Chapter 21 – The Balance of Payments, Exchange Rates, and Trade Deficits
21-1
CHAPTER 21
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?
Chapter 21 – The Balance of Payments, Exchange Rates, and Trade Deficits
21-2
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. What is a balance–of-payments deficit?
9. What is a balance–of-payments surplus?
10. What is the official reserves account? How is it used in the balance of payments?
11. 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
12. Distinguish between a balance–of-payments surplus and a balance-of-payments deficit in terms of payments
of official reserves.
13. If a nation’s balance of payments is always in balance, why isn’t it also always in equilibrium?
Chapter 21 – The Balance of Payments, Exchange Rates, and Trade Deficits
21-3
14. Explain how a nation might persistently import more than it exports and still maintain an equilibrium in its
balance of payments.
15. Why is a balance-of-payments deficit not necessarily good or bad if it occurs in one given year, but
potentially very harmful if maintained over a number of years?
16. Define the two “pure” types of exchange-rate systems.
17. Explain how the exchange rate gets determined in a flexible exchange rate system.
18. Explain how the dollar price of an imported good may change even though the foreign production cost of
that product remains unchanged.
19. Why is the price or exchange value of a nation’s currency an unusual price?
20. What are the economic effects of a depreciation of the dollar on foreign exchange markets?
21. What are the economic effects of an appreciation of the dollar in foreign exchange markets?
22. 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
price of a Swiss franc increased from $0.70 = 1 SF to $0.80 = 1 SF?
23. 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. $
CountryCurrencyYear 1 Year 2
Britainpound 0.50 0.60
Mexicopeso 6.00 6.50
Germanyeuro 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?
Explain the appreciation or depreciation using the nations and numbers in the table.
24. 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?
25. 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?
26. Explain how an increase or decrease in demand and supply will affect the value of a nation’s currency.
27. How are changes in one currency mirrored in changes in some other foreign currency?
28. Describe how changes in tastes affect the value of a nation’s currency.
29. Explain how changes in relative income affect the value of a nation’s currency.
30. Do changes in relative price levels affect the value of a nation’s currency?
31. Do changes in relative inflation rates affect the value of a nation’s currency?
32. Explain how changes in relative real interest rates affect the value of a nation’s currency.
33. Do changes in relative expected returns on stocks, real estate and production facilities affect the value of a
nation’s currency?
Chapter 21 – The Balance of Payments, Exchange Rates, and Trade Deficits
21-4
34. How does speculation in currencies affect the value of a nation’s currency?
35. How are flexible exchange rates used to eliminate a balance-of-payments deficit or surplus?
36. Why might a government intervene in the foreign exchange markets to try to increase or decrease the value
of its currency?
37. Suppose that Mexico devalues the peso. What objectives would prompt the devaluation? Be specific.
38. In the table below are the supply and demand schedules for euros.
Quantity of euros supplied
Price Quantity of euros demanded
800 $1.20 200
700 1.15 400
600 1.10 600
500 1.05 800
400 0.95 1000
300 0.90 1200
200 0.85 1400
(a) What will be the rate of exchange for the euro and for the U.S. dollar?
(b) What would happen if the U.S. and European governments wanted to fix or “peg” the price of a euro at
$0.95?
39. 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 would happen if the U.S. and Malaysian governments wanted to fix or “peg” the price of a
ringgit at $0.50?
40. 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.
Chapter 21 – The Balance of Payments, Exchange Rates, and Trade Deficits
21-5
(e) Suppose that to pull the U.S. economy out of a recession, the Federal Reserve decides to reduce
interest rates. Facing the same economic conditions, the European Central Bank decides to increase
the money supply. 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.
41. Describe the three major disadvantages of flexible exchange rates.
42. The graph below shows a change in the demand for Swiss francs from D1 to D2. What would happen when
D1 shifted to D2 under a flexible exchange rate system compared to a fixed exchange rate system?
43. How does a fixed exchange rate system work? How can a nation maintain its fixed exchange rate?
44. Explain the problems with exchange rate controls.
45. What domestic macroeconomic adjustments would be necessary to maintain fixed exchange rates when
there are persistent balance-of-payments deficits? What are the problems with these adjustments?
46. What is the “managed float”?
47. What are the advantages and disadvantages of the managed float system of exchange rates?
48. What effects do U.S. trade deficits have on the U.S. economy?
48. Explain the major causes of the persistent trade deficits in the United States in the past decade.
49. What have been the principal effects of the persistent trade deficits?
50. “Trade deficits are a mixed blessing.” Interpret and elaborate.
51. (Last Word) What are two positive roles that speculators play in currency markets?
Chapter 21 – The Balance of Payments, Exchange Rates, and Trade Deficits
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.
Chapter 21 – The Balance of Payments, Exchange Rates, and Trade Deficits
21-7
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?
Chapter 21 – The Balance of Payments, Exchange Rates, and Trade Deficits
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. What is a balance–of-payments deficit?
