Answers to End of Chapter Questions
1. Balance of Payments.
a. Of what is the current account generally composed?
ANSWER: The current account balance is composed of (1) the balance of trade, (2) the net
b. Of what is the capital account generally composed?
ANSWER: The capital account is composed of all capital investments made between countries,
2. Inflation Effect on Trade.
a. How would a relatively high home inflation rate affect the home country’s current account,
other things being equal?
ANSWER: A high inflation rate tends to increase imports and decrease exports, thereby
b. Is a negative current account harmful to a country? Discuss.
ANSWER: This question is intended to encourage opinions and does not have a perfect solution.
3. Government Restrictions. How can government restrictions affect international payments among
countries?
ANSWER: Governments can place tariffs or quotas on imports to restrict imports. They can also
4. IMF.
a. What are some of the major objectives of the IMF?
ANSWER: Major IMF objectives are to (1) promote cooperation among countries on
b. How is the IMF involved in international trade?
ANSWER: The IMF in involved in international trade because it attempts to stabilize international
International Flow of Funds 2
5. Exchange Rate Effect on Trade Balance. Would the U.S. balance of trade deficit be larger or
smaller if the dollar depreciates against all currencies, versus depreciating against some currencies
but appreciated against others? Explain.
ANSWER: If the dollar weakens against all currencies, the U.S. balance of trade deficit will likely
6. Demand for Exports. A relatively small U.S. balance of trade deficit is commonly attributed to a
strong demand for U.S. exports. What do you think is the underlying reason for the strong
demand for U.S. exports?
ANSWER: The strong demand for U.S. exports is commonly attributed to strong foreign
7. Impact on International Trade. Why do you think international trade volume has increased over
time? In general, how are inefficient firms affected by the reduction in trade restrictions among
countries and the continuous increase in international trade?
ANSWER. International trade volume has increased because of the reduction in trade restrictions
8. Effects of the Euro. Explain how the existence of the euro may affect U.S. international trade.
ANSWER: The euro allowed for a single currency among many European countries. It could
The euro can increase trade within Europe because it eliminates the need for several European
9. Currency Effects. When South Korea’s export growth stalled, some South Korean firms
suggested that South Korea’s primary export problem was the weakness in the Japanese yen. How
would you interpret this statement?
ANSWER: One of South Korea’s primary competitors in exporting is Japan, which produces and
exports many of the same types of products to the same countries. When the Japanese yen is
10. Effects of Tariffs. Assume a simple world in which the U.S. exports soft drinks and beer to France
and imports wine from France. If the U.S. imposes large tariffs on the French wine, explain the
likely impact on the values of the U.S. beverage firms, U.S. wine producers, the French beverage
firms, and the French wine producers.
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International Flow of Funds 3
ANSWER: The U.S. wine producers benefit from the U.S. tariffs, while the French wine
Advanced Questions
11. Free Trade. There has been considerable momentum to reduce or remove trade barriers in an
effort to achieve “free trade.” Yet, one disgruntled executive of an exporting firm stated, “Free
trade is not conceivable; we are always at the mercy of the exchange rate. Any country can use
this mechanism to impose trade barriers.” What does this statement mean?
ANSWER: This statement implies that even if there were no explicit barriers, a government could
attempt to manipulate exchange rates to a level that would effectively reduce foreign competition.
12. International Investments. U.S.-based MNCs commonly invest in foreign securities.
a. Assume that the dollar is presently weak and is expected to strengthen over time. How will
these expectations affect the tendency of U.S. investors to invest in foreign securities?
ANSWER: The expectations of a strong dollar would discourage U.S. investors from investing
abroad. If the dollar is relatively weak now, U.S. investors need more dollars to make purchase
b. Explain how low U.S. interest rates can affect the tendency of U.S.-based MNCs to invest
abroad.
ANSWER: Low U.S. interest rates can encourage U.S.-based MNCs to invest abroad, as investors
c. In general terms, what is the attraction of foreign investments to U.S. investors?
ANSWER: The main attraction is potentially higher returns. The international stocks can
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International Flow of Funds 4
Exchange Rate Effects on Trade.
a. Explain why a stronger dollar could enlarge the U.S. balance of trade deficit. Explain why a
weaker dollar could affect the U.S. balance of trade deficit.
ANSWER: A stronger dollar makes U.S. exports more expensive to importers and may reduce
imports. It makes U.S. imports cheap and may increase U.S. imports. A weaker home currency
b. It is sometimes suggested that a floating exchange rate will adjust to reduce or eliminate any
current account deficit. Explain why this adjustment would occur.
ANSWER: A current account deficit reflects a net sale of the home currency in exchange for other
currencies. This places downward pressure on that home currency’s value. If the currency
c. Why does the exchange rate not always adjust to a current account deficit?
ANSWER: In some cases, the home currency will remain strong even though a current account
14. Impact of Government Policies on Trade. Governments of many countries enact policies that
can have a major impact on international trade flows.
a. Explain how governments might give their local firms a competitive advantage in the
international trade arena.
