the terms of trade of Nation B d. any of the above Ans: a Level: Hard Heading: Growth, Changes in Tastes, and Trade in Both Nations

16. Technical progress is usually classified into all of the following except

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a. neutral b. negative c. labor saving d. capital saving Ans: b Level: Easy Heading: Technical Progress

17. The capital to labor ratios of countries over the last three decades has generally a. risen b. fallen c. remained relatively unchanged d. risen in developed nations and fallen in developing nations Ans: a Level: Medium Heading: Technical Progress

18. If the output of a nations exportable commodity increases proportionally more than the output of its importable commodity the output changes in considered a. neutral b. negative c. anti-trade d. pro-trade Ans: d Level: Medium Heading: Growth and Trade: The Small Country Case

19. Empirical studies have generally shown that most of the real per capita income increase in industrialized countries is due to a. capital accumulation b. population growth c. technical progress d. infrastructure improvements Ans: c Level: Easy Heading: Technical Progress

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20. When a nation’s growth deteriorates its terms of trade to the point that its welfare drops it is experiencing a. debilitating growth b. immiserizing growth c. population growth d. GDP per capital growth Ans: b Level: Medium Heading: Growth and Trade: The Large Country Case 21. The Rybczynski theorem postulates that doubling K at constant relative commodity prices: a. doubles the output of the L-intensive commodity b. more than doubles the output of the K-intensive commodity c. reduces the output of the K-intensive commodity d. increases the output of both commodities Ans: b Level: Medium Heading: Growth of Factors of Production 22. Immiserizing growth is most likely in which of the following cases? a. When the country is small. b. When the demand for the nation’s export good is inelastic. c. In developed countries. d. When growth causes the terms of trade to improve.

Ans: b Level: Hard Heading: Growth and Trade: The Large-Country Case 23. A shift in a nation’s offer curve toward the axis measuring the exportable commodity tends to ____________ trade at constant prices, and __________ the nation’s terms of trade. a. expand, improve b. expand, decrease c. decrease, improve d. decrease, decrease Ans: b Level: Hard Heading: Growth, Change in Tastes, and Trade in Both Nations

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Short Answer

24. What does it mean for a nation’s production to be pro-trade?

Ans: A nation’s production is pro-trade if it leads to a greater than proportionate increase in trade at constant prices.

Level: Medium Heading: Growth and Trade: The Small Country Case

25. What is meant by comparative static analysis?

Ans: Static analysis holds factor endowments, technology and tastes constant. Comparative static analysis explores how equilibrium changes in response to a change in one of these constants without regard to the transitional process of adjustment.

Level: Medium Heading: Introduction

26. What does the Rybczynski theorem postulate?

Ans: The Rybczynski theorem postulates that at constant commodity prices, an increase in the endowment of one factor will increase by a greater proportion the output of the commodity intensive in that factor and will reduce the output of the other commodity.

Level: Hard Heading: Growth of Factors of Production

27. How does a change in tastes that shifts in a nation’s offer curve toward the axis measuring its exportable commodity impact the nation?

Ans: Such a shift tends to expand trade at constant prices and reduce the nation’s terms of trade.

Level: Hard Heading: Growth, Changes in Tastes, and Trade in Both Nations

Essay

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28. Carefully identify and discuss the conditions which can lead to immiserizing growth.

Ans: The overall impact of growth depends on how it impacts the terms-of-trade and wealth effects.

The terms or trade are the import export price ratio. The wealth effect refers to the change in output per worker as a result of growth. If the both effects are favorable (i.e. the price of exports increases and worker productivity increases) the nation’s welfare will improve. However, if the terms-of trade deteriorate and overwhelm worker productivity increases, the net effect will be a an overall decline in welfare, or immerisizing growth.

Level: Medium Heading: Growth and Trade: The Large Country Case 29. Using the data presented in the chapter, explain how growth, trade, and welfare have changed in the leading industrial countries over the 1990-2010 period.

Ans: Answers will vary, but should include that the average growth rate of GDP has been about 2%, that the volume of exports has increased by about 5%, that per capita GDP has increased by 1.6%, and that the terms of trade have deteriorated slightly. The fact that exports rose much faster than GDP shows that they certainly played a role in growth, offsetting some other negative factors during the period. Students may pick out particular countries to discuss; notably, the terms of trade have not deteriorated for all countries, although the change has been relatively small in all cases.

Level: Hard Heading: Growth, Changes in Tastes, and Trade in Both Nations Problems 30. Use graphs to demonstrate the effect of an increase in a small country’s capital stock at constant commodity prices.

Ans: See graphs below. Numbers are optional and based on text example. Use of Edgeworth box analysis is optional.

Level: Medium Heading: Growth of Factors of Production

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File: Ch08; Chapter 8: Economic Growth and International Trade

Multiple Choice

1. Which of the following statements is incorrect? a. An ad valorem tariff is expressed as a percentage of the value of the traded commodity b. a specific tariff is expressed as a fixed sum of the value of the traded commodity. c. export tariffs are prohibited by the U.S. Constitution d. The U.S. uses exclusively the specific tariff Ans: d Level: Easy Heading: Introduction

2. A small nation is one which must have all of the following characteristics except: a. It does not affect world price by its trading. b. It faces an infinitely elastic world supply curve for its import commodity. c. It faces an infinitely elastic world demand curve for its export commodity. d. It has a small geographic area.

Ans: d Level: Easy Heading: Partial Equilibrium Analysis of a Tariff

3. If a small nation increases the tariff on its import commodity, its: a. consumption of the commodity increases b. production of the commodity decreases c. imports of the commodity increase d. domestic price of the commodity increases Ans: d Level: Medium Heading: Partial Equilibrium Analysis of a Tariff

4. The increase in producer surplus when a small nation imposes a tariff is measured by the area: a. to the left of the supply curve between the commodity price with and without the tariff b. under the supply curve between the quantity produced with and without the tariff

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c. under the demand curve between the commodity price with and without the tariff d. none of the above.

Ans: a Level: Medium Heading: Partial Equilibrium Analysis of a Tariff 5. If a small nation increases the tariff on its import commodity: a. the rent of domestic producers of the commodity increases b. the protection cost of the tariff decreases c. the deadweight loss decreases d. all of the above Ans: a Level: Hard Heading: Partial Equilibrium Analysis of a Tariff

6. Which of the following statements is incorrect with respect to the rate of effective protection? a. for given values of ai and ti, g is larger the greater is t b. for a given value of t and ti, g is larger the greater is ai c. g exceeds, is equal to or is smaller than t, as ti is smaller than, is equal to or is larger than t d. when aiti exceeds t, the rate of effective protection is positive Ans: d Level: Medium Heading: The Theory of Tariff Structure

7. With ai=50%, ti=0, and t=20%, g is: a. 40% b. 20% c. 80% d. 0 Ans: a Level: Hard Heading: The Theory of Tariff Structure

8. The imposition of an import tariff by a small nation: a. increases the relative price of the import commodity for domestic producers and consumers b. reduces the relative price of the import commodity for domestic producers and consumers

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c. increases the relative price of the import commodity for the nation as a whole d. any of the above is possible Ans: a Level: Medium Heading: General Equilibrium Analysis of a Tariff in a Small Country

9. The imposition of an import tariff by a small nation: a. increases the nation's welfare b. reduces the nation's welfare c. leaves the nation's welfare unchanged d. any of the above is possible Ans: b Level: Medium Heading: General Equilibrium Analysis of a Tariff in a Small Country

10. According to the Stolper-Samuelson theorem, the imposition of a tariff by a nation: a. increases the real return of the nation's abundant factor b. increases the real return of the nation's scarce factor c. reduces the real return of the nation's scarce factor d. any of the above is possible Ans: b Level: Medium Heading: General Equilibrium Analysis of a Tariff in a Small Country

11. The imposition of an import tariff by a nation results in: a. an increase in relative price of the nation's import commodity b. an increase in the nation's production of its importable commodity c. reduces the real return of the nation's abundant factor d. all of the above Ans: d Level: Hard Heading: General Equilibrium Analysis of a Tariff in a Small Country

12. The imposition of an import tariff by a nation can be represented by a rotation of the:

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a. nation's offer curve away from the axis measuring the commodity of its comparative advantage b. the nation's offer curve toward the axis measuring the commodity of its comparative advantage c. the other nation's offer curve toward the axis measuring the commodity of its comparative advantage d. the other nation's offer curve away from the axis measuring the commodity of its comparative advantage Ans: a Level: Hard Heading: General Equilibrium Analysis of a Tariff in a Small Country

13. The imposition of an import tariff by a large nation: a. increases the nation's terms of trade b. reduces the volume of trade c. may increase or reduce the nation's welfare d. all of the above Ans: d Level: Medium Heading: General Equilibrium Analysis of a Tariff in a Small Country

14. The imposition of an optimum tariff by a large nation: a. improves its terms of trade b. reduces the volume of trade c. increases the nation's welfare d. all of the above Ans: d Level: Medium Heading: The Optimum Tariff

15. The optimum tariff for a small nation is: a. 100% b. 50% c. 0 d. depends on elasticities Ans: c

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Level: Medium Heading: The Optimum Tariff

16. Which of the following statements is true? a. an ad valorem tariff is a fixed sum per unit b. the U.S. does not allow exports tariffs c. in the case of a small country the cost of a tariff is split between the buyer and seller d. a specific tariff is a % of the value of the unit Ans: b Level: Easy Heading: Introduction

17. The imposition of a tariff will a. increase imports, decrease domestic production, and increase consumption b. decrease imports, increase domestic production, and decrease consumption c. decrease imports, decrease domestic production, and increase consumption d. increase imports, increase domestic production, and decrease consumption Ans: b Level: Easy Heading: Partial Equilibrium Analysis of a Tariff

18. The optimum tariff is the tariff rate that a. saved the most domestic jobs b. generates the largest tax revenue c. maximizes domestic production d. maximizes the net benefit from improving the improvement in the terms of trade relative to loss from the reduction in the volume of trade Ans: d Level: Medium Heading: The Optimum Tariff

19. If the tariff rate in inputs is the same as the tariff rate of finished goods the effective rate of protection will be a. the same as the nominal rate of protection b. zero c. larger than the nominal rate of protection

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d. maximized Ans: a Level: Medium Heading: The Theory of Tariff Structure

20. In general, for the last 50 years tariff rates around the world have been a. rising b. falling c. relatively unchanged d. volatile – sometimes rising and sometimes falling quite dramatically Ans: b Level: Easy Heading: Introduction 21. A tariff in a small country will benefit a. domestic consumers. b. foreign producers. c. the government imposing the tariff. d. the world as a whole.

Ans: c Level: Medium Heading: Partial Equilibrium Analysis of a Tariff 22. A tariff in a large country a. will not benefit the country or the world. b. will benefit the country but not the world. c. will benefit the world but not the country. d. may benefit the country but not the world.

Ans: d Level: Medium Heading: The Optimum Tariff 23. Tariffs result in a loss of national social welfare because a. domestic consumption decreases and domestic production increases. b. domestic consumption increases and foreign production increases. c. foreign consumption decreases and domestic production decreases. d. domestic consumption increases and domestic production decreases.

Ans: a Level: Medium

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Heading: Partial Equilibrium Analysis of a Tariff Short Answer 24. Explain the difference between an ad valorem, specific and compound tariff Ans: An ad valorem tariff is a percentage of the value of the product. A specific tariff is a fixed amount per unit of the commodity. A compound tariff is a combination of both an ad valorem and a specific tariff.

Level: Easy Heading: Introduction

25. Is there such thing as an optimum tariff for a small nation?

Ans: No. A large country can use a tariff to improve its terms of trade by driving down the price of imports, the net benefit of which must then be gauged against the cost of a reduction in the volume of trade and then maximized. A small country cannot affect the terms of trade with a tariff so the only effect is a net loss in overall welfare due to a reduction in the volume of trade.

Level: Hard Heading: The Optimum Tariff

26. Explain the redistribution effects of a tariff.

Ans: A tariff increases the price of imports leading to an increase in the price of the domestic market. This transfers welfare away from consumers to domestic producers. A tariff also transfers welfare away from consumers to the government in the form of the tax revenue collected on imports.

Level: Medium Heading: General Equilibrium Analysis of a Tariff in a Small Country

27. Under what conditions can a tariff improve a nation’s welfare?

Ans: When a large nation imposes a tariff demand for imports fall driving down the price of imports and improving the terms of trade. If the benefit from the improvement in the terms of trade exceed the efficiency loss cause by fewer imports the nation’s overeall welfare will improve.

Level: Medium Heading: General Equilibrium Analysis of a Tariff in a Large Country

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Problems

28. From the following figure, in which Dc and Sc refer, respectively to the domestic demand and supply curves of cloth, and SF and SF+T refer, respectively, to the world supply curve of cloth under free trade and with a 50% import tariff imposed by the nation on the importation of cloth, determine: (a) the consumption, production effect, and the trade effect of the tariff. (b) the reduction in consumer surplus, the increase in producer surplus or rent, the tariff revenue, and the protection cost or deadweight loss to the economy as a result of the tariff.

Ans: (a) The consumption effect is equal to BR=-20c; the production effect is equal to GN=20C; therefore, the trade effect is equal to -(BR+GN)=-40c. (b) The reduction in consumer surplus is FJHB=$90; the increase in producer surplus is FJMG=$30; the revenue effect is NMHR=$40; the protection cost or deadweight loss to the economy is equal to the sum of the area of triangles GMN and BHR or $20.

Level: Medium Heading: Partial Equilibrium Analysis of a Tariff 29. A good is produced using $160 in imported inputs. The current domestic price of the good is $200. For each of the following cases, find the level of effective protection. a. The nominal tariff rate on the good is 10%, and there is no tariff on the inputs. b. The nominal tariff rate on the good is 10%, and there is a 10% tariff on the inputs. c. The nominal tariff rate on the good is 0%, and there is a 10% tariff on the inputs.

Ans: a. 50% b. 10% c. -40% Level: Medium Heading: The Theory of Tariff Structure

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Essay 30. Using the concept of effective protection, explain how and why tariffs tend to vary with the level of processing of goods (that is, raw materials, intermediate goods, and finished goods).

Ans: Tariffs tend to increase with the degree of processing. In general, tariffs on raw materials tend to be zero or very low. This is because tariffs on raw materials put domestic manufacturers at a disadvantage relative to foreign manufacturers (that is, all else equal, the rate of effective protection will be negative). As the degree of processing rises, the level of both nominal and effective protection rises (for goods produced with imported inputs).

Level: Hard Heading: The Theory of Tariff Structure

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File: Ch09; Chapter 9: Nontariff Trade Barriers and the New Protectionism

Multiple Choice 1. An import quota does all of the following except: a. increases the domestic price of the imported commodity b. reduces domestic consumption c. increases domestic production d. increases domestic social welfare Ans: d Level: Easy Heading: Import Quotas

2. An increase in the demand of the imported commodity subject to a given import quota: a. reduces the domestic quantity demanded of the commodity b. increases the domestic production of the commodity c. reduces the domestic price of the commodity d. reduces the producers' surplus Ans: b Level: Medium Heading: Import Quotas

3. Adjustment to any shift in the domestic demand or supply of an importable commodity occurs: a. in domestic price with an import quota b. in the quantity of imports with a tariff c. through the market mechanism with an import tariff but not with an import quota d. all of the above Ans: d Level: Medium Heading: Import Quotas

4. An international cartel refers to: a. dumping b. an organization of exporters

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c. an international commodity agreement d. voluntary export restraints Ans: b Level: Easy Heading: Other Nontariff Barriers and the New Protectionism

5. The temporary sale of a commodity at below cost or at a lower price abroad in order to drive foreign producers out of business is called: a. predatory dumping b. sporadic dumping c. continuous dumping d. voluntary export restraints Ans: a Level: Medium Heading: Other Nontariff Barriers and the New Protectionism

6. The type of dumping which would justify antidumping measures by the country subject to the dumping is: a. predatory dumping b. sporadic dumping c. continuous dumping d. all of the above Ans: a Level: Medium Heading: Other Nontariff Barriers and the New Protectionism

7. A fallacious argument for protection is: a. the infant industry argument b. protection for national defense c. the scientific tariff d. to correct domestic distortions Ans: c Level: Medium Heading: Other Non-Tariff Barriers and the New Protectionism

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8. Which of the following is true with respect to the infant-industry argument for protection? a. It refers to temporary protection to establish a domestic industry. b. To be valid, the return to the grown-up industry must be sufficiently high also to repay for the higher prices paid by domestic consumers of the commodity during the infancy period. c. It is inferior to an equivalent production subsidy to the infant industry. d. All of the above Ans: d Level: Hard Heading: Export Subsidies

9. Which of the following is false with respect to strategic trade policy? a. It postulates that a nation can gain by an activist trade policy. b. It is practiced to some extent by most industrial nations. c. It can easily be carried out. d. All of the above Ans: b Level: Easy Heading: Strategic Trade and Industrial Policies

