International Economics Theory and Policy, 10E Paul R Krugman Test Bank

International Economics Theory and Policy, 10E BY Paul R. Krugman

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International Economics, 10e (Krugman/Obstfeld/Melitz) Chapter 1 Introduction 1.1 What Is International Economics About? 1) Historians of economic thought often describe ________ written by ________ and published in ________ as the first real exposition of an economic model. A) "Of the Balance of Trade," David Hume, 1776 B) "Wealth of Nations," David Hume, 1758 C) "Wealth of Nations," Adam Smith, 1758 D) "Wealth of Nations," Adam Smith, 1776 E) "Of the Balance of Trade," David Hume, 1758 Answer: E Page Ref: 1 Difficulty: Easy 2) From 1960 to 2012 A) the U.S. economy roughly tripled in size. B) U.S. imports roughly tripled in size. C) the share of US Trade in the global economy roughly tripled in size. D) U.S. Imports roughly tripled as compared to U.S. exports. E) U.S. exports roughly tripled in size. Answer: C Page Ref: 1 Difficulty: Easy 3) The United States is less dependent on trade than most other countries because A) the United States is a relatively large country with diverse resources. B) the United States is a "Superpower." C) the military power of the United States makes it less dependent on anything. D) the United States invests in many other countries. E) many countries invest in the United States. Answer: A Page Ref: 2 Difficulty: Easy 4) Theories of international economics from the 18th and 19th Centuries are A) not relevant to current policy analysis. B) only of moderate relevance in today's modern international economy. C) highly relevant in today's modern international economy. D) the only theories that actually relevant to modern international economy. E) not well understood by modern mathematically oriented theorists. Answer: C Page Ref: 2 Difficulty: Easy

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5) An important insight of international trade theory is that when two countries engage in voluntary trade A) one country always benefits at the expense of the other. B) it is almost always beneficial to both countries. C) it only benefits the low wage country. D) it only benefits the high wage country. E) it is almost never beneficial to both countries. Answer: B Page Ref: 4 Difficulty: Easy 6) If there are large disparities in wage levels between countries, then A) trade is likely to be harmful to both countries. B) trade is likely to be harmful to the country with the high wages. C) trade is likely to be harmful to the country with the low wages. D) trade is likely to be harmful to neither country. E) trade is likely to have no effect on either country. Answer: D Page Ref: 4 Difficulty: Easy 7) The benefits of international trade are derived from trade in A) tangible goods only. B) intangible goods only. C) goods but not services. D) services but not goods. E) anything of value. Answer: E Page Ref: 4 Difficulty: Easy 8) Which of the following does NOT belong? A) NAFTA B) Uruguay Round C) World Trade Organization D) non-tariff barriers E) major free trade agreements of the 1990s Answer: D Page Ref: 5-6 Difficulty: Easy

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9) International economics ________ use the same fundamental methods of analysis as other branches of economics, because ________. A) does not, the level of complexity of international issues is unique B) does not, the interactions associated with international economic relations is highly mathematical C) does not, international economics takes a different perspective on economic issues D) does not, international economic policy requires cooperation with other countries E) does, the motives and behavior of individuals are the same in international trade as they are in domestic transactions Answer: E Page Ref: 3 Difficulty: Easy 10) Because the Constitution forbids restraints on interstate trade A) the U.S. may not impose tariffs on imports from NAFTA countries. B) the U.S. may not affect the international value of the $ U.S. C) the U.S. may not put restraints on foreign investments in California if it involves a financial intermediary in New York State. D) the U.S. may not impose export duties. E) the U.S. may not disrupt commerce between Florida and Hawaii. Answer: E Page Ref: 3 Difficulty: Easy 11) Which of the following is NOT a major concern of international economic theory? A) protectionism B) the balance of payments C) exchange rate determination D) bilateral trade relations with China E) the international capital market Answer: D Page Ref: 3 Difficulty: Easy 12) "Trade is generally harmful if there are large disparities between countries in wages." A) This is generally true. B) This is generally false. C) Trade theory has nothing to say about this issue. D) This is true if the trade partner ignores child labor laws. E) This is true if the trade partner uses prison labor. Answer: B Page Ref: 4 Difficulty: Easy

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13) Who sells what to whom A) has been a major preoccupation of international economics. B) is not a valid concern of international economics. C) is not considered important for government foreign trade policy since such decisions are made in the private competitive market. D) is determined by political rather than economic factors. E) is less important than international economic theory. Answer: A Page Ref: 5 Difficulty: Easy 14) The insight that patterns of trade are primarily determined by international differences in labor productivity was first proposed by A) Adam Smith. B) David Hume. C) David Ricardo. D) Eli Heckscher. E) Lerner and Samuelson. Answer: A Page Ref: 5 Difficulty: Easy 15) After World War II, the United States has pursued a broad policy of A) strengthening "Fortress America" protectionism. B) removing barriers to international trade. C) isolating Iran and other members of the "axis of evil." D) protecting the U.S. from the economic impact of oil producers. E) restricting trade of manufactured goods. Answer: B Page Ref: 5 Difficulty: Easy 16) The balance of payments has become a central issue for the United States because A) when the balance of payments is not balanced, society is unbalanced. B) the U.S. economy cannot grow when the balance of payments is in deficit. C) the U.S. has run huge trade deficits in every year since 1982. D) the U.S. never experienced a surplus in its balance of payments. E) the U.S. once ran a large trade surplus of about $40 billion. Answer: C Page Ref: 6 Difficulty: Easy

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17) The euro, a common currency for most of the nations of Western Europe, was introduced A) before 1900. B) before 1990. C) before 2000. D) in order to snub the pride of the U.S. E) in order to fix currencies in terms of the U.S dollar. Answer: C Page Ref: 6 Difficulty: Easy 18) During the first three years of its existence, the euro A) depreciated against the $U.S. B) maintained a strict parity with the $U.S. C) strengthened against the $U.S. D) proved to be an impossible dream. E) exported exclusively to the U.S. Answer: A Page Ref: 6 Difficulty: Easy 19) The study of exchange rate determination is a relatively new part of international economics, since A) for much of the past century, exchange rates were fixed by government action. B) the calculations required for this were not possible before modern computers became available. C) economic theory developed by David Hume demonstrated that real exchange rates remain fixed over time. D) dynamic overshooting asset pricing models are a recent theoretical development. E) the exchange rate never fluctuates. Answer: A Page Ref: 7 Difficulty: Easy 20) A fundamental problem in international economics is how to produce A) a perfect degree of monetary harmony. B) an acceptable degree of harmony among the international trade policies of different countries. C) a world government that can harmonize trade and monetary policies D) a counter-cyclical monetary policy so that all countries will not be adversely affected by a financial crisis in one country. E) a worldwide form of currency. Answer: B Page Ref: 7 Difficulty: Easy

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21) For almost 70 years international trade policies have been governed A) by the World Trade Organization. B) by the International Monetary Fund. C) by the World. D) by an international treaty known as the General Agreement on Tariffs and Trade (GATT). E) by the North American Free Trade Agreement (NAFTA). Answer: D Page Ref: 7 Difficulty: Easy 22) The international capital market is A) the place where you can rent earth moving equipment anywhere in the world. B) a set of arrangements by which individuals and firms exchange money now for promises to pay in the future. C) the arrangement where banks build up their capital by borrowing from the Central Bank. D) the place where emerging economies accept capital invested by banks. E) exclusively concerned with the debt crisis that ended in the 1990s. Answer: B Page Ref: 8 Difficulty: Easy 23) International capital markets experience a kind of risk not faced in domestic capital markets, namely A) "economic meltdown" risk. B) Flood and hurricane crisis risk. C) the risk of unexpected downgrading of assets by Standard and Poor. D) the risk of exchange rate fluctuations. E) the risk of political upheaval. Answer: D Page Ref: 6-7 Difficulty: Easy 24) Since 1994, trade rules have been enforced by A) the WTO. B) the G10. C) the GATT. D) The U.S. Congress. E) the European Union. Answer: A Page Ref: 5-6 Difficulty: Easy

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25) In 1998 an economic and financial crisis in South Korea caused it to experience A) a surplus in their balance of payments. B) a deficit in their balance of payments. C) a balanced balance of payments. D) an unbalanced balance of payments. E) a lull in international trade. Answer: A Page Ref: 6 Difficulty: Easy 26) In 1999, demonstrators representing a mix of traditional and new ideologies disrupted a major international trade meeting in Seattle of A) the OECD. B) NAFTA. C) the WTO. D) GATT. E) the G8. Answer: C Page Ref: 6 Difficulty: Easy 27) International Economists cannot discuss the effects of international trade or recommend changes in government policies toward trade with any confidence unless they know A) their theory is the best available. B) their theory is internally consistent. C) their theory passes the "reasonable person" legal criteria. D) their theory is good enough to explain the international trade that is actually observed. E) their theory accounts for China's unique position in international trade. Answer: D Page Ref: 5 Difficulty: Easy 28) Trade theorists have proven that the gains from international trade A) must raise the economic welfare of every country engaged in trade. B) must raise the economic welfare of everyone in every country engaged in trade. C) must harm owners of "specific" factors of production. D) will always help "winners" by an amount exceeding the losses of "losers." E) usually outweigh the benefits of protectionist policies. Answer: E Page Ref: 4 Difficulty: Easy

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29) The international financial crisis of 2007 was the result of A) failure of the Euro currency. B) runaway inflation in the U.S. C) a deep global recession. D) the collapse of global currency markets. E) defaults on U.S. mortgage-backed securities. Answer: E Page Ref: 8 Difficulty: Easy 30) In September 2010, the finance minister of ________ declared that the world was "in the midst of an international currency war" because of rapid appreciation in the value of the country's currency, the ________. A) England; pound sterling B) Germany; euro C) Japan; yen D) China; renminbi E) Brazil; Real Answer: E Page Ref: 8 Difficulty: Easy 1.2 International Economics: Trade and Money 1) Cost-benefit analysis of international trade A) is basically useless. B) is empirically intractable. C) focuses attention primarily on conflicts of interest within countries. D) focuses attention on conflicts of interest between countries. E) never leads to government intervention in international trade. Answer: C Page Ref: 8-9 Difficulty: Easy 2) An improvement in a country's balance of payments means a decrease in its balance of payments deficit, or an increase in its surplus. In fact we know that a surplus in a balance of payments A) is always beneficial. B) is usually beneficial. C) is never harmful. D) is sometimes harmful. E) is always harmful. Answer: D Page Ref: 8-9 Difficulty: Easy

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3) The GATT is A) an international treaty. B) an international U.N. agency. C) an international IMF agency. D) a U.S. government agency. E) a collection of tariffs. Answer: A Page Ref: 8-9 Difficulty: Easy 4) The international debt crisis of early 1982 was precipitated when ________ could not pay its international debts. A) Russia B) Mexico C) Brazil D) Malaysia E) China Answer: B Page Ref: 8-9 Difficulty: Easy 5) International economics can be divided into two broad sub-fields A) macro and micro. B) developed and less developed. C) monetary and barter. D) international trade and international money. E) static and dynamic. Answer: D Page Ref: 8-9 Difficulty: Easy 6) International monetary analysis focuses on A) the real side of the international economy. B) the international trade side of the international economy. C) the international investment side of the international economy. D) the issues of international cooperation between Central Banks. E) the monetary side of the international economy, such as currency exchange. Answer: E Page Ref: 8-9 Difficulty: Easy

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7) The distinction between international trade and international money is not entirely clear because A) real developments in the trade accounts do not have monetary implications. B) the balance of payments includes only real measures. C) developments caused by purely monetary changes have no real effects. D) trade models focus on real, or barter relationships. E) most international trade involves monetary transactions. Answer: E Page Ref: 8-9 Difficulty: Easy 8) It is argued that global trade tends to be more important to countries with smaller economies than the U.S. Is this empirically verified? Answer: Yes. Figure 1-2 shows exports and imports as a percentage of national income in the U.S. and five other countries and notes that "International trade is even more important to most other countries than it is to the U.S." Page Ref: 8-9 Difficulty: Easy 9) It is argued that if a rich high wage country such as the United States were to expand trade with a relatively poor and low wage country such as Mexico, then U.S. industry would migrate south, and U.S. wages would fall to the level of Mexico's. What do you think about this argument? Answer: The student may think anything. The purpose of the question is to set up a discussion, which will lead to the models in the following chapters. Page Ref: 8-9 Difficulty: Moderate 10) How are the patterns of international trade, that is the pattern of what different countries export and import, explained? Answer: Climate explains why Brazil exports coffee. Natural resources explain why Saudi Arabia exports oil. More generally, differences in labor productivity and in the availability of land, labor, and capital within different countries explain patterns of trade. More recent research suggests that there is a significant random component involved, as well. Page Ref: 8-9 Difficulty: Moderate 11) International trade theory implies that international trade is beneficial to all trading countries. However, casual observation leads to the conclusion that official obstruction of international trade flows is widespread. How might you reconcile these two facts? Answer: This question is meant to allow students to offer preliminary discussions of issues, which will be explored in depth later in the book. Page Ref: 8-9 Difficulty: Moderate

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International Economics, 10e (Krugman/Obstfeld/Melitz) Chapter 2 World Trade: An Overview 2.1 Who Trades with Whom? 1) Approximately what percent of all world production of goods and services is exported to other countries? A) 10% B) 30% C) 50% D) 100% E) 90% Answer: B Page Ref: 10 Difficulty: Easy 2) The gravity model offers a logical explanation for the fact that A) trade between Asia and the U.S. has grown faster than NAFTA trade. B) trade in services has grown faster than trade in goods. C) trade in manufactures has grown faster than in agricultural products. D) Intra-European Union trade exceeds international trade by the European Union. E) the U.S. trades more with Western Europe than it does with Canada. Answer: D Page Ref: 13 Difficulty: Moderate 3) The gravity model suggests that over time A) trade between neighboring countries will increase. B) trade between all countries will increase. C) world trade will eventually be swallowed by a black hole. D) trade between Earth and other planets will become important. E) the value of trade between two countries will be proportional to the product of the two countries' GDP. Answer: E Page Ref: 16 Difficulty: Moderate 4) The gravity model explains why A) trade between Sweden and Germany exceeds that between Sweden and Spain. B) countries with oil reserves tend to export oil. C) capital rich countries export capital intensive products. D) intra-industry trade is relatively more important than other forms of trade between neighboring countries. E) European countries rely most often on natural resources. Answer: A Page Ref: 11 Difficulty: Moderate 1 .

5) According to the gravity model, a characteristic that tends to affect the probability of trade existing between any two countries is A) their cultural affinity. B) the average weight/value of their traded goods. C) their colonial-historical ties. D) the distance between them. E) the number of different product varieties produced by their industries. Answer: D Page Ref: 12 Difficulty: Easy 6) In general, which of the following do NOT tend to increase trade between two countries? A) linguistic and/or cultural affinity B) historical ties C) larger economies D) mutual membership in preferential trade agreements E) the existence of well controlled borders between countries Answer: E Page Ref: 13 Difficulty: Easy 7) Why does the gravity model work? A) Large economies became large because they were engaged in international trade. B) Large economies have relatively large incomes, and hence spend more on government promotion of trade and investment. C) Large economies have relatively larger areas which raises the probability that a productive activity will take place within the borders of that country. D) Large economies tend to have large incomes and tend to spend more on imports. E) Large economies tend to avoid trading with small economies. Answer: D Page Ref: 13 Difficulty: Easy 8) We see that the Netherlands, Belgium, and Ireland trade considerably more with the United States than with many other countries. A) This is explained by the gravity model, since these are all large countries. B) This is explained by the gravity model, since these are all small countries. C) This fails to be consistent with the gravity model, since these are small countries. D) This fails to be consistent with the gravity model, since these are large countries. E) This is explained by the gravity model, since they do not share borders. Answer: C Page Ref: 13 Difficulty: Easy

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9) The two neighbors of the United States do a lot more trade with the United States than European economies of equal size. A) This contradicts predictions from gravity models. B) This is consistent with predictions from gravity models. C) This is irrelevant to any inferences that may be drawn from gravity models. D) This is because these neighboring countries have exceptionally large GDPs. E) This relates to Belgium's trade record with the U.S. Answer: B Page Ref: 13 Difficulty: Moderate 2.2 The Changing Pattern of World Trade 1) Since the period following World War II (the early 1950s), the proportion of most countries' production being used in some other country A) remained constant. B) increased. C) decreased. D) fluctuated widely with no clear trend. E) increased slightly before dropping off. Answer: B Page Ref: 17 Difficulty: Easy 2) Since World War II, the likelihood that foreign markets would gain importance to average exporters as a source of profits has A) remained constant. B) increased. C) decreased. D) fluctuated widely with no clear trend. E) increased slightly before dropping off. Answer: B Page Ref: 17 Difficulty: Easy 3) Since World War II, the likelihood that any single item in the typical consumption basket of a consumer in the U.S. originated outside of the U.S. A) remained constant. B) increased. C) decreased. D) fluctuated widely with no clear trend. E) increased slightly before dropping off. Answer: B Page Ref: 18 Difficulty: Easy

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4) Since World War II, the likelihood that the job of a new college graduate will be directly or indirectly affected by world trade A) remained constant. B) increased. C) decreased. D) fluctuated widely with no clear trend. E) increased slightly before dropping off. Answer: B Page Ref: 17 Difficulty: Easy 5) Since World War II, the relative importance of raw materials, including oil, in total world trade A) remained constant. B) increased. C) decreased. D) fluctuated widely with no clear trend E) increased slightly before dropping off. Answer: C Page Ref: 18-19 Difficulty: Easy 6) In the current Post-Industrial economy, international trade in services (including banking and financial services) A) dominates world trade. B) does not exist. C) is an increasingly important component of global trade. D) is relatively stagnant. E) far surpasses the predictions of economist Alan Blinder. Answer: C Page Ref: 20 Difficulty: Easy 7) In the pre-World War I period, the U.S. exported mainly A) manufactured goods. B) services. C) primary products including agricultural. D) technology intensive products. E) weapons. Answer: C Page Ref: 19 Difficulty: Easy

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8) In the pre-World War I period, the United Kingdom exported mainly A) manufactured goods. B) services. C) primary products including agricultural. D) technology intensive products. E) livestock. Answer: A Page Ref: 18 Difficulty: Easy 9) In the pre-World War I period, the United Kingdom imported mainly A) manufactured goods. B) services. C) primary products including agricultural. D) technology intensive products. E) from the United States. Answer: C Page Ref: 18 Difficulty: Easy 10) In the present, most of the exports from China are A) manufactured goods. B) services. C) primary products including agricultural. D) technology intensive products. E) overpriced by world market standards. Answer: A Page Ref: 19 Difficulty: Easy 11) Which of the following does NOT explain the extent of trade between Ireland and the U.S.? A) historical ties B) cultural Linguistic ties C) Gravity Model D) multinational corporations E) large numbers of Irish-Americans Answer: C Page Ref: 13 Difficulty: Moderate

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12) When comparing the composition of world trade in the early 20th century to the early 21st century, we find major compositional changes. These include a relative decline in trade in agricultural and primary-products (including raw materials). How would you explain this in terms of broad historical developments during this period? Answer: The typical composition of world production during this period experienced major changes. Focusing on today's Industrialized Countries (primarily members of the OECD), the industrial-employment composition was focused primarily on agriculture. Most value was in land. The predominant single consumption category was food. Since then, the economies shifted from the agricultural to the manufacturing sectors (continuing trends begun over a century earlier in the industrial revolution). Incomes rose, and consumption shifted in favor of (increasingly affordable) manufactures. Both income and price elasticities were greater in manufactures than in agricultural products. At the same time there was a steady tendency for synthetic (manufactured) inputs to replace agricultural based raw materials and industrial inputs. Hence, trade and of course international trade conformed to overall changes in patterns of world production and consumption. Page Ref: 17-21 Difficulty: Easy 13) In the past half century, the developing countries have experienced major compositional shifts from exports of primary products (including agricultural and raw materials) to exports of manufactures. How might you explain this in terms of broad historical developments during this period? Answer: Any discussion of the export experience of the developing countries must first clarify the problem of definitional inclusion. In particular, the exports of the (non-OECD) developing countries, has become increasingly dominated by the experience of a relatively small number of countries in South-East Asia, termed the New Industrialized Countries (NICs). Since they experienced both very rapid increases in their exports, and very rapid increases in the manufactured component of their exports, their experience alone may explain the bulk of the observed phenomenon. Many would exclude the NICs from the developing country category so as to be able to focus the discussion on a more representative sample of (the over 100) developing countries. More recently, a second wave of East Asian countries, notably including China have replicated the experience of the NICs, and this again muddies the water for one interested in focusing on the export experience of the increasingly heterogeneous category, developing countries. Another explanation of the growing dependence on manufactured exports on the part of the developing countries is the following: Since the consumer ( including industrial consumer) markets in OECD countries were rapidly shifting away from primary products, these markets were rapidly disappearing. In addition, the world market for primary products was generally limited by low price and especially income elasticities; agricultural sectors tended to be highly and rigidly protected in potential OECD markets; and escalating effective tariff structures levied systematically large levels of protection against the primary exports of the developing countries; export success had to be pursued outside of the traditional primary exports of these countries. Page Ref: 17-21 Difficulty: Difficult

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2.3 Do Old Rules Still Apply? 1) The Neoclassical Heckscher-Ohlin model assumes that all producers of any industrial product has knowledge of, and may avail itself of the same production technology available to producers in any other country. Many have flagged this identical technology assumption as unrealistic. During the past half century, the relative importance of Multinational Corporations (MNCs) in world trade has steadily increased. How would this trend affect the realism of the "identical technology" assumption? Answer: Noting that MNC plants tend to use more labor intensive production processes in countries where labor tends to be relatively cheap (both in "low" tech, e.g., Nike, and "high tech," e.g., Motorola), one may argue that MNCs use different technologies in developing countries. However, this is a gross misunderstanding of the identical technology assumption. It is axiomatically obvious that if the same MNC is producing something in both labor abundant and labor scarce using different processes, it nevertheless has knowledge (intimate knowledge in the case of proprietary patented processes) of available technology. The fact that the MNC may choose not to apply the same degree of capital intensity in environments with greatly different relative factor prices in no way lessens the fact that the Heckscher-Ohlin identical technology assumption is strengthened due to the growing relative strength of MNCs in developing countries. An additional fact that strengthens this argument is that, as compared to the early 1950s, a growing proportion of MNCs are themselves based in developing countries, such as China and Brazil. Page Ref: 21 Difficulty: Difficult 2) One of the major political developments of the past several decades is the growing size and economic/monetary integration of the European Union. What effect do you think this will have on international trade between countries? Answer: The growing economic integration between the various countries of Europe, both the old and existing members of the European Union (EU) and the new countries joining it (including perhaps soon, Turkey), means that the barriers to trade are steadily falling in a region that has traditionally dominated world trade. The common monetary unit should in itself go far to promote inter-country trade within the growing EU (judging by the positive historical effect of a single currency in the U.S.). The standardization of transportation (including railroad gauges, highway signs etc.) and product codes will also promote expansion of intra-EU trade. The decline in the probability of political conflict associated with this comprehensive economic union, plus conscious attempts to cooperate in fiscal and monetary policy stances again point to growing international trade, allowing these countries to increasingly enjoy the fruits of potential positive scale economies, and more traditional classical and neo-classical gains from trade. The scale economies will also tend to increase trade between the EU and other countries. Page Ref: 21 Difficulty: Difficult

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3) The Services sector has been steadily rising in relative importance in GDP of the United States, as well as elsewhere around the world. Since "services" have been identified as "nontradable" (e.g., it is difficult to export haircuts), it may be argued that this trend will likely slow the rapid growth in international trade. Discuss. Answer: This argument stands on questionable logical foundations. The past half century has seen a steady growth in the absolute and relative importance of international trade. This trend has been reversed only by global conflicts, i.e. the two World Wars. This trend has remained steady and robust despite major compositional shifts (e.g., from primary to manufacturing), and location shifts (e.g., the sudden rise of NICs as significant group of exporters). The trend will probably continue into the reasonable future, fueled by both super-regional preferential trade regions and a growing impact of the multilateral forces, represented institutionally by the World Trade Organization (WTO)—as illustrated by the recent abolishment of the epitome cartelized trade, the world trade in textiles. Driven by technology—especially in the areas of communication and transportation—a reversal of the growing trade trend is not likely in the near future. In any case, many "services" are in fact quite tradable. Examples would be financial services, long-distance teaching, "help-desk" outsourcing, consulting and management services and others. In fact, when a tourist gets a haircut, we see that even haircuts become a "tradable" service. Page Ref: 17-21 Difficulty: Difficult

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International Economics, 10e (Krugman/Obstfeld/Melitz) Chapter 3 Labor Productivity and Comparative Advantage: The Ricardian Model 3.1 The Concept of Comparative Advantage 1) Trade between two countries can benefit both countries if A) each country exports that good in which it has a comparative advantage. B) each country enjoys superior terms of trade. C) each country has a more elastic demand for the imported goods. D) each country has a more elastic supply for the exported goods. E) each country produces a wide range of goods for export. Answer: A Page Ref: 24 Difficulty: Easy 2) In order to know whether a country has a comparative advantage in the production of one particular product we need information on at least ________ unit labor requirements A) one B) two C) three D) four E) five Answer: D Page Ref: 29 Difficulty: Easy 3) A country engaging in trade according to the principles of comparative advantage gains from trade because it A) is producing exports indirectly more efficiently than it could alternatively. B) is producing imports indirectly more efficiently than it could domestically. C) is producing exports using fewer labor units. D) is producing imports indirectly using fewer labor units. E) is producing exports while outsourcing services. Answer: B Page Ref: 26 Difficulty: Easy

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4) Given the information in the table above, if it is ascertained that Foreign uses prison-slave labor to produce its exports, then home should A) export cloth. B) export widgets. C) export both and import nothing. D) export and import nothing. E) export widgets and import cloth. Answer: A Page Ref: 29 Difficulty: Moderate 5) Given the information in the table above, if the Home economy suffered a meltdown, and the Unit Labor Requirements doubled to 20 for cloth and 40 for widgets then home should A) export cloth. B) export widgets. C) export both and import nothing. D) export and import nothing. E) export widgets and import cloth. Answer: A Page Ref: 29 Difficulty: Moderate 6) The earliest statement of the principle of comparative advantage is associated with A) David Hume. B) David Ricardo. C) Adam Smith. D) Eli Heckscher. E) Bertil Ohlin. Answer: B Page Ref: 26 Difficulty: Easy 7) The Ricardian model attributes the gains from trade associated with the principle of comparative advantage result to A) differences in technology. B) differences in preferences. C) differences in labor productivity. D) differences in resources. E) gravity relationships among countries. Answer: C Page Ref: 25 Difficulty: Easy 2 .

8) The Ricardian model demonstrates that A) trade between two countries will benefit both countries. B) trade between two countries may benefit both regardless of which good each exports. C) trade between two countries may benefit both if each exports the product in which it has a comparative advantage. D) trade between two countries may benefit one but harm the other. E) trade between two countries always benefits the country with a larger labor force. Answer: C Page Ref: 26 Difficulty: Easy 3.2 A One-Factor Economy 1) Use the information in the table below to answer the following questions.

(a) Does either country have an absolute advantage in the production of wheat or beef? Explain. (b) What is the opportunity cost of wheat in each country? (c) What is the opportunity cost of beef in each country? (d) Analyze comparative advantage and opportunities for trade between the U.S. and Argentina. Answer: (a) The U.S. has an absolute advantage in the production of both wheat and beef because labor productivity in the U.S. exceeds labor productivity in Argentina for both products. (b) In the U.S., the opportunity cost of wheat is 100/300 or 0.33 units of beef. In Argentina, the opportunity cost of wheat is 20/20 or 1.0 unit of beef. (c) In the U.S., the opportunity cost of beef is 300/100 or 3.0 units of wheat. In Argentina, the opportunity cost of beef is 20/20 or 1.0 unit of wheat. (d) The U.S. has a comparative advantage in wheat production and Argentina has a comparative advantage in beef production. If the U.S. can trade wheat to Argentina at a rate of more than 0.33 units of beef per unit of wheat, then the U.S. will benefit. If Argentina can trade beef to the U.S. at a rate of more than one unit of wheat per unit of beef, then Argentina will benefit. Page Ref: 26-29 Difficulty: Moderate

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2) Use the information in the table below to answer the following questions.

(a) Does either country have an absolute advantage in the production of wheat or beef? Explain. (b) What is the opportunity cost of wheat in each country? (c) What is the opportunity cost of beef in each country? (d) Analyze comparative advantage and opportunities for trade between the U.S. and Argentina. Answer: (a) The U.S. has an absolute advantage in the production of both wheat and beef because labor productivity in the U.S. exceeds labor productivity in Argentina for both products. (b) In the U.S., the opportunity cost of wheat is 100/200 or 0.5 units of beef. In Argentina, the opportunity cost of wheat is 80/20 or 4.0 units of beef. (c) In the U.S., the opportunity cost of beef is 200/100 or 2.0 units of wheat. In Argentina, the opportunity cost of beef is 20/80 or 0.25 units of wheat. (d) The U.S. has a comparative advantage in wheat production and Argentina has a comparative advantage in beef production. If the U.S. can trade wheat to Argentina at a rate of more than 0.5 units of beef per unit of wheat, then the U.S. will benefit. If Argentina can trade beef to the U.S. at a rate of more than 0.25 unit of wheat per unit of beef, then Argentina will benefit. Page Ref: 26-29 Difficulty: Moderate

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3) Use the information in the table below to answer the following questions.

(a) Does either country have an absolute advantage in the production of wheat or beef? Explain. (b) What is the opportunity cost of wheat in each country? (c) What is the opportunity cost of beef in each country? (d) Analyze comparative advantage and opportunities for trade between the U.S. and Argentina. Answer: (a) Argentina has an absolute advantage in the production of both wheat and beef because labor productivity in Argentina exceeds labor productivity in the U.S. for both products. (b) In the U.S., the opportunity cost of wheat is 200/100 or 2.0 units of beef. In Argentina, the opportunity cost of wheat is 400/200 or 2.0 units of beef. (c) In the U.S., the opportunity cost of beef is 100/200 or 0.5 units of wheat. In Argentina, the opportunity cost of beef is 400/200 or 0.5 units of wheat. (d) Neither country has a comparative advantage and there is, therefore, no opportunity for beneficial trade. Page Ref: 26-29 Difficulty: Moderate 3.3 Trade in a One-Factor World

1) Given the information in the table above A) neither country has a comparative advantage in cloth. B) Home has a comparative advantage in cloth. C) Foreign has a comparative advantage in cloth. D) Home has a comparative advantage in both cloth and widgets. E) neither country has a comparative advantage in widgets. Answer: B Page Ref: 29 Difficulty: Moderate

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2) Given the information in the table above, if wages were to double in Home, then Home should A) export cloth. B) export widgets. C) export both and import nothing. D) export and import nothing. E) export widgets and import cloth. Answer: A Page Ref: 29 Difficulty: Moderate 3) Given the information in the table above A) neither country has a comparative advantage in cloth. B) Home has a comparative advantage in widgets. C) Foreign has a comparative advantage in widgets. D) Home has a comparative advantage in both cloth and widgets. E) neither country has a comparative advantage in widgets. Answer: C Page Ref: 29 Difficulty: Moderate 4) Given the information in the table above, Home's opportunity cost of cloth is A) 0.5. B) 2.0. C) 6.0. D) 1.5. E) 3.0. Answer: A Page Ref: 29 Difficulty: Moderate 5) Given the information in the table above, Home's opportunity cost of widgets is A) 0.5. B) 2.0. C) 6.0. D) 1.5. E) 3.0. Answer: B Page Ref: 29 Difficulty: Moderate

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6) Given the information in the table above, Foreign's opportunity cost of cloth is A) 0.5. B) 2.0. C) 6.0. D) 1.5. E) 3.0. Answer: B Page Ref: 29 Difficulty: Moderate 7) Given the information in the table above, Foreign's opportunity cost of widgets is A) 0.5. B) 2.0. C) 6.0. D) 1.5. E) 3.0. Answer: A Page Ref: 29 Difficulty: Moderate 8) Given the information in the table above, if the world equilibrium price of widgets were 4 cloth, then A) both countries could benefit from trade with each other. B) neither country could benefit from trade with each other. C) each country will want to export the good in which it enjoys comparative advantage. D) neither country will want to export the good in which it enjoys comparative advantage. E) both countries will want to specialize in cloth. Answer: A Page Ref: 30 Difficulty: Moderate 9) Given the information in the table above, if the world equilibrium price of widgets were 40 cloths, then A) both countries could benefit from trade with each other. B) neither country could benefit from trade with each other. C) each country will want to export the good in which it enjoys comparative advantage. D) neither country will want to export the good in which it enjoys comparative advantage. E) both countries will want to specialize in cloth. Answer: A Page Ref: 30 Difficulty: Moderate

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10) In a two product two country world, international trade can lead to increases in A) consumer welfare only if output of both products is increased. B) output of both products and consumer welfare in both countries. C) total production of both products but not consumer welfare in both countries. D) consumer welfare in both countries but not total production of both products. E) prices of both goods in both countries. Answer: B Page Ref: 31 Difficulty: Moderate 11) As a result of trade, specialization in the Ricardian model tends to be A) complete with constant costs and with increasing costs. B) complete with constant costs and incomplete with increasing costs. C) incomplete with constant costs and complete with increasing costs. D) incomplete with constant costs and incomplete with increasing costs. E) dependent on the specific opportunity costs involved in production. Answer: B Page Ref: 34 Difficulty: Easy 12) As a result of trade between two countries which are of completely different economic sizes, specialization in the Ricardian 2X2 model tends to A) be incomplete in both countries. B) be complete in both countries. C) be complete in the small country but incomplete in the large country. D) be complete in the large country but incomplete in the small country. E) sustain one countries economy in in direct proportion to the other. Answer: C Page Ref: 35 Difficulty: Easy 13) A nation engaging in trade according to the Ricardian model will find its consumption bundle A) inside its production possibilities frontier. B) on its production possibilities frontier. C) outside its production possibilities frontier. D) inside its trade-partner's production possibilities frontier. E) on its trade-partner's production possibilities frontier. Answer: C Page Ref: 34 Difficulty: Easy

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14) In the Ricardian model, if a country's trade is restricted, this will cause all EXCEPT which? A) limited specialization and the division of labor B) reduced volume of trade and reduced gains from trade C) nations to produce inside their production possibilities curves D) a country to produce some of the product of its comparative disadvantage E) raised costs as more diverse product is produced internally Answer: C Page Ref: 36 Difficulty: Easy 15) If a very small country trades with a very large country according to the Ricardian model, then A) the small country will suffer a decrease in economic welfare. B) the large country will suffer a decrease in economic welfare. C) the small country only will enjoy gains from trade. D) the large country will enjoy gains from trade. E) both countries will enjoy equal gains from trade. Answer: C Page Ref: 37 Difficulty: Easy 16) If the world terms of trade for a country are somewhere between the domestic cost ratio of H and that of F, then A) country H but not country F will gain from trade. B) country H and country F will both gain from trade. C) neither country H nor F will gain from trade. D) only the country whose government subsidizes its exports will gain. E) country F but not country H will gain from trade. Answer: B Page Ref: 37 Difficulty: Moderate 17) If the world terms of trade equal those of country F, then A) country H but not country F will gain from trade. B) country H and country F will both gain from trade. C) neither country H nor F will gain from trade. D) only the country whose government subsidizes its exports will gain. E) country F but not country H will gain from trade. Answer: A Page Ref: 37 Difficulty: Easy

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18) If the world terms of trade equal those of country H, then A) country H but not country F will gain from trade. B) country H and country F will both gain from trade. C) neither country H nor F will gain from trade. D) only the country whose government subsidizes its exports will gain. E) country F but not country H will gain from trade. Answer: E Page Ref: 32 Difficulty: Easy 19) According to Ricardo, a country will have a comparative advantage in the product in which its A) labor productivity is relatively low. B) labor productivity is relatively high. C) labor mobility is relatively low. D) labor mobility is relatively high. E) labor is outsourced to neighboring countries. Answer: B Page Ref: 29 Difficulty: Easy 20) Assume that labor is the only factor of production and that wages in the United States equal $20 per hour while wages in Japan are $10 per hour. Production costs would be lower in the United States as compared to Japan if A) U.S. labor productivity equaled 40 units per hour and Japan's 15 units per hour. B) U.S. labor productivity equaled 30 units per hour and Japan's 20 units per hour. C) U.S. labor productivity equaled 20 units per hour and Japan's 30 units per hour. D) U.S. labor productivity equaled 15 units per hour and Japan's 25 units per hour. E) U.S. labor productivity equaled 15 units per hour and Japan's 40 units per hour. Answer: A Page Ref: 27 Difficulty: Moderate 21) If two countries engage in Free Trade following the principles of comparative advantage, then A) neither relative prices nor relative marginal costs (marginal rates of transformation-MRTs) in one country will equal those in the other country. B) both relative prices and MRTs will become equal in both countries. C) relative prices but not MRTs will become equal in both countries. D) MRTs but not relative prices will become equal in both countries. E) trade will be unrestricted, regardless of relative costs and MRTs. Answer: C Page Ref: 31 Difficulty: Moderate

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22) Let us define the real wage as the purchasing power of one hour of labor. In the Ricardian 2X2 model, if two countries under autarky engage in trade then A) the real wage will not be affected since this is a financial variable. B) the real wage will increase only if a country attains full specialization. C) the real wage will increase in one country only if it decreases in the other. D) the real wage will rise in both countries. E) the real wage will fall under pressure of international competition. Answer: D Page Ref: 36 Difficulty: Moderate 23) In a two country and two product Ricardian model, a small country is likely to benefit more than the large country because A) the large country will wield greater political power, and hence will not yield to market signals. B) the small country is less likely to trade at price equal or close to its autarkic (domestic) relative prices. C) the small country is more likely to fully specialize. D) the small country is less likely to fully specialize. E) the small country can raise wages. Answer: B Page Ref: 37 Difficulty: Moderate 24) In the Ricardian model, comparative advantage is likely to be due to A) scale economies. B) home product taste bias. C) greater capital availability per worker. D) labor productivity differences. E) political pressure. Answer: D Page Ref: 45 Difficulty: Easy

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25) An examination of the Ricardian model of comparative advantage yields the clear result that trade is (potentially) beneficial for each of the two trading partners since it allows for an expanded consumption choice for each. However, for the world as a whole the expansion of production of one product must involve a decrease in the availability of the other, so that it is not clear that trade is better for the world as a whole as compared to an initial situation of non-trade (but efficient production in each country). Are there in fact gains from trade for the world as a whole? Explain. Answer: If we were to combine the production possibility frontiers of the two countries to create a single world production possibility frontier, then it is true that any change in production points (from autarky to specialization with trade) would involve a tradeoff of one good for another from the world's perspective. In other words, the new solution cannot possibly involve the production of more of both goods. However, since we know that each country is better off at the new solution, it must be true that the original points were not on the trade contract curve between the two countries, and it was in fact possible to make some people better off without making others worse off, so that the new solution does indeed represent a welfare improvement from the world's perspective. Page Ref: 34-36 Difficulty: Difficult 26) It is generally claimed that a movement from autarky to free trade consistent with Ricardian comparative advantage increases the economic welfare of each of the trade partners. However, it may be demonstrated that under certain circumstances, not everyone in each country is made better off. Illustrate such a case. Answer: (a) If inter-generational, or economic growth considerations are taken into account, then a country may end up specializing in a good that has no or few growth linkages with the rest of the economy (e.g., an "enclave" sector). (b) If some of the residents of a country have tastes biased toward their exportable, then they may suffer due to the trade-affected increase in the market price of the exportable good. Page Ref: 50 Difficulty: Moderate 27) It is generally claimed that state trading, or centrally controlled trading will tend to reach a lower economic welfare than would be reached by allowing market forces to determine trade flow directions and terms of trade. Illustrate a counter-example to this proposition. Answer: In general, if we begin with any suboptimal distortion, the theory of the second best tells us that an additional "distortion" may move a country in the correct direction of a welfare improvement. For example, If a country has an overvalued exchange rate (that is, its currency is overpriced in the foreign exchange markets), it is possible that it will find itself in an autarkic equilibrium (that is, it might "overprice itself out of the international market"). In such a case it is easy to demonstrate that if the government exports the goods in which the country enjoys comparative advantage, and imports the other (bypassing market prices and mechanisms), the country's economic welfare will improve. Page Ref: 36 Difficulty: Difficult

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28) The Ricardian proposition that international trade will benefit any country ("gains from trade") as long as the world terms of trade do not equal its autarkic relative prices is a straightforward and powerful concept. Nevertheless, it is impossible to demonstrate empirically. Why? Answer: This is because there is no way of knowing exactly what are, or would have been, the autarky MRTs or MRSs. This is because there is no single example in the world of a country that is totally unengaged in international trade. Page Ref: 36 Difficulty: Difficult

29) Given the information in the table above. What is the opportunity cost of Cloth in terms of Widgets in Foreign? Answer: One half a widget. Page Ref: 34 Difficulty: Moderate 30) Given the information in the table above. If these two countries trade these two goods in the context of the Ricardian model of comparative advantage, then what is the lower limit of the world equilibrium price of widgets? Answer: 1/2 Cloths. Page Ref: 35 Difficulty: Moderate 31) Given the information in the table above. If these two countries trade these two goods with each other in context of the Ricardian model of comparative advantage, what is the lower limit for the price of cloth? Answer: One half a widget. Page Ref: 34 Difficulty: Moderate 32) Given the information in the table above. What is the opportunity cost of cloth in terms of Widgets in Foreign? Answer: 2 widgets. Page Ref: 34 Difficulty: Moderate

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3.4 Misconceptions About Comparative Advantage 1) If a production possibilities frontier is bowed out (concave to the origin), then production occurs under conditions of A) constant opportunity costs. B) increasing opportunity costs. C) decreasing opportunity costs. D) infinite opportunity costs. E) uncertain opportunity costs. Answer: B Page Ref: 34 Difficulty: Easy 2) If the production possibilities frontier of one trade partner ("Country A") is bowed out (concave to the origin), then increased specialization in production by that country will A) increase the economic welfare of both countries. B) increase the economic welfare of only Country A. C) decrease the economic welfare of Country A. D) decrease the economic welfare of Country B. E) not affect the economic welfare of either country. Answer: A Page Ref: 35 Difficulty: Easy 3) If two countries have identical production possibility frontiers, then trade between them is likely to be beneficial if A) their supply curves are identical. B) their cost functions are identical. C) their demand conditions are identical. D) their incomes are identical. E) their demand functions differ. Answer: E Page Ref: 37 Difficulty: Moderate 4) If one country's wage level is very high relative to the other's (the relative wage exceeding the relative productivity ratios), then if they both use the same currency A) neither country has a comparative advantage. B) only the low wage country has a comparative advantage. C) only the high wage country has a comparative advantage. D) consumers will still find trade worth while from their perspective. E) it is possible that both will enjoy the conventional gains from trade. Answer: E Page Ref: 37-39 Difficulty: Moderate

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5) If one country's wage level is very high relative to the other's (the relative wage exceeding the relative productivity ratios) then it is probable that A) free trade will not improve either both countries welfare. B) free trade will result in no trade taking place. C) free trade will result in each country exporting the good in which it enjoys comparative advantage. D) free trade will result in each country exporting the good in which it suffers the greatest comparative disadvantage. E) free trade will not affect the economic welfare of either country. Answer: C Page Ref: 37-39 Difficulty: Moderate 6) In a two-country, two-product world, the statement "Germany enjoys a comparative advantage over France in autos relative to ships" is equivalent to A) France having a comparative advantage over Germany in ships. B) France having a comparative disadvantage compared to Germany in autos and ships. C) Germany having a comparative advantage over France in autos and ships. D) France having no comparative advantage over Germany. E) France should produce autos. Answer: A Page Ref: 37 Difficulty: Easy 7) If the United States' production possibility frontier was flatter to the widget axis, whereas Germany's was flatter to the butter axis, we know that A) the United States has no comparative advantage B) Germany has a comparative advantage in butter. C) the U.S. has a comparative advantage in butter. D) Germany has comparative advantages in both products. E) the U.S. has a comparative disadvantage in widgets. Answer: B Page Ref: 37 Difficulty: Moderate 8) Suppose the United States' production possibility frontier was flatter to the widget axis, whereas Germany's was flatter to the butter axis. We now learn that the German mark sharply depreciates against the U.S. dollar. We now know that A) the United States has no comparative advantage B) Germany has a comparative advantage in butter. C) the United States has a comparative advantage in butter. D) Germany has a comparative advantage in widgets. E) Germany has lost its comparative advantage. Answer: B Page Ref: 37 Difficulty: Moderate 15 .

9) Suppose the United states production possibility frontier was flatter to the widget axis, whereas Germany's was flatter to the butter axis. We now learn that the German wage doubles, but U.S. wages do not change at all. We now know that A) the United States has no comparative advantage. B) Germany has a comparative advantage in butter. C) the United States has a comparative advantage in butter. D) Not enough information is given. E) Germany gains a comparative advantage in widgets. Answer: B Page Ref: 37 Difficulty: Moderate 10) Which of the following statements is TRUE? A) Free trade is beneficial only if your country is strong enough to stand up to foreign competition. B) Free trade is beneficial only if your competitor does not pay unreasonably low wages. C) Free trade is beneficial only if both countries have access to the same technology. D) Free trade is never beneficial for developing countries. E) Free trade can be beneficial to economic welfare of all countries involved. Answer: E Page Ref: 37-39 Difficulty: Moderate 11) Mahatma Gandhi exhorted his followers in India to promote economic welfare by decreasing imports. This approach A) makes no sense. B) makes no economic sense. C) is consistent with the the Ricardian model of comparative advantage. D) is not consistent with the Ricardian model of comparative advantage. E) guarantees benefits for Indian workers. Answer: D Page Ref: 37-39 Difficulty: Moderate 12) The Country of Rhozundia is blessed with rich copper deposits. The cost of copper produced (relative to the cost of widgets produced) is therefore very low. From this information we know that A) Rhozundia has a comparative advantage in copper. B) Rhozundia should import copper and export widgets. C) Rhozundia should export both widgets and copper. D) Rhozundia should invest in more in widget production. E) Rhozundia may or may not have a comparative advantage in copper. Answer: E Page Ref: 37-39 Difficulty: Moderate

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13) We know that in antiquity, China exported silk because no one in any other country knew how to produce this product. From this information we know that A) China had a comparative advantage in silk. B) China had an absolute advantage, but not a comparative advantage in silk. C) no comparative advantage could exist because the technology was not diffused. D) China exported silk for political reasons even though it had no comparative advantage. E) China was unable to profit by exporting silk because it was unknown in the rest of the world. Answer: A Page Ref: 37-41 Difficulty: Moderate 14) The pauper labor theory, and the exploitation argument A) are theoretical weaknesses that limit the applicability of the Ricardian concept of comparative advantage. B) are theoretically irrelevant to the Ricardian model, and do not limit its logical relevance. C) are not relevant because the Ricardian model is based on the labor theory of value. D) are not relevant because the Ricardian model allows for different technologies in different countries. E) invalidate the Ricardian model. Answer: B Page Ref: 39 Difficulty: Easy 15) If labor productivities were exactly proportional to wage levels internationally, this would A) not negate the logical basis for trade in the Ricardian model. B) render the Ricardian model theoretically correct but practically useless. C) negate the logical basis for trade in the Ricardian model. D) negate the applicability of the Ricardian model if the number of products were greater than the number of trading partners. E) demonstrate the validity of the Ricardian model. Answer: A Page Ref: 35 Difficulty: Moderate 16) Many countries in sub-Saharan Africa have very low labor productivities in many sectors, for example in manufacturing and agriculture. They often despair of even trying to attempt to build their industries unless it is done in an autarkic context, behind protectionist walls because they do not believe they can compete with more productive industries abroad. Discuss this issue in the context of the Ricardian model of comparative advantage. Answer: The Ricardian model of comparative advantage argues that every country must have a comparative advantage in some product (assuming there are more products than countries). However, the Ricardian model is not a growth model, and cannot be used to identify growth modes or linkages. Page Ref: 38 Difficulty: Moderate

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17) In 1975, wage levels in South Korea were roughly 5% of those in the United States. It is obvious that if the United States had allowed Korean goods to be freely imported into the United States at that time, this would have caused devastation to the standard of living in the United States, because no producer in this country could possibly compete with such low wages. Discuss this assertion in the context of the Ricardian model of comparative advantage. Answer: Regardless of relative wage levels, the United States would be able to provide its populace with a higher standard of living than would be possible without trade. Also, low wages tend to be associated with low productivities. Page Ref: 38 Difficulty: Moderate 18) The evidence cited in the chapter using the examples of the East Asia New Industrializing Countries suggests that as international productivities converge, so do international wage levels. Why do you suppose this happened for the East Asian NICs? In light of your answer, what do you think is likely to happen to the relative wages (relative to those in the United States) of China in the coming decade? Explain your reasoning. Answer: Following the logic of the Ricardian model of comparative advantage, the East Asian countries played to their respective comparative advantages. This allowed the world demand to provide excess demands for their relatively abundant labor, which in turn tended to raise these wages. If China follows the same pattern, their wages levels should also be expected over time to converge to those in their industrialized country markets. Page Ref: 37-39 Difficulty: Moderate 3.5 Comparative Advantage with Many Goods 1) The two-country, multi-product model differs from the two-country, two-product model in that, in the former A) the relative wage ratio will determine the pattern of trade ( which good is exported by which country. B) which country will export which product is determined entirely by labor productivity data. C) full specialization is likely to hold in equilibrium. D) none of the goods are potentially nontraded. E) domestic relative prices are not relevant. Answer: A Page Ref: 42-48 Difficulty: Moderate

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2) How does the two-good, two-country version of the Ricardian model differ from the twocountry, many-good model in terms of the determination which goods are produced and exported by each country? Answer: In the two-good-two-country version of the Ricardian model, comparative advantage is totally determined by physical productivity ratios. Changes in wage rates in either country do not change physically determined comparative advantages, and therefore cannot affect which product will be exported by which country. However, when there are more than two goods in the two-country model, changes in wage rates in one or the other country can in fact determine which good or goods each of the countries will export. The physical productivity definition of comparative advantage employed in the two-good model becomes ambiguous. Instead, changes in relative wage rates will alter international competitiveness along the "chain of comparative advantage." Page Ref: 42-48 Difficulty: Moderate 3.6 Adding Transport Costs and Nontraded Goods 1) Assume that transportation costs are especially high for Widgets in the two-country, twoproduct Ricardian model, and Country A enjoys a comparative advantage in Widgets, then A) country B must also enjoy a comparative advantage in Widgets. B) country B may end up exporting Widgets. C) country A may switch to having a comparative advantage in the other good. D) country A will still export Widgets. E) Trade may be impossible between the two countries. Answer: E Page Ref: 47 Difficulty: Moderate 2) Which of the following is most likely to be an untraded good in a Ricardian two-country, multi-good model? A) steel B) textiles C) haircuts D) petroleum E) telemarketer services Answer: C Page Ref: 47-48 Difficulty: Easy

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3.7 Empirical Evidence on the Ricardian Model 1) Which of the following has been confirmed by empirical tests of the Ricardian model? A) All predictions of the model for a multi-product, multi-country world are highly unrealistic. B) The existence of nontraded goods results in a high degree of specialization among countries. C) International trade has no impact on income distribution. D) The unimportance of economies of scale as a cause of trade. E) Companies tend to export goods in which they have a relatively high level of productivity. Answer: E Page Ref: 45 Difficulty: Moderate 2) When compared with China, the growth of clothing exports originating in Bangladesh clearly illustrates the difference between absolute and comparative advantage. Discuss and explain. Answer: While Bangladesh has an absolute disadvantage in clothing (and, on average everything else), the country has a comparative advantage in clothing manufacture and export. Exports of clothing from Bangladesh have consequently surpassed those from China. Page Ref: 47 Difficulty: Moderate 3) When compared with China, the growth of clothing exports originating in Bangladesh clearly illustrates the Ricardian model of comparative advantage. Discuss and explain. Answer: While Bangladesh has an absolute disadvantage in clothing (and, on average everything else), the country has a comparative advantage in clothing manufacture and export. Exports of clothing from Bangladesh have consequently surpassed those from China. Page Ref: 47 Difficulty: Moderate 4) When compared with China, the growth of clothing exports originating in Bangladesh is the result of A) the comparative advantage that Bangladesh has in the production of clothing for export. B) the absolute advantage that China has in the production of clothing for export. C) the absolute advantage that Bangladesh has in the production of clothing for export. D) the comparative and absolute advantage that China has in the production of clothing for export. E) the comparative and absolute advantage that Bangladesh has in the production of clothing for export. Answer: A Page Ref: 47 Difficulty: Easy

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5) The growth of clothing exports originating in Bangladesh is the result of the A) high productivity of workers in Bangladesh. B) low wages in Bangladesh. C) low productivity of workers in other countries. D) low productivity of workers in Bangladesh in industries other than those that produce clothing for export. E) high wages in other countries. Answer: D Page Ref: 47 Difficulty: Easy

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International Economics, 10e (Krugman/Obstfeld/Melitz) Chapter 4 Specific Factors and Income Distribution 4.1 The Specific Factors Model 1) The Ricardian model of international trade demonstrates that trade can be mutually beneficial. Why, then, do governments restrict imports of some goods? A) Trade can have substantial effects on a country's distribution of income. B) The Ricardian model is often incorrect in its prediction that trade can be mutually beneficial. C) Import restrictions are the result of trade wars between hostile countries. D) Imports are only restricted when foreign-made goods do not meet domestic standards of quality. E) Restrictions on imports are intended to benefit domestic consumers. Answer: A Page Ref: 50 Difficulty: Easy 2) The Ricardian two-country two-good model predicts that there are potential benefits from trade, but NOT A) the effect of trade on income distribution. B) the mechanism that determines which country will specialize in which good. C) when one country has an absolute advantage in the production of both goods. D) when one country has significantly lower wages than the other country. E) when both countries have the same types of technology available. Answer: A Page Ref: 50 Difficulty: Easy 3) International trade can have important effects on the distribution of income because A) some resources are immobile in the short run. B) of government corruption. C) the more powerful country dictates the terms of trade. D) rich countries take advantage of poor countries. E) different countries use different currencies. Answer: A Page Ref: 50 Difficulty: Easy

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4) The Ricardian model of international trade demonstrates that trade can be mutually beneficial. Why, then, do governments restrict imports of some goods? A) Trade can have significant harmful effects on some segments of a country's economy. B) The Ricardian model is often incorrect in its prediction that trade can be mutually beneficial. C) Import restrictions are the result of trade wars between hostile countries. D) Imports are only restricted when foreign-made goods do not meet domestic standards of quality. E) Restrictions on imports can have significant beneficial effects on domestic consumers. Answer: A Page Ref: 50 Difficulty: Easy 5) International trade can have important effects on the distribution of income because A) different industries employ different factors of production. B) of government corruption. C) the more powerful country dictates the terms of trade. D) rich countries take advantage of poor countries. E) different countries use different currencies. Answer: A Page Ref: 50 Difficulty: Easy 6) Japan's trade policies with regard to rice reflect the fact that A) japanese rice farmers have significant political power. B) Japan has a comparative advantage in rice production and therefore exports most of its rice crop. C) there would be no gains from trade available to Japan if it engaged in free trade in rice. D) there are gains from trade that Japan captures by engaging in free trade in rice. E) Japan imports most of the rice consumed in the country. Answer: A Page Ref: 51 Difficulty: Easy 7) The specific factors model was developed by A) Paul Samuelson and Ronald Jones. B) Adam Smith and David Ricardo. C) Richard Nixon and Robert Kennedy. D) C.B. deMille and Gordon Willis. E) Bill Clinton and Monica Lewinsky. Answer: A Page Ref: 51 Difficulty: Easy

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8) In the specific factors model, labor is defined as a(an) A) mobile factor. B) specific factor. C) fixed factor. D) variable factor. E) intensive factor. Answer: A Page Ref: 52 Difficulty: Easy 9) In the specific factors model, which of the following is treated as a specific factor? A) land B) labor C) cloth D) food E) technology Answer: A Page Ref: 52 Difficulty: Easy 10) In the specific factors model, which of the following is treated as a specific factor? A) capital B) labor C) cloth D) food E) technology Answer: A Page Ref: 52 Difficulty: Easy 11) A factor of production that cannot be used outside of a particular sector of an economy is a(an) A) specific factor. B) mobile factor. C) variable factor. D) import-competing factor. E) export-competing factor. Answer: A Page Ref: 52 Difficulty: Easy

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12) A factor of production that can be used in any sector of an economy is a(an) A) mobile factor. B) specific factor. C) variable factor. D) import-competing factor. E) export-competing factor. Answer: A Page Ref: 52 Difficulty: Easy 13) The specific factors model assumes that there are ________ goods and ________ factor(s) of production. A) two; three B) two; two C) two; one D) three; two E) four; three Answer: A Page Ref: 52 Difficulty: Easy 14) The degree of a factor's specificity is directly related to A) the amount of time required to redeploy the factor to a different industry. B) the cost of the factor as a proportion of the long-run total cost of production. C) the mobility of the factor, with more mobile factors having more specificity. D) technology differences between two countries, with a more advanced technology resulting in more factor specificity. E) factor quality, with higher quality factors having a higher level of specificity. Answer: A Page Ref: 52 Difficulty: Easy 15) The degree of a factor's specificity is inversely related to A) the mobility of the factor, with more mobile factors having less specificity. B) the amount of time required to redeploy the factor to a different industry. C) the cost of the factor as a proportion of the long-run total cost of production. D) technology differences between two countries, with a less advanced technology resulting in less factor specificity. E) factor quality, with lower quality factors having a lower level of specificity. Answer: A Page Ref: 52 Difficulty: Easy

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16) A worker who has invested in ________ skills will be ________ mobile than would otherwise be the case. A) occupation-specific; less B) occupation-specific; more C) ethical; less D) ethical; more E) occupation-nominal; less Answer: A Page Ref: 52 Difficulty: Easy 17) In the specific factors model, a country's production possibility frontier is ________ because of ________. A) a straight line; diminishing marginal returns B) a curved line; diminishing marginal returns C) a straight line; constant marginal returns D) a curved line; constant marginal returns E) a curved line; a limited supply of labor Answer: B Page Ref: 56 Difficulty: Easy 18) In the specific factors model, a country's production function is ________ because of ________. A) a straight line; diminishing marginal returns B) a curved line; diminishing marginal returns C) a straight line; constant marginal returns D) a curved line; constant marginal returns E) a curved line; a limited supply of labor Answer: B Page Ref: 56 Difficulty: Easy 19) In the four-quadrant diagram of the specific factors model, the graph in the upper right quadrant is a country's A) production possibility frontier. B) labor allocation constraint. C) production function for food. D) production function for cloth. E) labor supply curve. Answer: A Page Ref: 56 Difficulty: Easy

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20) In the four-quadrant diagram of the specific factors model, the graph in the lower right quadrant is a country's A) production function for cloth. B) production possibility frontier. C) labor allocation constraint. D) production function for food. E) labor supply curve. Answer: A Page Ref: 56 Difficulty: Easy 21) In the four-quadrant diagram of the specific factors model, the graph in the upper left quadrant is a country's A) production function for food. B) production possibility frontier. C) labor allocation constraint. D) production function for cloth. E) labor supply curve. Answer: A Page Ref: 56 Difficulty: Easy 22) In the four-quadrant diagram of the specific factors model, the graph in the upper right quadrant is a country's A) labor allocation constraint. B) production possibility frontier. C) production function for food. D) production function for cloth. E) labor supply curve. Answer: B Page Ref: 56 Difficulty: Easy 23) The slope of a country's production possibility frontier with cloth measured on the horizontal and food measured on the vertical axis in the specific factors model is equal to ________ and it ________ as more cloth is produced. A) -MPLF/MPLC; becomes steeper B) -MPLF/MPLC; becomes flatter C) -MPLF/MPLC; is constant D) -MPLC/MPLF; becomes steeper E) -MPLC/MPLF; is constant Answer: A Page Ref: 56 Difficulty: Easy

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24) The slope of a country's production possibility frontier with cloth measured on the horizontal and food measured on the vertical axis in the Ricardian model is equal to ________ and it ________ as more cloth is produced. A) -MPLF/MPLC; is constant B) -MPLF/MPLC; becomes steeper C) -MPLF/MPLC; becomes flatter D) -MPLC/MPLF; becomes steeper E) -MPLC/MPLF; is constant Answer: A Page Ref: 56 Difficulty: Easy 25) Under perfect competition, the equilibrium price of labor used to produce cloth will be equal to A) the marginal product of labor in the production of cloth times the price of cloth. B) the average product of labor in the production of cloth times the price of cloth. C) the ratio of the marginal product of labor in the production of cloth to the marginal product of labor in the production of food times the ratio of the price of cloth. to the price of food. D) the slope of the production possibility frontier. E) the price of cloth divided by the marginal product of labor in the production of cloth. Answer: A Page Ref: 56 Difficulty: Easy 26) When a country's labor market is in equilibrium in the specific factors model, the wage rate A) will be the same in both sectors. B) will be higher in the export-competing sector. C) will be higher in the import-competing sector. D) will be higher in the sector where product price is higher. E) will be higher in the sector where product price is lower. Answer: A Page Ref: 57 Difficulty: Easy 27) In the specific factors model, which of the following will increase the quantity of labor used in food production? A) an increase in the price of food relative to that of cloth B) an increase in the price of cloth relative to that of food C) a decrease in the price of labor D) an equal percentage decrease in the price of food and cloth E) an equal percentage increase in the price of food and cloth Answer: A Page Ref: 57 Difficulty: Easy

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28) In the specific factors model, which of the following will increase the quantity of labor used in cloth production? A) an increase in the price of cloth relative to that of food B) an increase in the price of food relative to that of cloth C) a decrease in the price of labor D) an equal percentage decrease in the price of food and cloth E) an equal percentage increase in the price of food and cloth Answer: A Page Ref: 57 Difficulty: Easy 29) In the specific factor model, the effect of an increase in the productivity of labor in the production of cloth will cause a(an) ________ in the quantity of labor used to produce cloth, a(an) ________ in the quantity of labor used to produce food and a(an) ________ in the wage rate. A) increase; decrease; increase B) decrease; increase; increase C) increase; decrease; decrease D) decrease; increase; no change E) increase; increase; no change Answer: A Page Ref: 57 Difficulty: Easy 30) In the specific factor model, the effect of an increase in the productivity of labor in the production of food will cause a(an) ________ in the quantity of labor used to produce cloth, a(an) ________ in the quantity of labor used to produce food and a(an) ________ in the wage rate. A) decrease; increase; increase B) increase; decrease; increase C) increase; decrease; decrease D) decrease; increase; no change E) increase; increase; no change Answer: A Page Ref: 57 Difficulty: Easy

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31) The slope of a country's production possibility frontier is equal to ________ and the optimal production point is located where the slope is equal to ________. Assume that output of good Y is measured on the vertical axis, output of good X is measured on the horizontal axis, MPL is the marginal product of labor with a subscript indicating which good, P is the price of a good, and w is the wage rate. A) -MPLY/MPLX; -PX/PY B) -PX/PY; -MPLY/MPLX; C) -PX/w; -PY/w D) -MPLY/w; -MPLF/w E) -MPLX/MPLY; -PX/PY Answer: A Page Ref: 58 Difficulty: Moderate 32) In the specific factors model, a 5% increase in the price of food accompanied by a 5% increase in the price of cloth will cause wages to ________, the production of cloth to ________, and the production of food to ________. A) increase by 5%; remain unchanged; remain unchanged B) increase by less then 5%; decrease; increase C) increase by more then 5%; increase; remain unchanged D) remain constant; increase; increase E) remain constant; decrease; decrease Answer: A Page Ref: 58-60 Difficulty: Moderate 33) In the specific factors model, a 5% increase in the price of food accompanied by a 0% increase in the price of cloth will cause wages to ________, the production of cloth to ________, and the production of food to ________. A) increase by less then 5%; decrease; increase B) increase by 5%; remain unchanged; remain unchanged C) increase by more then 5%; increase; remain unchanged D) remain constant; increase; increase E) remain constant; decrease; decrease Answer: A Page Ref: 58-60 Difficulty: Moderate

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34) In the specific factors model, a 0% increase in the price of food accompanied by a 5% increase in the price of cloth will cause wages to ________, the production of cloth to ________, and the production of food to ________. A) increase by less then 5%; increase; decrease B) increase by 5%; remain unchanged; remain unchanged C) increase by more then 5%; increase; remain unchanged D) remain constant; increase; increase E) remain constant; decrease; decrease Answer: A Page Ref: 58-60 Difficulty: Moderate 35) In the specific factors model, a 5% increase in the price of food accompanied by a 5% increase in the price of cloth will cause ________ in the welfare of labor, ________ in the welfare of the fixed factor in the production of food, and ________ in the welfare of the fixed factor in the production of cloth. A) no change; no change; no change B) an increase; an increase; an increase C) a decrease; an increase; an increase D) an increase; a decrease; a decrease E) a decrease; a decrease; a decrease Answer: A Page Ref: 60-62 Difficulty: Moderate 36) In the specific factors model, a 5% decrease in the price of food accompanied by a 5% decrease in the price of cloth will cause ________ in the welfare of labor, ________ in the welfare of the fixed factor in the production of food, and ________ in the welfare of the fixed factor in the production of cloth. A) no change; no change; no change B) an increase; an increase; an increase C) a decrease; an increase; an increase D) an increase; a decrease; a decrease E) a decrease; a decrease; a decrease Answer: A Page Ref: 60-62 Difficulty: Moderate

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37) In the specific factors model, a 5% increase in the price of food accompanied by a 10% increase in the price of cloth will cause ________ in the welfare of labor, ________ in the welfare of the fixed factor in the production of food, and ________ in the welfare of the fixed factor in the production of cloth. A) an ambiguous change; a decrease; an increase B) an ambiguous change; an ambiguous change; an ambiguous change C) a decrease; an ambiguous change; an ambiguous change D) an increase; a decrease; an increase E) an ambiguous change; an increase; a decrease Answer: A Page Ref: 60-62 Difficulty: Moderate 38) In the specific factors model, a 5% increase in the price of food accompanied by a 1% increase in the price of cloth will cause ________ in the welfare of labor, ________ in the welfare of the fixed factor in the production of food, and ________ in the welfare of the fixed factor in the production of cloth. A) an ambiguous change; an increase; a decrease B) an ambiguous change; a decrease; an increase C) an ambiguous change; an ambiguous change; an ambiguous change D) a decrease; an ambiguous change; an ambiguous change E) an increase; a decrease; an increase Answer: A Page Ref: 60-62 Difficulty: Moderate

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39) Refer to the production possibility graph above. Assume that the economy is in equilibrium at point e. If there is an increase in the wage rate, the new equilibrium is most likely to be A) point e. B) point d. C) point f. D) point h. E) point b. Answer: A Page Ref: 60-62 Difficulty: Easy 40) Refer to the production possibility graph above. Assume that the economy is in equilibrium at point e. If the price of good A increases, the new equilibrium is most likely to be A) point d. B) point e. C) point f. D) point h. E) point b. Answer: A Page Ref: 60-62 Difficulty: Easy

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41) Refer to the production possibility graph above. Assume that the economy is in equilibrium at point e. If the price of good B increases, the new equilibrium is most likely to be A) point f. B) point d. C) point e. D) point h. E) point b. Answer: A Page Ref: 60-62 Difficulty: Easy 42) Refer to the production possibility graph above. Assume that the economy is in equilibrium at point e. If the labor supply increases due to immigration, the new equilibrium is most likely to be A) point h. B) point f. C) point d. D) point e. E) point b. Answer: A Page Ref: 60-62 Difficulty: Easy 43) Refer to the production possibility graph above. Assume that the economy is in equilibrium at point e. If a war reduces the country's capital stock by 40%, the new equilibrium is most likely to be A) point b. B) point h. C) point f. D) point d. E) point e. Answer: A Page Ref: 60-62 Difficulty: Easy 4.2 International Trade in the Specific Factors Model 1) A country that does NOT engage in trade can benefit from trade only if A) pre-trade and free-trade relative prices are not identical. B) it employs a unique technology. C) it has an absolute advantage in at least one good. D) its wage rate is below the world average. E) pre-trade and free-trade relative prices are identical. Answer: A Page Ref: 63-64 Difficulty: Moderate 13 .

