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16) Explain how a country with a current account surplus is a ripe candidate for currency
revaluation.
Answer: If a country like Germany had a current account surplus, it would sell its currency in
19.6 Analyzing Policy Options for Reaching Internal and External Balance
1) When the exchange rate, E, and the foreign price level, P*, is fixed, domestic inflation
depends primarily on
A) amount of aggregate demand.
B) home price level set by IMF.
C) current account balance.
D) government tax policy.
E) foreign interest rates.
2) The current account surplus is
A) an increasing function of disposable income and an increasing function of the real exchange
rate.
B) a decreasing function of disposable income and a decreasing function of the real exchange
rate.
C) a decreasing function of disposable income and an increasing function of the real exchange
rate.
D) only a decreasing function of disposable income.
E) only an increasing function of the real exchange rate.
3) Under fixed exchange rates
A) monetary policy is not an effective policy.
B) fiscal policy is not an effective policy.
C) monetary policy and fiscal policy are not effective.
D) both monetary and fiscal policies are effective.
E) monetary policy has an unpredictable effect on the domestic money supply.
4) Under fixed exchange rates, domestic asset transactions by the central bank
A) can be used to alter the level of foreign reserves but not to affect the state of employment and
output.
B) cannot be used to alter the level of foreign reserves but only to affect the state of employment
and output.
C) can be used to alter the level of foreign reserves and to affect the state of employment and
output.
D) can be used to alter the domestic money supply and the level of foreign reserves.
E) can raise output to full-employment level.
5) The XX schedule shows how much
A) fiscal expansion is needed to hold the current account surplus at X as the currency is devalued
by a given amount.
B) monetary expansion is needed to hold the current account surplus at X as the currency is
devalued by a given amount.
C) fiscal expansion is needed to hold the current account surplus at X as the currency is
evaluated by a given amount.
D) fiscal and monetary expansions are needed to hold the current account surplus at X as the
currency is devalued by a given amount.
E) foreign funding is needed to hold the current account surplus at X as the currency is devalued
by a given amount.
6) The current account surplus
A) is a decreasing function of disposable income and an increasing function of the real exchange
rate.
B) is an increasing function of disposable income and an increasing function of the real exchange
rate.
C) is an increasing function of disposable income and a decreasing function of the real exchange
rate.
D) is a decreasing function of disposable income and a decreasing function of the real exchange
rate.
E) is an increasing function of disposable income and a decreasing function of aggregate
demand.
7) Fiscal expansion
A) stimulates aggregate demand and causes output to decline.
B) decreases aggregate demand and causes output to decline.
C) stimulates aggregate demand and causes output to rise.
D) decreases aggregate demand and causes output to rise.
E) decreases government expenditures.
8) A devaluation of the home currency
A) makes foreign goods and services cheaper relative to those sold at home.
B) makes domestic goods and services more expensive relative to those sold abroad.
C) decreases demand and output.
D) increases demand for domestic goods and services.
E) increases output and makes domestic goods and services cheaper relative to those sold abroad.
9) An attempt by a central bank to alter the money supply by buying or selling domestic assets
A) will leave both domestic money supply and foreign reserves unchanged.
B) will cause an offsetting change in aggregate demand.
C) will lead to a rise in domestic employment and output.
D) will lead to a decrease in domestic employment and output.
E) will cause an offsetting change in foreign reserves and leave the domestic money supply
unchanged.
10) An expenditure-changing policy
A) alters the direction of the economy's total demand for goods and services.
B) alters the level of the economy's total demand for goods and services.
C) has no effect on aggregate demand.
D) is the same thing as an expenditure-switching policy.
E) affects aggregate supply but not aggregate demand.
11) The alteration of exchange rates to move the economy to internal and external balance may
lead to all EXCEPT
A) a balance of payments crisis.
B) changes in the terms of trade.
C) changes in the level of imports or exports.
D) changes in interest rates.
E) a guaranteed unilateral improvement in economic wealth.
12) "A monetary policy is not a policy tool under fixed exchange rates." Discuss.
13) What is the difference between an expenditure-changing policy and an expenditure-
switching policy?
25
14)
(a) Assume that R denotes the domestic interest rate and R denotes the foreign interest rate.
Under a fixed exchange rate what is the relation between R and R
(b) Assume E denotes the domestic currency price of the dollar for a country which is not the
United States. If one wants to analyze only the short run effects of a policy, what does one
assume about the Home and Foreign price levels, P and P , respectively.
(c) Assume that there is no ongoing balance of payment crisis. What is this assumption really
assume?
(d) Assume a fixed exchange rate system. What does this tell you about E?
(e) Under the above assumptions what are the conditions for internal balance?
(f) How is your answer to Part D above would change if P is unstable due to foreign inflation.