10. Industrial policy refers to: a. an activist policy by the government of an industrial country to stimulate the development of an industry b. the granting of a subsidy to a domestic industry to stimulate the development of an industry c. the granting of a subsidy to a domestic industry to counter a foreign subsidy d. all of the above Ans: d Level: Medium Heading: Strategic Trade and Industrial Policies

11. Game theory refers to: a. a method of choosing the optimal strategy in conflict situations b. the granting of a subsidy to correct a domestic distortion c. the theory of tariff protection d. the theory of comparative advantage Ans: a

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Level: Easy Heading: Strategic Trade and Industrial Policies

12. Trade protection in the United States is usually provided to: a. low-wage workers b. well-organized industries with large employment c. industries producing consumer products d. all of the above Ans: d Level: Easy Heading: History of U.S. Commercial Policy

13. The most-favored-nation principle refers to: a. extension to all trade partners of any reciprocal tariff reduction negotiated by the U.S. with any of its trade partners b. multilateral trade negotiation c. the General Agreement on Tariffs and Trade d. the International Trade Organization Ans: a Level: Medium Heading: The History of U.S. Commercial Policy

14. On which of the following principles does GATT rest? a. nondiscrimination b. elimination of nontariff barriers c. consultation among nations in solving trade disputes d. all of the above Ans: d Level: Medium Heading: The History of U.S. Commercial Policy

15. Which of the following was not negotiated under the Uruguay Round? a. reduction of tariffs on industrial goods b. replacement of quotas with tariffs c. reduction of subsidies on industrial products and on agricultural exports

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d. liberalization in trade in most services Ans: d Level: Easy Heading: The Uruguay Round, Outstanding Trade Problem, and the Doha Round 16. One of the most dramatic examples of voluntary export restraints (VER’s) centered around a. agriculture b. automobiles c. textiles d. pharmaceuticals Ans: b Level: Easy Heading: Import Quotas

17. Quotas are similar to tariffs in that they do all of the following except a. increase domestic production b. decrease consumption c. directly raise price d. reduce imports Ans: c Level: Medium Heading: Import Quotas

18. All of the following are examples of protectionism except a. most favored nation treatment b. voluntary export restraints c. tariffs d. dumping Ans: a Level: Medium Heading: Other Nontariff Barriers and the New Protectionism

19. The WTO grew out of the following organization a. the Bretton Woods system

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b. The UN c. The World Bank d. The GATT Ans: d Level: Easy Heading: History of U.S. Commercial Policy

20. The WTO was established during the a. Kennedy Round b. Uruguay Round c. Tokyo Round d. Doha Round Ans: b Level: Easy Heading: History of U.S. Commercial Policy 21. Which of the following is a correct statement about tariffs and quotas? a. Tariffs and quotas both increase social welfare. b. Tariffs are less restrictive than quotas if demand increases. c. Quotas have less of an impact on markets than tariffs do. d. Tariffs are restricted under GATT rules but quotas are not.

Ans: c Level: Hard Heading: Import Quotas 22. Suppose that domestic demand for a product is more inelastic than demand in the foreign country. A seller with market power would set a price in the foreign market that is ______ than the domestic price; this is an example of _________. a. higher, predatory dumping b. lower, predatory dumping c. higher, international price discrimination d. lower, international price discrimination Ans: d Level: Medium Heading: Other Nontariff Barriers and the New Protectionism 23. As of 2012, the status of the Doha Round is a. There is a new agreement in place. b. Negotiations are continuing. c. Negotiations have collapsed.

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d. Negotiations have not yet begun.

Ans: c Level: Easy Heading: History of U.S. Commercial Policy

Short Answer 24. What is a quota and how does it compare to the economic effects of a tariff?

Ans: A quota is a quantitative restriction on imports or exports. In general, the effects of quotas are quite similar to the effects of tariffs. Both raise price, increase domestic production, reduce imports, and reduce consumption. One difference is that a tariff generates tax revenue while a quota results in the higher price going to the foreign manufacturer.

Level: Medium Heading: Import Quotas

25. Summarize the Smoot-Hawley Tariff Act and its effects.

Ans: The Smoot-Hawley Tariff Act was passed in 1930. It raised the average tariff in the United States to an all-time high of 59% by 1932. President Hoover signed the bill in spite the urging of thousands of economists to veto it. The act resulted in severe foreign retaliation. World trade collapsed, deepening the worldwide depression.

Level: Medium Heading: The History of U.S. Commercial Policy

26. What is dumping and what are its various forms?

Ans: Dumping is the export of a commodity at below cost or at a lower cost than the price being charged in the domestic market. Persistent dumping occurs continuously and is viewed as international price discrimination. Predatory dumping is a temporary sale with the goal of driving competition out of business. Sporadic dumping is the occasional sale below cost to unload excess inventory.

Level: Medium Heading: Other Nontariff Barriers and the New Protectionism 27. What is an infant industry, and why would a country want to protect it?

A new industry may have the potential to be internationally competitive, but because its initial production costs are too high (due to lack of know-how and the initial small level of output), this industry cannot be established or grow in the face of foreign competition. If such an industry is

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protected, it is possible that the long-term benefits from the industry may more than compensate for the short-run costs.

Level: Medium Heading: Other Nontariff Barriers and the New Protectionism

Essay 28. Explain why and under what conditions the infant-industry argument for an import tariff is valid. How must this argument be qualified?

Ans: The infant-industry argument for tariffs is generally valid, especially for less developed countries (LDCs). It holds that an LDC may have a potential comparative advantage in a particular commodity, say textiles, but that because its initial production costs are too high (due to lack of know-how and the initial small level of output), this industry cannot be established or grow in the LDC in the face of foreign competition. An import tariff is then justified to help the LDC establish the industry and protect it during its "infancy," until the industry has grown in size and efficiency and is able to meet foreign competition. At that time, the tariff is to be removed.

In order for the infant-industry argument to be valid, not only must the tariff eventually be removed and the "grown up" industry be able to compete with foreign firms without protection, but the extra return in the industry (after the removal of the protection) must be high enough to justify the costs involved during the period of protection. These costs arise because the commodity is produced domestically rather than imported for less. It may also be difficult a priori to determine which industry or potential industry qualifies for this treatment and to eventually remove the tariff once it is imposed. Economists also agree that what a tariff can do here, a direct subsidy to the infant industry can do better. This is because a subsidy can be varied so as to provide the infant industry with the same degree of protection as an equivalent import tariff but without distorting relative prices and domestic consumption. However, a subsidy requires revenue, rather than generating it as the tariff does.

Level: Medium Heading: Other Nontariff Barriers and the New Protectionism

29. How can strategic trade policy justify trade protection? What difficulties arise in carrying out a strategic trade policy?

Ans: According to strategic trade policy, a nation can create a comparative advantage through temporary trade protection in such fields as semiconductors, computers, telecommunications, and other industries that are deemed crucial to future growth in the nation. These high-technology industries are subject to high risks, require large scale production to achieve economies of scale and give rise to extensive external economies when successful. Strategic trade policy suggests that by encouraging such industries, the nation can enhance its future growth prospects. This is similar to the infant-industry argument in developing nations, except that it is advanced for industrial nations to acquire a comparative advantage in crucial high-technology industries. Most nations do some of

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this. Indeed, some economists would go so far as to say that a great deal of the postwar industrial and technological success of Japan is due to its strategic industrial and trade policies.

There are three serious difficulties in carrying out strategic trade policy. First, it is extremely difficult to pick winners (i.e., choose the industries that will provide large external economies in the future) and devise appropriate policies to successfully nurture them. Second, since most leading nations undertake strategic trade policies at the same time, their efforts are largely neutralized so that the potential benefits to each may be small. Third, when a country does achieve substantial success with strategic trade policy, this comes at the expense of other countries (i.e., it is a beggarthy-neighbor policy) and so other countries are likely to retaliate. Faced with all these practical difficulties, even supporters of strategic trade policy grudgingly acknowledge that free trade is still the best policy, after all.

Level: Hard Heading: Strategic Trade and Industrial Policies 30. Carefully explain the current status of the Doha Round of trade negotiations and the challenges presented.

Ans: The Doha Round of negotiations collapsed in 2006. The WTO is working on a Plan B to reach agreement in some possible areas, and bilateral negotiations continue. Challenges in the Doha round include: 1) continued widespread protectionism; 2) high subsidies on agricultural commodities; 3) trading blocs that make worldwide negotiations difficult; and 4) demand in developed countries for labor and environmental standards.

Level: Medium Heading: The History of U.S. Commercial Policy

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File: c10; Chapter 10: Economic Integration: Customs Unions and Free Trade Areas

Multiple Choice

1. Which of the following statements is correct? a. In a customs union, member nations apply a uniform external tariff b. in a free-trade area, member nations harmonize their monetary and fiscal policies c. within a customs union there is unrestricted factor movement d. a customs union is a higher form of economic integration than a common market Ans: a Level: Easy Heading: Introduction

2. A customs union that allows for the free movement of labor and capital among its member nations is called a: a. preferential trade arrangement b. free-trade area c. common market d. all of the above Ans: c Level: Easy Heading: Introduction

3. A trade-creating customs union is one where: a. lower-cost imports from outside the customs union are replaced by higher-cost imports from a union member b. some domestic production in a member nation is replaced by lower-cost imports from another member nation c. trade among members increases but trade with nonmembers decreases d. trade among members decreases while trade with nonmembers increases Ans: b Level: Medium Heading: Trade-Creating Customs Union

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4. A trade-diverting customs union: a. increases trade among union members and with nonmember nations b. reduces trade among union members and with nonmember nations c. increases trade among members but reduces trade with non-members d. reduces trade among union members but increases it with nonmembers Ans: c Level: Medium Heading: Trade-Diverting Customs Union

5. A trade-diverting customs union results in: a. trade diversion only b. trade creation only c. both trade creation and trade diversion d. we cannot say Ans: c Level: Hard Heading: Trade-Diverting Customs Union

6. The formation of a trade-creating customs union where all economic resources of member nations are fully employed before and after the formation of the customs union leads to an: a. increase in the welfare of member and nonmember nations b. increase in the welfare of member nations only c. increase in the welfare of nonmember nations only d. increase or decrease in the welfare of member and nonmember nations Ans: a Level: Medium Heading: The Theory of Second Best and Other Static Welfare Effects of Customs Unions

7. A trade-diverting customs union: a. increases the welfare of member and nonmember nations b. reduces the welfare of member and nonmember nations c. increases the welfare of member nations but reduces that of nonmembers d. reduces the welfare of nonmembers and may increase or reduce that of members Ans: d Level: Medium

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Heading: The Theory of Second Best and Other Static Welfare Effects of Customs Unions

8. A trade-diverting customs union is more likely to lead to trade creation: a. the lower are the pre-union trade barriers of the member countries b. the lower are the customs union's barriers on trade with the rest of the world c. the smaller is the number of countries forming the customs union and the smaller their size d. the more complementary rather than competitive are the economies of the nations forming the customs union Ans: b Level: Medium Heading: The Theory of Second Best and Other Static Welfare Effects of Customs Unions

9. The theory of customs union is a special case of the theory of: a. effective protection b. the second best c. the product cycle d. comparative advantage Ans: b Level: Medium Heading: The Theory of Second Best and Other Static Welfare Effects of Customs Unions

10. Which is not a dynamic benefit from the formation of a customs union? a. increased competition b. economies of scale c. stimulus to investment d. trade creation Ans: d Level: Easy Heading: Dynamic Benefits from Customs Unions

11. The formation of the EU resulted in: a. trade creation in industrial and agricultural products b. trade diversion in industrial and agricultural products c. trade creation in industrial products and trade diversion in agricultural products d. trade diversion in industrial products and trade creation in agricultural products

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Ans: c Level: Medium Heading: History of Attempts at Economic Integration

12. The benefit that the United States is likely to receive from NAFTA: a. increasing competition in product and resource markets b. greater technical innovation c. improvements in its terms of trade d. all of the above Ans: a Level: Medium Heading: History of Attempts at Economic Integration

13. The benefit that Mexico is likely to receive from NAFTA: a. greater export-led growth b. encouraging the return of flight capital c. more rapid structural change d. all of the above Ans: d Level: Medium Heading: History of Attempts at Economic Integration

14. Which is a stumbling block to successful economic integration among groups of developing nations? a. benefits are not evenly distributed among nations b. many developing nations are not willing to relinquish part of their newly-acquired sovereignty to a supranational community body, as required for successful economic integration c. the complementary nature of their economies and competition for the same world markets for their agricultural exports d. all of the above Ans: d Level: Medium Heading: History of Attempts at Economic Integration

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15. The formation of a free trade area among the countries of Eastern Europe is advocated in order to: a. restore trade trading b. retain the traditional trade links that can be justified on market principles c. reduce the need for structural change d. none of the above Ans: b Level: Medium Heading: History of Attempts at Economic Integration

16. The North American Free Trade Agreement (NATFA) is best defined as a a. free trade area b. customs union c. preferential trade arrangement d. economic union Ans: a Level: Introduction Heading: Easy

17. One potential outcome from the formation of a regional trade agreement is a. trade creation b. trade diversion c. economies of scale d. all of the above Ans: d Level: Medium Heading: Dynamic Benefits from Customs Unions

18. The European Union currently has a. 6 members b. 12 members c. 15 members d. 27 members Ans: d Level: Easy Heading: History of Attempts at Economic Integration

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19. A customs union is more like to lead to trade creation and increased welfare under the following condition a. lower pre-union trade barriers b. lower trade barriers with the rest of the world c. complementary economies d. a smaller number of members Ans: b Level: Hard Heading: The Theory of Second Best and other Static Welfare Effects of Customs Unions

20. The following country is not a member of the European Union a. Switzerland b. Sweden c. Ireland d. Greece Ans: a Level: Medium Heading: History of Attempts at Economic Integration 21. Which of the following describes a case in which there are likely to be net benefits from a customs union? a. The union includes the least-cost producers of the traded goods. b. There are low barriers to trade prior to the union. c. The countries are complementary rather than competitive. d. The countries are a larger geographic distance from each other.

Ans: a Level: Medium Heading: The Theory of Second Best and other Static Welfare Effects of Customs Unions 22. Which of the following is not a trading bloc or agreement including some South American countries? a. MERCOSUR b. ASEAN c. FTAA d. CACM Ans: b Level: Easy

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Heading: History of Attempts at Economic Integration 23. Which of the following best describes economic integration in Central and Eastern Europe? a. The Council of Mutual Economic Assistance is the primary current organization. b. The Baltic states are actively organized into their own trading bloc. c. The more developed countries of Central Europe are attempting to become EU members. d. All of Eastern and Central Europe will become part of the EU. Ans: b Level: Easy Heading: History of Attempts at Economic Integration

Short Answer

24. What is trade diversion?

Ans: Trade diversion occurs when lower cost of production non-member imported goods are replaced with higher cost of production imported goods from a member due to differentials in the tariff rate between non-members and members.

Level: Medium Heading: Trade-Diverting Customs Unions

25. What is the theory of second best?

Ans: The theory of second best postulates that when all conditions to reach a Pareto optimal solution cannot be satisfied, trying to satisfy as many of these conditions as possible does not necessarily lead to a second-best welfare position.

Level: Hard Heading: The Theory of Second Best and other Static Welfare Effects of Customs Unions

26. Discuss the potential dynamic welfare gains that can result from the formation of a customs union.

Ans: Increased competition, economies of scale, stimulus to investment, more efficient use of resources.

Level: Medium Heading: Dynamic Benefits from Customs Unions

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27. Discuss the conditions which are more likely to lead to increased welfare with the formation of a customs union.

Ans: Higher pre-union barriers to trade with potential members, lower barriers to trade with the rest of the world, a larger number and larger size group of nations, competitive rather than complementary industry within the members, close geographical proximity, significant pre-union trade among potential members.

Level: Hard Heading: The Theory of Second Best and other Static Welfare Effects of Customs Unions

28. Why do economies that are competitive rather than complementary tend to increase the benefits from customs unions?

Ans: Countries that are competitive (produce similar goods) will tend to have less comparative advantage based trade, which tends to occur even when there are trade barriers. Complementary industries allow greater scope for gains from specialization, and thus greater expansion of trade.

Level: Medium Heading: The Theory of Second Best and other Static Welfare Effects of Customs Unions

Essay

29. (a) Why did the United States supported economic integration in Europe after World War II? (b) What direct or indirect evidence can you give to conclude that U.S. support for economic integration in Europe did in fact result in the hope-for outcome? (c) What are the major economic disputes between the United States and Europe about these days? What dangers do they create?

Ans: (a) The United States supported economic integration in Europe to foster and Strengthen democratic systems in Europe after World War II, resist communism, and to promote peaceful coexistence among European countries, especially Germany and France, which were once bitter enemies. (b) Evidence that U.S. support for economic integration in Europe achieved its goals is provided by the fact that the members of the European Union have strong democratic governments and economies, communist regimes have collapsed in Eastern Europe and the Soviet Union, and Germany and France are so closely integrated economically that a future armed conflict between them is practically nil. (c) The major economic disputes between the United States and Europe (the European Union) today are about trade protection in agriculture and some services as well as subsidies that the European Union provides to some of its industries, such as Airbus Industrie.

