International Economics, 10e (Krugman/Obstfeld/Melitz)
Chapter 21 (10) Optimum Currency Areas and the Euro
21.1 How the European Single Currency Evolved
1) The European Economic and Monetary Union
A) set up a single currency and sole bank for European economic monetary policy.
B) eliminated all barriers to trade such as tax differentials between borders.
C) produced a single government for handling European affairs.
D) created the Common Agricultural Pact.
E) eliminated all local currencies in Western Europe.
2) The birth of the Euro
A) resulted in fixed exchange rates between all EMU member countries.
B) resulted in flexible exchange rates between all EMU member countries.
C) resulted in crawling-peg exchange rates between all EMU member countries.
D) resulted in non currency board exchange rates between all EMU member countries.
E) resulted in floating exchange rates between all EMU member countries.
3) Which of the following is TRUE?
A) All European countries are part of the EMU.
B) All Western European countries are part of the EMU.
C) Originally, 20 countries joined the EMU on January 1999.
D) No Western European countries are part of the EMU.
E) Not all Western European countries are part of the EMU.
4) The EMU created a currency area with more than
A) 200 million consumers.
B) 250 million consumers.
C) about a billion.
D) 500 million consumers.
E) 300 million consumers.
5) The EU countries were prompted to seek closer coordination of monetary policies and greater
exchange rate stability in order
A) to enhance Europe’s role in the world monetary system.
B) to turn the European Union into a truly unified market.
C) both to enhance Europe’s role in the world monetary system and to turn the European Union
into a truly unified market.
D) both to turn the European Union into a truly unified market and to counter the rise of Japan in
international financial markets.
E) to homogenize all European cultures.
6) Which of the following statements is TRUE?
A) The 1957 Treaty of Rome founded the EU and created a custom union.
B) The 1957 Treaty of Rome founded the EU.
C) The 1957 Treaty of Rome founded the euro.
D) The 1957 Treaty of Rome founded the European Central Bank.
E) The 1957 Treaty of Rome founded the Stability and Growth Pact. known as SGP.
7) The credibility theory of the EMS implies in effect that the political costs of violating
international exchange rate agreements
A) cannot restrain governments from depreciating their currency.
B) can restrain governments from depreciating their currency.
C) cannot restrain governments from depreciating their currency in the short run.
D) cannot restrain governments from depreciating their currency in the long run.
E) can control the political policies of member nations.
8) The credibility theory of the EMS implies in effect that the political costs of violating
international exchange rate agreements
A) cannot restrain governments from depreciating their currency to gain the short-term
advantage of an economic boom at the long-term cost of higher inflation.
B) can restrain governments from depreciating their currency to gain the short-term advantage of
an economic boom at the long-term cost of higher inflation.
C) cannot restrain governments from depreciating their currency in the short run.
D) cannot restrain governments from depreciating their currency in the long run.
E) cannot restrain governments from depreciating their currency to gain the long-term advantage
of an economic boom.
9) Under the EMS, Germany set the system’s
A) monetary policy while the other European countries pegged their currencies to the DM.
B) fiscal policy while the other European countries pegged their currencies to the DM.
C) monetary policy while the other European countries kept their currencies fluctuating relative
to the DM.
D) fiscal policy while the other European countries kept their currencies fluctuating relative to
the DM.
E) monetary policy, while other European countries maintained their traditional policies.
10) An inflation-prone country
A) gains from vesting its monetary policy decisions with a “conservative” central bank.
B) loses from vesting its monetary policy decisions with a “conservative” central bank.
C) gains from vesting its fiscal policy decisions with a “conservative” central bank.
D) loses from vesting its fiscal policy decisions with a “conservative” central bank.
E) remains constant when vesting its fiscal policy decisions with a “conservative” central bank.
11) The most important feature of the Single European Act of 1986, which amended the
founding Treaty of Rome, was dropping the requirement of
A) unanimous consent for measures related to market completion and making it a decision that
only Germany and France agreed about.
B) unanimous consent for measures related to market completion.
C) majority consent for measures related to market completion and making it a decision that only
Germany and France agreed about.
D) unanimous consent for measures related to agricultural policies only.
E) unanimous consent for measures related only to fiscal policies.
12) The 1991 Maastricht Treaty can be best described as
A) a peace treaty between Europe and the United States.
B) an agreement for the accession of the Netherlands into the EU.
C) an agreement for the creation of a free trade area.
D) a provision for the introduction of a single European currency and European central bank.
E) the beginning of a floating exchange rate European monetary system.