(g) Given the definitions above, how one defines the real exchange rate?
(h) Write the condition for internal balance.
(i) Define the variable not defined before in Part G above.
(j) Using the equation for internal balance derived above, given our assumptions analyze the
effects of a fiscal expansion.
(k) What would happen if the government of that country, which is not the United States under
Bretton Woods, decides to devaluate its currency?
(l) What would happen if the government of that country, which is not the United States under
Bretton Woods, decides to use monetary policy rather than fiscal policy?
(m) Given all of the above, what is the relation between the exchange rate, E, and fiscal ease,
i.e., an increase in G or a reduction in T?
(n) Assume that the economy is at internal balance. What will happen if G goes up for a given
level of E?
(o) Assume that the economy is at internal balance. What will happen if G goes down for a
given level of E?
26
Copyright © 2015 Pearson Education, Inc.
Answer:
(a) R = R
(b) Constant prices.
(c) That Ee, the expected exchange rate, is equal to the exchange rate today, E. In other words,
E = Ee.
(d) E is constant, i.e., E = E0.
(e) Since P and E are fixed, the expected price is fixed; thus, no inflation is expected. Then,
internal balance will require only full employment, aggregate demand equaling the full-
employment level, Yf.
(f) In this case, full employment alone will not guarantee price stability under a fixed exchange
rate.
(g) The real exchange rate is equal to EP /P.
(h) Yf = C(Yf - T) + I + G + CA(EP /P, Yf - T)
(i) C = consumption, I = Investment, (Yf - T) = disposable income, T = taxes.
(j) An increase in G or a reduction in T will increase aggregate demand and will cause output to
rise in the short run.
(k) A rise in E makes domestic goods and services cheaper relative to those sold abroad and
thus increases demand for output.
(l) A monetary policy is not a policy tool under fixed exchange rates. Under fixed exchange
rates, domestic asset transactions by the central bank can be used to alter the level of foreign
reserves but not to affect the state of employment and output.
(m) Negative relation.
(n) Over-employment.
(o) Under employment.
Page Ref: 560-564
Difficulty: Moderate
15) Assume that the government has a target value, X, for the current account surplus.
(a) What is the goal of external balance?
(b) Assume that we are dealing with only the short run, what are the values of P and P∗?
(c) Given fixed P and P , what would happen if E rises?
(d) Given P and P , what would happen if T decreases, i.e., an expansionary fiscal policy?
(e) Given P and P , what would happen if G increases, i.e., an expansionary fiscal policy?
(f) Given all of the above, what is the relation between the exchange rate, E, and fiscal ease, i.e.,
an increase in G or a reduction in T?
(g) Assume that the economy is in external balance. What will happen if the government
maintains its current account at X, but devaluates the domestic currency?
(h) Assume that the economy is at external balance. What will happen if the government raises
E?
(i) Assume that the economy is at external balance. What will happen if the government lowers
E?
16) Use a figure below to describe the four zones of economic discomfort.
17) Using the II-XX framework, show using a figure that fiscal policies by themselves cannot
bring the economy to both internal and external balances.
Answer: Starting at point 2, fiscal policy is shown as only horizontal movements. This means
that the economy can reach either point 3 (internal balance) or point 4 (external balance) in the
19.7 The External Balance Problem of the United States Under Bretton Woods
1) The confidence problem of the Bretton Woods systems articulated by Robert Triffin refers to
A) the unwillingness of central banks to accumulate currency for fear of not being able to
convert it to gold in case a run on the banks occurs.
B) consumer fear of stock market instability.
C) producer fear of rising wages.
D) the lack of convertibility of gold into silver.
E) low consumer spending because of balance of payment crises.
2) A two-tier gold market like the one created during the Bretton Woods System refers to
A) a private tier for private gold traders where the price would not be allowed to fluctuate, and
an official tier for central banks where the official gold price would be allowed to fluctuate.
B) a private tier for private gold traders where the price would not be allowed to fluctuate, and an
official tier for central banks where the official gold price would rise on a yearly basis by pre-
determined increments.
C) a private tier for private gold traders where the price would be allowed to fluctuate, and an
official tier for central banks where the official gold price would be set at $35 an ounce.
D) a private tier for private gold traders where the price would be set at $35 an ounce, and an
official tier for central banks where the official gold price would be allowed to fluctuate.
E) a private tier for private gold traders where the price of gold would rise on a yearly basis by
pre-determined increments, and an official tier for central banks where the official gold price
would be set at $35 an ounce.
3) In order to bring about a real depreciation of the dollar, the U.S. can hope for
A) a rise in the U.S. price level.
B) a fall in foreign price levels.
C) a rise in the dollar's nominal value in terms of foreign currencies.
D) a rise in foreign price levels or a fall in the dollar's nominal value in terms of foreign
currencies.
