Suggested answer to case study discussion question
What Role for Gold?:Probably not. Internal balance is achieved by
maintaining a reasonable level (and growth rate) of GDP so that the county
has a reasonable (probably fairly low) unemployment rate and an acceptable
(probably fairly low) rate of product price ination. Macroeconomic shocks hit
a country’s economy from time to time. Some of these shocks reduce
aggregate demand and lead to recessions and rising unemployment. Some
of these shocks expand aggregate demand excessively and put upward
pressure on domestic prices and the country’s ination rate. A national
government has three types of macroeconomic policy that can be used to
pursue internal balance. The national government generally can use
monetary policy, (scal policy, and exchange rate policy. A new gold standard
would obligate the central banks of countries who choose it to defend the
(xed price of gold by buying and selling gold at the (xed price. If the
country’s central bank is fully committed, then this is a rather strong form of
(xed exchange rates, because the exchange rates among the currencies of
the countries on the gold standard are implied by the (xed gold prices.
Exchange rate policy cannot be a major tool to pursue internal balance. And,
monetary policy is also not a major tool to pursue internal balance, because
the central bank alters the country’s money supply in response to changes in
gold supply and demand, rather than in response to shock-driven shifts in
aggregate demand and GDP. Fiscal policy is still available as a tool for the
government to pursue internal balance, but in many countries (scal policy is
the least exible or the most politicized tool.
Suggested answers to end of chapter questions and problems
1. Disagree. Countries must follow policies that are not too different if they are to be able to
maintain the fixed exchange rates. The policies need not be exactly the same, but the
policies must lead to private demand and supply in the foreign exchange market that
permits the countries to defend the fixed rates successfully. The most obvious need for
200
© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not
authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated,
forwarded, distributed, or posted on a website, in whole or part.
2. Probably agree, but with a caution. It is usually argued that the average rate of global
inflation would tend to be lower if most countries adhered to a system of fixed exchange
rates. Countries that succeed in maintaining fixed exchange rates among their currencies
3. A oating exchange rate provides some insulation from foreign
business cycles because the rate tends to change in a way that
counters the spread of the business cycle through international trade.
4. Agree or disagree. If you say agree, then you will emphasize points like the following.
With a clean floating exchange rate, the rate is set by private competitive supply and
demand in the market. This rate is a market price that represents all information about
201
© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not
authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated,
forwarded, distributed, or posted on a website, in whole or part.
5. Possible criteria include the following. First, if the country wants to shift
to a (xed exchange rate to promote international trade by reducing
exchange-rate risk, then it should consider (xing its exchange rate to
the currency of one of its major trading partners. Second, the country
should look for a country whose priorities and policies are compatible
6. a. These economists believe that the variability exists for good reasons, and that many of
the supposed bad effects of exchange rate variability are not that large. They believe that
the variability results from rational and reasonable responses of market participants,
especially international investors, to various kinds of shocks and news. As economic and
b. These economists believe that the variability is excessive, and that the risks do have an
undesirable impact on international transactions. They believe that the variability
sometimes results from bandwagons and similar expectations that carry exchange rates
away from their appropriate economic values. In addition, overshooting can cause
202
© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not
authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated,
forwarded, distributed, or posted on a website, in whole or part.
7. a. In the short run the country must implement policies to reduce
aggregate demand. The reduction in aggregate demand will create the
discipline of weak demand in putting downward pressure on the
b. The major countries of the world generally have low ination rates.
Adopting a currency board and a (xed exchange rate with one of
these currencies may help the country reduce its ination rate for
several reasons. First, the country is accepting the discipline e2ect of
(xed exchange rates. If the country’s demand expands too rapidly or
8. A currency board is a form of national monetary authority that focuses solely on
maintaining a fixed exchange rate value of the country’s currency. It holds only foreign
currency monetary assets, and its monetary liabilities are high-powered domestic money.
203
© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not
authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated,
forwarded, distributed, or posted on a website, in whole or part.
9. Dollarization is the process of a country (unilaterally) replacing its own
currency with the currency of some other country, for general use in
transactions within the country. Compared to using the national
currency, having a national central bank, and maintaining a (xed
exchange rate between the country’s currency and the currency of the
10. The five convergence criteria are: (1) the country’s inflation rate must be no more than
1.5 percentage points above the average inflation rate of the three lowest inflation EU
countries, (2) the country’s exchange rates must have been maintained within the ERM
band with no realignments during the previous two years, (3) the country’s long-term
204
© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not
authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated,
forwarded, distributed, or posted on a website, in whole or part.
11. There are several strong arguments. Here are four. First, joining the
monetary union and adopting the euro will eliminate the transactions
costs of exchanging pounds for euros. Resources used for this purpose
can be shifted to other uses. The lower costs will encourage more
205
© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not
authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated,
forwarded, distributed, or posted on a website, in whole or part.
12. Here are several arguments in favor of a Britain staying out of the European Monetary
Union and instead maintaining its policy of an independently floating exchange rate for
the pound. First, changes in the floating exchange-rate value of the pound can be used in
adjusting to reduce external imbalances that Britain might face. Changes in the
206
© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not
authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated,
forwarded, distributed, or posted on a website, in whole or part.