14) What happens in the short run in the Keynesian model to the exchange rate and net exports in
each of the following cases?
(a) The foreign real interest rate falls.
(b) Foreign output rises.
(c) Foreign demand for domestic goods rises.
(d) Domestic output rises.
(e) The domestic real interest rate falls.
15) Describe the effects of a rise in the domestic real interest rate on the exchange rate and on
both domestic and foreign net exports.
13.3 The IS—LM Model for an Open Economy
1) Goods market equilibrium in the open economy occurs when
A) desired saving equals desired investment.
B) output equals desired consumption plus desired investment plus government spending.
C) desired consumption equals desired investment.
D) desired saving minus desired investment equals net exports.
2) In an open economy, a decrease in net exports because of reduced demand for domestic
products by foreigners should cause the domestic real interest rate to ________ and should cause
desired saving minus desired investment to ________.
A) rise; rise
B) rise; fall
C) fall; rise
D) fall; fall
3) In an open economy, an increase in net exports because of increased demand for domestic
products by foreigners should cause the domestic real interest rate to ________ and should cause
desired saving minus desired investment to ________.
A) rise; rise
B) rise; fall
C) fall; rise
D) fall; fall
4) A decrease in foreign output would cause the domestic country’s net exports to ________ and
cause the domestic country’s IS curve to ________.
A) rise; shift up
B) rise; shift down
C) fall; shift up
D) fall; shift down
5) An increase in foreign output would cause the domestic country’s net exports to ________ and
cause the domestic country’s IS curve to ________.
A) rise; shift up
B) rise; shift down
C) fall; shift up
D) fall; shift down
6) A decrease in the foreign real interest rate would cause the domestic country’s net exports to
________ and cause the domestic country’s IS curve to ________.
A) rise; shift up
B) rise; shift down
C) fall; shift up
D) fall; shift down
7) An increase in the foreign real interest rate would cause the domestic country’s net exports to
________ and cause the domestic country’s IS curve to ________.
A) rise; shift up
B) rise; shift down
C) fall; shift up
D) fall; shift down
8) A shift in demand toward the home country’s goods would ________ the domestic real
interest rate and ________ net desired saving (desired saving less desired investment) in the
economy.
A) lower; increase
B) lower; decrease
C) raise; increase
D) raise; decrease
9) A shift in demand toward the foreign country’s goods would ________ the domestic real
interest rate and ________ net desired saving (desired saving less desired investment) in the
economy.
A) lower; increase
B) lower; decrease
C) raise; increase
D) raise; decrease
10) In an open economy, a shift down and to the left of the IS curve could have been caused by
A) a decline in the foreign real interest rate.
B) an increase in the demand for domestic goods relative to foreign goods.
C) an increase in foreign output.
D) a decline in domestic output.
11) In an open economy, an increase in foreign output would cause the IS curve to shift
________ and a decrease in the foreign real interest rate would cause the IS curve to shift
________.
A) down; down
B) down; up
C) up; down
D) up; up
12) In an open economy, an increase in savings because of concerns about the future should
cause the domestic real interest rate to ________ and should cause net exports to ________.
A) rise; rise
B) rise; fall
C) fall; rise
D) fall; fall
13) In a Keynesian model, what are the short-run effects on output, the real interest rate, and the
real exchange rate, for both the domestic economy and a foreign economy, of a decline in
investment?
13.4 Macroeconomic Policy in an Open Economy with Flexible Exchange Rates
1) In the Keynesian model of an open economy, a temporary decrease in government purchases
would ________ the domestic real interest rate and ________ net desired saving (desired saving
less desired investment) in the economy.
A) lower; increase
B) lower; decrease
C) raise; increase
D) raise; decrease
2) A temporary increase in government purchases would ________ the domestic real interest rate
and ________ net desired saving (desired saving less desired investment) in the economy.
A) lower; increase
B) lower; decrease
C) raise; increase
D) raise; decrease
3) A temporary decrease in government purchases would ________ the domestic real interest
rate and ________ net desired saving (desired saving less desired investment) in the economy.