These disputes could degenerate into trade wars that would harm both the European Union and the United States.

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Level: Medium Heading: History of Attempts at Economic Integration 30. Discuss the attempts at economic integration in developing countries. Why have these attempts been less successful than in developed countries?

Ans: There are many examples of economic integration in developing countries, most notably MERCOSUR and ASEAN. Most of these groups have been explicitly trade-diverting in nature, and thus the benefits accrue largely to the larger countries, making it less desirable for other countries to participate. The countries also tend to be complementary rather than competitive, have poor communications and road systems, and may be unwilling to relinquish any sovereignty, all of which hamper efforts.

Level: Hard Heading: History of Attempts at Economic Integration

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File: c11; Chapter 11: International Trade and Economic Development

Multiple Choice

1. According to traditional trade theory, a developing nation should export the commodity: a. of its comparative advantage b. that it cannot produce relatively more efficiently c. that intensive in the nation's relatively scarce factor d. that is most differentiated.

Ans: a Level: Easy Heading: The Importance of Trade to Development

2. Which of the following is false with respect to traditional trade theory? a. it can incorporate changes in factor endowments and technology b. it leads to the best allocation of resources at any point in time c. it is a dynamic theory d. it is based on comparative advantage Ans: c Level: Medium Heading: The Importance of Trade to Development

3. According to Nurkse, international trade was an engine of growth for: a. the regions of recent settlements during the 19th century b. regions of recent settlements during the 20th century c. developed nations during the 19th century d. developed nations during the 20th century Ans: a Level: Medium Heading: The Importance of Trade to Development

4. Trade cannot be an engine of growth for today's developing nations because: a. the income elasticity for many of their exports is less than 1 b. there are many substitutes for their goods.

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c. technical advances have increased the the raw-material content of many products d. there are too many trade restrictions.

Ans: a Level: Hard Heading: The Importance of Trade to Development

5. If the prices of a nation's exports and imports both rise, the nation's commodity terms of trade may: a. improve b. deteriorate c. remain unchanged d. any of the above Ans: d Level: Medium Heading: The Terms of Trade and Economic Development

6. The nation's commodity terms of trade times the productivity index in its export sector gives the nation's a. income terms of trade b. double factoral terms of trade c. single factoral terms of trade d. barter terms of trade Ans: c Level: Medium Heading: The Terms of Trade and Economic Development

7. When a nation's commodity terms of trade deteriorate and its single factor terms of trade improve, the nation's welfare: a. falls b. rises c. remains unchanged d. any of the above Ans: b Level: Medium Heading: The Terms of Trade and Economic Development

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8. Developing nations often experience wildly fluctuating export prices for their primary products because of: a. inelastic and stable demand and supply b. elastic and unstable demand and supply c. inelastic and unstable demand and supply d. elastic and stable demand and supply Ans: c Level: Easy Heading: Export Instability and Economic Development

9. MacBean found that the export instability faced by developing nations was: a. not very large and did not seriously interfere with development b. very large and seriously interfered with development c. very large but did not seriously interfere with development d. not very large but seriously interfered with development Ans: a Level: Medium Heading: Export Instability and Economic Development

10. Supporting the price of a commodity by buying it when its price is low is: a. a buffer stock b. a purchase contract c. an export control d. a marketing board Ans: a Level: Medium Heading: Export Instability and Economic Development

11. The policy of import substitution was most vigorously followed by: a. large developing nations during the 1970's b. large developing nations during the 1960's c. small developing nations during the 1970's d. small developing nations during the 1960's Ans: b

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Level: Easy Heading: Import Substitution versus Export Orientation

12. What is the advantage of a policy of import substitution? a. setting up an industry to replace imports minimizes risk of failure because the market for the product already exists in the nation as evidenced by the nation's imports of the commodity b. It is easier for developing nations to protect their domestic market against foreign competition than to force developed nations to lower their trade barriers against their manufactured exports c. foreign firms are induced to establish tariff factories to overcome the tariff wall of developing nations d. all of the above.

Ans: d Level: Hard Heading: Export Instability and Economic Development

13. Which are is not an advantage of export-oriented industrialization? a. It overcomes the smallness of the domestic market and allows developing nations to take advantage of economies of scale b. domestic industries grow accustomed to protection and have an incentive to become more efficient c. production of manufactured goods for export requires and stimulates efficiency throughout the economy d. the expansion of manufactured exports is not limited by the size of the domestic market Ans: b Level: Hard Heading: Export Instability and Economic Development

14. Those nations that liberalized trade during the past decade a. grew faster than those that did not b. grew more slowly than those that did not c. grew at about the same rate as those that did not d. any of the above Ans: a Level: Medium Heading: Export Instability and Economic Development

15. Which of the following is not part of the demand for a NIEO?

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a. the establishment of international commodity agreements b. preferential access for the manufactured exports of developed nations c. removal of the agricultural trade barriers in developed nations d. increasing the yearly flow of foreign aid to developing nations Ans: b Level: Medium Heading: Problems Facing Developing Counties

16. During the 1950’s, 1960’s and 1970’s the predominant growth strategy for developing nations was one of a. import substitution b. export orientation c. communism d. none of the above Ans: a Level: Easy Heading: Import Substitution versus Export Orientation

17. The terms of trade for most developing nations over the last thirty years have generally been a. improving b. about the same c. worsening d. depend largely on the export commodity Ans: d Level: Medium Heading: The Terms of Trade and Economic Development

18. The primary exports of developing nations tend to face demand that is _______ and supply that is _______. a. elastic; elastic b. inelastic; inelastic c. elastic; inelastic d. inelastic; elastic Ans: b Level: Medium Heading: Export Instability and Economic Development

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19. The following is not an example of an international commodity agreement. a. marketing boards b. buffer stocks c. export controls d. purchase contracts Ans: a Level: Medium Heading: Export Instability and Economic Development

20. The following region of the world has been the least successful in creating economic development and growth over the last thirty years a. Latin America b. Asia c. Africa d. Europe Ans: c Level: Easy Heading: Import Substitution versus Export Orientation 21. If the income elasticity of a good is positive but less than 1, as income increases a. demand for the good will decrease. b. demand for the good will increase, but less than proportionately to the income increase. c. demand for the good will increase, but more than proportionately to the income increase. d. demand will not change.

Ans: b Level: Medium Heading: The Importance of Trade to Development 22. In most developing countries, import substitution policies have resulted in a. optimal use of excess supplies of labor. b. industries that are over-capitalized. c. rapid economic growth. d. more rapid growth than export-oriented policies.

Ans: b Level: Medium Heading: Import Substitution versus Export Orientation

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23. In the 2000s, the most rapid rate of economic growth has been observed in a. b. c. d.

rich countries. globalizers. nonglobalizers.

Rate of growth have been roughly equivalent among all groups.

Ans: b Level: Easy Heading: Import Substitution versus Export Orientation

Short Answer

24. Explain why international trade cannot be expected to be the primary engine of growth for today’s developing nations.

Ans: The supply and demand conditions are unfavorable. In many cases, the terms of trade are worsening. The supply and demand inelasticity associated with primary commodities leads to price instability.

Level: Medium Heading: The Terms of Trade and Economic Development

25. What is the difference between import substitution and export orientation?

Ans: Import substitution is a strategy of self-sufficiency. The goal is to develop national industries in order to minimize dependence on imports from other nations. Export orientation involves focusing on comparative advantages and embracing international trade.

Level: Easy Heading: Import Substitution versus Export Orientation

26. List the current problems facing developing countries?

Ans: Extreme poverty, particularly in Sub-Saharan Africa; unsustainable foreign debt; protectionism by developed nations against developing nations exports.

Level: Medium Heading: Current Problems Facing Developing Countries

27. List four of the Millennium Development Goals.

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Ans: Halve extreme poverty and hunger relative to 1990; achieve universal education; promote gender equality; reduce child mortality; improve maternal health; combat HIV/AIDS and other disease; ensure environmental sustainability; establish a global partnership for development Level: Medium Heading: Current Problems Facing Developing Countries 28. Explain why import substitution strategies have largely been less than successful.

Ans: High rates of effective protection have led to negative value added. Heavy subsidization of industries has led to overcapitalized industries and little labor absorption. Focus on these industries has diverted resources from primary industries, such as agriculture.

Level: Hard Heading: Import Substitution versus Export Orientation

Essay 29. (a) Why did large developing nations generally follow a policy of import substitution as a strategy for growth during the 1950s, 1960s, and 1970s? Why was this not generally possible for small developing nations? (b) Why was the policy of import substitution generally a failure?

Ans: (a) Large developing nations generally followed a policy of import substitution during the 1950s, 1960s, and 1960s because their large domestic market allowed them to reap many of the benefits economies of scale in production even without international trade. On the other hand, small developing nations generally did not have the choice of industrializing through import substitution because their small domestic market would have made production costs unacceptably high. (b) The policy of import substitution was generally a failure even in large developing nations because once protection was granted to a domestic industry in order to encourage it establishment and growth, it becomes practically impossible to remove the protection. This led to inefficiencies and higher costs in the developing country even for unprotected industries that use the output of protected industries as intermediate products or inputs in their production processes.

Level: Medium Heading: Import Substitution versus Export Orientation 30. Why did developing nations that switched from a policy of import substitution to a policy of export promotion generally grow faster during the past decade?

Ans: The developing countries that switched from a policy of import substitution to export promotion generally grew faster than those developing countries that did not make that switch because production for export and international competition stimulated efficiency throughout the economy and resulted in domestic prices more closely reflecting the true opportunity costs of commodities and inputs.

Level: Medium

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Heading: Import Substitution versus Export Orientation

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File: c12; Chapter 12: International Resource Movements and Multinational Corporations

Multiple Choice

1. Portfolio investments refer primarily to: a. direct investments b. bonds c. liquid assets d. short-term assets Ans: b Level: Easy Heading: Introduction

2. Direct investments usually involve the transfer of all of the above except: a. capital b. technology c. management d. bonds Ans: d Level: Easy Heading: Introduction

3. Which of the following is not true with regard to direct investments? a. U.S. direct investments abroad and foreign direct investments in the U.S. grew very rapidly from 1950 to 2004 b. the amount of U.S. direct investments abroad is similar to the amount of foreign direct investments in the U.S. c. U.S. direct investments in Canada are higher than in Europe d. U.S. private holdings of foreign long-term securities grew very rapidly from 1950 to 2004 Ans: c Level: Medium Heading: Some Data on International Capital Flows

4. Two-way international capital flows can be explained by the desire to: a. earn higher yields abroad

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b. avoid tariffs c. diversify risks d. all of the above Ans: c Level: Easy Heading: Motives for International Capital Flows

5. Portfolio theory tells us that by investing in securities with yields that are inversely related over time: a. a given yield can be obtained at a smaller risk b. a higher yield can be obtained for the same level of risk c. a two-way capital flow may be required to achieve a balanced portfolio d. all of the above Ans: d Level: Medium Heading: Motives for International Capital Flows

6. The reason the residents of a nation do not borrow from other nations and themselves undertake real investments in their own nation is that: a. multinationals want to retain control over their own technology b. banks do not want to lend to foreigners c. vertical integration is not possible for foreigners d. multinationals want to avoid horizontal integration Ans: a Level: Medium Heading: Motives for International Capital Flows

7. Which is not a reason for private foreign direct investments? a. horizontal and vertical integration b. to maximize profits and diversify risks c. to stimulate development d. to avoid tariffs Ans: c Level: Medium Heading: Motives for International Capital Flows

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8. Which of the following is not a beneficial effect of direct investments on the investing country: a. the transfer of technology b. higher profits c. risk diversification d. avoids the possible loss of export markets Ans: a Level: Medium Heading: Welfare Effects of International Capital Flows

9. Foreign direct investment benefits the host nation because it: a. increases the K/L ration b. increases the productivity of labor c. increases per capita income d. all of the above Ans: d Level: Medium Heading: Welfare Effects of International Capital Flows

10. U.S. labor generally a. opposes U.S. investments abroad b. favors U.S. investments abroad c. is indifferent to U.S. investments abroad d. we cannot say without additional information Ans: a Level: Hard Heading: Welfare Effects of International Capital Flows

11. Labor in developing countries generally a. opposes an inflow of foreign direct investments from abroad b. favors an inflow of foreign direct investments from abroad c. is indifferent to foreign direct investments from abroad d. we cannot say without additional information Ans: b Level: Medium

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Heading: Welfare Effects of International Capital Flows

12. Owners of capital in developing countries generally a. oppose an inflow of foreign direct investments from abroad b. favor an inflow of foreign direct investments from abroad c. are indifferent to foreign direct investments from abroad d. we cannot say without additional information Ans: a Level: Hard Heading: Welfare Effects of International Capital Flows

13. The basic reason for the existence of MNC is the: a. competitive advantage of a global network of production and distribution. b. incentives provided by the investing nation c. incentives provided by the host nation d. imperfections of international capital markets Ans: a Level: Medium Heading: Multinational Corporations

14. Transfer pricing refers to: a. risk diversification b. the pricing of the technology transferred c. the artificial overpricing of components shipped to an affiliate in a higher tax nation d. portfolio theory Ans: c Level: Medium Heading: Multinational Corporations

15. The brain drain refers to the transfer of: a. technology from developed to developing nations b. skilled labor and professionals from developed to developing nations c. unskilled labor from developing to developed nations d. skilled labor and professionals from less advanced to more advanced nations

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Ans: d Level: Easy Heading: Motives for and Welfare Effects of International Labor

16. U.S. holdings of foreign long-term securities (stocks and bonds) have ________ over the last fifty years. a. decreased b. increased c. remained unchanged d. been volatile, at times increasing and at time decreasing Ans: b Level: Medium Heading: Some Data on International Capital Flows

17. Foreign holdings of U.S. long-term securities (stocks and bonds) have ________ over the last fifty a. decreased b. increased c. remained unchanged d. been volatile, at times increasing and at time decreasing Ans: b Level: Medium Heading: Some Data on International Capital Flows

18. Today’s multinational corporations account for roughly what percentage of world output a. 10% b. 25% c. 50% d. 75% Ans: b Level: Easy Heading: Multinational Corporation

19. In 2010 the percentage of Americans that were not born in the United States was roughly a. 5 %

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b. 12 ½ % c. 25 % d. 37 ½ % Ans: b Level: Easy Heading: Motives for and Welfare Effects of International Labor 20. The most prominent form of private international economic organization today is the a. European Union b. World Trade Organization c. multinational corporation d. individual investor Ans: c Level: Medium Heading: Multinational Corporations 21. Most foreign assets in the U.S. are ___________; most U.S. assets abroad are ________. a. direct investment; direct investment b. direct investment; foreign securities c. U.S. securities; direct investment d. U.S. securities; foreign securities Ans: d.

Level: Easy Heading: Some Data on International Capital Flows 22. Which of the following areas accounts for the largest amount of U.S. foreign direct investment? a. Asia and the Pacific b. Europe c. Latin America d. Canada Ans: b Level: Easy Heading: Some Data on International Capital Flows 23. International capital flows a. increase world social welfare. b. increase the welfare of the host country but not the investing country. c. increase the welfare of the investing country but not the host country. d. decrease world social welfare.

Ans: a

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Level: Medium Heading: Welfare Effects of International Capital Flows 24. The largest multinationals produce a. motor vehicles. b. petroleum. c. financial products. d. electronics.

Ans: b Level: Medium Heading: Multinational Corporations Short Answer

25. What are the basic motives for international portfolio investments?

Ans: Yield maximization and risk diversification Level: Easy Heading: Introduction

26. Discuss the changes in the magnitude of foreign investment into the U.S. and U.S. investment overseas over the last fifty years.

Ans: Both the U.S. and foreigners hold far more of each others assets today than they did fifty years ago. The increase of foreign ownership of U.S. assets has increased much faster than the U.S.’s increase in ownership of foreign assets. This difference in these rates explains the U.S.’s growing trade deficit.

Level: Medium Heading: Some Data on International Capital Flows

27. What is vertical integration and how is it related to direct foreign investment?

Ans: Vertical integration occurs when a company owns the inputs and raw material necessary for production in their industry. Foreign direct investment can occur to gain control of ownership of such materials, ensuring an uninterrupted supply chain at the lowest possible cost.

Level: Medium Heading: Motives for Direct Foreign Investments

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28. Explain how international capital transfers impact employment in the receiving and investing nation.

Ans: In the investing nation the relative share of income going to capital and the share going to labor falls, while the opposite is true in the receiving nation. As a result, the level of employment tends to fall in the investing nation and rise in the receiving nation.

Level: Hard Heading: Motives for and Welfare Effects of International Labor 29. What are the primary reasons for the existence of multinational corporations?

Ans: The basic reason is the competitive advantage of a global production and distribution network, due to horizontal and vertical integration. There are also advantages in flexibility and tax minimization.

Level: Medium Heading: Multinational Corporations

Essay 30. Discuss the motives for international labor migration.