2) The relative price of a unit of cloth in the small isolated country of Moribundia is 5 units of food. When then central city, Mudhole, puts in an airstrip, the country is able to engage in trade. If the relative price of cloth in the outside world is 3 units of food, then Moribundia will export ________ and ________ factors used in the production of ________ will benefit. A) food; immobile; food B) food; mobile; food C) cloth; immobile; cloth D) cloth; mobile; cloth E) food; immobile; cloth Answer: A Page Ref: 63-64 Difficulty: Moderate 3) The relative price of a unit of cloth in the small isolated country of Moribundia is 5 units of food. When then central city, Mudhole, puts in an airstrip, the country is able to engage in trade. If the relative price of cloth in the outside world is 8 units of food, then Moribundia will export ________ and ________ factors used in the production of ________ will benefit. A) cloth; immobile; cloth B) food; immobile; food C) food; mobile; food D) cloth; mobile; cloth E) cloth; immobile; food Answer: A Page Ref: 63-64 Difficulty: Moderate 4.3 Income Distribution and the Gains from Trade 1) In the specific factors model, the effects of trade on welfare are ________ for mobile factors, ________ for fixed factors used to produce the exported good, and ________ for fixed factors used to produce the imported good. A) ambiguous; positive; negative B) ambiguous; negative; positive C) positive; ambiguous; ambiguous D) negative; ambiguous; ambiguous E) positive; positive; positive Answer: A Page Ref: 64-66 Difficulty: Easy

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2) In the specific factors model, the effects of trade on welfare overall are ________ and for fixed factors used to produce the exported good they are ________. A) positive; positive B) negative; positive C) positive; negative D) ambiguous; positive E) positive; ambiguous Answer: A Page Ref: 64-66 Difficulty: Easy 3) In the specific factors model, the effects of trade on welfare overall are ________ and for fixed factors used to produce the imported good they are ________. A) positive; negative B) positive; positive C) negative; positive D) ambiguous; positive E) positive; ambiguous Answer: A Page Ref: 64-66 Difficulty: Easy 4) The overall welfare effects of trade are ________ if ________. A) positive; those who gain can compensate those who lose and still be better off B) positive; more people gain from trade than lose from it C) negative; some people are made worse off by trade D) negative; those who lose can compel those who gain to compensate them for their losses E) positive; the domestic economy grows faster than do foreign economies Answer: A Page Ref: 64-66 Difficulty: Easy 5) The effect of trade on income distribution A) can be significant in the sort run. B) is positive for all segments of an economy. C) is insignificant in the short run. D) implies that there are no real gains from trade. E) refutes the model of comparative advantage. Answer: A Page Ref: 64-66 Difficulty: Easy

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6) A country's budget constraint states that A) the value of exports must be equal to the value of imports. B) real income in the exporting country must be equal to real income in the importing country. C) unless a country engages in trade, the value of exports cannot exceed the value of goods produced. D) a country will engage in trade only if the value of imports exceed the value of exports. E) a country will engage in trade only if the value of exports exceeds the value of imports. Answer: A Page Ref: 64-66 Difficulty: Easy 7) A country's budget constraint states that A) whether or not a country engages in trade, the value of goods consumed must be equal to the value of goods produced. B) real income in the exporting country must be equal to real income in the importing country. C) unless a country engages in trade, the value of goods consumed cannot exceed the value of goods produced. D) a country will engage in trade only if the value of goods consumed exceeds the value of goods produced. E) a country will engage in trade only if the value of goods produced exceeds the value of goods consumed. Answer: A Page Ref: 64-66 Difficulty: Easy 8) A country will realize no gains from trade if A) pre-trade and free-trade relative prices are identical. B) all countries employ the same technology. C) it does not have an absolute advantage in at least one good. D) its wage exceeds the world average. E) pre-trade and free-trade relative prices are not identical. Answer: A Page Ref: 64-66 Difficulty: Moderate 4.4 The Political Economy of Trade: A Preliminary View 1) Those who will lose from free trade are ________ factors in sectors that produce goods that are ________. A) immobile; also imported B) mobile; also imported C) immobile; exported D) mobile; exported E) mobile; untraded Answer: A Page Ref: 67-70 Difficulty: Easy 16 .

2) Those who will unambiguously gain from free trade are ________ factors in sectors that produce goods that are ________. A) immobile; exported B) immobile; also imported C) mobile; also imported D) mobile; exported E) mobile; untraded Answer: A Page Ref: 67-70 Difficulty: Easy 3) The effect of trade on specialized employees of import-competing industries will be ________ jobs and ________ pay because they are relatively ________. A) fewer; lower; immobile B) fewer; lower; mobile C) more; lower; immobile D) more; higher; mobile E) more; higher; immobile Answer: A Page Ref: 67-70 Difficulty: Moderate 4) The effect of trade on specialized employees of exporting industries will be ________ jobs and ________ pay because they are relatively ________. A) more; higher; immobile B) fewer; lower; immobile C) fewer; lower; mobile D) more; lower; immobile E) more; higher; mobile Answer: A Page Ref: 67-70 Difficulty: Moderate 5) Economists consider the effects of free trade on income distribution to be ________ important than the effects on overall welfare because ________. A) less; those who are harmed can be compensated by those who gain B) more; those who are harmed are not compensated by those who gain C) less; the effects on income distribution are minor and inconsequential D) more; the effects on income distribution are major and consequential E) less; the wealthy benefit and only the poor lose Answer: A Page Ref: 67-70 Difficulty: Easy

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6) Economists consider the effects of free trade on income distribution to be ________ important than the effects on overall welfare because ________. A) less; many factors besides trade affect income distribution B) more; those who are harmed are not compensated by those who gain C) less; the effects on income distribution are minor and inconsequential D) more; the effects on income distribution are major and consequential E) less; the wealthy benefit and only the poor lose Answer: A Page Ref: 67-70 Difficulty: Easy 7) There is a bias in the political process against free trade because A) those who lose from free trade are better organized than those who gain. B) the gains from free trade cannot be measured. C) those who gain from free trade can't compensate those who lose. D) foreign governments make large donations to U.S. political campaigns. E) there is a high correlation between the volume of imports and the unemployment rate. Answer: A Page Ref: 67-70 Difficulty: Moderate 8) U.S. imports of sugar are limited by an import quota that, according to a study updated in 2013, imposed annual costs on American consumers of A) $2,000,000. B) $1,500,000. C) $1,000,000,000. D) $200,000. E) $370,000. Answer: A Page Ref: 70 Difficulty: Easy 9) U.S. imports of sugar are limited by an import quota that, according to a study updated in 2013, imposed a total cost on American consumers close to $________, or an average cost of ________ per year for every man, woman, and child in the country. A) $3 billion; $10 B) $105 million; $3 C) $2 billion; $110 D) $3 billion; $2,000 E) $370 million; $2,000 Answer: A Page Ref: 70 Difficulty: Easy

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10) U.S. imports of sugar are limited by an import quota that, according to a study updated in 2013, imposed a total cost on American consumers close to $________, or an average cost of ________ per year for every job saved in the U.S sugar industry. A) $3 billion; $10 B) $105 million; $3 C) $2 billion; $110 D) $3 billion; $1,000,000 E) $370 million; $20 Answer: D Page Ref: 70 Difficulty: Easy 4.5 International Labor Mobility 1) In modern economies, A) restrictions on international labor mobility are common. B) labor is far more mobile internationally than capital. C) restrictions on international labor mobility are rare. D) labor is far more mobile internationally than it is intra-nationally. E) outsourcing increases international labor mobility. Answer: A Page Ref: 70-76 Difficulty: Easy

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2) Refer to the graph above. Points A, B, and C represent ________, ________, and ________, respectively. A) equilibrium wage rate after migration from home to foreign has occurred; the wage rate in foreign before migration; the wage rate in home before migration B) equilibrium wage rate after migration from foreign to home has occurred; the wage rate in home before migration; the wage rate in foreign before migration C) the wage rate in home before migration; the wage rate in home after migration; the wage rate in foreign after migration D) the global wage rate before migration; the wage rate in foreign after migration; the wage rate in home after migration E) the global wage rate before migration; the wage rate in home after migration; the wage rate in foreign after migration Answer: A Page Ref: 70-76 Difficulty: Easy 3) In the two-country model of international labor mobility A) the effect of migration is to cause real wages in the two countries to converge. B) the effect of migration is to cause real wages in the two countries to diverge. C) labor has only limited international mobility. D) the long-run equilibrium global real wage is equal to the lesser of the pre-migration wages in the two countries. E) the long-run equilibrium global real wage is equal to the greater of the pre-migration wages in the two countries. Answer: A Page Ref: 70-76 Difficulty: Easy

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4) In the two-country model of international labor mobility A) the long-run equilibrium assumes that desired and actual migration are equal. B) the long-run equilibrium assumes that desired migration exceeds actual migration. C) the long-run equilibrium assumes that actual migration exceeds desired migration. D) the long-run equilibrium assumes countries' policies place significant restrictions on migration. E) the long-run equilibrium is the result of a divergence of the real wages in the two countries. Answer: A Page Ref: 70-76 Difficulty: Easy 5) In the two-country model of international labor mobility A) migration results in increased global output, although some groups are made worse off. B) migration results in increased global output, and all groups are made better off. C) migration has no effect on global output, although some groups are made worse off. D) migration has no effect on global output, although some groups are made better off. E) migration may reduce global output, although some groups are made better off. Answer: A Page Ref: 70-76 Difficulty: Easy 6) Immigration into the U.S. over the past century has caused the percentage of immigrants in the U.S. population to A) fall steadily until the 1970s and increase thereafter. B) remain relatively constant over the time period. C) fall steadily over the entire century. D) rise steadily over the entire century. E) rise steadily until the 1970s and fall thereafter. Answer: A Page Ref: 70-76 Difficulty: Easy

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International Economics, 10e (Krugman/Obstfeld/Melitz) Chapter 5 Resources and Trade: The Heckscher-Ohlin Model 5.1 Model of a Two-Factor Economy 1) In the 2-factor, 2 good Heckscher-Ohlin model, an influx of workers from across the border would A) move the point of production along the production possibility curve. B) shift the production possibility curve outward, and increase the production of both goods. C) shift the production possibility curve outward and decrease the production of the laborintensive product. D) shift the production possibility curve outward and decrease the production of the capitalintensive product. E) shift the possibility curve outward and displace preexisting labor. Answer: D Page Ref: 93-94 Difficulty: Moderate 2) In the 2-factor, 2 good Heckscher-Ohlin model, the two countries differ in A) tastes and preferences. B) military capabilities. C) the size of their economies. D) relative abundance of factors of production. E) labor productivities. Answer: D Page Ref: 84 Difficulty: Easy 3) One way in which the Heckscher-Ohlin model differs from the Ricardo model of comparative advantage is by assuming that ________ is (are) identical in all countries. A) factor endowments B) scale of production C) factor intensities D) technology E) opportunity costs Answer: D Page Ref: 94 Difficulty: Easy

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4) If a country produces good Y (measured on the vertical axis) and good X (measured on the horizontal axis), then the absolute value of the slope of its production possibility frontier is equal to A) the opportunity cost of good X. B) the price of good X divided by the price of good Y. C) the price of good Y divided by the price of good X. D) the opportunity cost of good Y. E) the cost of capital (assuming that good Y is capital intensive) divided by the cost of labor. Answer: A Page Ref: 87 Difficulty: Easy 5) The Heckscher-Ohlin model differs from the Ricardian model of Comparative Advantage in that the former A) has only two countries. B) has only two products. C) has two factors of production. D) has two production possibility frontiers (one for each country). E) has varying wage rates. Answer: C Page Ref: 84 Difficulty: Easy 6) "A good cannot be both land- and labor-intensive." Discuss. Answer: In a two good, two factor model, such as the original Heckscher-Ohlin framework, the factor intensities are relative intensities. Hence, the relevant statistic is either workers per acre (or acres per worker); or wage per rental unit (or rental per wage). In order to illustrate the logic of the statement above, let us assume that the production of a broom requires 4 workers and 1 acre. Also, let us assume that the production of one bushel of wheat requires 40 workers and 80 acres. In this case the acres per person required to produce a broom is one quarter, whereas to produce a bushel of wheat requires 2 acres per person. The wheat is therefore (relatively) land intensive, and the broom is (relatively) labor intensive. Page Ref: 89-90 Difficulty: Moderate 7) "No country is abundant in everything." Discuss. Answer: The concept of factor abundance is (like factor intensities) a relative concept. When we identify a country as being capital abundant, we mean that it has more capital per worker than does the other country. If one country has more capital worker than another, it is an arithmetic impossibility that it also has more workers per unit of capital. Page Ref: 92-94 Difficulty: Moderate

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8) In the 2-factor, 2 good Heckscher-Ohlin model, the country with a relative abundance of ________ will have a production possibility frontier that is biased toward production of the ________ good. A) labor; labor intensive B) labor; capital intensive C) land; labor intensive D) land; capital intensive E) capital; land intensive Answer: A Page Ref: 92-94 Difficulty: Easy 9) In the 2-factor, 2 good Heckscher-Ohlin model, the country with a relative abundance of ________ will have a production possibility frontier that is biased toward production of the ________ good. A) capital; capital intensive B) labor; capital intensive C) land; labor intensive D) land; capital intensive E) labor; land intensive Answer: A Page Ref: 92-94 Difficulty: Easy 10) In the 2-factor, 2 good Heckscher-Ohlin model, the production possibility frontier is kinked when A) there is no factor substitution in production. B) the opportunity cost of production is constant. C) there are unemployed factor resources. D) a country does not engage in trade. E) transportation costs are very high. Answer: A Page Ref: 86-87 Difficulty: Moderate 11) The assumption of diminishing returns in the Heckscher-Ohlin model means that, unlike in the Ricardian model, it is likely that A) countries will not be fully specialized in one product. B) countries will benefit from free international trade. C) countries will consume outside their production possibility frontier. D) comparative advantage will not determine the direction of trade. E) global production will decrease under trade. Answer: A Page Ref: 87 Difficulty: Moderate

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12) In the Heckscher-Ohlin model, countries are assumed to differ only in terms of their A) factor endowments. B) tastes and preferences. C) available technologies. D) factor productivities. E) physical size. Answer: A Page Ref: 90 Difficulty: Easy 5.2 Effects of International Trade Between Two-Factor Economies 1) In the 2-factor, 2 good Heckscher-Ohlin model, trade will ________ the owners of a country's ________ factor and will ________ the good that uses that factor intensively. A) benefit; abundant; export B) harm; abundant; import C) benefit; scarce; export D) benefit; scarce; import E) harm; scarce; export Answer: A Page Ref: 91 Difficulty: Easy 2) According to the Heckscher-Ohlin model, the source of comparative advantage is a country's A) factor endowments. B) technology. C) advertising. D) human capital. E) political system. Answer: A Page Ref: 94-95 Difficulty: Easy 3) In the 2-factor, 2 good Heckscher-Ohlin model, trade will ________ the owners of a country's ________ factor and will ________ the good that uses that factor intensively. A) harm; scarce; import B) harm; abundant; import C) benefit; scarce; export D) benefit; scarce; import E) harm; scarce; export Answer: A Page Ref: 96 Difficulty: Easy

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4) According to the Heckscher-Ohlin model A) the gainers from trade could compensate the losers and still retain gains. B) everyone gains from trade. C) the scarce factor gains from trade and the abundant factor loses. D) a country gains from trade if its exports have a high value added. E) only the country with the more advanced technology gains from trade. Answer: A Page Ref: 96 Difficulty: Easy 5) In the Heckscher-Ohlin model, when two countries begin to trade with each other A) the relative prices of traded goods in the two countries converge. B) relative factor prices in the two countries diverge. C) benefits from trade are evenly distributed between the two countries. D) all factors in both countries will gain from trade. E) all factors in one country will gain, but there may be no gains in the other country. Answer: A Page Ref: 95 Difficulty: Easy Assume that only two countries, A and B, exist.

6) Refer to the table above. If good S is capital intensive, then following the Heckscher-Ohlin Theory A) country B will export good S. B) country A will export good S. C) both countries will export good S. D) trade will not occur between these two countries. E) both countries will import good S. Answer: A Page Ref: 94-95 Difficulty: Moderate 7) Refer to the table above. If you are told that Country B is very much richer than Country A, then the correct answer is A) country B will export good S. B) country A will export good S. C) both countries will export good S. D) trade will not occur between these two countries. E) both countries will import good S. Answer: A Page Ref: 94-95 Difficulty: Moderate 5 .

8) Refer to the table above. You are told that Country B is very much larger than country A. The correct answer is A) country B will export good S. B) country A will export good S. C) both countries will export good S. D) trade will not occur between these two countries. E) both countries will import good S. Answer: A Page Ref: 94-95 Difficulty: Moderate 9) Refer to the table above. You are told that Country B has no minimum wage or child labor laws. Now the correct answer is A) country B will export good S. B) country A will export good S. C) both countries will export good S. D) trade will not occur between these two countries. E) both countries will import good S. Answer: A Page Ref: 94-95 Difficulty: Moderate 10) If a good is labor intensive it means that the good is produced A) using relatively more labor than goods that are not labor intensive. B) using labor as the only input. C) using more labor per unit of output than goods that are not labor intensive. D) using labor such that the total cost of labor is greater than the total cost of capital. E) using labor such that the cost of labor is more than 50% of total cost. Answer: A Page Ref: 94-95 Difficulty: Easy 11) In the Heckscher-Ohlin model, when there is international-trade equilibrium A) the relative price of the capital intensive good in the capital rich country will be the same as that in the capital poor country. B) the capital rich country will charge less for the capital intensive good than the price paid by the capital poor country for the capital-intensive good. C) the capital rich country will charge more for the capital intensive good than the price paid by the capital poor country for the capital-intensive good. D) workers in the capital rich country will earn more than those in the poor country. E) the workers in the capital rich country will earn less than those in the poor country. Answer: A Page Ref: 96 Difficulty: Moderate

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12) If a good is capital intensive it means that the good is produced A) using relatively more capital than goods that are not labor intensive. B) using capital as the only input. C) using more capital per unit of output than goods that are not capital intensive. D) using capital such that the total cost of capital is greater than the total cost of labor. E) using capital such that the cost of capital is more than 50% of total cost. Answer: A Page Ref: 90 Difficulty: Easy 13) The Heckscher-Ohlin model predicts all of the following EXCEPT A) the volume of trade. B) which country will export which product. C) which factor of production within each country will gain from trade. D) that relative wages will tend to become equal in both trading countries. E) that trade increases a country's overall welfare. Answer: A Page Ref: 89-97 Difficulty: Moderate 14) If Australia has relatively more land per worker, and Belgium has relatively more capital per worker, then if trade began between these two countries A) the relative price of the land-intensive product would increase in Australia. B) the relative price of the capital-intensive product would increase in Australia. C) the relative price of the land-intensive product would increase in Belgium. D) the relative price of the capital-intensive product would decrease in Belgium. E) relative product prices would diverge between Australia and Belgium. Answer: A Page Ref: 95-96 Difficulty: Moderate 15) If Australia has more land per worker, and Belgium has more capital per worker,then if trade began between these two countries A) the real income of landowners in Belgium would decline. B) the real income of capital owners in Australia would increase. C) the real income of labor in Australia would decline. D) the real income of labor in Belgium would decline. E) the real income of labor in both countries would decline. Answer: A Page Ref: 95-96 Difficulty: Moderate

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16) If Japan is relatively capital rich and the United States is relatively land rich, and if food is relatively land intensive then trade between these two, formerly autarkic countries will result in A) an increase in the relative price of food in the U.S. B) an increase in the relative price of food in Japan. C) a global increase in the relative price of food. D) a decrease in the relative price of food in both countries. E) an increase in the relative price of food in both countries. Answer: A Page Ref: 95-96 Difficulty: Moderate 17) Trade benefits a country by A) increasing available consumption choices. B) reducing the need for specialization in production. C) reducing the relative price of the exported good. D) increasing the real income of all resource owners. E) increasing the wage rate. Answer: A Page Ref: 95-96 Difficulty: Easy 18) If Gambinia has many workers but very little land and even less productive capital, then, following the Heckscher-Ohlin model, we predict that Gambinia will export A) labor-intensive goods. B) capital-intensive goods. C) both capital- and land-intensive goods. D) land-intensive goods. E) both labor- and land-intensive goods. Answer: A Page Ref: 95-96 Difficulty: Moderate 19) If Gambinia has many workers but very little land and even less productive capital, then, following the Heckscher-Ohlin model, in order to improve the country's economic welfare, the Gambinian government should A) engage in free trade. B) protect the capital-intensive product. C) protect the land-intensive product. D) protect the labor-intensive product. E) discontinue all international trade. Answer: A Page Ref: 95-96 Difficulty: Easy

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20) International trade leads to complete equalization of factor prices. Discuss. Answer: This statement is typically "true . . . but." Under a strict and limited set of assumptions, such as the original Heckscher-Ohlin model which excludes country specific technologies; nonhomothetic tastes; factor intensity reversals; large country differences in (relative) factor abundances, more factors than goods, and an equilibrium solution within the "cone of specialization"; then it may be demonstrated that internal consistency demands that the above stated sentence is "true." However, the minute one relaxes any of the above listed assumptions one may easily identify solutions, which contradict the factor price equalization theorem. Page Ref: 95-96 Difficulty: Moderate 21) Why is the H.O. model called the factor-proportions theory? Answer: The H.O. model explores the nature and the limitations of assuming that the sole determinant of comparative advantage is inter-country differences in (relative) factor proportions. Page Ref: 95-96 Difficulty: Easy

22) Refer to above figure. Two countries exist in this model, P and R. P is relatively labor (L) abundant, as is evident in the bottom right horizontal axis. If Country P were to be completely specialized in the labor-intensive product, C, it would be producing at point 4. In fact, it produces both C and P, at point 5. The (autarky) relative price of C (in terms of F) of Country P is at point 3; and of Country R at point 1. If trade were to open up between these two countries, which would export C and which would export F? Is this consistent with the Heckscher-Ohlin model? Explain. Answer: Country R would export F. This is consistent with the H-O model. The country which is relatively capital abundant exports the product which is relatively capital intensive. Page Ref: 95-96 Difficulty: Moderate 9 .

23) Refer to above figure. If trade were to open up between P and R, where would the world terms of trade locate in the figure above (somewhere on the PC/PF axis)? Would relative wages (w/r) in the two countries become equal? Is this consistent with the Heckscher-Ohlin model? Explain. Answer: The terms of trade would settle somewhere between the two autarky relative prices on the PC/PF axis. The relative wages (w/r) will be lower than the highest and higher than the lowest on the vertical axis above, but will not coincide. This last result is in contradiction to the factor price equalization expectation we have from the model. Page Ref: 95-96 Difficulty: Moderate 24) Refer to above figure. Would you expect to find that the real wages become equalized in both countries? Explain the reason for any differences you note. Answer: We would expect that one single relative wage will be established for both countries. This happens because the two countries do not differ in relative factor availability by much, and hence a zone of overlap exists which allows for this result. Page Ref: 102-103 Difficulty: Moderate 25) Refer to above figure. In autarky, Country P was producing at point 5. With trade, would its production point be found above or below point 5? Explain why. What must happen in the K/L intensity ratio in the production of each of the products in this country when moving from autarky to free trade? Answer: The point of production with trade will be above point 5. The country will be shifting its production composition to be more heavily weighted in labor intensive good, C. Within each industry, the production technique will be more capital intensive, since with the rising relative wage, the optimal point of production will involve sliding around the isoquants in the direction of saving on the now relatively more expensive labor. Page Ref: 102-103 Difficulty: Moderate

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26) One of the commonly used assumptions in deriving the Heckscher-Ohlin model is that tastes are homothetic, or that if the per capita incomes were the same in two countries, the proportions of their expenditures allocated to each product would be the same as it is in the other country. Imagine that this assumption is false, and that in fact, the tastes in each country are strongly biased in favor of the product in which it has a comparative advantage. How would this affect the relationship between relative factor abundance between the two countries, and the nature (factorintensity) of the product each exports? What if the taste bias favored the imported good? Answer: If in fact national tastes were strongly biased in favor of the product in which the country enjoyed a comparative advantage, then we would expect a bias in favor of rejecting the Heckscher-Ohlin Theorem in actual trade data. The engine driving the H-O model is that a country should be expected to have a relatively low cost of producing the good in which it has a comparative advantage. However, the respective demand forces would tend to raise the price of this good, so that the expected pattern would not generally be observed. However, if the tastes were biased in favor of the imported good, then the predictions of the Heckscher-Ohlin Theorem would be expected to be generally observed. Page Ref: 102-103 Difficulty: Difficult

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Suppose Australia, a land (K)-abundant country, and Sri-Lanka, a labor(L)-abundant country, both produce labor and land intensive goods with the same technology.

27) Use the diagram above to identify the pre-trade situation for Australia and Sri-Lanka. Where on the K/L axis will you find each of the two countries? Which of the two countries has a higher relative wage, w/r? Which product is the labor intensive, and which is the land intensive one? Show where the relative price of cloth to food will be found once trade opens between these two countries. Show where the relative wages of each will appear. Answer: You will find Sri-Lanka to the left of Australia on the K/L axis. Australia has a higher relative wage. Food is the land intensive product. The relative price PC/PF is found between the two autarkic prices. The post trade relative wage is between the two autarkic ones on the vertical axis. Page Ref: 95-96 Difficulty: Difficult 28) Using the figure above, demonstrate what happens to the composition of production (that is quantity of cloth per 1 unit of food) in Australia once trade is established between the two countries. Which country will export cloth? What happens to the relative income of workers in Australia as a result of trade? Does it increase or decrease? Would land owners in Australia lobby for or against free trade? Would land owners in Australia lobby for or against free admittance of immigrant workers? Answer: The proportion of food to cloth will increase in the production of Australia Sri Lanka will export cloth. The relative (and real) incomes of workers will fall in Australia as a result of trade. Land Owners in Australia should lobby in favor of trade. They would also lobby for free labor mobility (of workers into Australia), since the marginal product of labor is high, the owners of land have much (Ricardian) rents to gain from an inflow of workers. Page Ref: 95-96 Difficulty: Difficult

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29) Refer to above figure. Imagine that the relative capital abundance of Australia was so much greater than that of Sri-Lanka, that we would have to locate Australia far to the right on the K/L axis. If this were so far to the right that there was no area of overlap on the w/r axis, then what product would Australia export? Which product will each of the trade partners export? Will the relative wages as calculated now be the same or different in both Australia and Sri Lanka? Answer: Australia would still export food. As a result of trade, wages will fall in Australia and will rise in Sri-Lanka. However, in this case, the wages in Australia will remain higher than in Sri-Lanka, creating an incentive for migration from the latter to the former country. Page Ref: 95-96 Difficulty: Difficult 30) Starting from an autarky (no-trade) situation with Heckscher-Ohlin model, if Country H is relatively labor abundant, then once trade begins A) wages should rise and rents should fall in H. B) wages and rents should rise in H. C) wages and rents should fall in H. D) wages should fall and rents should rise in H. E) rent will be unchanged but wages will rise in H. Answer: A Page Ref: 95-96 Difficulty: Moderate 31) Suppose that there are two factors, capital and land, and that the United States is relatively land endowed while the European Union is relatively capital-endowed. According to the Heckscher-Ohlin model A) European capitalists should support U.S.-European free trade. B) European landowners should support U.S.-European free trade. C) all capitalists in both countries should support free trade. D) all landowners should support free trade. E) the U.S. should compensate European countries once trade commences. Answer: A Page Ref: 95-96 Difficulty: Easy 32) International trade has strong effects on income distributions. Therefore, international trade A) will tend to hurt some groups in each trading country. B) is beneficial to everyone in both trading countries. C) will tend to hurt one trading country. D) will tend to hurt everyone in both countries. E) will be beneficial to all those engaged in international trade. Answer: A Page Ref: 95-96 Difficulty: Easy

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33) Factors tend to be specific to certain uses and products A) in the short run. B) in countries lacking comparative advantage. C) in capital-intensive industries. D) in labor-intensive industries. E) in countries lacking fair labor laws. Answer: A Page Ref: 96 Difficulty: Easy 34) If the price of the capital intensive product rises more than does the price of the land intensive product, then A) the relative price of the capital intensive product will fall to some point between the pretrade relative prices. B) demand will shift away from the capital-intensive product, and its production will decrease. C) demand will shift away from the capital-intensive product, and its production will decrease relative to that of the land intensive product. D) the production of the capital-intensive product will decrease, but by less than production of the land-intensive product. E) the country that exports the capital-intensive good will lose its comparative advantage. Answer: A Page Ref: 96 Difficulty: Easy 35) If trade opens up between the two formerly autarkic countries, Australia and Belgium, then A) the real income of both countries may increase. B) the real income of Australia and of Belgium will increase. C) the real income of Australia but not of Belgium will increase. D) the real income of neither country will increase. E) the real income of both countries will increase. Answer: A Page Ref: 96 Difficulty: Easy 5.3 Empirical Evidence on the Heckscher-Ohlin Model 1) The Leontief Paradox A) failed to support the validity of the Heckscher-Ohlin model. B) supported the validity of the Ricardian theory of comparative advantage. C) supported the validity of the Heckscher-Ohlin model. D) failed to support the validity of the Ricardian theory. E) proved that the U.S. economy is different from all others. Answer: A Page Ref: 104 Difficulty: Easy

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2) The Leontief Paradox A) refers to the finding that U.S. exports were more labor intensive than its imports. B) refers to the finding that U.S. Exports were more capital intensive than its exports. C) refers to the finding that the U.S. produces outside its Edgeworth Box. D) still accurately applies to today's pattern of U.S. international trade. E) refers to the fact that Leontief—an American economist—had a Russian name. Answer: A Page Ref: 104 Difficulty: Easy 3) The 1987 study by Bowen, Leamer and Sveikauskas A) supported the validity of the Leontief Paradox. B) supported the validity of the Heckscher-Ohlin model. C) used a two-country and two-product framework. D) demonstrated that in fact countries tend to use different technologies. E) proved that the U.S.'s comparative advantage relied on skilled labor. Answer: A Page Ref: 105 Difficulty: Easy 4) Empirical observations on actual North-South trade patterns tend to A) support the validity of the Heckscher-Ohlin model. B) support the validity of the Leontief Paradox. C) support the validity of the Rybczynski Theorem. D) support the validity of the wage equalization theorem. E) support the validity of the neo-imperialism exploitation theory. Answer: A Page Ref: 110 Difficulty: Moderate 5) The Case of the Missing Trade refers to A) the fact that factor trade is less than predicted by the Heckscher-Ohlin theory. B) the 9th volume of the Hardy Boys' Mystery series. C) the fact that world exports does not equal world imports. D) the fact that the Heckscher Ohlin theory predicts much less volume of trade than actually exists. E) the fact that the Heckscher Ohlin theory never applies to China-U.S. trade practices. Answer: A Page Ref: 105 Difficulty: Moderate

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6) Countries do not in fact export the goods the H.O. theory predicts. Discuss. Answer: This statement is not true. Although one may find many cases where it seems to be true (e.g., the Leontief Paradox), all one needs to do in order to render the above statement not (generally) true is to find one counter example. In fact, one can find large subsets of agricultural and commodity products in which the H.O predictions are generally fulfilled. Labor-intensive countries such as Bangladesh do in fact export relatively labor-intensive goods. Capital-intensive countries such as Germany do in fact export capital-intensive products (at least to South countries). Countries such as Costa Rica ("sunshine abundant") tend to export bananas (sunshine-intensive products). The U.S. (a wheat-land-abundant country) does indeed export wheat (a wheat-land intensive product). In fact, since the early 1980s, the Leontief Paradox was not found to describe the U.S. trade data (hence ratifying the H.O. theory). Page Ref: 109-110 Difficulty: Moderate 7) Why do we observe the Leontief paradox? Answer: There are many possible answers. They may be classified into three groups. One would argue that the model, or theory is wrong. The second would argue that the theory is correct (internally consistent and descriptive of real world data), but the real world data is incorrectly perceived, defined or measured. The third would argue that the statement itself is wrong, and that in fact the Leontief paradox itself is not actually observed, but rather is due to faulty logical rendering of the original model. Empirical studies conducted since Leontief's work was published suggest that, by relaxing the model's restrictive assumptions regarding technology, goods, and trade costs, evidence in support of the HO model was strengthened and evidence of the Leontief effect was diminished. Page Ref: 105-107 Difficulty: Moderate 8) Why are prices of factors of production NOT equalized? Answer: Again this statement may or may not be argued to be true. On the one hand, the large volume and growth in world trade between the United States and other OECD countries during the 50 years since World War II has clearly been related to a near universal (average) convergence in real wage levels in these countries, whereas the most obvious cases in which such a convergence did not take place (North-South countries) also happened to be cases in which trade was relatively small and "missing." There are many theoretical reasons why factor price equalization may not occur. If the relative country relative abundances are very different, then the theory itself does not predict that the wage equalization will occur. The same is true of factor intensity reversals exist within relevant relative wage ranges. Dynamic migration models such as Harris-Todaro are another class of theory that may suggest that even if the static equilibrium solution does include the factor-price equalization, the dynamic path of the model may never reach this solution, so that when observed within any finite time frame, it a lack of equalization would exist.. Page Ref: 109-110 Difficulty: Difficult

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9) The Heckscher-Ohlin model is famous for being elegant and mathematically sophisticated, yet failing to describe reality. One manifestation of this fact is Trefler's Case of Missing Trade. Explain what exactly is missing. In what sense is it missing? How would you explain why it is missing? How can a relaxation of the identical production functions explain the case of the missing trade? How did the results obtained by Davis and Weinstein strengthen support for the validity of the HO model? Answer: Trefler demonstrated that the actual volume of world trade is significantly less than that which would be predicted by the Heckscher-Ohlin model. One explanation is that North-South trade is especially less than would be predicted by a factor proportions model. If technologies differ in the poorer countries, then it is possible that the cost of producing a product, which uses relatively much of their abundant factor may still be higher than the cost of producing it in the other country. Davis and Weinstein showed that, relaxing the restrictive assumptions regarding technology, goods, and trade costs, yielded empirical results that support the model. Page Ref: 106-107 Difficulty: Difficult 10) Factor-intensity reversals describe a situation in which the production of a product may be land-intensive in one country, and relatively labor intensive in another (at given relative wage levels). For example, cotton may be land intensive in the U.S., and labor intensive in Egypt where land is relatively scarce and expensive. Suppose factor-intensity reversals were common. How would that affect the conclusion that a country in which land is relatively scarce will not be the country with a comparative advantage in the land-intensive product? Answer: The answer here is straightforward (though it has various interesting implications). In this case we cannot define or identify a product in terms of its relative factor intensity (at all or any relative wage level). Therefore, the Heckscher-Ohlin Theorem is ipso-facto inapplicable. Page Ref: 103-110 Difficulty: Difficult 11) Why is it that North-South trade in manufactures seems to be consistent with the results or expectations generated by the factor-proportions theory of international trade, whereas NorthNorth trade is not? Answer: There is a clear difference in relative factor availabilities between North and South countries, no matter how we define and measure the factors of production. Hence, the factorproportions theory of trade may be sensibly expected to explain the pattern (though not the volume) of trade between these two groups of countries. However, the North North trade partners do not vary significantly in their relative factor availabilities, so that other forces, such as scale economies play a relatively large role in determining trade patterns. Page Ref: 94-102 Difficulty: Difficult

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12) Why do you suppose that South-South trade does not conform in volume, but does conform in pattern with expectations generated by the Heckscher-Ohlin model? Answer: The pattern of trade is generally observed to conform to the Heckscher-Ohlin models expectations. That is, the developing countries tend to export labor-intensive goods, such as textiles, and import capital-intensive goods such as machinery. The volume however is quite lower than what would be expected from the Neoclassical model. There are many possible reasons, such as financial crises necessitating premia in the financing of this trade. Page Ref: 94-102 Difficulty: Moderate 13) If two countries are very different in relative factor abundance, then empirical support for which of the following would less likely? A) the Factor Price Equalization Theorem B) the Heckscher-Ohlin Theorem C) the Law of One Price D) the Law of Demand E) the Gravity Theorem Answer: A Page Ref: 102 Difficulty: Easy 14) Which of the following empirical studies cast the most doubt on the Heckscher-Ohlin model? A) the study by Wassily Leontief B) the study by Bowen, Leamer, and Sveikauskas C) the study by David Ricardo D) the study by Adam Smith E) the study by Davis and Weinstein Answer: A Page Ref: 106-107 Difficulty: Easy 15) Which of the following empirical studies provided the most support for the heckscher-Ohlin model? A) the study by Wassily Leontief B) the study by Bowen, Leamer, and Sveikauskas C) the study by David Ricardo D) the study by Adam Smith E) the study by Davis and Weinstein Answer: E Page Ref: 106-107 Difficulty: Easy

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16) Empirical support for the Heckscher-Ohlin model was weakest when the study applied A) all of the assumptions of the model. B) all of the assumptions of the model except that regarding technology. C) all of the assumptions of the model except those regarding technology, goods and shipping costs. D) all of the assumptions of the model except those regarding technology, shipping costs and gravity. E) all of the assumptions of the model except those regarding shipping costs. Answer: C Page Ref: 106-107 Difficulty: Easy 5.4 Appendix to Chapter 5: Factor Prices, Goods Prices, and Production Decisions 1) Which of the following is an assertion of the Heckscher-Ohlin model? A) The wage-rental ratio is determined by relative product prices. B) An increase in a country's labor supply will increase production of both the capital-intensive and the labor-intensive good. C) In the long-run, labor is mobile and capital is not. D) Factor price equalization will occur only if there is costless mobility of all factors across borders. E) Factor endowments determine the technology that is available to a country, which determines the good in which the country will have a comparative advantage. Answer: A Page Ref: 114-117 Difficulty: Moderate 2) Which of the following is an assertion of the Heckscher-Ohlin model? A) The wage-rental ratio determines the capital-labor ratio in a country's industries. B) An increase in a country's labor supply will increase production of both the capital-intensive and the labor-intensive good. C) In the long-run, labor is mobile and capital is not. D) Factor price equalization will occur only if there is costless mobility of all factors across borders. E) Factor endowments determine the technology that is available to a country, which determines the good in which the country will have a comparative advantage. Answer: A Page Ref: 114-117 Difficulty: Moderate

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3) Which of the following is an assertion of the Heckscher-Ohlin model? A) An increase in a country's labor supply will increase production of the labor-intensive good and decrease production of the capital-intensive good. B) An increase in a country's labor supply will increase production of both the capital-intensive and the labor-intensive good. C) In the long-run, labor is mobile and capital is not. D) Factor price equalization will occur only if there is costless mobility of all factors across borders. E) Factor endowments determine the technology that is available to a country, which determines the good in which the country will have a comparative advantage. Answer: A Page Ref: 114-117 Difficulty: Moderate

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International Economics, 10e (Krugman/Obstfeld/Melitz) Chapter 6 The Standard Trade Model 6.1 A Standard Model of a Trading Economy 1) The meaning of "terms of trade" is A) the price of a country's exports divided by the price of its imports. B) the amount of exports sold by a country. C) the price conditions bargained for in international markets. D) the quantities of imports received in free trade. E) the tariffs in place between two trading countries. Answer: A Page Ref: 119 Difficulty: Easy 2) A country cannot produce a mix of products with a higher value than where A) the isovalue line is tangent to the production possibility frontier. B) the isovalue line intersects the production possibility frontier. C) the isovalue line is above the production possibility frontier. D) the isovalue line is below the production possibility frontier. E) the isovalue line is tangent with the indifference curve. Answer: A Page Ref: 120 Difficulty: Easy 3) Tastes of individuals are represented by A) indifference curves. B) production possibility frontiers. C) isovalue lines. D) production functions. E) the terms of trade. Answer: A Page Ref: 121 Difficulty: Easy 4) If the ratio of price of cloth (PC) divided by the price of food (PF) increases in the international marketplace, then A) the terms of trade of cloth exporters will improve. B) all countries would be better off. C) the terms of trade of food exporters will improve. D) the terms of trade of all countries will improve. E) the terms of trade of cloth exporters will worsen. Answer: A Page Ref: 120 Difficulty: Easy

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5) If the ratio of price of cloth (PC) divided by the price of food (PF) increases in the international marketplace, then A) the cloth exporter will increase the quantity of cloth produced. B) the cloth exporter will increase the quantity of cloth exported. C) the food exporter will increase the quantity of food exported. D) the cloth exporter will decrease the quantity of cloth exported. E) the country would import more cloth. Answer: A Page Ref: 123 Difficulty: Easy 6) If the ratio of price of cloth (PC) divided by the price of food (PF) increases in the international marketplace, then A) world relative quantity of cloth supplied will increase. B) world relative quantity of cloth supplied and demanded will increase. C) world relative quantity of cloth supplied and demanded will decrease. D) world relative quantity of cloth demanded will decrease. E) world relative quantity of food will increase. Answer: A Page Ref: 123 Difficulty: Easy 7) A country will be able to consume a combination of goods that is not attainable solely from domestic production if A) the world terms of trade differ from its domestic relative costs. B) the country specializes in one product. C) the country avoids international trade. D) the world terms of trade equal the domestic relative costs. E) the country's domestic production value equals world relative value. Answer: A Page Ref: 125 Difficulty: Moderate 8) Terms of trade refers to A) the relative price at which trade occurs. B) what goods are imported. C) what goods are exported. D) the volume of trade. E) the tariffs applied to trade. Answer: A Page Ref: 119 Difficulty: Easy

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9) If points A and B are two locations on a country's production possibility frontier, then A) the country could produce either of the two bundles. B) consumers are indifferent between the two bundles. C) producers are indifferent between the two bundles. D) at any point in time, the country could produce both. E) both bundles must have the same relative cost. Answer: A Page Ref: 119 Difficulty: Easy 10) If the economy is producing at point a on its production possibility frontier, then A) all of the country's workers are employed. B) all of the country's workers are specialized in one product. C) all of the country's capital is used for one product. D) all of its capital is used, but not efficiently. E) all of the country's exports are produced in equal amounts. Answer: A Page Ref: 119-120 Difficulty: Easy

11) Refer to the figure above, which shows a country's possible production possibility frontiers and indifference curves. If the country is producing at ________, then moving to ________ will cause utility to ________. A) point b; point c; remain unchanged B) point a; point b; increase C) point c; point b; increase D) point c; point b; decrease E) point a; point c; remain unchanged Answer: A Page Ref: 121-122 Difficulty: Easy

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12) If two countries with diminishing returns and different marginal rates of substitution between two products were to engage in trade, then A) the marginal rates of substitution of both would become equal. B) the shapes of their respective production possibility frontiers would change. C) the larger of the two countries would dominate their trade. D) the country with relatively elastic supplies would export more. E) the opportunity costs for the smaller country would increase. Answer: A Page Ref: 125 Difficulty: Easy 13) If a country began exporting product A and importing product B, then, as compared to the autarky (no-trade) situation, the marginal cost of product A will A) increase. B) decrease. C) shift outward. D) shift inward. E) remain the same. Answer: A Page Ref: 123 Difficulty: Easy 14) When the production possibility frontier shifts out relatively more in one direction, we have A) biased growth. B) unbiased growth. C) immiserizing growth. D) balanced growth. E) imbalanced growth. Answer: A Page Ref: 126 Difficulty: Easy 15) Suppose that a country experiences growth strongly biased toward its export, cloth A) this will tend to worsen the country's terms of trade. B) this will tend to improve the country's terms of trade. C) this will tend to leave the country's terms of trade unchanged. D) this will tend to worsen the terms of trade for the country's trading partner. E) this will increase the price of cloth relative to the imported good. Answer: A Page Ref: 126 Difficulty: Moderate

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16) Suppose that a "small country" experiences growth strongly biased toward its export, cloth A) this will have no effect on terms of trade for the country's trading partner. B) this will tend to worsen the country's terms of trade. C) this will tend to improve the country's terms of trade. D) this will tend to worsen terms of trade for the country's trading partner. E) this will tend to improve terms of trade for the country's trading partner. Answer: A Page Ref: 129 Difficulty: Moderate 17) Other things being equal, a rise in a country's terms of trade increases its welfare. What would happen if we relax the ceteris paribus assumption, and allow for the law of demand to operate internationally? Answer: Let us assume that the terms of trade (or technically the net commodity terms of trade) improve, thus the relative price of a country's exports increase. This would, logically, lead to a shift away by world consumers to substitute goods. If the demand for a country's exports is elastic, the quantity decrease would be proportionally larger than the per unit price increase. This term of trade effect would actually lower the country's real income and economic welfare. Page Ref: 129 Difficulty: Moderate

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18) Refer to above figure. Albania refused to engage in international trade for ideological reasons. To maximize its economic welfare it would choose to produce at which point in the diagram above? Suppose the PA/PB at point a was equal to 1. Given this information, in which good (A or B) does Albania enjoy a comparative advantage? Now that the Cold War is over, Albania is interested in obtaining economic welfare gains from trade. The relevant international relative price is PA/PB = 2. Albania would therefore choose to produce at which point (a, b, or c)? Given this additional information, in which good does Albania enjoy a comparative advantage? Answer: Albania would choose to produce at point a. With no reference to world terms of trade, one cannot establish Albania's comparative advantage. Later, when Albania discovers that the relative price of A equals twice the price of B, it knows that it has a comparative advantage in A. Therefore Albania would produce at production point b. Page Ref: 121-123 Difficulty: Moderate 19) Refer to above figure. Now, suppose that the relative price of A is actually not higher than Albania's autarkic level of 1, but quite the opposite (e.g., PA/PB = 0.5). Would Albania still be able to gain from trade? If so, where would be its production point? Given the information in this question, where is Albania's comparative advantage? Answer: Yes. As long as the world's terms of trade differed from those of Albania, that country stands to gain from international trade. In this particular case, its point of production with trade would be at point c. Page Ref: 121-123 Difficulty: Moderate

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20) Refer to the figure above, which shows a country's possible production possibility frontiers and indifference curves. If the country is producing at ________, then moving to ________ will cause utility to ________. A) point c; point b; remain unchanged B) point a; point b; increase C) point c; point b; increase D) point c; point b; decrease E) point a; point c; remain unchanged Answer: A Page Ref: 121-123 Difficulty: Easy 21) Refer to the figure above, which shows a country's possible production possibility frontiers and indifference curves. If the country is producing at ________, then moving to ________ will cause utility to ________. A) point b; point a; increase B) point a; point b; increase C) point c; point b; increase D) point c; point b; decrease E) point a; point c; remain unchanged Answer: A Page Ref: 121-123 Difficulty: Easy 6.2 Tariffs and Export Subsidies: Simultaneous Shifts in RS and RD 1) If the U.S. (a large country) imposes a tariff on its imported good, this will tend to A) improve the terms of trade of the United States. B) have no effect on terms of trade. C) improve the terms of trade of all countries. D) cause a deterioration of U.S. terms of trade. E) raise the world price of the good imported by the United States. Answer: A Page Ref: 132-133 Difficulty: Easy 7 .

2) If Slovenia is a small country in world trade terms, then if it imposes a large series of tariffs on many of its imports, this would A) have no effect on its terms of trade. B) improve its terms of trade. C) deteriorate its terms of trade. D) decrease its marginal propensity to consume. E) increase its exports. Answer: A Page Ref: 132-133 Difficulty: Easy 3) If Slovenia is a large country in world trade, then if it imposes a large set of tariffs on many of its imports, this would A) improve its terms of trade. B) have no effect on its terms of trade. C) harm its terms of trade. D) decrease its marginal propensity to consume. E) increase its exports. Answer: A Page Ref: 132-135 Difficulty: Easy 4) If Slovenia were a large country in world trade, then if it imposes a large set of tariffs on its imports, this must A) decrease the internal price of imports below the world market rate. B) cause retaliation on the part of its trade partners. C) harm Slovenia's real income. D) improve Slovenia's real income. E) improve the real income of its trade partners. Answer: A Page Ref: 132-135 Difficulty: Easy 5) If Slovenia were a large country in world trade, then if it instituted a large set of subsidies for its exports, this must A) harm its terms of trade. B) have no effect on its terms of trade. C) improve its terms of trade. D) decrease its marginal propensity to consume. E) harm world terms of trade. Answer: A Page Ref: 132-135 Difficulty: Easy

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6) If Slovenia were a large country in world trade, then if it instituted a large set of subsidies for its exports, this must A) improve the real income of its trade partners. B) cause retaliation on the part of its trade partners. C) harm Slovenia's real income. D) improve Slovenia's real income. E) increase internal prices above the world market rate. Answer: A Page Ref: 132-135 Difficulty: Easy 7) An export subsidy has the opposite effect on terms of trade to the effect of an import tariff. Domestically a tariff will raise the price of the import good, deteriorating the domestic terms of trade. A production subsidy for the export product will lower the local price of the export good, lowering the domestic terms of trade for the country. Hence the export subsidy and the import tariff have the same effect. This analysis seems to contradict the first sentence in this paragraph. Discuss this paradox. Answer: While this (Lerner) equivalence may well occur domestically, internationally the tariff will improve a country's terms of trade. An export subsidy on the other hand will in fact lower the international price of the (now readily available) export good, hence hurting a country's terms of trade. Page Ref: 132-135 Difficulty: Moderate

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8) Suppose, as a result of various dynamic factors associated with exposure to international competition, Albania's economy grew, and is now represented by the rightmost production possibility frontier in the figure above. If its point of production with trade was point c, would you consider this growth to be export-biased or import biased? If Albania were a large country with respect to the world trade of A and B, how would this growth affect Albania's terms of trade? Its real income? Answer: If point c is the production point with trade, then Albania has a comparative advantage in good B. Therefore, from the shape of the new production possibility frontier (as compared to the original one), this is clearly an export-biased growth. This ceteris paribus would tend to worsen Albania's terms of trade. The terms of trade effect would, again ceteris paribus, worsen its real income. However, the growth itself acts in the opposite direction. Page Ref: 132-135 Difficulty: Moderate 9) Suppose, as a result of various dynamic factors associated with exposure to international competition, Albania's economy grew, and is now represented by the rightmost production possibility frontier in the figure above. If its point of production with trade was point b, would you consider this growth to be export-biased or import biased? If Albania were a large country with respect to the world trade of A and B, how would this growth affect Albania's terms of trade? Its real income? What if Albania were a small country? Answer: If the production with trade point was point b, then the observed growth is a case of import-biased growth, and would improve Albania's terms of trade. If Albania were a small country, the world's terms of trade would not change at all. In such a case, economic growth (with no induced change in income distributions) would always increase its real income. Page Ref: 132-135 Difficulty: Moderate

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10) Suppose Albania is exporting product B, and experienced economic growth biased in favor of product B as seen in the figure above. We are also told that Albania's new consumption point is at point d. Would you still consider the economic growth, which took place biased in favor of B? If Albania were a large country how would this growth affect its terms of trade? Answer: This is a relatively difficult case. On the one hand, the growth is still technically export biased. However, Albania's consumption clearly shifted in favor of its import product, A. In this case, the deterioration in the terms of trade would be much more pronounced than before, and may lead to a case of immiserizing growth. However, for this to occur, there must have been a major shift in the taste patterns (the old community indifference map is not longer applicable). Therefore, when we try to judge the direction and magnitude of the welfare change, we are comparing the old versus new taste preferences, which raises the classic index number problem. Page Ref: 132-135 Difficulty: Difficult 11) If a small country were to levy a tariff on its imports then this would A) decrease the country's economic welfare. B) have no effect on that country's economic welfare. C) increase the country's economic welfare. D) change the terms of trade. E) raise prices on its exports in other countries. Answer: A Page Ref: 132-135 Difficulty: Easy 12) An increase in a country's net commodity terms of trade will A) not always guarantee positive changes in the country's economy. B) always increase the country's economic welfare. C) always increase the country's real income. D) never increase the country's quantity of exports. E) always increase the country's production of its import competing good. Answer: A Page Ref: 132-135 Difficulty: Easy 13) An import tariff will cause the relative demand for ________ to ________ and the relative supply for ________ to ________. A) imports; decrease; imports; increase B) imports; increase; imports; decrease C) exports; increase; exports; decrease D) exports; decrease; exports; increase E) exports; increase; imports; decrease Answer: A Page Ref: 132-135 Difficulty: Moderate

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14) An export subsidy will cause the relative demand for ________ to ________ and the relative supply for ________ to ________. A) exports; decrease; exports; increase B) imports; decrease; imports; increase C) imports; increase; imports; decrease D) exports; increase; exports; decrease E) exports; increase; imports; decrease Answer: A Page Ref: 132-135 Difficulty: Moderate 15) An import tariff will cause the terms of trade of the ________ country to ________ and will ________ the country. A) importing; improve; benefit B) exporting; improve; benefit C) importing; suffer; harm D) exporting; improve; harm E) importing; improve; harm Answer: A Page Ref: 132-135 Difficulty: Moderate 16) An export subsidy will cause the terms of trade of the ________ country to ________ and will ________ the country. A) exporting; suffer; harm B) exporting; improve; benefit C) importing; suffer; harm D) importing; suffer; benefit E) importing; improve; harm Answer: A Page Ref: 132-135 Difficulty: Moderate 6.3 International Borrowing and Lending 1) International borrowing and lending may be interpreted as one form of A) intertemporal trade. B) intermediate trade. C) trade in services. D) unrequited international transfers. E) aid to offset trade advantages. Answer: A Page Ref: 135-136 Difficulty: Easy

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2) If one observes that Japan was traditionally a net foreign lender, one could conclude that relative to its international trade and financial partners A) Japan's intertemporal production possibilities are biased toward present consumption. B) Japan's intertemporal production possibilities are biased toward future consumption. C) Japan's intertemporal production possibilities are larger than that of the other countries. D) Japan's intertemporal production possibilities are not biased. E) Japan preferred to consume beyond its production in the present. Answer: A Page Ref: 135-136 Difficulty: Easy 3) Rapidly growing developing countries tend to be borrowers on the international capital markets. From this information we may surmise that they have a comparative advantage in A) future income. B) capital goods. C) disposable income. D) consumer goods. E) present income. Answer: A Page Ref: 135-136 Difficulty: Easy 4) It may be argued that theoretically, international capital movements A) tend to hurt labor in donor countries. B) tend to hurt the donor countries. C) tend to hurt the recipient countries. D) tend to hurt labor in recipient countries. E) increase future production in donor countries. Answer: A Page Ref: 135-136 Difficulty: Moderate 5) The intertemporal tradeoff between present and future consumption is measured by the A) real interest rate. B) inflation rate. C) nominal interest rate. D) terms of trade. E) rate of economic growth. Answer: A Page Ref: 136-37 Difficulty: Easy

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6) A fall in the real interest rate, all other things held constant, will cause a country's ________ to ________. A) current consumption: increase B) current consumption: decrease C) terms of trade; improve D) terms of trade; worsen E) welfare level; improve Answer: A Page Ref: 136-37 Difficulty: Easy 7) An increase in the real interest rate, all other things held constant, will cause a country's ________ to ________. A) current consumption: increase B) current consumption: decrease C) terms of trade; improve D) terms of trade; worsen E) welfare level; improve Answer: B Page Ref: 136-37 Difficulty: Easy 8) What is intertemporal comparative advantage? Answer: Intertemporal comparative advantage arises when a country can produce goods for future consumption at a relatively low cost in terms of current consumption. Such a country can import investments (loans) from other countries with intertemporal comparative disadvantages at terms of trade that benefit both countries. Page Ref: 138 Difficulty: Moderate 6.4 Appendix to Chapter 6: More on Intertemporal Trade 1) The price of ________ consumption in terms of ________ consumption is ________. A) future; current; 1/(1 + r) B) present; future; 1/(1 + r) C) future; current; r D) present; future; r E) future; current; 1 + r Answer: A Page Ref: 142 Difficulty: Easy

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2) The intertemporal budget constraint is defined as: A) DP + DF/(1 + r) = QP + QF/(1 + r) B) V = QP + QF/(1 + r) C) V = DP + DF/(1 + r) D) DF + DP/(1 + r) = QF + QP/(1 + r) E) DP + DF(1 + r) = QP + QF(1 + r) Answer: A Page Ref: 143 Difficulty: Easy 3) Describe the nature of trade between two countries based on intertemporal comparative advantage. Answer: Intertemporal comparative advantage arises when a country can produce goods for future consumption at a relatively low cost in terms of current consumption when compared with its trading partner. This implies that the first country offers a relatively high return on investment when compared to the second. As a result, the first country will import goods for current consumption (investments or loans) and will export goods for future consumption (return on investment or interest). The resulting pattern of trade is one which will tend to equalize returns on investment in the two countries. Page Ref: 143-144 Difficulty: Moderate

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International Economics, 10e (Krugman/Obstfeld/Melitz) Chapter 7 External Economies of Scale and the International Location of Production 7.1 Economies of Scale and International Trade: An Overview 1) If a firm's output more than doubles when all inputs are doubled, production is said to occur under conditions of A) increasing returns to scale. B) imperfect competition. C) intra-industry equilibrium. D) constant returns to scale E) decreasing returns to scale. Answer: A Page Ref: 146-147 Difficulty: Easy 2) One advantage of the specialization that results from international trade is that countries can take advantage of A) scale economies. B) production diversification C) smaller countries. D) taste reversals. E) lower transport costs. Answer: A Page Ref: 146-147 Difficulty: Moderate 3) Why are increasing returns to scale and fixed costs important in models of international trade and imperfect competition? Answer: There are many answers. Three of these are (a) Increasing returns to scale and high fixed costs may be inconsistent with perfect competition. In such a case, the initial autarkic state may be a suboptimal equilibrium. For example, relative prices may not equal marginal rates of transformation. It follows from this that a change in output compositions associated with trade may result in a national welfare for one or both trading countries that is inferior to that associated with the initial autarkic conditions. Hence no "gains from trade." (b) In a case of increasing scale economies at the firm or plant level, the determination of which product will be exported by which country is ex-ante indeterminate. Therefore, deriving clear implications concerning the effects of trade on income distributions such as may be derived from the Samuelson-Stolper Theorem is no longer generally possible. (c) Market structures containing positive scale economies and imperfect competition may allow for "two-way trade," or intra-industry trade. As in b. above, the various theorems derivable from the Heckscher-Ohlin model concerning directions of trade and income distributions are no longer generally applicable. Page Ref: 146-147 Difficulty: Difficult 1 .