A) lower; increase
B) lower; decrease
C) raise; increase
D) raise; decrease
4) In a Keynesian model, a temporary increase in government purchases would cause output to
________ and the domestic real interest rate to ________, in the short run.
A) remain unchanged; increase
B) remain unchanged; decrease
C) increase; increase
D) increase; decrease
5) A classical IS—LM model of the world economy can be used to show that in a flexible
exchange-rate system, a temporary increase in government purchases will cause
A) output and the real interest rate to rise, which reduces net exports but has an ambiguous effect
on the real exchange rate.
B) output and the real interest rate to rise, which increases net exports but has an ambiguous
effect on the real exchange rate.
C) output to rise and the real interest rate to fall, which reduces net exports and causes the
exchange rate to depreciate.
D) the real interest rate to fall, which causes the exchange rate to rise, which reduces net exports.
6) In the short run in the Keynesian model, an increase in the domestic money supply would
cause domestic output to ________ and the domestic real interest rate to ________.
A) rise; rise
B) fall; rise
C) rise; fall
D) fall; fall
7) An increase in the U.S. money supply would cause the value of the dollar to ________ and
U.S. net exports to ________ in the short run using a Keynesian model.
A) fall; fall
B) fall; rise
C) rise; rise
D) rise; fall
8) The Federal Reserve has just purchased bonds in the market, carrying out open market
operations. In the short run in the Keynesian model, this would cause the foreign real interest rate
to ________ and foreign output to ________.
A) increase; increase
B) increase; decrease
C) decrease; increase
D) decrease; decrease
9) According to the classical model, an increase in the American nominal money supply would
cause the nominal exchange rate to ________ and the real exchange rate to ________.
A) depreciate; appreciate
B) appreciate; depreciate
C) depreciate; remain unchanged
D) appreciate; remain unchanged
10) Suppose Japan is currently running a current account surplus. The most effective way of
eliminating this current account surplus would be to temporarily ________ government
purchases and ________ the domestic money supply.
A) increase; increase
B) increase; decrease
C) decrease; increase
D) decrease; decrease
11) You have just noticed that the dollar appreciated and you suspect that U.S. policymakers
were behind this change. Which would you choose as the most likely cause of this appreciation
in the real exchange rate?
A) An increase in the money supply
B) A decrease in the money supply
C) A temporary increase in government purchases
D) A temporary decrease in taxes
12) Assume the United States is currently running a current account deficit. The most effective
way of eliminating this current account deficit would be to temporarily ________ government
purchases and ________ the domestic money supply.
A) increase; increase
B) increase; decrease
C) decrease; increase
D) decrease; decrease
13) To encourage more investment, Mexico has lowered its tax rates to reduce the user cost of
capital. Argentina is unable to pay back its foreign debts, causing its expected future marginal
product of capital to fall. Mexico’s real exchange rate will ________ and its net exports will
________.
A) depreciate; fall
B) appreciate; rise
C) depreciate; rise
D) appreciate; fall
14) Describe the effects of contractionary fiscal policy by the domestic government on output,
the real interest rate, and net exports in both the domestic and foreign country, using a Keynesian
model.
15) Describe the effects of contractionary monetary policy by the domestic central bank on
output, the real interest rate, and net exports in both the domestic and foreign country, using a
Keynesian model in the short run. What happens in the long run? Show a diagram to illustrate
the short- and long-run effects in both countries.
16) For this question, use the Keynesian IS—LM model with flexible exchange rates.
Eastland’s main trading partner is Westland. Suppose Westland undertakes an expansionary
monetary policy.
(a) What is the effect of Westland’s expansionary monetary policy on Eastland’s real exchange
rate in the short run, assuming no change in Eastland’s policies?
(b) What is the effect of Westland’s expansionary monetary policy on Eastland’s real exchange
rate in the long run, assuming no change in Eastland’s policies?
(c) What is the effect of Westland’s expansionary monetary policy on Eastland’s nominal
exchange rate in the short run and in the long run?
Answer:
13.5 Fixed Exchange Rates
1) Under a system of fixed exchange rates, what happens if a country’s currency is overvalued?
A) The central bank loses official reserve assets.
B) The central bank gains official reserve assets.
C) The currency appreciates.
D) The exchange rate rises.
2) Under a system of fixed exchange rates, what happens if a country’s currency is undervalued?
A) The central bank loses official reserve assets.
B) The central bank gains official reserve assets.