13) During the period from 1978-2012, the difference between annual inflation rates of EU
countries and the German inflation rate
A) grew at an accelerating rate.
B) remained fairly constant.
C) largely disappeared.
D) went through periods of hyperinflation.
E) trended upward at a declining rate.
14) How many countries are in the EU as of January 1, 2014?
A) 9
B) 15
C) 17
D) 18
E) 25
15) Did the 1957 Treaty of Rome turn the EU into a truly unified market?
A) Yes, it paved the way for the current EMU.
B) No, although it established a customs union, it failed to remove barriers to the movement of
goods and factors within Europe.
C) No, it was only after the German unification and locating the ECB in Frankfurt that unity was
achieved.
D) No, since the Northern members of the EU had larger endowments of capital and skilled
labor.
E) No, the Treaty of Rome created more trade barriers between European countries.
16) The German central bank in the European Monetary System, 1979-1998
A) was very inflation-averse.
B) was moderately inflation-averse.
C) was willing to accept inflation.
D) lacked control over inflation since it had fixed its exchange rate.
E) lacked sufficient reserves.
17) The result of the reunification of eastern and western Germany in 1990
A) was a boom in Germany and higher inflation, with no effect on nearby countries.
B) was a recession in Germany and lower inflation, with no effect on nearby countries.
C) was a boom in Germany and higher inflation, and, with other EMS countries’ commitment to
fixed exchange rates, a deep recession in nearby countries.
D) was a recession in Germany and lower inflation, and, with other EMS countries’ commitment
to fixed exchange rates, a deep recession in nearby countries.
E) was a recession in Germany and lower inflation, causing a boom in nearby countries.
18) The credibility theory of EMS had as an effect
A) the inflation rates of member countries converging to the low German levels, a result that was
not matched by similar countries who did not fix their exchange rates.
B) the inflation rates of member countries failing to converge to the low German levels.
C) the inflation rates of member countries converging to the low German levels, but other
countries including U.S. and Britain also reduced inflation in this time period without fixing
exchange rates.
D) the inflation rate in Germany rose to match the inflation rates of other member countries.
E) the inflation rate in the U.S. dropped to the low German levels.
19) How and why did Europe set up its single currency?
20) How did the European single currency evolved?
21) What prompted the EU countries to seek closer coordination of monetary policies and greater
exchange rate stability in the late 1960s?
22) Discuss the effects of the reunification of eastern and western Germany in 1990 on both
Germany and its neighboring European countries.
23) Explain why the EMS countries decided to fix their exchange rates against the German DM.
24) Explain the credibility theory of the EMS.
25) Explain how the German Bundesbank gained its low-inflation reputation.
26) Describe the main provisions of the Maastricht Treaty of 1991.
27) Why did the EU countries move away from the EMS toward the goal of a single shared
currency?
28) Describe the effects of the reunification of eastern and western Germany in 1990 on both
Germany and its neighboring European countries using the AA-DD framework.
29) What is the purpose of the following figure?
Answer: The purpose of the figure is to show the inflation convergence within the six original
21.2 The Euro and Economic Policy in the Euro Zone
1) To join the EMU, a country should have no more than
A) 1.5 percent inflation rate above the average of the three EU member states with the highest
inflation.
B) 3 percent inflation rate above the average of the three EU member states with the lowest
inflation.
C) 4 percent inflation rate above the average of the three EU member states with the lowest
inflation.
D) 1.5 percent inflation rate above the average of the three EU member states with the lowest
inflation.
E) 2 percent inflation rate above the average of the three EU member states with the lowest
inflation.
2) To join the EMU, a country must have
A) a public-sector deficit no higher than 3 percent of its GDP in general.
B) a public-sector deficit no higher than 2 percent of its GDP in general.
C) a public-sector deficit no higher than 1 percent of its GDP in general.
D) a zero public-sector deficit.
E) a public-sector deficit no higher than 4 percent of its GDP in general.
3) To join the EMU, a country must have a public debt below or approaching a reference level of
A) 50 percent of its GDP.
B) 10 percent of its GDP.
C) 60 percent of its GDP.
D) 100 percent of its GDP.
E) 5 percent of its GDP.
4) The European Central Bank has its headquarter in
A) London.
B) Berlin.
C) Frankfurt.
D) Paris.
E) Brussels.
5) Under ERM 2 rules, the national central bank of an EU member with its own currency can
suspend euro intervention operations
A) if there is a civil war.
B) if they result in money supply changes that threaten to destabilize the domestic price level.
C) if there is a current account deficit.
D) if there is a current account surplus.
E) if they result in a weakened current account.
