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Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
4. A meal at a McDonald’s restaurant in New York costs $8. The identical meal at a McDonald’s
restaurant in London costs £4. According to the purchasing-power-parity theory of exchange
rates, the exchange rate between U.S. dollars and British pounds should tend to move toward:
LO3
a. $2 = £1.
b. $1 = £2.
c. $4 = £1.
d. $1 = £4.
Feedback: The correct answer is that the purchasing-power-parity theory of exchange
According to the theory, exchange rates should adjust so that they equate the
purchasing powers of various currencies. Applying that logic to our McDonald’s
example, if a particular meal costs $8 in New York and £4 in London, the exchange rate
5. Suppose that a country has a flexible exchange rate. Also suppose that at the current exchange
rate, the country is experiencing a balance-of-payments deficit. Then would it be true or false that
a sufficiently large depreciation of the local currency could eliminate the balance-of-payments
deficit. LO3
Feedback: This statement is true because a sufficiently large depreciation of the local
currency could indeed eliminate the balance-of-payments deficit. To see why, recall what
it means to have a balance of payments deficit at the current
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Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
our exports will rise. But that means foreigners will need to convert more for their foreign
money into our local money in order to purchase the larger quantity of our exports that
6. Diagram a market in which the equilibrium dollar price of 1 unit of fictitious currency zee (Z)
is $5 (the exchange rate is $5 =Z1). Then show on your diagram a decline in the demand for zee.
LO4
a. Referring to your diagram, discuss the adjustment options the United States would have in
maintaining the exchange rate at $5 = Z1 under a fixed-exchange-rate system.
b. How would the U.S. balance-of-payments surplus that is caused by the decline in demand be
resolved under a system of flexible exchange rates?
a. The decrease in demand for zees from D1 to D2 will create a surplus (ab) of
zees at the $5 price. To maintain the $5 to Z1 exchange rate, the United States
must undertake policies to shift the demand-for-zee curve rightward or shift the-
supply-of zee curve leftward. To increase the demand for zees, the United States
b. Under a system of flexible exchange rates, the ab surplus of zees (the U.S.
balance of payments surplus) will cause the zee to depreciate and the dollar to
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Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
7. Suppose that the government of China is currently fixing the exchange rate between the U.S.
dollar and the Chinese yuan at a rate of $1 = 6 yuan. Also suppose that at this exchange rate, the
people who want to convert dollars to yuan are asking to convert $10 billion per day of dollars
into yuan, while the people who are wanting to convert yuan into dollars are asking to convert 36
billion yuan into dollars. What will happen to the size of China’s official reserves of dollars? LO4
a. Increase.
b. Decrease.
c. Stay the same.
Feedback: The correct answer is that the size of China’s official reserves of dollars will
increase. To see why this is true, note that the people wanting to convert dollars into yuan
Thus, those bringing dollars to exchange for yuan will be brining $10 billion per day
while those wishing to convert yuan into dollars will only want $6 billion per day. As a
8. Suppose that a country follows a managed-float policy but that its exchange rate is currently
floating freely. In addition, suppose that it has a massive current account deficit. Does it also
necessarily have a balance-of -payments deficit? If it decides to engage in a currency intervention
to reduce the size of its current account deficit, will it buy or sell its own currency? As it does so,
will its official reserves of foreign currencies get larger or smaller? Would that outcome indicate a
balance-of-payments deficit or a balance-of- payments surplus? LO5
Answer: No, if the exchange rate is floating freely this market is adjusting to
bring the balance of payments into balance-no need for intervention (the current
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Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
9. If the economy booms in the United States while going into recession in other countries, the
U.S. trade deficit will tend to ______. LO6
a. Increase.
b. Decrease.
c. Remain the same.
Answer: a. Increase.
Feedback: If the U.S. economy booms while recessions start in other countries, the U.S.
trade deficit will tend to increase.
This will happen because rising incomes in the United States will increase the overall
At the same time, the recessions in other countries will mean that incomes abroad will be
falling. As a result, consumers in those other countries will demand less goods and
10. Other things equal, if the United States continually runs trade deficits, foreigners will own
________ U.S. assets. LO6
a. More and more.
b. Less and less.
c. The same amount of.
Feedback: The correct answer is that if the U.S. continually runs trade deficits,
foreigners will own more and more U.S. assets.
This is true because U.S. purchases of foreign goods have to be paid for either with U.S.
then be paid for with pre-existing U.S. assets.
As a concrete example, if Ford exports $5 billion of cars but imports $6 billion of parts,
The foreigners may then use that $1 billion of cash to purchase U.S. real estate, U.S.