C) The currency depreciates.
D) The exchange rate falls.
3) If a country has an overvaluation problem, the best solution is to
A) increase the official rate.
B) buy less of its currency in the foreign exchange market.
C) sell more of its currency in the foreign exchange market.
D) decrease the money supply.
4) If the fundamental value of the exchange rate is ________ than the official (fixed) exchange
rate, the country has an ________ problem, and it will gain reserves.
A) less; overvaluation
B) greater; overvaluation
C) less; undervaluation
D) greater; undervaluation
5) If a country that fixes its exchange rate has an undervalued exchange rate, then it will
________ reserves, unless it ________ its money supply to the appropriate level.
A) gain; increases
B) lose; increases
C) lose; decreases
D) gain; decreases
6) International businesses like a fixed exchange-rate system because
A) they like large swings in currency values when devaluation or revaluation occur.
B) they profit by speculating on devaluation or revaluation.
C) they can plan better if they know what the exchange rate will be.
D) fixed exchange rates are economically efficient.
7) When a group of countries agree to share a common currency, they are said to have formed a
A) currency union.
B) welfare state.
C) monetary alliance.
D) monetary cartel.
8) The currency created by the European Monetary Union, for which notes and coins became
available in 2002, is the
A) ECU.
B) euro.
C) EMU.
D) pound.
9) Currency unions are rare because
A) they’re to no one’s advantage.
B) countries are reluctant to give up having their own currencies.
C) having flexible exchange rates has the same benefits and none of the costs.
D) speculative attacks are likely to occur.
10) Compared to a system of fixed exchange rates, currency unions are beneficial because they
A) allow exchange rates to float.
B) allow every country to have an independent monetary policy.
C) reduce the costs of trading goods and assets.
D) restrict what countries can do with fiscal policy.
11) Compared with a system of fixed exchange rates, currency unions are beneficial because
they
A) restrict what countries can do with fiscal policy.
B) allow exchange rates to float.
C) allow every country to have an independent monetary policy.
D) eliminate the possibility of speculative attacks.
12) An optimum currency area is a geographic region
A) with inflation near zero.
B) that allows exchange rates to float.
C) that has fixed exchange rates.
D) for which the benefits of having a common currency exceed the costs.
13) A geographic region in which the benefits of having a common currency exceed the costs is
A) an optimum currency area.
B) an exchange-rate mechanism.
C) a currency board area.
D) a common currency area.
14) Criteria for an optimum currency area include all the following except
A) fiscal transfers.
B) similar business cycle patterns.
C) extensive trade with each other.
D) a common language.
15) Europe may not be an optimum currency area because
A) people speak different languages.
B) workers are not very mobile.
C) the countries do not trade very much with each other.
D) financial markets are weak.
16) Europe may not be an optimum currency area because
A) people speak different languages.
B) fiscal transfers are weak.
C) the countries do not trade very much with each other.
D) financial markets are weak.
17) Monetary policy in the European Monetary Union is determined by
A) the Bundesbank.
B) the European Union Senate.
C) the European Central Bank.
D) None of the above.
18) The Maastricht treaty was the first step toward
A) having free trade between Russia and China.
B) European monetary union.
C) gaining credibility for monetary policy.
D) reducing the costs of disinflation.
19) A classical economy is described by the equations
AD: Y = 1000 + 100M/P
AS: = 1500
The real exchange rate is 3 bushels/bottle, the domestic nominal money supply is 30 florins, and
the foreign price level is 8 crowns/bushel.
(a) What is the nominal exchange rate?
(b) If the government wants to maintain an official nominal exchange rate of 6 crowns/florin,
what must the nominal money supply be?
20) (a) What happens to the fundamental value of a country’s exchange rate when it raises its
money supply in a fixed exchange-rate system? Does this make the currency overvalued or
undervalued if originally the official rate equaled the fundamental value?
(b) What happens to the fundamental value of a country’s exchange rate when the foreign
country raises its money supply? Does this make the currency overvalued or undervalued if
originally the official rate equaled the fundamental value?
(c) So, if a country wants to maintain its official rate equal to its fundamental value, what must it
do when the foreign country raises its money supply? What happens to inflation?
21) Describe how the euro was created. What are the benefits of the monetary union? What are
the costs?