Ans: International labor migration can occur for economic and non-economics reasons. Noneconomic migrations take place to political and religious oppression, as was the case when Europeans migrated to America in the 1800’s. Since World War II, most migration is for economic reasons. The decision to migrate is similar to any other investment decision; it involves costs and benefits which must be against one another. Immigration tends to reduce wages in the nation that labor is migrating to and raise wages in the nation that the labor is leaving, ultimately putting pressure on factor (labor) prices to equalization.

Level: Medium Heading: Motives for International Labor Migration

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File: c13; Chapter 13: Balance of Payments

Multiple Choice

1. Which of the following is false? a. A credit transaction leads to a payment from foreigners b. A debit transaction leads to a payment to foreigners c. A credit transaction is entered with a negative sign d. Double-entry bookkeeping refers to each transaction entered twice.

Ans: c Level: Easy Heading: Balance-of-Payments Accounting Principles

2. Which of the following is a debit? a. The export of goods b. The export of services c. Unilateral transfers given to foreigners d. Capital inflows Ans: c Level: Easy Heading: Balance-of-Payments Accounting Principles

3. Capital inflows: a. refer to an increase in foreign assets in the nation b. refer to a reduction in the nation's assets abroad c. lead to a payment from foreigners d. all of the above Ans: d Level: Medium Heading: Balance-of-Payments Accounting Principles

4. When a U.S. firm imports goods to be paid in three months the U.S. credits: a. the current account

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b. unilateral transfers c. financial account d. official reserves Ans: c Level: Medium Heading: The International Transactions of the United States

5. The receipt of an interest payment on a loan made by a U.S. commercial bank to a foreign resident is entered in the U.S. balance of payments as a: a. credit in the financial account b. credit in the current account c. credit in official reserves d. debit in unilateral transfers Ans: b Level: Medium Heading: The International Transactions of the United States

6. The payment of a dividend by an American company to a foreign stockholder represents: a. a debit in the U.S. financial account b. a credit in the U.S. financial account c. a credit in the U.S. official reserve account d. a debit in the U.S. current account Ans: d Level: Medium Heading: The International Transactions of the United States

7. When a U.S. firm imports a good from England a pays for it by drawing on its pound sterling balances in a London Bank, the U.S. debits its current account and credits its: a. official reserve account b. unilateral transfers account c. services in its current account d. financial account Ans: d Level: Hard Heading: Accounting Balances and the Balance of Payments

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8. When the U.S. ships food aid to a developing nation, the U.S. debits: a. unilateral transfers b. services c. financial account d. official reserves Ans: a Level: Medium Heading: Accounting Balances and the Balance of Payments

9. When the resident of a foreign nation (1) sells a U.S. stock and (2) deposits the proceeds in a U.S. bank, the U.S.: a. credits financial for (1) and debits financial for (2) b. credits the current account and debits financial c. debits financial and credits official reserves d. debits financial for (1) and credits financial for (2) Ans: d Level: Heading: Accounting Balances and the Balance of Payments

10. When a U.S. resident (1) purchases foreign treasury bills and pays by (2) drawing down his bank balances abroad, the U.S.: a. debits short-term financial and credits official reserves b. debits capital for (1) and credits capital for (2) c. debits official reserves and credits capital d. credits short-term capital and debits official reserves Ans: b Level: Hard Heading: Accounting Balances and the Balance of Payments

11. From the U.S. point of view, drawing on (reducing) foreign bank balances in a New York bank represents a: a. capital inflow b. capital outflow c. outflow of official reserves d. debit in the current account

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Ans: b Level: Hard Heading: Accounting Balances and the Balance of Payments

12. Which is not an official reserve asset of the U.S.? a. U.S. holdings of Special Drawing Rights b. The U.S. reserve position in the International Monetary Fund c. Foreign official holdings of U.S. dollars d. Official holdings of foreign currencies by U.S. monetary authorities Ans: c Level: Medium Heading: The International Transactions of the United States

13. The financial account of the U.S. includes: a. the change in U.S. assets abroad and foreign assets in the U.S. b. the change in U.S. assets abroad and foreign assets in the U.S., other than official reserve assets c. all financial assets d. all but current account transactions Ans: b Level: Medium Heading: The International Transactions of the United States

14. Accommodating items are: a. transactions in official reserve assets b. the items below the line c. needed to balance international transactions d. all of the above Ans: d Level: Easy Heading: Accounting Balances and the Balance of Payments

15. Which of the following is false?

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a. a net debit balance in the current and capital accounts measures the surplus in the nation's balance of payments b. a balance of payments deficit must be settled by a net credit in the official reserve account c. a deficit in the balance of payments can be measured by the excess of credits over debits in the official reserve account d. a net debit balance in the official reserve account refers to a surplus Ans: a Level: Medium Heading: Accounting Balances and the Balance of Payments

16. Over the last fifty years the current account balance of the Untied States has a. been deteriorating b. been improving c. remained roughly the same d. always been in balance Ans: a Level: Easy Heading: The Postwar Balance of Payment of the United States

17. The largest trading partner of the United States is a. Mexico b. China c. Japan d. Canada Ans: d Level: Easy Heading: The Postwar Balance of Payment of the United States

18. Which of the following is NOT an explanation for the growth of the trade deficit in the United States over the last thirty years a. the rising price of oil in the 1970’s b. the rising value of the dollar in the 1980’s c. the higher growth rate of the U.S. in the 1990’s d. The lower levels of protectionist policies in the 1990’s Ans: d Level: Medium

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Heading: The Postwar Balance of Payment of the United States

19. The international investment position of a nation measures a. the current account minus the financial account b. the current account plus the financial account c. the total assets owned abroad minus the domestic assets owned by foreigners d. the total assets owned abroad plus the domestic assets owned by foreigners Ans: c Level: Medium Heading: The International Investment Position of the United States

20. In the 1960’s the international investment position of the United States was ______ and today the international investment position of the United States is a. positive; positive b. negative; negative c. positive; negative d. negative; positive Ans: c Level: Easy Heading: The International Investment Position of the United States 21. A French investor sells $200,000 worth of stock in a U.S. company and puts the proceeds into a bank in the United States. In the U.S. balance of payments, the sale of stock is recorded as a ______ to the ________ account; the bank deposit is recorded as a a ______ to the ________ account. a. b. c. d.

credit, financial; debit, financial. debit, financial; credit, financial. credit, financial; debit, current. debit, financial; debit, current.

Ans: b Level: Hard Heading: Balance-of-Payments Accounting Principles 22. The U.S. government gives $1,000,000 to Somalia. In the U.S. balance of payments, the gift of funds is recorded as a ______ to the ________ account. and as a ______ to the ________ account. a. debit, current; there is no offsetting transaction because it is a gift. b. debit, financial; credit, current.

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c. credit, financial; debit, current. d. debit, current; credit, financial.

Ans: d Level: Hard Heading: Balance-of-Payments Accounting Principles

Short Answer

23. Carefully define the balance of payments.

Ans: The balance of payments is a summary statement of the transactions one nation has with the rest of the world during a particular period of time, usually one year.

Level: Easy Heading: Introduction

24. What is meant by autonomous transactions?

Ans: Autonomous transactions are all transaction in the current, capital, and financial accounts other than official reserve assets recorded within the balance of payments.

Level: Medium Heading: Accounting Balances and the Balance of Payments

25. What is the difference between a credit transaction and a debit transaction in the balance of payments?

Ans: Credit transactions involve a receipt of payment from foreigners and debit transactions involve the making of payment to a foreigner. For example, the purchase of an import would be recorded as a debit in the current account and the sale of an export would be recorded as a credit in the current account. Similarly, the purchase of a foreign asset would be recorded as a debit in the financial account and the sale of an asset to a foreigner would be recorded as a credit in the financial account.

26. What is the international investment position and how has it changed for the United States over the last fifty years.

Ans: The international investment position of a nation measure the total assets owned abroad minus the domestic assets owned by foreigners at the end of any given year. In the 1960’s the

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United States was a net creditor to the rest of the world. By the 1970’s the United States became a net debtor and has continued so since.

Level: Medium Heading: The International Investment Position of the United States Problems 27. For the following set of international transactions with the United States, indicate in what specific category and account in the United States balance of payments each transaction would be included and whether it is a credit or debit.

A U.S. citizen receives dividends on German stock, and puts the funds into a German bank account.

Ans: Receipt of dividends: credit to net investment in the current account.

German bank account: debit to the financial account Level: Medium Heading: Balance-of-Payments Accounting Principles 28. For the following set of international transactions with the United States, indicate in what specific category and account in the United States balance of payments each transaction would be included and whether it is a credit or debit.

Kodak, a U.S. company, sells photographic film in Europe and receives 50,000 euros in exchange.

Ans: Sale of film: credit to exports in the current account.

Receipt of euros: debit to the financial account (currency) Level: Medium Heading: Balance-of-Payments Accounting Principles 29. For the following set of international transactions with the United States, indicate in what specific category and account in the United States balance of payments each transaction would be included and whether it is a credit or debit.

Kodak exchanges € 50,000 received from export sales for dollars at the Federal Reserve bank of New York.

Ans: Exchange of funds: debit to the financial account Credit to official settlements balance for the increase in euro holdings by the NY Fed. Level: Hard Heading: Balance-of-Payments Accounting Principles

Essay

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30. (a) If, for every debit or credit in the balance of payments, an offsetting credit or debit, respectively, of an equal amount is entered, how can a nation have a deficit or a surplus in the balance of payments? (b) How is a deficit of a surplus in the balance of payments measured? (c) Why are the concepts and measurement of deficit or surplus not appropriate under a flexible exchange rate system? (d) What is the difference between a disequilibrium and a deficit in the balance of payments?

Ans: (a) We have seen that because of double-entry bookkeeping, total credits always equal total debits when the three accounts are summed (including the allocation of SDRs and the statistical discrepancy). However, the deficit or surplus is measured by summing all items in the balance of payments except those in the nation's official reserve account. Only if the net balance on the nation's official reserve account was zero would the nations' balance of payments be in equilibrium. (b) If total debits exceed total credits in the current and capital accounts (including the statistical discrepancy), the net debit balance measures the deficit in the nation’s balance of payments. The deficit must be settled (under a fixed exchange rate system) with an equal net credit balance in the official reserve account. On the other hand, if total credits exceed total debits in the current and capital accounts (and the statistical discrepancy), the net credit balance measures the surplus in the nation's balance of payments. This surplus must be settled (under a fixed exchange rate system) with an equal net debit balance in the official reserve account.

All transactions in the current and capital accounts are called autonomous items because they take place for business or profit motive (except unilateral transfers) and are independent of balance of payments considerations. On the other hand, the items in the official reserve account are called accommodating items because they result from and are needed to balance international transactions. Thus, a deficit in a nation's balance of payments is given either by the net debit balance in the nation's autonomous items or by an equal net credit balance in the nation's accommodating items. The opposite is true for a surplus. (c) The concept and measurement of deficit or surplus in the balance of payments are not very appropriate under a freely flexible exchange rate system because of the tendency for a deficit to occur would be prevented by a depreciation of the nation's currency. Under a managed floating exchange rate system, part of the deficit would be corrected by a depreciation of the nations' currency and part would be financed by a net credit balance in the nation's official reserve account. (d) A disequilibrium refers to an actual or potential deficit. A nation has a potential deficit whenever it imposes import or other restrictions specifically designed to suppress an actual or open deficit. Then the nation is also in disequilibrium.

Level: Medium Heading: Balance-of-Payments Accounting Principles

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File: c14; Chapter 14: Foreign Exchange Markets and Exchange Rates

Multiple Choice

1. Which is not a function of the foreign exchange market? a. to transfer funds from one nation to another b. to finance trade c. to diversify risks d. to provide the facilities for hedging Ans: c Level: Easy Heading: Functions of the Foreign Exchange Market

2. An increase in the pound price of the dollar represents: a. an appreciation of the dollar b. a depreciation of the dollar c. an appreciation of the pound d. a devaluation of the dollar Ans: a Level: Easy Heading: Foreign Exchange Rates

3. A change from $1=€1 to $2=€1 represents a. depreciation of the dollar b. an appreciation of the dollar c. a depreciation of the pound d. none of the above Ans: a Level: Easy Heading: Foreign Exchange Rates

4. A shortage of pounds under a flexible exchange rate system results in: a. a depreciation of the pound

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b. a depreciation of the dollar c. an appreciation of the dollar d. no change in the exchange rate Ans: b Level: Medium Heading: Foreign Exchange Rates

5. An effective exchange rate is a: a. spot rate b. forward rate c. flexible exchange rates d. weighted average of the exchange rates between the domestic currency and the nation's most important trade partners Ans: d Level: Medium Heading: Foreign Exchange Rates

6. The exchange rate is kept within narrow limits in different monetary centers by: a. hedging b. exchange arbitrage c. interest arbitrage d. speculation Ans: b Level: Medium Heading: Foreign Exchange Rates

7. If SR=$1/€1 and the three-month FR=$0.99/€1: a. the euro is at a three-month forward discount of 1% b. the euro is at a forward discount of 1% per year c. the euro is at a three-month forward premium of 1% d. the dollar is at a three-month forward discount of 1% Ans: a Level: Easy Heading: Spot and Forward Rates, Currency Swaps, Futures, and Options

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8. Hedging refers to: a. the acceptance of a foreign exchange risk b. the covering of a foreign exchange risk c. foreign exchange speculation d. foreign exchange arbitrage Ans: b Level: Easy Heading: Foreign Exchange Risks, Hedging and Speculation

9. A U.S. importer scheduled to make a payment of €100,000 in three months can hedge his foreign exchange risk by: a. purchasing $100,000 in the forward market for delivery in three months b. selling €100,000 in the spot market for delivery in three months c. purchasing €100,000 in the forward market for delivery in three months d. selling €100,000 in the spot market for delivery in three months Ans: c Level: Easy Heading: Foreign Exchange Risks, Hedging and Speculation

10. If the three-month FR=$1/€1, and a speculator anticipates that SR=$1.02/€1 in three months, he can earn a profit by: a. selling euros forward b. purchasing euros forward c. selling dollars forward d. purchasing dollars forward Ans: b Level: Medium Heading: Foreign Exchange Risks, Hedging and Speculation

11. Destabilizing speculation refers to the: a. sale of the foreign currency when the exchange rate falls or is low b. purchase of the foreign currency when the exchange rate falls or is low c. sale of the foreign currency when the exchange rate rises or is high d. all of the above Ans: a

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Level: Medium Heading: Foreign Exchange Risks, Hedging and Speculation

12. A capital outflow from New York to Frankfurt under covered interest arbitrage can take place if the interest differential in favor of Frankfurt is: a. smaller than the forward discount on the euro b. equal to the forward discount on the euro c. larger than the forward discount on the euro d. none of the above Ans: c Level: Hard Heading: Interest Arbitrage and the Efficiency of Foreign Exchange Markets

13. According to the theory of covered interest arbitrage, if the interest differential in favor of the foreign country exceeds the forward discount on the foreign currency, there will be a: a. capital inflow under covered interest arbitrage b. capital outflow under covered interest arbitrage c. no capital flow under a covered interest arbitrage d. any of the above Ans: b Level: Hard Heading: Interest Arbitrage and the Efficiency of Foreign Exchange Markets

14. When the interest differential in favor of the foreign country is equal to the forward premium on the foreign currency, we: a. are at covered interest arbitrage parity b. are not at covered interest arbitrage parity c. may or may not be at covered interest arbitrage parity d. cannot say without additional information Ans: b Level: Hard Heading: Interest Arbitrage and the Efficiency of Foreign Exchange Markets

15. The currency of the nation with the lower interest rate is usually at a a. forward premium

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b. forward discount c. covered interest arbitrage parity d. any of the above Ans: a Level: Medium Heading: Interest Arbitrage and the Efficiency of Foreign Exchange Markets

16. Commercial bank deposits outside the country of their issue are commonly referred to as a. reserve deposits b. Eurocurrency c. foreign deposits d. exchange deposits Ans: b Level: Easy Heading: Eurocurrency or Offshore Financial Markets

17. Which of the following is NOT a reason for the smaller interest rate spread in Eurocurrency markets a. the absence of legal reserve requirements b. lack of competition for deposits c. economies of scale d. risk diversification Ans: b Level: Medium Heading: Eurocurrency or Offshore Financial Markets

18. Spot currency transactions must settle within a. two business days b. one week c. one month d. one year Ans: a Level: Easy Heading: Spot and Forward Rates, Currency Swaps, Futures, and Options

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19. The spot sale of a currency combined with a forward repurchase of the same currency is a a. stop gap transaction b. forward discount transaction c. premium transaction d. currency swap Ans: d Level: Medium Heading: Spot and Forward Rates, Currency Swaps, Futures, and Options 20. The opposite of hedging is a. speculation b. interest arbitrage c. holding d. none of the above Ans: a Level: Easy Heading: Foreign Exchange Risks, Hedging and Speculation 21. Carry trade refers to a. covered interest arbitrage in the spot and forward markets. b. moving investment funds to countries in which there is less risk. c. borrowing low-yielding currencies and lending high-yielding currencies. d. exporting to one country and importing from another.