6) The main function of the 1997 Stability and Growth Pact (SGP) was to
A) exclude a highly indebted EMU country
B) enhance cooperation between France and Germany.
C) make the Euro a weak currency.
D) distribute the Euro banknote among European central banks and to create a timetable for the
imposition of financial penalties on countries that fail to correct situations of “excessive” deficits
and debt promptly enough.
E) determine specialized penalties for each member nation.
7) How were the initial members of EMU chosen? How will new members be admitted? What is
the structure of the complex of financial and political institutions that govern economic policy in
the euro zone?
21.3 The Theory of Optimum Currency Areas
1) What are the biggest advantages the U.S. has over the EU in terms of being an Optimum
Currency Area?
A) low mobility of labor, higher labor productivity, lower level of intra-regional trade
B) high unionization of U.S. Labor force
C) high mobility of labor force, more transfer payments between regions
D) higher uniformity of population’s taste in consumption
E) more specialized labor force and natural resource advantages
2) A major economic
A) benefit of fixed exchange rates is that they simplify economic calculations and provide a
more predictable basis for decisions that involve international transactions than do floating rates.
B) benefit of floating exchange rates it that they simplify economic calculations and provide a
more predictable basis for decisions that involve international transactions than do fixed rates.
C) cost of fixed exchange rates it that they simplify economic calculations and provide a more
predictable basis for decisions that involve international transactions than do currency board
rates.
D) benefit of flexible exchange rates it that they simplify economic calculations and provide a
more predictable basis for decisions that involve international transactions than do crawling peg
rates.
E) benefit of fixed exchange rates is that the value of goods will remain constant across a large
region of consumers.
3) The efficiency
A) gain from a fixed exchange rate with the euro is smaller when trade between say, Norway and
the euro zone, is extensive than when it is small.
B) gain from a fixed exchange rate with euro is greater when trade between say, Norway and the
euro zone, is extensive than when it is small.
C) loss from a fixed exchange rate with the euro is smaller when trade between say, Norway and
the euro zone, is extensive than when it is small.
D) gain from a fixed exchange rate with euro is the same as when trade between say, Norway
and the euro zone, is extensive than when it is small.
E) gain from a fixed exchange rate with euro is the same as when trade between say, Norway and
the euro zone, is small than when it is small.
4) The monetary efficiency
A) loss from pegging the Norwegian krone to the euro (for example) will be higher if factors of
production can migrate freely between Norway and the euro area.
B) gain from pegging the Norwegian krone to the euro (for example) will be lower if factors of
production can migrate freely between Norway and the euro area.
C) gain from pegging the Norwegian krone to the euro (for example) will be higher if factors of
production can not migrate freely between Norway and the euro area.
D) gain from pegging say the Norwegian krone to the euro (for example) will be higher if factors
of production can migrate freely between Norway and the euro area.
E) gain or loss from pegging the Norwegian krone to the Euro cannot be predicted using the
available information.
5) Which one of the following statements is TRUE?
A) The less extensive are cross-border trade and factor movements, the greater is the gain from a
fixed cross-border exchange rate.
B) The more extensive are cross-border trade and factor movements, the greater is the loss from
a fixed cross-border exchange rate.
C) The more extensive are cross-border trade and factor movements, the greater is the gain from
a fixed cross-border exchange rate.
D) The more extensive are cross-border trade, the greater is the loss from a fixed cross-border
exchange rate.
E) The more extensive are factor movements, the greater is the loss from a fixed cross-border
exchange rate.
6) A country that joins an exchange rate area
A) gives up its ability to use the exchange rate for the purpose of stabilizing output and
employment.
B) does not give up its ability to use the exchange rate and monetary policy for the purpose of
stabilizing output and employment.
C) gives up its ability to use the exchange rate and monetary policy for the purpose of stabilizing
output and employment.
D) gives up its ability to use only monetary policy for the purpose of stabilizing output and
employment.
E) does not gives up its ability to use only monetary policy for the purpose of stabilizing output
and employment.
7) When the economy is disturbed by a change in the output market
A) a fixed exchange rate has an advantage over a flexible rate.
B) a floating exchange rate has an advantage over a fixed rate.
C) a crawling peg exchange rate has an advantage over a flexible rate.
D) a floating exchange rate has the same effect as fixed rate.
E) a flexible exchange rate is not as effective as a fixed exchange rate.
8) Which one of the following statements is TRUE?
A) A fixed exchange rate automatically cushions the economy’s output and employment by
allowing an immediate change in the relative price of domestic and foreign goods.