E) increased output and full employment.
4) The collapse of the Bretton Woods system marked
A) the end of floating exchange rates and a move to fixed exchange rates.
B) marked the end of fixed exchange rates and a move to floating exchange rates.
C) the beginning of the gold standard.
D) a plunge in the price of gold.
E) the elimination of paper currencies.
5) Which of the following statements is MOST accurate?
A) A revaluation restores internal and external balance immediately, without causing domestic
inflation.
B) A devaluation restores internal and external balance immediately, without causing domestic
inflation.
C) A revaluation restores internal and external balance immediately, but also causes domestic
inflation.
D) A devaluation restores internal and external balance immediately, but also causes domestic
inflation.
E) A devaluation restores external balance in the long run, without causing immediate domestic
inflation.
6) Which of the following is the MOST accurate?
A) U.S. macroeconomic policies in the late 1960s helped cause the breakdown of the Bretton
Woods system by early 1973.
B) U.S. macroeconomic policies in the late 1970s helped cause the breakdown of the Bretton
Woods system by early 1983.
C) U.S. macroeconomic policies in the late 1980s helped cause the breakdown of the Bretton
Woods system by early 1993.
D) U.S. macroeconomic policies in the late 1950s helped cause the breakdown of the Bretton
Woods system by early 1963.
E) U.S. macroeconomic policies in the late 1960s delayed the breakdown of the Bretton Woods
system to early 1973.
7) Refer to the graph below, which shows the effect of ________ on the home economy.
A) foreign inflation
B) domestic inflation
C) foreign deflation
D) domestic recession
E) foreign recession
8) Refer to the graph below. The movement from point 1 to point 2 is stimulated by a
disequilibrium in which there is domestic ________ and ________.
A) overemployment; trade surplus
B) unemployment; trade surplus
C) overemployment; trade deficit
D) unemployment; trade deficit
E) inflation; unemployment
19.8 The Case for Floating Exchange Rates
1) Advocates of floating rate suggested it is favorable for economies for all of the following
reasons EXCEPT
A) it discourages attack from foreign exchange speculators because of the fact that exchange rate
adjustment is immediate.
B) it helps stabilize the shock effect on unemployment in case of economic changes such as fall
in export demand.
C) it automatically matches the domestic inflation with ongoing foreign inflation.
D) it gives every country the opportunity to guide its own monetary conditions at home.
E) it brings the LR exchange rate to the level predicted by PPP without government policy
decisions.
2) Which of the following is NOT a result of a temporary fall in foreign demand on one
country's exports under floating exchange rate?
A) The DD curve shifts to the left due to reduction of aggregate demand.
B) The AA curve shifts downwards due to reduction of money supply.
C) a fall in aggregate output
D) depreciation in home country's currency
E) a fall in the home interest rate
3) Which of the following is NOT a result of a permanent fall in foreign demand on one
country's exports under floating exchange rate?
A) The DD curve shifts to the left due to reduction of aggregate demand.
B) The AA curve shifts upwards due to the increased expected long-run exchange rate.
C) a reduction in output by a smaller degree compared to temporary fall in demand
D) depreciation in home country's currency
E) a raised level of unemployment
4) Which one of the following is/are INCORRECT?
An argument against floating exchange rates is that
A) a fixed rate automatically prevents instability in the domestic money market from affecting
the economy if shocks come from home domestic money market.
B) a fixed rate might become unpredictable, complicating economic planning.
C) a rise in money demand under a fixed exchange rate would have no effect on the exchange
rate and output.
D) a fixed rate functions within the price-specie-flow mechanism and maintains a balance of
payments equilibrium.
E) a fixed rate automatically prevents instability in the economy from output market shocks.
5) If central banks were no longer obliged to intervene in currency markets to fix exchange rates,
governments would be able to use monetary policy to reach
A) internal balance.
B) external balance.
C) internal and external balance.
D) internal but not external balance.
E) external but not internal balance.
6) Advocates of flexible exchange rates claim that under flexible exchange rates
A) no country would be forced to import only inflation from abroad.
B) no country would be forced to import only deflation from abroad.
C) no country would be forced to import inflation and deflation from abroad.
D) flexible exchange rates are not able to halt importing inflation from abroad.
E) flexible exchange rates are not able to halt importing deflation from abroad.
7) Advocates of flexible exchange rates claim that under flexible exchange rates
A) the United States would now be able to set world monetary conditions all by itself.
B) Germany would no longer be able to set world monetary conditions all by itself.
C) the United Kingdom would no longer be able to set world monetary conditions all by itself.
D) the United States would no longer be able to set world monetary conditions all by itself.
E) Germany would now be able set world monetary conditions all by itself.