Ans: c Level: Medium Heading: Interest Arbitrage and the Efficiency of Foreign Exchange Markets 22. Most activity in the foreign exchange market consists of a. spot transactions and foreign exchange swaps b. currency swaps. c. options. d. futures.

Ans: a Level: Easy Heading: Spot and Forward Rates, Currency Swaps, Futures, and Options Short Answer

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23. What is the principle function of foreign exchange markets?

Ans: The principle function is to transfer purchasing power from one nation and currency to another. The supply and demand of/for foreign arises because of the desire to import/export goods, services and investment assets.

Level: Easy Heading: Functions of the Foreign Exchange Markets 24. What is arbitrage and how does it impact the exchange rate across foreign exchange markets?

Ans: Arbitrage is the purchase of a currency in a low price market followed by the sale of that currency in a higher price market in order to make a profit. The act of buying in low price markets raise the price and the act of selling in high price markets lowers the price, ensuring that the any given exchange rate will driven toward the same rate across all foreign exchange markets.

Level: Easy Heading: Foreign Exchange Rates 25. Discuss the reasons for the existence and growth of Eurocurrency markets Ans: The higher interest rates paid on Eurocurrency deposits; the convenience Eurocurrency markets provide international corporations; the ability to escape national monetary controls.

Level: Medium Heading: Eurocurrency or Offshore Financial Markets 26. How does covered interest arbitrage create efficiency in foreign exchange markets?

Ans: Covered interest arbitrage refers to the spot purchase of a foreign currency to make an investment and the simultaneous forward sale of that same currency to eliminate exchange rate risk. The goal is to create a higher return without exchange rate risk exposure. The return on the arbitrage is the interest differential of the foreign money minus the forward market discount rate.

Participation in such interest arbitrage opportunities will eventually eliminate any net gain, at which point the markets are in interest parity. The market is efficient if the forward rate accurately predicts the future spot rate.

Level: Hard Heading: Interest Arbitrage and the Efficiency of Foreign Exchange Markets 27. Explain what carry trade is.

Ans: Carry trade refers to the borrowing of funds in low-yielding currencies and lending them in high-yielding currencies. For example, funds might be borrowed in a country with a low interest rate and lent in a country with a higher interest rate.

Level: Medium Heading: Interest Arbitrage and the Efficiency of Foreign Exchange Markets

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Problems 28. The U.S. interest rate is 2%. The U.K. interest rate is 2.25% The spot rate is 2.01 $/£, and the forward rate (for a 12 month contract) is 1.96 $/£ .

Does the covered interest arbitrage condition hold? If not, in which country would you be better off investing? Show how you know.

Ans: The interest rate differential is -0.25%. The pound is trading at a -0.2% forward discount.

You are better off investing in the UK. Level: Hard Heading: Interest Arbitrage and the Efficiency of Foreign Exchange Markets 29. The U.S. interest rate is 2%. The U.K. interest rate is 2.25% The spot rate is 2.01 $/£, and the forward rate (for a 12 month contract) is 1.96 $/£ .

What do you expect to happen to forward and spot rates? Explain carefully why this must happen.

Ans: The interest rate differential is -0.25%. The pound is trading at a -0.2% forward discount.

Since it is better to invest in the UK, the demand for pounds will increase, and thus spot rate will fall as the pound appreciates. The forward rate may also rise as investors wish to sell their pound earnings for dollars in the future. This will continue until the interest rate differential is equal to the forward premium or discount.

Level: Hard Heading: Interest Arbitrage and the Efficiency of Foreign Exchange Markets 30. (a) If the positive interest rate differential in favor of a foreign monetary center is 3 percent per year and the foreign currency is at a forward discount of 1 percent per year, roughly how much would an interest arbitrageur earn from the purchase of foreign three-month treasury bills if he covers the foreign exchange risk? (b) How much would an interest arbitrageur earn if the foreign currency were instead at a forward premium of 1 percent per year? (c) What would happen if the foreign currency were at a forward discount of 3 percent per year?

Ans: (a) The interest arbitrageur will earn 2% per year from the purchase of foreign three- month treasury bills if he covers the foreign exchange risk. (b) If the foreign currency was instead at a forward premium of 1 percent per year, the interest arbitrageur would earn 4% per year. (c) If the foreign currency was at a forward discount of 3 percent per year, it would pay for investors to transfer funds from the higher- to the lower-interest center and lose 2% interest but gain 3% from the foreign exchange transaction, for a net gain of 2% per year.

Level: Hard Heading: Interest Arbitrage and the Efficiency of Foreign Exchange Markets

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File: c15; Chapter 15: Exchange Rate Determination

Multiple Choice

1. Which is correct with respect to the absolute PPP theory? a. It postulates that the exchange rate between two currencies is equal to the ratio of the price levels in the two nations b. it does not take into consideration transportation costs or other obstructions to the flow of international trade c. can be very misleading d. all of the above Ans: d Level: Medium Heading: Purchasing Power Parity Theory

2. The relative purchasing power-parity theory postulates that: a. The equilibrium exchange rate is equal to the ratio of the price level in the two nations b. the change in the exchange rate over a period of time should be proportional to the relative change in the price level in the two nations over the same time period c. the change in the exchange rate over a period of time should be proportional to the absolute change in the price level in the two nations over the same time period d. the exchange rate at a period of time should be proportional to the relative prices in the two nations Ans: b Level: Medium Heading: Purchasing Power Parity Theory

3. The relative PPP theory gives better results: a. in the long run than in the short run b. when structural changes take place c. the greater is the level of commodity aggregation d. in tests including developed and developing countries Ans: a Level: Hard Heading: Purchasing Power Parity Theory

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4. The monetary approach to the balance of payments: a. views the balance of payments as an essentially monetary phenomenon b. rests on the purchasing power-parity theory c. postulates that money plays the crucial role in the long run both as a disturbance and adjustment in the nation's balance of payments d. all of the above Ans: d Level: Easy Heading: Monetary Approach to the Balance of Payments and Exchange Rates

5. If a nation's money GDP is 100 and the velocity of circulation of money is 4, the quantity demanded of money in the nation is: a. 20 b. 25 c. 50 d. 100 Ans: b Level: Medium Heading: Monetary Approach to the Balance of Payments and Exchange Rates

6. The monetary base of the nation refers to the: a. domestic credit created by the nation's monetary authorities or the domestic assets backing of the nation's money supply b. international reserves of the nation c. domestic credit created by the nation's monetary authorities or the domestic assets backing of the nation's money supply plus the international reserves of the nation d. legal reserve requirements in the nation Ans: c Level: Medium Heading: Monetary Approach to the Balance of Payments and Exchange Rates

7. If the legal reserve requirement of the nation is 25%, the money multiplier in the nation is: a. 2 b. 4

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c. 5 d. 6 Ans: b Level: Medium Heading: Monetary Approach to the Balance of Payments and Exchange Rates

8. According to the monetary approach to the balance of payments, a deficit in the nation's balance of payments results from: a. an excess in the nation's stock of money supply that is not eliminated or corrected by the nation's monetary authorities b. an excess in the stock of money demanded in the nation that is not satisfied by domestic monetary authorities c. an excess in the stock of money demanded in the other nation that is not satisfied by the other nation's monetary authorities d. an excess of imports over exports in the nation Ans: a Level: Hard Heading: Monetary Approach to the Balance of Payments and Exchange Rates

9. If the increase in a nation's money supply grows less rapidly than its GNP, the nation will face a: a. once-and-for-all balance of payments deficit b. once-and-for-all balance of payments surplus c. continuous balance of payments deficit d. continuous balance of payments surplus Ans: d Level: Medium Heading: Monetary Approach to the Balance of Payments and Exchange Rates

10. According to the monetary approach to the balance of payments a non-reserve currency nation: a. has no control over its money supply in the long-run under fixed exchange rates b. has no control over its money supply in the short-run under fixed exchange rates c. has no control over its money supply in the long-run under flexible exchange rates d. retains complete control over its money supply in the long-run Ans: a

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Level: Hard Heading: Monetary Approach to the Balance of Payments and Exchange Rates

11. According to the monetary approach to the balance of payments, a surplus nation will have to give up in the long-run its goal of: a. price stability b. fixed exchange rate c. price stability or fixed exchange rate d. price stability and fixed exchange rate Ans: c Level: Medium Heading: Monetary Approach to the Balance of Payments and Exchange Rates

12. Which of the following statements is true with respect to the monetary approach to the balance of payments: a. the interest differential in favor of the dollar equals the expected rate of appreciation of the euro b. the interest differential in favor of the dollar equals the expected rate of depreciation of the dollar c. the interest differential in favor of the pound equals the expected rate of depreciation of the pound d. all of the above Ans: d Level: Hard Heading: Monetary Approach to the Balance of Payments and Exchange Rates

13. The monetary approach assumes that the following assumption holds: a. domestic and foreign bonds are perfect substitutes b. covered interest arbitrage holds c. expectations do not affect the future spot exchange rate. d. the risk premium is positive Ans: a Level: Easy Heading: Monetary Approach to the Balance of Payments and Exchange Rates

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14. The portfolio balance approach: a. can be regarded as an extension of the monetary approach b. deals with money and other domestic and foreign financial assets c. can more readily be extended than the monetary approach to deals with the real sector d. all of the above Ans: d Level: Easy Heading: Portfolio Balance Model and Exchange Rates

15. According to the portfolio balance approach, an increase in the expected appreciation of the foreign currency leads domestic residents to increase: a the demand for domestic money b. the demand for the domestic bond c. the demand for the foreign bond d. the risk premium Ans: c Level: Medium Heading: Portfolio Balance Model and Exchange Rates

16. According to the portfolio balance approach, a reduction in the risk premium on the foreign bond leads domestic residents to increase the demand for the: a. domestic money b. domestic bond c. foreign bond d. all of the above Ans: c Level: Medium Heading: Portfolio Balance Model and Exchange Rates

17. According to the portfolio balance approach, an increase in domestic real income or GDP leads domestic residents to increase the demand for the: a domestic money b. domestic bond c. foreign bond d. all of the above

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Ans: a Level: Medium Heading: Portfolio Balance Model and Exchange Rates

18. According to the portfolio balance approach, an increase in domestic wealth leads domestic residents to increase the demand for the: a domestic money b. domestic bond c. foreign bond d. all of the above Ans: d Level: Easy Heading: Portfolio Balance Model and Exchange Rates

19. Which of the following is false with regard to exchange rate dynamics: a. seeks to explain exchange rate fluctuations over time b. results because the real sector adjusts instantaneously to disturbances c. in the short run, the exchange rate overshoots its long-run equilibrium d. results from the stock adjustment in financial assets Ans: b Level: Easy Heading: Exchange Rate Dynamics

20. An unexpected increase in the U.S. money supply leads to: a. an immediate reduction in the U.S. interest rate b. an immediate larger dollar depreciation c. a gradual appreciation of the dollar over time d. all of the above Ans: d Level: Medium Heading: Exchange Rate Dynamics 21. Since the creation of the euro, forecasts have a. accurately predicted changes in the euro. b. correctly predicted changes in the euro most of the time. c. not been used to chart movements in the euro. d. not been able to correctly chart movements in the euro.

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Ans: d Level: Medium Heading: Exchange Rate Dynamics 22. If the rate of inflation in the United States is 4% and the rate of inflation in the United Kingdom is 3%, relative purchasing power would predict that a. the pound will appreciate relative to the dollar. b. the pound will depreciate relative to the dollar. c. both the dollar and the pound will depreciate due to inflation. d. both the dollar and the pound will appreciate due to inflation.

Ans: a Level: Medium Heading: Purchasing Power Parity Theory 23. A Big Mac costs 6.60 lira in Turkey and $4.20 in the United States. If the actual exchange rate is 1.85 lire/dollar, the Turkish lira is _________, and U.S. tourists will find that Big Macs are _______ than in the United States. a. b. c. d.

overvalued, more expensive overvalued, less expensive undervalued, more expensive undervalued, less expensive

Ans: d Level: Hard Heading: Purchasing Power Parity Theory Short Answer 24. Explain the fundamental difference between modern exchange rate theories and traditional exchange rate theories.

Ans: Modern exchange rate theories, such as the monetary and asset market or portfolio balance approaches, view exchange rates as primarily a financial phenomenon, being driven by changes in relative money supplies and investment holdings. Traditional exchange rate theories view the exchange rate to be driven trade flows, with surplus nations eventually experiencing cu8rrency appreciation and visa versa.

Level: Medium Heading: Monetary Approach to the Balance of Payments and Exchange Rates 25. Explain absolute and relative purchasing power parity (PPP).

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Ans: Absolute PPP postulates that the exchange rate between two currencies is equal to the ration of the price levels, resulting in the same price for any given commodity across countries.

Relative PPP postulates that changes in the exchange rate will be proportional to relative changes in price.

Level: Easy Heading: Purchasing Power Parity Theory Problems 26. Suppose that the price level in the United States is 135 and the price level in Germany is 234. What would absolute purchasing power parity theory predict the dollar/euro exchange rate to be?

Ans: 135 = 235/R. R = 1.74 ($/€) Level: Medium Heading: Purchasing Power Parity Theory 27. If the United States rate of inflation is 2% and the German rate of inflation is 5%, what would relative purchasing power parity predict about the value of the euro relative to the dollar, all other things equal?

Ans: The euro would depreciate by 3% relative to the dollar.

Level: Medium Heading: Purchasing Power Parity Theory Essay 29. Discuss (a) the exchange dynamics of the dollar resulting from an unanticipated reduction of the U.S. money supply and (b) indicate the final long-run equilibrium interest rate, price index, and exchange rate as compared with the original equilibrium position.

Ans: (a) The unanticipated reduction in the U.S. money supply leads to an immediate increase in the U.S. interest rate and a magnified (i.e., a larger percentage) appreciation of the dollar. Over time, prices and interest rates in the United States all and the dollar depreciates so as to remove the excessive appreciation that took place at the time the U.S. money supply was reduced. (b) At the new long-run equilibrium level, the U.S. interest rate is the same as it was before the reduction of the U.S. money supply. The U.S. price index will be lower by the same percentage by which the U.S. money supply was reduced. The exchange rate will also be lower (i.e., the dollar will have appreciated) by the same percentage by which the U.S. money supply was reduced.

Level: Medium Heading: Monetary Approach to the Balance of Payments and Exchange Rates 30. What is the empirical evidence for the monetary and portfolio balance model of exchange rate determination?

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Ans: Initial papers by Frenkel (1976), Bilson (1978) and Dornbusch (1979) showed evidence in support of the monetary model during the 1920’s German hyperinflation and the 1970’s inflationary era. Since then, however, there is little evidence supporting the model, particularly in the short run. Less work has been done on the portfolio model and, in general, the work that has been done has failed to support the model.

Level: Hard Heading: Empirical Tests of the Monetary and Portfolio Balance Models and Exchange Rate Forecasting

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File: c17; Chapter 17: The Income Adjustment Mechanism and Synthesis Of Automatic Adjustments

Multiple Choice

1. In order to isolate the income adjustment mechanism, we assume that: a. the nation operates under a fixed exchange rate system b. all prices, wages, and interest rates are constant c. the nation operates at less than full employment d. all of the above Ans: d Level: Easy Heading: Introduction

2. The marginal propensity to consume measures: a. the ratio of imports to income b. the ratio of income to imports c. the change in imports over the change in income d. the change in income over the change in imports Ans: c Level: Easy Heading: Income Determination in a Closed Economy

3. The income elasticity of imports is given by: a. the percentage change in income over the percentage change in imports b. the change in imports over the change in income c. the marginal propensity to import over the average propensity to import d. the average propensity to import over the marginal propensity to import Ans: c Level: Medium Heading: Income Determination in a Small Open Economy

4. The equilibrium level of national income in an open economy is given by:

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a. I + X = S + M b. X - M = S - I c. I + (X-M) = S d. all of the above Ans: d Level: Easy Heading: Income Determination in a Closed Economy

5. If MPS=0.2 and MPM=0.3, the foreign trade multiplier is: a. 5 b. 3.3 c. 3 d. 2 Ans: d Level: Medium Heading: Income Determination in a Small Open Economy

6. When S exceeds I, an open economy has a trade: a. surplus b. deficit c. equilibrium d. any of the above Ans: a Level: Easy Heading: Income Determination in a Small Open Economy

7. The S-I function is upward sloping because: a. rising I are subtracted from constant S b. constant I are subtracted from rising S c. rising I are subtracted from rising S d. constant I are added to falling S Ans: b Level: Medium Heading: Income Determination in a Small Open Economy

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8. An autonomous fall in M from a condition of equilibrium in national income and in the trade balance results in the nation's income: a. rising and its trade balance turning to deficit b. falling and its trade balance turning into surplus c. rising and its trade balance turning into surplus d. rising and the trade balance remaining in equilibrium Ans: c Level: Hard Heading: Income Determination in a Small Open Economy

9. An autonomous increase in S from a condition of equilibrium in national income and in the trade balance results in the nation's income: a. rising and its trade balance turning into surplus b. falling and its trade balance turning into surplus c. falling and its trade balance turning into deficit d. rising and its trade balance turning into deficit Ans: b Level: Hard Heading: Income Determination in a Small Open Economy

10. The foreign trade multiplier of nation 1 is largest: a. when there are no foreign repercussions b. with foreign repercussions for an autonomous increase in nation 1's X that replace domestic production in nation 2 c. with foreign repercussions for an autonomous increase in I in nation 1 d. with foreign repercussions for an autonomous increase in I in nation 2 Ans: c Level: Medium Heading: Income Determination in a Small Open Economy

11. By itself, the automatic income adjustment mechanism is likely to bring about: a. incomplete adjustment b. complete adjustment c. perverse adjustment d. any of the above

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Ans: a Level: Medium Heading: Monetary Adjustments and Synthesis of the Automatic Adjustments

12. A depreciation of a deficit nation's currency from a condition of full employment: a. may improve the nation's trade balance b. will improve the nation's trade balance c. will leave the nation's trade balance unchanged d. will cause a deterioration in the nation's trade balance Ans: a Level: Easy Heading: Income Determination in a Small Open Economy

13. The improvement in a nation's balance of trade and payments resulting from a depreciation of its currency is: a. reinforced by the induced fall in imports b. partly neutralized by the induced rise in imports c. partly neutralized by the induced fall in imports d. any of the above.