ANSWER: Some governments offer subsidies to their domestic firms so that those firms can
b. Why might different tax laws on corporate income across countries allow firms from some
countries to have a competitive advantage in the international trade arena?
ANSWER: When a government imposes lower corporate tax rates, firms may be able to charge
c. If a country imposes lower corporate income tax rates, does that provide an unfair advantage?
ANSWER: Lower tax rates should not be viewed as unfair, unless the government only allows its
15. China – U.S. Balance of Trade. There is an ongoing debate between the U.S. and China regarding
whether the Chinese yuan’s value should be revalued upward. The cost of labor in China is
substantially lower than that in the U.S.
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International Flow of Funds 5
a. Would the U.S. balance of trade deficit in China be eliminated if the yuan was revalued upward
by 20%? Or by 40%? Or by 80%?
ANSWER: This is an open question without a perfect answer. Yet, it should at least make students
b. If the yuan was revalued to the extent that it substantially reduced the U.S. demand for Chinese
products, would this shift the U.S. demand toward the U.S. or toward other countries where wage
rates are relatively low? In other words, would the correction of the U.S. balance of trade deficit
have a major impact on U.S. productivity and jobs?
ANSWER: To the extent that there are decent substitute products in other low wage countries, it
Solution to Continuing Case Problem: Blades, Inc.
1. How could a higher level of inflation in Thailand affect Blades (assume U.S. inflation remains
constant)?
ANSWER: A high level of inflation in Thailand relative to the United States could affect Blades
2. How could competition from firms in Thailand and from U.S. firms conducting business in
Thailand affect Blades?
ANSWER: Blades would be favorably affected relative to Thai roller blade manufacturers and
relative to other U.S. roller blade manufacturers with operations in Thailand. Both groups of firms
3. How could a decreasing level of national income in Thailand affect Blades?
ANSWER: At first glance, it would appear that a decreasing level of national income in Thailand
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International Flow of Funds 6
4. How could a continued depreciation of the Thai baht affect Blades? How would it affect Blades’
relative to U.S. exporters invoicing their roller blades in U.S. dollars?
ANSWER: A continued depreciation of the Thai baht would hurt Blades, especially because the
firm invoices its roller blades in baht. A continued depreciation of the baht means that the
Although Blades would be hurt by a depreciating baht because its exports are denominated in baht,
5. If Blades increases its business in Thailand and experiences serious financial problems, are there
any international agencies that the company could approach for loans or other financial assistance?
ANSWER: An agency extending direct loans to corporations involved in international trade is the
Solution to Supplemental Case: Maple Leaf Paper Company
This case reflects the actual experience of a Canadian exporting firm (although the name and industry
have been changed) to the free-trade agreement on January 2, 1989. The appreciation in Canadian
dollars (resulting from the agreement) offset the tariff, so that the firm was no better off with the
free-trade agreement. The case shows that the effects of free trade are not always so obvious and may
differ across firms.
a. While the tariff allowed for a 12 percent decline in price, the U.S. clients will have to pay more
dollars to obtain Canadian dollars in the future, based on the forecast of the exchange rate. The
exchange rate is expected to rise by 13.15 percent. Given that the 12 percent tariff is removed
along with the exchange rate movement, the net effect will be an increase in price to U.S. clients
of about one percent. Based on the relationship between the price and U.S. demand, the U.S.
demand for Maple Leaf paper should decline 3 percent in response to the one percent increase in
price. This implies a U.S. demand of 174,600 rolls of paper per year.
In Canada, the 20 percent increase in demand (provided in the case) implies an annual demand of
24,000 rolls. Therefore, the total demand for Maple Leaf paper should be around 198,600 rolls,
which is slightly less than the total demand in the past.
b. The precise forecast is not as important as the general concept here. What seemed to be a
favorable event does not benefit Maple Leaf. While the free-trade agreement allows for the
removal of tariffs, it causes a shift in international trade flows, which places upward pressure on
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International Flow of Funds 7
the Canadian dollar’s value. The appreciation of the Canadian dollar is expected to overwhelm the
effect of removing the tariff, forcing the price in U.S. dollars to rise.
c. The U.S. exporting firm is not directly affected by the removal of the tariff on Canadian exports,
but would benefit from the appreciation of the Canadian dollar.
Small Business Dilemma
Identifying Factors That Will Affect the Foreign Demand at the Sports Exports
Company
Identify the factors that affect the current account balance between the U.S. and the U.K. Explain how
each factor may possibly affect the British demand for the footballs that are produced by the Sports
Exports Company.
ANSWER:
1. High inflation in the U.K. could cause a shift in the demand for U.S. products instead of British
2. High national income in the U.K. could increase the amount of spending by British consumers,
3. Government restrictions could be imposed by the British government on goods (such as the
4. The exchange rate of the British pound will change over time. However, since the Sports Exports
Company is willing to accept pounds when it sells footballs to the distributor, the distributor does
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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.