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CHAPTER 41
The Balance of Payments, Exchange Rates, and Trade Deficits
A. Short-Answer, Essays, and Problems
1. Define international trade and international financial transactions. Give an example of each one.
2. What are the major components of the current account in the balance of payments? How is the current
account balance determined?
3. What are the major components of the capital and financial account?
4. Explain the relationship between the current account and the capital account in the balance of payments.
5. Answer the next five questions on the basis of the following hypothetical data for a nation Malthusia. All
numbers are in billions of dollars.
Goods exports +$45
Goods imports −51
Service exports +15
Service imports −6
Net investment income −10
Balance on capital account +3
Net transfers +12
Foreign purchases of Malthusia assets +25
Malthusia purchases of assets abroad −33
(a) What was the balance on goods?
(b) What was the balance on goods and services?
(c) What was the balance on the current account?
(d) What is the balance on the financial account?
(e) What is the balance on the capital and financial account?
6. Answer the next five questions on the basis of the following hypothetical data for a hypothetical nation
Economia. All numbers are in billions of dollars.
Goods exports +$90
Goods imports −79
Service exports +10
Service imports −28
Net investment income −15
Net transfers +17
Balance on the capital account 0
Foreign purchases of Economia assets +48
Economia purchases of assets abroad −47
(a) What is the balance of trade?
(b) What is the balance on goods and services?
(c) What is the balance on the current account?
(d) What is the balance on the financial account?
(e) What official reserves will be needed to settle the balance-of-payment accounts?
7. The table below contains the international balance-of-payments data for the United States in a past year.
All figures are in billions. Compute with the appropriate sign (+ or −) and enter in the table the six missing
items. What was the condition of the balance of payments in the United States?
Current account
(1) U.S. goods exports +$390
(2) U.S. goods imports −498
(3) Balance on goods _____
(4) U.S. exports of services +133
(5) U.S. imports of services −107
(6) Balance on services _____
(7) Balance on goods and services _____
(8) Net investment income +12
(9) Net transfers −22
(10) Balance on current account _____
Capital and financial account
Capital account
(11) Balance on capital account +34
Financial account
(12) Foreign purchases of assets in the U.S. +117
(13) U.S. purchases of assets abroad −59
(14) Balance on financial account _____
(15) Balance on capital and financial account_____
$ 0
8. The table below contains hypothetical international balance-of-payments data for the United States. All
figures are in billions. Compute with the appropriate sign (+ or −) and enter in the table the six missing
items. What was the condition of the balance of payments in the United States?
Current account
(1) U.S. goods exports +$367
(2) U.S. goods imports −284
(3) Balance on goods _____
(4) U.S. exports of services +33
(5) U.S. imports of services −107
(6) Balance on services _____
(7) Balance on goods and services _____
(8) Net investment income +25
(9) Net transfers −12
(10) Balance on current account _____
Capital and financial account
Capital account
(11) Balance on capital account −7
Financial account
(12) Foreign purchases of assets in the U.S. +49
(13) U.S. purchases of assets abroad −64
(14) Balance on financial account _____
(15) Balance on capital and financial account_____
$ 0
9. Define the two “pure” types of exchange-rate systems.
10. Explain how the exchange rate gets determined in a flexible exchange rate system.
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11. Explain how the dollar price of an imported good may change even though the foreign production cost of
12. Why is the price or exchange value of a nation’s currency an unusual price?
13. What are the economic effects of a depreciation of the dollar on foreign exchange markets?
14. What are the economic effects of an appreciation of the dollar in foreign exchange markets?
15. Explain what is meant by an appreciation and depreciation of the dollar. What does it mean if the dollar
price of a Swiss franc (SF) decreases from $0.80 = 1 SF to $0.70 = 1 SF? What does it mean if the dollar
16. The table below shows four different currencies and how much of each currency can be purchased with a
U.S. dollar.
Currency per U.S. $
Country
Currency
Year 1
Year 2
Britain
pound
0.50
0.60
Mexico
peso
6.00
6.50
Germany
euro
1.20
1.00
Japan
yen
110.00
125.00
Among which nations has the U.S. dollar appreciated (A) or depreciated (D) from year 1 to year 2?
17. What effect might the depreciation of the U.S. dollar relative to the Japanese yen have on imports and
exports to and from each country?
18. How would a substantial appreciation in the European euro in the foreign exchange market affect the
quantity of imports of European products by the U.S.? How would such an appreciation of the European
euro affect travel by Americans to Europe?