Ans: b Level: Medium Heading: Income Determination in a Small Open Economy

14. In the real world, the automatic income, price, and interest adjustment mechanisms, if allowed to operate, are likely to: a. reinforce each other but still result in incomplete adjustment b. reinforce each other and result in complete adjustment c. work at cross purposes from each other and result in incomplete adjustment d. work at cross purposes from each other and result in perverse adjustment Ans: b Level: Medium Heading: Monetary Adjustments and Synthesis of the Automatic Adjustments

15. A benefit of automatic adjustment mechanisms is that they:

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a. avoid the possibility of policy mistakes b. avoid the time lags associated with adjustment policies c. begin to operate as soon as balance of payments disequilibria develop d. all of the above Ans: d Level: Medium Heading: Monetary Adjustments and Synthesis of the Automatic Adjustments

16. One disadvantage facing a freely flexible exchange rate system is that is can cause a. overshooting b. competitive devaluations c. hedging d. loss of monetary policy control Ans: a Level: Easy Heading: Monetary Adjustments and Synthesis of the Automatic Adjustments

17. When considering the impact of foreign repercussions relative to a scenario without such repercussions, for a large nation the foreign trade multiplier will be a larger b. smaller c. exactly the same d. any of the above Ans: b Level: Medium Heading: Foreign Repercussions

18. When considering the impact of foreign repercussions relative to a scenario without such repercussions, for a small nation the foreign trade multiplier will be a larger b. smaller c. exactly the same d. any of the above Ans: c Level: Medium Heading: Foreign Repercussions

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19. The United States current account deficit as a percentage of GDP has generally a. worsened in the 2000s b. improved in the 2000s c. remained relatively unchanged in the 2000s d. the U.S. has been running a current account surplus in the 2000s Ans: a Level: Easy Heading: Income Determination in a Small Open Economy

20. Of the G-7 industrialized economies, the following nation has the lowest income elasticity of imports a. The U.S. b. German c. Canada d. Japan Ans: d Level: Easy Heading: Income Determination in a Small Open Economy 21. If MPC=0.8 and MPM=0.05, the foreign trade multiplier is: a. 5 b. 4 c. 3 d. 2 Ans: b Level: Medium Heading: Income Determination in a Small Open Economy 22. . If MPC=0.8 and MPM=0.05, a $100 million increase in exports will lead to: a. a $400 million increase in equilibrium GDP. b. a $400 million decrease in equilibrium GDP. c. a $500 million increase in equilibrium GDP. d. a $500 million increase in equilibrium GDP. Ans: a Level: Medium Heading: Income Determination in a Small Open Economy

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23. In the Keynesian model, in short-run equilibrium, the trade balance must be a. positive. b. equal to zero. c. negative. d. could be positive, negative, or equal to zero.

Ans: d Level: Medium Heading: Income Determination in a Small Open Economy Short Answer 24. In what way does the automatic income adjustment mechanism differ from the traditional or classical adjustment mechanism?

Ans: The automatic income adjustment mechanism represents the application of Keynesian economics to open economies, while the traditional approach relied on price changes to bring about balance of payments adjustments.

Level: Easy Heading: Introduction

25. What are some of the disadvantages of a freely flexible exchange rate system with respect to the adjustment process?

Ans: The disadvantages may include overshooting and erratic fluctuations in exchange rates.

Such behavior interferes with the flow of trade and imposes costly adjustment burdens to patterns of specialization and resource allocation which may only be temporary in nature.

Level: Medium Heading: Monetary Adjustments and Synthesis of the Automatic Adjustments

26. Why is the foreign trade multiplier smaller than the corresponding multiplier in a closed economy?

Ans: the foreign trade multiplier is smaller than the corresponding multiplier in a closed economy because there is an additional to savings there is another domestic income leakage – the purchase of imports.

Level: Medium Heading: Income Determination in a Small Open Economy

27. Why is the foreign trade multiplier smaller in a large nation relative to small nation?

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Ans: When a large nation increases exports it implies that another nation must be increasing imports. An increase in imports by that nation may occur at the expense of domestic production, leading to a reduction in income and an decrease in imports, which impacts the large nation’s ability to sell exports.

Level: Hard Heading: Foreign Repercussions

28. According to the absorption approach, under what conditions will a competitive devaluation fail to reduce a balance of payments deficit?

Ans: When a nation is at full employment a devaluation will simply lead to an offsetting increase in the price level, leaving the deficit in tact. However, if real absorption (expenditures) is reduced through contractionary policy, only then is it possible to improve a balance of payments deficit under full employment conditions.

Level: Medium Heading: Absorption Approach Problems 29. An open economy can be described by the following functions (all figures in millions of dollars): C = 500 + 0.8Y I = 600 X = 400 M = 200 + 0.05Y Calculate equilibrium income and the trade balance.

Ans: Y= $5,200; (X-M) = 400 – 200 -0.05(5200) = -$60 (trade deficit) Level: Medium Heading: Income Determination in a Small Open Economy 30. In an open economy, the marginal propensity to consumer is 0.75, and the marginal propensity to import is 0.15. Calculate the change in equilibrium GDP if exports fall by $50 billion.

Ans: -$100 billion (=2*-50) Level: Medium Heading: Income Determination in a Small Open Economy

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File: c18; Chapter 18: Open-Economy Macroeconomics: Adjustment Policies

Multiple Choice

1. The most important economic objective of industrial nations is: a. external balance b. internal balance c. a reasonable rate of growth d. an equitable distribution of income Ans: b Level: Easy Heading: Introduction

2. In order to achieve internal and external balance simultaneously, a nation must usually use at least: a. one policy b. two policies c. three policies d. cannot say Ans: b Level: Easy Heading: Internal and External Balance with Expenditure-Changing and Expenditure-Switching Policies

3. Points below internal balance line YY in the Swan diagram indicate: a. a balance of payments deficit b. a balance of payments surplus c. unemployment d. inflation Ans: c Level: Medium Heading: Internal and External Balance with Expenditure-Changing and Expenditure-Switching Policies

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4. To correct a balance of payments deficit and unemployment a nation requires a: a. devaluation and expansionary fiscal and monetary policies b. devaluation and contractionary fiscal and monetary policies c. devaluation and either expansionary or contractionary fiscal and monetary policies d. revaluation and either expansionary or contractionary fiscal and monetary policies Ans: c Level: Medium Heading: Internal and External Balance with Expenditure-Changing and Expenditure-Switching Policies

5. To correct a balance of payments deficit and inflation a nation requires a: a. devaluation and expansionary fiscal and monetary policies b. devaluation and contractionary fiscal and monetary policies c. devaluation or revaluation and contractionary fiscal and monetary policies d. revaluation and either expansionary or contractionary fiscal and monetary policies Ans: c Level: Medium Heading: Internal and External Balance with Expenditure-Changing and Expenditure-Switching Policies

6. To correct a balance of payments surplus and unemployment a nation requires a: a. devaluation and expansionary fiscal and monetary policies b. devaluation and contractionary fiscal and monetary policies c. devaluation or revaluation and expansionary fiscal and monetary policies d. revaluation and either expansionary or contractionary fiscal and monetary policies Ans: c Level: Medium Heading: Internal and External Balance with Expenditure-Changing and Expenditure-Switching Policies

7. To correct a balance of payments surplus and inflation a nation requires a: a. devaluation and expansionary fiscal and monetary policies b. devaluation and contractionary fiscal and monetary policies c. devaluation and either expansionary or contractionary fiscal and monetary policies d. revaluation and either expansionary or contractionary fiscal and monetary policies

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Ans: c Level: Medium Heading: Internal and External Balance with Expenditure-Changing and Expenditure-Switching Policies

8. The IS curve is negatively sloped because: a. the higher is the rate of interest the smaller is the quantity of money demanded for speculative purposes b. higher rates of interest lead to greater capital flows c. at lower interest rates the levels of investment and national income are higher d. at lower interest rates the level of national income is lower Ans: c Level: Easy Heading: Equilibrium in the Goods Market, in the Money Market, and in the Balance of Payments

9. If the BP curve is above the point of intersection of the IS and LM curves, the nation will: a. have a balance of payments deficit at that level of income b. have a balance of payments surplus at that level of income c. be in recession d. face inflation Ans: a Level: Hard Heading: Equilibrium in the Goods Market, in the Money Market, and in the Balance of Payments

10. To correct unemployment from a condition of external balance, a nation will usually have to use: a. expansionary fiscal policy only b. easy monetary policy only c. expansionary fiscal policy and easy monetary policy d. expansionary fiscal policy and tight monetary policy Ans: d Level: Medium Heading: Fiscal and Monetary Policies for Internal and External Balance with Fixed Exchange Rates

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11. To achieve external balance and correct a recession, a nation will always have to use tight monetary policy if at the full employment level of national income the nation's BP curve is: a. above the LM curve b. below the LM curve c. steeper than the LM curve d. above the IS curve Ans: a Level: Hard Heading: Fiscal and Monetary Policies for Internal and External Balance with Fixed Exchange Rates 12. In a world of perfectly elastic international capital flows and fixed exchange rates: a. fiscal policy is completely ineffective b. monetary policy is completely ineffective c. both fiscal and monetary policies are completely ineffective d. both fiscal and monetary policies are effective Ans: b Level: Medium Heading: Fiscal and Monetary Policies for Internal and External Balance with Fixed Exchange Rates 13. To correct unemployment and a balance of payments deficits with flexible exchange rates and imperfect capital mobility: a. both fiscal and monetary policies are required b. fiscal policy is required c. monetary policy is required d. either monetary or fiscal policy is required Ans: d Level: Hard Heading: The IS-LM-BP model with Flexible Exchange Rates

14. To correct a balance of payments surplus and inflation a nation requires: a. expansionary fiscal policy and easy monetary policy b. contractionary fiscal policy and tight monetary policy c. contractionary fiscal policy and easy monetary policy d. expansionary fiscal policy and tight monetary fiscal policy Ans: c Level: Medium

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Heading: The IS-LM-BP model with Flexible Exchange Rates

15. To correct a balance of payments deficit and inflation a nation requires: a. contractionary fiscal policy and easy monetary policy b. contractionary fiscal policy and tight monetary policy c. expansionary fiscal policy and tight monetary policy d. any of the above depending on the level of inflation and the size of the initial deficit Ans: d Level: Hard Heading: The IS-LM-BP model with flexible Exchange Rates 16. Direct controls refer to: a. tariffs, quotas, and other quantitative restrictions on the flow of international trade b. restrictions on international capital flows c. multiple exchange rates d. all of the above Ans: d Level: Easy Heading: Direct Controls

17. The Mundell-Fleming model shows a How a nation can use fiscal and monetary policy to achieve both internal and external balance without any change in the exchange rate b. How a nation can use fiscal policy to achieve both internal and external balance without any change in the exchange rate c. How a nation can use monetary policy to achieve both internal and external balance with a corresponding change in the exchange rate d. How a nation can use fiscal policy to achieve both internal and external balance with a complementary change in the exchange rate Ans: a Level: Medium Heading: Equilibrium in the Goods Market, in the Money Market, and in the Balance of Payments

18. A nation can eliminate domestic unemployment and a balance of payments deficit while maintaining a fixed exchange rate through a. expansionary fiscal policy and expansionary monetary policy b. expansionary fiscal policy and contractionary monetary policy

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c. contractionary fiscal policy and expansionary monetary policy d. contractionary fiscal policy and contractionary monetary policy Ans: b Level: Hard Heading: Fiscal and Monetary Policies for Internal and External Balance with Fixed Exchange Rates 19. Over the last decade the U.S. budget deficit and the U.S. balance of payments deficit have moved a. in the same direction b. in opposite directions c. in the same direction some years and the opposite direction other years d. none of the above Ans: c Level: Medium Heading: Equilibrium in the Goods Market, in the Money Market, and in the Balance of Payments 20. Restrictions on capital exports is an example of a(n) a. exchange control b. trade control c. quota d. none of the above Ans: a Level: Easy Heading: Direct Controls 21. It is preferable to use monetary and fiscal policies rather than direct controls to correct external balance problems because direct controls a. are ineffective. b. are not legal under WTO rules. c. interfere with the market mechanism. d. cannot be used with other economic policies.

Ans: c Level: Medium Heading: Direct Controls

22. The LM curve is positively sloped because:

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a. at higher levels of income, the transactions demand for money is higher. b. higher rates of interest lead to lower capital flows c. at lower interest rates the levels of investment and national income are higher d. at lower interest rates the level of national income is higher Ans: a Level: Easy Heading: Equilibrium in the Goods Market, in the Money Market, and in the Balance of Payments

23. A nation can eliminate domestic overemployment and a balance of payments surplus while maintaining a fixed exchange rate through a. expansionary fiscal policy and expansionary monetary policy b. expansionary fiscal policy and contractionary monetary policy c. contractionary fiscal policy and expansionary monetary policy d. contractionary fiscal policy and contractionary monetary policy Ans: c Level: Hard Heading: Fiscal and Monetary Policies for Internal and External Balance with Fixed Exchange Rates

Short Answer

24.What are direct controls?

Ans: The two primary types of direct controls are trade controls and exchange controls. Trade controls include tariffs, quotas and other quantitative restrictions. Exchange controls involve the restriction of international capital flows and multiple exchange rates. All such controls can impact a nation’s balance of payments.

Level: Easy Heading: Direct Controls

25. Can a nation reach both internal and external balance under fixed exchange rates using only monetary policy? Explain.

Ans: No. Monetary policy alone cannot simultaneously achieve both objectives. Monetary policy will induce capital flow which must be countered with an offsetting fiscal policy response. Such policies, however, are likely to only be effective in the short-run.

Level: Medium

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Heading: Fiscal and Monetary Policies for Internal and External Balance with Fixed Exchange Rates

26. What is meant by a three market balance equilibrium?

Ans: A three market equilibrium occurs when the goods market, the money market, and the balance of payments are simultaneously in equilibrium. That is, the quantity of goods and services demanded equals their supply, the quantity of money demanded is equal to the money supply, and the trade deficit/surplus is matched by an equal capital inflow/outflow.

Level: Medium Heading: Equilibrium in the Goods Market, in the Money Market, and in the Balance of Payments Problems 27. Use graph to illustrate the effect of perfect capital mobility under fixed and flexible exchange rate regimes.

Ans: Graphs should resemble Figures 18.7 and 18.9 in the text, and must clearly make the point that with perfect capital flows, fiscal policy is effective with a fixed exchange rate regime, while monetary policy is effective with a flexible exchange rate regime.

Level: Hard Heading: Fiscal and Monetary Policies for Internal and External Balance with Fixed Exchange Rates, The IS-LM-BP Model with Flexible Exchange Rates 28. Use a Swan diagram to identify a point at which a nation has domestic unemployment and a trade surplus. What combination of policies should be used to restore balance?

Ans: Graph should be as Figure 18.1 in the text. Identified point must be leftward of the EE curve and below the YY curve. Restoring balance requires an increase in domestic expenditures; the exchange rate movement required depends on the point selected.

Level: Medium Heading: Internal and External Balance with Expenditure-Changing and Expenditure-Switching Policies Essay

29. Suppose a nation faces domestic unemployment and a surplus in its balance of payments. (a) Explain in detail the expenditure-changing policies required to cure the unemployment. (b) What would happen to the nation's external balance? Why?