4) If a firm's output doubles when all inputs are doubled, production is said to occur under conditions of A) increasing returns to scale. B) imperfect competition. C) intra-industry equilibrium. D) constant returns to scale E) decreasing returns to scale. Answer: D Page Ref: 146-147 Difficulty: Easy 5) If a firm's output less than doubles when all inputs are doubled, production is said to occur under conditions of A) increasing returns to scale. B) imperfect competition. C) intra-industry equilibrium. D) constant returns to scale E) decreasing returns to scale. Answer: E Page Ref: 146-147 Difficulty: Easy 7.2 Economies of Scale and Market Structure 1) The existence of external economies of scale A) may be associated with a perfectly competitive industry. B) cannot be associated with a perfectly competitive industry. C) tends to result in one huge monopoly. D) tends to result in large profits for each firm. E) focuses more on individual firms than the industry as a whole. Answer: A Page Ref: 147-148 Difficulty: Moderate 2) The existence of internal economies of scale A) cannot be associated with a perfectly competitive industry. B) may be associated with a perfectly competitive industry. C) is associated only with sophisticated products such as aircraft. D) cannot form the basis for international trade. E) focuses more on the industry than individual firms. Answer: A Page Ref: 147-148 Difficulty: Moderate

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3) When there are external economies of scale, an increase in the size of the market will A) increase the number of firms and lower the price per unit. B) increase the number of firms and raise the price per unit. C) decrease the number of firms and raise the price per unit. D) decrease the number of firms and lower the price per unit. E) not affect the number of firms, but will lower the price per unit. Answer: A Page Ref: 147-148 Difficulty: Easy 4) If some industries exhibit internal increasing returns to scale in each country, we should not expect to see A) perfect competition in these industries. B) intra-industry trade between countries. C) inter-industry trade between countries. D) high levels of specialization in both countries. E) increased productivity in both countries. Answer: A Page Ref: 147-148 Difficulty: Moderate 5) If a scale economy is the dominant technological factor defining or establishing comparative advantage, then the underlying facts explaining why a particular country dominates world markets in some product may be pure chance, or historical accident. Explain, and compare this with the answer you would give for the Heckscher-Ohlin model of comparative advantage. Answer: This statement is true, since the reason the seller is a monopolist may be that it happened to have been the first to produce this product in this country. It may have no connection to any supply or demand related factors; nor to any natural or man-made availability. This is all exactly the opposite of the Heckscher-Ohlin Neo-Classical model's explanation of the determinants of comparative advantage. Page Ref: 147-148 Difficulty: Difficult 6) External economies of scale arise when the cost per unit A) falls as the industry grows larger and rises as the average firm grows larger. B) rises as the industry grows larger and falls as the average firm grows larger. C) falls as the industry and the average firm grows larger. D) remains constant over a broad range of output. E) rises as the industry and the average firm grows larger. Answer: A Page Ref: 147-148 Difficulty: Easy

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7) Internal economies of scale arise when the cost per unit A) falls as the average firm grows larger. B) rises as the industry grows larger. C) falls as the industry grows larger. D) rises as the average firm grows larger. E) remains constant over a broad range of output. Answer: A Page Ref: 147-148 Difficulty: Easy 8) Where there are internal economies of scale, the scale of production possible in a country is constrained by A) the size of the domestic plus the foreign market. B) the size of the country. C) the size of the trading partner's country. D) the size of the domestic market. E) the size of the foreign market. Answer: A Page Ref: 147-148 Difficulty: Easy 9) Internal economies of scale will ________ average cost when output is ________ by ________. A) reduce; increased; a firm B) increase; increased; a firm C) reduce; increased; the industry D) increase; increased; the industry E) reduce; reduce; the industry Answer: A Page Ref: 147-148 Difficulty: Moderate 10) Why is it that if an industry is operating under conditions of internal scale economies then the resultant equilibrium cannot be consistent with the pure competition model? Answer: Because once one firm will becomes bigger than another, or if one firm began the industry, then no other firm will be able to match its per unit cost, so that they would be driven out of the industry. The firm would become a natural monopoly. Page Ref: 147-148 Difficulty: Moderate 11) Is it possible for an equilibrium that is consistent with purely competitive conditions to arise in an industry with positive scale economies? If so, explain how this could happen. If not, why not? Answer: Yes. If the scale economies were external to the firm, then there is no reason why the firms may not be in perfect competition. Page Ref: 147-148 Difficulty: Moderate 4 .

12) External economies of scale will ________ average cost when output is ________ by ________. A) reduce; increased; the industry B) reduce; increased; a firm C) increase; increased; a firm D) increase; increased; the industry E) reduce; reduce; the industry Answer: A Page Ref: 147-148 Difficulty: Moderate 7.3 The Theory of External Economies 1) What is meant by an "industrial district" and what are the three main sources of the economic advantages derived from locating in such a district? Answer: An industrial community is a geographical concentration of firms in the same industry. Silicon Valley and Bollywood are modern examples. The advantages are (1) specialized suppliers, (2) labor market pooling, and (3) knowledge spillovers. Page Ref: 148-151 Difficulty: Moderate 2) External economies of scale often arise because similar firms A) locate in the same geographic region. B) collude to fix prices and increase profits. C) have excellent internal logistics. D) agree to cooperate to expand global trade. E) have economies of scale in production. Answer: A Page Ref: 148-151 Difficulty: Easy 3) The Internet has made transactions between businesses (B2B trading) fast and easy. Any business in any location can access specialized knowledge, labor, and materials. It is likely that these virtual economic communities will result in A) external economies of scale. B) internal economies of scale. C) consolidation of industries into a small number of powerful firms. D) suppression of innovations and collusive behavior, driving up prices. E) government intervention and regulation. Answer: A Page Ref: 148-151 Difficulty: Moderate

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4) The long-run market supply curve in the presence of internal economies of scale is ________, and in the presence of external economies of scale, it is ________. A) downward sloping; downward sloping B) upward sloping; horizontal C) horizontal; upward sloping D) downward sloping; horizontal E) upward sloping; downward sloping Answer: A Page Ref: 148-151 Difficulty: Easy 5) If output is increased in the long-run, average production costs in the presence of internal economies of scale will ________, and in the presence of external economies of scale, will ________. A) decrease; decrease B) increase; remain constant C) remain constant; increase D) decrease; remain constant E) increase; decrease Answer: A Page Ref: 148-151 Difficulty: Easy 6) If the firms in a market have constant returns to scale internally while there are external economies of scale for the industry, a firm's long-run supply curve will be ________ and the long-run market supply curve will be ________. A) downward sloping; downward sloping B) upward sloping; horizontal C) horizontal; downward sloping D) downward sloping; horizontal E) upward sloping; downward sloping Answer: C Page Ref: 148-151 Difficulty: Easy 7) If output is increased in the long-run, then in the presence of internal economies of scale the number of firms will ________, and in the presence of constant external returns to scale the number of firms will ________. A) decrease; decrease B) increase; remain constant C) remain constant; increase D) decrease; remain constant E) increase; decrease Answer: C Page Ref: 148-151 Difficulty: Easy 6 .

8) If output is increased in the long-run, average production costs in the presence of internal diseconomies of scale will ________, and in the presence of external diseconomies of scale, will ________. A) decrease; decrease B) increase; remain constant C) remain constant; increase D) decrease; remain constant E) increase; decrease Answer: C Page Ref: 148-151 Difficulty: Easy 7.4 External Economies and International Trade 1) If two countries begin trade and both produce a product subject to external economies of scale, then the country with the ________ rate of production will ________ production until it controls ________ of the market. A) higher; increase; 100% B) higher; increase; 50% C) lower; increase; 100% D) lower; increase; 50% E) higher; decrease; 0% Answer: A Page Ref: 152-158 Difficulty: Easy 2) Explain why positive economies of scale in one (of two) sectors may establish a comparative advantage for the large (as compared to the small) country in the production of the commodity which exhibits positive scale economies. Answer: In the case of the H-O model, the actual size of the country is irrelevant in the determination of the direction of trade (though it may affect the equilibrium terms of trade). When positive scale economies apply to the production of one product, the country that can devote more resources (in absolute terms) will be able to sell that product cheaper, and therefore will be more likely to gain a "revealed" comparative advantage in that product. This will be the country with more factors (both labor and capital)-the larger country. Page Ref: 152-158 Difficulty: Difficult

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3) In the presence of external economies of scale, trade A) may or may not improve welfare in both countries. B) will unambiguously improves welfare in both countries. C) will unambiguously worsens welfare in both countries. D) will unambiguously worsen welfare in the exporting country and improve welfare in the importing country. E) will unambiguously improve welfare in the exporting country and worsen welfare in the importing country. Answer: A Page Ref: 152-158 Difficulty: Moderate 4) A learning curve relates ________ to ________ and is a case of ________ returns. A) unit cost; cumulative production; dynamic increasing returns B) output per time period; long-run marginal cost; dynamic increasing returns C) unit cost; cumulative production; dynamic decreasing returns D) output per time period; long-run marginal cost; dynamic decreasing returns E) labor productivity; education; increasing marginal returns Answer: A Page Ref: 152-158 Difficulty: Easy 5) The learning curve describes the ________ relationship between ________ and ________. A) inverse; unit cost; cumulative output B) direct; unit cost; cumulative output C) inverse; education; annual income D) direct; education; annual income E) direct; education; labor productivity Answer: A Page Ref: 152-158 Difficulty: Easy 6) If two countries begin trade and both produce a product subject to internal economies of scale, then the country with the ________ rate of production will ________ production until it controls ________ of the market. A) higher; increase; 100% B) higher; increase; 50% C) lower; increase; 100% D) lower; increase; 50% E) higher; decrease; 0% Answer: A Page Ref: 152-158 Difficulty: Easy

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7) Suppose that two countries, A and B, employ the same technology in the production of a good. External economies of scale apply in both countries. Analyze the effects of trade on longrun production levels if country A has a comparatively lower cost of production when trade begins. Answer: Initially, country B will have a comparative advantage in production of the good. Over time, as production shifts to Country B, costs will decline there while increasing in country A. In the absence of market intervention, country B will have a monopoly. Note that no individual firm will have a monopoly unless internal economies of scale also apply. Page Ref: 152-158 Difficulty: Moderate 7.5 Interregional Trade and Economic Geography 1) Restaurant meals are an example of a ________ good and clothing is an example of a ________ good. The pattern of interregional trade is determined primarily by ________. A) nontraded; traded; external economies. B) traded; nontraded; internal economies C) nondurable; durable; natural resource D) durable; nondurable; natural resources E) consumer; style; population Answer: A Page Ref: 158-161 Difficulty: Easy 2) The share of ________ goods in employment is ________ across the country. The share of ________ goods in employment is ________ across the country. A) nontraded; uniform; traded; variable B) traded; uniform; nontraded; variable C) durable; uniform; nondurable; variable D) nondurable; uniform; durable; variable E) nontraded; variable; traded; uniform Answer: A Page Ref: 158-161 Difficulty: Moderate 3) Patterns of interregional trade are primarily determined by ________ rather than ________ because factors of production are generally ________. A) external economies; natural resources; mobile B) internal economies; external economies; mobile C) external economies; population; immobile D) internal economies; population; immobile E) population; external economies; immobile Answer: A Page Ref: 158-161 Difficulty: Easy

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4) The primary determinant of patterns of interregional trade is A) accidents of history. B) resource allocations. C) factor abundance. D) weather. E) centralized optimization. Answer: A Page Ref: 158-161 Difficulty: Easy 5) The study of factors that influence both international and interregional trade is referred to as A) accidents of history. B) economic geography. C) factor abundance theory. D) weather analysis. E) centralized optimization. Answer: B Page Ref: 158-161 Difficulty: Easy

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International Economics, 10e (Krugman/Obstfeld/Melitz) Chapter 8 Firms in the Global Economy: Export Decisions, Outsourcing, and Multinational Enterprises 8.1 The Theory of Imperfect Competition 1) A monopolistic firm A) will never sell a product whose demand is inelastic at the quantity sold. B) can sell as much as it wants for any price it determines in the market. C) cannot determine the price, which is determined by consumer demand. D) cannot sell additional quantity unless it raises the price on each unit. E) will always earn a profit in the long run. Answer: A Page Ref: 166-168 Difficulty: Easy 2) Monopolistic competition is associated with A) product differentiation. B) price-taking behavior. C) explicit consideration at the firm level of the strategic impact of other firms' pricing decisions. D) high profit margins in the long run. E) increasing returns to scale. Answer: A Page Ref: 169-173 Difficulty: Easy 3) Modeling trade in imperfectly competitive industries is problematic because A) there is no single generally accepted model of behavior by imperfectly competitive firms. B) there are no models of imperfectly competitive behavior. C) it is difficult to find an imperfectly competitive firm in the real world. D) collusion among imperfectly competitive firms makes usable data rare. E) there is only a single model of imperfect competition (monopoly) but imperfect competition can take many forms in the real world. Answer: A Page Ref: 165-166 Difficulty: Easy 4) The simultaneous export and import of widgets by the United States is an example of A) intra-industry trade. B) increasing returns to scale. C) imperfect competition. D) inter-industry trade. E) the effect of a monopoly on international trade. Answer: A Page Ref: 177-178 Difficulty: Easy 1 .

5) When a country both exports and imports a type of commodity, the country is engaged in A) intra-industry trade. B) increasing returns to scale. C) imperfect competition. D) inter-industry trade. E) an attempt to monopolize the relevant industry. Answer: A Page Ref: 177-178 Difficulty: Easy 6) If there are a large number of firms in a monopolistically competitive industry A) long-run profit will be equal to zero. B) the country in which the firms are located can be expected to export the goods they produce. C) there will be barriers to entry that prevent addition firms from entering the industry. D) the firms will converge production on a standardized product. E) there will be a small number of firms that are very large and the rest will be very small. Answer: A Page Ref: 170-172 Difficulty: Easy 7) It is possible that trade based on external scale economies may leave a country worse off than it would have been without trade. Explain how this could happen. Answer: One answer is that the terms of trade effects may dominate any other factors. Page Ref: 177-178 Difficulty: Easy 8) If a firm increases its output in the ________ and unit costs ________, then the firm is experiencing ________ of scale. A) long-run; decrease; economies B) short-run; decrease; economies C) long-run; decrease; diseconomies D) short-run; decrease; diseconomies E) long-run; increase; economies Answer: A Page Ref: 177-178 Difficulty: Easy 9) If a firm increases its output in the ________ and unit costs ________, then the firm is experiencing ________ of scale. A) long-run; increase; diseconomies B) short-run; decrease; economies C) long-run; decrease; diseconomies D) short-run; decrease; diseconomies E) long-run; increase; economies Answer: A Page Ref: 177-178 Difficulty: Easy 2 .

10) If a firm that uses a production process that yields economies of scale charges a price equal to ________, then profit will be ________. A) marginal cost; negative B) marginal revenue; maximized C) marginal cost; maximized D) marginal revenue; positive E) marginal cost; positive Answer: A Page Ref: 177-178 Difficulty: Moderate 11) Firms that produce ________ products must be ________ competitive. A) differentiated; imperfectly B) differentiated; perfectly C) standardized; imperfectly D) standardized; perfectly E) exported; imperfectly Answer: A Page Ref: 177-178 Difficulty: Moderate 12) Imperfectly competitive firms have a demand curve that ________ and a marginal revenue curve that ________ and is ________ the demand curve. A) slopes downward; slopes downward; below B) is horizontal; is horizontal; the same as C) slopes downward; is horizontal; above D) is horizontal; slopes downward; below E) slopes downward; slopes downward; the same as Answer: A Page Ref: 177-178 Difficulty: Easy 13) An imperfectly competitive firm has the following demand curve: Q = 100 - 2P. What is marginal revenue equal to when P = 30? Answer: Q = 40, so MR = 30 - (40/2) = 10. Page Ref: 167 Difficulty: Moderate 14) An imperfectly competitive firm has the following demand curve: Q = 100 - 2P. What is marginal revenue equal to when P = 40? Answer: Q = 20, so MR = 40 - (20/2) = 30. Page Ref: 167 Difficulty: Moderate

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15) An imperfectly competitive firm has the following total cost curve: C = 100 + 4Q. What is marginal cost equal to when Q = 10? Answer: MC = 4 for any Q Page Ref: 167 Difficulty: Moderate 16) An imperfectly competitive firm has the following total cost curve: C = 100 + 4Q. What is total cost equal to when Q = 10? Answer: C = 100 + (4)(10) = 140 Page Ref: 167 Difficulty: Moderate 17) An imperfectly competitive firm has the following total cost curve: C = 100 + 4Q. What is average total cost equal to when Q = 10? Answer: C/Q = [100 + (4)(10)]/10 = 14 Page Ref: 167 Difficulty: Moderate 18) An imperfectly competitive firm has the following total cost curve: C = 100 + 4Q. What is average fixed cost equal to when Q = 10? Answer: F/Q = 100/10 = 10 Page Ref: 167 Difficulty: Moderate 19) Under oligopoly, firms' pricing policies are ________ and, under monopolistic competition, they are ________. A) interdependent; independent B) independent; interdependent C) cooperative; uncooperative D) uncooperative; cooperative E) profit maximizing; revenue maximizing Answer: A Page Ref: 168-172 Difficulty: Moderate 20) Under the model of monopolistic competition, a(an) ________ in the number of firms in the industry will cause ________ to ________. A) increase; average price; decrease B) increase; average price; increase C) increase; average cost; decrease D) decrease; markup; decrease E) increase; marginal cost; decrease Answer: A Page Ref: 168-172 Difficulty: Moderate

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21) Under the model of monopolistic competition, a(an) ________ in the number of firms in the industry will cause ________ to ________. A) increase; markup; decrease B) increase; average price; increase C) increase; average cost; decrease D) decrease; markup; decrease E) increase; marginal cost; decrease Answer: A Page Ref: 168-172 Difficulty: Moderate 8.2 Monopolistic Competition and Trade 1) Intra-industry trade is most common in the trade patterns of A) the industrial countries of Western Europe. B) the developing countries of Asia and Africa. C) raw material producers. D) China with the rest of the world. E) labor-intensive products. Answer: A Page Ref: 179 Difficulty: Easy 2) If the market for products produced by firms in a monopolistically competitive industry becomes ________, then there will be ________ firms and each firm will produce ________ output and charge a ________ price. A) larger; more; more; lower B) larger; fewer; more; lower C) larger; fewer; more; higher D) larger; more; more; higher E) larger; more; less; higher Answer: A Page Ref: 173-175 Difficulty: Easy 3) International trade based on external scale economies in both countries is likely to be carried out by A) a relatively large number of price competing firms. B) a relatively small number of price competing firms. C) a relatively small number of imperfect competitors. D) monopolists in each country. E) a large number of oligopolists in each country. Answer: A Page Ref: 173-178 Difficulty: Easy

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4) International trade based solely on internal scale economies in both countries is likely to be carried out by A) monopolists in each country. B) a relatively large number of price competing firms. C) a relatively small number of price competing firms. D) a relatively small number of imperfect competitors. E) a large number of oligopolists in each country. Answer: A Page Ref: 173-178 Difficulty: Easy 5) A monopoly firm engaged in international trade will A) equate marginal costs with marginal revenues in both domestic and foreign markets. B) equate average to local costs. C) equate marginal costs with foreign marginal revenues. D) equate marginal costs with the highest price the market will bear. E) equate marginal costs with the relative world prices. Answer: A Page Ref: 173-178 Difficulty: Easy 6) A monopoly firm will maximize profits by producing where A) marginal revenue is the same in domestic and foreign markets. B) prices are the same in domestic and foreign markets. C) marginal revenue is higher in foreign markets. D) marginal revenue is higher in the domestic market. E) total revenue from domestic and foreign sales is maximized. Answer: A Page Ref: 173-178 Difficulty: Moderate 7) A firm in long-run equilibrium under monopolistic competition will earn A) zero economic profits because of free entry. B) positive monopoly profits because each sells a differentiated product. C) positive oligopoly profits because each firm sells a differentiated product. D) negative economic profits because it has economies of scale. E) positive economic profit if it engages in international trade. Answer: A Page Ref: 173-178 Difficulty: Easy

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8) An industry is characterized by scale economies, and exists in two countries. Should these two countries engage in trade such that the combined market is supplied by one country's industry, then A) consumers in both countries would have more varieties and lower prices. B) consumers in both countries would have higher prices and fewer varieties. C) consumers in the importing country only would have higher prices and fewer varieties. D) consumers in the exporting country only would have higher prices and fewer varieties. E) consumers in both countries would have fewer varieties at lower prices. Answer: A Page Ref: 173-178 Difficulty: Easy 9) An industry is characterized by scale economies and exists in two countries. In order for consumers of its products to enjoy both lower prices and more variety of choice A) the two countries must engage in international trade with each other. B) each country's marginal cost must equal that of the other country. C) the marginal cost of this industry must equal marginal revenue in the other. D) the monopoly must lower prices in order to sell more. E) they must combine to become a multinational corporation. Answer: A Page Ref: 173-178 Difficulty: Moderate 10) A product is produced in a monopolistically competitive industry with scale economies. If this industry exists in two countries, and these two countries engage in trade with each other, then we would expect A) each country will export different varieties of the product to the other. B) the country in which the price of the product is lower will export the product. C) the country with a relative abundance of the factor of production in which production of the product is intensive will export this product. D) neither country will export this product since there is no comparative advantage. E) the countries will trade only with other nations they are not in competition with. Answer: A Page Ref: 173-178 Difficulty: Easy 11) Two countries engaged in trade in products with no scale economies, produced under conditions of perfect competition, are likely to be engaged in A) inter-industry trade. B) monopolistic competition. C) intra-industry trade. D) Heckscher-Ohlin trade. E) oligopolistic competition Answer: A Page Ref: 173-178 Difficulty: Easy 7 .

12) Two countries engaged in trade in products with scale economies, produced under conditions of monopolistic competition, are likely to be engaged in A) intra-industry trade. B) price competition. C) inter-industry trade. D) Heckscher-Ohlinean trade. E) immiserizing trade. Answer: A Page Ref: 173-178 Difficulty: Easy 13) We often observe "pseudo-intra-industry trade" between the United States and Mexico. Actually, such trade is consistent with A) comparative advantage associated with Heckscher-Ohlin model. B) oligopolistic markets. C) optimal tariff issues. D) the Ricardian model of trade. E) the specific factors model of trade. Answer: A Page Ref: 173-178 Difficulty: Easy 14) Intra-industry trade will tend to dominate trade flows when which of the following exists? A) small differences between relative country factor availabilities B) large differences between relative country factor availabilities C) homogeneous products that cannot be differentiated D) constant cost industries E) uneven distribution of abundant resources between two countries Answer: A Page Ref: 173-178 Difficulty: Easy 15) Trade without serious income distribution effects is most likely to happen A) in sophisticated manufactures trade between rich countries. B) in simple manufactures trade between developing countries. C) in sophisticated manufactures trade between rich and poor countries. D) in agricultural trade between rich countries. E) in labor-intensive industries like clothing. Answer: A Page Ref: 173-178 Difficulty: Moderate

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16) Imagine scale economies were not only external to firms, but were also external to individual countries. That is, the larger the worldwide industry (regardless of where firms or plants are located), the cheaper would be the per-unit cost of production. Describe what world trade would look like in this case. Answer: Presumably each country would specialize in some component of the final product. This would result in in a high volume of intra-industry trade. Page Ref: 173-178 Difficulty: Difficult

17) Refer to above figure. The monopolist can export as much as it likes of its steel at the world price of $5/ton. How much steel will the monopolist sell, and at what price? Answer: It would sell 10 million tons at $5/ton. Page Ref: 173-178 Difficulty: Moderate 18) Refer to above figure. Given the opportunity to sell at world prices, the marginal (opportunity) cost of selling a ton domestically is what? Answer: $5/ton. Page Ref: 173-178 Difficulty: Easy 19) Refer to above figure. While selling exports it would also maximize its domestic sales by equating its marginal (opportunity) cost to its marginal revenue of $5. How much steel would the firm sell domestically, and at what price? Answer: 4 million tons at $10/ton. Page Ref: 173-178 Difficulty: Easy

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20) If the market for products produced by firms in a monopolistically competitive industry becomes ________, then there will be ________ firms and each firm will produce ________ output and charge a ________ price. A) smaller; fewer; less; higher B) smaller; more; less; higher C) smaller; more; less; lower D) smaller; fewer; less; lower E) smaller; fewer; more; higher Answer: A Page Ref: 173-178 Difficulty: Easy 21) In an industry where firms experience internal scale economies, the long-run cost of production will depend on A) the size of the market. B) the size of the labor force. C) whether the country engages in intra-industry trade. D) individual firms' fixed costs. E) whether the country engages in inter-industry trade. Answer: A Page Ref: 177-178 Difficulty: Easy 8.3 Firm Responses to Trade: Winners, Losers, and Industry Performance 1) In the model of monopolistic competition, if firms have ________ average cost curves, then opening trade will ________ the total number of firms and ________ the average price. A) downward sloping; decrease; decrease B) downward sloping; decrease; increase C) downward sloping; increase; decrease D) upward sloping; decrease; increase E) upward sloping; increase; decrease Answer: A Page Ref: 181-185 Difficulty: Moderate 2) In the model of monopolistic competition, if firms have ________ average cost curves, then opening trade will cause ________ firms to ________ the industry. A) different; less efficient; exit B) different; more efficient; enter C) symmetric; less efficient; exit D) symmetric; more efficient; enter E) symmetric; less efficient; enter Answer: A Page Ref: 181-185 Difficulty: Easy 10 .

3) In the model of monopolistic competition, compared to a firm with a higher marginal cost, a firm with a lower marginal cost will set a ________ price, produce ________ output, and earn ________ profits. A) lower; more; more B) higher; more; more C) lower; less; less D) higher; less; less E) higher; less; more Answer: A Page Ref: 181-185 Difficulty: Easy 4) In the model of monopolistic competition, compared to a firm with a lower marginal cost, a firm with a higher marginal cost will set a ________ price, produce ________ output, and earn ________ profits. A) higher; less; less B) lower; more; more C) higher; more; more D) lower; less; less E) higher; less; more Answer: A Page Ref: 181-185 Difficulty: Easy 5) In the model of monopolistic competition, an increase in industry output will cause individual firms' demand curves to become ________, which will ________ demand for higher-priced goods and ________ demand for lower-priced goods. A) flatter; reduce; increase B) steeper; reduce; increase C) flatter; increase; reduce D) steeper; increase; reduce E) horizontal; reduce; reduce Answer: A Page Ref: 181-185 Difficulty: Easy 6) In the model of monopolistic competition, an increase in industry output will ________ producers of ________ higher-priced goods and ________ producers of lower-priced goods. A) harm; benefit B) benefit; harm C) harm; harm D) benefit; benefit E) benefit; have no effect on Answer: A Page Ref: 181-185 Difficulty: Easy 11 .

7) In the model of monopolistic competition, an increase in industry output will ________ market shares and ________ profits of producers of higher-priced goods and will ________ market shares and ________ profits of producers of lower-priced goods. A) reduce; reduce; increase; increase B) increase; increase; reduce; reduce C) increase; reduce; increase; reduce D) reduce; increase; reduce; increase E) reduce; increase; increase; reduce Answer: A Page Ref: 181-185 Difficulty: Easy 8.4 Trade Costs and Export Decisions 1) In the model of monopolistic competition, trade costs between countries will cause domestic and foreign markets to have ________ prices, ________ quantities sold, and ________ profit levels. A) different; different; different B) identical; different; different C) different; different; identical D) identical; different; identical E) identical; identical; different Answer: A Page Ref: 185-187 Difficulty: Easy 2) In the model of monopolistic competition, trade costs between countries cause A) marginal costs of exported goods to exceed the marginal costs of goods sold domestically. B) marginal costs of goods sold domestically to exceed the marginal costs of exported goods. C) all firms that can earn a profit on domestic sales to export their goods at lower prices. D) all firms that can earn a profit on domestic sales to export their goods at higher prices. E) countries to negotiate the elimination of trade costs by mutual subsidization of trade. Answer: A Page Ref: 185-187 Difficulty: Easy 3) In the model of monopolistic competition, trade costs between countries cause A) some firms that can earn a profit on domestic sales to refrain from exporting their goods. B) prices of goods sold domestically to exceed the prices of exported goods. C) marginal costs of goods sold domestically to exceed the marginal costs of exported goods. D) all firms that can earn a profit on domestic sales to export their goods at higher prices. E) countries to negotiate the elimination of trade costs by mutual subsidization of trade. Answer: A Page Ref: 185-187 Difficulty: Easy

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8.5 Dumping 1) The most common form of price discrimination in international trade is A) dumping. B) non-tariff barriers. C) Voluntary Export Restraints. D) preferential trade arrangements. E) product boycotts. Answer: A Page Ref: 188-190 Difficulty: Easy 2) If an industry is imperfectly competitive, and markets are segmented then A) a firm may find that it is profitable to engage in dumping. B) a firm may find that international trade is unprofitable. C) a firm may find that it should promote scale economies. D) a firm may find that it has lost its comparative advantage. E) a firm may find that it should become more specialized. Answer: A Page Ref: 188-190 Difficulty: Easy 3) Complaints are often made to the International Trade Commission concerning foreign "dumping" practices. These complaints typically claim that A) U.S. firms are harmed by the unfair pricing of foreign exporters. B) foreign companies are charging exorbitant prices that are higher than the true value of the products. C) foreign companies are charging prices that are lower than prices they charge countries other than the U.S. D) U.S. consumers are harmed by the lack of quality control or health concerns in foreign countries. E) U.S. consumers cannot differentiate between the foreign and domestic goods. Answer: A Page Ref: 188-190 Difficulty: Easy

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4) The figure above represents the demand and cost functions facing a Brazilian Steel producing monopolist. If it were unable to export, and was constrained by its domestic market, what quantity would it sell at what price? Answer: It would sell 5 (million tons) at a price of $8/ton. Page Ref: 188-190 Difficulty: Moderate 5) The figure above represents the demand and cost functions facing a Brazilian Steel producing monopolist. The Brazilian firm is charging its foreign (U.S.) customers one half the price it is charging its domestic customers. Is this good or bad for the real income or economic welfare of the United States? Is the Brazilian firm engaged in dumping? Is this predatory behavior on the part of the Brazilian steel company? Answer: It is good for U.S. customers.Yes, this is dumping if you define dumping as selling abroad at a price lower than domestically. No, it is not dumping if by dumping you mean selling below marginal cost. No, this is not predatory, since it is not being done in order to capture market share, but rather is "mere" static profit maximization behavior, as is expected of any selfrespecting monopolist. Page Ref: 188-190 Difficulty: Moderate 8.6 Multinationals and Outsourcing 1) A corporation is considered a multinational ________ if ________. A) parent; it owns more than 10% of a foreign firm B) parent; more than 10% of its stock is held by a foreign company C) child; more than 10% of its stock is held by a foreign company D) child; more than 50% of its stock is held by a foreign company E) monopolist; it owns more than 50% of a foreign firm Answer: A Page Ref: 190-194 Difficulty: Easy

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2) A corporation is considered a multinational ________ if ________. A) affiliate; more than 10% of its stock is held by a foreign company B) parent; more than 10% of its stock is held by a foreign company C) child; more than 10% of its stock is held by a foreign company D) child; more than 50% of its stock is held by a foreign company E) monopolist; it owns more than 50% of a foreign firm Answer: A Page Ref: 190-194 Difficulty: Easy 3) Consider the following two cases. In the first, a U.S. firm purchases 18% of a foreign firm. In the second, a U.S. firm builds a new production facility in a foreign country. Both are ________, with the first referred to as ________ and the second as ________. A) foreign direct investment (FDI) outflows; greenfield; brownfield B) foreign direct investment (FDI) inflows; greenfield; brownfield C) foreign direct investment (FDI) outflows; brownfield; greenfield D) foreign direct investment (FDI) inflows; brownfield; greenfield E) foreign direct investment (FDI); inflows; outflows Answer: A Page Ref: 190-194 Difficulty: Moderate 4) When a multinational affiliate replicates production in a foreign country it is called ________ foreign direct investment. A) horizontal B) vertical C) transitional D) bisectional E) direct Answer: A Page Ref: 190-194 Difficulty: Easy 5) When a multinational affiliate replicates elements of a production process in a foreign country it is called ________ foreign direct investment. A) vertical B) horizontal C) transitional D) bisectional E) direct Answer: A Page Ref: 190-194 Difficulty: Easy

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6) What is the nature of the proximity-concentration tradeoff that firms have to deal with then making decisions regarding foreign direct investment? Answer: If the firm has numerous production facilities close to their various international markets, trade costs will be relatively low. However, when there are numerous production facilities, each will be relatively small, and opportunities for economies of scale will be foregone. Page Ref: 190-194 Difficulty: Moderate 7) Foreign outsourcing is A) the transfer of operations to foreign contractors. B) an example of internalization. C) an example of foreign direct investment. D) currently illegal in the U.S. E) the substitution of immigration for foreign direct investment. Answer: A Page Ref: 190-194 Difficulty: Moderate 8.7 The Firm's Decision Regarding Foreign Direct Investment 1) A firm is more likely to engage in horizontal foreign direct investment if A) trade costs are high and there are internal economies of scale. B) trade costs are low and there are internal economies of scale. C) trade costs are high and there are external economies of scale. D) trade costs are low and there are external economies of scale. E) trade costs are low and firms experience constant returns to scale in production. Answer: A Page Ref: 194-197 Difficulty: Easy 2) A firm's foreign direct investment. decisions are, in the case of horizontal FDI, strongly influenced by ________ and, in the case of vertical FDI, strongly influenced by ________. A) trade costs; production costs B) materials costs; labor costs C) production costs; materials costs D) production costs; trade costs E) labor costs; trade costs Answer: A Page Ref: 194-197 Difficulty: Easy

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3) During the past decade, U.S. imports of business services have ________, U.S. exports of business services have ________, and U.S. net exports of business services have ________. A) increased; increased; increased B) increased; decreased; decreased C) decreased; increased; increased D) increased; increased; not changed E) decreased; decreased; increased Answer: A Page Ref: 197-199 Difficulty: Moderate 4) What are the consequences of outsourcing production on the welfare of countries? Answer: By taking advantage of cost differentials between countries, both countries can enjoy gains from trade. However, income distribution effects will result in winners and losers. Gains from trade are therefore thought of in terms of net gains in which the winners could compensate the losers and still be better off. Page Ref: 199-200 Difficulty: Moderate 5) Product differentiation and internal economies of scale yield gains from trade in the form of A) lower production costs and a greater variety of goods. B) higher profits and lower trade costs. C) the proximity-concentration effect. D) a proliferation of competitive firms. E) the substitution of immigration for foreign direct investment. Answer: A Page Ref: 199-200 Difficulty: Moderate

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International Economics, 10e (Krugman/Obstfeld/Melitz) Chapter 9 The Instruments of Trade Policy 9.1 Basic Tariff Analysis 1) Specific tariffs are A) import taxes stated in specific legal statutes. B) import taxes calculated as a fixed charge for each unit of imported goods. C) import taxes calculated as a fraction of the value of the imported goods. D) the same as import quotas. E) import taxes calculated based solely on the origin country. Answer: B Page Ref: 206-207 Difficulty: Easy 2) Ad valorem tariffs are A) import taxes stated in ads in industry publications. B) import taxes calculated as a fixed charge for each unit of imported goods. C) import taxes calculated as a fraction of the value of the imported goods. D) the same as import quotas. E) import taxes calculated solely on the origin country. Answer: C Page Ref: 206-207 Difficulty: Easy 3) The excess supply curve of a product we (H) import from foreign countries (F) increases as A) excess demand of country H increases. B) excess demand of country F increases. C) excess supply of country H increases. D) excess supply of country F increases. E) excess supply of country F decreases. Answer: D Page Ref: 207-209 Difficulty: Easy 4) Suppose the United States eliminates its tariff on ball bearings used in producing exports. Ball bearing prices in the United States would be expected to A) increase, and the foreign demand for U.S. exports would increase. B) decrease, and the foreign demand for U.S. exports would increase. C) increase, and the foreign demand for U.S. exports would decrease. D) decrease, and the foreign demand for U.S. exports would decrease. E) decrease, and the foreign demand would be unchanged. Answer: C Page Ref: 209-210 Difficulty: Easy

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5) A specific tariff provides home producers more protection when A) the home market buys cheaper products rather than expensive products. B) it is applied to a commodity with many grade variations. C) the home demand for a good is elastic with respect to price changes. D) it is levied on manufactured goods rather than primary products. E) the home supply outnumbers the foreign imports. Answer: A Page Ref: 210-212 Difficulty: Easy 6) A lower tariff on imported steel would most likely benefit A) foreign producers at the expense of domestic consumers. B) domestic manufacturers of steel. C) domestic consumers of steel. D) workers in the steel industry. E) foreign consumers of steel. Answer: C Page Ref: 209-210 Difficulty: Easy 7) A problem encountered when implementing an "infant industry" tariff is that A) domestic consumers will purchase the foreign good regardless of the tariff. B) the industry may never "mature." C) most industries require tariff protection when they are mature. D) the tariff may hurt the industry's domestic sales. E) the tariffs fail to protect the domestic producers. Answer: B Page Ref: 211-212 Difficulty: Easy 8) Which of the following is a fixed percentage of the value of an imported product? A) specific tariff B) ad valorem tariff C) nominal tariff D) effective protection tariff E) infant industry tariff Answer: B Page Ref: 206-207 Difficulty: Easy

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9) A tax of 20 cents per unit of imported garlic is an example of a(n) A) specific tariff. B) ad valorem tariff. C) nominal tariff. D) effective protection tariff. E) a disadvantageous tariff. Answer: A Page Ref: 206-207 Difficulty: Easy 10) A tax of 20 percent per unit of imported garlic is an example of a(n) A) specific tariff. B) ad valorem tariff. C) nominal tariff. D) effective protection tariff. E) a disadvantageous tariff Answer: B Page Ref: 206-207 Difficulty: Easy 11) Which type of tariff is forbidden in the United States on Constitutional grounds? A) import tariff B) export tariff C) specific tariff D) prohibitive tariff E) import quota Answer: B Page Ref: 206-207 Difficulty: Moderate 12) Tariffs are NOT defended on the grounds that they A) improve the terms of trade of foreign nations. B) protect jobs and reduce unemployment. C) promote growth and development of young industries. D) prevent over-dependence of a country on only a few industries. E) protect domestic producers from foreign low prices. Answer: A Page Ref: 209-212 Difficulty: Easy

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13) The most vocal political pressure for tariffs is generally made by A) consumers lobbying for export tariffs. B) consumers lobbying for import tariffs. C) consumers lobbying for lower import tariffs. D) producers lobbying for export tariffs. E) producers lobbying for import tariffs. Answer: E Page Ref: 209-212 Difficulty: Easy 14) Tariff rates on products imported into the U.S. A) have dropped substantially over the past 50 years. B) were prohibited by the Constitution. C) reached an all time high in 2002. D) have risen steadily since 1920. E) were the government's main source of income in 2006. Answer: A Page Ref: 209-212 Difficulty: Easy 15) What is a TRUE statement concerning the imposition in the U.S. of a tariff on cheese? A) It lowers the price of cheese domestically. B) It raises the price of cheese internationally. C) It raises revenue for the government. D) It will always result in retaliation from abroad. E) it leads to higher domestic demand for cheese. Answer: C Page Ref: 209-212 Difficulty: Easy 16) The tariff levied in a "large country" (Home), lowers the world price of the imported good. This causes A) foreign consumers to demand less of the good on which was levied a tariff. B) domestic demand for imports to decrease. C) domestic demand for imports to increase. D) foreign suppliers to produce less of the good on which was levied a tariff. E) no change in the foreign price of the good it imports. Answer: D Page Ref: 209-212 Difficulty: Easy

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17) It is argued that a tariff may help promote employment in a single industry, but is not likely to help employment in general. Discuss. Answer: A general tariff on all imports is equivalent to a depreciation in the value of the country's currency. It would raise the prices of all imports, and have a considerable income effect. This income effect will have a negative effect on total consumption of the importcompeting sector (as well as the exportables and non-tradables). In addition, under conditions of a flexible exchange rate regime (assuming the Marshal-Lerner Conditions hold) it will lower the supply of the country's currency in the foreign exchange market, and hence cause an appreciation of the currency. This will harm the country's exports, and negatively affect this sector's employment. Page Ref: 209-212 Difficulty: Moderate

18) Refer to above figure. In the absence of trade, how many Widgets does this country produce? Answer: 60 Page Ref: 209-212 Difficulty: Easy 19) Refer to above figure. In the absence of trade, how many Widgets does this country consume? Answer: 60 Page Ref: 209-212 Difficulty: Easy 20) Refer to above figure. With free trade and no tariffs, what is the quantity of Widgets imported? Answer: 90 Page Ref: 209-212 Difficulty: Easy

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21) Refer to above figure. With a specific tariff of $3 per unit, what is the quantity of Widgets imported? Answer: 40 Page Ref: 209-212 Difficulty: Easy 22) Refer to above figure. With free trade and no tariffs, what is the quantity of Widgets produced domestically? Answer: 10 Page Ref: 209-212 Difficulty: Easy 23) Refer to above figure. The lowest specific tariff which would be considered prohibitive is ________. Answer: $5 Page Ref: 209-212 Difficulty: Easy 24) Refer to above figure. With a specific tariff of $3 per unit, what is the quantity of Widgets produced domestically? Answer: 40 Page Ref: 209-212 Difficulty: Easy 25) Refer to above figure. With free trade and no tariffs, what is the quantity of Widgets consumed domestically? Answer: 100 Page Ref: 209-212 Difficulty: Easy 26) Refer to above figure. With a specific tariff of $3 per unit, what is the quantity of Widgets consumed domestically? Answer: 80 Page Ref: 209-212 Difficulty: Easy 27) The effective rate of protection measures A) the "true" ad valorem value of a tariff. B) the quota equivalent value of a tariff. C) the efficiency with which the tariff is collected at the customhouse. D) the protection given by the tariff to domestic value added. E) the difference between domestic and foreign prices of the import. Answer: D Page Ref: 210-213 Difficulty: Easy

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28) If the tariff on computers is not changed, but domestic computer producers shift from domestically produced semiconductors to imported components, then the effective rate of protection in the computer industry will A) increase. B) decrease C) remain the same. D) depend on whether computers are PCs or "Supercomputers." E) no longer apply. Answer: A Page Ref: 210-213 Difficulty: Easy 29) If the tariff on computers is not changed, but the government then adds hitherto nonexistent tariffs on imported semi-conductor components, then the effective rate of protection in the computer industry will A) increase. B) decrease. C) remain the same. D) depend on whether computers are PCs or "Supercomputers." E) no longer apply. Answer: B Page Ref: 210-213 Difficulty: Easy 30) When a government allows raw materials and other intermediate products to enter a country duty free, this generally results in a(an) A) effective tariff rate less than the nominal tariff rate. B) nominal tariff rate less than the effective tariff rate. C) rise in both nominal and effective tariff rates. D) fall in both nominal and effective tariff rates. E) rise in only the effective tariff rate. Answer: B Page Ref: 210-213 Difficulty: Easy 31) Of the many arguments in favor of tariffs, the one that has enjoyed significant economic justification has been the A) cheap foreign labor argument. B) infant industry argument. C) even playing field argument. D) balance of payments argument. E) domestic living standard argument. Answer: B Page Ref: 211-212 Difficulty: Easy

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32) As globalization tends to increase the proportion of imported inputs relative to domestically supplied components A) the nominal tariff automatically increases. B) the rate of (effective) protection automatically decreases. C) the nominal tariff automatically decreases. D) the rate of (effective) protection automatically increases. E) the amount of tariffs levied increases. Answer: D Page Ref: 210-212 Difficulty: Easy 33) In an inflationary environment, then over time A) a specific tariff will tend to raise more revenue than an ad valorem tariff. B) an ad valorem tariff will tend to raise more revenue than a specific tariff. C) an optimum tariff will tend to raise more revenue than an escalating tariff. D) a tariff quota will tend to raise more revenue than a specific tariff. E) an import quota would raise more revenue than a specific tariff. Answer: B Page Ref: 206-207 Difficulty: Easy 34) Some argue that tariffs always hurt the imposing country's economic welfare, and are typically designed to shift resources from one sector to another, protected or preferred one, within an economy. Find and discuss a counter example to this argument. Answer: The optimum tariff is theoretically a first-best trade policy. Page Ref: 210-212 Difficulty: Moderate 35) The effective rate of protection is a weighted average of nominal tariffs and tariffs on imported inputs. It has been noted that in most industrialized countries, the nominal tariffs on raw materials or intermediate components or products are lower than on final-stage products meant for final markets. Why would countries design their tariff structures in this manner? Who tends to be helped, and who is harmed by this cascading tariff structure? Answer: The cascading tariff structure is probably the result of systematic lobbying on the part of manufacturing interests and lobbies to lower costs of production (in terms of imported inputs). The end result is in fact to create effective rates of protection for downstream, or final manufacturing processes that are often much higher than nominal tariffs on these products. An important group, which is hurt by this are exporters of raw materials and components in developing countries. Page Ref: 210-212 Difficulty: Moderate

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9.2 Costs and Benefits of a Tariff 1) If a good is imported into (large) country H from country F, then the imposition of a tariff in country H A) raises the price of the good in both countries (the "Law of One Price"). B) raises the price in country H and cannot affect its price in country F. C) lowers the price of the good in both countries. D) lowers the price of the good in H and could raise it in F. E) raises the price of the good in H and lowers it in F. Answer: E Page Ref: 212-217 Difficulty: Easy 2) If a good is imported into (small) country H from country F, then the imposition of a tariff In country H A) raises the price of the good in both countries (the "Law of One Price"). B) raises the price in country H and does not affect its price in country F. C) lowers the price of the good in both countries. D) lowers the price of the good in H and could raise it in F. E) raises the price of the good in H and lowers it in F. Answer: B Page Ref: 212-217 Difficulty: Easy 3) If a small country imposes a tariff, then A) the producers must suffer a loss. B) the consumers must suffer a loss. C) the government revenue must suffer a loss. D) the demand curve must shift to the left. E) the world price on that item will shift. Answer: B Page Ref: 212-217 Difficulty: Easy 4) The imposition of tariffs on imports results in deadweight (triangle) losses. These are A) production and consumption distortion effects. B) redistribution effects. C) revenue effects D) efficiency effects. E) distortion of incentives. Answer: E Page Ref: 212-217 Difficulty: Easy

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5) The main redistribution effect of a tariff is the transfer of income from A) domestic producers to domestic buyers. B) domestic buyers to domestic producers. C) domestic producers to domestic government. D) domestic government to domestic consumers. E) foreign producers to domestic consumers. Answer: B Page Ref: 212-217 Difficulty: Easy 6) The principle benefit of tariff protection goes to A) domestic consumers of the good produced. B) foreign consumers of the good produced. C) domestic producers of the good produced. D) foreign producers of the good produced. E) the domestic government. Answer: C Page Ref: 212-217 Difficulty: Easy 7) Should the home country be "large" relative to its trade partners, its imposition of a tariff on imports would lead to an increase in domestic welfare if the terms of the trade rectangle exceed the sum of the A) revenue effect plus redistribution effect. B) protective effect plus revenue effect. C) consumption effect plus redistribution effect. D) production distortion effect plus consumption distortion effect. E) terms of trade gain. Answer: D Page Ref: 212-217 Difficulty: Easy 8) The deadweight loss of a tariff A) is a social loss because it promotes inefficient use of national resources. B) is a social loss because it reduces the revenue of the government. C) is not a social loss because it merely redistributes revenue from one sector to another. D) is not a social loss because it is paid for by rich corporations. E) is not a social loss because it aids domestic consumers. Answer: A Page Ref: 212-217 Difficulty: Easy

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9) A policy of tariff reduction in the computer industry is A) in the interest of the United States as a whole and in the interest of computer producing regions of the country. B) in the interest of United States as a whole but not in the interest of computer producing regions of the country. C) not in the interest of the United States as a whole but in the interests of computer producing regions of the country. D) not in the interest of the United States as a whole and not in the interests of computer consumers. E) not in the interest of the United States as a whole but in the interests of foreign computer producers. Answer: B Page Ref: 212-217 Difficulty: Easy 10) The fact that industrialized countries levy very low or no tariff on raw materials and semi processed goods A) helps developing countries export manufactured products. B) has no effect on developing country exports. C) hurts developing country efforts to export manufactured goods. D) hurts developing country efforts to export raw materials. E) does not affect industrialized countries' exports. Answer: C Page Ref: 212-217 Difficulty: Easy 11) The imposition of tariffs will help a nation attain which of the following goals? A) decreased domestic consumer prices B) increased domestic employment C) increased amount and variety of goods available for consumers D) increased competition between domestic and foreign producers E) gains for domestic producers Answer: E Page Ref: 212-217 Difficulty: Easy 12) The change in the economic welfare of a country associated with an increase in a tariff equals A) efficiency loss - terms of trade gain. B) efficiency gain - terms of trade loss. C) efficiency loss + tax revenue gain. D) efficiency loss + tax revenue gain + terms of trade gain. E) efficiency loss - tax revenue gain. Answer: A Page Ref: 212-217 Difficulty: Easy 11 .

13) The two deadweight triangles are the Consumption distortion and Production distortion losses. It is easy to understand why the Consumption distortion constitutes a loss for society. After all it raises the prices of goods to consumers, and even causes some consumers to drop out of the market altogether. It seems paradoxical that the Production distortion is considered an equivalent burden on society. After all, in this case, profits increase, and additional production (with its associated employment) comes on line. This would seem to be an offset rather than an addition to the burden or loss borne by society. Explain why the Production distortion is indeed a loss to society, and what is wrong with the logic that leads to the apparent paradox. Answer: The Production Distortion represents an inefficient shift of society's resources to produce a good, which it could not sell profitably at world prices. Since (with full employment assumed) these resources were formerly used to produce export goods, which could compete profitably, the net result is a loss in real income to the country. Page Ref: 212-217 Difficulty: Moderate 14) In the country levying the tariff, the tariff will A) increase both consumer and producer surplus. B) decrease both the consumer and producer surplus. C) decrease consumer surplus and increase producer surplus. D) increase consumer surplus and decrease producer surplus. E) decrease consumer surplus but leave producers surplus unchanged. Answer: C Page Ref: 212-217 Difficulty: Easy

15) Refer to above figure. In the absence of trade, what is the country's consumer surplus? Answer: $180 Page Ref: 212-217 Difficulty: Easy

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16) Refer to above figure. In the absence of trade, what is the country's producer surplus? Answer: $180 Page Ref: 212-217 Difficulty: Easy 17) Refer to above figure. The loss of Consumer Surplus due to the tariff equals ________. Answer: $230 Page Ref: 212-217 Difficulty: Easy 18) Refer to above figure. In the absence of a tariff and in the presence of trade, what is the country's consumer surplus? Answer: $550 Page Ref: 212-217 Difficulty: Easy 19) Refer to above figure. Given a tariff of $3 per unit, what is the country's consumer surplus? Answer: $320 Page Ref: 212-217 Difficulty: Easy 20) Refer to above figure. What is the amount of efficiency loss resulting from imposition of the tariff? Answer: $75 Page Ref: 212-217 Difficulty: Easy 21) Refer to above figure. What is the amount of government revenue resulting from imposition of the tariff? Answer: $120 Page Ref: 212-217 Difficulty: Easy 9.3 Other Instruments of Trade Policy 1) An important difference between tariffs and quotas is that tariffs A) raise the price of the good. B) generate tax revenue for the government. C) stimulate international trade. D) help domestic producers. E) are paid by foreign producers. Answer: B Page Ref: 217-223 Difficulty: Easy

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2) Throughout the post-World War II era, the importance of tariffs as a trade barrier has A) increased. B) decreased. C) remained the same. D) fluctuated wildly. E) demonstrated a classic random walk with a mean-reversion tendency. Answer: B Page Ref: 217-223 Difficulty: Easy 3) In the exporting country, an export subsidy will A) help consumers and raise the overall economic welfare of the exporting country. B) hurt consumers but raise the overall economic welfare of the exporting country. C) hurt consumers and lower the overall economic welfare of the exporting country. D) help consumers but lower economic welfare of the exporting country. E) help consumers and have no effect on the economic welfare of the exporting country. Answer: C Page Ref: 217-223 Difficulty: Easy 4) Economic theory in general, and trade theory in particular are replete with equivalencies. For example, it is argued that for any specific tariff one can find an equivalent ad valorem tariff; and that for any quota one can calculate a tariff equivalent. Discuss conditions or situations under which a specific and an ad valorem tariff are not equivalent. Discuss conditions or situations when a tariff and a quota are not equivalent. Answer: E.g., during a period of price inflation, an ad valorem tariff would become increasingly more effective. The government does not receive any of the quota revenues, unless the import licenses are sold or auctioned. Page Ref: 217-223 Difficulty: Easy 5) An export subsidy is A) a payment to a firm or individual that ships a good abroad. B) a fee that is charged to a country that ships goods to the U.S. C) a payment made to a foreign government in return for preferential trade treatment. D) illegal in the U.S. but is fairly common in the rest of the world. E) a limit on the quantity of a good or service that can be sold abroad. Answer: A Page Ref: 217-223 Difficulty: Easy

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6) An export subsidy differs from a tariff in each of the following ways EXCEPT A) a tariff generates revenue. B) a tariff is applied to imports. C) a tariff results in an efficiency loss. D) a tariff is a tax. E) a tariff discourages imports. Answer: C Page Ref: 217-223 Difficulty: Easy 7) The European Union's Common Agricultural Policy (CAP) is, in effect A) a tariff imposed on agricultural exports. B) a tariff imposed on agricultural imports. C) a subsidy that reduces the cost of agricultural exports. D) a subsidy that increases the cost of agricultural exports. E) a quota that limits production of agricultural goods by EU nations. Answer: C Page Ref: 217-223 Difficulty: Easy 8) An import quota is similar to a ________ in its effect on imports, except that an import quota ________. A) tariff; does not generate revenue B) tariff; generates revenue C) subsidy; does not generate revenue D) subsidy; generates revenue E) tariff; does not result in an efficiency loss. Answer: A Page Ref: 217-223 Difficulty: Easy 9) The U.S. sugar quota A) generates government revenue. B) results in net welfare benefits to the U.S. economy. C) results in benefits to sugar producers that exceed the cost to consumers. D) results in costs to consumers that exceed the benefits to sugar producers. E) does not result in an efficiency loss. Answer: D Page Ref: 221-223 Difficulty: Easy

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10) Which of the following are examples of goods that have been subject to voluntary export restraints? A) Japanese cars and Chinese solar panels B) Belgian chocolates and French wines C) French wines and cheeses D) Japanese sushi and German cars E) Taiwanese electronics and Canadian barley Answer: A Page Ref: 224-225 Difficulty: Easy 9.4 The Effects of Trade Policy: A Summary 1) An export tariff will ________ producer surplus, ________ consumer surplus, ________ government revenue, and ________ overall domestic national welfare. A) increase; decrease; increase; have an ambiguous effect on B) increase; decrease; decrease; decrease C) increase; decrease; have no effect on; have an ambiguous effect on D) increase; decrease; have no effect on; decrease E) increase; increase; decrease; have an ambiguous effect on Answer: A Page Ref: 227-228 Difficulty: Easy 2) An export subsidy will ________ producer surplus, ________ consumer surplus, ________ government revenue, and ________ overall domestic national welfare. A) increase; decrease; increase; have an ambiguous effect on B) increase; decrease; decrease; decrease C) increase; decrease; have no effect on; have an ambiguous effect on D) increase; decrease; have no effect on; decrease E) increase; increase; decrease; have an ambiguous effect on Answer: B Page Ref: 227-228 Difficulty: Easy 3) An import quota will ________ producer surplus, ________ consumer surplus, ________ government revenue, and ________ overall domestic national welfare. A) increase; decrease; increase; have an ambiguous effect on B) increase; decrease; decrease; decrease C) increase; decrease; have no effect on; have an ambiguous effect on D) increase; decrease; have no effect on; decrease E) increase; increase; decrease; have an ambiguous effect on Answer: C Page Ref: 227-228 Difficulty: Easy

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4) A voluntary export restraint will ________ producer surplus, ________ consumer surplus, ________ government revenue, and ________ overall domestic national welfare. A) increase; decrease; increase; have an ambiguous effect on B) increase; decrease; decrease; decrease C) increase; decrease; have no effect on; have an ambiguous effect on D) increase; decrease; have no effect on; decrease E) increase; increase; decrease; have an ambiguous effect on Answer: D Page Ref: 227-228 Difficulty: Easy 9.5 Appendix to Chapter 9: Tariffs and Import Quotas in the Presence of Monopoly 1) If an import-competing firm is imperfectly competitive, then under free trade an export tariff will ________ domestic market price, ________ producer surplus, ________ consumer surplus, ________ government revenue, and ________ overall domestic national welfare. A) increase; have no effect on; decrease; increase; decrease B) decrease; decrease; increase; decrease; have no effect on C) increase; have no effect on; increase; decrease; increase D) decrease; increase; decrease; increase; decrease E) have no effect on; have no effect on; decrease; increase; decrease Answer: A Page Ref: 232-235 Difficulty: Easy 2) If an import-competing firm is imperfectly competitive, than under free trade an import quota will ________ domestic market price, ________ producer surplus, ________ consumer surplus, ________ government revenue, and ________ overall domestic national welfare. A) increase; increase; decrease; have no effect on; decrease B) decrease; decrease; increase; decrease; have no effect on C) increase; have no effect on; decrease; increase; decrease D) decrease; increase; decrease; increase; decrease E) have no effect on; have no effect on; decrease; increase; decrease Answer: A Page Ref: 232-235 Difficulty: Easy

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3) Suppose an import-competing firm is imperfectly competitive. Replacement of an export tariff with an import quota that yields the same level of imports will ________ market price, ________ producer surplus, ________ consumer surplus, ________ government revenue, and ________ overall domestic national welfare. A) increase; increase; decrease; decrease; decrease B) have no effect on; have no effect on; have no effect on; decrease; decrease C) increase; have no effect on; decrease; decrease; increase D) increase; increase; increase; decrease; have an ambiguous effect on E) decrease; decrease; increase; decrease; increase Answer: A Page Ref: 232-235 Difficulty: Easy 4) If an import-competing firm is the only domestic producer of a good, then a transition from autarky to free trade will ________ domestic price, ________ producer surplus, ________ consumer surplus, and ________ overall domestic national welfare. A) decrease; decrease; increase; increase B) increase; increase; increase; increase C) decrease; decrease; decrease; decrease D) increase; increase; decrease; decrease E) increase; increase; decrease; increase Answer: A Page Ref: 232-235 Difficulty: Easy

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International Economics, 10e (Krugman/Obstfeld/Melitz) Chapter 10 The Political Economy of Trade Policy 10.1 The Case for Free Trade 1) The efficiency case made for free trade is that as trade distortions such as tariffs are dismantled and removed A) government tariff revenue will decrease, and therefore national economic welfare will decrease. B) government tariff revenue will decrease, and therefore national economic welfare will increase. C) deadweight losses for producers and consumers will decrease, hence increasing national economic welfare. D) deadweight losses for producers and consumers will decrease, hence decreasing national economic welfare. E) government tariff revenue will increase, hence increasing national economic welfare. Answer: C Page Ref: 236-241 Difficulty: Easy 2) The opportunity to exploit economies of scale is one of the gains to be derived by removing tariffs and other trade distortions. These gains will be the result of a decrease in A) world prices of imports. B) the consumption distortion loss triangle. C) the production distortion loss triangle. D) international labor mobility. E) excessive entry and inefficient business practices. Answer: E Page Ref: 236-241 Difficulty: Easy 3) Judging by the ongoing changes in tariff rates in major trading countries, the world has been experiencing a great A) trade liberalization. B) surge of protectionism. C) lack of progress in the trade-policy area. D) move towards regional integration. E) shift from export subsidies to specific tariffs. Answer: A Page Ref: 236-241 Difficulty: Easy