9. What is a balance–of-payments surplus?
Chapter 21 – The Balance of Payments, Exchange Rates, and Trade Deficits
21-9
10. What is the official reserves account? How is it used in the balance of payments?
11. 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
Chapter 21 – The Balance of Payments, Exchange Rates, and Trade Deficits
12. Distinguish between a balance–of-payments surplus and a balance-of–payments deficit in terms of payments
of official reserves.
13. If a nation’s balance of payments is always in balance, why isn’t it also always in equilibrium?
14. Explain how a nation might persistently import more than it exports and still maintain an equilibrium in its
balance of payments.
15. Why is a balance–of-payments deficit not necessarily good or bad if it occurs in one given year, but
potentially very harmful if maintained over a number of years?
16. Define the two “pure” types of exchange-rate systems.
Chapter 21 – The Balance of Payments, Exchange Rates, and Trade Deficits
17. Explain how the exchange rate gets determined in a flexible exchange rate system.
18. Explain how the dollar price of an imported good may change even though the foreign production cost of
that product remains unchanged.
19. Why is the price or exchange value of a nation’s currency an unusual price?
20. What are the economic effects of a depreciation of the dollar on foreign exchange markets?
21. What are the economic effects of an appreciation of the dollar in foreign exchange markets?
22. 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
price of a Swiss franc increased from $0.70 = 1 SF to $0.80 = 1 SF?
Chapter 21 – The Balance of Payments, Exchange Rates, and Trade Deficits
21–12
23. 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. $
CountryCurrencyYear 1 Year 2
Britainpound 0.50 0.60
Mexicopeso 6.00 6.50
Germanyeuro 1.20 1.00
Japan yen 110.00 125.00
24. 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?
25. 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?
26. Explain how an increase or decrease in demand and supply will affect the value of a nation’s currency.
27. How are changes in one currency mirrored in changes in some other foreign currency?
Chapter 21 – The Balance of Payments, Exchange Rates, and Trade Deficits
21–13
28. Describe how changes in tastes affect the value of a nation’s currency.
29. Explain how changes in relative income affect the value of a nation’s currency.
30. Do changes in relative inflation rates affect the value of a nation’s currency?
31. Explain how changes in relative real interest rates affect the value of a nation’s currency.
32. Do changes in relative expected returns on stocks, real estate and production facilities affect the value of a
nation’s currency?
33. How does speculation in currencies affect the value of a nation’s currency?
34. How are flexible exchange rates used to eliminate a balance-of-payments deficit or surplus?
Chapter 21 – The Balance of Payments, Exchange Rates, and Trade Deficits
21–14
35. Why might a government intervene in the foreign exchange markets to try to increase or decrease the value
of its currency?
36. Suppose that Mexico devalues the peso. What objectives would prompt the devaluation? Be specific.
37. In the table below are the supply and demand schedules for euros.
Quantity of euros supplied
Price Quantity of euros demanded
800 $1.20 200
700 1.15 400
600 1.10 600
500 1.05 800
400 0.95 1000
300 0.90 1200
200 0.85 1400
(a) What will be the rate of exchange for the euro and for the U.S. dollar?
(b) What would happen if the U.S. and European governments wanted to fix or “peg” the price of a euro at
$0.95?
38. In the table below are the supply and demand schedules for Malaysian ringgits.
Quantity of ringgits supplied
Price Quantity of ringgits demanded
Chapter 21 – The Balance of Payments, Exchange Rates, and Trade Deficits
21–15
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 would happen if the U.S. and Malaysian governments wanted to fix or “peg” the price of a
ringgit at $0.50?
39. 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
interest rates. Facing the same economic conditions, the European Central Bank decides to increase
the money supply. 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.
Chapter 21 – The Balance of Payments, Exchange Rates, and Trade Deficits
40. Describe the three major disadvantages of flexible exchange rates.
41. The graph below shows a change in the demand for Swiss francs from D1 to D2. What would happen when
D1 shifted to D2 under a flexible exchange rate system compared to a fixed exchange rate system?
42. How does a fixed exchange rate system work? How can a nation maintain its fixed exchange rate?
43. Explain the problems with exchange rate controls.
Exchange rate controls or rationing would require foreign currency obtained in a trade transaction to be
sold to the government. Foreign currency needed for an import transaction would be bought from the
government. The government would ration foreign currency to meet currency exchange needs.
Chapter 21 – The Balance of Payments, Exchange Rates, and Trade Deficits
44. What domestic macroeconomic adjustments would be necessary to maintain fixed exchange rates when
there are persistent balance-of-payments deficits? What are the problems with these adjustments?
45. What is the “managed float”?
46. What are the advantages and disadvantages of the managed float system of exchange rates?
Chapter 21 – The Balance of Payments, Exchange Rates, and Trade Deficits
21–18
47. What effects do U.S. trade deficits have on the U.S. economy?
48. Explain the major causes of the persistent trade deficits in the United States in the past decade.
49. What have been the principal effects of the persistent trade deficits?
50. “Trade deficits are a mixed blessing.” Interpret and elaborate.
Chapter 21 – The Balance of Payments, Exchange Rates, and Trade Deficits
51. (Last Word) What are two positive roles that speculators play in currency markets?