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Ans: (a) Domestic unemployment can be corrected with expenditure- or demand-increasing policies. These refer to expansionary fiscal and monetary policies. Expansionary fiscal policy refers to an increase in government expenditures and/or a reduction in taxes. A reduction in taxes leads to an increase in consumption which, as for an increase in government expenditures, results in a multiple expansion in national income. On the other hand, easy monetary policy refers to an increase in the money supply and reduction in interest rates. These stimulate investment and also result in a multiple expansion of national income. (b) If domestic unemployment was accompanied by a surplus in the nation's balance of payments, the expansion in national income (to eliminate unemployment) induces a rise in imports, and the reduction in interest rates (from the easy monetary policy) may lead to a larger short-term capital outflow (or reduced inflow), both of which reduce the surplus. Sometimes the original surplus could even turn into a deficit. This is more likely to occur when the original surplus is small, unemployment is large (so that strongly expansionary fiscal and monetary policies are needed), the marginal propensity to import is high, domestic prices rise as the economy approaches full employment, and capital movements readily respond to the fall in the interest rate. Only rarely and by coincidence will the elimination of unemployment also lead to complete external balance.

Level: Hard Heading: Fiscal and Monetary Policies for Internal and External Balance with Fixed Exchange Rates

30. Explain why according to monetarists (a) nations retain control over their money supply under a flexible exchange rate system but not under a fixed exchange rate system, (b) nations could not sterilize continuous money outflows or inflows under a fixed exchange rate system in order to retain control over their money supply.

Ans: (a) According to monetarists, balance of payments disequilibria are corrected by exchange rate changes without any international flow of money or reserves under a flexible exchange rate system. Thus, the nation retains control over its money supply in the long run. For example, if a nation in balance of payments equilibrium increases its money supply (easy monetary policy), its currency would depreciate and absorb the excess supply of money, without any outflow of money or reserves from the nation. Thus, the increase in the nation's money supply would be retained in the nation. On the other hand, if the nation reduced its money supply (tight monetary policy), the excess demand for money would be eliminated by an appreciation of the nation's currency, without any inflow of money or reserves from the nation. As a result, the nation's attempt to reduce its money supply would succeed.

Under a fixed exchange rate system, the attempt of a nation to increase its money supply and conduct easy monetary policy would simply lead to an outflow of the excess supply of money in the long run, while a nation's attempt to reduce its supply of money and conduct tight monetary

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policy would simply lead to an outflow of money or reserves. As a result, non-reserve currency nations have little or no control over their money supply in the long run under a fixed exchange rate system. (b) A deficit nation could not sterilize continuous international money flows in the long run under a fixed exchange rate system because the nation would run out of international reserves.

On the other hand, a surplus nation would run out of domestic assets backing the nation's money supply. In the long run, a surplus nation would either have to give up its goal of domestic price stability or revalue its currency. This is, in fact, what happened in Germany during the 1960s, when the large inflow of reserves led to some domestic inflation and a revaluation of the mark in 1961 and 1969.

Level: Hard Heading: The IS-LM-BP Model with Flexible Exchange Rates

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File: c19; Chapter 19: Prices and Output in an Open Economy: Aggregate Demand and Aggregate Supply

Multiple Choice

1. In general, as the economy expands or contracts over the business cycle a. prices change rapidly b. prices remain unchanged except in a recession c. prices remain unchanged until the economy reaches full employment d. prices change, but slowly Ans: d Level: Easy Heading: Aggregate Demand, Aggregate Supply, and Equilibrium in a Closed Economy

2. The aggregate demand curve (AD) for closed economy is derived from the a. IS curve b. LM curve c. FE curve d. IS and LM curves Ans: d Level: Easy Heading: Aggregate Demand, Aggregate Supply, and Equilibrium in a Closed Economy

3. A reduction in the general price level with a constant money supply is shown by a a. leftward shift in the LM curve b. movement down along a given aggregate demand curve c. rightward shift in the aggregate supply curve d. a rightward shift in the IS curve Ans: b Level: Medium Heading: Aggregate Demand, Aggregate Supply, and Equilibrium in a Closed Economy

4. An increase in the money supply with constant prices leads to a

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a. leftward shift in the LM curve b. movement along a given aggregate demand curve c. rightward shift in the aggregate demand curve d. rightward shift in the IS curve Ans: c Level: Medium Heading: Aggregate Demand, Aggregate Supply, and Equilibrium in a Closed Economy

5. An increase in government expenditures leads to a. a rightward shift in the IS curve b. a rightward shift in the AD curve c. an increase in the level of national income d. all of the above Ans: d Level: Medium Heading: Aggregate Demand, Aggregate Supply, and Equilibrium in a Closed Economy

6. A nation's output in the short-run can a. exceed its natural level b. fall short of its natural level c. equal to its natural level d. any of the above Ans: d Level: Medium Heading: Aggregate Demand, Aggregate Supply, and Equilibrium in a Closed Economy

7. Which of the following statements is false? a. a nations' natural level of output can increase as a result of growth b. imperfection in product markets can lead to temporary deviations in a nation's output from its long-run natural level c. sticky wages cannot lead to temporary deviations in a nation's output from its long-run natural level d. none of the above Ans: c Level: Medium Heading: Aggregate Demand, Aggregate Supply, and Equilibrium in a Closed Economy

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8. Output in the short run exceeds the natural level of output if expected prices a. exceed actual prices b. are lower than actual prices c. are equal to actual prices d. any of the above Ans: a Level: Medium Heading: Aggregate Demand, Aggregate Supply, and Equilibrium in a Closed Economy

9. The aggregate demand curve (AD) for an open economy is derived from the a. IS curve b. LM curve c. BP curve d. all of the above Ans: d Level: Easy Heading: Aggregate Demand in an Open Economy under Fixed and Flexible Exchange Rates

10. The aggregate demand curve for an open economy under fixed exchange rates is a. less elastic than if the economy were closed b. more elastic than in the economy were closed c. more elastic than in the economy operated with flexible exchange rates d. all of the above Ans: b Level: Medium Heading: Aggregate Demand in an Open Economy under Fixed and Flexible Exchange Rates

11. An autonomous improvement in the nation's trade balance under fixed exchange rates will cause the nation's aggregate demand curve to a. shift to the right b. shift to the left c. remain unchanged d. any of the above

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Ans: a Level: Easy Heading: Effects of Economic Shocks and Macroeconomic Policies on Aggregate Demand in Open Economies with Flexible Prices

12. An autonomous short-term capital outflow under flexible exchange rates causes the nation's aggregate demand curve to a. shift to the right b. shift to the left c. remain unchanged d. any of the above Ans: a Level: Medium Heading: Effects of Economic Shocks and Macroeconomic Policies on Aggregate Demand in Open Economies with Flexible Prices

13. With high short-term international capital flows, fixed exchange rates, and flexible prices a. monetary policy is effective b. fiscal policy is effective c. both fiscal and monetary policies are effective d. neither fiscal policy nor monetary policies are effective Ans: b Level: Medium Heading: Aggregate Demand in an Open Economy under Fixed and Flexible Exchange Rates

14. Which of the following statements is false? a. expansionary fiscal or monetary policy can increase the nation's output temporarily above its natural level b. expansionary fiscal or monetary policy can used to correct a recession but only at the expense of higher prices in the nation c. a recession cannot be eliminated automatically even if domestic prices are flexible downward d. when prices are not flexible downward inflation may be less costly that recession Ans: c Level: Hard Heading: Macroeconomic Policy to Stimulate Growth and Adjust to Supply Shocks

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15. Which of the following statements is false with regard to the effect of macroeconomic policies? a. they generally cause shifts in the aggregate demand curve b. they can possibly increase long-run growth c. they can help correct supply shocks that increases production costs but only at the expense of even higher inflation d. they always cause shifts in the long-run aggregate supply curve Ans: d Level: Medium Heading: Macroeconomic Policy to Stimulate Growth and Adjust to Supply Shocks

16. The long run aggregate supply curve is a. independent of prices and is vertical at the nation’s natural rate of output b. dependent on prices and is vertical at the nation’s natural rate of output c. independent of prices and is horizontal at the nation’s natural rate of output d. dependent on prices and is horizontal at the nation’s natural rate of output Ans: a Level: Medium Heading: Introduction

17. An autonomous short term capital inflow or reduced capital outflow results in a a rightward shift in aggregate demand under flexible exchange rates and a leftward shift under fixed exchange rates b. rightward shift in aggregate demand under flexible exchange rates and no shift under fixed exchange rates c. leftward shift in aggregate demand under flexible exchange rates and a rightward shift under fixed exchange rates d. leftward shift in aggregate demand under flexible exchange rates and a no shift under fixed exchange rates Ans: c Level: Hard Heading: Effect of Fiscal and Monetary Policies in Open Economies with Flexible Prices

18. During the last decade the inflation rate in the U.S. has been roughly a. 0% b. 3%

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c. 5% d. 8% Ans: b Level: Easy Heading: Macroeconomic Policies to Stimulate Growth and Adjust to Supply Shocks

19. The correlation between the degree of central bank independence and average rate of inflation tends to be a. negative b. positive c. there is no correlation d. none of the above Ans: a Level: Easy Heading: Macroeconomic Policies to Stimulate Growth and Adjust to Supply Shocks

20. Stagflation is most likely to be caused by a. both a leftward shift in aggregate supply and a rightward shift in aggregate demand b. both a rightward shift in aggregate supply and a rightward shift in aggregate demand c. a leftward shift in aggregate supply d. a leftward shift in aggregate demand Ans: c Level: Medium Heading: Macroeconomic Policies to Stimulate Growth and Adjust to Supply Shocks 21. Inflation targeting refers to: a. central banks targeting a precise number for the inflation rate. b. central banks targeting a range for the inflation rate. c. fiscal policies that target a precise number for the inflation rate. d. fiscal policies that target a range for the inflation rate.

Ans: b Level: Easy Heading: Effect of Fiscal and Monetary Policies in Open Economies with Flexible Prices 22. Empirical evidence suggests which of the following about central bank independence and inflation rates? a. More independent central banks are associated with lower rates of inflation.

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b. More independent central banks are associated with constant rates of inflation. c. More independent central banks are associated with higher rates of inflation. d. There is no observable relationship between inflation rates and central bank independence.

Ans: a Level: Medium Heading: Effect of Fiscal and Monetary Policies in Open Economies with Flexible Prices 23. Which of the following is a correct statement about the effects of monetary and fiscal policies? a. Monetary policy is effective under a fixed exchange rate regime, but not under flexible rates. b. A monetary shock will shift the aggregate demand curve in the same direction, whether exchange rates are fixed or flexible. c. A real shock will shift the aggregate demand curve under fixed but not flexible exchange rates. d. Monetary policy can always be used to correct real shocks, whether exchange rates are fixed or flexible.

Ans: c Level: Hard Heading: Effect of Fiscal and Monetary Policies in Open Economies with Flexible Prices

Short Answer

24. What conditions lead to the stagflationary environment of the 1970s?

Ans: Stagflation in the 1970s was caused primarily by a negative aggregate supply shock due to rising oil prices.

Level: Easy Heading: Macroeconomic Policies to Stimulate Growth and Adjust to Supply Shocks

25. How does an increase in government expenditure impact aggregate demand?

Ans: An increase in government expenditure will shift aggregate demand to the right, putting pressure on prices and GDP to rise. Expansionary fiscal policy via increased spending and/or tax cuts will are examples of increased government expenditure.

Level: Easy Heading: Effects of Economic Shocks and Macroeconomic Policies on Aggregate Demand in Open Economies with Flexible Prices

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26. Why is monetary policy ineffective under a fixed exchange rate system?

Ans: The long-run exchange rate is essentially based on a the ratio of money supply relative to output between two nations. As such, any change in the money supply through expansionary or contractionary monetary policy will necessarily impact he exchange rate, which must be held constant under a fixed rate system.

Level: Medium Heading: Aggregate Demand in an Open Economy under Fixed and Flexible Exchange Rates

27. What is the natural level of output?

Ans: The natural level of output is where long-run aggregate supply equally aggregate demand. The natural rate of output is associated with full employment at the natural rate of unemployment.

Level: Easy Heading: Aggregate Demand, Aggregate Supply, and Equilibrium in a Closed Economy

28. Why does the ease of combating a recession with expansionary fiscal or monetary policy depend on how flexible prices are downward?

Ans: The easier prices fall the easier it is for short-run aggregate supply to increase and for the quantity of aggregate demand to increase until output is restored.

Level: Medium Heading: Macroeconomic Policies to Stimulate Growth and Adjust to Supply Shocks Essay 29. Suppose that the economy is in long-run equilibrium, and people in other countries suddenly decide to purchase fewer US goods. Explain the short-run effects on the US economy under both fixed and flexible exchange rates.

Ans: Under fixed exchange rates, aggregate demand will decrease, causing output and prices to decrease. The economy will be in a recession. Under flexible exchange rates, the decrease in demand for exports will cause the currency to depreciate, which offsets the decrease, and thus aggregate demand will not change. (Students should support answers with appropriate graphs.)

Level: Hard Heading: Effect of Fiscal and Monetary Policies in Open Economies with Flexible Prices

30. Suppose that the economy is in long-run equilibrium, and interest rates in the rest of the world rise. Explain the short-run effects on the US economy under fixed and flexible exchange rates.

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Ans: Under fixed exchange rates, there will be capital outflow, which will cause a decrease in aggregate demand. Thus output and prices will fall as the economy moves into a recession.

Under flexible exchange rates, the capital outflow will cause the currency to depreciate. As exports rise and imports fall, aggregate demand shifts rightward, causing output and prices to rise.

Level: Hard Heading: Effect of Fiscal and Monetary Policies in Open Economies with Flexible Prices

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File: c20; Chapter 20: Flexible Versus Fixed Exchange Rates, The European Monetary System, And Macroeconomic Policy Coordination

Multiple Choice

1. An alleged advantage of flexible over fixed exchange rates is: a. market efficiency b. stabilizing speculation c. price discipline d. all of the above Ans: a Level: Easy Heading: The Case for Flexible Exchange Rates

2. Flexible exchange rates: a. enhance the effectiveness of fiscal policy b. reduce the effectiveness of fiscal policy c. enhance the effectiveness of monetary policy d. reduce the effectiveness of monetary policy Ans: c Level: Easy Heading: The Case for Flexible Exchange Rates

3. Under a flexible as compared to a fixed exchange rate system: a. a nation can more easily achieve its desired inflation-unemployment tradeoff b. it is more difficult for a nation to achieve its desired inflation-unemployment tradeoff c. it is more difficult for a nation to achieve internal balance d. it is more difficult for a nation to achieve external balance Ans: a Level: Medium Heading: The Case for Flexible Exchange Rates

4. Everything else being the same, the volume of trade is likely to be:

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a. larger under a flexible than under a fixed exchange rate system b. larger under a fixed than under a flexible exchange rate system c. equal under a flexible and fixed exchange rate system d. any of the above Ans: b Level: Easy Heading: The Case for Fixed Exchange Rates

5. Most economists believe that under "normal conditions" speculation: a. is stabilizing b. is destabilizing c. is neither stabilizing nor destabilizing d. seldom occurs Ans: a Level: Easy Heading: The Case for Fixed Exchange Rates

6. Price discipline is: a. greater under a fixed than under a flexible exchange rate system b. greater under a flexible than under a fixed exchange rate system c. about the same under a fixed as under a flexible exchange rate system d. is unrelated to the type of exchange rate system Ans: a Level: Easy Heading: The Case for Fixed Exchange Rates

7. Which of the following statements is correct with respect to flexible exchange rates? a. they insulate the domestic economy from external shocks much more than fixed exchange rates b. they are particularly attractive to nations subject to large external shocks c. they provide less stability to an open economy subject to large internal shocks d. all of the above Ans: d Level: Medium Heading: The Case for Fixed Exchange Rates

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8. The formation of an optimum currency area is more likely to be beneficial: a. the smaller is the mobility of resource among the various nations of the optimum currency area b. the smaller the structural similarities of member nations are c. the more willing member nations to closely coordinate their fiscal, monetary, and other policies are d. all of the above Ans: c Level: Easy Heading: Optimum Currency Areas, the European Monetary System, and the European Monetary Union

9. The European Monetary System is or resembles a: a. fixed exchange rate system b. a managed exchange rate system c. a crawling peg system d. a freely flexible exchange rate system Ans: a Level: Heading: Optimum Currency Areas, the European Monetary System, and the European Monetary Union

10. The European Monetary Union: a. has a common currency b. has a single central bank c. conducts a common monetary policy d. all of the above Ans: d Level: Easy Heading: Optimum Currency Areas, the European Monetary System, and the European Monetary Union

11. If the band of allowed fluctuation under a fixed exchange rate system is made very wide, the system will resemble: a. a flexible exchange rate system

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b. the gold standard c. an adjustable peg d. a crawling peg Ans: a Level: Medium Heading: Exchange Rate Bands, Adjustable Pegs, Crawling Pegs, and Managed Floating

12. A fixed exchange rate system without a band of allowed fluctuation would require the nation's monetary authorities to intervene in the foreign exchange market: a. never b. seldom c. constantly d. we cannot say Ans: c Level: Medium Heading: Exchange Rate Bands, Adjustable Pegs, Crawling Pegs, and Managed Floating

13. The policy of changing par values by small preannounced amounts at frequent intervals until the equilibrium exchange rate is reached is called: a. crawling peg b. adjustable peg c. managed float d. dirty float Ans: a Level: Easy Heading: Exchange Rate Bands, Adjustable Pegs, Crawling Pegs, and Managed Floating

14. The policy of intervention in the foreign exchange market to smooth out short-run fluctuations in exchange rates is called: a. crawling peg b. adjustable peg c. leaning against the wind d. managed float Ans: c Level: Easy Heading: Exchange Rate Bands, Adjustable Pegs, Crawling Pegs, and Managed Floating

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15. International macroeconomic policy coordination has become more useful and essential in recent decades because: a. the interdependence among countries has increased b. the volume of trade has grown more rapidly than GNP c. of the large increase in international capital flows d. all of the above Ans: d Level: Easy Heading: International Macroeconomic Policy Coordination

16. The following established the conditions under which and European Union member nation could join the currency union: a. The Treaty of Rome b. The Single European Act c. The Maastricht Treaty d. The Treaty of Paris Ans: c Level: Easy Heading: Optimum Currency Areas, the European Monetary System, and the European Monetary Union

17. The most extreme form of an exchange rate peg is a a currency board b. flexible rate c. floating rate d. adjustable rate Ans: a Level: Easy Heading: Currency Board Arrangements and Dollarization

18. Which if the following is not a benefit of participation in the euro currency are a. elimination of the need to exchange currencies b. more rapid financial integration c. maintenance of independent monetary policy

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d. greater economic discipline Ans: c Level: Medium Heading: Currency Board Arrangements and Dollarization

19. Which of the following exchange rate systems is must susceptible to speculation attack? a. an adjustable peg b. a currency board c. a managed float d. a free float Ans: a Level: Medium Heading: Exchange Rate Bands, Adjustable Pegs, Crawling Pegs, and Managed Floating

20. International policy coordination may help avoid a. beggar-thy-neighbor policies b. competitive devaluations c. retaliatory behavior d. all of the above Ans: d Level: Easy Heading: International Macroeconomic Policy Coordination 21. The open economy trilemma is that: a. fiscal policies, monetary policies, and direct controls cannot manage all macroeconomic problems. b. a fixed exchange rate, unrestricted capital flows, and monetary independence cannot all be achieved at the same time. c. unrestricted capital flows cannot be achieved when fiscal and monetary policies are being implemented. d. monetary shocks, real shocks, and supply shocks all disturb long run macroeconomic equilibrium.