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4) A trade policy designed to alleviate some domestic economic problem by exporting it to foreign countries is know as a(n) A) international dumping policy. B) countervailing tariff policy. C) beggar thy neighbor policy. D) trade adjustment assistance policy. E) redistribution quota policy. Answer: C Page Ref: 236-241 Difficulty: Easy 5) Trade theory suggests that Japan would gain from a subsidy the United States provides its grain farmers if the gains to Japanese consumers of wheat products more than offsets the losses to Japanese wheat farmers. This would occur as long as Japan A) is a net importer in bilateral trade flows with the United States. B) is a net importer of wheat. C) has a comparative advantage in wheat. D) has an absolute advantage in producing wheat. E) is involved in intra-industry trade with the United States. Answer: B Page Ref: 236-241 Difficulty: Easy 6) It is argued that the United States would be foolish to maintain a free-trade stance in a world in which all other countries exploit child or prisoner labor, or are protectionist. On the other hand, Ricardo's classic demonstration of the sources and effects of comparative advantage cogently demonstrates that regardless of other country policy, free trade remains the first best policy for a country to follow, since it will maximize its consumption possibilities (conditional upon other country policies). Explain. Discuss the contradiction with the argument in the preceding paragraph. Answer: In the context of the Ricardian model, it is true that gains from trade are strictly a result of world terms of trade, which differ from domestic marginal rates of substitution. In such a world, the reason why foreign goods are cheap is of no concern to domestic consumers. However, in a world which allows for large-scale labor migration, ignoring labor conditions abroad may ultimately result in living standards for domestic workers to be dragged down. Page Ref: 236-241 Difficulty: Moderate

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10.2 National Welfare Arguments Against Free Trade 1) The optimum tariff is A) the best tariff a country can obtain via a WTO negotiated round of compromises. B) the tariff, which maximizes the terms of trade gains. C) the tariff, which maximizes the difference between terms of trade gains and terms of trade loses. D) not practical for a small country due to the likelihood of retaliation. E) not practical for a large country due to the likelihood of retaliation. Answer: E Page Ref: 242 Difficulty: Easy 2) The optimum tariff is most likely to apply to A) a small tariff imposed by a small country. B) a small tariff imposed by a large country. C) a large tariff imposed by a small country. D) a large tariff imposed by a large country. E) an ad valorem tariff on a small country. Answer: B Page Ref: 242 Difficulty: Easy 3) The prohibitive tariff is a tariff that A) is so high that it eliminates imports. B) is so high that it causes undue harm to trade-partner economies. C) is so high that it causes undue harm to import competing sectors. D) is so low that the government prohibits its use since it would lose an important revenue source. E) is so low that it causes domestic producers to leave the industry. Answer: A Page Ref: 242 Difficulty: Easy 4) The existence of marginal social benefits which are not marginal benefits for the industry producing the import substitutes A) is an argument supporting free trade and non-governmental involvement. B) is an argument supporting the use of an optimum tariff. C) is an argument supporting the use of market failures as a trade-policy strategy. D) is an argument rejecting free trade and supporting governmental involvement. E) is an argument rejecting the domestic market failure concept. Answer: D Page Ref: 242-246 Difficulty: Easy

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5) The domestic market failure argument is a particular case of the theory of A) the optimum, or first-best. B) the second best. C) the third best. D) the sufficing principle. E) the efficiency case for free trade. Answer: B Page Ref: 242-246 Difficulty: Easy 6) The difficulty of ascertaining the right second-best trade policy to follow A) reinforces support for the third-best policy approach. B) reinforces support for increasing research capabilities of government agencies. C) reinforces support for abandoning trade policy as an option. D) reinforces support for free-trade options. E) reinforced support for the domestic market failure argument. Answer: D Page Ref: 242-246 Difficulty: Easy 7) The reason protectionism remains strong in the United States is that A) economists can produce any result they are hired to produce. B) economists cannot persuade the general public that free trade is beneficial. C) economists do not really understand how the real world works. D) the losses associated with protectionism are diffuse, making lobbying by the public impractical. E) economists cannot agree on trade policy recommendations. Answer: D Page Ref: 242-246 Difficulty: Easy 8) The United States appears at times to have a totally schizophrenic attitude toward protectionism. The United States was the country that proposed the establishment of the World Trade Organization as early as the late 1940s, and was also the only industrialized country that refused to ratify this at that time. The United States has consistently argued on the side of multinational free trade in GATT Rounds, and yet maintains many protectionist laws such as those which reserve oil shipments from Alaska to U.S. flag carriers. How can you explain this apparent lack of national consistency on this issue? Answer: This reflects the fact that international trade typically has many winners and relatively fewer, but politically powerful losers. Short of guaranteed (constitutional?) non-conditional compensatory mechanisms, the basic conflict between these two groups will always be there. Page Ref: 242-246 Difficulty: Moderate

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Assume that Boeing (U.S.) and Airbus (European Union) both wish to enter the Hungarian market with the next new generation airliner. They both have identical cost and demand conditions (as indicated in the graph above). 9) Refer to above figure. Assume that Boeing is the first to enter the Hungarian market. Without a government subsidy what price would they demand, and what would be their total profits? Answer: $12 Million, $16. Page Ref: 242-246 Difficulty: Moderate 10) Refer to above figure. What is the consumer surplus enjoyed by Hungarian consumers of Boeing aircraft in the situation? Answer: $8 Million. Page Ref: 242-246 Difficulty: Moderate 11) Refer to above figure. Suppose the European government provides Airbus with a subsidy of $4 for each airplane sold, and that the subsidy convinces Boeing to exit the Hungarian market. Now Airbus would be the monopolist in this market. What price would they charge, and what would be their total profits? Answer: $10 Million, and $36 Million. Page Ref: 242-246 Difficulty: Moderate 12) Refer to above figure. What would be the cost of the subsidy to European taxpayers? Answer: $24 Million. Page Ref: 242-246 Difficulty: Moderate

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13) Refer to above figure. What happens to the Consumer Surplus of Hungarian customers as a result of this subsidy? Answer: An increase of $10 Million. Page Ref: 242-246 Difficulty: Moderate 14) Refer to above figure. What is the revenue gain or loss for Europe as a whole (including taxpayers)? Answer: A gain of $12 Million. Page Ref: 242-246 Difficulty: Moderate 10.3 Income Distribution and Trade Policy 1) It is argued that special interest groups are likely to take over and promote protectionist policies, which may lead to a decrease in national economic welfare. This argument leads to A) a presumption that in practice a free trade policy is likely to be better than alternatives. B) a presumption that trade policy should be shifted to Non-Governmental Organizations, so as to limit taxpayer burden. C) a presumption that free trade is generally a second-best policy, to be avoided if feasible alternatives are available. D) a presumption that free trade is the likely equilibrium solution if the government allows special interest groups to dictate its trade policy. E) a presumption that protectionist policies will better serve a country as a whole than free trade policies. Answer: A Page Ref: 246-251 Difficulty: Easy 2) The authors of the text believe that A) second-best policy is worse than optimal policy. B) special interest groups generally enhance national welfare. C) national welfare is likely to be enhanced by the imposition of an optimal tariff. D) market failure arguments tend to support free-trade policy. E) there is no such thing as national welfare. Answer: D Page Ref: 246-251 Difficulty: Easy

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3) The median voter model A) works well in the area of trade policy. B) is not intuitively reasonable. C) tends to result in biased tariff rates. D) does not work well in the area of trade policy. E) is not widely practiced in the United States. Answer: D Page Ref: 246-251 Difficulty: Easy 4) The fact that trade policy often imposes harm on large numbers of people, and benefits only a few may be explained by A) the lack of political involvement of the public. B) the power of advertisement. C) the problem of collective action. D) the basic impossibility of the democratic system to reach a fair solution. E) a cycle of political corruption. Answer: C Page Ref: 246-251 Difficulty: Easy 5) Protectionism tends to be concentrated in two sectors A) agriculture and clothing. B) high-tech and national security sensitive industries. C) capital and skill intensive industries. D) industries concentrated in the South and in the Midwest of the country. E) financial services and manufacturing based in the Midwest. Answer: A Page Ref: 246-251 Difficulty: Easy 6) Export embargoes cause greater losses to consumer surplus in the target country A) the lesser its initial dependence on foreign produced goods. B) the more elastic is the target country's demand schedule. C) the more elastic is the target country's domestic supply. D) the more inelastic the target country's supply. E) the larger the target country's labor force is. Answer: D Page Ref: 246-251 Difficulty: Easy

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7) The strongest political pressure for a trade policy that results in higher protectionism comes from A) domestic workers lobbying for import restrictions. B) domestic workers lobbying for export restrictions. C) domestic workers lobbying for free trade. D) domestic consumers lobbying for export restrictions. E) domestic consumers lobbying for import restrictions. Answer: A Page Ref: 246-251 Difficulty: Easy 8) The average tariff rate dutiable imports in the United States is approximately A) less than 10 % of the value of imports. B) 15% of the value of imports. C) 20 % of the value of imports. D) 25% of the value of imports. E) more than 30% of the value of imports. Answer: A Page Ref: 246-251 Difficulty: Easy 9) In 1990 the United States imposed trade embargoes on Iraq's international trade. The negative effect on Iraq's consumer surplus would be greater the A) less elastic Iraq's demand schedule. B) more elastic Iraq's demand schedule. C) greater Iraq's dependence on foreign products. D) more inelastic Iraq's supply schedule. E) less elastic Iraq's labor force is. Answer: B Page Ref: 246-251 Difficulty: Easy 10) Today U.S. protectionism is concentrated in A) high-tech industries. B) labor-intensive industries. C) industries in which Japan has a comparative advantage. D) computer intensive industries. E) capital-intensive industries. Answer: B Page Ref: 246-251 Difficulty: Easy

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11) The quantitative importance of U.S. protection of the domestic clothing industry is best explained by the fact that A) this industry is an important employer of highly skilled labor. B) this industry is an important employer of low skilled labor. C) most of the exporters of clothing into the U.S. are poor countries. D) this industry is a politically well organized sector in the U.S. E) the technology involved is very advanced. Answer: D Page Ref: 246-251 Difficulty: Easy 12) It may be demonstrated that any protectionist policy, which effectively shifts real resources to import competing industries or sectors will harm export industries or sectors. This may, for example, happen by the strengthening U.S. dollar in the foreign exchange market. Would you propose therefore that export industries lobby against protectionism in International Trade Commission proceedings? What of consumer advocates? Discuss the pros and the problems of such a suggestion. Answer: Actually this is an interesting idea. It is well known that the public interest is put on hold as the ITC considers only the squeaky wheels of those allegedly hurt by trade. While "consumers" may be too amorphous a group to successfully organize and pursue a political agenda, the exporters and consumer advocates may be able to form a counter weight to the import competing industries. Page Ref: 246-251 Difficulty: Moderate 10.4 International Negotiations and Trade Policy 1) The simple model of competition among political parties long used by political scientists tends to lead to the practical solution of selecting the A) optimal tariff. B) prohibitive tariff. C) zero (free-trade) tariff. D) the tariff rate favored by the median voter. E) the tariff rate supported by exporters. Answer: D Page Ref: 252-261 Difficulty: Easy

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2) The General Agreement on Tariffs and Trade and the World Trade Organization have resulted in A) termination of export subsidies applied to manufactured goods. B) termination of import tariffs applied to manufactures. C) termination of import tariffs applied to agricultural commodities. D) termination of international theft of copyrights. E) a number of rounds of multilateral trade agreements. Answer: E Page Ref: 252-261 Difficulty: Easy 3) The General Agreement on Tariffs and Trade and the World Trade Organization have resulted in A) the establishment of universal trade adjustment assistance policies. B) the establishment of the European Union. C) the reciprocal trade clause. D) reductions in trade barriers via multilateral negotiations. E) the total protection of all intellectual property rights. Answer: D Page Ref: 252-261 Difficulty: Easy 4) Countervailing duties are intended to neutralize any unfair advantage that foreign exporters might gain because of foreign A) tariffs. B) subsidies. C) quotas. D) Local-Content legislation. E) comparative advantage. Answer: B Page Ref: 252-261 Difficulty: Easy 5) In 1980 the United States announced an embargo on grain exports to the Soviet Union in response to the Soviet invasion of Afghanistan. This embargo was mainly resisted by A) U.S. grain consumers of bread. B) U.S. grain producers. C) foreign grain producers. D) U.S. communists. E) economists concerned with U.S. terms of trade. Answer: B Page Ref: 252-261 Difficulty: Easy

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6) Under U.S. commercial policy, the escape clause results in A) temporary quotas granted to firms injured by import competition. B) tariffs that offset export subsidies granted to foreign producers. C) a refusal of the U.S. to extradite anyone who escaped political oppression. D) tax advantages extended to minority-owned exporting firms. E) tariff advantages extended to certain Caribbean countries in the U.S. market. Answer: A Page Ref: 252-261 Difficulty: Easy 7) Under U.S. commercial policy, which clause permits the modification of a trade liberalization agreement on a temporary basis if serious injury occurs to domestic producers as a result of the agreement? A) adjustment assistance clause B) escape clause C) most favored nation clause D) prohibitive tariff clause E) anti-dumping legislation Answer: B Page Ref: 252-261 Difficulty: Easy 8) An issue never confronted effectively by GATT, but considered an important issue for WTO is that of A) the promotion of freer World trade. B) the promotion of freer World commodity trade. C) the promotion of freer World services trade. D) the lowering of tariff rates. E) the liberalization of trade. Answer: C Page Ref: 252-261 Difficulty: Easy 9) The political wisdom of choosing a tariff acceptable to the median U.S. voter is A) a good example of the principle of the second best. B) a good example of the way in which actual tariff policies are determined. C) a good example of the principle of political negotiation. D) not evident in actual tariff determination. E) usually evident in actual tariff determination. Answer: D Page Ref: 252-261 Difficulty: Easy

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10) A game-theory explanation of the paradox that even though all countries would benefit if each chose free trade, in fact each tends to follow protectionist policies is A) trade war. B) collective action. C) prisoner's dilemma. D) benefit-cost analysis. E) rent seeking. Answer: C Page Ref: 252-261 Difficulty: Easy 11) When the U.S. placed tariffs on French wine, France placed high tariffs on U.S. chickens. This is an example of A) deadweight losses. B) multilateral negotiations. C) bilateral trade negotiations. D) international market failures. E) a trade war. Answer: E Page Ref: 252-261 Difficulty: Easy 12) Presumably, since the United States is a large country in many of its international markets, a positive optimum tariff exists for this country. It follows therefore that when any legislator or government official who promotes zero-tariff free trade policies, is by definition not acting in the public's best interest. Discuss. Answer: Technically this is true. However, this is true only within the context of a generally myopic view of international relations. If the tariff imposing country is large enough to make a substantial difference in its welfare by seeking an optimum tariff, then it cannot hope to remain invisible, as its policies are substantially harming its trade partners. Foreign repercussions are almost a certainty. In such a "game" it is not at all certain that seeking the optimum tariff dominates alternative strategies. Page Ref: 252-261 Difficulty: Moderate 13) It has been claimed that foreign governments have attempted to influence votes in the U.S. that would promote policies of protectionism within the U.S. On the surface this appears to be totally illogical and counter intuitive, as this would presumably lessen the possibilities of foreigners' exports to the U.S. Answer: This would make sense only if the form of protectionism is a tariff. However, if it is a quota, then the scarcity rents may be captured by established foreign producers. Hence, the reaction of the Japanese to automobile quotas was to dramatically increase the high-end, highly profitable automobiles. This would be even more self-evident if the protectionism took the form of a Voluntary Export Restraint (VER), or a detailed formalized bilateral cartel, such as the old Multi-Fibre Agreement. Page Ref: 252-261 Difficulty: Moderate 12 .

14) The U.S. producer Boeing, and the European Airbus are contemplating the next generation mid-sized fuel efficient generation of air carrier. If both produce their respective models, then each would lose $50 million (because the world market is just not large enough to enable either to capture potential scale economies if they had to share the world market). If neither produce, then each one's net gain would of course be zero. If either one produces while the other does not, then the producer will gain $500 million. (a) What is the correct strategy for either company? (b) What is the correct strategy for a government seeking to maximize national economic welfare? (c) If a national government decides to subsidize its aircraft producer, how high should be the subsidy? Answer: (a) enter the market first. Then the other company knows that if it also enters, it will not be able to cover costs. (b) Subsidize its producer. If this allows it to enter first, then we get the same solution as answer (a) above. (c) Any figure above $50 million (e.g., $55 million). This would promise positive profits regardless of the decision of the competitor. The "winner" then may turn out to be that country whose voters are least sensitive to on-the-books, transparent subsidies given to rich corporations (these subsidies will have to continue year after year until the other country stops its subsidies). Page Ref: 252-261 Difficulty: Moderate 15) In recent cases, the U.S. placed quotas or protectionist tariffs on imported steel and imported microchips. In both cases the damage to "downstream" industries was obvious to all and relatively easy to quantify and demonstrate. Assuming that the U.S. lawmakers are not plain dumb, why did they enact these protectionist policies? Answer: The system by which these protectionist policies are set into law is biased in favor of the producers of import competitive goods. Other sectors of the economy that may be affected are not parties in the petitions made to the ITC seeking redress. Page Ref: 252-261 Difficulty: Moderate 16) The World Trade Organization (WTO) was organized as a successor to the A) IMF. B) UN. C) UNCTAD. D) GATT. E) the World Bank. Answer: D Page Ref: 252-261 Difficulty: Easy

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17) The WTO was established by the ________ of multilateral trade negotiations. A) Kennedy Round B) Tokyo Round C) Uruguay Round D) Dillon Round E) NAFTA Round Answer: C Page Ref: 252-261 Difficulty: Easy 18) The Smoot-Hawley Tariff Act of 1930 has generally been associated with A) falling tariffs. B) free trade. C) intensifying the worldwide depression. D) recovery from the worldwide depression. E) non-tariff barriers. Answer: C Page Ref: 252-261 Difficulty: Easy 19) The World Trade Organization provides for all of the following EXCEPT A) the usage of the most favored nation clause. B) assistance in the settlement of trade disagreements. C) bilateral tariff reductions. D) multilateral tariff reductions. E) the prevention of nontariff interventions in trade. Answer: C Page Ref: 252-261 Difficulty: Easy 20) Which organization determines procedures for the settlement of international trade disputes? A) World Bank B) World Trade Organization C) International Monetary Organization D) International Bank for Reconstruction and Development E) The League of Nations Answer: B Page Ref: 252-261 Difficulty: Easy

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21) The WTO's intervention against clean air standards A) has earned it universal approval. B) was done in order to limit national sovereignty. C) has resulted in much criticism. D) has resulted in much criticism among professional economists. E) was championed in developing countries. Answer: C Page Ref: 252-261 Difficulty: Easy 10.5 The Doha Disappointment 1) For most developing countries A) productivity is high among domestic workers. B) population growth and illiteracy rates are low. C) saving and investment levels are high. D) agricultural goods and raw materials constitute a high proportion of domestic output. E) pollution emissions are relatively low. Answer: D Page Ref: 261-267 Difficulty: Moderate 2) Developing countries have often attempted to establish cartels so as to counter the actual or perceived inexorable downward push on the prices of their exported commodities. OPEC is the best well known of these. How are such cartels expected to help the developing countries? At times importing countries profess support for such schemes. Can you think of any logical basis for such support? How are cartels like monopolies, and how are they different from monopolies. Why is there a presupposition among economists that such schemes are not likely to succeed in the long run? Answer: Such cartels are expected to shift the exporters' terms of trade in their favor. Also they are expected to produce the maximum profit, which the market will bear. Importing countries may benefit from the price stability generated by the cartel. Cartels are like monopolies in that their total output is the same as that which would be generated by a single monopoly. They differ from monopolies in that the monopoly profits need to be divided among the producing countries, which have different cost structures. Page Ref: 261-267 Difficulty: Moderate

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3) The U.S. is probably the most open international market among the industrialized countries. What then does the U.S. have to gain by joining the WTO? Answer: There are two answers. First, the U.S. exporters stand to gain profitable markets if foreign protectionism in areas of U.S. comparative advantage (e.g., soy) is removed due to WTO efforts. The second is that the WTO offers the U.S. government administration a counterweight to regional and sectoral interests demanding protection. It is always politically easier to bring about more efficient resource allocations if the complaints of the losers may be deflected by the presence of a binding treaty with an international organization ("our hands are tied"). Page Ref: 261-267 Difficulty: Moderate 4) The world trading system combines negotiated agreements that promote trade liberalization called ________ with binding agreements called ________ that block tariff increases. A) fiscal policies; monetary policies B) truces; aggressions C) free trade; enforcement contracts D) levers; ratchets E) wheels; walls Answer: D Page Ref: 261-267 Difficulty: Moderate 5) One of the major issues that arose during the Doha round of negotiations involved complaints by ________ about ________. A) developing countries; agricultural subsidies. B) manufacturers; intellectual property C) industrialized countries; enforcement of contracts D) Eastern European countries; European Union tariffs E) South and Central American countries; domestic content requirements Answer: A Page Ref: 261-267 Difficulty: Moderate 10.6 Appendix to Chapter 10: Proving That the Optimum Tariff Is Positive 1) The effect of an export tariff on a large country is to ________ the terms of trade. A) always improve B) sometimes improve C) leave unchanged D) sometimes worsen E) always worsen Answer: A Page Ref: 272-274 Difficulty: Easy

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2) Assume that a country has a domestic demand curve defined as Qd = 100 - 2P and a domestic supply curve defined as Qs = -20 + 3P. What is the autarchy equilibrium price and quantity? Answer: 100 - 2P = -20 + 3P => P = 120/5 = 24 and Q = 52 Page Ref: 272-274 Difficulty: Moderate 3) Assume that a country has a domestic demand curve defined as Qd = 100 - 2P and a domestic supply curve defined as Qs = -20 + 3P. What is the country's import demand curve (Qm)? Answer: Qm = Qd - Qs = (100 - 2P) - (-20 + 3P) = 120 - 5P Page Ref: 272-274 Difficulty: Moderate

4) Refer to the figure above, which shows domestic supply and demand. If P1 is equal to P2 (the world price) plus a tariff, then the social loss from the tariff is equal to A) a + c B) b C) P1 ( Q3 - Q2) D) P2 [(Q2 - Q1) + (Q4 - Q3)] E) a + b + c Answer: A Page Ref: 272-274 Difficulty: Easy 5) Refer to the figure above, which shows domestic supply and demand. If P1 is equal to P2 (the world price) plus a tariff, then government revenue from the tariff is equal to A) a + c B) b C) P1 ( Q3 - Q2) D) P2 [(Q2 - Q1) + (Q4 - Q3)] E) a + b + c Answer: B Page Ref: 272-274 Difficulty: Easy

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International Economics, 10e (Krugman/Obstfeld/Melitz) Chapter 11 Trade Policy in Developing Countries 11.1 Import-Substituting Industrialization 1) The infant industry argument was an important theoretical basis for A) neo-colonialist theory of international exploitation. B) import-substituting industrialization. C) historiography of the industrial revolution in Western Europe. D) the East-Asian miracle. E) the reduction of tariffs on Western Europe. Answer: B Page Ref: 275-281 Difficulty: Easy 2) Sophisticated theoretical arguments supporting import-substitution policies include A) terms of trade effects. B) scale economy arguments. C) learning curve considerations. D) the problem of appropriability. E) domestic market failure arguments. Answer: D Page Ref: 275-281 Difficulty: Easy 3) Which of the following could explain why the terms of trade of developing countries might deteriorate over time? A) Developing country exports consist mainly of manufactured goods. B) Developing country exports consist mainly of primary products. C) Commodity export prices are determined in highly competitive markets. D) Commodity export prices are solely determined by developing countries. E) Developing country exports are too diverse. Answer: C Page Ref: 275-281 Difficulty: Easy 4) Which trade strategy have developing countries used to restrict imports of manufactured goods so that the domestic market is preserved for home producers? A) international commodity agreement B) export promotion C) multilateral contract D) import substitution E) export subsidies Answer: D Page Ref: 275-281 Difficulty: Easy 1 .

5) The infant industry argument is that A) comparative advantage is irrelevant to economic growth. B) developing countries have a comparative advantage in agricultural goods. C) developing countries have a comparative advantage in manufacturing. D) developing countries have a potential comparative advantage in manufacturing. E) developing countries have no chance to compete with industrialized countries. Answer: D Page Ref: 275-281 Difficulty: Easy 6) The infant industry argument calls for active government involvement A) only if the government forecasts are accurate. B) only if some market failure can be identified. C) only if the industry is not one already dominated by industrial countries. D) only if the industry has a high value added. E) only if the industry is independently able to earn high returns. Answer: B Page Ref: 275-281 Difficulty: Easy 7) The imperfect capital market justification for infant industry promotion A) assumes that new industries will tend to have low profits. B) assumes that infant industries will soon mature. C) assumes that infant industries will be in products of comparative advantage. D) assumes that banks can allocate resources efficiently. E) assumes that developing country will reward the donor country. Answer: A Page Ref: 275-281 Difficulty: Easy 8) The United States, as it began its long and successful growth in the early 19th century, consciously promoted domestic production through such activities as tariffs, Clay's American System, and many direct subsidies to railroads, canal companies, farmers (free land) etc. Today we view this blatant example of large scale and extensive import-substitution industrialization as having been very successful. Comment on this. Answer: This is an interesting point and emphasizes that economic models tend to be ahistorical. That is, they lack the historic perspective; and thus may be misleading as guides to long run issues, such as economic growth. This also suggests that trade policy per se is almost certainly not sufficient to explain why some countries grow and others do not. Page Ref: 275-281 Difficulty: Moderate

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9) Refer to above figure. If OmL1 workers are employed in manufacturing then what is the marginal productivity of labor in manufacturing? Answer: OmWm. Page Ref: 275-281 Difficulty: Moderate 10) Refer to above figure. If OmL1 workers are employed in manufacturing then what is the marginal productivity of labor in agriculture? Answer: OfWf. Page Ref: 275-281 Difficulty: Moderate 11) Refer to above figure. If manufacturing labor were to increase to OmL2, how much value would the economy as a whole gain? Answer: The triangle ABC. Page Ref: 275-281 Difficulty: Moderate 12) Refer to above figure. Why would workers not shift from agriculture to manufacturing in the initial situation where wages are higher in the latter? Answer: Imperfections in the labor market. Page Ref: 275-281 Difficulty: Moderate 13) Refer to above figure. If the economy were in the initial position (where OmL1 workers were in manufacturing, what trade policy might gain ABC of economic welfare? Answer: Import-substitution giving protection to manufacturing. Page Ref: 275-281 Difficulty: Moderate

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11.2 Results of Favoring Manufacturing: Problems of Import-Substituting Industrialization 1) General equilibrium considerations lead to the realization that import-substituting policies have the effect of A) discouraging exports. B) encouraging exports. C) encouraging an efficient use of a country's resources. D) generating large tariff revenues for the government. E) creating competitive manufacturing sectors. Answer: A Page Ref: 281-282 Difficulty: Easy 2) A reason why it is difficult for developing countries to maintain a cartel is that A) the elasticity of demand for a cartel's output decreases over time. B) producers in the cartel have an economic incentive to cheat. C) economic profits discourage other producers from entering the industry. D) producers in the cartel have the motivation to lower prices but not to raise prices. E) tariffs allow producers in the cartel to produce items that make no profit. Answer: B Page Ref: 281-282 Difficulty: Easy 3) Import substitution policies make use of A) tariffs that discourage goods from entering a country. B) quotas applied to goods that are shipped abroad. C) production subsidies granted to industries with comparative advantage. D) tax breaks granted to industries with comparative advantage. E) production facilities provided by industrialized countries. Answer: A Page Ref: 281-282 Difficulty: Easy 4) Brazil's export record in 1999 illustrated the principle that A) a large country will tend to have few exports. B) a small country will tend to have a high export ratio. C) protectionist policies tend to discourage exports. D) export-promoting policies do not tend to work. E) import substitution policies helped the Brazilian economy. Answer: C Page Ref: 281-282 Difficulty: Easy

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5) The disappointment with import-substitution policies is in part because A) of the rapid and continuous growth record of South American countries. B) many countries pursuing this strategy experienced stagnation in their growth. C) this policy is inconsistent with sophisticated economic growth models. D) this policy tended to create world-class industrial competitors. E) of the financial investment lost by the U.S. Answer: B Page Ref: 281-282 Difficulty: Easy 6) It is argued that import substitution is a misguided trade policy if the intent is to promote longterm economic growth. Explain the reasons underlying this argument. Answer: Import substitution promotes that economic activity in which the country is relatively inefficient. This lowers the real income at any given time and decreases the resources which can be used for investment purposes, hence lower growth rates. An additional answer is that import substitution by creating a protected domestic market fails to provide incentives to produce high, or world-class quality-which means this country, cannot market in foreign countries. With such a (perceived) limited market, endogenous economic growth will not be forthcoming. Finally, it may be that exposure to world competition has its own dynamic effect promoting economic growth. Page Ref: 281-282 Difficulty: Moderate 11.3 Trade Liberalization Since 1985 1) The high correlation between rapid growth in exports and rapid economic growth observed in several East Asia countries in recent decades A) proves that export promoting trade policy leads to relatively rapid economic growth. B) proves that a free-trade orientation of trade policy results in rapid economic growth. C) proves that exports help growth, whereas imports impede growth. D) proves that trade policy is the most important policy area for promotion of economic development. E) does not prove that trade liberalization always leads to rapid economic growth. Answer: E Page Ref: 282-284 Difficulty: Easy 2) The relatively rapid economic growth experienced by Chile in the late 1980s A) supported the conventional Latin American reliance on import substitution. B) relied on the Harris-Todaro model to explain this growth. C) rejected the conventional Latin American reliance on import substitution. D) demonstrated the importance of market failure as a reason for import substitution. E) relied on high tariffs and import substitution. Answer: C Page Ref: 282-284 Difficulty: Easy 5 .

3) To help developing countries expand their industrial base, some industrial countries have reduced tariffs on designated manufactured imports from developing countries below the levels applied to imports from industrial countries. This policy is called A) export-led growth. B) generalized system of preferences. C) Most Favored Nation. D) reciprocal trade agreement. E) outsourcing. Answer: B Page Ref: 282-284 Difficulty: Easy 4) To help developing nations strengthen their international competitiveness, many industrial nations have granted tariff reductions to developing nations under the A) international commodity agreements program. B) multilateral contract program. C) generalized system of preferences program. D) export led growth program. E) import substitution policy. Answer: C Page Ref: 282-284 Difficulty: Easy 5) Export-led growth tends to A) discourage competition in the global economy. B) exploit domestic comparative advantages. C) lead to unemployment among domestic workers. D) help firms benefit from diseconomies of large-scale production. E) lower the overall volume of imports. Answer: B Page Ref: 282-284 Difficulty: Easy 6) An efficient economy would set the marginal product in the traditional sector A) lower than that in the modern non-traditional sector. B) higher than that in the modern sophisticated sector. C) equal to that in the modern sophisticated sector. D) lower in the relatively capital intensive sector. E) higher in the relatively capital intensive sector. Answer: C Page Ref: 282-284 Difficulty: Easy

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7) The experience of sub-Saharan Africa, as compared to that of "Other Asia" (not including the HPAEs) supports the argument that A) high rates of protection tend to harm economic growth. B) the poorer is the country the easier it is for it to "catch up" economically. C) low rates of protection tend to promote economic growth. D) free trade always best stimulates a developing country's economy. E) neither trade liberalization nor import substitution is a foolproof strategy for economic development. Answer: E Page Ref: 282-284 Difficulty: Easy 8) The experience of Chile's foreign sector in the last two decades of the 20th century supports the proposition that economic growth is supported by A) import substitution. B) industrialization policies. C) trade liberalization policies. D) intra-industry trading. E) trade embargoes. Answer: C Page Ref: 282-284 Difficulty: Easy 9) China's recent experience supports the proposition that A) "economic miracles" are solely to be expected in small countries. B) central planning and socialism can promote sustained economic growth. C) a lessening of income disparities is a prerequisite for economic growth. D) growth in a large country cannot be affected by its foreign sector. E) policy changed can dramatically prompt export oriented growth Answer: E Page Ref: 282-284 Difficulty: Easy 10) The consensus today is that import-substitution protectionist industrial policy has not served the developing countries' growth ambitions well. This fact proves that policies relying on exportdriven growth are the "winning ticket" for these countries. Answer: Although there are many who draw precisely this lesson from the " East Asian Miracle" of the past half-century, such a conclusion does not necessarily follow logically. Although the four HPAEs succeeded in their economic as well as in their export sector growth, they differed among themselves considerably in the degree and manner with which they abjured protectionist policies. In any case, export-promotion policies may distort relative prices to the same extent as import protectionist policies, and hence may lead to the same waste and misallocation of national resources. Page Ref: 282-284 Difficulty: Moderate

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11.4 Trade and Growth: Takeoff in Asia 1) Historically those few developing countries which have succeeded in significantly raising their per-capita income levels A) did not accomplish this with import-substituting industrialization. B) did accomplish this with import-substituting industrialization. C) tended to provide heavy protection to domestic industrial sectors. D) favored industrial to agricultural or service sectors. E) did so to the detriment of their nearest neighbors. Answer: A Page Ref: 284-287 Difficulty: Easy 2) Statistical evidence suggests that A) free trade policies promote economic growth more effectively than do import substitution policies. B) import substituting policies tend to promote effective exploitation of scale economies. C) import substitution tends to lead to relatively low effective rates of protection. D) import substitution is to this day the preferred growth strategy promoted by the World Bank. E) import substitution proved to be the most effective aid for developing countries before 1970. Answer: A Page Ref: 284-287 Difficulty: Easy 3) The growth successes of the high performance Asian economies A) supports the belief that economic development requires import substitution policies. B) rejects the belief that export-oriented industrialization is likely to promote economic development. C) rejects the belief that economic development requires import substitution policies. D) suggests that free trade policies are required for successful economic development. E) enforces United States' hesitation to trade with developing countries. Answer: C Page Ref: 284-287 Difficulty: Easy 4) Which industrialization policy used by developing countries places emphasis on the comparative advantage principle as a guide to resource allocation? A) export promotion B) import substitution C) international commodity agreements D) Infant Industry promotion E) intra-industry trade practice Answer: A Page Ref: 284-287 Difficulty: Easy

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5) Taiwan and South Korea are examples of developing nations that have recently pursued these industrialization policies A) import substitution. B) export promotion. C) commercial dumping. D) multilateral contract. E) trade embargoes. Answer: B Page Ref: 284-287 Difficulty: Easy 6) All the following nations except ________ have recently utilized export-led growth policies. A) Hong Kong B) South Korea C) Argentina D) Singapore E) Taiwan Answer: C Page Ref: 284-287 Difficulty: Easy 7) The development of countries like South Korea has been supported by all of the following EXCEPT A) high domestic interest rates. B) high domestic saving rates. C) large endowments of human capital. D) high levels of labor productivity. E) reduced government regulation. Answer: A Page Ref: 284-287 Difficulty: Easy 8) In 2003, the per-capita income in China was roughly ________ of that in the U.S. A) one hundredth B) one eighth C) one half D) the same as E) one twentieth Answer: B Page Ref: 284-287 Difficulty: Easy

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9) The "East Asian Miracle" is A) the ability of so many people to live in such small areas. B) the fact that so many Influenza varieties originate from this region. C) the fact that poor dualistic economies managed to escape the vicious circle of poverty. D) the ability to maintain large positive trade balances with the U.S. E) the advent of completely free labor mobility between east Asian countries. Answer: C Page Ref: 284-287 Difficulty: Easy 10) The HPAE (High Performance Asian Economies) countries A) have all consistently supported free trade policies. B) have all consistently maintained import-substitution policies. C) have all consistently maintained non-biased efficient free capital markets. D) have all maintained openness to international trade. E) have all outperformed the U.S. Answer: D Page Ref: 284-287 Difficulty: Easy 11) The remarkable success of the HPAEs proves that A) trade policy is the key to successful economic growth. B) trade policy is irrelevant to successful economic growth. C) high educational standards is the key to successful economic growth. D) dual economies must suffer economic stagnation. E) trade policy can lead to a higher standard of living for developing countries. Answer: E Page Ref: 284-287 Difficulty: Easy 12) The HPAE "economic miracle" illustrates a clear case in which A) exports and growth were positively related. B) exports were promoted by successful economic growth. C) economic growth was determined by successful export promotion. D) trade policy dominated other considerations in promoting economic growth. E) import substitution enhanced economic development. Answer: A Page Ref: 284-287 Difficulty: Easy

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13) The "East Asian Miracle" of the "Four Tigers" in the 1960s was replicated by A) developing countries around the world. B) other East Asian countries. C) Sub Sahara African countries. D) Industrialized countries. E) Eastern European countries. Answer: B Page Ref: 284-287 Difficulty: Easy 14) Classical and Neoclassical trade theory makes the case that free trade can bring a country to an optimum and economically efficient use of its resources; and hence is an optimal trade-policy, if the objective is maximizing long term economic growth. There are those who argue that the experience of the Asian Miracle countries, such as Taiwan, South Korea and Singapore verify this argument in the real world. Explain. There are others who argue that the experience of these countries cannot be used to verify or support the argument above. Explain. Answer: Both arguments may indeed be made. These countries did in fact tend to promote exports in a consistent set of policies. However, they tended to do this via conscious National industrial-policy (e.g., South Korea using "the Japanese system"), and hence (with the possible exception of Hong Kong) do not provide a good test-tube for the long run effects of a free-trade stance. Page Ref: 284-287 Difficulty: Moderate

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International Economics, 10e (Krugman/Obstfeld/Melitz) Chapter 12 Controversies in Trade Policy 12.1 Sophisticated Arguments for Activist Trade Policy 1) The existence of positive externalities due to the impossibility of full appropriability A) supports the conclusions of the Heckscher-Ohlin model. B) rejects the usefulness of government protectionism. C) supports the concept that the government should support only high-tech industries. D) provides support for government protectionism. E) supports arguments for free trade. Answer: D Page Ref: 290-299 Difficulty: Easy 2) The United States A) does not provide more support for R&D as compared to other forms of investment. B) provides support for R&D by imposing high tariffs on R&D intensive products. C) provides support for R&D by providing direct subsidies for such activities. D) provides support for R&D through tax legislation. E) provides support for R&D through grant incentives. Answer: D Page Ref: 290-299 Difficulty: Easy 3) The Brander-Spencer model identified market failure in certain industries due to A) unfair competition. B) wildcat destructive competition. C) environmental negative externalities associated with pollution. D) limited competition. E) lack of excess returns. Answer: D Page Ref: 290-299 Difficulty: Easy 4) In the Brander-Spencer model the subsidy raises profits by more than the subsidy because of A) the "multiplier" effect of government expenditures. B) the military-industrial complex. C) the forward and backward linkage effects of certain industries. D) the deterrent effect of the subsidy on foreign competition. E) the economies of scale once the company enters the market. Answer: D Page Ref: 290-299 Difficulty: Easy

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5) Criticisms of the Brander-Spencer model include all EXCEPT which of the following? A) the problem of insufficient information B) the problem of likely foreign retaliation C) the problem of harm to interests of consumers D) the problem of adverse effects of trade policy politics E) the problem of simultaneously causing harm to other industries Answer: C Page Ref: 290-299 Difficulty: Easy 6) Japan's protection of its semiconductor (RAM) producers is today seen as an object lesson in A) how strategic planning may backfire and cause a large waste of resources. B) how externalities may be successfully exploited by protectionist policies. C) how excess returns may be successfully exploited by protectionist policies. D) how government intervention may create a meaningful comparative advantage. E) how monopolies can outlast government intervention. Answer: A Page Ref: 290-299 Difficulty: Easy 7) The Heckscher-Ohlin, factor-proportions model lends support to the argument that A) trade tends to worsen the conditions of unskilled labor in rich countries. B) trade tends to worsen the conditions of owners of capital in rich countries. C) trade tends to worsen the conditions of workers in poor countries. D) trade tends to worsen the conditions of workers in rich countries. E) trade tends to worsen the conditions of highly skilled workers in rich countries. Answer: A Page Ref: 290-299 Difficulty: Easy 8) If firms in an industry are generating knowledge that other firms can use without paying for it, this industry is characterized by A) social costs that exceed private costs. B) social benefits that exceed private benefits. C) social costs that exceed social benefits. D) private benefits that exceed social benefits. E) social benefits that undermine private benefits. Answer: B Page Ref: 290-299 Difficulty: Easy

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9) It is argued that high-tech industries typically generate new technologies but cannot fully appropriate the commercial benefits associated with their inventions or discoveries. If this is true then in order to maximize a country's real income, the government should A) tax the high-tech firms. B) subsidize the high-tech firms. C) protect the high-tech firms. D) outsource high-tech production. E) discourage high-tech investments. Answer: B Page Ref: 290-299 Difficulty: Easy 10) In effect, the U.S. does subsidize high-tech firms by subsidizing R&D. This is done through A) the budget of the Department of Education. B) systematic protection through the levying of tariffs. C) systematic protection through the establishment of NTBs. D) relatively accelerated "depreciation" of R&D investment in the Federal tax codes. E) subsidies for high-tech firms. Answer: D Page Ref: 290-299 Difficulty: Easy 11) The best economic case one can make for an active industrial policy involves A) the national security argument. B) the technological spillover argument. C) the environment preservation argument. D) the high value added argument. E) raising the national income. Answer: E Page Ref: 290-299 Difficulty: Easy 12) Spencer and Brander's model highlights the existence of A) aircraft industries. B) excess returns present in highly competitive markets. C) excess returns, or rents, available in non-competitive markets. D) the futility of government bureaucrats' attempts to build an airplane. E) natural advantages in foreign technology firms. Answer: C Page Ref: 290-299 Difficulty: Easy

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13) Spencer and Brander's model highlights the conventional assumption that A) government involvement in business or in the economy tends to fail. B) government subsidies tend to waste taxpayer's money. C) government subsidies cannot create a successfully competing export. D) government tends to distort when it displaces Adam Smith's Invisible Hand. E) government subsidies can produce profits that exceed the subsidy's value. Answer: E Page Ref: 290-299 Difficulty: Easy 14) The reason Airbus succeeded in the Brander Spencer example is that A) Boeing made the first move in this strategic game. B) Europeans tend to be better strategists than corn-fed Americans. C) the Airbus actually was a better plane than the Boeing 747. D) U.S. laws actually prohibit U.S. exporters from bribing foreign officials. E) the subsidy removed the advantage that Boeing gained with their head start in production. Answer: E Page Ref: 290-299 Difficulty: Easy 15) The reason Airbus succeeded in the Brander Spencer example is that A) the European government made an explicit subsidy offer, but the U.S. government did not. B) Airbus' prices were better when adjusted for quality and warranty services. C) Boeing traditionally refused to undertake any exchange rate risk in its transactions. D) the U.S. acted in accordance with its ideological reliance on market solutions, whereas the Europeans ignored market and technological factors. E) the Airbus plane benefited from more advanced technology. Answer: A Page Ref: 290-299 Difficulty: Easy 16) The argument that strategic planning is not likely to be practical due to insufficient information means that A) because of trade secrets, the government does not know true cost relationships in any given industry. B) if the government had all the relevant information in a given industry then it could decide whether a subsidy would enhance the public's welfare. C) even if the government had all the relevant information in a given industry, it still could not decide whether a subsidy would enhance the public's welfare. D) due to recent cuts in the Department of the Census' sampling budgets, industry surveys are no longer reliable, so that there is no way to determine if a subsidy is in the public's interest. E) the government would need to employ its intelligence agencies in order to gain a complete understanding of the market. Answer: C Page Ref: 290-299 Difficulty: Easy 4 .

17) The invocation of beggar-thy-neighbor arguments with respect to industrial policies A) strengthens the argument for subsidies. B) makes sense if the international Keynesian multipliers exceed unity. C) applies only to rich countries most of whose trade partners are very poor countries. D) weakens the argument for subsidies. E) does not apply to rich countries who can influence relative world prices. Answer: D Page Ref: 290-299 Difficulty: Easy 18) When the WTO met in Seattle to initiate a further move towards free international trade, thousands of activists met A) in order to promote the WTO's goals of "Trade-not Aid." B) in order to laud the WTO policy orientation which would bust local monopolies and therefore help ordinary relatively poor consumers everywhere. C) in order to laud the WTO policy of disallowing government sweetheart deals, which typically meant that corrupt governments subsidized their in-laws' conglomerates on the backs of poor taxpayers. D) in order to support the WTO efforts of bringing about a universal shift of resources in poor countries to higher efficiency and productivity uses, which would raise the real incomes of everyone. E) in order to protest WTO free trade policies that they believed hurt workers. Answer: E Page Ref: 290-299 Difficulty: Easy 19) When one applies the Heckscher-Ohlin model of trade to the issue of trade-related income redistributions, one must conclude that North South trade, such as U.S.-Mexico trade A) must help low skill workers on both sides of the border. B) is likely to hurt high-skilled workers in the U.S. C) is likely to hurt low-skilled workers in the U.S. D) is likely to hurt low-skilled workers in Mexico. E) is likely to help highly skilled workers in Mexico. Answer: C Page Ref: 290-299 Difficulty: Easy 20) The evidence usually cited to prove that globalization hurts workers in developing countries A) is inconclusive due to poor statistical design of the underlying samples. B) is inconclusive due to the poorly funded Central Statistical Office of Mexico. C) is inconclusive due to the ambiguous theoretical implications of the findings. D) is conclusive. E) does not take into account the Heckscher-Ohlin model. Answer: C Page Ref: 290-299 Difficulty: Easy 5 .

21) The proposal that trade agreements should include a system which monitors worker conditions and make the results available to consumers in the rich importing country A) is consistent with the Invisible Hand paradigm. B) is consistent with the market failure approach. C) is consistent with the Ricardian theory of comparative advantage. D) is consistent with the scale economies approach to trade theory. E) is consistent with the principles laid out by the WTO. Answer: B Page Ref: 290-299 Difficulty: Easy 22) Labor standards in trade are typically opposed by most developing countries who believe that they will be used A) to further neo-imperialist colonial exploitation. B) to charge these countries with crimes against child-labor standards at the Hague. C) as a protectionist tool by import-competing producers in industrial countries. D) as a means of spreading U.S. Corporate Values and destroying local cultures. E) to hinder investment in foreign-based multinational corporations. Answer: C Page Ref: 290-299 Difficulty: Easy 23) The WTO seems at times to be interfering in domestic policy since A) the line between domestic policies and de factor protectionism is often fuzzy. B) it is a supra-national organization with the power to overturn governments. C) it determines which nations may trade what with whom. D) it punishes naughty nations. E) it exempts the U.S. and other powerful member nations from many of its edicts. Answer: A Page Ref: 290-299 Difficulty: Easy 24) It may be argued that Japan's explicit promotion of its microchip industry was an excellent example of successful industrial policy. What criteria would you apply to determine whether such a policy is or is not successful? Judging from your own stated criteria, was Japan's exercise successful? Why or why not? What information would a government require in order to increase the probability that its industrial policy would promote long term self-generated economic growth? Answer: It is argued that Japan's subsidies to its nascent microchip industry was an important factor in putting Japan on the world map in this area. However, a minimal criteria for a successful industrial policy would be that the infant industry mature, and that it prove to be a profitable area of the country's comparative advantage. In this case, one might argue that the latter part of the above statement was not fulfilled, since the microchip industry was adopted by so many countries, that it became a "commodity." That is, it became a product with a very low profit margin, which was not really a good use of Japan's resources, given their alternative uses. Page Ref: 290-299 Difficulty: Moderate 6 .

25) Refer to the above table. Suppose Airbus is set to produce the aircraft before Boeing. Which company will enter the market? Answer: Airbus will produce and Boeing will not. Page Ref: 290-299 Difficulty: Moderate 26) Refer to the above table. Suppose both governments offer their respective company a subsidy of $4(million). Answer: Only Airbus will produce since it knows that the subsidy would not be sufficiently large to entice Boeing to also enter the market. Page Ref: 290-299 Difficulty: Moderate 27) Refer to the above table. Suppose both governments offer their respective company a $10 million subsidy. Answer: Both companies would enter the market, since each knows that regardless of the other's decision, it will make some profit here. Page Ref: 290-299 Difficulty: Moderate 28) Refer to the above table. Suppose the U.S. government (but not Europe) offers a $10 million subsidy? Answer: In this case Airbus would decide not to enter the market since it knows Boeing will, and that therefore its own production will entail a loss of $5 million. Page Ref: 290-299 Difficulty: Moderate 29) Refer to the above table. How could the U.S. government justify its decision to offer a subsidy to a profitable and successful business? Answer: It could point out that this $10 million pump-priming expenditure results in a profit of $110 million. If Boeing paid a marginal income tax of 20%, this would net the government $55 million, which is more than 5 times the original subsidy, so that the decision may be justified not only in terms of benefit/cost considerations, but even in terms of pure budgetary terms. Page Ref: 290-299 Difficulty: Moderate

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12.2 Globalization and Low-Wage Labor 1) In today's world markets, poor developing countries tend to rely primarily on exports of A) agricultural products. B) primary products. C) mineral products. D) manufactured products. E) high-tech products. Answer: D Page Ref: 299-305 Difficulty: Easy 2) In the second half of the 1990s a rapidly growing movement focused on the harm caused by international trade to A) land owners in poor countries. B) capital owners in rich industrialized countries. C) land owners in rich industrialized countries. D) production workers in both rich and poor countries. E) terms of trade in developing countries. Answer: D Page Ref: 299-305 Difficulty: Easy 3) The Ricardian model of comparative advantage lends support to the argument that A) trade tends to worsen the conditions of unskilled labor in rich countries. B) trade tends to worsen the conditions of owners of capital in rich countries. C) trade tends to worsen the conditions of workers in poor countries. D) trade tends to worsen the conditions of workers in rich countries. E) trade is mutually beneficial to the countries that engage in it. Answer: E Page Ref: 299-305 Difficulty: Easy 4) Most developing countries oppose including labor standards in trade agreements because A) they believe this would involve a loss of their national sovereignty. B) they believe this would limit their ability to export to rich markets. C) they believe this would create an uneven playing field. D) multinational corporations control them. E) they do not want to improve wages for their workers. Answer: B Page Ref: 299-305 Difficulty: Easy

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5) When Japan's MITI (Ministry of International Trade and Industry) focused resources on the semiconductor industry, and in particular on Random Access Memory (RAM), it was viewed as a typically successful Japanese foray into a new dynamic strategic sector. The results, as viewed by the late 1990s A) justified this view. B) led to similar structuring of industrial policy in the U.S. C) lent support to the Brander-Spencer model. D) helped shift the focus of economists away from Japanese-style industrial policy. E) propelled Japan into the leading country in high-tech manufacturing. Answer: D Page Ref: 299-305 Difficulty: Easy 6) Low wages and poor working conditions in many U.S. trade partners A) prove that the gains-from-trade arguments of the Ricardian model are false. B) may be a fact of life, but economists don't care. C) are facts emphasized by U.S. labor in its contract negotiations. D) prove that the gains-from-trade arguments of the Ricardian model are true. E) prove that international trade is exploitative. Answer: C Page Ref: 299-305 Difficulty: Easy 7) The fact that articles of clothing sold in Walmart are produced by very poorly paid workers in Honduras, is a fact that if taken into account A) would prove to economists that the Ricardian model of comparative advantage is false. B) would prove to economists that the equal-value in trade concept summed up in the trade triangles is incorrect. C) proves to economists that trade is a negative sum game. D) proves to the Anti-Globalization Movement that trade is a negative sum game. E) proves that corporations are exempt from labor standards. Answer: D Page Ref: 299-305 Difficulty: Easy 8) Faced with the evidence of poor working conditions and low wages in the border maquiladoras, economists A) shrug their shoulders and ignore the issue. B) agree that trade theory is thus proven hollow and internally inconsistent. C) argue that U.S. consumers should not consume lettuce. D) argue that the poor conditions and low wages are actually improvements for the Mexican workers, and may be cited as gains-from-trade. E) argue that Mexico's generally high overall productivity offsets these conditions. Answer: D Page Ref: 299-305 Difficulty: Easy 9 .

9) The shipbreakers of Alang are A) a metaphysical representation of the WTO, deriving from Edgar Rice Burroughs' Princess of Mars. B) an early version of the Russian Ice-breaker of the Dnieper-Alang class. C) a capital-intensive industry. D) competing with pollution-producing industries in countries outside of India. E) doing environmentally conscious work. Answer: D Page Ref: 299-305 Difficulty: Easy 10) The Shipbreakers of Alang utilize much labor and little capital, thereby supporting the applicability of the A) factor proportions explanation of the sources of comparative advantage. B) specific factor theory of comparative advantage. C) monopolistic competition theory of comparative advantage. D) scale economies theory of comparative advantage. E) basis of the non-dumping legislation. Answer: A Page Ref: 299-305 Difficulty: Easy 11) The Shipbreakers of Alang arouse the ire of Greenpeace because of A) India's non-repentant nuclear stance. B) India's import-competing industrialization policies. C) the difficulty of avoiding ship accidents between Greenpeace's sailboat and the reconstructed Container ships of Alang. D) the large amount of pollution associated with the operations at Alang. E) their competition with capital-intensive industries. Answer: D Page Ref: 299-305 Difficulty: Easy 12) The Shipbreakers of Alang represent a perfect example of how a developing country can apply the principles of the Heckscher-Ohlin model, since A) shipbreaking is generally considered to be a capital-intensive operation and India, being a large country has much capital. B) shipbreaking is a labor-intensive operation in India, and India has many workers since it is such a large country. C) shipbreaking is a labor-intensive operation in India, and India's availability of capital per worker is less than that of its trade partners. D) shipbreaking is a capital-intensive operation elsewhere in the world, and therefore represents a case of a factor intensity reversal. E) India's climate lends itself to the work involved in shipbreaking. Answer: C Page Ref: 299-305 Difficulty: Easy 10 .

13) When one applies the Heckscher-Ohlin model of trade to the issue of trade-related income redistributions, one must conclude that North South trade, such as U.S.-Mexico trade, A) must help low skill workers on both sides of the border. B) is likely to hurt high-skilled workers in the U.S. C) is likely to involve higher overall national economic gains that will be greater than any harm done to low-skilled workers in the U.S. D) is likely to hurt low-skilled workers in Mexico. E) gives no advantage to the workers in either country. Answer: C Page Ref: 299-305 Difficulty: Easy 14) Working conditions for clothing workers in Bangladesh are very poor. If countries refuse to buy clothing from Bangladesh in order to encourage change, the effect is likely to be that A) firms will be forced to comply and workers will be better off. B) firms will refuse to comply, but workers will be better off. C) firms will try to comply and workers will be worse off. D) firms will try to comply and workers will be better off. E) regardless of how firms respond, workers will be better off. Answer: C Page Ref: 299-305 Difficulty: Easy 12.3 Globalization and the Environment 1) Free trade and globalization is generally believed A) to cause a degradation in the world's environment. B) to improve the environment by correcting for distortions caused by import competing policies. C) to help spread the best of each country's culture, so as to uplift global cultural standards. D) to help each country safeguard the best of its own culture. E) to make no difference in the economic welfare of the world. Answer: A Page Ref: 305-310 Difficulty: Easy 2) It is still the conventional wisdom in the U.S. that compliance with NAFTA requirements is having a deleterious effect on U.S. highway safety standards, on U.S. pollution and other environmental standards, and on U.S. jobs. What facts would proponents of an expansion of NAFTA (e.g., to include all of Central and South American countries) need to marshall in order to convince you? Answer: The answer is subjective. Presumably the answer should include reasonable and objective counter-factual scenarios (what would be the job or pollution situation with and without NAFTA). Page Ref: 305-310 Difficulty: Moderate 11 .

3) Describe the environmental Kuznets curve. Answer: This curve shows the effect of increased per capita income on environmental damage. It has an inverted U shape that indicates that increased per capita income first increases and then decreases environmental damage. Page Ref: 305-310 Difficulty: Moderate 4) What is a pollution haven? Answer: A pollution haven is a country with relatively lax environmental standards or enforcement. In effect, countries with strict standards export activities that pose high environmental risks to countries that are willing to accept the risks. Page Ref: 305-310 Difficulty: Moderate

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International Economics, 10e (Krugman/Obstfeld/Melitz) Chapter 13 (Finance Ch 2) National Income Accounting and the Balance of Payments 13.1 The National Income Accounts 1) A country's gross national product (GNP) is A) the value of all final goods and services produced by its factors of production and sold on the market in a given time period. B) the value of all intermediate goods and services produced by its factors of production and sold on the market in a given time period. C) the value of all final goods produced by its factors of production and sold on the market in a given time period. D) the value of all final goods and services produced by its factors of production and sold on the market. E) the value of all final goods and services produced by its factors of production, excluding land, and sold on the market in a given time period. Answer: A Page Ref: 313-318 Difficulty: Easy 2) For most macroeconomists A) national income accounts and national output accounts are equal to each other. B) national income accounts exceed national output accounts. C) national output accounts exceed national income accounts. D) it is impossible to tell whether national income accounts equal to national output accounts. E) national income accounts is much more important than national output accounts. Answer: A Page Ref: 313-318 Difficulty: Easy 3) For most macroeconomists A) gross national income and gross national product are the same. B) gross national income exceeds gross national product. C) gross national product exceeds gross national product. D) it is hard to tell whether gross national income equal gross national product. E) gross national product is much more important than gross national income. Answer: A Page Ref: 313-318 Difficulty: Easy

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4) The highest component of GNP is A) the current account. B) investment. C) government purchases. D) consumption. E) trade. Answer: D Page Ref: 313-318 Difficulty: Easy 5) An example of how GNP accounts for services provided by foreign-owned capital (and GDP does not) is A) earnings of a Spanish factory with British owners counts only in Spain's GDP. B) earnings of a Spanish factory with British owners counts only in Britain's GNP. C) earnings of a Spanish factory counts in Spain's GNP but are part of Britain's GDP. D) earnings of a Spanish factory counts in Spain's GDP but are part of Britain's GNP. E) earnings of a Spanish factory counts in Spain's GNP but not in Britain's GDP or GNP. Answer: D Page Ref: 313-318 Difficulty: Easy 6) The sale of A) a used textbook does enter GNP. B) a used textbook does not enter GNP, but the sale of a used house does. C) both a used textbook and a used house do not enter GNP. D) a used house does not enter GNP, but the sale of a used book does. E) the GNP does not include sale of used items priced below $1000. Answer: C Page Ref: 313-318 Difficulty: Easy 7) Which one of the following statements is the MOST accurate? A) The sale of a used textbook does generate income for factors of production. B) The sale of a used textbook does not generate income for any factor of production. C) The sale of a used textbook sometimes does and sometimes does not generate income for factors of production. D) It is hard to tell whether a sale of a used textbook does or does not generate income for factors of production. E) The sale of a used textbook is a part of the GNP. Answer: B Page Ref: 313-318 Difficulty: Easy

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8) Which one of the following statements is the MOST accurate? A) GNP plus depreciation is called net national product (NNP). B) GNP less depreciation is called net national product (NNP). C) GNP less depreciation is called net factor product (NFP). D) GDP plus depreciation is called net national product (NNP). E) GDP less depreciation is called net national product (NNP). Answer: B Page Ref: 313-318 Difficulty: Easy 9) National income equals GNP A) less depreciation, less net unilateral transfers, less indirect business taxes. B) less depreciation, plus net unilateral transfers, plus indirect business taxes. C) less depreciation, less net unilateral transfers, plus indirect business taxes. D) plus depreciation, plus net unilateral transfers, less indirect business taxes. E) less depreciation, plus net unilateral transfers, less indirect business taxes. Answer: E Page Ref: 313-318 Difficulty: Easy 10) The United States began to report its gross domestic product (GDP) only since A) 1900. B) 1921. C) 1931. D) 1941. E) 1991. Answer: E Page Ref: 313-318 Difficulty: Easy 11) GDP is supposed to measure A) the volume of production within a country's borders. B) the volume of services generated within a country's borders. C) the volume of production of a country's output. D) GNP plus depreciation. E) net unilateral transfers from foreigners. Answer: A Page Ref: 313-318 Difficulty: Easy

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12) GNP equals GDP A) minus net receipts of factor income from the rest of the world. B) plus receipts of factor income from the rest of the world. C) minus receipts of factor income from the rest of the world. D) plus net receipts of factor income from the rest of the world. E) minus depreciation. Answer: D Page Ref: 313-318 Difficulty: Easy 13) Movements in GDP A) and GNP usually do not differ greatly. B) and GNP usually do not differ greatly, as a practical matter. C) and GNP usually do differ greatly. D) are usually smaller than those of GNP movements, in practice. E) are inversely proportional to movements in GNP. Answer: B Page Ref: 313-318 Difficulty: Easy 14) In 2006, the United States had A) a surplus in the current account. B) a balance in the current account. C) a deficit in the current account. D) From 2006 data, it is too difficult to determine whether a surplus or a deficit existed in the current account. E) a positive balance of net financial flows. Answer: C Page Ref: 313-318 Difficulty: Easy 15) Net unilateral transfers A) are part of a national income. B) are part of a country's product. C) must be added to NNP in calculations of national income. D) are part of a country's GNP. E) Only A and C. Answer: E Page Ref: 313-318 Difficulty: Easy

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16) GDP is different than GNP in that A) it accounts for net unilateral transfers. B) it does not account for indirect business taxes. C) it does not account for a country's production using services with foreign-owned capital. D) it accounts for depreciation. E) it is unhelpful when tracking national income. Answer: C Page Ref: 313-318 Difficulty: Easy 17) What are the main aspects of economic life that macroeconomics analysis is most concerned with? Answer: There are four main aspects: unemployment, saving, trade imbalances, and money and the price level. Page Ref: 313-318 Difficulty: Easy 18) What can you learn from the figure below (Figure 13-1 from the text) which depicts the U.S. GNP and its components for the year 2009?

