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 rates
According to the theory, exchange rates should adjust so that they equate the
In this case, $8 if converted into pounds at the $2 = £1 exchange rate will yield £4, which is
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
exchange rate. Basically, it means that the quantity demanded of the foreign currency exceeds the
quantity supplied of the foreign currency at the current exchange rate.
currency. This will take place because a depreciation of our local currency implies an appreciation
of the foreign currency. Thus, from the perspective of foreigners, our export goods will appear to
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
b. Under a system of flexible exchange rates, the ab surplus of zees (the U.S. balance of
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 will be
Keep in mind, however, that this increase in official reserves is caused entirely by
China’s decision to fix its exchange rate at its current level. If it were to allow the exchange rate
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 account deficit is
counter-balanced by the capital account). If this country wishes to reduce its current
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.
Feedback: If the U.S. economy booms while recessions start in other countries, the U.S. trade
At the same time, the recessions in other countries will mean that incomes abroad will be falling.
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. exports
As a concrete example, if Ford exports $5 billion of cars but imports $6 billion of parts, then it
The foreigners may then use that $1 billion of cash to purchase U.S. real estate, U.S. government
PROBLEMS
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)
Feedback: a. Balance on goods: Goods Exports minus Goods Imports (reported as a negative
b. Balance on goods and services: (Goods Exports minus Goods Imports) plus (Service Exports
c. Balance on current account: (Goods Exports minus Goods Imports) plus (Service Exports
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 surplus could only be
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.
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 dollar and
(1) More rapid inflation in the United States than in Japan. The increase in the relative price of
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. 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 example,
assume a candy bar costs $1 in the U.S. An individual with $0.85 Canadian cents could use this to
purchase a U.S. dollar and buy the candy bar. Thus, the candy bar only costs $0.85 in Canadian
We apply the same logic to the iPhone. The iPhone costs $300 U.S. dollars, which implies it costs
If the CAD to US dollar exchange rate moves to $.96 CAD = $1 US, the price of the iPhone
Since the price of the iPhone increases for Canadians (the Canadian currency has depreciated)
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).
The graph below demonstrates this process. The original equilibrium is 115 with a quantity of 20.
The decrease in supply of Yen at every exchange rate implies the ‘Supply of Yen’ schedule shifts
$/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