B) A flexible exchange rate does not automatically cushions the economy’s output and
employment by allowing an immediate change in the relative price of domestic and foreign
goods.
C) A flexible exchange rate automatically cushions the economy’s output and employment by
allowing an immediate change in the relative price of domestic and foreign goods.
D) A flexible exchange rate automatically cushions the economy’s output and employment by
allowing an immediate change in the absolute price of domestic and foreign goods.
E) A fixed exchange rate automatically cushions the economy’s output and employment by
allowing an immediate change in the absolute price of domestic and foreign goods.
9) When the exchange rate is
A) flexible, purposeful stabilization is more difficult because monetary policy has no power at all
to affect domestic output and employment.
B) fixed, purposeful stabilization is less difficult because monetary policy has no power at all to
affect domestic output and employment.
C) fixed, purposeful stabilization is more difficult because monetary policy has no power at all to
affect domestic output and employment.
D) a crawling peg, rather than fixed, purposeful stabilization is more difficult because monetary
policy has no power at all to affect domestic output and employment.
E) fixed rather than crawling peg purposeful stabilization is more difficult because fiscal policy
has no power at all to affect domestic output and employment.
10) When Norway unilaterally fixes its exchange rate against the euro and leaves the krone
A) free to float against the non-euro currencies, it is able to keep at least some monetary
independence.
B) free to float against the non-euro currencies, it is unable to keep at least some monetary
independence.
C) free to float against the non-euro currencies, it is able to keep its monetary independence.
D) run by crawling peg against the non-euro currencies, it is able to keep at least some monetary
independence.
E) fixed against the non-euro currencies, it is unable to keep its monetary independence.
11) After Norway unilaterally pegs the krone to the euro, domestic money market disturbances
will
A) no longer affect domestic output despite the continuation of float-rate regime against non-
euro currencies.
B) now have major effect on domestic output despite the continuation of float-rate regime against
non-euro currencies.
C) have some effect on domestic output despite the continuation of float-rate regime against non-
euro currencies.
D) have major effect on domestic employment despite the continuation of float-rate regime
against non-euro currencies.
E) no longer affect foreign imports despite the continuation of float-rate regime against non-euro
currencies.
12) A krone/euro peg alone is
A) not enough to provide automatic stability in the face of any monetary shocks that shift the AA
schedule.
B) enough to provide automatic stability in the face of any monetary shocks that shift the AA
schedule.
C) not enough to provide automatic stability in the face of any monetary shocks that shift the AA
schedule, provided fiscal policy will be used as well.
D) enough to provide automatic stability in the face of any monetary shocks that shift the AA
schedule, provided the government runs a budget deficit.
E) enough to provide partial stability in the face of smaller monetary shocks that shift the AA
schedule.
13) Since Norway has close trading links with the euro zone
A) a small reduction in its price will lead to an increase in euro zone demand for Norwegian
goods that is large relative to Norway’s output. Thus, full employment can be restored fairly
quickly.
B) a small reduction in its price will lead to a decrease in euro zone demand for Norwegian
goods that is large relative to Norway’s output. Thus, full employment can be restored fairly
quickly.
C) a small reduction in its price will lead to an increase in euro zone demand for Norwegian
goods that is small relative to Norway’s output. Thus, full employment can be restored fairly
quickly.
D) a big reduction in its price will lead to an increase in euro zone demand for Norwegian goods
that is large relative to Norway’s output. Thus, full employment can be restored fairly quickly.
E) a big reduction in its price will lead to a decrease in euro zone demand for Norwegian goods
that is small relative to Norway’s output. Thus, full employment can be restored fairly quickly.
14) If Norway’s labor and capital markets are highly correlated with those of its euro zone
neighbors
A) unemployed workers can easily move abroad to find work and domestic capital can be shifted
to more profitable uses in other countries.
B) unemployed workers cannot easily move abroad to find work and domestic capital cannot be
shifted to more profitable uses in other countries.
C) while unemployed workers can easily move abroad to find work, domestic capital cannot be
shifted to more profitable uses in other countries.
D) while capital can easily move abroad to be put to a more profitable use, unemployed workers
cannot easily move abroad to find work.
E) unemployment will rise, thanks to competition from foreign labor.
15) The ability of factors to migrate abroad
A) reduces the severity of unemployment and the fall in the rate of return available to investors.
B) increases the severity of unemployment and the fall in the rate of return available to investors.
C) reduces the severity of unemployment but increases the fall in the rate of return available to
investors.
D) cannot change the severity of unemployment and the constant rate of return available to
investors.
E) reduces the migration of highly-skilled workers.