Ans: b Level: Medium Heading: The Case for Fixed Exchange Rates 22. A primary cause of the Eurozone Crisis has been a. excessive borrowing by weaker countries in the euro area. b. too rapid growth that has fueled inflation.

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c. the failure of some nations to join the Eurozone. d. recession in the United States, which caused a recession in Europe.

Ans: a Level: Medium Heading: Optimum Currency Areas, the European Monetary System, and the European Monetary Union 23. Most countries in the International Monetary Fund have which of the following currency arrangements? a. floating rates b. a hard peg c. a soft peg d. some other type of arrangement Ans: c Level: Medium Heading: Currency Board Arrangements and Dollarization Short Answer 24. What are the advantages of the adoption of the euro as common currency for the euro member nations?

Ans: Elimination of the need to exchange currencies; elimination of exchange rate volatility; more rapid financial integration; increased ability to practice expansionary monetary policy; greater economic discipline; seignorage from the use of the euro as an international currency Level: Medium Heading: Currency Board Arrangements and Dollarization

25. What is a currency board?

Ans: Currency boards are the most extreme for of exchange rate peg, short of adopting another nation’s currency (dollarization). The nation fixes the value of its currency to another – often by law – and fully backs it’s currency through 100% reserve backing. Such policy guarantees the nation can defend the value of its currency, but at the cost of giving up autonomy over its own ability to conduct independent monetary policy.

Level: Medium Heading: Currency Board Arrangements and Dollarization

26. Why is a flexible exchange rate system likely to be more efficient that a fixed exchange rate system?

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Ans: It relies on exchange rate adjustments, as opposed to internal price adjustments, to bring about balance of payments adjustments; it makes the adjustment process smooth and continuous; it clearly identifies competitive advantages for commodities across countries.

Level: Medium Heading: The Case for Flexible Rates

27. Under what conditions is the formation of an optimum currency area likely to be more beneficial?

Ans: An optimum currency area will be more beneficial with greater mobility of resources, greater structural similarities greater, and greater willingness to coordinate fiscal and monetary policies.

Level: Medium Heading: Optimum Currency Areas, the European Monetary System, and the European Monetary Union

Essay

28. Explain what are the benefits and costs for a European nation contemplating joining the European Monetary Union.

Ans: There are some major benefits that the nation can expect to get from joining the monetary union. The nation will no longer have to exchange its currency for that of the other union members and, of course, will no longer have to worry about exchange rate volatility or misalignments with respect to other members. The nation can expect greater and faster economic and financial integration with the other union members and to participate in deciding union wide monetary and other policies. The nation will also be able to undertake domestic policies that are important for its future growth and wellbeing, but which would be political impossible if the nation remained outside the union. The nation will also share in the seigniorage that results from issuing the currency, face lower borrowing costs, and share in the political importance of belonging to a large economic and monetary union.

The most serious problem resulting from joining the monetary union is that the nation will lose complete control over its money supply and exchange rates. As a result, in case of a recession, the nation cannot adopt an expansionary monetary policy and/or allow its currency to depreciate (so as to stimulate exports and discourage imports and thus stimulate domestic production). It is true that in a world of open capital markets, the nation would have limited monetary and exchange rate policy independence, but by joining the monetary union it loses all monetary and exchange rate policy independence. This is a serious shortcoming because labor mobility out of (ch20(1))

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the nation in recession and fiscal redistribution in favor of the nation n are very limited in the European Union as compared, for example, with the United States.

Level: Medium Heading: Optimum Currency Areas, the European Monetary System, and the European Monetary Union 29. Carefully explain the costs and benefits of a flexible exchange rate regime.

Ans: A freely floating exchange rate corrects balance of payments disequilibria as they occur. It relies on exchange rate adjustments, as opposed to internal price adjustments, to bring about balance of payments adjustments; it makes the adjustment process smooth and continuous; it clearly identifies competitive advantages for commodities across countries. It also helps to shield countries from the monetary excesses of other nations. Flexible rates increase the effectiveness of monetary policy and make it easier for countries to focus on internal balance.

However, flexible rates increase uncertainty for importers and exporters. Flexible rates are more prone to destabilizing speculation. There may be less price discipline.

Level: Medium Heading: The Case for Flexible Exchange Rates

30. Carefully explain the costs and benefits of a flexible exchange rate regime.

Ans: There is less uncertainty for importers and exporters, because the exchange rate does not change, and thus this may facilitate trade. Fixed rates are more likely to have stabilizing rather than destabilizing speculation, as long as the government is committed to the rate. Fixed rates impose price (and monetary) discipline on governments. However, fixed rates mean that nations cannot use monetary policy, and they must also focus policy on external balance as well as internal balance.

Level: Medium Heading: The Case for Fixed Exchange Rates

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File: c21; Chapter 21: The International Monetary System: Past, Present, and Future

Multiple Choice

1. Which of the following statements about the gold standard is not true? a. London was the undisputed center of international trade and finance b. International trade and international capital flows were mostly unrestricted c. International liquid capital flows were mostly stabilizing d. Countries were able to return to pre-war parities after World War I. Ans: d Level: Easy Heading: The Gold Standard and Interwar Experience

2. Balance of payments adjustment under the gold standard is now believed to have occurred primarily through: a. the price-specie-flow mechanism b. gold shipments c. stabilizing short-term capital flows and changes in national incomes d. free trade Ans: c Level: Medium Heading: The Gold Standard and Interwar Experience

3. The interwar period was characterized by: a. the operation of the gold standard b. chaotic conditions in international trade and finance c. free trade d. stabilizing international capital flows Ans: b Level: Medium Heading: The Gold Standard and Interwar Experience

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4. The Bretton Woods System was a: a. gold standard b. managed floating exchange rate system c. gold-exchange standard d. crawling peg system Ans: c Level: Easy Heading: The Bretton Woods System

5. On which of the following principles was the Bretton Woods System based on? a. Fixed exchange rates b. Currency convertibility c. Free trade d. All of the above Ans: d Level: Easy Heading: The Bretton Woods System

6. The Bretton Woods System: a. allowed nation to change their par values when facing fundamental disequilibrium b. allowed nations to change their par values when facing a temporary disequilibrium c. did not allow nations to change their par exchange rates under any circumstance d. allowed only deficit nations to change their par values, but not surplus nations Ans: a Level: Medium Heading: Operation and Evolution of the Bretton Woods System

7. Which of the following did not represent an evolution of the Bretton Woods System? a. General Arrangements to Borrow b. managed floating c. standby arrangements d. Special Drawing Rights

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Ans: b Level: Medium Heading: Operation and Evolution of the Bretton Woods System

8. Which of the following was a primary cause of the U.S. balance of payments deficits during the late 1960s? a. Capital outflows b. Domestic inflation c. Increased foreign competition d. All of the above Ans: d Level: Easy Heading: U.S. Balance-of-Payments Deficits and Collapse of the Bretton Woods System

9. During the 1960s the U.S. attempted to correct its balance of payments deficits by: a. ad hoc measures b. devaluing the dollar c. deflating the economy d. restricting imports Ans: a Level: Medium Heading: U.S. Balance-of-Payments Deficits and Collapse of the Bretton Woods System

10. The immediate cause for the collapse of the Bretton Woods System was: a. the expectation that the United States would soon be forced to devalue the dollar b. the massive flight of liquid capital from the United States c. the attempt by three small European central banks to convert part of their dollar holdings into gold at the Fed d. all of the above Ans: d Level: Medium Heading: U.S. Balance-of-Payments Deficits and Collapse of the Bretton Woods System

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11. The fundamental cause for the collapse of the Bretton Woods System was: a. lack of confidence b. inadequate liquidity c. lack of an adequate adjustment mechanism d. all of the above Ans: c Level: Medium Heading: U.S. Balance-of-Payments Deficits and Collapse of the Bretton Woods System

12. The present international monetary system is a: a. gold standard b. flexible exchange rate system c. managed exchange rate system d. a target zone system Ans: c Level: Easy Heading: The International Monetary System: Present and Future

13. Which of the following is false with regard to the present international monetary system? a. Special Drawing Rights are the primary reserve asset b. Monetary authorities intervene in foreign exchange markets to smooth out excessive short-run fluctuations in exchange rates c. It was forced on the world by the collapse of the Bretton Woods System d. It was formally recognized in the Jamaica Accords Ans: a Level: Hard Heading: The International Monetary System: Present and Future

14. Which of the following statements is false with regard to 11 countries of the European Monetary Union? a. They have adopted a single currency

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b. They have established a single central bank c. Conduct a common fiscal policy d. Conduct a single monetary policy Ans: b Level: Medium Heading: The International Monetary System: Present and Future

15. Which is one of the most serious international economic problems facing the world today? a. Large volatility and disequilibria in exchange rates and frequent crises in emerging markets b. The rise of protectionism in developed countries and the high structural unemployment in Western Europe c. The restructuring problems of Eastern Europe and the former Soviet Union and the deep poverty of some of the poorest developing countries d. All of the above Ans: d Level: Medium Heading: The International Monetary System: Present and Future

16. The International Monetary Fund was initially established to manage a. the Gold Standard b. the Gold-Exchange Standard c. the euro-dollar exchange rate d.the Dollarization initiative Ans: b Level: Easy Heading: The Bretton Woods System

17. One reason for the collapse of the Bretton Woods system was a the U.S. balance of payments deficit b. the U.S. balance of payments surplus c. the depletion of reserve dollars by foreign central banks d. none of the above Ans: a Level: Medium Heading: U.S. Balance-of-Payments Deficits and Collapse of the Bretton Woods System

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18. Today, roughly how many members of the IMF opt for some form of exchange rate flexibility? a. 10% b. 25% c. 50% d. 90% Ans: c Level: Easy Heading: The International Monetary System: Present and Future

19. The global financial crisis of 2008-2009 began as a a. subprime mortgage crisis in the U.S. b. exchange rate crisis in Japan c. corruption crisis in Russia d. banking crisis in China Ans: a Level: Easy Heading: The International Monetary System: Present and Future

20. In the wake of the 2008-2009 global financial crisis the following is a potential economic problem facing the world today a. rising trade protection b. a large U.S. balance of payments deficit c. deep poverty in many developing nations d. all of the above Ans: d Level: Easy Heading: The International Monetary System: Present and Future 21. Under a gold standard a. there cannot be a balance of payments deficit. b. there cannot be a balance of payments surplus. c. balance of payments imbalances should be quickly corrected by gold flows. d. countries must sterilize all gold transactions.

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Ans: c Level: Easy Heading: The Gold Standard and Interwar Experience 22. Sterilization refers to actions taken by central banks a. to neutralize the effects of balance of payments disequilibria on the money supply. b. to increase gold inflows when there is a balance of payments surplus. c. to decrease gold outflows when there is a balance of payments surplus. d. to cause the exchange rate to appreciate or depreciate.

Ans: a Level: Medium Heading: The Gold Standard and Interwar Experience 23. Even with persistent trade deficits, the value of the U.S. dollar continued to rise into the mid2000s primarily due to a. strong dollar policies of the U.S. Treasury. b. falling U.S. fiscal deficits. c. economic growth in the U.S.. d. expansionary U.S. monetary policy.

Ans: c Level: Medium Heading: The International Monetary System: Present and Future

Short Answer 24. What type of international monetary system(s) operated before WWI, between WWI and WWII, and shortly after WWII? Ans: The world operated under the gold standard from 1880 and fell apart with the onset of WWII in 1914, with exchange rate fluctuating wildly after that until 1924. In 1925, the UK went back to gold but was forced to abandon it 1931 following France’s attempt to become a financial center. By now the great depression was underway and nations began a series of competitive devaluation in an attempt to export unemployment. In 1947 the Bretton Woods Gold Exchange Standard was established and lasted until 1971. Since 1971 nations have employed a variety of managed floating and pegged exchange rate systems, with major world currencies generally being allowed to float against on another.

Level: Medium Heading: The Gold Standard and the Interwar Experience

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25. What is IMF conditionality?

Ans: IMF Conditionality are the requirements the IMF imposes on nations that require emergency loans. They include reductions in government spending, reductions in growth of the money supply and reductions in wage increases in order to stimulate exports and encourage selfsufficiency.

Level: Medium Heading: The International Monetary System: Present and Future

26. What measure have been taken to avoid or minimize future financial crises and strengthen the architecture of the current international financial system?

Ans: Increasing transparency in international monetary relations; strengthening banking and financial systems; promoting greater private-sector involvement.

Level: Easy Heading: The International Monetary System: Present and Future

27. What are the most serious economic problems facing the world today?

Ans: The danger of rising protectionism in advanced nations; large structural imbalances in the U.S. and slow growth in Europe and Japan; deep poverty in many developing nations; resource scarcity and environmental concerns.

Level: Easy Heading: The International Monetary System: Present and Future

Essay

28. Explain why the establishment of a freely-flexible exchange rate system is unlikely today.

Ans: Under a freely-flexible exchange rate system, exchange rates are determined exclusively by the forces of demand and supply without any foreign exchange market intervention on the part of monetary authorities. Under such a self-adjusting system, the need for international reserves would virtually disappear and monetary authorities could devote most of their energies to achieve internal balance. At least, this is how a freely-flexible exchange rate system was supposed to operate. In reality, huge international capital flows rob the nation of most of its monetary independence. Huge international capital flows are also likely to lead to excessive

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volatility of exchange rate. Exchange rates could also become grossly misaligned for long periods of time. This would seriously distort the pattern of world trade and specialization. As a result, it is rather unlikely that the present managed exchange rate system will evolve in a truly freely flexible exchange rate system. Indeed, it is more likely that more restrictions will be imposed in the future on exchange rate fluctuations.

Level: Medium Heading: The International Monetary System: Present and Future 29. Explain the Mexican peso currency crisis.

A sharp increase in U.S. interest rate in 1994 reversed U.S.-to-Mexico capital flows, putting pressure on the peso. To try to stop the capital flows, Mexico issued short-term, dollar-denominated securities. However, investors still lacked confidence in the peso, and thus the capital outflow did not stop. Mexico was forced to devalue the peso by 15%, but when this turned out not to be sufficient, the peso was allowed to float, resulting in a rapid depreciation. The U.S. and the IMF provided support to help to stabilize the peso, but Mexico was unable to avoid a severe recession.

Level: Hard Heading: The International Monetary System: Present and Future

30. Identify the major trade imbalances in the world today, and explain why they are not sustainable and what must happen in the long run.

The U.S. and the U.K.: persistent deficits. Germany and Japan: persistent surpluses. These imbalances are not sustainable in the long run because investors will not continue to be willing to hold ever-increasing amounts of currencies and securities from the deficit nations. Thus the currencies of the deficit nations must eventually depreciate, but as seen in other parts of the text, currency depreciation is probably insufficient to solve the imbalance problems of the United States, and more fundamental structural change will be necessary.

Level: Medium Heading: The International Monetary System: Present and Future

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