Answer: The highest component of GNP is consumption and the U.S. has a negative current balance. Page Ref: 313-318 Difficulty: Easy

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13.2 National Income Accounting for an Open Economy 1) Movements in GDP A) differ greatly from movements in GNP. B) do not differ greatly from movements in GNP. C) are not allowed to differ at all from movements in GNP by definition. D) need to be inflation adjusted in order to match movements in GNP. E) are not relevant to an examination of national income. Answer: B Page Ref: 318-326 Difficulty: Easy 2) Purchases of inventories by A) firms are not counted in investment spending. B) firms are also counted in investment spending. C) households are also counted in investment spending. D) households and Firms are also counted in investment spending. E) foreign consumers are counter in investment spending. Answer: B Page Ref: 318-326 Difficulty: Easy 3) In open economies A) saving and investment are necessarily equal. B) as in a closed economy, saving and investment are not necessarily equal. C) saving and investment are not necessarily equal as they are in a closed economy. D) saving and investment are necessarily equal contrary to the case of a closed economy. E) investment always refers to the domestic stock market. Answer: C Page Ref: 318-326 Difficulty: Easy 4) Investment is usually A) more variable than consumption. B) less variable than consumption. C) as variable as consumption. D) It is hard to tell from the data whether investment is more or less variable than consumption. E) a larger component of the GNP than consumption. Answer: A Page Ref: 318-326 Difficulty: Easy

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5) Government purchases are defined as A) only goods purchased by federal, state, or local governments. B) all goods and services purchased by the federal government. C) all goods and services purchased by the federal or state government. D) all goods and services purchased by the federal, state, or local government. E) goods and services purchased from the government. Answer: D Page Ref: 318-326 Difficulty: Easy 6) Government transfer payments like social security and unemployment benefits are A) included in government purchases. B) not included in government purchases. C) not included in government purchases, but they are included in the consumption component of GNP. D) not included in government purchases, but they are part of the investment component of GNP. E) included in government purchases but not in the GNP. Answer: B Page Ref: 318-326 Difficulty: Easy 7) In 1929, government purchases accounted for A) only 18.5 percent of U.S. GNP. B) only 8.5 percent of U.S. GNP. C) 28.5 percent of U.S. GNP. D) 38.5 percent of U.S. GNP. E) 48.5 percent of U.S. GNP. Answer: B Page Ref: 318-326 Difficulty: Easy 8) Which one of the following expressions is the MOST accurate? A) CA = EX - IM B) CA = IM - EX C) CA = EX = IM D) CA = EX + IM E) CA - IM = EX Answer: A Page Ref: 318-326 Difficulty: Easy

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9) A country's current account A) balance equals the change in its net foreign wealth. B) balance equals the change in its foreign wealth. C) surplus equals the change in its foreign wealth. D) deficit equals the change in its foreign wealth. E) balance equals its GNP. Answer: A Page Ref: 318-326 Difficulty: Easy 10) The CA is equal to A) Y - (C - I + G). B) Y + (C + I + G). C) Y - (C + I + G). D) Y - (C + I - G). E) Y + (C - I - G). Answer: A Page Ref: 318-326 Difficulty: Easy 11) Which of the following is TRUE? A) A country with a current account surplus is earning more from its exports than it spends on imports. B) A country could finance a current account deficit by using previously accumulated foreign wealth to pay for its imports. C) A country with a current account deficit must be increasing its net foreign debts by the amount of the deficit. D) We can describe the current account surplus as the difference between income and absorption. E) All of the above are true of current account balances. Answer: E Page Ref: 318-326 Difficulty: Easy 12) Over the 1980s A) there is no question that a large increase in U.S. foreign assets did occur. B) there is a question whether a large decrease in U.S. foreign assets did occur. C) there is no question that a large decrease in U.S. foreign assets did occur. D) there is no question that there was almost no change in U.S. foreign assets. E) there is no question that rising exports exceeded U.S. foreign debt. Answer: C Page Ref: 318-326 Difficulty: Easy

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13) In a closed economy, national saving A) sometimes equals investment. B) always equals investment. C) is always less than investment. D) is always more than investment. E) is never equal to investment. Answer: B Page Ref: 318-326 Difficulty: Easy 14) For open economies, A) S = I. B) S = I + CA. C) S = I - CA. D) S > I + CA. E) S < I + CA. Answer: B Page Ref: 318-326 Difficulty: Easy 15) An open economy A) can save only by building up its capital stock. B) can save only by acquiring foreign wealth. C) cannot save either by building up its capital stock or by acquiring foreign wealth. D) can save either by building up its capital stock or by acquiring foreign wealth. E) can save by avoiding excessive imports. Answer: D Page Ref: 318-326 Difficulty: Easy 16) A closed economy A) can save either by building up its capital stock or by acquiring foreign wealth. B) can save only by building up its capital stock. C) can save only by acquiring foreign wealth. D) cannot save either by building up its capital stock or by acquiring foreign wealth. E) can save by avoiding excessive imports. Answer: B Page Ref: 318-326 Difficulty: Easy

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17) Disposable income is National income A) less taxes collected from households and firms by the government. B) plus net taxes collected from households and firms by the government. C) less net taxes collected from firms by the government. D) less net taxes collected from households by the government. E) less net taxes collected from households and firms by the government. Answer: E Page Ref: 318-326 Difficulty: Easy 18) Government savings, A) T - G. B) T + G. C) T = G. D) T + G - I. E) T - G = I. Answer: A Page Ref: 318-326 Difficulty: Easy

, is equal to

19) Which of the following is FALSE about private savings and government savings? A) SP = Y - T - C B) Unlike private saving decisions, government saving decisions are often made with an eye toward their effect on output and employment. C) Total savings (S) = SP + . D) The national income identity can help us to analyze the channels through which government saving decisions influence macroeconomic conditions. E) None of the above; all statements are true. Answer: E Page Ref: 318-326 Difficulty: Easy 20) In a closed economy, private saving, A) I - (G - T). B) I + (G - T). C) I + (G + T). D) I - (G + T). E) I + (G - T) + C. Answer: B Page Ref: 318-326 Difficulty: Easy

, is equal to

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21) In an open economy, private saving, A) I - CA + (G - T). B) I + CA - (G - T). C) I + CA + (G - T). D) I - CA - (G - T). E) I + CA + (G + T). Answer: C Page Ref: 318-326 Difficulty: Easy

, is equal to

22) Ricardian equivalence argues that when the government cuts taxes and raises its deficit, A) consumers anticipate that they will face lower taxes later to pay for the resulting government debt. B) consumers anticipate that they will higher services from the government. C) consumers anticipate that they will face higher taxes later to pay for the resulting government debt. D) consumers anticipate it will affect their future taxes, in general in the direction of lowering future taxes. E) consumers anticipate that the low tax rates will continue. Answer: C Page Ref: 318-326 Difficulty: Easy 23) Ricardian equivalence argues that when the government A) increases taxes and raises its deficit, consumers anticipate that they will face higher taxes later to pay for the resulting government debt, thus people will raise their own private saving to offset the fall in government saving. B) cuts taxes and decreases its deficit, consumers anticipate that they will face higher taxes later to pay for the resulting government debt, thus people will raise their own private saving to offset the fall in government saving. C) cuts taxes and raises its surplus, consumers anticipate that they will face higher taxes later to pay for the resulting government debt, thus people will raise their own private saving to offset the fall in government saving. D) cuts taxes and raises its deficit, consumers anticipate that they will face lower taxes later to pay for the resulting government debt, thus people will raise their own private saving to offset the fall in government saving. E) cuts taxes and raises its deficit, consumers anticipate that they will face higher taxes later to pay for the resulting government debt, thus people will raise their own private saving to offset the fall in government saving. Answer: E Page Ref: 318-326 Difficulty: Easy

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24) In the United States over the past fifty years, the fraction of GNP devoted to consumption has fluctuated in a range of about A) 42 to 49 percent. B) 32 to 39 percent. C) 22 to 29 percent. D) 82 to 89 percent. E) 62 to 70 percent. Answer: E Page Ref: 318-326 Difficulty: Easy 25) In the United States, (gross) investment has fluctuated between ________ of GNP in recent years. A) 2 and 12 percent B) 11 and 22 percent C) 22 and 32 percent D) 32 and 42 percent E) 42 and 52 percent Answer: B Page Ref: 318-326 Difficulty: Easy 26) Government purchases currently take up about A) 20 percent of U.S. GNP, and this share has not changed much since the late 1950s. B) 38 percent of U.S. GNP, and this share has not changed much since the late 1950s. C) 18 percent of U.S. GNP, and this share has been increasing since the late 1950s. D) 18 percent of U.S. GNP, and this share has been decreasing since the late 1950s. E) 25 percent of U.S. GNP, and this share has been decreasing since the late 1950s. Answer: A Page Ref: 318-326 Difficulty: Easy 27) The position of the United States current account balance in 2009 was A) lent over 6 percent of its GNP, resulting in a large current account surplus. B) borrowed over 9 percent of its GNP, leading to a large current account deficit. C) achieved a currant account balance of zero. D) borrowed over 10 percent of its GNP, leading to a large current account deficit. E) borrowed less then 5 percent of its GNP, leading to a large current account surplus. Answer: B Page Ref: 318-326 Difficulty: Easy

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28) Which one of the following statements is FALSE? A) The United States had accumulated substantial foreign wealth by the early 1980s. B) The 1980s witnessed a sustained current account deficit of proportions unprecedented in the twentieth century opened up. C) In 1987, the country became a net debtor to foreigners for the first time since World War I. D) U.S. foreign debt has continued to grow and now stands at 25 percent of GNP. E) The U.S. foreign debt was paid off in the 1990s, allowing the U.S. to attain a current account surplus. However, the deficit has returned in recent years. Answer: E Page Ref: 318-326 Difficulty: Easy 29) What is the national income identity for a closed economy? Answer: Y = C + I + G Page Ref: 318-326 Difficulty: Easy 30) What is the national income identity for an open economy? Answer: Y = C + I + G + EX - IM Page Ref: 318-326 Difficulty: Easy 31) Discuss the values of private saving in closed and open economies. Answer: In a closed economy, private saving, , is equals to, I + (G - T). In a open economy, private saving, , is equals to I + CA + (G - T). Open economy helps in extending the opportunities for private saving or dis-saving, or borrowing. Page Ref: 318-326 Difficulty: Moderate

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32) Discuss the effects of government deficits on the current account. Answer: A hard and difficult issue. During the Reagan administration, the creation of twin deficits, where by slashing taxes, government deficits increased, which was accompanied with increased current account deficits. Using the identity, CA = SP + Sg - I and Ricardian equivalence, which argues that an increase in the government deficit (by definition lowers ) will cause a roughly equal increase in SP to offset an expected tax hike in the future. Thus, for I constant, there is roughly no effect on the current account. However, government budget deficit may change both private savings and investment, thus avoiding a creation of the twin deficits. An example is the European countries reducing their budget deficits just prior to the introduction of the euro in January 1999. Now, under the "twin deficits: theory, one would have expected the EU's current account surpluses to increase. This has never happened. The main reason was sharp reduction in private saving rates. A good answer should discuss Ricardian equivalence that argues that when the government cut taxes and raises its deficit, consumers anticipate that they will face higher taxes later to pay for the resulting government debt. In anticipation, they raise their own private saving to offset the fall in government saving. In addition, one should mention wealth effect in anticipation of one Europe, assets prices increased, lowering private saving rates. Page Ref: 318-326 Difficulty: Difficult 33) Explain how government deficits fell yet current account surpluses remained the same in the EU prior to adopting the euro. Also explain this in the context of the "twin deficits" theory. Answer: Current accounts didn't change due to a sharp fall in the private saving rate, which declined by about 4 percent of output, almost as much as the increase in government saving. The behavior of private savers neutralized the government's efforts to raise national saving. The twin deficits theory, the idea of government deficit coupled with a sharply increased current account deficit, expects the EU's current account surplus sharply as a result of the fiscal change, which didn't work in this case. Page Ref: 318-326 Difficulty: Moderate 34) Explain the concept of Ricardian equivalence. Answer: This an economic theory of taxes and government deficits. It argues that when the government cuts taxes and raises its deficit, consumers anticipate higher taxes later to pay off the eventual government debt. Thus, they will raise their own private saving to offset the fall in government saving. Governments that lower their deficits will induce the private sector to lower its own saving. However, this doesn't hold in practice. Economists attribute only half of the decline in European private saving to Ricardian effects. Page Ref: 318-326 Difficulty: Moderate

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35) Assume: C = 40 + 0.8(Y - T) G = 10 I = 20 T = 0, where T are taxes. (a) Calculate Y at equilibrium. (b) Calculate C, I, and G at equilibrium. (c) Now assume, EX = 5 + 4EP /P IM = 10 + 0.1 (Y - T) - 3EP /P E=3 P = 1.5 P=2 Find equilibrium Y. Answer: (a) Y = C + I + G Y = 350 (b) C = 40 + 0.8 Y = 320 I = 20 G = 10 (c) Y = 269.1667 Page Ref: 318-326 Difficulty: Moderate

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36) Fill in the following table.

Answer:

Page Ref: 318-326 Difficulty: Moderate

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37) What can one learn from the following figure?

Answer: The figure shows the U.S. current account and net foreign wealth from 1977 until 2008. It shows that a string of current account deficits in the 1980s reduced America's net foreign wealth until, by the end 2008, the country had accumulated a substantial net foreign debt. In 1987 the country became a net debtor to foreigners for the first time since World War I. Page Ref: 318-326 Difficulty: Easy

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38) Assume: C = 50 + 0.6 (Y - T) G = 15 I = 15 T=2 (a) Calculate Y at equilibrium (b) Calculate C (c) Assume EX = 4 + 3EP /P IM = 8 + 0.1 (Y - T) - 2EP /P E=3 P =1 P = 1.5 Find equilibrium Y. Answer: (a) Y = C + I + G Y = 50 + 0.6(Y - 2 + 15 + 15) Y = 197 (b) C = 50 + 0.6 (197 - 2) = 117 (c) Y = 170 Page Ref: 318-326 Difficulty: Moderate

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39) Fill in the following table.

Answer:

Page Ref: 318-326 Difficulty: Moderate

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40) Fill in the following table.

Answer:

Page Ref: 318-326 Difficulty: Moderate 13.3 The Balance of Payments Accounts 1) Every international transaction automatically enters the balance of payments A) once either as a credit or as a debit. B) twice, once as a credit and once as a debit. C) once as a credit. D) twice, both times as debit. E) the times, once as a credit, onces as a debit, and once as an exchange. Answer: B Page Ref: 326-337 Difficulty: Easy

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2) The official settlements balance or balance of payments is the sum of A) the current account balance, the capital account balance, the non reserve portion of the financial account balance, the statistical discrepancy. B) the current account balance and the capital account balance. C) the current account balance, the capital account balance, the non reserve portion of the financial account balance. D) the current account balance and the non reserve portion of the financial account balance. E) the current account balance and the interest in all investments. Answer: A Page Ref: 326-337 Difficulty: Easy 3) An American buys a Japanese car, paying by writing a check on an account with a bank in New York. How would this be accounted for in the balance of payments? A) current account, a Japanese good import B) current account, a U.S. good import C) financial account, a U.S. asset import D) financial account, a U.S. asset export E) a current account as a U.S. good import and a financial account, a U.S. asset export Answer: E Page Ref: 326-337 Difficulty: Easy 4) The United States issues a $10,000 debt forgiveness to Argentina. How is this accounted for in the balance of payments? A) financial account, U.S. asset import B) current account, Argentina transfer payment C) current account, U.S. service export D) financial account, U.S. asset export E) current account, Argentina good import Answer: D Page Ref: 326-337 Difficulty: Easy 5) A U.S. citizen buys a newly issued share of stock in England, paying for his order with a check, which the British company deposits in its own U.S. bank account in New York. How is this transaction accounted for in the balance of payments? A) financial account, U.S. asset export B) current account, U.S. service import C) current account, British good export D) financial account, British asset import E) financial account, U.S. asset import Answer: A Page Ref: 326-337 Difficulty: Easy

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6) You travel to Paris and pay for a $100 dinner with your credit card. How is this accounted for in the balance of payments? A) current account, French service import B) current account, U.S. good export C) financial account, U.S. asset export D) financial account, U.S. asset import E) financial account, French asset export Answer: C Page Ref: 326-337 Difficulty: Easy 7) The German government carries out an official foreign exchange intervention in which it uses dollars held in an American bank to buy French currency from its citizens. How is this accounted for in the balance of payments? A) current account, French good export B) current account, German good import C) financial account, French asset export D) financial account, German asset export E) financial account, German asset import Answer: C Page Ref: 326-337 Difficulty: Easy 8) The earnings of a Spanish factory with British owners are A) counted in Spain's GDP. B) part of Britain's GNP. C) only counted in Britain's GDP. D) only part of Spain's GNP. E) counted in Britain's GDP and are a part of Spain's GNP. Answer: E Page Ref: 326-337 Difficulty: Easy 9) The services British capital provides in Spain are a service export from Britain A) therefore they are subtracted from British GDP in calculating British GNP. B) therefore they are added to Spanish GDP in calculating Spanish GDP. C) therefore they are added to British GDP in calculating British GNP. D) therefore they are added to Spanish GNP in calculating Spanish GDP. E) therefore they are subtracted from Spanish GNP. Answer: C Page Ref: 326-337 Difficulty: Easy

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10) Unilateral transfers between countries are A) long-term loans. B) only international gifts, never payments that do not correspond to the purchase of any good, service, or asset. C) part of the current account but not a part of national income. D) known for reducing the income of capital owners. E) the difference between Y and GNP if the identity Y = C + I + G + CA holds exactly. Answer: E Page Ref: 326-337 Difficulty: Easy 11) Which of the following statements about the central bank is TRUE? A) Only the central bank may hold foreign reserves and intervene officially in exchange markets. B) Central banks have little power to alter macroeconomic conditions. C) Today, central banks' reserves consist largely of gold. D) The Federal Reserve holds only a small level of official reserve assets other than gold. E) Central banks never inject money into the economy. Answer: D Page Ref: 326-337 Difficulty: Easy 12) How do we allocate statistical discrepancy among the current, capital, and financial accounts? A) We have no way of knowing exactly how to allocate this discrepancy. B) Depend on the degree of certainty by which we attribute to these accounts. C) Divide it evenly amongst the three accounts. D) Depend on the convention adopted by the specific financial institution. E) Statistical discrepancy signals human errors made when dealing with financial accounts. Answer: A Page Ref: 326-337 Difficulty: Easy 13) Which of the following is TRUE about current cost method and market value method? A) They are used by the BEA to place current values on foreign indirect investments. B) These methods lead to the same valuations. C) Based on the current cost method, the BEA's 2009 estimate of U.S. net foreign wealth was $2,737.86 billion. D) The current cost method is preferred by the BEA. E) Foreign direct investments of the U.S. are valued at their original purchase price. Answer: C Page Ref: 326-337 Difficulty: Moderate

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14) What types of international transactions are recorded in the balance of payment accounts? Answer: Three types: transactions that involve exports and imports of good and services; transactions that involve the purchase or sell of financial assets; and exports and imports of good and services; other activities resulting in transfer of wealth between countries which are recorded in the capital account. Page Ref: 326-337 Difficulty: Moderate 15) "The Balance of payments is always balances." Discuss. Answer: True. Every international transaction automatically enters the balance of payments twice, once as a credit and once as a debit. Current account + financial account + capital account = 0 Page Ref: 326-337 Difficulty: Easy 16) "The balance of payments is seldom in balance in practice." Discuss. Answer: True. The main reasons are due to the fact that data collected or received from different sources may differ in coverage, accuracy, and timing. In addition, data on services are not reliable as well as data from the financial account. Moreover, accurate measurements of international interest and dividend receipts are particularly difficult. Page Ref: 326-337 Difficulty: Easy 17) How does an economy's central bank manage the supply of money through official reserve transactions? Answer: Official foreign exchange interventions are a way for the central bank to inject money into the economy or withdraw it from circulation. They can buy or sell international reserves in private asset markets in order to alter macroeconomic conditions without noticeably impacting the money supply. When a central bank purchases or sells a foreign asset, the transaction appears in its country's financial account as if a private citizen had carried out the same transaction. Page Ref: 326-337 Difficulty: Moderate 18) How can changes in the market price of wealth previously acquired alter a country's net foreign wealth? Answer: When Japan's stock market lost value in the 1990s, American and European owners of Japanese asset lost value in their claims, while Japan's net foreign wealth increased. Similarly, exchange rate changes can have this effect. When the dollar depreciates against foreign currency, foreigners who hold dollar assets will see their wealth fall when measured in their home currencies. Page Ref: 326-337 Difficulty: Moderate

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19) Discuss the two different methods the Bureau of Economic Analysis (BEA) uses to place current values on foreign direct investments. Answer: The current cost method values direct investments at the cost of buying them today. The market value method is meant to measure the price at which the investments could be sold. These two methods can lead to different valuations because the cost of replacing a particular direct investment and the price it would command if sold on the market may be hard to measure. Page Ref: 326-337 Difficulty: Moderate 20) Consider how the United States balance of payments accounts are affected when U.S. banks forgive two billion in debt owed to them by the government of Argentina. Answer: In this case, the United States makes a two billion dollars capital transfer to Argentina, which should appear as a negative two billions entry in the capital account. The associated credit is in the financial account, in the form of a two billion dollars reduction in U.S. assets held abroad, i.e., a net asset "export," and therefore a positive balance of payments entry. Page Ref: 326-337 Difficulty: Moderate 21) What can one learn from Figure 13-3 from the text, shown below?

Answer: This figure shows that since the 1980s, United States foreign assets and liabilities have both increased rapidly. However, liabilities have risen faster than assets, resulting in a substantial net foreign debt. Page Ref: 326-337 Difficulty: Easy

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International Economics, 10e (Krugman/Obstfeld/Melitz) Chapter 14 (3) Exchange Rates and the Foreign Exchange Market: An Asset Approach 14.1 Exchange Rates and International Transactions 1) How many dollars would it cost to buy an Edinburgh Woolen Mill sweater costing 50 British pounds if the exchange rate is 1.25 dollars per one British pound? A) 50 dollars B) 60 dollars C) 70 dollars D) 62.5 dollars E) 40 British pounds Answer: D Page Ref: 342-346 Difficulty: Easy 2) How many dollars would it cost to buy an Edinburgh Woolen Mill sweater costing 50 British pounds if the exchange rate is 1.50 dollars per one British pound? A) 50 dollars B) 60 dollars C) 70 dollars D) 80 dollars E) 75 dollars Answer: E Page Ref: 342-346 Difficulty: Easy 3) How many dollars would it cost to buy an Edinburgh Woolen Mill sweater costing 50 British pounds if the exchange rate is 1.80 dollars per one British pound? A) 40 dollars B) 90 dollars C) 50 dollars D) 100 dollars E) 95 dollars Answer: B Page Ref: 342-346 Difficulty: Easy 4) The Japanese currency is called the A) DM. B) Yen. C) Euro. D) Dollar. E) Pound. Answer: B Page Ref: 342-346 Difficulty: Easy 1 .

5) How many British pounds would it cost to buy a pair of American designer jeans costing $45 if the exchange rate is 1.50 dollars per British pound? A) 10 British pounds B) 20 British pounds C) 30 British pounds D) 35 British pounds E) 25 British pounds Answer: C Page Ref: 342-346 Difficulty: Easy 6) How many British pounds would it cost to buy a pair of American designer jeans costing $45 if the exchange rate is 1.80 dollars per British pound? A) 10 British pounds B) 25 British pounds C) 20 British pounds D) 30 British pounds E) 40 British pounds Answer: B Page Ref: 342-346 Difficulty: Easy 7) How many British pounds would it cost to buy a pair of American designer jeans costing $45 if the exchange rate is 2.00 dollars per British pound? A) 22.5 British pounds B) 32.5 British pounds C) 12.5 British pounds D) 40 British pounds E) 30 British pounds Answer: A Page Ref: 342-346 Difficulty: Easy 8) How many British pounds would it cost to buy a pair of American designer jeans costing $45 if the exchange rate is 1.60 dollars per British pound? A) 38.125 British pounds B) 28.125 British pounds C) 48.125 British pounds D) 58.125 British pounds E) 18.125 British pounds Answer: B Page Ref: 342-346 Difficulty: Easy

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9) What is the exchange rate between the dollar and the British pound if a pair of American jeans costs 50 dollars in New York and 100 Pounds in London? A) 1.5 dollars per British pound B) 0.5 dollars per British pound C) 2.5 dollars per British pound D) 3.5 dollars per British pound E) 2 dollars per British pound Answer: B Page Ref: 342-346 Difficulty: Easy 10) What is the exchange rate between the dollar and the British pound if a pair of American jeans costs 60 dollars in New York and 30 Pounds in London? A) 1.5 dollars per British pound B) 0.5 dollars per British pound C) 2.5 dollars per British pound D) 3.5 dollars per British pound E) 2 dollars per British pound Answer: E Page Ref: 342-346 Difficulty: Easy 11) When a country's currency depreciates A) foreigners find that its exports are more expensive, and domestic residents find that imports from abroad are more expensive. B) foreigners find that its exports are more expensive, and domestic residents find that imports from abroad are cheaper. C) foreigners find that its exports are cheaper; however, domestic residents are not affected. D) foreigners are not affected, but domestic residents find that imports from abroad are more expensive. E) foreigners find that its exports are cheaper and domestic residents find that imports from abroad are more expensive. Answer: E Page Ref: 342-346 Difficulty: Easy 12) An appreciation of a country's currency A) decreases the relative price of its exports and lowers the relative price of its imports. B) raises the relative price of its exports and raises the relative price of its imports. C) lowers the relative price of its exports and raises the relative price of its imports. D) raises the relative price of its exports and lowers the relative price of its imports. E) raises the relative price of its exports and does not affect the relative price of its imports. Answer: D Page Ref: 342-346 Difficulty: Easy

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13) Which one of the following statements is the MOST accurate? A) A depreciation of a country's currency makes its goods cheaper for foreigners. B) A depreciation of a country's currency makes its goods more expensive for foreigners. C) A depreciation of a country's currency makes its goods cheaper for its own residents. D) A depreciation of a country's currency makes its goods cheaper. E) An appreciation of a country's currency makes its goods more expensive. Answer: A Page Ref: 342-346 Difficulty: Easy 14) A(n) ________ of a nation's currency will cause imports to ________ and exports to ________, all other things held constant. A) depreciation; increase; decrease B) appreciation; decrease; increase C) depreciation; decrease; increase D) appreciation; increase; increase E) depreciation; decrease; decrease Answer: C Page Ref: 342-346 Difficulty: Easy 15) If the goods' money prices do not change, an appreciation of the dollar against the pound A) makes British sweaters cheaper in terms of American jeans. B) makes British sweaters more expensive in terms of American jeans. C) doesn't change the relative price of sweaters and jeans. D) makes American jeans cheaper in terms of British sweaters. E) makes British jeans more expensive in Britain. Answer: A Page Ref: 342-346 Difficulty: Easy 16) If the goods' money prices do not change, a depreciation of the dollar against the pound A) makes British sweaters cheaper in terms of American jeans. B) makes British sweaters more expensive in terms of American jeans. C) makes American jeans more expensive in terms of British sweaters. D) doesn't change the relative price of sweaters and jeans. E) makes British jeans more expensive in Britain. Answer: B Page Ref: 342-346 Difficulty: Easy

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17) In the year 2012, Shinzo Abe became prime minister of Japan, promising bold policies to improve Japan's economy. What was the focus of his policies and how did they affect Japan's trade position? Answer: What has been called "Abenomics" involved monetary policies designed to reduce the value of the Japanese Yen relative to other currencies. This resulted in increased exports and reduced imports, strengthening the Japanese economy. Page Ref: 342-346 Difficulty: Moderate 18) Based on the case study, "Exchange Rates, Auto Prices, and Currency Wars," explain why exchange rates are of critical importance to firms in the automobile industry, and how Japan has benefited from changes in the value of the Yen. Answer: See the discussion at the beginning of the chapter and in the case. Japan experienced a 15% drop in the value of the yen relative to the U.S. dollar in 2013. This increased Japanese exports of autos while reducing imports from the U.S. Page Ref: 342-346 Difficulty: Moderate

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19) Compute how many dollars it would cost to buy an Edinburgh Woolen Mill sweater costing 50 British pounds for the following exchange rates.

Answer:

Page Ref: 342-346 Difficulty: Easy

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20) Compute how many British pounds it would cost to buy a pair of American designer jeans costing $45.

Answer:

Page Ref: 342-346 Difficulty: Easy

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21) Find the exchange rate between the dollar and the British pounds for the following cases.

Answer:

Page Ref: 342-346 Difficulty: Moderate

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14.2 The Foreign Exchange Market 1) The largest trading of foreign exchange occurs in A) New York. B) London. C) Tokyo. D) Frankfurt. E) Singapore. Answer: B Page Ref: 346-352 Difficulty: Easy 2) Which of the following type of funds cater to wealthy individuals, are not bound by government regulations, and are actively traded in foreign exchange markets? A) pension funds B) mutual funds C) hedge funds D) exchange funds Answer: C Page Ref: 346-352 Difficulty: Easy 3) The future date on which the currencies are actually exchanged is called what? A) the value date B) the spot exchange date C) the two-day window D) the commitment date E) the forward exchange rate Answer: A Page Ref: 346-352 Difficulty: Easy 4) In 2010, about A) 20 percent of foreign exchange transactions involved exchanges of foreign currencies for U.S. dollars. B) 10 percent of foreign exchange transactions involved exchanges of foreign currencies for U.S. dollars. C) 30 percent of foreign exchange transactions involved exchanges of foreign currencies for U.S. dollars. D) 40 percent of foreign exchange transactions involved exchanges of foreign currencies for U.S. dollars. E) 85 percent of foreign exchange transactions involved exchanges of foreign currencies for U.S. dollars. Answer: E Page Ref: 346-352 Difficulty: Easy 9 .

5) Which one of the following statements is the MOST accurate? A) Spot exchange rates are always higher than forward exchange rates. B) Spot exchange rates are always lower than forward exchange rates. C) Spot exchange rates and forward exchanges rates are always equal. D) Spot exchange rates and forward exchanges rates are equal when the value date and the date of the spot transaction are the same. E) Spot exchange rates and forward exchange rates never move closely together. Answer: D Page Ref: 346-352 Difficulty: Easy 6) Forward and spot exchange rates A) are necessarily equal. B) do not move closely together. C) are always such that the forward exchange rate is higher. D) move closely together and are equal on the value date. E) are unrelated to the value date. Answer: D Page Ref: 346-352 Difficulty: Easy 7) A foreign exchange swap A) is a spot sale of a currency. B) is a forward repurchase of the currency. C) is a spot sale of a currency combined with a forward repurchase of the currency. D) is a spot sale of a currency combined with a forward sale of the currency. E) make up a negligible proportion of all foreign exchange trading. Answer: C Page Ref: 346-352 Difficulty: Easy 8) Nondeliverable forward exchange markets in centers such as Hong Kong and Singapore help to circumvent which problem? A) loss of goods shipped from Hong Kong and Singapore B) inconvertible currencies cannot be traded in foreign markets C) lag between the spot exchange date and the value date D) high travel costs from Asia to "traditional" foreign exchange markets E) unstable currencies that hold no purchasing power Answer: B Page Ref: 346-352 Difficulty: Easy

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9) The following is an example of Radio Shack hedging its foreign currency risk A) needing to pay 9,000 yen per radio to its suppliers in a month, Radio Shack makes a forwardexchange deal to buy yen. B) needing to pay 9,000 yen per radio to its suppliers in a month, Radio Shack makes a forwardexchange deal to sell yen. C) needing to pay 9,000 yen per radio to its suppliers in a month, Radio Shack buys yen at a spot-exchange 1 month from now. D) needing to pay 9,000 yen per radio to its suppliers in a month, Radio Shack sells yen at a spot-exchange 1 month from now. E) needing to pay 9,000 yen per radio to its suppliers in a month, Radio Shack sells yen in a forward-exchange deal. Answer: A Page Ref: 346-352 Difficulty: Easy 10) Which of the following is NOT an example of a financial derivative? A) forwards B) bonds C) swaps D) futures E) options Answer: B Page Ref: 346-352 Difficulty: Easy 11) Which major actor is at the center of the foreign exchange market? A) corporations B) central banks C) commercial banks D) non-bank financial institutions E) individual firms Answer: C Page Ref: 346-352 Difficulty: Easy 12) Which of the following is NOT a major actor in the foreign exchange market? A) corporations B) central banks C) commercial banks D) non-bank financial institutions E) tourists Answer: E Page Ref: 346-352 Difficulty: Easy

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13) By April 2010 A) only about 10 percent of foreign exchange trades were against euros. B) only about 24 percent of foreign exchange trades were against euros. C) only about 39 percent of foreign exchange trades were against euros. D) only about 42 percent of foreign exchange trades were against euros. E) only about 60 percent of foreign exchange trades were against euros. Answer: C Page Ref: 346-352 Difficulty: Easy 14) Which of the following statements is TRUE about a vehicle currency? A) It is widely used to denominate contracts made by parties who reside in the country that issues the vehicle currency. B) The dollar is sometimes called a vehicle currency because of its pivotal role in many foreign exchange deals. C) There is much skepticism that the euro will ever evolve into a vehicle currency on par with the dollar. D) The pound sterling, once second only to the dollar as a key international currency, is beginning to rise in importance. E) Vehicle currencies include nondeliverable currencies like the renminbi. Answer: B Page Ref: 346-352 Difficulty: Easy 15) The action of arbitrage is A) the process of buying a currency cheap and selling it dear. B) the process of buying a currency dear and selling it cheap. C) the process of buying and selling currency at the same price. D) the process of selling currency at different prices in different markets. E) the process of buying a currency and holding onto it to take it off the market. Answer: A Page Ref: 346-352 Difficulty: Easy 16) Futures contracts differ from forward contracts in that A) future contracts ensures you will receive a certain amount of foreign currency at a specified future date. B) future contracts bind you into your end of the deal. C) future contracts allow you to sell your contract on an organized futures exchange. D) future contracts are a disadvantage if your views about the future spot exchange rate are to change. E) futures contracts don't allow you to realize a profit of a loss right away. Answer: C Page Ref: 346-352 Difficulty: Easy

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17) Exxon Mobil wants to pay 160,000 to a German supplier. They get an exchange rate quotation from its own commercial bank and instructs it to debit their dollar account and pay 160,000 to the supplier's German account. If the exchange rate quoted is $1.2 per euro, how much is debited to Exxon Mobil's account? A) $160,000 B) $172,000 C) $180,000 D) $192,000 E) $150,000 Answer: D Page Ref: 346-352 Difficulty: Easy 18) Who are the major participants in the foreign exchange market? Answer: (1) Commercial banks (2) Corporations (3) Nonbank financial institutions (4) Central banks Page Ref: 346-352 Difficulty: Easy 19) Explain what is a "vehicle currency." Why is the U.S. dollar considered a vehicle currency? Answer: A vehicle currency is one that is widely used to denominate international contracts made by parties who do not reside in the country that issues the vehicle currency. Since in 2004, nearly 90 percent of foreign exchange transactions involve exchanges of foreign currencies for U.S. dollars; therefore, it is considered a vehicle currency. Page Ref: 346-352 Difficulty: Moderate 20) Explain the purpose of the following figure.

Answer: To show that spot and forward exchange rates are in general close to each other. Page Ref: 346-352 Difficulty: Easy

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21) Explain the purpose of the following figure 14-2 from the text in the context of the interest rates on the dollar and the Japanese Yen between 1980 and 2010.

Answer: Since the dollar and the Yen interest rates are not measured in comparable terms, they can move quite differently over time. Except for a period from 1990 to 1993 when the Yen interest rate was higher than the dollar, dollar interest rates have been higher than the Yen, indicating depreciation of the dollar against the Yen. Page Ref: 346-352 Difficulty: Easy 14.3 The Demand for Foreign Currency Assets 1) What is the expected dollar rate of return on euro deposits if today's exchange rate is $1.10 per euro, next year's expected exchange rate is $1.166 per euro, the dollar interest rate is 10%, and the euro interest rate is 5%? A) 10% B) 11% C) -1% D) 0% E) 15% Answer: B Page Ref: 352-361 Difficulty: Easy 2) What is the expected dollar rate of return on dollar deposits if today's exchange rate is $1.10 per euro, next year's expected exchange rate is $1.165 per euro, the dollar interest rate is 10%, and the euro interest rate is 5%? A) 10% B) 11% C) -1% D) 0% E) 15% Answer: A Page Ref: 352-361 Difficulty: Easy

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3) What is the expected dollar rate of return on euro deposits if today's exchange rate is $1.167 per euro, next year's expected exchange rate is $1.10 per euro, the dollar interest rate is 10%, and the euro interest rate is 5%? A) 10% B) 11% C) -1% D) 0% Answer: C Page Ref: 352-361 Difficulty: Easy 4) The dollar rate of return on euro deposits is A) approximately the euro interest rate plus the rate of depreciation of the dollar against the euro. B) approximately the euro interest rate minus the rate of depreciation of the dollar against the euro. C) the euro interest rate minus the rate of inflation against the euro. D) the rate of appreciation of the dollar against the euro. E) the euro interest rate plus the rate of inflation against the euro. Answer: A Page Ref: 352-361 Difficulty: Easy 5) If the dollar interest rate is 10 percent and the euro interest rate is 6 percent, then an investor should A) invest only in dollars. B) invest only in euros. C) be indifferent between dollars and euros. D) invest only in dollars if the exchange rate is expected to remain constant. E) invest only in euros if the exchange rate is expected to remain constant. Answer: D Page Ref: 352-361 Difficulty: Easy 6) If the dollar interest rate is 4 percent, the euro interest rate is 6 percent, then A) an investor should invest only in dollars. B) an investor should invest only in euros. C) an investor should be indifferent between dollars and euros. D) invest only in dollars if the exchange rate is expected to remain constant. E) invest only in euros if the exchange rate is expected to remain constant. Answer: E Page Ref: 352-361 Difficulty: Easy

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7) If the dollar interest rate is 10 percent, the euro interest rate is 6 percent, then A) an investor should invest only in dollars if the expected dollar depreciation against the euro is 4 percent. B) an investor should invest only in euros if the expected dollar depreciation against the euro is 4 percent. C) an investor should be indifferent between dollars and euros if the expected dollar depreciation against the euro is 4 percent. D) an investor should invest only in dollars. E) an investor should invest only in euros. Answer: C Page Ref: 352-361 Difficulty: Easy 8) If the dollar interest rate is 10 percent and the euro interest rate is 6 percent, then A) an investor should invest only in dollars if the expected dollar depreciation against the euro is 8 percent. B) an investor should invest only in euros if the expected dollar depreciation against the euro is 8 percent. C) an investor should be indifferent between dollars and euros if the expected dollar depreciation against the euro is 8 percent. D) an investor should invest only in dollars. E) an investor should invest only in euros. Answer: B Page Ref: 352-361 Difficulty: Easy 9) If the dollar interest rate is 10 percent, the euro interest rate is 12 percent, then A) an investor should invest only in dollars if the expected dollar appreciation against the euro is 4 percent. B) an investor should invest only in euros an investor should invest only in dollars if the expected dollar appreciation against the euro is 4 percent. C) an investor should be indifferent between dollars and euros an investor should invest only in dollars if the expected dollar appreciation against the euro is 4 percent. D) an investor should invest only in dollars. E) an investor should invest only in euros. Answer: A Page Ref: 352-361 Difficulty: Easy

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10) A the beginning of 2012, you pay $100 for a share of stock that then pays you a dividend of $1 at the beginning of 2013. If the stock price rises from $100 to $109 per share over the year, then you have earned an annual rate of return of A) 5 percent. B) 1 percent. C) 9 percent. D) 4 percent. E) 10 percent. Answer: E Page Ref: 352-361 Difficulty: Easy 11) What are the three factors that affect the demand for foreign currency? Answer: The three factors that affect the demand for foreign currency are expected return, risk and liquidity. Page Ref: 352-361 Difficulty: Easy 12) Explain risk and liquidity of assets. Answer: Risk is the variability an asset contributes to a savers' wealth. An asset's real return can be unpredictable and savers dislike this uncertainty if the return fluctuates widely. Liquidity refers to the ease with which an asset can be sold or exchanged for goods. Cash is the most liquid of assets because it is always acceptable at face value as payment for goods or other assets. Thus, savers consider an asset's liquidity and its expected return and risk in deciding how much of it to hold. Page Ref: 352-361 Difficulty: Moderate

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13) For the following 15 cases, compare the dollar rates of return on dollar and euro deposits.

Answer:

Page Ref: 352-361 Difficulty: Moderate 18 .

14) For the table below calculate the EXACT relationship.

Answer:

Page Ref: 352-361 Difficulty: Moderate 19 .

15) Assume that the euro interest rate is constant at 5 percent, and that the expected exchange rate is 1.05 dollars per one euro. Find the expected dollar return on euro deposits for the following cases.

Answer:

Page Ref: 352-361 Difficulty: Moderate

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16) Using the data in the table above, plot today's dollar/euro exchange rate against the expected dollar return on euro deposits. Answer:

Page Ref: 352-361 Difficulty: Moderate

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17) Determine for each, whether the interest parity condition holds or not, if

= 1.10

Answer:

Page Ref: 352-361 Difficulty: Moderate 14.4 Equilibrium in the Foreign Exchange Market 1) Which one of the following statements is the MOST accurate? A) Since dollar and yen interest rates are measured in comparable terms, they can move quite differently over time. B) Since dollar and yen interest rates are not measured in comparable terms, they can move quite differently over time. C) Since dollar and yen interest rates are measured in comparable terms, they move quite the same over time. D) Since dollar and yen interest rates are measured in comparable terms, they still move quite differently over time. E) Since dollar and yen interest rates are so similar, they move quite the same way over time. Answer: B Page Ref: 361-365 Difficulty: Easy

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2) Suppose that the one-year forward price of euros in terms of dollars is equal to $1.113 per euro. Further, assume that the spot exchange rate is $1.05 per euro, and the interest rate on dollar deposits is 10 percent and on euro it is 4 percent. Under these assumptions A) interest parity does not hold. B) interest parity does hold. C) it is hard to tell whether interest parity does or does not hold. D) Not enough information is given to answer the question. E) interest parity fluctuates. Answer: B Page Ref: 361-365 Difficulty: Easy 3) What is the interest parity condition? Answer: The condition that the expected returns on deposits of any two currencies are equal when measured in the same currency is called the interest parity condition. It implies that potential holders of foreign currency deposits view them as equally desirable assets, i.e. risk is assumed away. In notational forms: R$ = RE + (

- E$/E)/E$/E

Page Ref: 361-365 Difficulty: Easy 4) Explain why the interest parity condition must hold if the foreign exchange market is in equilibrium. Answer: The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return. Potential holders of foreign currency deposits view them all as equally desirable assets. If expected rate of return on any currency deposit is higher or lower than the other, there will exist an excess supply or demand for that currency because one will yield a higher return than the other. Page Ref: 361-365 Difficulty: Moderate

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5) Calculate the interest rate in the United States, if interest parity condition holds, for the following 15 cases.

Answer:

Page Ref: 361-365 Difficulty: Moderate

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6) Calculate the interest rate in the euro zone if interest parity condition holds, for the following 15 cases.

Answer:

Page Ref: 361-365 Difficulty: Moderate

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7) Assume the U.S. interest rate is 10 percent, and the interest rate on euro deposits is 5 percent. For the following exchange rates, find the forward exchange rates.

Answer: Using the covered interest rate parity will yield the second column in the table: F$/E = (R$ - RE) E$/E + E$/E

Page Ref: 361-365 Difficulty: Moderate

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8) Calculate the Expected Dollar Depreciation Rate against the euro and the expected dollar return on euro deposits if the expected exchange rate is $1.10 per euro.

Answer:

Page Ref: 361-365 Difficulty: Moderate 14.5 Interest Rates, Expectations, and Equilibrium 1) Which one of the following statements is the MOST accurate? A) A rise in the interest rate offered by dollar deposits causes the dollar to appreciate. B) A rise in the interest rate offered by dollar deposits causes the dollar to depreciate. C) A rise in the interest rate offered by dollar deposits does not affect the U.S. dollar. D) For a given euro interest rate and constant expected exchange rate, a rise in the interest rate offered by dollar deposits causes the dollar to appreciate. E) A rise in the interest rate offered by the dollar causes the euro to appreciate. Answer: D Page Ref: 366-370 Difficulty: Easy

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2) Which one of the following statements is the MOST accurate? A) For a fixed interest rate, a rise in the expected future exchange rate causes a rise in the current exchange rate. B) For a fixed interest rate, a rise in the expected future exchange rate causes a fall in the current exchange rate. C) For a fixed interest rate, a rise in the expected future exchange rate does not cause a change in the current exchange rate. D) For a given dollar interest rate and a constant expected exchange rate, a rise in the interest rate of the euro causes the dollar to depreciate. E) For a fixed interest rate, a fall in the expected future exchange rate causes a rise in the current exchange rate. Answer: A Page Ref: 366-370 Difficulty: Easy

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3) Discuss the effects of a rise in the dollar interest rate on the exchange rate. Answer: There are two effects to consider. A rise in the interest rate offered by dollar deposits combined with a constant expected exchange rate will cause the dollar to appreciate (see Figure 14-5 from the text). However, the expected exchange rate will likely change. As Figure 14-6 from the text shows, if the expected exchange rate increases, the dollar will depreciate.

Figure 14-5

Figure 14-6 Page Ref: 366-370 Difficulty: Moderate

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4) Discuss the effects of a rise in the interest rate paid by euro deposits on the exchange rate. Answer: There are two effects to consider. If we make the unrealistic assumption that the expected exchange rate will not change, then a rise in the interest rate paid by Euro deposits causes the dollar to depreciate. However, if the expected exchange rate were to rise, then the current exchange rate would also rise. (See Figure 14-6 from the text.)

Page Ref: 366-370 Difficulty: Moderate 5) Explain why (holding interest rates constant), a rise in the expected depreciation in a country's currency leads to depreciation of that currency today. Answer: A rise in the expected depreciation rate of the dollar raises the expected dollar return on euro deposits. Now, there are excess supply of dollar deposits (euro deposits offer higher expected rate of return than do dollar deposits). The dollar must depreciate to remove this excess supply. Page Ref: 366-370 Difficulty: Moderate

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6) Show graphically a drop in the interest rate paid by euro deposits. What is the effect on the dollar? Answer: A drop in the interest rate from R1$ to R2$ causes the dollar to depreciate from (point 2) to

(point 1). (See Figure 14-5 from the text.)

Page Ref: 366-370 Difficulty: Difficult

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7) Show graphically a drop in the interest rate offered by dollar deposits, R$, and the effect on the exchange rate, . Answer: A drop in the interest rate paid by euro deposits causes the dollar to appreciate from (point 2) to

(point 1). The expected future exchange rate also drops. (See Figure 14-6

from the text.)

Page Ref: 366-370 Difficulty: Difficult 14.6 Appendix to Chapter 14: Forward Exchange Rates and Covered Interest Parity 1) The covered interest rate parity condition can be stated as follows: The interest rate on dollar deposits equals the interest rate on euro deposits ________ the forward ________ on euros against dollars. A) plus; premium B) minus; premium C) plus; discount D) minus; discount E) times; premium Answer: A Page Ref: 376-378 Difficulty: Easy

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2) The covered interest rate parity condition can be stated as follows: The interest rate on dollar deposits equals the interest rate on euro deposits ________ the forward ________ on dollars against euros. A) plus; discount B) minus; premium C) plus; premium D) minus; discount E) times; premium Answer: A Page Ref: 376-378 Difficulty: Easy

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International Economics, 10e (Krugman/Obstfeld/Melitz) Chapter 15 (4) Money, Interest Rates, and Exchange Rates 15.1 Money Defined: A Brief Review 1) The exchange rate between currencies depends on A) the interest rate that can be earned on deposits of those currencies. B) the interest rate that can be earned on deposits of those currencies and the expected future exchange rate. C) the expected future exchange rate. D) national output. E) the interest rate that can be earned on deposits of those countries and the national output. Answer: B Page Ref: 379-381 Difficulty: Easy 2) Money serves as all of the following EXCEPT A) a medium of exchange. B) a unit of account. C) a store of value. D) a symbol that is made of or can be redeemed for a fixed amount of precious metal. E) a highly liquid asset. Answer: D Page Ref: 379-381 Difficulty: Easy 3) Money includes A) currency. B) checking deposits held by households and firms. C) deposits in the foreign exchange markets. D) currency and checking deposits held by households and firms. E) futures and deposits in the foreign exchange market. Answer: D Page Ref: 379-381 Difficulty: Easy 4) In the United States at the end of 2012, the total money supply, M1, amounted to approximately A) 16 percent of that year's GNP. B) 20 percent of that year's GNP. C) 30 percent of that year's GNP. D) 40 percent of that year's GNP. E) 50 percent of that year's GNP. Answer: A Page Ref: 379-381 Difficulty: Easy 1 .

5) What are the main functions of money? Answer: Money serves in general three important functions: a medium of exchange; a unit of account; and a store of value. As a medium of exchange, money avoids going back to a barter economy, with the enormous search costs connected with it. As a unit of account, the use of money economizes on the number of prices an individual faces. Consider an economy with N goods, then one needs only (N - 1) prices. As a store of value, the use of money in general ensures that you can transfer wealth between periods. Page Ref: 379-381 Difficulty: Moderate 15.2 The Demand for Money by Individuals 1) Individuals base their demand for an asset on A) the expected return the asset offers compared with the returns offered by other assets. B) the riskiness of the asset's expected return. C) the asset's liquidity. D) the expected return, how risky that expected return is, and the asset's liquidity. E) the aesthetic qualities of the asset. Answer: D Page Ref: 382-383 Difficulty: Easy 2) A family's summer house on Cape Cod pays a return in the form of A) interest rate. B) capital gains. C) the pleasure of vacations at the beach. D) stock options. E) capital gains and pleasure. Answer: E Page Ref: 382-383 Difficulty: Easy 3) In a world with money and bonds only A) it is not risky to hold money. B) it is risky to hold money. C) risk is an important factor in the demand for money. D) there is no relationship between risk and holding money. E) assets become meaningless. Answer: B Page Ref: 382-383 Difficulty: Easy

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4) Which one of the following statements is the MOST accurate? A) A rise in the average value of transactions carried out by a household or a firm causes its demand for money to fall. B) A reduction in the average value of transactions carried out by a household or a firm causes its demand for money to rise. C) A rise in the average value of transactions carried out by a household or a firm causes its demand for money to rise. D) A rise in the average value of transactions carried out by a household or a firm causes its demand for real money to rise. E) a decrease in the average value of transactions carried out by a household or a firm causes its demand for real money to rise. Answer: D Page Ref: 382-383 Difficulty: Easy 5) An individual's need for liquidity would increase if A) the average value of transactions carried out by the individual fell. B) the average value of transactions carried out by the individual rose. C) the individual got a raise. D) the individual received a new ATM card. E) the individual wanted to avoid risks. Answer: B Page Ref: 382-383 Difficulty: Easy 6) What are the factors that determine the amount of money an individual desires to hold? Answer: Three main factors: first, the expected return the asset offers compared with the returns offered by other assets; second, the riskiness of the asset's expected return; and third, the asset's liquidity. Page Ref: 382-383 Difficulty: Moderate 15.3 Aggregate Money Demand 1) The aggregate money demand depends on A) the interest rate. B) the price level. C) real national income. D) the interest rate, price level, and real national income. E) the price level and the liquidity of the asset. Answer: D Page Ref: 383-385 Difficulty: Easy

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2) If there is initially an A) excess demand for money, the interest rate will fall, and the supply of money it will rise. B) excess supply of money, the interest rate will fall, and if there is initially an excess demand, it will rise. C) excess supply of money, the interest rate will rise, and if there is initially an excess demand, it will fall. D) excess supply of money, the interest rate will fall, and if there is also an excess demand, it will fall rapidly. E) excess supply of money, the interest rate will rise, and if there is also an excess demand, it will rise rapidly. Answer: B Page Ref: 383-385 Difficulty: Easy 3) Which one of the following statements is the MOST accurate? A) A decrease in the money supply lowers the interest rate while an increase in the money supply raises the interest rate, given the price level and output. B) An increase in the money supply lowers the interest rate while a fall in the money supply raises the interest rate, given the price level. C) An increase in the money supply lowers the interest rate while a fall in the money supply raises the interest rate, given the output level. D) An increase in the money supply lowers the interest rate while a fall in the money supply raises the interest rate, given the price level and output. E) An increase in the money supply does not usually affect the interest rate. Answer: D Page Ref: 383-385 Difficulty: Easy 4) An increase in A) nominal output raises the interest rate while a fall in real output lowers the interest rate, given the price level and the money supply. B) real output decreases the interest rate while a fall in real output increases the interest rate, given the price level. C) real output raises the interest rate while a fall in real output lowers the interest rate, given the money supply. D) nominal output raises the interest rate while a fall in real output lowers the interest rate, given the price level. E) real output raises the interest rate while a fall in real output lowers the interest rate, given the price level and the money supply. Answer: E Page Ref: 383-385 Difficulty: Easy

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5) The aggregate demand for money can be expressed by A) Md = P × L(R,Y). B) Md = L × P(R,Y). C) Md = P × Y(R, L). D) Md = R × L(P,Y). E) Md = R × L(R, P). Answer: A Page Ref: 383-385 Difficulty: Easy 6) What are the main factors that determine aggregate money demand? Answer: The three main factors are interest rate, the price level and real national income. A rise in the interest rate causes individuals in the economy to reduce their demand for money. If the price level rises, individual households and firms will spend more money than before. When real national income (GNP) rises the demand for money will also rise. Page Ref: 383-385 Difficulty: Moderate 7) Explain why one can write the demand for money as the price level times a function of the interest rate and real income as follows: = PxL (R, Y) Answer: The aggregate money demand is proportional to the price level. Imagine that all prices in an economy doubled, but the interest rate and everyone's real incomes remained unchanged. Then, the money value of each individual's average daily transactions would simply double, as would the amount of money each wishes to hold. Page Ref: 383-385 Difficulty: Moderate 15.4 The Equilibrium Interest Rate: The Interaction of Money Supply and Demand 1) The aggregate real money demand schedule L(R,Y) A) slopes upward because a fall in the interest rate raises the desired real money holdings of each household and firm in the economy. B) slopes downward because a fall in the interest rate reduces the desired real money holdings of each household and firm in the economy. C) has a zero slope because a fall in the interest rate keeps constant the desired real money holdings of each household and firm in the economy. D) slopes downward because a fall in the interest rate raises the desired real money holdings of each household and firm in the economy. E) slopes downward because a rise in the interest rate makes consumers less focused on the liquidity of their assets. Answer: D Page Ref: 385-388 Difficulty: Easy

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2) For a given level of A) nominal GNP, changes in interest rates cause movements along the L(R,Y) schedule. B) real GNP, changes in interest rates cause a decrease of the L(R,Y) schedule. C) real GNP, changes in interest rates cause an increase of the L(R,Y) schedule. D) nominal GNP, changes in interest rates cause an increase in the L(R,Y) schedule. E) real GNP, changes in interest rates cause movements along the L(R,Y) schedule. Answer: E Page Ref: 385-388 Difficulty: Easy 3) The money supply schedule is A) horizontal because is set by the central bank while P is taken as given. B) horizontal because is set by the central bank. C) vertical because is set by the households and firms while P is taken as given. D) vertical because and P are set by the central bank. E) vertical because is set by the central bank while P is taken as given. Answer: E Page Ref: 385-388 Difficulty: Easy 4) If individuals are holding more money than they desire A) they will attempt to reduce their liquidity by using money to purchase goods. B) they will attempt to reduce their liquidity by using money to purchase interest-bearing assets. C) they will attempt to reduce their liquidity by converting real money holdings into nominal money holdings. D) they will keep their holdings constant. Answer: B Page Ref: 385-388 Difficulty: Easy 5) If there is an excess supply of money A) the interest rate falls. B) the interest rate rises. C) the real money supply shifts left to make an equilibrium. D) the real money supply shifts right to make an equilibrium. E) the interest rate stays constant, but consumer confidence falters. Answer: A Page Ref: 385-388 Difficulty: Easy

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6) A reduction in a country's money supply causes A) its currency to depreciate in the foreign exchange market. B) its currency to appreciate in the foreign exchange market. C) does not affect its currency in the foreign market. D) does affect its currency in the foreign market in an ambiguous manor. E) affects other countries currency in the foreign market. Answer: B Page Ref: 385-388 Difficulty: Easy 7) What will be the effects of an increase in the money supply on the interest rate? Answer: An increase in the money supply will cause interest rate to decrease. This should increase investment and possibly consumption of durable goods. The reduction in the interest rate will cause a depreciation of the dollar. Page Ref: 385-388 Difficulty: Moderate 8) What will be the effects of an increase in real output on the interest rate? Answer: An increase in real output will increase the interest rate. If investment depends only on interest rate, this will cause investment to go down. The increases interest rate will cause an appreciation of the dollar. Page Ref: 385-388 Difficulty: Moderate 15.5 The Money Supply and the Exchange Rate in the Short Run 1) An increase in a country's money supply causes A) its currency to appreciate in the foreign exchange market while a reduction in the money supply causes its currency to depreciate. B) its currency to depreciate in the foreign exchange market while a reduction in the money supply causes its currency to appreciate. C) no effect on the values of it currency in international markets. D) its currency to depreciate in the foreign exchange market while a reduction in the money supply causes its currency to further depreciate. E) its currency to depreciate in the domestic market and appreciate in the foreign market. Answer: B Page Ref: 389-394 Difficulty: Easy

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2) Which one of the following statements is the MOST accurate? A) Given PUS, when the money supply rises, the dollar interest rate declines and the dollar depreciates against the euro. B) Given YUS, when the money supply rises, the dollar interest rate declines and the dollar depreciates against the euro. C) Given PUS and YUS, when the money supply decreases, the dollar interest rate declines and the dollar depreciates against the euro. D) Given PUS and YUS, when the money supply rises, the dollar interest rate declines and the dollar appreciates against the euro. E) Given PUS and YUS, when the money supply rises, the dollar interest rate declines and the dollar depreciates against the euro. Answer: E Page Ref: 389-394 Difficulty: Easy 3) Given PUS and YUS A) An increase in the European money supply causes the euro to appreciate against the dollar, but it does not disturb the U.S. money market equilibrium. B) An increase in the European money supply causes the euro to appreciate against the dollar, and it creates excess demand for dollars in the U.S. money market. C) An increase in the European money supply causes the euro to depreciate against the dollar, and it creates excess demand for dollars in the U.S. money market. D) An increase in the European money supply causes the euro to depreciate against the dollar, but it does not disturb the U.S. money market equilibrium. E) An increase in the European money supply causes the euro to depreciate against the dollar, and disturbing the U.S. money market equilibrium. Answer: D Page Ref: 389-394 Difficulty: Easy 4) Analyze the effects of an increase in the European money supply on the dollar/euro exchange rate. Answer: The main points are: An increase in the European money supply will reduce the interest rate on the euro, and thus causes the euro to depreciates against the dollar. The U.S. money demand and money supply are not going to be affected, and thus the interest rate in the U.S. will remain the same. Page Ref: 389-394 Difficulty: Moderate

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5) Explain how the money markets of two countries are linked through the foreign exchange market. Answer: The monetary policy actions by the Fed affect the U.S. interest rate, changing the dollar/euro exchange rate that clears the foreign exchange market. The European System of Central Banks (ESCB) can affect the exchange rate by changing the European money supply and interest rate. Page Ref: 389-394 Difficulty: Moderate 6) What would be the effect of an increase in the European Money Supply in the Dollar Euro Exchange Rate? Answer: An increase in the European money supply lowers the dollar return on Euro deposits, i.e. the dollar appreciates against the Euro. There is no change in the US money market. Page Ref: 389-394 Difficulty: Moderate

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7) Using a figure describing both the U.S. money market and the foreign exchange market, analyze the effects of a temporary increase in the European money supply on the dollar/euro exchange rate. Answer: An increase in the European money supply will reduce the interest rate on the euro and thus will cause the schedule of the expected euro return expresses in dollars to shift down, causing a reduction in the dollar/euro exchange rate, i.e., an appreciation of the U.S. Dollar. The euro depreciates against the dollar. The U.S. money demand and money supply are not going to be affected, and thus the interest rate in the U.S. will remain the same.

Page Ref: 389-394 Difficulty: Moderate

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8) Using a figure describing both the U.S. money market and the foreign exchange market, analyze the effects of an increase in the U.S. money supply on the dollar/euro exchange rate. Answer: An increase in the U.S. money supply will cause interest rate to decrease. This should increase investment and possibly consumption of durable goods. The reduction in the interest rate will cause a movement to the left along the schedule depicting the expected euro return expressed in dollar. The result is an increase in E or a depreciation of the dollar.

Page Ref: 389-394 Difficulty: Moderate

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9) Explain the following figure.

Answer: The figure explains how the money markets of two countries are linked through the foreign exchange market. The monetary policy actions by the Fed affect the U.S. interest rate, changing the dollar/euro exchange rate that clears the foreign exchange market. The European System of Central Banks (ESCB) can affect the exchange rate by changing the European money supply and interest rate. Page Ref: 389-394 Difficulty: Moderate

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10) Combine a graph showing the interest parity condition and one showing money demand and supply to demonstrate simultaneous equilibrium in the money market and the foreign exchange market. How would an increase in the U.S. money supply affect the Dollar/Euro exchange rate and the U.S. interest rate? Illustrate your answer graphically and explain. Answer: Above the axis is depicted the foreign exchange market, where changes in the rate of return on the dollar are mapped into changes in the exchange rate. Below the axis is depicted the U.S. money market and shows the relation between the rate of return on the dollar and U.S. real money holdings. The mechanism works as follows. Consider an increase in the U.S. real money holdings. Supply and demand dictate that the demand for money must increase, so the rate of return must lower to equilibrate at point 2. The lower rate of return on the dollar will cause the dollar to depreciate (exchange rate moves to point ).