8) Advocates of flexible exchange rates claim that under flexible exchange rates
A) the United States would no longer have the same opportunity as other countries to influence
its exchange rate against foreign currencies.
B) the United States would have the same opportunity as other countries to influence its
exchange rate against foreign currencies.
C) the United Kingdom would not have the same opportunity as other countries to influence its
exchange rate against foreign currencies.
D) Germany would not have the same opportunity as other countries to influence its exchange
rate against foreign currencies.
E) China would have the same opportunity as other countries to influence its exchange rate
against foreign currencies.
9) Some claim that the long and agonizing periods of speculation preceding exchange rate
realignments would
A) not occur under fixed exchange rate regime.
B) not occur under floating.
C) become more severe under currency board.
D) become less severe under floating.
E) be prolonged under floating.
10) Advocates of floating rates pointed out that
A) removal of the obligation to peg currency values would restore monetary control to central
banks.
B) imposing of the obligation to peg currency values would restore monetary control to central
banks.
C) removing of the obligation to peg currency values would restore fiscal control.
D) imposing of the obligation to peg currency values would restore fiscal control.
E) imposing of the obligation to peg currency would restore monetary control to the consumer.
11) Advocates of flexible exchange rates claim that under flexible exchange rates, if the central
bank faced unemployment
A) and thus wished to decrease its money supply, there would no longer be any legal barrier to
the currency depreciation this would cause.
B) and thus wished to expand its money supply, there would no longer be any legal barrier to the
currency depreciation this would cause.
C) and wished to expand its money supply, there would no longer be any legal barrier to the
currency appreciation this would cause.
D) and wished to decrease its money supply, there now would be a legal barrier to the currency
depreciation this would cause.
E) and wished to increase output, there would no longer be a legal barrier to the currency
appreciation this would cause.
12) Advocates of flexible exchange rates claim that under flexible exchange rates, a currency
A) appreciation caused by increasing the money supply would reduce unemployment by
lowering the relative price of domestic products.
B) depreciation caused by increasing the money supply would increase unemployment by
lowering the relative price of domestic products.
C) depreciation caused by increasing the money supply would reduce unemployment by
lowering the relative price of domestic products.
D) depreciation caused by increasing the money supply would reduce unemployment by
increasing the relative price of domestic products.
E) depreciation cause by decreasing the money supply would not effect unemployment, but
would increase the relative price of domestic products.
13) Advocates of flexible exchange rates claim that under flexible exchange rates, a currency
A) depreciation caused by increasing the money supply would reduce unemployment by
increasing world demand for them.
B) appreciation caused by increasing the money supply would reduce unemployment by
increasing world demand for them.
C) appreciation caused by decreasing the money supply would reduce unemployment by
increasing world demand for them.
D) appreciation caused by increasing the money supply would increase unemployment by
increasing world demand for them.
E) appreciation caused by increasing the money supply would increase unemployment by
decreasing world demand for them.
14) Advocates of flexible exchange rates claim that under flexible exchange rates, a currency
A) depreciation caused by increasing the money supply would reduce unemployment by
lowering the relative price of domestic products and increasing the world demand for them.
B) appreciation caused by increasing the money supply would reduce unemployment by
lowering the relative price of domestic products and increasing world demand for them.
C) appreciation caused by decreasing the money supply would reduce unemployment by
lowering the relative price of domestic products and increasing world demand for them.
D) appreciation caused by increasing the money supply would increase unemployment by
lowering the relative price of domestic products and increasing world demand for them.
E) appreciation caused by increasing the money supply would increase unemployment by
lowering the relative price of domestic products and by decreasing world demand for them.
15) Advocates of flexible exchange rates claim that under flexible exchange rates, the central
bank of
A) an overheated economy could cool down activity by increasing the money supply without
worrying that undesired reserve inflow would undermine its stabilization effort.
B) a cooled economy could cool down activity by contracting the money supply without
worrying that undesired reserve inflow would undermine its stabilization effort.
C) an overheated economy could cool down activity by contracting the money supply without
worrying that undesired reserve inflow would undermine its stabilization effort.
D) an overheated economy could cool down activity by contracting the money supply without
worrying that undesired reserve outflow would undermine its stabilization effort.
E) an overheated economy could cool down activity by decreasing employment and increasing
output without worrying that this would undermine its stabilization effort.
16) Advocates of flexible exchange rates claim that under flexible exchange rates
A) enhanced control over fiscal policy would allow countries to dismantle their distorting
barriers to international payments.
B) reduced control over monetary policy would allow countries to dismantle their distorting
barriers to international payments.
C) enhanced control over monetary policy would allow countries to increase their distorting
barriers to international payments.
D) enhanced control over monetary policy would allow countries to dismantle their distorting
barriers to international payments.
E) enhanced control over monetary policy would destabilize exchange rates.