19. Explain how an increase or decrease in demand and supply will affect the value of a nation’s currency.
20. How are changes in one currency mirrored in changes in some other foreign currency?
21. Describe how changes in tastes affect the value of a nation’s currency.
22. Explain how changes in relative income affect the value of a nation’s currency.
23. Do changes in relative price levels affect the value of a nation’s currency?
24. Do changes in relative inflation rates affect the value of a nation’s currency?
25. Explain how changes in relative real interest rates affect the value of a nation’s currency.
26. Do changes in relative expected returns on stocks, real estate and production facilities affect the value of a
nation’s currency?
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27. How does speculation in currencies affect the value of a nation’s currency?
28. Determine the effect the following situations will have the exchange rate for the U.S. dollar.
29.Why might a government intervene in the foreign exchange markets to try to increase or decrease the value
of its currency?
30. Suppose that Mexico devalues the peso. What objectives would prompt the devaluation? Be specific.
31. In the table below are the supply and demand schedules for euros.
Price
Quantity of
euros
demanded
$1.20
200
1.15
400
1.10
600
1.05
800
0.95
1000
0.90
1200
0.85
1400
(a) What will be the rate of exchange for the euro and for the U.S. dollar?
(b) What happens if the U.S. and European governments fix or “peg” the price of a euro at $0.95?
32. In the table below are the supply and demand schedules for Malaysian ringgits.
Quantity of
ringgits
supplied
Price
Quantity of
ringgits
demanded
700
$0.55
100
600
0.50
200
500
0.45
300
400
0.40
400
300
0.35
500
200
0.30
600
100
0.25
700
(a) What will be the rate of exchange for the Malaysian ringgit and for the U.S. dollar?
(b) What happens if the U.S. and Malaysian governments fix or “peg” the price of a ringgit at $0.50?
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33.The table below summarizes the exchange market for the dollar and euro. Use this information to answer the
following questions.
Dollar
price of
euro
Demand
for euro
Supply of
euro
0.00
275
25
0.25
250
50
0.50
225
75
0.75
200
100
1.00
175
125
1.25
150
150
1.50
125
175
1.75
100
200
2.00
75
225
(a) What is the equilibrium exchange rate and quantity?
(b) Suppose the European Central Bank decides to counter rampant growth by reducing the money supply
to moderate the European economy. How will the supply and demand situation for the euro change?
What likely effect will this have on the equilibrium exchange rate and quantity?
(c) Suppose that inflation increases in Europe. How will the supply and demand situation for the euro
change? What likely effect will this have on the equilibrium exchange rate and quantity?
(d) Suppose Europeans decide to take more vacations in the United States. Using the data in the table
above, calculate the new equilibrium. Assume the subsequent shift(s) (if one or more occur), causes
the affected curve(s) to shift by 50 in the appropriate direction.
(e) Suppose that to pull the U.S. economy out of a recession, the Federal Reserve decides to reduce
34. Describe the three major disadvantages of flexible exchange rates.
35. The graph below shows a change in the demand for Swiss francs from D1 to D2. What would happen when
36. Determine whether each of the following characteristics is most likely an attribute of a flexible, fixed, or
managed exchange rate system.
(a) Consumer choice of imported goods may be restricted.
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37. How does a fixed exchange rate system work? How can a nation maintain its fixed exchange rate?
38. Discuss the difference in the foreign exchange market when a fixed exchange rate policy is used, as
39. Explain what foreign exchange reserves are and how they are used when a country implements a fixed
40. Suppose the U.S. Dollar were fixed to the Mexican Peso and the demand for the peso decreased. Examine,
41. Discuss the relationship between the foreign exchange reserves and the domestic money supply.
42. Describe the problem that will arise if there is a sustained difference between the fixed and equilibrium
43. Explain how a fixed exchange rate policy may result in undesired inflation and how a government may go
44. (Consider This) Discuss the effect of China’s fixed exchange rate policy.
45. Provide methods a country can use they experience a continual decrease in their foreign exchange reserves.
46. Explain the problems with exchange rate controls.
47. What domestic macroeconomic adjustments would be necessary to maintain fixed exchange rates when
48. What is a balance-of-payments surplus?
49. What is the “managed float”?
50. What are the advantages and disadvantages of the managed float system of exchange rates?
51. What effects do U.S. trade deficits have on the U.S. economy?
52. Explain the major causes of the persistent trade deficits in the United States in the past decade.
53. What have been the principal effects of the persistent trade deficits?
54. “Trade deficits are a mixed blessing.” Interpret and elaborate.
55. (Last Word) Examine the decision to develop a shared currency across economies.
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B. Answers to Short-Answer, Essays, and Problems
1. Define international trade and international financial transactions. Give an example of each one.
2. What are the major components of the current account in the balance of payments? How is the current
account balance determined?