Page Ref: 389-394 Difficulty: Moderate

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15.6 Money, the Price Level, and the Exchange Rate in the Long Run 1) An economy's long-run equilibrium is A) the equilibrium that would occur if prices were perfectly flexible. B) the equilibrium that would occur if prices were perfectly flexible and always adjusted immediately. C) the equilibrium that would occur if prices were perfectly flexible and always adjusted immediately to preserve full employment. D) the equilibrium that would occur if prices were perfectly fixed to preserve full employment. E) the equilibrium that would occur if prices were perfectly fixed at the full employment point. Answer: C Page Ref: 394-397 Difficulty: Easy 2) A permanent increase in a country's money supply A) causes a more than proportional increase in its price level. B) causes a less than proportional increase in its price level. C) causes a proportional increase in its price level. D) leaves its price level constant in long-run equilibrium. E) causes an inversely proportional fall in its price level. Answer: C Page Ref: 394-397 Difficulty: Easy 3) A change in the level of the supply of money A) increases the long-run values of the interest rate and real output. B) decreases the long-run values of the interest rate and real output. C) has no effect on the long-run values of the interest rate, but may affect real output. D) has no effect on the long-run values of real output, but may affect the interest rate. E) has no effect on the long-run values of the interest rate and real output. Answer: E Page Ref: 394-397 Difficulty: Easy 4) Changes in the money supply growth rate A) are neutral in the short run. B) need not be neutral in the short run. C) are neutral in the long run. D) need not be neutral in the long run. E) affect the real output of the economy. Answer: D Page Ref: 394-397 Difficulty: Easy

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5) A sustained change in the monetary growth rate will A) immediately affect equilibrium real money balances by raising the money interest rate. B) eventually affect equilibrium nominal money balances by raising the money interest rate. C) eventually affect equilibrium real money balances by reducing the money interest rate. D) eventually affect equilibrium real money balances by raising the real interest rate. E) eventually affect equilibrium real money balances by raising the money interest rate. Answer: E Page Ref: 394-397 Difficulty: Easy 6) Money demand behavior may A) change as a result of demographic trends or financial innovations such as electronic cashtransfer facilities. B) change only as a result of demographic trends. C) change only as a result of financial innovations such as electronic cash-transfer facilities. D) not change as a result of demographic trends or financial innovations such as electronic cashtransfer facilities. E) change as a result of demographic trends but not as a result of financial innovations such as electronic cash-transfer facilities. Answer: A Page Ref: 394-397 Difficulty: Easy 7) Using year-by-year data from 1987-2007 shows that A) there is a strong positive relation between average Latin American money-supply growth and inflation. B) there is a strong negative relation between average Latin American money-supply growth and inflation. C) there is a strong positive relation between average Latin American money-supply growth and deflation. D) it is difficult to find a strong positive relation between average Latin American money-supply growth and inflation. E) there is a weak positive relation between average Latin American money-supply growth and inflation. Answer: A Page Ref: 394-397 Difficulty: Easy

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8) Which one of the following statements is the MOST accurate? A) A permanent increase in a country's money supply causes a proportional long-run depreciation of its currency against foreign currencies. B) A temporary increase in a country's money supply causes a proportional long-run depreciation of its currency against foreign currencies. C) A permanent increase in a country's money supply causes a proportional long-run appreciation of its currency against foreign currencies. D) A permanent increase in a country's money supply causes a proportional short-run depreciation of its currency against foreign currencies. E) A permanent increase in a country's money supply causes a proportional short-run appreciation of its currency against foreign currencies. Answer: A Page Ref: 394-397 Difficulty: Easy 9) The long run effects of money supply change A) ambiguous effect on the long-run values of the interest rate or real output, a proportional change in the price level's long-run value in the opposite direction. B) proportional effect on the long-run values of the interest rate or real output, a proportional change in the price level's long-run value in the same direction. C) no effect on the long-run values of the interest rate or real output, a proportional change in the price level's long-run value in the same direction. D) no effect on the long-run values of the interest rate or real output, no change in the price level's long-run value. E) ambiguous effect on the long-run values of the interest rate or real output, A disproportional change in the price level's long-run value in the same direction. Answer: C Page Ref: 394-397 Difficulty: Easy 15.7 Inflation and Exchange Rate Dynamics 1) What term means an explosive and seemingly uncontrollable inflation in which money loses value rapidly and may even go out of use? A) superinflation B) stagflation C) hyperinflation D) maginflation E) deflation Answer: C Page Ref: 398-405 Difficulty: Easy

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2) The most extreme inflationary conditions occurred A) in Zimbabwe in 2008. B) in Chile in 2012. C) in Eastern Europe in the 1990s. D) in Western Europe in the 1980s. E) in Germany in 20013. Answer: A Page Ref: 398-405 Difficulty: Easy 3) For main industrial countries such as Japan and the U.S. A) there is much less month-to-month variability of the exchange rate, suggesting that price levels are relatively sticky in the short run. B) there is much more month-to-month variability of the exchange rate, suggesting that price levels are relatively sticky in the short run. C) there is almost the same month-to-month variability of the exchange rate and price levels. D) it is hard to tell whether month-to-month variability of the exchange rate is similar to changes in price levels. E) there is much more month-to-month variability of the exchange rate, suggesting that price levels are relatively sticky in the long run. Answer: B Page Ref: 398-405 Difficulty: Easy 4) Which one of the following statements is the MOST accurate? A) There is a lively academic debate over the possibility that seemingly sticky wages and prices are in reality quite fixed. B) There is a lively academic debate over the possibility that seemingly sticky wages and prices are in reality much more sticky than theory assumes. C) There is a lively academic debate over the possibility that seemingly sticky wages and prices are in reality quite flexible. D) There is no debate over the possibility that wages and prices are sticky in the long run. E) There is no debate over the possibility that wages and prices are sticky in the short run. Answer: C Page Ref: 398-405 Difficulty: Easy

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5) During hyperinflation, exploding inflation causes real money demand to A) fall over time, and this additional monetary change makes money prices rise even more quickly than the money supply itself rises. B) increase over time, and this additional monetary change makes money prices rise even more quickly than the money supply itself rises. C) fall over time, and this additional monetary change makes money prices decrease even more quickly than the money supply itself rises. D) increase over time, and this additional monetary change makes money prices decrease even more quickly than the money supply itself rises. E) fall over time, and this additional monetary change makes money prices decrease even less quickly than the money supply itself rises. Answer: A Page Ref: 398-405 Difficulty: Easy 6) In a classic paper, Columbia University economist Phillip Cagan drew the line between inflation and hyperinflation at an inflation rate of A) 50 percent per month. B) 10 percent per month. C) 20 percent per month. D) 5 percent per month. E) 25 percent per month. Answer: A Page Ref: 398-405 Difficulty: Easy 7) In a classic paper, Columbia University economist Phillip Cagan drew the line between inflation and hyperinflation at an inflation rate of A) more than 120 percent per year. B) more than 100 percent per year. C) more than 200 percent per year. D) more than 12,000 percent per year. E) more than 1,000 percent per year. Answer: D Page Ref: 400 Difficulty: Easy

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8) In a world where the price level could adjust immediately to its new long-run level after a money supply increase A) The dollar interest rate would increase because prices would adjust immediately and prevent the money supply from rising. B) The dollar interest rate would fall because prices would adjust immediately and prevent the money supply from rising. C) The dollar interest rate would fall because prices would adjust immediately and prevent the money supply from decreasing. D) The dollar interest rate would decrease because prices would adjust immediately and prevent the money supply from decreasing. E) The dollar interest rate would fall because prices would not be able to prevent the money supply from rising. Answer: B Page Ref: 398-405 Difficulty: Easy 9) After a permanent increase in the money supply A) the exchange rate overshoots in the short run. B) the exchange rate overshoots in the long run. C) the exchange rate smoothly depreciates in the short run. D) the exchange rate smoothly appreciates in the short run. E) the exchange rate remains the same. Answer: A Page Ref: 398-405 Difficulty: Easy 10) A change in the money supply creates demand and cost pressures that lead to future increases in the price level from which main sources? I. Excess demand for output and labor II. Inflationary expectations III. Raw materials prices A) I B) II C) II and III D) I and II E) I, II, and III Answer: E Page Ref: 398-405 Difficulty: Easy

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11) In Zimbabwe, the government stopped the country's hyperinflation by A) reducing domestic monetary growth drastically. B) returning to a gold/silver currency standard. C) switching to foreign currencies. that are relatively stable. D) passing a law making price increases illegal. E) implementing a new currency based on diamonds. Answer: C Page Ref: 400-401 Difficulty: Easy 12) Which of the following can help to explain why higher inflation may lead to currency appreciations? A) The interest rate is not the prime target of monetary policy. B) Most central banks adjust their policy interest rates expressly so as to keep inflation in check. C) Central banks increase the money supply leading to overshooting of the exchange rate. D) Inflation will increase the purchasing power of a currency. E) The world market does not adjust their currency trade to reflect inflation. Answer: B Page Ref: 398-405 Difficulty: Easy 13) Which one of the countries below announces inflation targets? A) Japan B) U.S. C) Canada D) Mexico E) Nicaragua Answer: C Page Ref: 398-405 Difficulty: Easy 14) Michael Woodford says the following is an advantage of interest-rate instruments for central banks. A) Conduct monetary policy without inflation. B) Conduct monetary policy even if checking deposits pay interest at competitive rates. C) Conduct monetary policy without government approval. D) Conduct monetary policy with consumers in mind. E) Conduct monetary policy with workers in mind. Answer: B Page Ref: 405 Difficulty: Easy

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15) Inflation targeting was initiated by which central bank in 1989? A) U.S. B) Japan C) Canada D) New Zealand E) U.K. Answer: D Page Ref: 398-405 Difficulty: Easy 16) "Although the price levels appear to display short-run stickiness in many countries, a change in the money supply creates immediate demand and cost pressures that eventually lead to future increase in the price level." Discuss. Answer: (See Section 7). The statement is true. The pressures come from three main sources: excess demand for output and labor; inflationary expectations; and, raw material prices. Page Ref: 398-405 Difficulty: Moderate 17) Explain the effects of a permanent increase in the U.S. money supply in the short run and in the long run. Assume that the U.S. real national income is constant. Answer: An increase in the nominal money supply raises the real money supply, lowering the interest rate in the short run. The money supply increase is considered to continue in the future; thus, it will affect the exchange rate expectations. This will make the expected return on the euro more desirable and thus the dollar depreciates. In the case of a permanent increase in the U.S. money supply, the dollar depreciates more than under a temporary increase in the money supply. Now, in the long run, prices will rise until the real money balances are the same as before the permanent increase in the money supply. Since the output level is given, the U.S. interest rate, which decreased before, will start to increase, until it will move back to its original level. The equilibrium interest rate must be the same as its original long run value. This increase in the interest rate must cause the dollar to appreciate against the euro after its sharp depreciation as a result of the permanent increase in the money supply. So a large depreciation is followed by an appreciation of the dollar. Eventually, the dollar depreciates in proportion to the increase in the price level, which in turn increases by the same proportion as the permanent increase in the money supply. Thus, money is neutral, in the sense that it cannot affect in the long run real variables, such as output, investment, etc. Page Ref: 398-405 Difficulty: Difficult

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18) Explain the exchange rate over-shooting hypothesis. Answer: Many prices in the economy are written into long-term contracts and cannot be changed immediately when changes in the money supply occur. A permanent increase in M, holding P constant, increases the real money supply (M/P) and lowers the nominal interest rate (R). This shifts the dollar return schedule left. A permanent increase in M also creates the expectation that in the long run all prices including the exchange rate would rise. A rise in the expected exchange rate shifts the ERR(DM) schedule right. Therefore, in the short run equilibrium is established at point 2 In the long run the price level adjusts and rises proportionately with the money supply. Therefore, M/P and R return to their initial levels in the long run and the equilibrium exchange rate is determined at point 3. In other words, the exchange rate first overshoots and then returns to its long run level. Therefore, the fluctuations in E are much stronger than those of P. Page Ref: 398-405 Difficulty: Difficult

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19) Using figures for both the short run and the long run, show the effects of a permanent increase in the U.S. money supply. Try to line up your figures to the short and long run equilibria side by side. Assume that the U.S. real national income is constant. Answer:

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An increase in the nominal money supply raises the real money supply, lowering the interest rate in the short run (the movement from 1 to 2 on the lower left figure). The money supply increase is considered to continue in the future, and thus it will affect the exchange rate expectations. This will make the expected return on the euro more desirable and thus the dollar depreciates. In the case of a permanent increase in the U.S. money supply, the dollar depreciates more than under a temporary increase in the money supply (from point to point in the upper left figure). Now, in the long run, (the right hand side figure), prices will rise until the real money balances are the same as before the permanent increase in the money supply (from point 2 to point 4, in the lower right figure). Since the output level is given, the U.S. interest rate which decreased before, will start to increase, until it will move back to its original level (from Point 2 to 4 in the lower left figure). The equilibrium interest rate must be the same as its original long run value (at point 4 in the lower right figure). This increase in the interest rate must cause the dollar to appreciate against the euro after its sharp depreciation as a result of the permanent increase in the money supply (this process is depicted in the upper right figure from point to ). So a large depreciation (from Point in the left upper figure to pint in both the left and right upper figures) is followed by an appreciation of the dollar (the movement from to point in the upper right hand side figure). Eventually, the dollar depreciates in proportion to the increase in the price level, which in turn increases by the same proportion as the permanent increase in the money supply. Thus, money is neutral, in the sense that it cannot affect in the long run real variables, such as output, investment, etc. Note that points and represent the same exchange rate. Page Ref: 398-405 Difficulty: Moderate

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20) Using 4 different figures, plot the time paths showing the effects of a permanent increase in the United States money supply on: (a) U.S. Money supply (b) The dollar interest rate. (c) The U.S. price level (d) The dollar/euro exchange rate Answer: See below.

Page Ref: 398-405 Difficulty: Difficult

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International Economics, 10e (Krugman/Obstfeld/Melitz) Chapter 16 (5) Price Levels and the Exchange Rate in the Long Run 16.1 The Law of One Price 1) Which of the following statements is the MOST accurate? The law of one price states A) in competitive markets free of transportation costs and official barriers to trade, identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency. B) in competitive markets free of transportation costs and official barrier to trade, identical goods sold in the same country must sell for the same price when their prices are expressed in terms of the same currency. C) in competitive markets free of transportation costs and official barrier to trade, identical goods sold in different countries must sell for the same price. D) identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency. E) in competitive markets free of official barrier to trade, identical goods are sold at the same price regardless of transportation costs. Answer: A Page Ref: 413-415 Difficulty: Easy 2) Under Purchasing Power Parity A) E$/E = PUS/PE. B) E$/E = PE/PES. C) E$/E = PUS + PE. D) E$/E = PUS - PE. E) E$/P = PUS/PE. Answer: A Page Ref: 413-415 Difficulty: Easy 3) Explain the Law of One Price. Give an example. Answer: The law of one price states that in competitive markets free of transportation costs and trade barriers, identical goods sold in different countries must sell for the same price when expressed in terms of the same currency. = (E$/£) × ( E$/£ =

) for good i.

/

If, for example, the price of the same sweater was cheaper in London than in New York, U.S. importers and British exporters would have an incentive to buy sweaters in London and ship them to New York, pushing the London price up and the New York price down, until both were equal. Page Ref: 413-415 Difficulty: Moderate 1 .

4) Fill in the following table, assuming the law of one price prevails.

Answer:

Page Ref: 413-415 Difficulty: Moderate 16.2 Purchasing Power Parity 1) Under Purchasing Power Parity A) E$/E = PiUS/PiE. B) E$/E = PiE/PiUS. C) E$/E = PUS/PE. D) E$/E = PE/PES. E) E$/E = PiE + PiUS/PiE. Answer: C Page Ref: 415-417 Difficulty: Easy

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2) Which of the following statements is the MOST accurate? A) The law of one price applies only to the general price level. B) The law of one price applies to the general price level while PPP applies to individual commodities. C) The law of one price applies to individual commodities while PPP applies to both the general price level and to individual commodities. D) PPP applies only to individual commodities. E) The law of one price applies to individual commodities while PPP applies to the general price level. Answer: E Page Ref: 415-417 Difficulty: Easy 3) Which of the following statements is the MOST accurate? A) If PPP holds true, then the law of one price holds true for every commodity as long as the reference baskets used to reckon different countries' price levels are the same. B) If the law of one price holds true for every commodity, PPP must hold automatically. C) If the law of one price holds true for every commodity, PPP must automatically hold as long as the reference baskets used to reckon different countries' price levels are the same. D) If the law of one price does not hold true for every commodity, PPP cannot be true as long as the reference baskets used to reckon different countries' price levels are the same. E) If PPP holds true, then the law of one price must hold true automatically. Answer: C Page Ref: 415-417 Difficulty: Easy 4) Which of the following statements is the MOST accurate? A) Absolute PPP does not imply relative PPP. B) Relative PPP implies absolute PPP. C) There is no causality relation between the two. D) Absolute PPP implies relative PPP. E) Absolute PPP is inversely related to relative PPP. Answer: D Page Ref: 415-417 Difficulty: Easy

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5) Which of the following statements is the MOST accurate? A) Relative PPP may be valid even when absolute PPP is not, provided the factors causing deviations from absolute PPP are more or less stable over different commodities space. B) Absolute PPP may be valid even when relative PPP is not, provided the factors causing deviations from relative PPP are more or less stable over time. C) Relative PPP may be valid even when absolute PPP is not, provided the factors causing deviations from absolute PPP are more or less stable over time. D) Relative PPP is not valid when absolute PPP is not. E) Relative PPP is only valid when absolute PPP is valid, providing the factors causing deviations from relative PPP are more or less stable over time. Answer: C Page Ref: 415-417 Difficulty: Easy 6) Explain Purchasing Power Parity. Answer: PPP states that the exchange rate between two countries' currencies equals the ratio of the countries' price levels. A fall in a currency's domestic purchasing power (i.e. an increase in the domestic price level) will be associated with a proportional currency depreciation in the foreign exchange market and vice versa. = PUS/PE where P is the price of a reference commodity basket. Rearrange: PUS = × (PE) Thus, PPP asserts that all countries' price levels are equal when measured in terms of the same currency. Page Ref: 415-417 Difficulty: Moderate 7) Discuss the relationship between PPP and the Law of One Price. Answer: The law of one price applies to individual commodities while PPP applies to the general price level. Proponents of PPP argue that its validity in the long run doesn't require the law of one price to hold exactly. When goods and services temporarily become more expensive in one country than in others, the demands for its currency and its products falls, pushing the exchange rate and domestic prices back in line with PPP and vice versa. Page Ref: 415-417 Difficulty: Moderate 8) Discuss the differences between Absolute PPP and Relative PPP. Answer: Absolute PPP states that the exchange rate between two currencies equals the ratio of their price levels. Relative PPP states that the percentage change in the exchange rate between two currencies over a given period equals the difference between the inflation rates of those two currencies. Page Ref: 415-417 Difficulty: Moderate

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9) Explain why Relative PPP is useful when comparing countries that base their price levels on different product baskets. Answer: For Example: If the U.S. price level rises by 10% over a year while Europe's rises by only 5%, relative PPP predicts a 5% depreciation of the dollar against the euro. This just cancels the 5% by which U.S. inflation exceeds European, leaving the relative domestic and foreign purchasing powers of both currencies unchanged. ( )/ = ( )US,t - ( )E,t between dates t and t - 1. Relative PPP is useful when comparing countries that base their price levels on different product baskets. Relative PPP may be valid even when absolute PPP is not. Page Ref: 415-417 Difficulty: Moderate 10) Suppose Russia's inflation rate is 200% over one year but the inflation rate in Switzerland is only 2%. According to relative PPP, what should happen over the year to the Swiss franc's exchange rate against the Russian ruble? Answer: (Eruble/franc, t - Eruble/franc, t-1)/Eruble/franc, t-1 = 2 - 0.02 = 1.98 So there will be a 198% depreciation of the ruble against the franc or, conversely, a 198% appreciation of the franc against the ruble. Page Ref: 415-417 Difficulty: Moderate

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11) Assuming relative PPP, fill in the table below:

Answer: Using (

-

)/

= ΠUS, t - ΠE, t one gets:

Page Ref: 415-417 Difficulty: Moderate 16.3 A Long-Run Exchange Rate Model Based on PPP 1) In order for the condition E$/HK$ = PUS/PHK to hold, what assumptions does the principle of purchasing power parity make? A) Only that there are no transportation costs and restrictions on trade. B) Only that the markets are perfectly competitive, i.e., P = MC. C) The factors of production are identical between countries. D) No arbitrage exists. E) HK and the US are perfectly competitive and there are no transportation costs or restrictions on trade. Answer: E Page Ref: 417-423 Difficulty: Easy

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2) Which of the following statements is the MOST accurate? A) In the long run, national price levels play a minor role in determining both interest rates and the relative prices at which countries' products are traded. B) In the long run, national price levels play a key role only in determining interest rates. C) In the long run, national price levels play a key role only in determining the relative prices at which countries' products are traded. D) In the long run, national price levels play a key role in determining both interest rates and the relative prices at which countries' products are traded. E) In the long run, national price levels play no role in determining interest rates and the relative prices at which countries' products are traded. Answer: D Page Ref: 417-423 Difficulty: Easy 3) Which of the following statements is the MOST accurate? In general A) the monetary approach to the exchange rate is a long run theory. B) the monetary approach to the exchange rate is a short run theory. C) the monetary approach to the exchange rate is both a short and long run theory. D) the monetary approach to the exchange rate neither long run nor short run theory. E) the monetary approach to the exchange rate is considered less practical than the law of one price. Answer: A Page Ref: 417-423 Difficulty: Easy 4) The monetary approach makes the general prediction that A) the exchange rate, which is the relative price of American and European money, is fully determined in the long run by the relative supplies of those monies. B) the exchange rate, which is the relative price of American and European money, is fully determined in the short run by the relative supplies of those monies and the relative demands for them. C) the exchange rate, which is the relative price of American and European money, is fully determined in the short run and long run by the relative supplies of those monies and the relative demands for them. D) the exchange rate, which is the relative price of American and European money, is fully determined in the long run by the relative supplies of those monies and the relative demands for them. E) the money supply in the U.S. will adjust to European monetary equilibrium. Answer: D Page Ref: 417-423 Difficulty: Easy

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5) Under the monetary approach to exchange rate theory, money supply growth at a constant rate A) eventually results in ongoing price level deflation at the same rate, but changes in this longrun deflation rate do not affect the full-employment output level or the long-run relative prices of goods and services. B) eventually results in ongoing price level inflation at the same rate, but changes in this longrun inflation rate do affect the full-employment output level and the long-run relative prices of goods and services. C) eventually results in ongoing price level inflation at the same rate, but changes in this longrun inflation rate do not affect the full-employment output level or the long-run relative prices of goods and services. D) eventually results in ongoing price level inflation at the same rate, but changes in this longrun inflation rate do not affect the full-employment output level, only the long-run relative prices of goods and services. E) eventually results in ongoing price level deflation at the same rate, but changes in this longrun deflation rate do not affect the full-employment output level, only the long-run relative prices of goods and services. Answer: C Page Ref: 417-423 Difficulty: Easy 6) Which of the following statements is the MOST accurate? In general, under the monetary approach to the exchange rate A) the interest rate is not independent of the money supply growth rate in the short run. B) the interest rate is independent of the money supply growth rate in the long run. C) the interest rate is not independent of the money supply growth rate in the long run, but independent in the short run. D) the interest rate is not independent of the money supply growth rate in the long run. E) the interest rate is a factor of the money supply growth rate only in the short term. Answer: D Page Ref: 417-423 Difficulty: Easy 7) Which of the following statements is the MOST accurate? In general, under the monetary approach to the exchange rate A) while the short-run interest rate does not depend on the absolute level of the money supply, continuing growth in the money supply eventually will affect the interest rate. B) while the long-run interest rate does depend on the absolute level of the money supply, continuing growth in the money supply do not affect the interest rate. C) while the long-run interest rate does not depend on the absolute level of the money supply, continuing growth in the money supply eventually will affect the interest rate. D) the long-run interest rate does not depend on the absolute level of the money supply, and thus continuing growth in the money supply will not affect the interest rate. E) while the short-run interest rate does not depend on the absolute level of the money supply, continuing decline in the money supply eventually will not affect the interest rate. Answer: C Page Ref: 417-423 Difficulty: Easy 8 .

8) Who among the following list of people is an early 20th century economist from Yale University who wrote the book The Theory of Interest? A) Gustav Cassel B) Irving Fisher C) David Ricardo D) Paul Krugman E) Israel Kirzner Answer: B Page Ref: 417-423 Difficulty: Easy 9) If people expect relative PPP to hold A) the difference between the interest rates offered by dollar and euro deposits will equal the difference between the inflation rates expected, in the United States and Europe, respectively, over the relevant horizon. B) the difference between the interest rates offered by dollar and euro deposits will equal the difference between the inflation rates expected in Europe and the United States, respectively. C) the difference between the interest rates offered by dollar and euro deposits will equal the difference between the inflation rates expected, over the relevant horizon, in the United States and Europe, respectively, in the short run. D) the difference between the interest rates offered by dollar and euro deposits will be above the difference between the inflation rates expected, over the relevant horizon, in the United States and Europe, respectively. E) the difference between the interest rates offered by dollar and euro deposits will be below the difference between the inflation rates expected, over the relevant horizon, in the United States and Europe, respectively. Answer: A Page Ref: 417-423 Difficulty: Easy 10) Under PPP (and by the Fisher Effect), all else equal A) a rise in a country's expected inflation rate will eventually cause a more-than proportional rise in the interest rate that deposits of its currency offer in order to accommodate for the higher inflation. B) a fall in a country's expected inflation rate will eventually cause an equal rise in the interest rate that deposits of its currency offer. C) a rise in a country's expected inflation rate will eventually cause an equal rise in the interest rate that deposits of its currency offer. D) a rise in a country's expected inflation rate will eventually cause a less than proportional rise in the interest rate that deposits of its currency offer to accommodate the rise in expected inflation. E) a fall in a country's expected inflation rate will eventually cause an inversely proportional rise in the interest rate that deposits of its currency offer to accommodate the rise in expected inflation. Answer: C Page Ref: 417-423 Difficulty: Easy 9 .

11) In the short run A) the interest rate can rise when the domestic money supply falls. B) the interest rate can decrease when the domestic money supply falls. C) the interest rate stays constant when the domestic money supply falls. D) the interest rate rises in the same proportion as the domestic money supply falls. E) the interest rate never rises when the domestic money supply falls. Answer: A Page Ref: 417-423 Difficulty: Easy 12) Under a flexible-price monetary approach to the exchange rate A) when the domestic money supply falls, the price level would eventually fall, increasing the interest rate. B) when the domestic money supply falls, the price level would fall right away, causing a reduction in the interest rate. C) when the domestic money supply falls, the price level would fall right away, causing an increase in the interest rate. D) when the domestic money supply falls, the price level would eventually fall, keeping the interest rate constant. E) when the domestic money supply falls, the price level would fall right away, keeping the interest rate constant. Answer: E Page Ref: 417-423 Difficulty: Easy 13) Under sticky prices A) a fall in the money supply raises the interest rate to preserve money market equilibrium. B) a fall in the money supply reduces the interest rate to preserve money market equilibrium. C) a fall in the money supply keeps the interest rate intact to preserve money market equilibrium. D) a fall in the money supply does not affect the interest rate in the short run, only in the long run. E) a fall in the money supply raises the interest rate to preserve money market equilibrium in the long run. Answer: A Page Ref: 417-423 Difficulty: Easy

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14) Under sticky prices A) an interest rate rise is associated with lower expected deflation and a long-run currency appreciation, so the currency appreciates immediately. B) an interest rate rise is associated with higher expected inflation and a long-run currency appreciation, so the currency appreciates immediately. C) an interest rate rise is associated with lower expected inflation and a long-run currency depreciation, so the currency appreciates immediately. D) an interest rate rise is associated with lower expected inflation and a long-run currency depreciation, so the currency depreciates immediately. E) an interest rate rise is associated with lower expected inflation and a long-run currency appreciation, so the currency appreciates immediately. Answer: E Page Ref: 417-423 Difficulty: Easy 15) Under the monetary approach to the exchange rate A) an interest rate decrease is associated with higher expected inflation and a currency that will be weaker on all future dates. B) an interest rate increase is associated with higher expected deflation and a currency that will be weaker on all future dates. C) an interest rate increase is associated with higher expected inflation and a currency that will be strengthened on all future dates. D) an interest rate increase is associated with higher expected deflation and a currency that will be strengthened on all future dates. E) an interest rate increase is associated with higher expected inflation and a currency that will be weaker on all future dates. Answer: E Page Ref: 417-423 Difficulty: Easy 16) Under the monetary approach to the exchange rate A) a reduction in the money supply will cause immediate currency depreciation. B) a rise in the money supply will cause currency depreciation. C) a rise in the money supply will cause immediate currency appreciation. D) a rise in the money supply will cause depreciation. E) a rise in the money supply will cause immediate currency depreciation. Answer: E Page Ref: 417-423 Difficulty: Easy

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17) Explain why exchange rate model based on PPP is a long run theory. Answer: PPP theory is a monetary approach to the exchange rate. It is a long-run theory because it does not allow for price rigidities. It assumes that prices can adjust right away to maintain full employment as well as PPP. Page Ref: 417-423 Difficulty: Moderate 18) Present and explain the Fundamental Equation of the Monetary Approach. Answer: Assume = PUS/PE and that domestic price levels depend on domestic money demands and supplies: PUS = MUSS/L(R$, YUS) PE = MES/L( , YE) Therefore, the exchange rate is fully determined in the long run by the relative supplies of those monies and the relative real demands for them. Shifts in interest rates and output levels affect the exchange rate only through their influence on money demand. Page Ref: 417-423 Difficulty: Moderate 19) What are the predictions for the long run equilibrium of the Monetary Approach? Answer: Money supplies: Given the equations, = PUS/PE PUS = MUSS/L(R$, YUS) PE = MES/L( , YE) one can show that an increase in the U.S. money supply MUSS causes a proportional increase in the U.S. price level PUS, which in turn causes a proportional increase in . Thus, an increase in U.S. money supply causes a proportional long-run depreciation of the dollar against the euro and vice versa. Interest rates: A rise in the interest rate R$ lowers U.S. money demand L(R$, YUS) thereby causing a rise in the U.S. price level and a proportional depreciation of the dollar against the euro. Output levels: A rise in U.S. output YUS raises real U.S. money demand leading to a fall in the long-run U.S. price level and an appreciation of the dollar against the euro. Page Ref: 417-423 Difficulty: Moderate

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20) Discuss the effects of ongoing inflation based on the PPP theory. Answer: Other things equal, money supply growth at a constant rate eventually results in ongoing price level inflation at the same rate as the money supply growth, but changes in this long-run inflation rate do not affect the full-employment output level or the long-run relative prices of goods and services. The interest rate, however, is affected by continuing growth in the money supply (inflation). This can be shown by combining PPP with the interest parity condition. To show it analytically, recall that the condition of parity between dollar and euro assets is: R$ =

+(

-

)/

And according to relative PPP: ( )/ = ΠUS,t - ΠE,t If people expect relative PPP to hold, the difference between interest rates offered by dollar and euro deposits will equal the difference between the expected inflation rates, over the relative horizon, in the U.S. and Europe. Page Ref: 417-423 Difficulty: Moderate 21) Describe and explain the relationship between expected inflation rates in two countries and their interest rate differential according to the PPP theory. Answer: Expected inflation is given by the following equation: Πe = (Pe - P)/P where Pe is the expected price level in a country a year from today. If relative PPP is expected to hold then: (

-

)/

-

Combine the expected version of relative PPP with the interest parity condition: R$ =

+(

R$ -

=

-

)/

Rearrange: -

If, as PPP predicts, currency depreciation is expected to offset international inflation difference, the interest rate difference must equal the expected inflation difference. Page Ref: 417-423 Difficulty: Difficult

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22) What is the Fisher Effect? Provide an example. Answer: All else equal, a rise in a country's expected inflation rate will eventually cause an equal rise in the interest rate that deposits of its currency offer. Similarly, a fall in the expected inflation rate will eventually cause a fall in the interest rate. Ex: If the expected U.S. inflation were to rise permanently from Π to Π + ΔΠ, current dollar interest rates R$ would eventually catch up to the higher inflation, rising by a value ΔR$ = ΔΠ in accordance with the Monetary Approach that in the long run purely monetary developments should have no effect on an economy's relative prices since the real rate of return on dollar assets would remain unchanged. Page Ref: 417-423 Difficulty: Moderate

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23) To answer the following question, please refer to the figure below. Concentrating only at the lower right quadrant, discuss the effects of a change in U.S. expected inflation.

Answer: Lower right quadrant shows the equilibrium in the U.S. Money Market, where =

/

A given interest rate R1$ corresponds with a given U.S. real money supply,

/

.

Consider a rise of ΔΠ in the future rate of U.S. money supply growth (i.e. an increase in the expected rate of inflation). The Key Point: The rise in expected future inflation generates expectations of more rapid currency depreciation in the future. Under PPP the dollar now depreciates at a rate of Π + ΔΠ. Interest parity therefore requires the dollar interest rate to rise where =

+ ΔΠ. (Point 2 in the figure.) Note: R$ -

=

-

This relation shows a change in the U.S. interest rate due to an increase in expected U.S. inflation has no effect on the euro interest rate.

15 .

The rise in the interest rate from

to

creates a momentary excess supply of real U.S.

money balances at the prevailing price level . However, since under this. Monetary Approach, prices are assumed to be flexible, prices will immediately adjust from to , thus causing the following two effects: One, Reducing real money supply and two, bringing U.S. money market back into equilibrium. Page Ref: 417-423 Difficulty: Moderate

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24) To answer the following question, please refer to the figure below. Concentrating only at the lower left quadrant, discuss the relationship between the U.S. real money supply and the dollar/euro exchange rate, E$/E.

Answer: The lower left quadrant in the figure described the Purchasing Power Parity (PPP) relationship. The relationship between the U.S. real money supply and the dollar/euro exchange rate, E$/E is negative. is equal to the price level ratio, PUS/ . In this derivation of the relationship, the following variables are assumed constants: and So,

. =

/PUS PUS ↑ →

↑

→ Thus, the purchasing power of dollar decreases due to the increase in the price level. → i.e., dollar depreciates due to PPP Page Ref: 417-423 Difficulty: Moderate

17 .

,

,

25) To answer the following question, please refer to the figure below. Concentrating only at the upper right quadrant, discuss the foreign exchange market equilibrium.

Answer: The upper right quadrant describes the equilibrium in the foreign exchange market. We begin with the Interest Parity Condition. R$ =

+(

-

)/

In general, two effects are present: →

and

→

A rise in the interest rate normally creates an excess demand for dollar deposits and appreciation in the currency market. However, in this case the increase is due to higher expected inflation or higher expected monetary growth in the U.S. which implies a faster expected depreciation of the dollar against the euro, , thus,

goes up and thus reduced the attractiveness of U.S. deposits.

Page Ref: 417-423 Difficulty: Moderate

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26) Is a depreciation of the dollar/euro exchange rate correlated with a decrease in the dollar return on U.S. deposits? Answer: No. Assume that the Interest Parity is maintained, i.e., R$ =

+(

-

)/

Holding constant, one would expect a depreciation of the dollar/euro exchange rate (i.e. increase in ) to be correlated with a decrease in R$, dollar returns on euro deposits. However, the higher expected inflation in the U.S. implies an increase in the , the expected future dollar to euro exchange rate. Thus, the quantity (

-

despite a depreciation in the current dollar to euro exchange rate, Page Ref: 417-423 Difficulty: Difficult

)/

goes up and, increases .

27) Does the existence of non-tradable goods allow for deviations from Purchasing power Parity? Answer: Yes, the existence of nontradables allows deviations from PPP. This is because the price of a nontradable is determined entirely by its domestic supply and demand curves, and in turn fluctuations in demand and supply for these good will affect the price level. Examples include housing, haircut, services etc. Page Ref: 417-423 Difficulty: Moderate 28) What effect do non-tradable goods have on PPP? Answer: The effect is quite substantial. In 2006, the output of non-tradable goods accounted for about 46% of U.S. GNP. Along with haircuts, non-tradable goods include routine medical treatment, housing etc. For the most part, non-tradable goods are comprised of services, and the output of the construction industry. Nontradable help explain much of the wide departure from PPP that is present in empirical data. Page Ref: 417-423 Difficulty: Moderate 29) How can long run values in the real exchange rate change? Answer: An increase in world relative demand for U.S. output causes a long-run real appreciation of the dollar against the euro (a fall in real dollar/euro exchange rate). A relative expansion of U.S. output causes a long-run real depreciation of the dollar against the euro (a rise in real dollar/euro exchange rate). Page Ref: 417-423 Difficulty: Moderate

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30) Describe the chain of events leading to exchange rate determination for the following cases: (a) An increase in U.S. money supply (d) Increase in growth rate of U.S. money supply (c) Increase in world relative demand for U.S. products (d) Increase in relative U.S. output supply Answer: Chain of events leading to exchange rate determination: = × (Pus/PE) Increase in U.S. money supply: Pus rises in proportion to the money supply; q remains the same. All dollar prices will rise (including dollar price of euro). Increase in growth rate of U.S. money supply: Inflation rate, dollar interest rate, Pus, E, rises in proportion to Pus. Increase in world relative demand for U.S. products: E falls, and q does as well. Increase in relative U.S. output supply: Dollar depreciates, lowers relative price of U.S. output, rise in q, effect on E is not clear since q and Pus work in opposite directions. Page Ref: 417-423 Difficulty: Difficult 31) Construct a table that will summarize the effects of money market and output market changes on the long-run nominal dollar/euro exchange rate Answer:

Page Ref: 417-423 Difficulty: Difficult 16.4 Empirical Evidence on PPP and the Law of One Price 1) In practice A) changes in national price levels often tell us relatively little about exchange rate movements. B) changes in national price levels raise the exchange rate. C) changes in national price levels lower the exchange rate. D) changes in national price levels often tell us about exchange rate movements. E) changes in national price levels match identical changes in the exchange rate. Answer: A Page Ref: 423-424 Difficulty: Easy

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2) Which of the following statements is the MOST accurate? A) The prices of identical commodity baskets, when converted to a single currency, are the same across countries. B) The prices of identical commodity baskets, when converted to a single currency, differ substantially across countries. C) The prices of identical commodity baskets, when converted to a single currency, do not differ substantially across countries. D) The prices of identical commodity baskets, when converted to a single currency, are often the same across countries. E) The prices of identical commodity baskets, when converted to a single currency, are the same across countries more than 50% of the time. Answer: B Page Ref: 423-424 Difficulty: Easy 3) Which of the following statements is the MOST accurate? A) The law of one price does fare well in all recent studies. B) The law of one price does fare well in many recent studies. C) The law of one price sometimes fares well in recent studies. D) The law of one price does not fare well in recent studies. E) The law of one price has not been studied recently. Answer: D Page Ref: 423-424 Difficulty: Easy 4) Which of the following statements is the MOST accurate? A) Relative PPP is not a reasonable approximation to the data. B) Relative PPP is sometimes a reasonable approximation to the data but often performs poorly. C) Relative PPP is sometimes a reasonable approximation to the data. D) PPP is sometimes a reasonable approximation to the data. E) PPP is sometimes a reasonable approximation to the data but usually performs poorly. Answer: B Page Ref: 423-424 Difficulty: Easy

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5) What can explain the failure of relative PPP to hold in reality? Answer: Government measures of the price level differ from country to country. One reason for these differences is that people living in different countries spend their income in different ways. Because of this inherent difference among countries, certain baskets will be affected more by price changes given their consumptions basket. For example, consumers in country, X, eats more fish relative to another country. More than likely, the government, upon determining a commodity basket to reflect preference, will have an overwhelming representation of fish in their basket. Any price level change in the fish market will be felt particularly by country X, and their overall price level will reflect this. Thus, changes in the relative prices of basket components can cause relative PPP to become distorted. Page Ref: 423-424 Difficulty: Moderate 16.5 Explaining the Problems with PPP 1) Which of the following are theories meant to explain "Why Price Levels are Lower in Poorer Countries"? A) only Bhagwati-Kravis-Lipsey B) only Balassa-Samuelson C) only Goldberg-Knetter D) Bhagwati-Kravis-Lipsey and Balassa-Samuelson E) Bhagwati-Kravis-Lipsey and Goldberg-Knetter Answer: D Page Ref: 425-432 Difficulty: Easy 2) In January 2013, the world's cheapest Big Macs were sold in A) the Philippines. B) Russia. C) China. D) Malysia. E) the Czech Republic. Answer: D Page Ref: 425-432 Difficulty: Easy 3) The PPP theory fails in reality for all of the following reasons EXCEPT A) transport costs. B) monopolistic or oligopolistic practices in goods markets. C) the inflation data reported in different countries are based on different commodity baskets. D) restrictions on trade. E) inflation rates are unrelated to money supply growth. Answer: E Page Ref: 425-432 Difficulty: Easy 22 .

4) Which one of the following statements is the MOST accurate? A) The purchasing power of any given country's currency will increase in countries where the prices of non-tradable goods rise. B) The purchasing power of any given country's currency will fall in countries where the prices of non-tradable goods fall. C) The purchasing power of any given country's currency will fall in countries where the prices of non-tradable goods rise. D) The purchasing power of any given country's currency will remain constant in countries where the prices of non-tradable goods rise. E) The purchasing power of any given country's currency will fall in countries where the prices of non-tradable goods remain constant. Answer: C Page Ref: 425-432 Difficulty: Easy 5) Which one of the following statements is the MOST accurate? A) Relative price changes could not lead to PPP violations even if trade were free and costless. B) Relative price changes could lead to PPP violations only if trade were free and costless. C) Relative price changes could lead to PPP violations even if trade were free and costless. D) Price changes could lead to PPP violations even if trade were free and costless. E) Price changes could not lead to PPP violations even if trade were free and costless. Answer: C Page Ref: 425-432 Difficulty: Easy 6) Which one of the following statements is the MOST accurate? A) Departures from PPP are similar in both the short run and long run. B) Departures from PPP are even greater in the long run than in the long run. C) Departures from PPP are always greater in the short run than in the long run. D) It is hard to tell whether departures from PPP are greater in the short run than in the long run. E) Departures from PPP may often be greater in the short run than in the long run. Answer: E Page Ref: 425-432 Difficulty: Easy

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7) Floating exchange rates A) systematically lead to much larger but less frequent short-run deviations from the absolute PPP. B) systematically lead to much larger and more frequent short-run deviations from the relative PPP. C) systematically lead to much smaller and less frequent short-run deviations from the relative PPP. D) systematically lead to much smaller but more frequent short-run deviations from the relative PPP. E) systematically lead to much smaller and less frequent short-run deviations from the absolute PPP. Answer: B Page Ref: 425-432 Difficulty: Easy 8) Explain why price levels are lower in poorer countries. Answer: One theory explains the difference in prices on different endowments of capital and labor (Bhagwait, Kravis, and Lipsey). The explanation is as follows: ∙ Rich countries have high capital-labor ratios while poor countries have much more labor relative to capital. ∙ Because rich countries have high capital labor ratios, the MPL is greater and thus they have a higher wage. ∙ Higher wages lead to higher disposable income, and citizens' demand for goods will increase. ∙ Because labor is cheaper in poor countries and is used intensively in producing non-tradable goods; non-tradable goods will be cheaper in the poor countries than in the rich. ∙ The price of non-tradable goods will move with the increase in wage, thus increasing the price level of the good. Rich Countries: Expensive Non-tradable goods vs. Poor Countries: Cheap Non-tradable goods. Page Ref: 425-432 Difficulty: Moderate 16.6 Beyond Purchasing Power Parity: A General Model of Long-Run Exchange Rates 1) Which of the following statements is the MOST accurate about the Law of One Price on Scandinavian ferry lines? A) Due to menu costs, the Law of One Price does not hold. B) To avoid arbitrage opportunities, the Law of One Price must hold. C) Transaction costs of exchanging currency causes the Law of One Price to fail. D) Transportation costs between ferry lines leads to a violation of the Law of One Price. E) The physical distance allowed the Law of One Price to hold. Answer: C Page Ref: 432-440 Difficulty: Easy

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2) Which of the following statements is MOST accurate? A) The United States price level will place a relatively light weight on commodities produced and consumed in America, while the European price level will place a relatively heavy weight on commodities produced and consumed in Europe. B) The United States price level will place a relatively light weight on commodities produced and consumed in America, and the European price level will place a relatively light weight on commodities produced and consumed in Europe. C) The United States price level will place a relatively heavy weight on commodities produced and consumed in America, and the European price level will place a relatively heavy weight on commodities produced and consumed in Europe. D) The United States price level will place a relatively heavy weight on commodities produced and consumed in Europe, and the European price level will place a relatively heavy weight on commodities produced and consumed in America. E) The United States price level will place a relatively light weight on commodities produced and consumed in Europe, and the European price level will place a relatively heavy weight on commodities produced and consumed in America. Answer: C Page Ref: 432-440 Difficulty: Easy 3) When the domestic money prices of goods are held constant A) a nominal dollar appreciation makes U.S. goods cheaper compared with foreign goods. B) a nominal dollar depreciation makes U.S. goods less appealing in foreign markets. C) a nominal dollar appreciation does not affect the prices of U.S. goods. D) a nominal dollar depreciation makes U.S. goods more expensive compared with foreign goods. E) a nominal dollar depreciation makes U.S. goods cheaper compared with foreign goods and a nominal dollar appreciation makes U.S. goods more expensive compared with foreign goods. Answer: E Page Ref: 432-440 Difficulty: Easy 4) An increase in the world relative demand for U.S. output causes A) a short-run real depreciation of the dollar against the euro. B) a long-run real appreciation of the dollar against the euro. C) a long-run real depreciation of the dollar against the euro. D) a short-run real appreciation of the euro against the dollar. E) a long-run real appreciation of the euro against the dollar. Answer: B Page Ref: 432-440 Difficulty: Easy

25 .

5) Which of the following statements is MOST accurate? A) A relative expansion of U.S. output causes a long-run depreciation of the dollar against the euro, while a relative expansion of European output causes a long-run real appreciation of the dollar against the euro. B) A relative decline of U.S. output causes a long-run depreciation of the dollar against the euro, while a relative expansion of European output causes a long-run real appreciation of the dollar against the euro. C) A relative expansion of U.S. output causes a long-run appreciation of the dollar against the euro, while a relative expansion of European output causes a long-run real depreciation of the dollar against the euro. D) A relative expansion of U.S. output causes a long-run depreciation of the dollar against the euro, while a relative decline of European output causes a long-run real appreciation of the dollar against the euro. E) A relative decline of U.S. output causes a long-run depreciation of the dollar against the euro, while a relative decline of European output causes a long-run real appreciation of the dollar against the euro. Answer: A Page Ref: 432-440 Difficulty: Easy 6) When all variables start out at their long-run equilibrium levels, the most important determinant of long-run swings in nominal exchange rates is A) a shift in relative money supply levels. B) a shift in relative money supply growth rates. C) a change in relative output demand. D) a change in relative output supply. E) a change in relative inflation rates. Answer: E Page Ref: 432-440 Difficulty: Easy 7) Which of the following statements is MOST accurate? A) In the output market, an increase in demand for U.S. output leads to an increase in the longrun nominal dollar/euro exchange rate. B) In the output market, an increase in the demand for European output leads to an increase in the long-run nominal dollar/euro exchange rate. C) In the output market, a decrease in demand for U.S. output leads to a decrease in the long-run nominal dollar/euro exchange rate. D) In the output market, an increase in the demand for European output leads to a decrease in the long-run nominal dollar/euro exchange rate. E) In the output market, an increase in the demand for European output leads to an increase in the long-run nominal euro/dollar exchange rate. Answer: B Page Ref: 432-440 Difficulty: Easy

26 .

8) Which of the following statements is MOST accurate? A) In the money market, an increase in U.S. money supply level leads to a proportional increase in the long-run nominal dollar/euro exchange rate. B) In the money market, an increase in European money supply level leads to a proportional increase in the long-run nominal dollar/euro exchange rate. C) In the money market, an increase in U.S. money supply growth rate leads to a decrease in the long-run nominal dollar/euro exchange rate. D) In the money market, an increase in European money supply growth leads to an increase in the long-run nominal dollar/euro exchange rate. E) In the money market, an increase in U.S. money supply level leads to a proportional decrease in the long-run nominal dollar/euro exchange rate. Answer: A Page Ref: 432-440 Difficulty: Easy 9) In the long run A) exchange rates obey relative PPP when all disturbances occur in the output markets. B) exchange rates obey absolute PPP when all disturbances occur in the output markets. C) exchange rates are unlikely to obey relative PPP when all disturbances occur in the output markets. D) exchange rates are unlikely to obey relative PPP when all disturbances are monetary in nature. E) exchange rates obey absolute PPP when all disturbances are monetary in nature. Answer: C Page Ref: 432-440 Difficulty: Easy 10) Discuss the different effects on the domestic interest rates when prices are assumed flexible and when they are assumed to be sticky. Answer: When prices are flexible, a decrease in the domestic money supply has no effect on the interest rate, because of the immediate decrease in the price level. However, when prices are assumed to be sticky, a decrease in the domestic money supply will cause the interest rate to rise, because the sticky domestic price level leads to an excess demand for real money balances at the initial interest rate. Page Ref: 432-440 Difficulty: Moderate 11) What are the predictions of the PPP theory with regards to the real exchange rates? Answer: The real exchange rate between two countries is a broad summary measure of the prices one country's goods and services relative to the other's. PPP predicts that the real exchange rate never permanently changes, which is different from nominal exchange rates that deals with the relative price of two currencies. Page Ref: 432-440 Difficulty: Moderate

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12) What is the real exchange rate between the dollar and the euro equal to? Answer: Let ∙ Real dollar/euro exchange rate = ∙ Nominal exchange rate = ∙ Price of an unchanging basket in US = Pus ∙ Price of an unchanging basket in Europe = PE Then, =( × PE)/PUS A rise in the real dollar/euro exchange rate is called a real depreciation of the dollar against the euro, a fall in purchasing power of the dollar. A fall in the real dollar/euro exchange rate is called a real appreciation of the dollar against the euro, a rise in purchasing power of the dollar. Page Ref: 432-440 Difficulty: Difficult 13) Discuss why the empirical support for PPP and the law of one price is weak in recent data. Answer: The failure of these propositions in the real world is related to trade barriers and departures from free competition, factors that can result in pricing to market by exporters. In addition, different definitions of price levels in different countries bedevil attempts to test PPP using the price indexes governments publish. For some products, including many services, international transport costs are so steep that these products become non-tradable (see page 425). Page Ref: 432-440 Difficulty: Moderate 14) Define the concept of the real exchange rate and explain how it differs from the nominal exchange rate. Answer: In general, the real exchange rate between two countries' currencies is the price of the second country's commodity basket (in terms of the first country's currency) relative to the price of the first country's commodity basket. For example, in the case of U.S. and Europe, the real dollar/euro exchange rate is the dollar value of Europe's price level divided by the U.S. price level. We can thus denote the real dollar/euro exchange rate ( =(

) as:

× PE)/PUS

where is the nominal dollar/euro exchange rate, PE is Europe's price level, and PUS is the U.S. price level. Unlike the real exchange rate, which is the relative price of two output baskets, the nominal exchange rate is the relative price of two currencies. However, as we can see from the equation above, real exchange rates are defined in terms of nominal exchange rates. Page Ref: 432-440 Difficulty: Difficult

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16.7 International Interest Rate Differences and the Real Exchange Rate 1) Interest rate differences between countries depend on A) differences in expected inflation, but not on expected changes in the real exchange rate. B) differences in expected changes in the real exchange rate, but not on expected inflation. C) neither differences in expected inflation, nor on expected changes in the real exchange rate. D) differences in expected inflation and nothing else. E) differences in expected inflation, and on expected changes in the real exchange rate. Answer: E Page Ref: 440-441 Difficulty: Easy 2) The expected rate of change in the nominal dollar/euro exchange rate is best described as A) the expected rate of change in the real dollar/euro exchange rate minus the U.S.-Europe expected inflation difference. B) the expected rate of change in the real dollar/euro exchange rate plus the U.S.-Europe real interest rate difference. C) the expected rate of change in the real dollar/euro exchange rate plus the U.S.-Europe expected inflation difference. D) the expected rate of change in the real dollar/euro exchange rate minus the U.S.-Europe real interest rate difference. E) the expected rate of change in the real dollar/euro exchange rate plus the European expected inflation. Answer: C Page Ref: 440-441 Difficulty: Easy 16.8 Real Interest Parity 1) The expected real interest rate (re) in terms of the nominal interest rate (R) and the expected inflation rate (πe) is given by A) re = πe + R. B) re = 2πe + R2. C) re = πe + R2. D) re = R - πe. E) re = R2 - πe. Answer: D Page Ref: 441-442 Difficulty: Easy

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2) The difference between nominal and real interest rates is that A) nominal interest rates are measured in terms of a country's output, while real interest rates are measured in monetary terms. B) nominal interest rates are measured in monetary terms, while real interest rates are measured in terms of a country's output. C) nominal interest rates can fluctuate, while real interest rates always remain fixed. D) real interest rates can fluctuate, while nominal interest rates always remain fixed. E) real interest rates are the same in every country, while nominal interest rates are different for every country. Answer: B Page Ref: 441-442 Difficulty: Easy 3) What is the real interest rate parity condition? Answer: The nominal interest rates are rates of return measured in monetary terms. The real interest rates are rates of return measured in real terms. Real Interest Parity Condition: (

-

)=(

-

)/

Page Ref: 441-442 Difficulty: Moderate 16.9 Appendix to Chapter 16: The Fisher Effect, the Interest Rate, and the Exchange Rate Under the Flexible-Price Monetary Approach 1) The monetary approach to interest rates assumes that the prices of goods are ________, which implies that a country's currency will ________, when nominal interest rates ________ because of ________ expected future inflation. A) perfectly flexible; depreciate; increase; higher B) perfectly flexible; appreciate; increase; higher C) immutable; depreciate; increase; higher D) immutable; appreciate; decrease; higher E) absolutely inflexible; depreciate; decrease; higher Answer: A Page Ref: 448-450 Difficulty: Moderate 2) When the nominal dollar interest rate ________, money demand will ________, and the general price level will ________. A) increases; decrease; increase B) increases; increase; increase C) increases; decrease; decrease D) increases; increase; decrease E) decreases; increase; increase Answer: A Page Ref: 448-450 Difficulty: Easy 30 .

International Economics, 10e (Krugman/Obstfeld/Melitz) Chapter 17 (6) Output and the Exchange Rate in the Short Run 17.1 Determinants of Aggregate Demand in an Open Economy 1) How does an increase in the real exchange rate affect exports and imports? A) Exports increase; imports decrease. B) Exports decrease; imports increase. C) Exports increase; imports change ambiguously. D) Exports change ambiguously; imports decrease. E) Exports increase; imports are constant. Answer: C Page Ref: 451-455 Difficulty: Easy 2) Which one of the following statements is MOST accurate? A) In general, consumption demand rises by less than disposable income. B) In general, consumption demand rises by more than disposable income. C) In general, consumption demand rises by more than income. D) In general, consumption demand rises by the same amount as disposable income rises. E) In general, consumption demand rises are unrelated to disposable income rises. Answer: A Page Ref: 451-455 Difficulty: Easy 3) The current account balance is A) the supply of a country's exports less the country's own demand for imports. B) the demand for a country's exports plus the country's own demand for imports. C) the country's own demand for imports less the demand for a country's exports. D) the demand for a country's exports less the country's own demand for imports. E) the country's federal reserves minus the national debt. Answer: D Page Ref: 451-455 Difficulty: Easy 4) The domestic currency price of a representative foreign expenditure basket is A) P, the domestic price level. B) E, the nominal exchange rate. C) P times E, the domestic price level times the domestic price level. D) P , the foreign price level. E) P times E, the foreign price level times the nominal exchange rate. Answer: E Page Ref: 451-455 Difficulty: Easy

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5) Current account is given by the equation: A) CA = IM - EX (measured in terms of domestic output). B) CA = IM - EX (measured in terms of foreign output). C) CA = EX - IM (measured in terms of domestic output). D) CA = EX - IM (measured in terms of foreign output). E) CA = EX + IM (measured in terms of domestic output). Answer: C Page Ref: 451-455 Difficulty: Easy 6) The domestic currency price of a representative domestic expenditure basket is A) P, the domestic price level. B) E, the nominal exchange rate. C) P times E, the domestic price level times the domestic price level. D) P , the foreign price level. E) P times E, the foreign price level times the nominal exchange rate. Answer: A Page Ref: 451-455 Difficulty: Easy 7) The real exchange rate, q, is defined as A) the price of the foreign basket in terms of the domestic one. B) the price of the domestic basket in terms of the foreign one. C) the price of the foreign basket. D) the price of the domestic basket. E) the nominal exchange rate in terms of the domestic basket. Answer: A Page Ref: 451-455 Difficulty: Easy 8) A country's domestic currency's real exchange rate, q, is defined as A) E. B) E times P. C) E times P . D) (E times P )/P. E) P/(E times P ). Answer: D Page Ref: 451-455 Difficulty: Easy

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9) If the representative basket of European goods and services costs 40 euros, the representative U.S. basket costs $50, and the dollar/euro exchange rate is $0.90 per euro, then the price of the European basket in terms of U.S. basket is A) [(0.9 $/euro) (40 euro per a European basket)]/[(50 $/U.S. basket)]. B) [(0.9 $/euro) (50 $/U.S. basket)]/[(40 euro per a European basket)]. C) [(40 euro per a European basket)]/[(50 $/U.S. basket) (0.9 $/euro)]. D) [(50 $/U.S. basket)]. E) [(0.9 $/euro) (40 euro per a European basket) (50 $ U.S. basket)]. Answer: A Page Ref: 451-455 Difficulty: Easy 10) When EP /P rises A) IM will rise. B) IM will fall. C) IM may rise or fall. D) IM is not affected. E) IM and P* will both rise. Answer: C Page Ref: 451-455 Difficulty: Easy 11) When the real exchange rate rises A) imports measured in terms of domestic output will rise. B) imports measured in terms of domestic output will fall. C) imports measured in terms of domestic output will never be affected. D) imports measured in terms of domestic output may rise or fall. E) imports measured in terms of foreign output will rise. Answer: D Page Ref: 451-455 Difficulty: Easy 12) Which one of the following statements is the MOST accurate? A) An increase in disposable income improves the current account. B) An increase in disposable income does not affect the current account. C) An increase in disposable income worsens the current account. D) An increase in income worsens the current account. E) An increase in income improves the current account. Answer: C Page Ref: 451-455 Difficulty: Easy

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13) Which one of the following statements is the MOST accurate? A) An increase in the real exchange rate and an increase in disposable income improve the current account. B) A decrease in the real exchange rate and a decrease in disposable income improve the current account. C) A decrease in the real exchange rate and a increase in disposable income improve the current account. D) An increase in the real exchange rate and a decrease in disposable income improve the current account. E) An increase in the real exchange rate and a decrease in disposable income lowers the current account. Answer: D Page Ref: 451-455 Difficulty: Easy 14) Disposable income is defined as A) Y - C. B) Y - T. C) C - T. D) I - C. E) Y - I. Answer: B Page Ref: 451-455 Difficulty: Easy 15) The real exchange rate is: A) how much of a foreign currency you can buy with the domestic currency. B) foreign CPI divided by the domestic CPI. C) the price of foreign goods in terms of domestic goods. D) the price of foreign goods in dollars. E) the domestic currency divided by the price level. Answer: C Page Ref: 451-455 Difficulty: Easy 16) An increase in the real exchange rate A) makes imports more expensive. B) makes imports less expensive. C) does not affect import values. D) always makes the number of imports rise. E) makes domestic consumers spend more on only foreign imports. Answer: A Page Ref: 451-455 Difficulty: Easy

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17) Which of the following compete to determine whether the current account improves or worsens following a rise in the real exchange rate? A) appreciation and depreciation B) crowding Out effect and producers effect C) volume effect and value effect D) volume effect and inflation E) producers effect and value effect Answer: C Page Ref: 451-455 Difficulty: Easy 18) Assuming that the value effect dominates, the current account will increase if A) the real exchange rate decreases. B) the real exchange rate increases. C) disposable income increases. D) exports fall. E) domestic prices fall. Answer: B Page Ref: 451-455 Difficulty: Easy 19) Which of the following would cause the current account to decrease? A) an increase in the nominal exchange rate, E B) an appreciation of the home currency C) an increase in disposable income D) an increase in foreign prices, P E) a decrease in domestic prices, P Answer: C Page Ref: 451-455 Difficulty: Easy 20) What is the best way to describe aggregate demand? A) quantity required to satisfy equilibrium B) exports decrease; imports increase C) amount of a country's goods and services demanded by household and firms throughout the world D) individual's demand E) domestic demand of foreign imports. Answer: C Page Ref: 451-455 Difficulty: Easy

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21) What have we assumed when we conclude that a real depreciation of the currency improves the current account? A) The volume effect outweighs the value effect. B) The value effect outweighs the volume effect. C) All else equal and the volume effect outweighs the value effect. D) All else equal and the value effect outweighs the volume effect. E) All else equal and the volume effect equals the value effect. Answer: C Page Ref: 451-455 Difficulty: Easy 22) A country's domestic currency's real exchange rate, q, is best described by A) the price of similar goods in the same market. B) the price of the domestic basket in terms of the foreign one. C) the price of a domestic basket. D) the price of the foreign basket in terms of the domestic basket. E) the price of different goods baskets in the same market. Answer: D Page Ref: 451-455 Difficulty: Easy 23) Explain how does an increase in the real exchange rate affect exports and imports? Answer: When the real exchange rate increases, domestic products are cheaper relative to foreign products. Due to this, exports increase as foreigners demand more of our exports. The change in imports is ambiguous because fewer units of imports are purchased (the volume effect), but each foreign unit is now more expensive (the value effect). Remember: exports and imports are measured in terms of domestic output, i.e. dollar value, not volume of units. However, we often assume that the volume effect outweighs the value effect, so that imports decrease when the real exchange rate rises. Page Ref: 451-455 Difficulty: Moderate 24) Please discuss the volume effect and the value effect in regards to how the current account will move given a change in the real exchange rate. Answer: The volume effect takes place when consumer spending shifts on export and import quantities, while the value effect results when the domestic output worth of a given amount of foreign imports is changed. It is assumed that the volume effect outweighs the value effect, so that, other things equal, a real depreciation of the currency improves the current account. Page Ref: 451-455 Difficulty: Moderate

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25) What is the real exchange rate? What is its relationship to the current account? Answer: Defined as: EP /P (the exchange rate multiplied by foreign prices, divided by domestic prices). While the nominal exchange rate measures how much of a foreign currency one can buy with a unit of domestic currency, the real exchange rate measures how many goods and services one could buy. A rise in the real exchange rate (a depreciation of domestic currency) means that domestic goods are cheaper compared to foreign goods, so exports increase and imports decrease. Aggregate demand increases and the CA rises. A fall in the real exchange rate has the opposite effect: Aggregate demand decreases and the CA falls. Page Ref: 451-455 Difficulty: Moderate 26) Monetary expansion causes the current account balance to increase in the short run. Discuss. Is the same the case for fiscal expansion? Answer: Am increase in the money supply leads to an increase in Y and E (output increases and the currency depreciates, respectively). Because of the currency depreciation, domestic goods are now cheaper compared to foreign goods. Exports increase and imports decrease, therefore the CAB increases. An expansion of fiscal policy actually reduces the CAB: the DD curve is shifted right. Therefore Y rises, but E falls (output rises but the currency appreciates.) Domestic goods are more expensive, and the CAB falls. Page Ref: 451-455 Difficulty: Moderate 27) Find the real exchange rate for the following case: Assume that the representative basket of European goods and services costs 40 euros and the representative U.S. basket costs $50, and the dollar/euro exchange rate is $0.90 per euro, then the price of the European basket in terms of U.S. basket is ________. Answer: [(0.9 $/euro) (40 euro per a European basket)]/[(50 $/U.S. basket)] Page Ref: 451-455 Difficulty: Moderate 28) Find the real exchange rate for the following case: Assume that the representative basket of European goods costs 150 euros and the representative U.S. basket costs $90, and the dollar/euro exchange rate is $0.80 per euro, then the price of the European basket in terms of U.S. basket is: Answer: [(0.80 $/euro) (150 euro per a European basket)]/[(90 $/U.S. basket)] = 1.33 U.S. baskets/European basket. Page Ref: 451-455 Difficulty: Moderate

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29) Find the real exchange rate for the following case: Assume that the representative basket of European goods costs 150 euros and the representative U.S. basket costs $200, and the dollar/euro exchange rate is $1.20 per euro, then the price of the European basket in terms of U.S. basket is: Answer: [(1.20 $/euro) (150 euro per a European basket)]/[(200 $/U.S. basket)] = 0.9 U.S. baskets/European basket. Page Ref: 451-455 Difficulty: Moderate 30) Find the real exchange rate for the following case: Assume that the representative basket of European goods costs 100 euros and the representative U.S. basket costs $125, and the dollar/euro exchange rate is $0.75 per euro, then the price of the European basket in terms of U.S. basket is: Answer: [(0.75 $/euro) (100 euro per a European basket)]/[(125 $/U.S. basket)] = 0.60 U.S. baskets/European basket. Page Ref: 451-455 Difficulty: Moderate 31) Fill in the following table.