PROBLEMS
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Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
1. Alpha’s balance-of-payments data for 2012 are shown below. All figures are in billions of
dollars. What are the (a) balance on goods, (b) balance on goods and services, (c) balance on
current account, and (d) balance on capital and financial account? Suppose Alpha sold $10 billion
of official reserves abroad to balance the capital and financial account with the current account.
Does Alpha have a balance-of-payments deficit or does it have a surplus? LO2
Feedback: a. Balance on goods: Goods Exports minus Goods Imports (reported as a
b. Balance on goods and services: (Goods Exports minus Goods Imports) plus (Service
c. Balance on current account: (Goods Exports minus Goods Imports) plus (Service
d. Balance on capital and financial account: Balance on the capital account plus (foreign
2. China had a $214 billion overall current account surplus in 2012. Assuming that China’s net
debt forgiveness was zero in 2012 (its capital account balance was zero), by how much did
Chinese purchases of financial and real assets abroad exceed foreign purchases of Chinese
financial and real assets. LO2
Feedback: To offset the current account surplus, China would have to have a deficit in
the capital and financial account. Given the zero balance on the capital account, the
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consent of McGraw-Hill Education.
Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
3. Refer to following table, in which Qd is the quantity of yen demanded, P is the dollar price of
yen, Qs is the quantity of yen supplied in year 1, and Qs' is the quantity of yen supplied in year 2.
All quantities are in billions and the dollar-yen exchange rate is fully flexible. LO3
a. What is the equilibrium dollar price of yen in year 1?
b. What is the equilibrium dollar price of yen in year 2?
c. Did the yen appreciate or did it depreciate relative to the dollar between years 1 and 2?
d. Did the dollar appreciate or did it depreciate relative to the yen between years 1 and 2?
e. Which one of the following could have caused the change in relative values of the dollar and
yen between years 1 and 2: (1) More rapid inflation in the United States than in Japan; (2) an
increase in the real interest rate in the United States but not in Japan; or (3) faster growth of
income in the United States than in Japan.
Answers: a. 115; b. 120; c. yen appreciated; d. dollar depreciated; (1) More rapid
Feedback: a. What is the equilibrium dollar price of yen in year 1?
b. What is the equilibrium dollar price of yen in year 2?
c. Did the yen appreciate or did it depreciate relative to the dollar between years 1 and 2?
d. Did the dollar appreciate or did it depreciate relative to the yen between years 1 and 2?
e. Which one of the following could have caused the change in relative values of the
4. Suppose that the current Canadian dollar (CAD) to U.S. dollar exchange rate is $.85 CAD = $1
US and that the U.S. dollar price of an Apple iPhone is $300. What is the Canadian dollar price of
an iPhone? Next, suppose that the CAD to US dollar exchange rate moves to $.96 CAD = $1 US.
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consent of McGraw-Hill Education.
Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
What is the new Canadian dollar price of an iPhone? Other things equal, would you expect
Canada to import more or fewer iPhones at the new exchange rate? LO3
Feedback: The exchange rate is $0.85 Canadian dollars for $1 U.S dollar. As a simple
We apply the same logic to the iPhone. The iPhone costs $300 U.S. dollars, which
If the CAD to US dollar exchange rate moves to $.96 CAD = $1 US, the price of the
Since the price of the iPhone increases for Canadians (the Canadian currency has
5. Return to Problem 3 and assume the exchange rate is fixed against the dollar at the equilibrium
exchange rate that occurs in year 1. Also suppose that Japan and the United States are the only
two countries in the world. In year 2, what quantity of yen would the Japanese government have
to buy or sell to balance its capital and financial account with its current account? In what specific
account would this purchase or sale show up in Japan’s balance of payments statement: Foreign
purchases of assets in Japan or Japanese purchase of assets abroad? Would this transaction
increase Japan’s stock of official reserves or decrease its stock? LO6
Feedback: The year 1 equilibrium is 115, where Qd equals Qs (Qd = Qs =20).
In year 2 the quantity of Yen supplied at the exchange rate of 115 is 10 (Qs'=10). To
This would show up as Japanese purchase of assets abroad in Japan’s balance of
payments statement. The sale of Yen by the Japanese government is the equivalent to (the
The graph below demonstrates this process. The original equilibrium is 115 with a
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consent of McGraw-Hill Education.
$/Yen
Yen
Supply of Yen
Demand for Yen
New Supply of Yen
115
20
Decrease in Supply of Yen: Market
Increase in Supply of Yen: Japanese Government
Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
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