3. What are the major components of the capital and financial account?
4. Explain the relationship between the current account and the capital account in the balance of payments.
The current account basically shows the position of the United States in terms of trade in goods and
services with the rest of the world during a year. The capital account shows the capital flows in the
purchase or sale of real and financial assets during a year. The two accounts are interrelated.
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5. Answer the next five questions on the basis of the following hypothetical data for a nation Malthusia. All
numbers are in billions of dollars.
Goods exports +$45
Goods imports −51
Service exports +15
Service imports −6
Net investment income −10
Balance on capital account +3
Net transfers +12
Foreign purchases of Malthusia assets +25
Malthusia purchases of assets abroad −33
(a) What was the balance on goods?
(b) What was the balance on goods and services?
(c) What was the balance on the current account?
(d) What is the balance on the financial account?
(e) What is the balance on the capital and financial account?
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6. Answer the next five questions on the basis of the following hypothetical data for a hypothetical nation
Economia. All numbers are in billions of dollars.
Goods exports +$90
Goods imports −79
Service exports +10
Service imports −28
Net investment income −15
Net transfers +17
Balance on the capital account 0
Foreign purchases of Economia assets +48
Economia purchases of assets abroad −47
(a) What is the balance of trade?
(b) What is the balance on goods and services?
(c) What is the balance on the current account?
(d) What is the balance on the financial account?
(e) What official reserves will be needed to settle the balance-of-payment accounts?
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7. The table below contains the international balance-of-payments data for the United States in a past year.
All figures are in billions. Compute with the appropriate sign (+ or −) and enter in the table the six missing
items. What was the condition of the balance of payments in the United States?
Current account
(1) U.S. goods exports +$390
(2) U.S. goods imports −498
(3) Balance on goods _____
(4) U.S. exports of services +133
(5) U.S. imports of services −107
(6) Balance on services _____
(7) Balance on goods and services _____
(8) Net investment income +12
(9) Net transfers −22
(10) Balance on current account _____
Capital and financial account
Capital account
(11) Balance on capital account +34
Financial account
(12) Foreign purchases of assets in the U.S. +117
(13) U.S. purchases of assets abroad −59
(14) Balance on financial account _____
(15) Balance on capital and financial account_____
$ 0
Current account
(1) U.S. goods exports +$390
(2) U.S. goods imports −498
(3) Balance on goods −108
(4) U.S. exports of services +133
(5) U.S. imports of services −107
(6) Balance on services +23
(7) Balance on goods and services −82
(8) Net investment income +12
(9) Net transfers −22
(10) Balance on current account −92
Capital and financial account
Capital account
(11) Balance on capital account +34
Financial account
(12) Foreign purchases of assets in the U.S. +117
(13) U.S. purchases of assets abroad −59
(14) Balance on financial account +58
(15) Balance on capital and financial account +92
$ 0
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8. The table below contains hypothetical international balance-of-payments data for the United States. All
figures are in billions. Compute with the appropriate sign (+ or −) and enter in the table the six missing
items. What was the condition of the balance of payments in the United States?
Current account
(1) U.S. goods exports +$367
(2) U.S. goods imports −284
(3) Balance on goods _____
(4) U.S. exports of services +33
(5) U.S. imports of services −107
(6) Balance on services _____
(7) Balance on goods and services _____
(8) Net investment income +25
(9) Net transfers −12
(10) Balance on current account _____
Capital and financial account
Capital account
(11) Balance on capital account −7
Financial account
(12) Foreign purchases of assets in the U.S. +49
(13) U.S. purchases of assets abroad −64
(14) Balance on financial account _____
(15) Balance on capital and financial account_____
$ 0
Current account
(1) U.S. goods exports +$367
(2) U.S. goods imports −284
(3) Balance on goods +83
(4) U.S. exports of services +33
(5) U.S. imports of services −107
(6) Balance on services −74
(7) Balance on goods and services +9
(8) Net investment income +25
(9) Net transfers −12
(10) Balance on current account +22
Capital and financial account
Capital account
(11) Balance on capital account −7
Financial account
9. Define the two “pure” types of exchange-rate systems.
10. Explain how the exchange rate gets determined in a flexible exchange rate system.
If the foreign exchange rate floats freely, the demand for and the supply of foreign currency determine
foreign exchange rates. The exchange rate for any foreign currency is the rate at which the quantity of that
11. Explain how the dollar price of an imported good may change even though the foreign production cost of
that product remains unchanged.
12. Why is the price or exchange value of a nation’s currency an unusual price?
13. What are the economic effects of a depreciation of the dollar on foreign exchange markets?
14. What are the economic effects of an appreciation of the dollar in foreign exchange markets?