Answer:

Page Ref: 451-455 Difficulty: Moderate

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32) Fill in the following table.

Answer:

Page Ref: 451-455 Difficulty: Moderate 17.2 The Equation of Aggregate Demand 1) How does a rise in real income affect aggregate demand? A) Y ↑ implies Yd ↑ implies Im ↑ implies CA ↓ implies AD ↓, but Y ↑ implies Yd ↑ implies C ↑ implies AD ↑ by more. B) Y ↑ implies Yd ↑ implies Im ↓ implies CA ↓ implies AD ↓, but Y ↑ implies Yd ↑ implies C ↑ implies AD ↑ by more. C) Y ↑ implies Yd ↑ implies Im ↑ implies CA ↑ implies AD ↑, and Y ↑ implies Yd ↑ implies C ↑ implies AD ↑. D) Y ↑ implies Yd ↑ implies Im ↑ implies CA ↓ implies AD ↓, but Y ↑ implies Yd ↑ implies C ↑ implies AD ↑ by less. E) Y ↑ implies Yd ↑ implies Im ↓ implies CA ↓ implies AD ↓, but Y ↑ implies Yd ↑ implies C ↑ implies AD ↑ by less. Answer: A Page Ref: 455-456 Difficulty: Easy

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2) Which one of the following statements is the MOST accurate? A) A rise in domestic real income raises aggregate demand for home output. B) A rise in domestic real income decreases aggregate demand for home output because of the increase demand for import. C) A rise in domestic real income keeps aggregate demand for home output at the same level. D) It is difficult to tell whether a rise in domestic real income affects positively or negatively aggregate demand for home output. E) A rise in domestic real income decreases aggregate demand for home output because the CA is raised. Answer: A Page Ref: 455-456 Difficulty: Easy 3) The aggregate demand for home input can be written as a function of: I. Real exchange rate. II. Government spending. III. Disposable income. A) I only B) III only C) I and III D) II and III E) I, II, and III Answer: E Page Ref: 455-456 Difficulty: Easy 4) What is an accurate implication resulting from an increase in income? A) an increase in exchange rate B) a decrease in exchange rate C) a decrease in consumption D) a decrease in output E) an increase in consumption Answer: E Page Ref: 455-456 Difficulty: Easy 5) Explain how does a rise in real income affect aggregate demand? Answer: A rise in domestic real income, Y, leads to a rise in disposable income, Yd. This raises the spending on imports, IM, thus lowering the current account, CA, and reducing aggregate demand, AD. However, the rise in Yd also causes a rise in consumption, C, and raises aggregate demand, AD, by more than the corresponding decrease. Page Ref: 455-456 Difficulty: Easy

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6) Explain the difference between the following two expressions: Y = C(Yd) + I + G + CA(EP /P, Yd) and Y = C + I +G + CA Answer: The first one represents a behavioral equation and thus may express equilibrium condition for the output market or the aggregate desired demand for output. The second equation is only an identity that is always true. Page Ref: 455-456 Difficulty: Moderate 17.3 How Output Is Determined in the Short Run 1) Which one of the following statements is MOST accurate? A) Factors of production can only be over-employed in the short run. B) Factors of production can only be under-employed in the short run. C) Factors of production can be over- or under-employed in the long run. D) Factors of production can be over- or under-employed in the short run. E) Factors of production are fully employed in the short run. Answer: D Page Ref: 457-458 Difficulty: Easy 2) In the short-run, any rise in the real exchange rate, EP /P, will cause A) an upward shift in the aggregate demand function and a reduction in output. B) an upward shift in the aggregate demand function and an expansion of output. C) a downward shift in the aggregate demand function and an expansion of output. D) an downward shift in the aggregate demand function and a reduction in output. E) an upward shift in the aggregate demand function but leaves output intact. Answer: B Page Ref: 457-458 Difficulty: Easy 3) In the short-run, any fall in EP /P, regardless of its causes, will cause A) an upward shift in the aggregate demand function and an expansion of output. B) an upward shift in the aggregate demand function and a reduction in output. C) a downward shift in the aggregate demand function and an expansion of output. D) an downward shift in the aggregate demand function and a reduction in output. E) an upward shift in the aggregate demand function but leaves output intact. Answer: D Page Ref: 457-458 Difficulty: Easy

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4) The unique equilibrium output level in the short-run is found at the intersection of the following curves. A) aggregate demand and aggregate supply B) aggregate demand and 45 degree line C) aggregate supply and 45 degree line D) aggregate demand and short-run aggregate supply E) aggregate supply and long-run demand Answer: B Page Ref: 457-458 Difficulty: Easy 5) Why is the economy at full employment in the long run? A) Only wages have the ability to adjust. B) Only price can adjust. C) Prices don't adjust. D) Wages and the price level eventually adjust to full employment equilibrium levels. E) Government policies eventually converge on the full employment strategy. Answer: D Page Ref: 457-458 Difficulty: Easy 6) In the short-run, we assume that the money prices of goods and services are A) temporarily fixed. B) permanently fixed. C) allowed to fluctuate. D) equal to long-run prices. E) fully employed. Answer: A Page Ref: 457-458 Difficulty: Easy 7) What would be the best description of what we assume about money prices in the short run? A) Money prices of goods and services vary. B) Money prices of goods and services not related to each other. C) Money prices of goods are fixed. D) Money prices of services are fixed. E) Money prices of goods and services are only temporarily fixed. Answer: E Page Ref: 457-458 Difficulty: Easy

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17.4 Output Market Equilibrium in the Short Run: The DD Schedule 1) The DD schedule shows all combinations of which 2 variables so that the output market is in equilibrium? A) imports and exports B) exports and the exchange rate C) foreign prices and the exchange rate D) output and the exchange rate E) output and exports Answer: D Page Ref: 458-462 Difficulty: Easy 2) Which of the following does NOT affect the position of the DD curve? A) monetary policy B) government spending C) taxes D) export demand E) price levels Answer: A Page Ref: 458-462 Difficulty: Easy 3) Temporary tax cuts would cause A) the AA-curve to shift left. B) the AA-curve to shift right. C) the DD-curve to shift left. D) the DD-curve to shift right. E) a shift in the AA-curve, although the direction is ambiguous. Answer: D Page Ref: 458-462 Difficulty: Easy 4) How would you define a DD schedule? A) the combinations of output and the exchange rate that must hold when the home money market and the foreign exchange market are in equilibrium B) the combinations of output and the exchange rate that must hold when the output market is in short-run equilibrium C) factors of production in the long run D) the aggregate demand in relation to the foreign market value E) the currency depreciation in relation to the exchange rate Answer: B Page Ref: 458-462 Difficulty: Easy

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5) Which of the following is the MOST accurate? A) Any disturbance that lowers aggregate demand for domestic output shifts the DD schedule to the right. B) Any disturbance that lowers aggregate demand for foreign output shifts the DD schedule to the left. C) Any disturbance that raises aggregate demand for domestic output shifts the DD schedule to the right. D) Any disturbance that raises aggregate demand for domestic output shifts the DD schedule to the left. E) Any disturbance that lowers aggregate demand for domestic output shifts the DD schedule downward. Answer: C Page Ref: 458-462 Difficulty: Easy 6) Discuss the main factors affecting the position of the DD schedule. Answer: The level of government demand, taxes, and investment; the domestic and foreign price levels; variations in domestic consumption behavior; and the foreign demand for home output. Page Ref: 458-462 Difficulty: Moderate 7) Give 4 examples of situations that would cause the DD-curve to shift to the left. Answer: Correct answers include any situations that involve: (1) an decrease in government spending (e.g., decrease in military spending) (2) an increase in taxes (3) a fall in Investment demand (4) a price increase, which would lower net export demand (assuming E and P stay constant) (5) a fall in foreign prices (assuming E and P stay constant) (6) an autonomous fall in consumption demand (as long as it is not entirely a change in import demand) (7) a shift to demanding more foreign goods at the expense of domestic good demand Page Ref: 458-462 Difficulty: Difficult 8) Explain what are the factors that shift the DD Schedule. Answer: A change in government demand, change in Taxes, a change in investment, change in domestic prices, change in foreign prices, changes in the consumption function and a demand shift between foreign and domestic goods. Page Ref: 458-462 Difficulty: Moderate

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17.5 Asset Market Equilibrium in the Short Run: The AA Schedule 1) How is the AA schedule derived? A) The AA schedule has a positive slope because an increase in output leads to a depreciation of the currency. B) The AA schedule has a negative slope because an increase in output leads to a decrease in the domestic interest rate. C) The AA schedule has a negative slope because an increase in output leads to an increase in the domestic interest rate and a domestic currency appreciation. D) The AA schedule has a positive slope because an increase in the money supply leads to an increase in the domestic interest rate. E) The AA schedule has a positive slope because a decrease in output leads to a depreciation of the currency. Answer: C Page Ref: 462-466 Difficulty: Easy 2) Which one of the following statements is MOST accurate? A) In the long run, foreign output depends only on the available domestic supplies of factors of production. B) In the short run, domestic output depends only on the available domestic supplies of factors of production. C) In the long run, domestic output depends only on the available domestic supplies of factors of production. D) In the long run and in the short run, domestic output depends only on the available domestic supplies of factors of production. E) In the long run, domestic output depends only on the real exchange rate. Answer: C Page Ref: 462-466 Difficulty: Easy 3) In the short-run, a temporary increase in the money supply A) shifts the AA curve to the right, increases output and depreciates the currency. B) shifts the AA curve to the left, increases output and depreciates the currency. C) shifts the AA curve to the left, decreases output and depreciates the currency. D) shifts the AA curve to the left, increases output and appreciates the currency. E) shifts the AA curve to the right, increases output and appreciates the currency. Answer: A Page Ref: 462-466 Difficulty: Easy

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4) Which of the following equations does NOT state a condition required for equilibrium output:? A) Y = C(Yd) + I + G + CA(EP*/P,Yd) B) Y = C(Y - T) + I + G + CA(EP*/P,Y - T) C) Y = D(EP*/P,Y - T,I,G) D) R = R* + (EP/E) E) Y = D(EP*/P,Yd,I,G) Answer: D Page Ref: 462-466 Difficulty: Easy 5) The interest parity condition requires that: A) all countries have the same interest rate. B) there is a unique exchange rate for every output level. C) purchasing power parity hold. D) interest rates are fixed in the short run. E) the money supply is held constant. Answer: B Page Ref: 462-466 Difficulty: Easy 6) How is the AA schedule derived? A) It is derived by the schedule of interest rate and output combinations that are consistent with equilibrium in the domestic money market and the foreign exchange market. B) It is derived by the schedule of exchange rate and output combinations that are consistent with equilibrium in the foreign money market and the domestic exchange market. C) It is derived by the schedule of exchange rate and output combinations that are consistent with equilibrium in the domestic money market and the foreign exchange market. D) It is derived by the schedule of exchange rate and output combinations that are consistent with equilibrium in the domestic bond market and the foreign asset market. E) It is derived by the schedule of exchange rate and output combinations that are greater than equilibrium in the foreign money market and the domestic exchange market. Answer: C Page Ref: 462-466 Difficulty: Easy 7) Explain how the AA schedule is derived. Answer: For a fixed real money supply, an increase in output leads to an increase in the domestic interest rate. In the foreign exchange market, an increase in the domestic interest rate leads to a lower nominal exchange rate, thus appreciating the currency. Therefore, the relationship between nominal exchange rate and output is negative; this leads to a negative slope of the AA schedule, which has the nominal exchange rate and output on its axes. Page Ref: 462-466 Difficulty: Moderate

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8) Discuss the main factors affecting the position of the AA schedule. Answer: Changes in the domestic money supply; changes in the domestic price level; changes in the expected future exchange rate; changes in the foreign interest rate; and shifts in the aggregate real money demand schedule. Page Ref: 462-466 Difficulty: Moderate 9) What is the AA-curve? Why does it have a negative slope? What factors cause it to shift? Answer: The AA-curve is the specific levels of E and Y under which the money and foreign exchange markets are in equilibrium. The AA-curve has a negative slope because an increase in Y will cause E to fall (a domestic currency appreciation). The factors that affect it are: the money supply, price level, expected exchange rate, foreign interest rates, and the level of real money demand. Page Ref: 462-466 Difficulty: Difficult 10) Explain what are the factors that shift the AA Schedule? Answer: Changes in the domestic money supply; changes in the domestic price level; changes in the expected future exchange rates; changes in the foreign interest rate and shifts in the aggregate real money demand. Page Ref: 462-466 Difficulty: Moderate 11) Which one of the following statements is the MOST accurate? A) For asset markets to remain in equilibrium, a rise in domestic output must be accompanied by a depreciation of domestic currency, all else equal. B) For asset markets to remain in equilibrium, a fall in domestic output must be accompanied by a depreciation of foreign currency, all else equal. C) For asset markets to remain in equilibrium, a rise in domestic output must be accompanied by an appreciation of domestic currency, all else equal. D) For asset markets to remain in equilibrium, a fall in domestic output must be accompanied by an appreciation of domestic currency, all else equal. E) For asset markets to remain in equilibrium, a fall in domestic output must be accompanied by an appreciation of foreign currency, all else equal. Answer: C Page Ref: 462-466 Difficulty: Easy

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17.6 Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together 1) Imagine that the economy is at a point that is above both AA and DD, where both the output and asset markets are out of equilibrium. Which first action is TRUE? A) The economy will stay at this level in the short run. B) The exchange rate will first drop to a point on the AA schedule. C) The exchange rate will first move to a point on the DD schedule. D) The AA-DD equilibrium will shift to the position of the economy. E) The exchange rate will first move left to a position on the AA schedule. Answer: B Page Ref: 466-467 Difficulty: Easy 2) Which of the following have to be in equilibrium for the economy to be in equilibrium? A) the money market only B) the goods market only C) the output and asset markets D) the savings and investment markets E) the goods and output markets Answer: C Page Ref: 466-467 Difficulty: Easy 3) Assume the asset market is always in equilibrium. Therefore a fall in Y would result in A) higher inflation abroad. B) a decreased demand for domestic products. C) a contraction of the money supply. D) a depreciation of the home currency. E) an appreciation of the home currency. Answer: D Page Ref: 466-467 Difficulty: Easy 4) Why does an exchange rate-output combination lying above both DD and AA jump first to AA in equilibrium? A) Asset prices can adjust immediately. B) Production plans can adjust immediately. C) to preserve full employment D) Prices are nominal and demand is real. E) Aggregate demand adjusts faster than output. Answer: A Page Ref: 466-467 Difficulty: Easy

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5) Explain how an increase in government spending would affect the DD-AA schedule in the short run. Answer: An increase in government spending will increase aggregate demand, which will shift the DD to the right. If AA remains unchanged, the new equilibrium will be at a higher Y and lower E. Since E is the nominal exchange rate, a lower E is an appreciation of the currency. Page Ref: 466-467 Difficulty: Moderate 6) Imagine that the economy is at a point on the DD-AA schedule that is above both AA and DD and where both the output and asset markets are out of equilibrium. Explain what will happen next? Answer: Since the asset market adjusts very quickly, the exchange rate drops immediately to a point on the AA schedule. There will be excess demand for the domestic currency because the high expected future appreciation rate of the domestic currency implies that the expected domestic currency return on foreign deposits is below that on domestic deposits. This excess demand leads to an immediate fall in the exchange rate. Page Ref: 466-467 Difficulty: Moderate 7) A naïve implication of the DD-AA framework is that either fiscal or monetary policy can lead to full employment. Discuss why this view is naïve. Answer: (1) Inflation may arise without any gain in output if the government misuses its power to print money. (2) In practice, it is sometimes hard to be sure whether a disturbance to the economy originates in the output or assets markets. (3) Shifts in fiscal policy often can be made only after lengthy legislative deliberations. Governments are likely to respond to disturbances by changing the monetary policy even when a shift in fiscal policy would be more appropriate. (4) Fiscal policy impacts the government budget and may lead to government budget deficit that must be sooner or later be closed by a fiscal reversal. The state of the electoral cycle may be more important. (5) Policies operate in reality with lags of varying length. Page Ref: 466-467 Difficulty: Difficult

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8) Use a figure to study the following question: Imagine that the economy is at a point on the DD-AA schedule that is above both AA and DD, where both the output and asset markets are out of equilibrium. Explain what will happen next. Answer: Since the asset market adjusts very quickly, the exchange rate drops immediately to a point on the AA schedule. There will be excess demand for the domestic currency because the high expected future appreciation rate of the domestic currency implies that the expected domestic currency return on foreign deposits is below that on domestic deposits. This excess demand leads to an immediate fall in the exchange rate. The figure:

Page Ref: 466-467 Difficulty: Easy 9) Imagine that the economy is at a point on that is below both AA and DD, where both the output and asset markets are out of equilibrium. Which first action is TRUE? A) The economy will stay at this level in the short run. B) The exchange rate will first rise to a point on the AA schedule. C) The exchange rate will first rise to a point on the DD schedule. D) The AA-DD equilibrium will shift to the position of the economy. E) The output level will first increase to a position on the DD schedule. Answer: B Page Ref: 466-467 Difficulty: Easy 10) Assume the output market adjusts more rapidly than the asset market. A point of disequilibrium that is below both AA and DD will therefore initially result in A) an increase in output. B) a decrease in output. C) a contraction of the money supply. D) a depreciation of the home currency. E) an appreciation of the home currency. Answer: B Page Ref: 466-467 Difficulty: Easy

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17.7 Temporary Changes in Monetary and Fiscal Policy 1) In the short run, with prices fixed, how would an increase in government spending affect the DD-AA equilibrium? A) It will increase output and appreciate the currency. B) It will increase output and depreciate the currency. C) It will decrease output and appreciate the currency. D) It will decrease output and depreciate the currency. E) It will increase output and have no effect on the currency. Answer: A Page Ref: 468-471 Difficulty: Easy 2) In the short-run, an increase in government purchases will cause A) a shift of the DD curve to the left and an increase in output. B) a shift of the DD curve to the right and a decrease in output. C) a shift of the DD curve to the left and a decrease in output. D) a shift of the DD curve to the right and an increase in output. E) a shift of the DD curve the left and an appreciation of the currency. Answer: D Page Ref: 468-471 Difficulty: Easy 3) What are two ways the government can use to maintain full employment in an open economy? Also give an example for each. Answer: There are two types of government policy, monetary and fiscal policy. Examples of monetary policy are changes in the money supply. Examples of fiscal policy are changes in government spending or taxes. Page Ref: 468-471 Difficulty: Moderate

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4) Using a figure show that under full employment, a temporary fiscal expansion would increase output (over-employment) but cannot increase output in the long run. Answer: A temporarily fiscal expansion will move the economy from DD1 to DD2, and output increases. A permanent fiscal expansion will also shift the AA curve to the left and down. The nominal exchange rate appreciates, i.e. E decreases.

Page Ref: 468-471 Difficulty: Moderate 5) In the short-run, a temporary increase in money supply A) shifts the DD curve to the right, increases output and appreciates the currency. B) shifts the AA curve to the left, increases output and depreciates the currency. C) shifts the AA curve to the left, decreases output and depreciates the currency. D) shifts the AA curve to the left, increases output and appreciates the currency. E) shifts the AA curve to the right, increases output and depreciates the currency. Answer: E Page Ref: 468-471 Difficulty: Easy 6) In the short-run, a tax increase A) shifts the DD curve to the right, increases output and appreciates the currency. B) shifts the AA curve to the left, increases output and depreciates the currency. C) shifts the AA curve to the left, decreases output and depreciates the currency. D) shifts the AA curve to the left, increases output and appreciates the currency. E) shifts the DD curve to the left, decreases output and depreciates the currency. Answer: E Page Ref: 468-471 Difficulty: Easy

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17.8 Inflation Bias and Other Problems of Policy Formulation 1) What is inflation bias? What measures have governments taken to avoid it? Answer: Inflation bias is caused when a government is expected to use policy tools to create an economic expansion (such as before an election). Because it is expected, wages and therefore prices are increased. If the government did not pursue the expansionary policy then, there would be a recession! Inflation is increased without the advantage of an increase in output. Making the central bank independent of the political government is one answer to avoid inflation bias. Page Ref: 471-472 Difficulty: Moderate 2) Explain and give some examples of governmental policy problems. Answer: Steady nominal prices give government the power to raise output when it is low. It can also cause them to create a tool that can be used for an economic boom. An example is just before an election. The temptation can be a problem when workers and companies expect it in advance. This will cause a rise in wage demand and prices in the expected expansionary policies. An inflation bias causing high inflation but no average gains in output is also a problem. Others are the difficulty in showing the sources or time of economic changes, and time lags in implementing policies. Impact on the government budget by fiscal policy also causes problems by the way of a tax cut; increase in spending may lead to a government budget deficit that must sooner or later be closed by a fiscal reversal. Policy problem that seem to act quickly have actually a lag time with varying lengths. Page Ref: 471-472 Difficulty: Moderate 17.9 Permanent Shifts in Monetary and Fiscal Policy 1) If the economy starts in long-run equilibrium, a permanent fiscal expansion will cause A) an increase in exchange rate, E. B) a decrease in exchange rate, E. C) an increase in output, Y. D) a decrease in output, Y. E) shifting of the AA curve up and to the right. Answer: B Page Ref: 472-477 Difficulty: Easy 2) In long-run equilibrium after a permanent money-supply increase there follows: A) an increase in exchange rate, E. B) a decrease in exchange rate, E. C) an increase in output, Y. D) a decrease in output, Y. E) an unchanged exchange rate, E. Answer: A Page Ref: 472-477 Difficulty: Easy 23 .

3) Which one of the following statements is the MOST accurate? A) Over time, the inflationary pressure that follows a temporary money supply expansion pushes the price level to its long-run value and returns the economy to full employment. B) Over time, the inflationary pressure that follows a permanent money supply expansion pushes the price level to its long-run value and returns the economy to full employment. C) Over time, the inflationary pressure that follows a temporary money supply expansion pushes the price level to its long-run value, but leaves the economy in a state of artificially low employment. D) Over time, the inflationary pressure that follows a permanent money supply expansion pushes the price level to its long-run value, but leaves the economy in a state of artificially low employment. E) Over time, the inflationary pressure that follows a permanent money supply expansion pushes the price level beyond its long-run value and lower the level of employment. Answer: B Page Ref: 472-477 Difficulty: Easy 4) Using the DD-AA framework, which one of the following statements is the MOST accurate? A) Only monetary policy can bring the economy to full employment. B) Only fiscal policy can bring the economy to full employment. C) Only both monetary and fiscal policies can bring the economy to full employment. D) Both policies are capable of bringing the economy to full employment and low inflation. E) Monetary policy by itself or fiscal policy by itself can bring the economy to full employment. Answer: E Page Ref: 472-477 Difficulty: Easy 5) Which one of the following statements is the MOST accurate? A) A permanent increase in the money supply cannot have any short-run effects. B) A permanent increase in taxes cannot have any short-run effects. C) A permanent decrease in the money supply cannot have short-run effects. D) A permanent decrease in taxes cannot have short-run effects. E) A permanent increase in money demand can be offset with a permanent increase in the money supply of equal magnitude. Answer: E Page Ref: 472-477 Difficulty: Easy

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6) A permanent increase in the domestic money supply A) must ultimately lead to a proportional decrease in E, and, therefore, the expected future exchange rate must rise proportionally. B) must ultimately lead to a proportional decrease in E, and, therefore, the expected future exchange rate must decrease proportionally. C) must ultimately lead to a proportional rise in E, and, therefore, the expected future exchange rate must rise proportionally. D) must ultimately lead to a proportional rise in E, and, therefore, the expected future exchange rate must rise more than proportionally. E) must ultimately lead to a proportional rise in E, and, therefore, the expected future exchange rate must rise less than proportionally. Answer: C Page Ref: 472-477 Difficulty: Easy 7) In the short run, a permanent increase in the domestic money supply causes A) a greater upward shift in the DD curve than that caused by an equal, but transitory, increase. B) a greater downward shift in the AA curve than that caused by an equal, but transitory, increase. C) an smaller upward shift in the AA curve than that caused by an equal, but transitory, increase. D) a smaller downward shift in the AA curve than that caused by an equal, but transitory, increase. E) a greater upward shift in the AA curve than that caused by an equal, but transitory, increase. Answer: E Page Ref: 472-477 Difficulty: Easy 8) In the short run, a permanent increase in the domestic money supply A) has stronger effects on the exchange rate and output than an equal temporary increase. B) has stronger effects only on the exchange rate but not on output than an equal temporary increase. C) has weaker effects on the exchange rate and output than an equal temporary increase. D) has stronger effects on output, but lower effect the exchange rate than an equal temporary increase. E) has weaker effects only on the exchange rate than an equal temporary increase. Answer: A Page Ref: 472-477 Difficulty: Easy

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9) A permanent fiscal expansion A) shifts the DD and the AA schedules to the right, increasing output. B) shifts the DD and the AA schedules to the right, decreasing output. C) shifts the DD to the right and the AA schedule to the left, leaving output the same. D) shifts the DD to the left and the AA schedule to the left, decreasing output. E) shifts the DD and the AA schedules to the left, leaving output the same. Answer: C Page Ref: 472-477 Difficulty: Easy 10) Explain the following figure:

Answer: The figure depicts the effect of a permanent increase in the money supply starting from full employment equilibrium. After the initial increase in the money supply and the move of the AA curve to the right from AA1 to AA2, a steadily increasing price level shifts the AA and the DD schedules to the left until a new long-run equilibrium is reached. Note that point 3 is above point 1, because Ee is permanently higher after a permanent increase in the money supply. The expected exchange rate, Ee, has risen by the same percentage as Ms. Notice that along the adjustment path between the initial short-run equilibrium (point 2) and the long-run equilibrium (point 3) the domestic currency actually appreciates (from E2 to E3) following its initial sharp depreciation (from E1 to E2). Page Ref: 472-477 Difficulty: Moderate

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11) Using the DD-AA framework, show the phenomenon of overshooting. Use a figure to explain when it is taking place. Answer: The figure below shows the phenomenon of overshooting. A permanent increase in the money supply starting from full employment equilibrium will shift the AA curve to the right from AA1 to AA2. Now, a steadily increasing price level shifts the AA and the DD schedules to the left until a new long-run equilibrium is reached. Note that point 3 is above point 1, because Ee is permanently higher after a permanent increase in the money supply. The expected exchange rate, Ee, has risen by the same percentage as Ms. Notice that along the adjustment path between the initial short-run equilibrium (point 2) and the long-run equilibrium (point 3) the domestic currency actually appreciates (from E2 to E3) following its initial sharp depreciation (from E1 to E2). This exchange rate behavior is an example of overshooting, in which the exchange rate's initial response to some change is greater than its long-run response.

Page Ref: 472-477 Difficulty: Moderate 12) Demonstrate how a permanent fiscal expansion will not increase output in the long run. Answer: (1) E on Y-axis, Y on X-axis (2) DD shifts right (3) temporary equilibrium where E lower and Y increased (4) permanent increase in demand caused by increase in G causes currency to appreciate: AA shifts left (5) therefore Y returns to original levels, E decreases even more RESULT of permanent fiscal expansion: currency appreciation, output does not change. This effect is called "crowding out." Page Ref: 472-477 Difficulty: Moderate

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13) Show the effects of a permanent increase in the money supply. Answer: (1) AA-shifts right-increase in Y and E both higher than if money supply change was temporary rising price level makes AD decrease, DD shifts left (2) rising prices also reduce real money supply, so AA shifts left (although not all the way back to original position) (3) AA and DD reach short run equilibrium at an E that is higher than initially, but lower than the short run effects of the shift. (4) Output returns to initial level because higher prices reversed the effect of the initial depreciation on Aggregate Demand. Page Ref: 472-477 Difficulty: Moderate 14) Using the DD model, explain what happens to out put when Government demands increase. Use a figure to explain when it is taking place. Answer: The figure below shows the G1 to G2 raises output at every level of the exchange rate. The change shifts the DD to the right. Which in turns increases output to Y2.

Page Ref: 472-477 Difficulty: Easy 17.10 Macroeconomic Policies and the Current Account 1) Which of the following is TRUE of the current account balance? A) Monetary expansion has no effect on the current account balance. B) Monetary expansion decreases the current account balance. C) Fiscal expansion increases the current account balance. D) Fiscal expansion has no effect on the current account balance. E) Monetary expansion increases the current account balance. Answer: E Page Ref: 477-478 Difficulty: Easy

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2) In the short run A) monetary expansion causes the CA to increase & fiscal expansion causes the CA to decrease. B) monetary expansion causes the CA to decrease & fiscal expansion causes the CA to decrease. C) monetary expansion causes the CA to increase & fiscal expansion causes the CA to increase. D) monetary expansion causes the CA to decrease & fiscal expansion causes the CA to increase. E) monetary expansion causes the CA to increase & the effects of fiscal expansion are ambiguous. Answer: A Page Ref: 477-478 Difficulty: Easy 3) Which statement best describes the current account balance in the short run? A) Monetary expansion lowers the current account balance. B) Monetary expansion keeps the current account balance the same. C) Fiscal expansion increases the current account balance. D) Fiscal expansion keeps the current account balance the same. E) Monetary expansion increases the current account balance. Answer: E Page Ref: 477-478 Difficulty: Easy 17.11 Gradual Trade Flow Adjustment and Current Account Dynamics 1) According to historical data, what is the effect of a sharp change in the current account on the exchange rate (both in the short and long run)? A) At first, home currency will depreciate as CA balance falls, but over time, currency will begin to depreciate. B) At first, home currency will appreciate as CA balance falls, but over time, currency will begin to depreciate. C) At first, home currency will appreciate as CA balance rises, but over time, currency will begin to depreciate. D) At first, home currency will depreciate as CA balance falls, but over time, currency will begin to appreciate. E) At first, home currency will appreciate as CA balance falls, but over time, currency will begin to appreciate. Answer: B Page Ref: 478-481 Difficulty: Easy

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2) Which two time periods did the U.S. begin to experience a sharp increase in Current Account deficits? A) 1981, mid-1990s B) 1971, mid-1990s C) 1961, mid-1990s D) 1971, mid-1980s E) 1985, mid-1990s Answer: A Page Ref: 478-481 Difficulty: Easy 3) The J-curve illustrates which of the following? A) the effects of depreciation on the home country's economy B) the immediate increase in current account caused by a currency depreciation C) the gradual adjustment of home prices to a currency depreciation D) the short-term effects of depreciation on the current account E) the Keynesian view of international trade dynamics Answer: D Page Ref: 478-481 Difficulty: Easy 4) The percent by which import prices rise when the home currency depreciates by 1% is the degree of A) pass-forward from exchange rates to import prices. B) pass-through from exchange rates to import prices. C) pass-on from exchange rates to import prices. D) roll-forward from exchange rates to import prices. E) pass-beyond from exchange rates to import prices. Answer: B Page Ref: 478-481 Difficulty: Easy 5) In practice, many U.S. import prices tend to rise by only around A) 1/4 of a typical dollar depreciation over the following year. B) 1/3 of a typical dollar depreciation over the following year. C) 1/2 of a typical dollar depreciation over the following year. D) 2/3 of a typical dollar depreciation over the following year. E) 2/5 of a typical dollar depreciation over the following year. Answer: C Page Ref: 478-481 Difficulty: Easy

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6) Describe what is a J Curve? Answer: The time lag with which real currency depreciation improves the current account. The current account is measured in terms of domestic output, and can drop quickly right after real currency depreciation because most import and export orders are placed several months in advance. In the first few months after the depreciation, export and import volumes therefore may reflect buying decisions that were made on the basis of the old real exchange rate. Page Ref: 478-481 Difficulty: Moderate 17.12 The Liquidity Trap 1) If a country's nominal interest rate is zero, then A) the country's economy is in a liquidity trap. B) exchange rates with other countries are likely to decline. C) exchange rates with other countries are likely to increase. D) monetary policy is likely to be very effective in stimulating the economy. E) the country's economy has achieved monetary equilibrium. Answer: A Page Ref: 481-485 Difficulty: Moderate 2) When an economy is in a liquidity trap A) monetary policy cannot be used to influence the exchange rate. B) monetary policy can be used to drive interest rates down, but not to drive them up. C) there is an excess demand for bonds. D) people and institutions avoid holding cash balances. E) it can escape only by introducing a hard, or illiquid, currency. Answer: A Page Ref: 481-485 Difficulty: Moderate 3) Which of the following is an example of an "unconventional monetary policy" by a central bank? A) The purchase of specific categories of assets with new money. B) The sale of long-term government bonds for foreign exchange. C) the purchase of long-term government bonds using foreign exchange. D) raising reserve requirements by commercial banks. E) selling gold reserves. Answer: A Page Ref: 481-485 Difficulty: Moderate

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4) If an economy is in a liquidity trap, then the nominal interest rate is ________ and the only effective policy that can be used to stimulate the economy is ________. A) zero or negative; expansionary fiscal policy B) zero or negative; expansionary monetary policy C) high and rising; contractionary monetary policy D) high and rising; expansionary monetary policy E) high and rising; expansionary fiscal policy Answer: A Page Ref: 481-485 Difficulty: Moderate 17.13 Appendix 1 to Chapter 17: Intertemporal Trade and Consumption Demand 1) An intertemporal budget constraint A) requires the present value of consumption to be equal to the present value of production. B) requires total spending in each period to be equal to total consumption in each period. C) does not take into account the ability to borrow or loan goods domestically. D) categorizes income into permanent and temporary income. E) limits consumption to the amount produced in each time period. Answer: A Page Ref: 490-491 Difficulty: Easy 2) If consumers experience an increase in lifetime income, current spending will ________, current saving will ________, and future spending will ________. A) increase; increase; increase B) increase; decrease; decrease C) increase; decrease; increase D) increase; increase; decrease E) decrease; increase; increase Answer: A Page Ref: 490-491 Difficulty: Easy 3) If consumers experience an decrease in lifetime income, current spending will ________, current saving will ________, and future spending will ________. A) decrease; decrease; decrease B) increase; decrease; decrease C) increase; decrease; increase D) increase; increase; decrease E) decrease; increase; increase Answer: A Page Ref: 490-491 Difficulty: Easy

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17.14 Appendix 2 to Chapter 17: The Marshall-Lerner Condition and Empirical Estimates of Trade Elasticities 1) One implication of an empirical investigation of the Marshall-Lerner condition is that, in the ________, a real ________ in a nation's currency is likely to ________ the country's current account balance. A) long-run; depreciation; improve B) short-run; depreciation; improve C) long-run; appreciation; improve D) short-run; appreciation; improve E) short-run but not the long-run; appreciation; improve Answer: A Page Ref: 492-494 Difficulty: Easy 2) The Marshall-Lerner condition holds that a country's current account balance will ________ in response to a real ________ in a nation's currency if ________. A) improve; depreciation; sum of the price elasticities of export and import demand exceeds 1 B) worsen; depreciation; sum of the price elasticities of export and import demand exceeds 1 C) improve; appreciation; sum of the price elasticities of export and import demand exceeds 1 D) improve; appreciation; sum of the price elasticities of export and import demand exceeds 0 E) worsen; depreciation; sum of the price elasticities of export and import demand exceeds 0 Answer: A Page Ref: 492-494 Difficulty: Moderate 3) A real depreciation of a nation's currency gives rise to the ________ effect and the ________ effect on the current account. A) volume; value B) depletion; expansion C) surplus; deficit D) output; trade E) price; profit Answer: A Page Ref: 492-494 Difficulty: Easy

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4) The Marshall-Lerner Condition states that, all else equal A) nominal appreciation improves the current account if export and import volumes are sufficiently elastic with respect to the real exchange rate. B) real depreciation improves the current account if export and import volumes are sufficiently inelastic with respect to the real exchange rate. C) real appreciation improves the current account if export and import volumes are sufficiently elastic with respect to the real exchange rate. D) real depreciation improves the current account if export and import volumes are sufficiently elastic with respect to the real exchange rate. E) the sum of import and export elasticities must be equal to one in order for depreciation to occur. Answer: D Page Ref: 492-494 Difficulty: Easy

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International Economics, 10e (Krugman/Obstfeld/Melitz) Chapter 18 (7) Fixed Exchange Rates and Foreign Exchange Intervention 18.1 Why Study Fixed Exchange Rates? 1) Central banks often intervene in currency markets. This activity is called A) managed floating. B) fixing exchange rates. C) currency warfare. D) super-pegging. E) flexible floating. Answer: A Page Ref: 495-497 Difficulty: Easy 2) Why is it important to understand fixed exchange rates in the modern global economy? Answer: Fixed rates continue to be important for four reasons: 1. Managed floating: Central banks intervene in foreign exchange markets. 2. Regional currency arrangements: Some countries peg their currency to another currency. 3. Developing countries and countries in transition: These countries often attempt to peg their currency to another currency. 4. Lessons of the past: Fixed exchange rates could have a resurgence. Page Ref: 495-497 Difficulty: Moderate 3) Which of the following is an example of a regional currency arrangement? A) exchange rate union B) currency cartel associations C) free-trade zones D) most-favored nation status E) agreement on commercial trade Answer: A Page Ref: 495-497 Difficulty: Easy 4) Industrialized countries typically ________ their floating exchange rates. Developing countries often ________ their floating exchange rates. A) manage; peg B) peg; manage C) allow markets to determine; fix D) fix; manage E) fix; allow markets to determine Answer: A Page Ref: 495-497 Difficulty: Easy

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18.2 Central Bank Intervention and the Money Supply 1) A central bank's international reserves consists of its holdings of A) gold. B) silver and gold. C) foreign assets and gold. D) domestic assets and precious metals. E) foreign and domestic currency holdings. Answer: C Page Ref: 497-501 Difficulty: Easy 2) The liabilities side of a central bank's accounts consists of A) deposits held by private banks. B) currency in circulation. C) deposits held by private banks and currency in circulation. D) deposits held by foreign banks, domestic assets, and currency in circulation. E) foreign assets and domestic assets. Answer: C Page Ref: 497-501 Difficulty: Easy 3) Which one of the following statements is most correct? A) Any central bank purchase of assets automatically results in an increase in the domestic money supply, while any central bank sale of assets automatically causes the money supply to decline. B) Any central bank purchase of assets results in an increase in the domestic money supply, while any central bank sale of assets causes the money supply to decline. C) Any central bank purchase of assets automatically results in a decrease in the domestic money supply, while any central bank sale of assets automatically causes the money supply to decline. D) Any central bank purchase of assets automatically results in a decrease in the domestic money supply, while any central bank sale of assets automatically causes the money supply to increase. E) Any central bank purchase of assets automatically results in an increase in the domestic money supply, while any central bank sale of assets does not necessarily affect the money supply. Answer: A Page Ref: 497-501 Difficulty: Easy

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4) Which one of the following statements is the most correct? A) If central banks are not sterilizing and the home country has a balance of payments surplus, any associated increase in the home central bank's foreign asset implies an increased home money supply. B) If central banks are not sterilizing and the home country has a balance of payments surplus, any associated increase in the home central bank's foreign asset implies a decreased home money supply. C) If central banks are not sterilizing and the home country has a balance of payments surplus, any associated increase in the home central bank's foreign asset implies an increased home money demand. D) If central banks are not sterilizing and the home country has a balance of payments surplus, any associated decrease in the home central bank's foreign asset implies an increased home money supply. E) If central banks are not sterilizing and the home country has a balance of payments shortage, any associated decrease in the home central bank's foreign asset implies an increased home money supply. Answer: A Page Ref: 497-501 Difficulty: Easy 5) Which one of the following statements is most correct? A) If central banks are not sterilizing and the home country has a balance of payments surplus, any associated increase in a foreign central bank's claims on the home country implies a decreased foreign money supply. B) If central banks are not sterilizing and the home country has a balance of payments surplus, any associated decrease in a foreign central bank's claims on the home country implies a decreased foreign money demand. C) If central banks are not sterilizing and the home country has a balance of payments surplus, any associated decrease in a foreign central bank's claims on the home country implies a decreased foreign money supply. D) If central banks are not sterilizing and the home country has a balance of payments shortage, any associated decrease in a foreign central bank's claims on the home country implies a decreased foreign money supply. E) If central banks are not sterilizing and the home country has a balance of payments shortage, any associated decrease in a foreign central bank's claims on the home country implies an increased domestic money supply. Answer: C Page Ref: 497-501 Difficulty: Easy

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6) A balance sheet for the central bank of Pecunia is shown below: Central Bank Balance Sheet Assets Foreign assets $1,000 Domestic assets $1,500

Liabilities Deposits held by private banks Currency in circulation

$500 $2,000

Please write the new balance sheet if the bank sells $100 worth of foreign bonds for domestic currency. Answer: Central Bank Balance Sheet Assets Liabilities Foreign assets $900 Deposits held by private banks $500 Domestic assets $1,500 Currency in circulation $1,900 Page Ref: 497-501 Difficulty: Easy 7) A balance sheet for the central bank of Pecunia is shown below: Central Bank Balance Sheet Assets Foreign assets $1,000 Domestic assets $1,500

Liabilities Deposits held by private banks Currency in circulation

$500 $2,000

Please write the new balance sheet if the bank purchased $100 in foreign bonds by writing a check on itself. Answer: Central Bank Balance Sheet Assets Liabilities Foreign assets $1,100 Deposits held by private banks $600 Domestic assets $1,500 Currency in circulation $2,000 Page Ref: 497-501 Difficulty: Moderate

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8) A balance sheet for the central bank of Pecunia is shown below: Central Bank Balance Sheet Assets Foreign assets $1,000 Domestic assets $1,500

Liabilities Deposits held by private banks Currency in circulation

$500 $2,000

Please write the new balance sheet if the bank makes a sterilized transaction by selling $100 of foreign assets for domestic currency and then purchasing $100 of domestic assets by writing a check on itself. Answer: Central Bank Balance Sheet Assets Liabilities Foreign assets $900 Deposits held by private banks $600 Domestic assets $1,600 Currency in circulation $1,900 Page Ref: 497-501 Difficulty: Moderate 9) Please define and give an example of sterilized foreign exchange intervention. Answer: Sterilized foreign exchange intervention occurs when a central bank carries out equal foreign and domestic asset transactions in opposite directions to nullify the impact on the domestic money supply. An example is a central bank purchasing $100 of domestic assets but selling $100 of foreign bonds. Page Ref: 497-501 Difficulty: Moderate 10) If the central bank does not purchase foreign assets when output increases but instead holds the money stock constant, can it still keep the exchange rate fixed at ? Please explain. Answer: No, the rise in output leads to an excess demand for money. If the central bank does not increase supply to meet this demand, the domestic interest rate would rise above the foreign rate, R*. This higher rate of return (and given expectations in the foreign exchange market) would cause the exchange rate to fall below . Page Ref: 497-501 Difficulty: Difficult

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11) If the central bank does not purchase foreign assets when output increases but instead holds the money stock constant, can it still keep the exchange rate fixed at ? Please explain with the aid of a figure. Answer:

No, the rise in output leads to an excess demand for money. If the central bank does not increase supply to meet this demand, the domestic interest rate would rise above the foreign rate, R*. This higher rate of return (and given expectations in the foreign exchange market) would cause the exchange rate to fall below . Page Ref: 497-501 Difficulty: Moderate 18.3 How the Central Bank Fixes the Exchange Rate 1) A system of managed floating exchange rates is A) a system in which governments may attempt to moderate exchange rate movements without keeping exchange rates rigidly fixed. B) a system in which governments use flexible exchange rates. C) a system in which governments are forbidden from attempt to moderate exchange rate movements without keeping exchange rates rigidly fixed. D) a system in which governments need to reach a prior agreement among them before they may attempt to moderate exchange rate movements without keeping exchange rates rigidly fixed. E) a system in which governments use extensive fiscal policy to discourage exchange rate movements. Answer: A Page Ref: 501-504 Difficulty: Easy 6 .

2) Under fixed exchange rate, in general A) the domestic and foreign interest rates are equal, R = R . B) R = R + (Ee - E)/E. C) the foreign and domestic interest rates are unequal. D) the expected rate of domestic currency depreciation is high. E) the expected rate of currency depreciation is one. Answer: A Page Ref: 501-504 Difficulty: Easy 3) Under fixed exchange rate, in general which one of the following statements is the MOST accurate? A) The following condition should hold for domestic money market equilibrium: Ms/P = L(R , Y). B) The following condition should hold for domestic money market equilibrium: Md/P = L(R , Y). C) The following condition should hold for domestic money market equilibrium: Ms = L(R , Y). D) The following condition should hold for domestic money market equilibrium: P = L(R , Y). E) The following condition should hold for domestic money market equilibrium: R*Md/P = L(Y). Answer: A Page Ref: 501-504 Difficulty: Easy 4) Which one of the following statements is the MOST accurate? A) Under a fixed exchange rate, central bank monetary tools are powerless to affect the economy's money supply. B) Under a flexible exchange rate, central bank monetary tools are powerless to affect the economy's money supply or its output. C) Under a fixed exchange rate, fiscal policy tools are powerless to affect the economy's money supply or its output. D) Under a fixed exchange rate, central bank monetary tools are powerless to affect the economy's money supply or its output. E) Under a dirty float exchange rate, central bank monetary tools are powerless to affect the economy's money supply or its output. Answer: D Page Ref: 501-504 Difficulty: Easy

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5) What is the expected dollar rate of return on dollar deposits if today's exchange rate is $1.10 per euro, next year's expected exchange rate is $1.165 per euro, the dollar interest rate is 10%, and the euro interest rate is 5%? A) 10% B) 11% C) -1% D) 0% E) 5% Answer: A Page Ref: 501-504 Difficulty: Easy 6) What are the factors affecting the demand for foreign currency? Answer: Three factors affect the demand for foreign currency. They are expected return, risk, and liquidity. Page Ref: 501-504 Difficulty: Moderate 7) Explain risk and liquidity of assets. Answer: Risk is the variability an asset contributes to a savers' wealth. An asset's real return can be unpredictable and savers dislike this uncertainty if the return fluctuates widely. Liquidity refers to the ease with which an asset can be sold or exchanged for goods. Cash is the most liquid of assets because it is always acceptable at face value as payment for goods or other assets. Thus, savers consider an asset's liquidity and its expected return and risk in deciding how much of it to hold. Page Ref: 501-504 Difficulty: Moderate 18.4 Stabilization Policies with a Fixed Exchange Rate 1) By fixing the exchange rate, the central bank gives up its ability to A) adjust taxes. B) increase government spending. C) influence the economy through fiscal policy. D) depreciate the domestic currency. E) influence the economy through monetary policy. Answer: E Page Ref: 504-509 Difficulty: Easy

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2) Fiscal expansion under fixed exchange rates will have what temporary effect? A) the money supply will decrease. B) output will decrease. C) the exchange rate will increase. D) the exchange rate will decrease. E) there will be no effect. Answer: D Page Ref: 504-509 Difficulty: Easy 3) When a country's currency is devalued A) output decreases. B) output increases and the money supply decreases. C) the money supply decreases. D) output decreases and the money supply increases. E) both the output and the money supply increases. Answer: E Page Ref: 504-509 Difficulty: Easy 4) Under fixed rates, which one of the following statements is the MOST accurate? A) Monetary policy can affect only output. B) Monetary policy can affect only employment. C) Monetary policy can affect only international reserves. D) Monetary policy can not affect international reserves. E) Monetary policy can only affect money supply. Answer: C Page Ref: 504-509 Difficulty: Easy 5) Under fixed rates, which one of the following statements is the MOST accurate? A) Fiscal policy can affect output, employment and international reserves at the same time. B) Fiscal policy can affect only employment. C) Fiscal policy can affect only international reserves. D) Fiscal policy can affect only output and employment. E) Fiscal employment can affect only output and international reserves. Answer: A Page Ref: 504-509 Difficulty: Easy

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6) Which one of the following statements is the MOST accurate? A) Fiscal policy has the same effect on employment under fixed and flexible exchange rate regimes. B) Fiscal policy affects employment less under fixed than under flexible exchange rate regimes. C) Fiscal policy affects employment more under fixed than under flexible exchange rate regimes. D) Fiscal policy cannot affect employment under fixed exchange rate but does affect output under flexible exchange rate regimes. E) Fiscal policy can affect employment under fixed exchange rate regimes, but does not affect output under flexible exchange rate regimes. Answer: C Page Ref: 504-509 Difficulty: Easy 7) Which one of the following statements is the MOST accurate? A) Fiscal policy has the same effect on output under fixed and flexible exchange rate regimes. B) Fiscal policy affects output more under fixed than under flexible exchange rate regimes. C) Fiscal policy affects output less under fixed than under flexible exchange rate regimes. D) Fiscal policy cannot affect output under fixed exchange rate but does affect output under flexible exchange rate regimes. E) Fiscal policy can affect output under fixed exchange rate but does not affect output under flexible exchange rate regimes. Answer: B Page Ref: 504-509 Difficulty: Easy 8) Which one of the following statements is the MOST accurate? A) A devaluation occurs when the central bank lowers the domestic currency price of foreign currency, E, and a revaluation occurs when the central bank raises E. B) A devaluation occurs when the central bank raises the domestic currency price of foreign currency, E, and a revaluation occurs when the central bank lowers E. C) Devaluation occurs when the domestic currency price of foreign currency, E, raises and a revaluation occurs when E is lowered. D) A devaluation occurs when the central bank of the foreign country raises the domestic currency price of foreign currency, E, and a revaluation occurs when the central bank of the foreign country lowers E. E) A devaluation occurs when the central bank raises the foreign currency price of domestic currency, E, and a revaluation occurs when the central bank lowers E. Answer: B Page Ref: 504-509 Difficulty: Easy

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9) Which one of the following statements is the MOST accurate? A) Depreciation is a rise in E when the exchange rate is fixed while devaluation is a rise in E when the exchange rate floats. B) Depreciation is a decrease in E when the exchange rate floats while devaluation is a rise in E when the exchange rate is fixed. C) Depreciation is a rise in E when the exchange rate floats while devaluation is a rise in E when the exchange rate is fixed. D) Depreciation is a rise in E when the exchange rate floats while devaluation is a decrease in E when the exchange rate is fixed. E) Depreciation is a fall in E when the exchange rate is fixed while devaluation is a fall in E when the exchange rate floats. Answer: C Page Ref: 504-509 Difficulty: Easy 10) Which one of the following statements is the MOST accurate? A) Appreciation is a rise in E when the exchange rate floats while revaluation is a fall in E when the exchange rate is fixed. B) Appreciation is a fall in E when the exchange rate floats while revaluation is a fall in E when the exchange rate is fixed. C) Appreciation is a fall in E when the exchange rate is fixed while revaluation is a fall in E when the exchange rate is flexible. D) Appreciation is a fall in E when the exchange rate floats while revaluation is a rise in E when the exchange rate is fixed. E) Appreciation is a rise in E when the exchange rate floats while revaluation is a rise in E when the exchange rate is fixed. Answer: B Page Ref: 504-509 Difficulty: Easy 11) Which one of the following statements is the MOST accurate? A) Devaluation reflects a deliberate government decision. B) Depreciation reflects a deliberate government decision. C) Devaluation reflects a deliberate government decision while depreciation is an outcome of government actions and market forces acting together. D) Depreciation reflects a deliberate government decision while devaluation is an outcome of government actions and market forces acting together. E) Devaluation and depreciation have the same meaning and the same causes. Answer: C Page Ref: 504-509 Difficulty: Easy

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12) Which one of the following statements is the MOST accurate? A) Revaluation reflects an outcome of government actions and market forces acting together while appreciation reflects a deliberate government decision. B) Revaluation reflects a deliberate government decision while appreciation is an outcome of government actions and market forces acting together. C) Revaluation reflects a deliberate government decision while appreciation is an outcome of government actions. D) Revaluation and appreciation have the same meaning and the same causes. E) Appreciation reflects a deliberate government decision while revaluation is an outcome of government actions and market forces acting together. Answer: B Page Ref: 504-509 Difficulty: Easy 13) Under fixed exchange rates, which one of the following statements is the MOST accurate? A) Devaluation causes a decrease in output, a decrease in official reserves, and a contraction of the money supply. B) Devaluation causes a rise in output, a rise in official reserves, and an expansion of the money supply. C) Devaluation causes a rise in output and a rise in official reserves. D) Devaluation causes a rise in output and an expansion of the money supply. E) Devaluation causes a rise in official reserves, and an expansion of the money supply. Answer: B Page Ref: 504-509 Difficulty: Easy 14) Under fixed exchange rates, which one of the following statements is the MOST accurate? A) Devaluation causes a rise in output. B) Devaluation causes a decrease in output. C) Devaluation has no effect on output. D) Devaluation causes a rise in output and a decrease in official reserves. E) Devaluation causes a decrease in output and in official reserves. Answer: A Page Ref: 504-509 Difficulty: Easy 15) Under fixed exchange rates, which one of the following statements is the MOST accurate? A) Devaluation causes a reduction of the money supply. B) Devaluation has no effect on the stock of money. C) Devaluation causes an expansion of the money supply. D) Devaluation causes a reduction in output. E) Devaluation causes a reduction in official reserves. Answer: C Page Ref: 504-509 Difficulty: Easy

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16) The main reason(s) why governments sometimes chose to devalue their currencies is (are) A) devaluation makes domestic goods more expensive in relation to foreign goods. B) devaluation makes domestic services more expensive in relation to foreign services. C) devaluation increases foreign reserves held by the central bank. D) devaluation improves the current account and increases foreign reserves held by the central bank. E) devaluation hurts foreign currencies. Answer: D Page Ref: 504-509 Difficulty: Easy 17) Please draw a figure illustrating the actions the central bank must take to maintain a fixed exchange rate following an increase in output. Answer:

A rise in output from to will increase the real money demand, so the central bank must purchase foreign assets and raise the money supply from to , in order to maintain a fixed exchange rate . Page Ref: 504-509 Difficulty: Difficult

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18.5 Balance of Payments Crises and Capital Flight 1) A balance of payments crisis is best described as A) a sharp change in interest rates sparked by a change in expectations about the level of imports. B) a sharp change in foreign reserves sparked by a change in expectations about the future exchange rate. C) a sharp change in interest rates sparked by a change in expectations about the level of exports. D) a sharp change in foreign reserves sparked by a change in expectations about the level of imports. E) a sharp change in foreign reserves sparked by a change in expectations about domestic production. Answer: B Page Ref: 509-511 Difficulty: Easy 2) The expectation of future devaluation causes a balance of payments crisis marked by A) a sharp rise in reserves and a fall in the home interest rate below the world interest rate. B) a sharp fall in reserves and an even bigger fall in the home interest rate below the world interest rate. C) a sharp fall in reserves and a rise in the home interest rate above the world interest rate. D) a sharp rise in reserves and an even greater rise in the home interest rate above the world interest. E) a sharp rise in reserves and a rise in the home interest rate to the level of the world interest. Answer: C Page Ref: 509-511 Difficulty: Easy 3) The expectation of future revaluation causes a balance of payments crisis marked by A) a sharp rise in reserves and a fall in the home interest rate below the world interest rate. B) a sharp fall in reserves and an even bigger fall in the home interest rate below the world interest rate. C) a sharp fall in reserves and a rise in the home interest rate above the world interest rate. D) a sharp rise in reserves and an even greater rise in the home interest rate above the world interest. E) a sharp fall in reserves and an unchanged home interest rate. Answer: A Page Ref: 509-511 Difficulty: Easy

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4) Capital flight A) increases reserves. B) is never associated with the expectation of devaluation. C) may undo expected devaluation. D) reduces losses during a devaluation scare. E) decreases reserves and may induce devaluation. Answer: E Page Ref: 509-511 Difficulty: Easy 5) Currency crises may result from A) central bank balance sheets with higher liabilities than assets. B) political upheaval leading to lowering exports. C) a reconfiguration of central bank balance sheets. D) speculative attacks on the currency or central banks purchasing excessive amounts of government bonds. E) depreciation of foreign reserves. Answer: D Page Ref: 509-511 Difficulty: Easy 6) Which of the following best describes a deliberate government decision to lower the exchange rate, E? A) appreciation B) depreciation C) revaluation D) devaluation E) accumulation Answer: C Page Ref: 509-511 Difficulty: Easy 7) Please discuss the difference between the terms devaluation and depreciation. Answer: Depreciation is a rise in the exchange rate E when the exchange rate floats, while devaluation is a rise in E when the exchange rate is fixed. Devaluation reflects a deliberate government decision, while depreciation is an outcome of government actions and market forces ("the invisible hand") acting together. Page Ref: 509-511 Difficulty: Moderate

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8) Use a figure to illustrate the ineffectiveness of monetary policy to spur on an economy under a fixed exchange rate. Answer:

The initial equilibrium rests at point 1. If the central bank wishes to use monetary policy to increase output from to , then they might buy domestic assets and shift the AA curve outward. However, the central bank must maintain a fixed exchange rate , so would have to sell foreign assets for domestic currency, returning the economy to point 1. Page Ref: 509-511 Difficulty: Difficult 9) Use a figure to explain the potential effectiveness of fiscal policy to spur on the economy under a fixed exchange rate. Answer:

With an aim toward increasing output, the government could use fiscal policy to shift the DD curve outward. The central bank will have to take steps to maintain a fixed exchange rate , among the options is buying foreign assets with money, to shift the AA schedule outward until the equilibrium at point 3 is reached. Page Ref: 509-511 Difficulty: Difficult 16 .

10) Define devaluation and use a figure to show the effect of a currency devaluation on the economy. Answer:

A devaluation occurs when the central bank raises the domestic currency price of foreign currency. In the figure, the domestic currency is devalued from to . Since nothing in the DD schedule has changed, the new equilibrium at point 2 must be reached by an expansion of the money supply (AA curve shifts outward). Notice also that output has increased from to . Page Ref: 509-511 Difficulty: Difficult

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11) Please use a figure to discuss whether or not a devaluation under a fixed exchange rate has the same long-run effect as a proportional increase in the money supply under a floating rate. Answer:

A currency devaluation shifts the AA schedule outward from equilibrium point 1 to equilibrium point 2. The devaluation does not change long-run demand or supply conditions in the output market. Thus, the increase in the long-run price level will exactly offset the increase in exchange rate. Thus, a devaluation is neutral in the long run and this is the exact same scenario as for an increase in the money supply under a floating exchange rate. Page Ref: 509-511 Difficulty: Difficult 18.6 Managed Floating and Sterilized Intervention 1) Imperfect asset substitutability assumes A) the returns on foreign and domestic currency bonds are identical. B) the returns on foreign and domestic currency are unrelated. C) the risks of holding foreign and domestic currency are identical. D) the risks of holding foreign and domestic currency are unrelated to returns. E) the returns on foreign and domestic currency differ and are influenced by risk. Answer: E Page Ref: 512-517 Difficulty: Easy

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2) The global financial crisis of 2007-2008 resulted in a(n) ________ of the Swiss franc as foreign currency flowed ________ the country. As result, Swiss products became ________ competitive in world markets. A) depreciation; out of; more B) depreciation; into; more C) appreciation; out of; less D) depreciation; out of; less E) appreciation; into; less Answer: E Page Ref: 512-517 Difficulty: Easy 3) The global financial crisis of 2007-2008 resulted in a(n) ________ of the Swiss franc. In 2011, the Swiss central bank intervened in order to cause a(n) ________ of the franc. A) appreciation; appreciation B) depreciation; depreciation C) appreciation; revaluation D) depreciation; appreciation E) appreciation; depreciation Answer: E Page Ref: 512-517 Difficulty: Easy 4) Perfect asset substitutability is the assumption that A) the foreign exchange market is in equilibrium only when expected returns on domestic assets are greater than returns on foreign currency bonds. B) the foreign exchange market is in equilibrium only when expected returns on foreign currency bonds are greater than returns on domestic assets. C) the foreign exchange market is in equilibrium only when expected returns on all assets are negative. D) the foreign exchange market is in equilibrium only when expected returns on domestic assets are equal to returns on foreign currency bonds. E) the foreign exchange market is in equilibrium only when domestic assets are risk-free. Answer: D Page Ref: 512-517 Difficulty: Easy 5) Imperfect asset substitutability exists A) when it is possible for the expected returns on two assets to be different. B) when the expected returns on two assets are the same. C) only when one asset is foreign and the other is domestic. D) when there is risk in the foreign exchange market. E) when assets are liquid. Answer: D Page Ref: 512-517 Difficulty: Easy 19 .

6) The interest parity condition can be written as A) R = R - (Ee - E)/E. B) R = R + (Ee - E)/E. C) R = R2 - (Ee - E)/E. D) R = R /(Ee - E). E) R = R + (Ee + E)/E. Answer: B Page Ref: 512-517 Difficulty: Easy 7) When domestic and foreign currency bonds are imperfect substitutes, the domestic interest rate (R) can be written as A) R = R - (Ee - E)/E + ρ. B) R = R - (Ee - E)/E. C) R = R + (Ee - E)/E + ρ. D) R = R - (Ee + E)/E + ρ. E) R = R - (Ee - E)ρ. Answer: C Page Ref: 512-517 Difficulty: Easy 8) In the interest rate parity condition with imperfect substitutes and a risk premium of ρ A) an increased stock of domestic government debt will raise the difference between the expected returns on domestic and foreign currency bonds. B) a decreased stock of domestic government debt will raise the difference between the expected returns on domestic and foreign currency bonds. C) an increased stock of domestic government debt will reduce the difference between the expected returns on domestic and foreign currency bonds. D) an increased stock of domestic government debt will have no effect on the difference between the expected returns on domestic and foreign currency bonds. E) a decreased stock of domestic government debt will have no effect on the difference between the expected returns on domestic and foreign currency bonds. Answer: A Page Ref: 512-517 Difficulty: Easy

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9) The signaling effect of foreign exchange intervention A) never has any effect on exchange rates. B) can alter the market's view of exchange rates independent from the stance of monetary and fiscal policies. C) cannot cause an immediate exchange rate change when bonds denominated in different currencies are perfect substitutes. D) never leads to actual changes in monetary or fiscal policy. E) can alter the market's view of future monetary policies and cause an immediate exchange rate change. Answer: E Page Ref: 512-517 Difficulty: Easy 10) Please describe in detail a self-fulfilling currency crisis. Answer: Consider an economy in which domestic commercial banks' liabilities are mainly shortterm deposits, and in which many of the banks' loans to businesses are likely to go unpaid in the event of a recession. If the market suspects there will be devaluation, interest rates will rise, banks' borrowing costs go up, and a banks' assets have lower value if a recession hits. To prevent financial collapse, the central bank will lend money to banks and no longer be able to keep the exchange rate from rising. Thus, the emergence of devaluation expectations eventually leads to a devaluation of currency (self-fulfilling). Page Ref: 512-517 Difficulty: Moderate 11) Describe the effect of the 2008-2009 global financial crisis on the Swiss franc and the central bank's efforts to respond to the resulting problems. Answer: The 2008-2009 global financial crisis resulted in appreciation of the franc as currency traders purchased the franc as a safe haven currency. The Swiss economy consequently suffered as its products became less competitive with imports. The Swiss responded by committing to currency intervention designed to control appreciation of the franc and restore the country's competitiveness in global markets. Page Ref: 512-517 Difficulty: Moderate

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12) Use a figure to explain how a balance of payments crisis and its hand in capital flight. Answer:

Suppose the foreign exchange market expects the government to devalue the currency in the future and adopt a new fixed exchange rate > . This leads to a rightward shift in the curve that measures the expected domestic currency return on foreign currency deposits. Since the exchange rate remains fixed at , the domestic interest rate must rise to R* + ( - )/ . The central bank must sell foreign reserves and shrink the money supply in response. This reserve loss accompanying a devaluation scare is labeled capital flight. Page Ref: 512-517 Difficulty: Difficult 18.7 Reserve Currencies in the World Monetary System 1) Briefly describe two systems for fixing the exchange rates of all currencies against each other and the time periods in which they were used. Answer: The first is to single cut one country's currency as the reserve currency. The other countries hold this reserve currency and fix their interest rate to it by standing ready to exchange domestic currency for the reserve currency. The U.S. dollar was the reserve currency from 1945 to 1973. The second is the gold standard in which central banks peg the prices of their currencies in terms of gold and hold gold as official international reserves. This was used between 1870 and 1914. Page Ref: 518-519 Difficulty: Difficult

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2) This question concerns the mechanism of a reserve currency standard. Two countries, X and Y, have two currencies, x and y, fixed to the reserve currency, the U.S. dollar. Suppose the exchange rate between x and the U.S. dollar is 3x per dollar. Suppose the exchange rate between y and the U.S. dollar is 5y per dollar. Explain (using numbers) the mechanism if the x-y exchange rate was 0.5 x per y. Answer: At this exchange rate, an investor can make an arbitrage profit by selling $100 to the central bank of X (receiving 300 x), then selling your 300 x to the foreign exchange market for 300 x/(0.5 x per y) = 600 y, then buying U.S. dollars in the amount of $120 from the central bank of Y. Thus the foreign exchange market will bid the x-y exchange rate up to 0.6 x per y. Page Ref: 518-519 Difficulty: Difficult 3) This question concerns the mechanism of a reserve currency standard. Two countries, X and Y, have two currencies, x and y, fixed to the reserve currency, the U.S. dollar. Suppose the exchange rate between x and the U.S. dollar is 3x per dollar. Suppose the exchange rate between y and the U.S. dollar is 5y per dollar. Explain (using numbers) the mechanism if the x-y exchange rate was 0.8 x per y. Answer: At this exchange rate, an investor can make an arbitrage profit by selling $100 to the central bank of Y (receiving 500 y), then selling this 500 y to the foreign exchange market for 500 y/(0.8 x per y) = 400 x, then buying $133.33 U.S. dollars from the central bank of X with this 400 x. Thus the foreign exchange market will bid the x-y exchange rate down to 0.6. Page Ref: 518-519 Difficulty: Difficult 4) Explain how a country whose currency is the reserve currency can use monetary policy for macroeconomic stabilization. In particular, explain the result if that country doubled its domestic money supply. Answer: The immediate result of the doubling of the money supply in the reserve currency's country will be able to increase the exchange rate between the reserve currency and all other currencies. However, all other countries must fix their exchange rate to the reserve currency, so they will purchase the reserve currency and hold it as official international reserves (thus increase their own money supply) until the exchange rate has returned to normal. Thus, the reserve country has the power to affect its own economy and all other countries must adjust in response. Page Ref: 518-519 Difficulty: Moderate

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18.8 The Gold Standard 1) From 1837 and up until the Civil War, the United States adhered to a A) gold standard. B) silver standard. C) bimetallic standard. D) bronze standard. E) copper standard. Answer: C Page Ref: 520-526 Difficulty: Easy 2) From the Civil War up to 1914, the United States adhered to a A) gold standard. B) silver standard. C) bimetallic standard. D) bronze standard. E) copper standard. Answer: A Page Ref: 520-526 Difficulty: Easy 3) Assuming perfect asset substitutability, can sterilized intervention by the central bank be effective? Please discuss. Answer: No, a sterilized foreign exchange intervention by the central bank leaves the domestic money supply unchanged. Under floating exchange rates, a change in the interest rate is needed to affect the exchange rate, but the interest rate won't change if the money supply does not. Under a fixed exchange rate, an expansive policy needs to be offset by an increase in the domestic money supply. To avoid inflation, the central bank sterilizes this increase in the money supply by selling domestic assets. However, with a fixed exchange rate, this means buying foreign assets. If foreign assets are perfect substitutes for domestic assets, this sterilization is not effective. Page Ref: 520-526 Difficulty: Moderate 4) Does the signalling effect of foreign exchange intervention support or refute the claim that assets cannot be perfect substitutes if sterilized intervention is going to have any effect? Please explain. Answer: The signalling effect refutes the claim. Even with the assumption of perfect asset substitutability, if the market is unsure of the future direction of policy, then sterilized intervention can fix a market's expectations about the exchange rate in the future. From post discussion, a change in the expected exchange rate will lead to a change in the exchange rate today. Page Ref: 520-526 Difficulty: Moderate

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5) Briefly discuss the main advantage of the bimetallic standard over the gold standard. Answer: The advantage of bimetallism was that it might reduce the price level instability resulting from the use of gold alone. Were gold to become scarce and expensive, cheaper and relatively abundant silver would become the predominant form of money, thereby mitigating the deflation that a pure gold standard would imply. Page Ref: 520-526 Difficulty: Moderate 6) List the drawbacks of the gold standard. Answer: 1. Undesirable constraints on the use of monetary policy to fight unemployment. 2. A stable overall price level is achieved only if the relative price of gold and all other goods and services is stable. 3. A central bank cannot increase holdings of international reserves as its economy grows unless new gold is discovered. 4. Unfair advantage to gold-producing nations. Page Ref: 520-526 Difficulty: Moderate 7) Describe the mechanism which would take place if the Bank of England decides to increase its money supply by purchasing domestic assets under the gold standard. Answer: The increase in Britain's money supply would push interest rates down and make foreign currency assets more attractive than domestic ones. Holders of pound deposits will attempt to sell them for foreign deposits. To accomplish this, they sell pound deposits to the Bank of England for gold and then use this gold to purchase foreign deposits. England loses foreign reserves since it is selling gold and foreign countries are gaining reserves. Equilibrium is re-established after Britain's money supply has fallen enough to force the British interest rate up until it is equally as attractive as the interest rate on foreign currency. Page Ref: 520-526 Difficulty: Difficult 8) Please briefly describe what is meant by a gold exchange standard. Answer: Under a gold exchange standard, central banks' reserves consist of gold and currencies whose price in terms of gold are fixed, and each central bank fixes its exchange rate to a currency with a fixed gold price. The post-WWII currency system was supposed to be a gold exchange standard with the U.S. responsible for fixing the price of gold at $35 per ounce. Page Ref: 520-526 Difficulty: Moderate

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9) Use a figure to show the effect of a sterilized central bank purchase of foreign assets under the imperfect asset substitutability assumption. Answer:

The interest parity condition is given by R = R* + ( - E)/E + Suppose that the domestic assets of the central bank fall from to through a sterilized purchase of foreign assets. Then the risk-adjusted return increases and the exchange rate increases. Page Ref: 520-526 Difficulty: Difficult 10) Assume that initially, the risk premium, ρ = 0 and that the domestic and foreign interest rates are given by R = .06, R* = .05. Suppose that the risk premium depends linearly on the difference between domestic government debt, B, and domestic assets of the central bank, A, i.e., ρ= Find the new domestic interest rate if a sterilized purchase of foreign assets adjusts A s.t. (a) B - A = -.01/ (b) B - A = .01/ (c) B - A = .03/ Answer: (a) R = .05 + .01 + (-.01) = .05 (b) R = .05 + .01 + (.01) = .07 (c) R = .05 + .01 + (.03) = .09 Page Ref: 520-526 Difficulty: Moderate 26 .

11) Assume that initially, the risk premium, ρ = 0 and that the domestic and foreign interest rates are given by R = .06, R* = .05. Suppose that the risk premium depends linearly on the difference between domestic government debt, B, and domestic assets of the central bank, A, i.e., ρ= How much will the central bank have to reduce domestic assets A s.t. the domestic interest rate will increase by (a) 1% (b) 4%? Answer: (a) ρ = .01 = ΔA =

- (B -

)

- (B -

)

(b) ρ = .04 = ΔA =

Page Ref: 520-526 Difficulty: Moderate 12) Under the gold standard, if the dollar price of gold is pegged at $35 per ounce and the euro price of gold is pegged at 12 euro per ounce, what is the dollar/euro exchange rate? Answer: The dollar/euro exchange rate must be constant and equal to ($35 per ounce) / (12 euro per ounce) = $2.92 per euro. Page Ref: 520-526 Difficulty: Moderate 13) Under the gold standard, if the dollar price of gold is pegged at $35 per ounce and the dollar/euro exchange rate is set at $2.40 per euro, what must the euro price of gold be pegged at? Answer: The euro price of gold is constant and equal to ($35 per ounce) / ($2.40 per euro) = 14.58 euro per ounce. Page Ref: 520-526 Difficulty: Moderate

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14) From the figure below, please provide an explanation for the large decline in the growth rate of international reserves held by developing countries in the 2008-2009 period.

Answer: The growth of global capital markets has increased the potential variability of financial flaws across borders, and especially across the borders of developing countries. The sharp decline in developing country reserve growth was due to an international debt crisis from 20072009. Page Ref: 520-526 Difficulty: Difficult 18.9 Appendix 1 to Chapter 18: Equilibrium in the Foreign Exchange Market with Imperfect Asset Substitutability 1) If assets are imperfect substitutes, then an increase in the amount of domestic currency bonds held by the public will ________ the risk premium and ________ the amount of domestic currency bonds held by the central bank. A) increase; leave unchanged B) increase; decrease C) increase; increase D) decrease; decrease E) leave unchanged; decrease Answer: A Page Ref: 532-534 Difficulty: Moderate

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2) If assets are imperfect substitutes, then a decrease in the amount of domestic currency bonds held by the public will ________ the risk premium and ________ the amount of domestic currency bonds held by the central bank. A) decrease; leave unchanged B) increase; decrease C) increase; increase D) decrease; decrease E) leave unchanged; decrease Answer: A Page Ref: 532-534 Difficulty: Moderate 18.10 Appendix 2 to Chapter 18: The Timing of Balance of Payments Crises 1) Balance of payments crises under fixed exchange rates occur because of A) government policies that are inconsistent with fixed exchange rates. B) punitive currency wars. C) global inflation and trade imbalances due to war. D) excessive exports and imports that overload the global system. E) monotonic expansion in global currency volume. Answer: A Page Ref: 535-537 Difficulty: Easy 2) A balance of payments crises under fixed exchange rates occurs when A) a country runs out of foreign reserves. B) a country is in a liquidity trap. C) exports and imports expand beyond some point. D) marginal returns on foreign exchange investments approach zero. E) forward currency markets undergo high volatility. Answer: A Page Ref: 535-537 Difficulty: Easy

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International Economics, 10e (Krugman/Obstfeld/Melitz) Chapter 19 (8) International Monetary Systems: An Historical Overview 19.1 Macroeconomic Policy Goals in an Open Economy 1) A country seeking to maintain internal balance would be concerned A) only with attaining low levels of unemployment. B) primarily with ensuring that saving is weighted more towards domestic investment than the current account. C) with large fluctuations in output or prices. D) with maintaining an adequate stock of gold reserves. E) with stabilizing employment levels globally. Answer: C Page Ref: 538-547 Difficulty: Easy 2) By internal balance, most economists mean A) full employment. B) price stability. C) full employment and price stability. D) full employment and moderate increase in prices. E) full employment and high disposable income. Answer: C Page Ref: 538-547 Difficulty: Easy 3) By external balance, most economists mean A) avoiding excessive imbalances in international payments. B) balance between exports and imports. C) balance between the trade and service accounts. D) what amounts to fixed exchange rates. E) imbalance in internal transactions. Answer: A Page Ref: 538-547 Difficulty: Easy 4) Which one of the following statements is TRUE? A) Inflation but not deflation can occur even under conditions of full employment. B) Deflation but not inflation can occur even under conditions of full employment. C) Inflation or deflation can occur even under conditions of full employment. D) Inflation can occur even under conditions of full employment only in the long run. E) Inflation does not coincide with periods of high unemployment levels. Answer: C Page Ref: 538-547 Difficulty: Easy

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5) Inflation can occur under conditions of full employment A) only if the central bank continues to inject money into the economy and the agents' expectations of inflation are supported by the bank's activities. B) only if the central bank continues to inject money into the economy. C) only if the central bank continues to withdraw money from the economy. D) only if the central bank continues to inject money into the economy and all agents expect that inflation will not occur. E) only if the central bank fails to inject money into the economy. Answer: A Page Ref: 538-547 Difficulty: Easy 6) A sudden increase in the U.S. price level A) makes those with dollar debts worse off. B) makes those with dollar debts better off. C) does not affect those with dollar debts. D) makes those with foreign debts better off. E) increases all dollar debts. Answer: B Page Ref: 538-547 Difficulty: Easy 7) A sudden increase in the U.S. price level A) makes creditors in dollars better off. B) makes creditors in dollars worse off. C) do not affect creditors in dollars. D) makes creditors in DM worse off. E) makes lenders worse off. Answer: B Page Ref: 538-547 Difficulty: Easy 8) A sudden decrease in the U.S. price level A) makes those with dollar debts worse off. B) makes those with dollar debts better off. C) do not affect those with dollar debts. D) makes those with DM worse off. E) makes creditors worse off. Answer: A Page Ref: 538-547 Difficulty: Easy

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9) A sudden decrease in the U.S. price level A) makes creditors in dollars better off. B) makes creditors in dollars worse off. C) do not affect creditors in dollars. D) makes creditors in DM better off. E) makes those with dollar debts better off. Answer: A Page Ref: 538-547 Difficulty: Easy 10) A current account surplus A) poses a problem if domestic savings are being invested more profitably abroad than they would be at home. B) may pose no problem if domestic savings are being invested more profitably abroad than they would be at home. C) may pose no problem if domestic savings are being invested less profitably abroad than they would be at home. D) there is no relation between current account surplus and between savings and investment. E) poses a problem if domestic savings are being invested less profitably abroad than they would be at home. Answer: B Page Ref: 538-547 Difficulty: Easy 11) A current account deficit A) will not pose a problem, especially if it is accompanied by an expansionary fiscal policy. B) may pose no problem if the borrowed funds are channeled into productive domestic investment projects that pay for themselves with the revenue they generate in the future. C) may still pose a problem, even if the borrowed funds are channeled into productive domestic investment projects. D) There is no relation between current account surplus and between savings and investment. E) will pose a problem because the country is borrowing funds from the rest of the world that it won't be able to pay back later. Answer: B Page Ref: 538-547 Difficulty: Easy

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12) Which one of the following statements is TRUE? A) Countries with strong investment opportunities should invest little at home and channel their savings into more productive investment activity abroad. B) Countries with weak investment opportunities should invest little at home and channel their savings into more productive investment activity abroad. C) Countries with weak investment opportunities should invest more at home. D) Countries with weak investment opportunities should invest little abroad. E) Countries with weak investment opportunities should invest little abroad and channel their savings into more productive investment activity domestically. Answer: B Page Ref: 538-547 Difficulty: Easy 13) Countries with A) strong investment opportunities should invest little at home and channel their savings into more productive investment activity abroad. B) strong investment opportunities should invest more at home and less abroad. C) weak investment opportunities should invest more at home. D) weak investment opportunities should invest little abroad. E) countries with productive investment should invest exclusively at home. Answer: B Page Ref: 538-547 Difficulty: Easy 14) Countries where investment is relatively A) productive should be net exporters of currently available output. B) unproductive should be net importers of currently available output. C) unproductive should be net exporters of currently available output. D) unproductive should be net exporters of future available output. E) unproductive should focus on their internal balance. Answer: C Page Ref: 538-547 Difficulty: Easy 15) Countries where investment is relatively A) productive should have current account deficits. B) productive should have current account surpluses. C) unproductive should have current account surpluses. D) productive should balanced current account surpluses. E) productive should have low outputs. Answer: B Page Ref: 538-547 Difficulty: Easy

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16) Which one of the following statements is TRUE? A) Countries where investment is relatively productive should be net importers of current output. B) Countries where investment is relatively unproductive should be net importers of current output. C) Countries where investment is relatively productive should be net exporters of current output. D) Countries where investment is relatively productive should not export or import current output. E) Countries where investment is relatively unproductive should invest at home. Answer: A Page Ref: 538-547 Difficulty: Easy 17) Countries where investment is A) relatively unproductive should have current account deficits. B) relatively productive should have current account surpluses. C) relatively productive should have current account deficits. D) relatively productive should have balanced current accounts. E) relatively unproductive should have balanced current accounts. Answer: C Page Ref: 538-547 Difficulty: Easy 18) Governments prefer to avoid excessive current account surpluses because A) the returns to domestic savings are more difficult to tax than those on assets abroad. B) an addition to the home capital stock may increase domestic unemployment and therefore lead to higher national income. C) foreign investment in one firm may have beneficial technological spillover effects on other foreign producers that the investing firm does not capture. D) an addition to the home capital stock may reduce domestic unemployment and therefore lead to higher national income. E) domestic savings increase with more investment abroad. Answer: D Page Ref: 538-547 Difficulty: Easy 19) "The line distinguishing external from internal goals can be fuzzy." Discuss. Answer: This statement is true. For example, employment target for export industries when export growth influences the ability of the economy to repay its foreign debts. Page Ref: 538-547 Difficulty: Moderate

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20) Why do governments prefer to avoid current account deficits that are too large? Answer: A current account deficit may pose no problem if the borrowed funds are channeled into productive domestic investment projects that pay for themselves with the revenue they generate in the future. However, sometimes, large current account deficits represent temporarily high consumption resulting from misguided government policies or some other malfunctioning of the economy. Sometimes, the investment projects that draw on foreign funds may be badly planned, etc. In such cases, the government might wish to reduce the current account deficit immediately rather than face problems in repaying its foreign debt in the future. Page Ref: 538-547 Difficulty: Moderate 21) Why do governments prefer to avoid excessive current account surpluses? Or, why are growing domestic claims to foreign wealth ever a problem? Answer: For a given level of national saving, an increased current account surplus implies lower investment in domestic plant and equipment. A few reasons why: first, the returns to domestic savings may be easier to tax than those on assets abroad; second, an addition to the home capital stock may reduce domestic unemployment and therefore lead to higher national income; third, domestic investment by one firm may have beneficial technological spillover effects on other domestic producers that the investing firm does not capture. In addition, the country may in the future find itself unable to collect the money it is owed. Furthermore, countries with large surpluses can become targets for discriminatory protectionist measures by trading partners with external deficits. Page Ref: 538-547 Difficulty: Moderate 22) Using an equation, explain why governments prefer to avoid excessive current account surpluses? Answer: This follows from the national income identity, S = CA + I, which says that total domestic savings, S, is divided between foreign asset accumulation, CA, and domestic investment, I. Page Ref: 538-547 Difficulty: Moderate 23) The case of New Zealand, described in the text, asks what question about the country's international debt position? Answer: Fundamentally, the question is whether or not a country can sustain a current account deficit indefinitely. The answer is that, under certain conditions, yes it can. Page Ref: 538-547 Difficulty: Moderate 24) The case of New Zealand, as described in the text, draws what simple conclusion regarding the country's international debt position? Answer: Fundamentally, the question is whether or not a country can sustain a current account deficit indefinitely. The conclusion is that, under certain conditions, yes it can. Page Ref: 538-547 Difficulty: Moderate 6 .

25) The case of New Zealand, described in the text, draws what technical conclusion regarding the country's international debt position? Answer: Fundamentally, the question is whether or not a country can sustain a current account deficit indefinitely. The conclusion depends upon the country's future prospects. If net exports are expected to rise at a rate sufficient to counteract the effects of debt (including interest payments) over the relevant time period, than deficits could go on for an extended period. Page Ref: 538-547 Difficulty: Moderate 26) The case of New Zealand, described in the text, draws what technical conclusion regarding the country's international debt position? Answer: Fundamentally, the question is whether or not a country can sustain a current account deficit indefinitely. The conclusion depends upon the country's future prospects. If net exports are expected to rise at a rate sufficient to counteract the effects of debt (including interest payments) over the relevant time period, than deficits could go on for an extended period. Page Ref: 538-547 Difficulty: Moderate 27) The case of New Zealand, described in the text, is concerned with the country's A) prospects for long term growth. B) ability to sustain current account deficits. C) unproductive industrial sector and its prospects for long run growth. D) labor productivity. E) exchange rate volatility relative to other currencies. Answer: B Page Ref: 538-547 Difficulty: Easy 28) The case of New Zealand, described in the text, concludes that a country's current account deficits are not sustainable if a country's A) prospects for long term economic growth are above its global deficit growth. B) ability to sustain current account deficits is questionable. C) unproductive industrial sectors and its prospects for long run growth. D) labor productivity is below that of most other countries. E) exchange rate has fallen relative to other currencies. Answer: B Page Ref: 538-547 Difficulty: Easy

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19.2 Classifying Monetary Systems: The Open-Economy Monetary Trilemma 1) Which of the following is one component of the "trilemma" that is faced by policy makers in choosing monetary arrangements? A) exchange rate stability B) restrictions on international capital movements C) tariffs and subsidies D) restrictions on the migration of labor E) global inflation Answer: A Page Ref: 547-548 Difficulty: Easy 2) Which of the following is one component of the "trilemma" that is faced by policy makers in choosing monetary arrangements? A) freedom of international capital movements B) exchange rate instability C) tariffs and subsidies D) restrictions on the migration of labor E) global inflation Answer: A Page Ref: 547-548 Difficulty: Easy 3) Which of the following is one component of the "trilemma" that is faced by policy makers in choosing monetary arrangements? A) monetary policy oriented towards domestic goals B) exchange rate instability C) tariffs and subsidies D) restrictions on the migration of labor E) global inflation Answer: A Page Ref: 547-548 Difficulty: Easy

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4) What is the nature of the trilemma that is encountered when choosing monetary arrangements? A) Only two of the three aspects of internal and external balance can be accommodated simultaneously. B) Only three of the four aspects of internal and external balance can be accommodated simultaneously. C) Only one of the three aspects of internal and external balance can be accommodated simultaneously. D) Only two of the four aspects of internal and external balance can be accommodated simultaneously. E) Only one of the four aspects of internal and external balance can be accommodated simultaneously. Answer: A Page Ref: 547-548 Difficulty: Easy 5) What are the components of the trilemma that is encountered when a country chooses its monetary policy and what is the meaning of the term? Answer: The components are (1) exchange rates, (2) domestic goals, and (3) international capital movements. The monetary trilemma (a three-part dilemma) exists because only two of the three components can be influenced by monetary policy. Page Ref: 547-548 Difficulty: Moderate 19.3 International Macroeconomic Policy under the Gold Standard, 1870-1914 1) Under the price-specie-flow mechanism, what happens when, say, Germany's current account surplus is greater than its non-reserve capital account deficits? A) German loans will finance all foreign net imports. B) Automatic drop in German domestic prices and rise in foreign prices. C) Gold reserves will flow into Germany. D) Gold reserves will flow out of Germany. E) Germany will experience a deficit. Answer: C Page Ref: 548-553 Difficulty: Easy 2) The "rules of the game" under the gold standard can best be described as which of the following: A) selling domestic assets in a deficit and buying assets in a surplus. B) slowing down the automatic adjustments processes inherent in the gold standard. C) selling domestic assets in order to accumulate gold. D) selling foreign assets in a deficit and buying foreign assets in a surplus. E) selling domestic assets in a surplus. Answer: A Page Ref: 548-553 Difficulty: Easy 9 .

3) L. Frank Baum's classic 1900 children's book, The Wonderful Wizard of Oz, is A) an allegorical rendition of the U.S. political struggle over silver. B) an allegorical rendition of the U.S. political struggle over copper. C) an allegorical rendition of the U.S. political struggle over both silver and gold. D) an allegorical rendition of the U.S. political struggle over indebted farmers. E) an allegorical rendition of the U.S. political struggle over gold. Answer: E Page Ref: 548-553 Difficulty: Easy 4) Mercantilism held that A) silver alone was the mainstay of national wealth. B) gold alone was the mainstay of national wealth. C) silver and gold were the mainstays of national wealth. D) silver and gold are not important for national wealth of a country. E) labor forces were the mainstay of national wealth. Answer: C Page Ref: 548-553 Difficulty: Easy 5) The main policy goal for a country according to the mercantilists is A) to create a one-time deficit in the balance of payments. B) to create a continuing deficit in the balance of payments. C) to create a one-time surplus in the balance of payments. D) to create a continuing surplus in the balance of payments. E) to create specie overflows. Answer: D Page Ref: 548-553 Difficulty: Easy 6) The view of mercantilists can be summarized as follows A) to sell less to strangers yearly than we consume of theirs in value. B) to sell more to strangers yearly than we consume of theirs in value. C) to consume more of theirs in value than we sell to strangers. D) to consume the same amount as theirs in value as we sell to strangers. E) to sell gold and silver to strangers in exchange for services. Answer: B Page Ref: 548-553 Difficulty: Easy

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7) Until the United States Civil War, The Unites States had a A) gold-based monetary standard. B) silver-based monetary standard. C) bimetallic monetary standard consisting of silver and gold. D) bimetallic monetary standard consisting of copper and silver. E) bimetallic monetary standard consisting of copper and gold. Answer: C Page Ref: 548-553 Difficulty: Easy 8) In L. Frank Baum's classic 1900 children's book, The Wonderful Wizard of Oz, the name "oz" is a reference to A) an ounce (oz.) of gold. B) an ounce (oz.) of silver. C) an ounce (oz.) of copper. D) an ounce (oz.) of gold or silver. E) an ounce (oz.) of wheat. Answer: A Page Ref: 548-553 Difficulty: Easy 9) Under the gold standard era of 1870-1914 A) Tokyo was the center of the international monetary system. B) Paris was the center of the international monetary system. C) Berlin the center of the international monetary system. D) New York was the center of the international monetary system. E) London was the center of the international monetary system. Answer: E Page Ref: 548-553 Difficulty: Easy 10) Under the gold standard era of 1870-1914 A) central banks tried to have sharp fluctuations in the balance of payments. B) central banks tried to avoid sharp fluctuations in the current account of the balance of payments. C) central banks tried to avoid sharp fluctuations in the trade account of the balance of payments. D) central banks tried to avoid sharp fluctuations in the capital account of the balance of payments. E) central banks tried to avoid sharp fluctuations in the balance of payments. Answer: E Page Ref: 548-553 Difficulty: Easy

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11) A country is said to be in balance of payments equilibrium, when the sum of its current and its A) non-reserved capital accounts equals zero. B) reserved capital accounts equals zero. C) non-reserved capital accounts equals to the surplus in the capital account. D) non-reserved capital accounts equals to the deficit in the capital account. E) non-reserved capital accounts is higher than the total capital account balance. Answer: A Page Ref: 548-553 Difficulty: Easy 12) Under the Gold standard, a country is said to be in balance of payments equilibrium when the current account balance is A) financed entirely by international lending without reserve movements. B) financed by international lending and with reserve movements. C) equal to zero. D) financed entirely by international lending and past gold reserves. E) financed entirely by gold reserves. Answer: A Page Ref: 548-553 Difficulty: Easy 13) Explain why under the gold standard a perpetual surplus or a perpetual deficit is impossible. Answer: Since specie inflows drive up domestic prices and restore equilibrium in the balance of payments, any surplus eventually eliminates itself. A shortage of currency leads to low domestic prices and a foreign payments surplus, and any deficit eventually eliminates itself. Page Ref: 548-553 Difficulty: Easy 14) The price-specie-flow mechanism A) is an automatic mechanism for assuring external balance under floating exchange rates. B) is an automatic mechanism for assuring external balance under the gold standard. C) is an automatic mechanism for assuring internal balance under floating exchange rates. D) is an automatic mechanism for assuring internal balance under the gold standard. E) is an automatic mechanism for assuring internal balance under mercantilism. Answer: B Page Ref: 548-553 Difficulty: Easy 15) How did the international monetary system influenced macroeconomic policy-making and performance during the gold standard era (1870-1914)? Answer: London was the center of the international monetary system. The primary responsibility of the central bank was to preserve the official parity between its currency and gold. To maintain this price, the central bank needed an adequate stock of gold reserves. Central banks tried to avoid sharp fluctuations in the balance of payments. Page Ref: 548-553 Difficulty: Easy 12 .

16) Under the gold standard A) a perpetual surplus is possible. B) a perpetual deficit is possible. C) a perpetual surplus is impossible, but a perpetual deficit is possible. D) a perpetual deficit is impossible, but a perpetual surplus is possible. E) a perpetual surplus is impossible. Answer: E Page Ref: 548-553 Difficulty: Easy 17) Under the gold standard A) a shortage of currency leads to low domestic prices and a foreign payments surplus. B) a shortage of currency leads to high domestic prices and a foreign payments surplus. C) a shortage of currency leads to low domestic prices and a foreign payments deficit. D) a shortage of currency leads to low domestic prices but leaves the foreign balance of payments at equilibrium. E) a shortage of currency leads to a perpetual surplus. Answer: A Page Ref: 548-553 Difficulty: Easy 18) It is claimed that L. Frank Baum's classic 1900 children's book, The Wonderful Wizard of Oz, is an allegorical rendition of the U.S. political struggle over gold. Answer: This statement is true. In L. Frank Baum's classic 1900 children's book, The Wonderful Wizard of Oz, the name "oz" is a reference to an ounce (oz.) of gold, and the yellow brick road represents the false promise of gold. The story represents the struggle of farmers in the western US who were heavily indebted. Page Ref: 548-553 Difficulty: Easy 19) The gold standard period was A) up until the first world war. B) between the first and second world wars. C) following the second world war until 1970. D) between 1954 and 1970. E) between 1814 and 1865. Answer: A Page Ref: 548-553 Difficulty: Easy

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20) Once the United States Civil War broke out, the United States moved to a A) gold standard. B) silver standard. C) bimetallic monetary standard consisting of silver and gold. D) bimetallic monetary standard consisting of copper and gold. E) paper currency, called the "greenback." Answer: E Page Ref: 548-553 Difficulty: Easy 21) Refute the claim by mercantilists who claimed that without severe restrictions on international trade and payments, a country might find itself impoverished and without an adequate supply of circulating monetary gold as a result of balance of payments deficits. Answer: The balance of payments would automatically regulate itself to ensure an adequate supply of money in every country. Page Ref: 548-553 Difficulty: Moderate 19.4 The Interwar Years, 1918-1939 1) A policy of "beggar-thy-neighbor" is a policy that A) often benefits the home country in the long run. B) often benefits the foreign country in the long run. C) often benefits foreign country in the short run. D) does not often benefits any country in the long run. E) benefits the home country's neighbors in the long run. Answer: D Page Ref: 553-556 Difficulty: Easy 2) The Great Depression that started in 1929 was A) confined only to the United States. B) confined only to the United States and Britain. C) confined only to the United States and Europe. D) a global phenomenon. E) confined only to the Americas. Answer: D Page Ref: 553-556 Difficulty: Easy

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3) Which one of the following statements is the MOST accurate? By the year 1932, the United States A) and Canada alone held more than 70 percent of the world's monetary gold. B) and Germany alone held more than 70 percent of the world's monetary gold. C) and Britain alone held more than 70 percent of the world's monetary gold. D) Britain, and France alone held more than 70 percent of the world's monetary gold. E) and France alone held more than 70 percent of the world's monetary gold. Answer: E Page Ref: 553-556 Difficulty: Easy 4) Countries with the A) biggest deflations and output contractions are countries which were never on the gold standard until 1936. B) biggest inflations and output contractions are countries which were on the gold standard until 1936. C) lowest deflations and output contractions are countries which were on the gold standard until 1936. D) biggest deflations and output increases are countries which were on the gold standard until 1936. E) biggest deflations and output contractions are countries which stayed on the gold standard until 1936. Answer: E Page Ref: 553-556 Difficulty: Easy 5) How did the international monetary system influence macroeconomic policy-making and performance during the interwar period (1918-1939)? Answer: Governments effectively suspended the gold standard during World War I and financed part of their massive military expenditures by printing money. Further, labor forces and productivity capacity had been reduced sharply through war losses. As a result, price levels were higher everywhere at the conclusion of the war in 1918. Of special note is the German hyperinflation that occurred when prices in Germany increased by a factor of 481.5 billion! The United States returned to gold in 1919. In 1922, at a conference in Genoa, Italy, a group of countries including Britain, France, Italy and Japan agreed on a program of a partial gold exchange standard in which smaller countries could hold as reserves the currencies of several large countries whose own international reserves would consist entirely of gold. In 1925, Britain returned to the gold standard by pegging the pound to gold at the prewar price. Thus, the Bank of England was therefore forced to follow contractionary monetary policies that contributed to severe unemployment and to the decline of London as the leading financial center. The world economy disintegrated into increasingly autarkic (self-sufficient) national units in the early 1930s. Page Ref: 553-556 Difficulty: Moderate

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6) Describe the effects of the Smoot-Hawley tariff imposed by the United States in 1930. Answer: Had a damaging effect on employment abroad. The foreign response involved retaliatory trade restrictions and preferential trading arrangements among group of countries. This is an example of "beggar-thy-neighbor" policy, meaning a policy that benefits the home country only because it worsens economic conditions abroad. Page Ref: 553-556 Difficulty: Moderate 7) What explains the nearly universal scope of the Great Depression? Answer: The international gold standard played a central role in starting, deepening, and spreading the Great Depression. Page Ref: 553-556 Difficulty: Moderate 8) The following figure introduces the relationship between industrial production and wholesale price index changes between the years 1929-1935. What is the purpose of the following figure?

Answer: The purpose is to show that countries that left the gold standard early and adopted counter-deflationary monetary policies, such as Australia and the United Kingdom, experienced milder declines in output during the Great Depression. Countries such as France and Switzerland that stuck to the gold standard longer had greater decline in price level and output. Page Ref: 553-556 Difficulty: Moderate

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19.5 The Bretton Woods System and the International Monetary Fund 1) The costs of inflation have been most apparent in the post-war period in countries like A) Argentina. B) Belgium. C) the United States. D) Canada. E) Japan. Answer: A Page Ref: 556-559 Difficulty: Easy 2) The costs of inflation have been most apparent in the post-war period in countries like A) Brazil. B) Belgium. C) the United States. D) Canada. E) Japan. Answer: A Page Ref: 556-559 Difficulty: Easy 3) The costs of inflation have been most apparent in the post-war period in countries like A) Serbia. B) Belgium. C) the United States. D) Canada. E) Japan. Answer: A Page Ref: 556-559 Difficulty: Easy 4) A convertible currency is a currency that may be freely exchanged for A) domestic assets. B) only silver. C) only copper. D) national currency. E) foreign currencies. Answer: E Page Ref: 556-559 Difficulty: Easy

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5) Which of the two features of the IMF Articles of Agreement helped promote flexibility in external adjustment? A) IMF members helped countries maintain full employment. B) IMF allowed countries to attain internal balance. C) New countries would enter the agreement if they fixed their exchange rate. D) IMF members contributed their currency to form a pool of resources that IMF could lend to countries in need and parities in the exchange rate against the dollar could be adjusted with agreement of IMF. E) IMF members argued against the use of floating exchange rates. Answer: D Page Ref: 556-559 Difficulty: Easy 6) The dollar of the United States became the postwar world's key currency because of all EXCEPT A) the early convertibility of the U.S. dollar in 1945. B) the special position of the dollar under the Bretton Woods system. C) the strength of the American economy relative to the devastated economies of Europe and Japan. D) central banks naturally found it advantageous to hold their international reserves in the form of interest-bearing dollar assets. E) the ease of transporting U.S. dollars compared with other currencies. Answer: E Page Ref: 556-559 Difficulty: Easy 7) A person holding dollar deposits during the devaluation of the dollar would A) enjoy a monetary gain. B) see the foreign currency value of dollar assets increase by the amount of the exchange rate change. C) shift their wealth into domestic investments. D) suffer a monetary loss and see the foreign currency value of dollar assets decrease by the amount of the exchange rate change. E) see no change in their investments. Answer: D Page Ref: 556-559 Difficulty: Easy

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8) Countries with large current account surpluses might be viewed by the market as candidates for A) devaluation. B) revaluation. C) bankruptcy. D) depreciation. E) investment. Answer: B Page Ref: 556-559 Difficulty: Easy 9) The IMF agreement forced the U.S. to exchange gold for dollars at what price? A) $25/ ounce B) $35/ ounce C) $45/ ounce D) $55/ ounce E) $20/ ounce Answer: B Page Ref: 556-559 Difficulty: Easy 10) How did the international monetary system influence macroeconomic policy-making and performance during the post-World War II years during which exchange rates were fixed under the Bretton Woods agreement (1946-1973)? Answer: In July 1944, representatives of 44 countries met in Bretton Woods, New Hampshire, and drafted and signed the Articles of Agreement of the International Monetary Fund (IMF) and of the World Bank. The agreement established fixed exchange rates against the U.S. dollar and an unvarying dollar price of gold-$35 an ounce. The dollar of the United States became the postwar world's key currency because of a few factors: (1) The early convertibility of the U.S. dollar in 1945 (2) The special position of the dollar under the Bretton Woods system (3) The strength of the American economy relative to the devastated economies of Europe and Japan (4) Central banks naturally found it advantageous to hold their international reserves in the form of interest-bearing dollar assets The Marshall Plan, a program of dollar grants from the United States to European countries, was initiated in 1948. Most countries in Europe did not restore convertibility until the end of 1958, with Japan following in 1964. Page Ref: 556-559 Difficulty: Easy

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11) What is a convertible currency? Answer: A convertible currency is a currency that may be freely exchanged for foreign currencies. Page Ref: 556-559 Difficulty: Easy 12) Explain why the United States dollar became the postwar world's key currency. Answer: (1) The early convertibility of the U.S. dollar in 1945. (2) The special position of the dollar under the Bretton Woods system. (3) The strength of the American economy relative to the devastated economies of Europe and Japan. (4) Central banks naturally found it advantageous to hold their international reserves in the form of interest-bearing dollar assets. Page Ref: 556-559 Difficulty: Easy 13) How did the international monetary system created at Bretton Woods in 1944 allow its members to reconcile their external commitments with their internal goals of full employment and price stability? Answer: As the world economy evolved in the years after World War II, the meaning of "external balance" changed and conflicts between internal and external goals increasingly threatened the fixed exchange rate system. The United States, the issuer of the principal reserve currency, was a major concern, leading to proposals to reform the system. Page Ref: 556-559 Difficulty: Easy 14) Discuss the impact of the restoration of convertibility in 1958. Answer: As foreign exchange trading expanded, financial markets in different countries became more tightly integrated, an important step towards the creation of today's worldwide foreign exchange market. With growing opportunities to move funds across borders, national interest rates became more closely linked and the speed with which policy changes might cause a country to lose or gain international reserves increased. Page Ref: 556-559 Difficulty: Easy 15) Explain how a country with a current account deficit is a ripe candidate for currency devaluation. Answer: If, for example, Great Britain had a current account deficit, the holders of pounds would become nervous and shift their wealth into other currencies. In order hold the pound's exchange rate against the dollar pegged, the Bank of England would have to buy pounds and supply the foreign assets that market participants wished to hold. This resulting loss in foreign reserves, if large enough, would most likely force a devaluation by leaving the Bank of England without enough reserves to prop up the exchange rate. Page Ref: 556-559 Difficulty: Easy 20 .

16) Explain how a country with a current account surplus is a ripe candidate for currency revaluation. Answer: If a country like Germany had a current account surplus, it would sell its currency in the foreign exchange market in order to keep it from appreciating. The German central banks would thus find themselves swamped with official reserves, and Germany would face the problem of having its money supply grow uncontrollably, a trend that would most likely drive up the domestic price levels and upset internal balance. Revaluation of the currency would thus be a viable solution to this problem. Page Ref: 556-559 Difficulty: Easy 19.6 Analyzing Policy Options for Reaching Internal and External Balance 1) When the exchange rate, E, and the foreign price level, P*, is fixed, domestic inflation depends primarily on A) amount of aggregate demand. B) home price level set by IMF. C) current account balance. D) government tax policy. E) foreign interest rates. Answer: A Page Ref: 560-564 Difficulty: Easy 2) The current account surplus is A) an increasing function of disposable income and an increasing function of the real exchange rate. B) a decreasing function of disposable income and a decreasing function of the real exchange rate. C) a decreasing function of disposable income and an increasing function of the real exchange rate. D) only a decreasing function of disposable income. E) only an increasing function of the real exchange rate. Answer: C Page Ref: 560-564 Difficulty: Easy 3) Under fixed exchange rates A) monetary policy is not an effective policy. B) fiscal policy is not an effective policy. C) monetary policy and fiscal policy are not effective. D) both monetary and fiscal policies are effective. E) monetary policy has an unpredictable effect on the domestic money supply. Answer: A Page Ref: 560-564 Difficulty: Easy 21 .

4) Under fixed exchange rates, domestic asset transactions by the central bank A) can be used to alter the level of foreign reserves but not to affect the state of employment and output. B) cannot be used to alter the level of foreign reserves but only to affect the state of employment and output. C) can be used to alter the level of foreign reserves and to affect the state of employment and output. D) can be used to alter the domestic money supply and the level of foreign reserves. E) can raise output to full-employment level. Answer: A Page Ref: 560-564 Difficulty: Easy 5) The XX schedule shows how much A) fiscal expansion is needed to hold the current account surplus at X as the currency is devalued by a given amount. B) monetary expansion is needed to hold the current account surplus at X as the currency is devalued by a given amount. C) fiscal expansion is needed to hold the current account surplus at X as the currency is evaluated by a given amount. D) fiscal and monetary expansions are needed to hold the current account surplus at X as the currency is devalued by a given amount. E) foreign funding is needed to hold the current account surplus at X as the currency is devalued by a given amount. Answer: A Page Ref: 560-564 Difficulty: Easy 6) The current account surplus A) is a decreasing function of disposable income and an increasing function of the real exchange rate. B) is an increasing function of disposable income and an increasing function of the real exchange rate. C) is an increasing function of disposable income and a decreasing function of the real exchange rate. D) is a decreasing function of disposable income and a decreasing function of the real exchange rate. E) is an increasing function of disposable income and a decreasing function of aggregate demand. Answer: A Page Ref: 560-564 Difficulty: Easy

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7) Fiscal expansion A) stimulates aggregate demand and causes output to decline. B) decreases aggregate demand and causes output to decline. C) stimulates aggregate demand and causes output to rise. D) decreases aggregate demand and causes output to rise. E) decreases government expenditures. Answer: C Page Ref: 560-564 Difficulty: Easy 8) A devaluation of the home currency A) makes foreign goods and services cheaper relative to those sold at home. B) makes domestic goods and services more expensive relative to those sold abroad. C) decreases demand and output. D) increases demand for domestic goods and services. E) increases output and makes domestic goods and services cheaper relative to those sold abroad. Answer: E Page Ref: 560-564 Difficulty: Easy 9) An attempt by a central bank to alter the money supply by buying or selling domestic assets A) will leave both domestic money supply and foreign reserves unchanged. B) will cause an offsetting change in aggregate demand. C) will lead to a rise in domestic employment and output. D) will lead to a decrease in domestic employment and output. E) will cause an offsetting change in foreign reserves and leave the domestic money supply unchanged. Answer: E Page Ref: 560-564 Difficulty: Easy 10) An expenditure-changing policy A) alters the direction of the economy's total demand for goods and services. B) alters the level of the economy's total demand for goods and services. C) has no effect on aggregate demand. D) is the same thing as an expenditure-switching policy. E) affects aggregate supply but not aggregate demand. Answer: B Page Ref: 560-564 Difficulty: Easy

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11) The alteration of exchange rates to move the economy to internal and external balance may lead to all EXCEPT A) a balance of payments crisis. B) changes in the terms of trade. C) changes in the level of imports or exports. D) changes in interest rates. E) a guaranteed unilateral improvement in economic wealth. Answer: E Page Ref: 560-564 Difficulty: Easy 12) "A monetary policy is not a policy tool under fixed exchange rates." Discuss. Answer: True, under fixed exchange rates, domestic asset transactions by the central bank can be used to alter the level of foreign reserves but not to affect the state of employment and output. Page Ref: 560-564 Difficulty: Moderate 13) What is the difference between an expenditure-changing policy and an expenditureswitching policy? Answer: An expenditure-changing policy alters the level of the economy's total demand for goods and services. An expenditure-switching policy, on the other hand, induces an exchange rate adjustment and thus changes the direction of demand, shifting it between domestic output and imports. Page Ref: 560-564 Difficulty: Moderate

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14) (a) Assume that R denotes the domestic interest rate and R denotes the foreign interest rate. Under a fixed exchange rate what is the relation between R and R (b) Assume E denotes the domestic currency price of the dollar for a country which is not the United States. If one wants to analyze only the short run effects of a policy, what does one assume about the Home and Foreign price levels, P and P , respectively. (c) Assume that there is no ongoing balance of payment crisis. What is this assumption really assume? (d) Assume a fixed exchange rate system. What does this tell you about E? (e) Under the above assumptions what are the conditions for internal balance? (f) How is your answer to Part D above would change if P is unstable due to foreign inflation. (g) Given the definitions above, how one defines the real exchange rate? (h) Write the condition for internal balance. (i) Define the variable not defined before in Part G above. (j) Using the equation for internal balance derived above, given our assumptions analyze the effects of a fiscal expansion. (k) What would happen if the government of that country, which is not the United States under Bretton Woods, decides to devaluate its currency? (l) What would happen if the government of that country, which is not the United States under Bretton Woods, decides to use monetary policy rather than fiscal policy? (m) Given all of the above, what is the relation between the exchange rate, E, and fiscal ease, i.e., an increase in G or a reduction in T? (n) Assume that the economy is at internal balance. What will happen if G goes up for a given level of E? (o) Assume that the economy is at internal balance. What will happen if G goes down for a given level of E?

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Answer: (a) R = R (b) Constant prices. (c) That Ee, the expected exchange rate, is equal to the exchange rate today, E. In other words, E = Ee. (d) E is constant, i.e., E = E0. (e) Since P and E are fixed, the expected price is fixed; thus, no inflation is expected. Then, internal balance will require only full employment, aggregate demand equaling the fullemployment level, Yf. (f) In this case, full employment alone will not guarantee price stability under a fixed exchange rate. (g) The real exchange rate is equal to EP /P. (h) Yf = C(Yf - T) + I + G + CA(EP /P, Yf - T) (i) C = consumption, I = Investment, (Yf - T) = disposable income, T = taxes. (j) An increase in G or a reduction in T will increase aggregate demand and will cause output to rise in the short run. (k) A rise in E makes domestic goods and services cheaper relative to those sold abroad and thus increases demand for output. (l) A monetary policy is not a policy tool under fixed exchange rates. Under fixed exchange rates, domestic asset transactions by the central bank can be used to alter the level of foreign reserves but not to affect the state of employment and output. (m) Negative relation. (n) Over-employment. (o) Under employment. Page Ref: 560-564 Difficulty: Moderate

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15) Assume that the government has a target value, X, for the current account surplus. (a) What is the goal of external balance? (b) Assume that we are dealing with only the short run, what are the values of P and P∗? (c) Given fixed P and P , what would happen if E rises? (d) Given P and P , what would happen if T decreases, i.e., an expansionary fiscal policy? (e) Given P and P , what would happen if G increases, i.e., an expansionary fiscal policy? (f) Given all of the above, what is the relation between the exchange rate, E, and fiscal ease, i.e., an increase in G or a reduction in T? (g) Assume that the economy is in external balance. What will happen if the government maintains its current account at X, but devaluates the domestic currency? (h) Assume that the economy is at external balance. What will happen if the government raises E? (i) Assume that the economy is at external balance. What will happen if the government lowers E? Answer: (a) The goal of external balance requires the government to manage fiscal policy and the exchange rate so that the following equation is satisfied: CA(EP /P, Y - T) = X. (b) Constant prices. (c) An increase in E makes domestic goods cheaper, thus improving the current account. (d) A fall in T raises output, Y. The resulting increase in output increases disposable income and thus leads to increased home spending on foreign goods, worsening the current account. (e) Similar to the answer above. A rise in G causes CA to fall by increasing Y. (f) Positive relationship. (g) The government raises E; thus, either G should go up or T should go down to maintain the external balance. (h) An increase in E raises net exports and thus leads to a surplus in the current account higher than the target level of X. This will represent a point above the XX schedule. (i) A decrease in E reduces net exports and thus leads to a deficit in the current account lower than the target level of X. This will represent a point below the XX schedule. Page Ref: 560-564 Difficulty: Moderate

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16) Use a figure below to describe the four zones of economic discomfort.

Answer: The answer is given in the following figure.

Page Ref: 560-564 Difficulty: Moderate

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17) Using the II-XX framework, show using a figure that fiscal policies by themselves cannot bring the economy to both internal and external balances. Answer: Starting at point 2, fiscal policy is shown as only horizontal movements. This means that the economy can reach either point 3 (internal balance) or point 4 (external balance) in the figure, but not both internal and external balances. Only a devaluation of the currency accompanied with an increase in fiscal ease, namely increasing government expenditures or decreasing taxes, will move the economy to both internal and external balances at point 1 in the figure.

Page Ref: 560-564 Difficulty: Moderate 19.7 The External Balance Problem of the United States Under Bretton Woods 1) The confidence problem of the Bretton Woods systems articulated by Robert Triffin refers to A) the unwillingness of central banks to accumulate currency for fear of not being able to convert it to gold in case a run on the banks occurs. B) consumer fear of stock market instability. C) producer fear of rising wages. D) the lack of convertibility of gold into silver. E) low consumer spending because of balance of payment crises. Answer: A Page Ref: 564-568 Difficulty: Easy

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2) A two-tier gold market like the one created during the Bretton Woods System refers to A) a private tier for private gold traders where the price would not be allowed to fluctuate, and an official tier for central banks where the official gold price would be allowed to fluctuate. B) a private tier for private gold traders where the price would not be allowed to fluctuate, and an official tier for central banks where the official gold price would rise on a yearly basis by predetermined increments. C) a private tier for private gold traders where the price would be allowed to fluctuate, and an official tier for central banks where the official gold price would be set at $35 an ounce. D) a private tier for private gold traders where the price would be set at $35 an ounce, and an official tier for central banks where the official gold price would be allowed to fluctuate. E) a private tier for private gold traders where the price of gold would rise on a yearly basis by pre-determined increments, and an official tier for central banks where the official gold price would be set at $35 an ounce. Answer: C Page Ref: 564-568 Difficulty: Easy 3) In order to bring about a real depreciation of the dollar, the U.S. can hope for A) a rise in the U.S. price level. B) a fall in foreign price levels. C) a rise in the dollar's nominal value in terms of foreign currencies. D) a rise in foreign price levels or a fall in the dollar's nominal value in terms of foreign currencies. E) increased output and full employment. Answer: D Page Ref: 564-568 Difficulty: Easy 4) The collapse of the Bretton Woods system marked A) the end of floating exchange rates and a move to fixed exchange rates. B) marked the end of fixed exchange rates and a move to floating exchange rates. C) the beginning of the gold standard. D) a plunge in the price of gold. E) the elimination of paper currencies. Answer: B Page Ref: 564-568 Difficulty: Easy

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5) Which of the following statements is MOST accurate? A) A revaluation restores internal and external balance immediately, without causing domestic inflation. B) A devaluation restores internal and external balance immediately, without causing domestic inflation. C) A revaluation restores internal and external balance immediately, but also causes domestic inflation. D) A devaluation restores internal and external balance immediately, but also causes domestic inflation. E) A devaluation restores external balance in the long run, without causing immediate domestic inflation. Answer: A Page Ref: 564-568 Difficulty: Easy 6) Which of the following is the MOST accurate? A) U.S. macroeconomic policies in the late 1960s helped cause the breakdown of the Bretton Woods system by early 1973. B) U.S. macroeconomic policies in the late 1970s helped cause the breakdown of the Bretton Woods system by early 1983. C) U.S. macroeconomic policies in the late 1980s helped cause the breakdown of the Bretton Woods system by early 1993. D) U.S. macroeconomic policies in the late 1950s helped cause the breakdown of the Bretton Woods system by early 1963. E) U.S. macroeconomic policies in the late 1960s delayed the breakdown of the Bretton Woods system to early 1973. Answer: A Page Ref: 564-568 Difficulty: Easy

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7) Refer to the graph below, which shows the effect of ________ on the home economy.

A) foreign inflation B) domestic inflation C) foreign deflation D) domestic recession E) foreign recession Answer: A Page Ref: 564-568 Difficulty: Easy 8) Refer to the graph below. The movement from point 1 to point 2 is stimulated by a disequilibrium in which there is domestic ________ and ________.

A) overemployment; trade surplus B) unemployment; trade surplus C) overemployment; trade deficit D) unemployment; trade deficit E) inflation; unemployment Answer: A Page Ref: 564-568 Difficulty: Easy

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19.8 The Case for Floating Exchange Rates 1) Advocates of floating rate suggested it is favorable for economies for all of the following reasons EXCEPT A) it discourages attack from foreign exchange speculators because of the fact that exchange rate adjustment is immediate. B) it helps stabilize the shock effect on unemployment in case of economic changes such as fall in export demand. C) it automatically matches the domestic inflation with ongoing foreign inflation. D) it gives every country the opportunity to guide its own monetary conditions at home. E) it brings the LR exchange rate to the level predicted by PPP without government policy decisions. Answer: C Page Ref: 568-576 Difficulty: Easy 2) Which of the following is NOT a result of a temporary fall in foreign demand on one country's exports under floating exchange rate? A) The DD curve shifts to the left due to reduction of aggregate demand. B) The AA curve shifts downwards due to reduction of money supply. C) a fall in aggregate output D) depreciation in home country's currency E) a fall in the home interest rate Answer: B Page Ref: 568-576 Difficulty: Easy 3) Which of the following is NOT a result of a permanent fall in foreign demand on one country's exports under floating exchange rate? A) The DD curve shifts to the left due to reduction of aggregate demand. B) The AA curve shifts upwards due to the increased expected long-run exchange rate. C) a reduction in output by a smaller degree compared to temporary fall in demand D) depreciation in home country's currency E) a raised level of unemployment Answer: E Page Ref: 568-576 Difficulty: Easy

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4) Which one of the following is/are INCORRECT? An argument against floating exchange rates is that A) a fixed rate automatically prevents instability in the domestic money market from affecting the economy if shocks come from home domestic money market. B) a fixed rate might become unpredictable, complicating economic planning. C) a rise in money demand under a fixed exchange rate would have no effect on the exchange rate and output. D) a fixed rate functions within the price-specie-flow mechanism and maintains a balance of payments equilibrium. E) a fixed rate automatically prevents instability in the economy from output market shocks. Answer: E Page Ref: 568-576 Difficulty: Easy 5) If central banks were no longer obliged to intervene in currency markets to fix exchange rates, governments would be able to use monetary policy to reach A) internal balance. B) external balance. C) internal and external balance. D) internal but not external balance. E) external but not internal balance. Answer: C Page Ref: 568-576 Difficulty: Easy 6) Advocates of flexible exchange rates claim that under flexible exchange rates A) no country would be forced to import only inflation from abroad. B) no country would be forced to import only deflation from abroad. C) no country would be forced to import inflation and deflation from abroad. D) flexible exchange rates are not able to halt importing inflation from abroad. E) flexible exchange rates are not able to halt importing deflation from abroad. Answer: C Page Ref: 568-576 Difficulty: Easy 7) Advocates of flexible exchange rates claim that under flexible exchange rates A) the United States would now be able to set world monetary conditions all by itself. B) Germany would no longer be able to set world monetary conditions all by itself. C) the United Kingdom would no longer be able to set world monetary conditions all by itself. D) the United States would no longer be able to set world monetary conditions all by itself. E) Germany would now be able set world monetary conditions all by itself. Answer: D Page Ref: 568-576 Difficulty: Easy

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8) Advocates of flexible exchange rates claim that under flexible exchange rates A) the United States would no longer have the same opportunity as other countries to influence its exchange rate against foreign currencies. B) the United States would have the same opportunity as other countries to influence its exchange rate against foreign currencies. C) the United Kingdom would not have the same opportunity as other countries to influence its exchange rate against foreign currencies. D) Germany would not have the same opportunity as other countries to influence its exchange rate against foreign currencies. E) China would have the same opportunity as other countries to influence its exchange rate against foreign currencies. Answer: B Page Ref: 568-576 Difficulty: Easy 9) Some claim that the long and agonizing periods of speculation preceding exchange rate realignments would A) not occur under fixed exchange rate regime. B) not occur under floating. C) become more severe under currency board. D) become less severe under floating. E) be prolonged under floating. Answer: D Page Ref: 568-576 Difficulty: Easy 10) Advocates of floating rates pointed out that A) removal of the obligation to peg currency values would restore monetary control to central banks. B) imposing of the obligation to peg currency values would restore monetary control to central banks. C) removing of the obligation to peg currency values would restore fiscal control. D) imposing of the obligation to peg currency values would restore fiscal control. E) imposing of the obligation to peg currency would restore monetary control to the consumer. Answer: A Page Ref: 568-576 Difficulty: Easy

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11) Advocates of flexible exchange rates claim that under flexible exchange rates, if the central bank faced unemployment A) and thus wished to decrease its money supply, there would no longer be any legal barrier to the currency depreciation this would cause. B) and thus wished to expand its money supply, there would no longer be any legal barrier to the currency depreciation this would cause. C) and wished to expand its money supply, there would no longer be any legal barrier to the currency appreciation this would cause. D) and wished to decrease its money supply, there now would be a legal barrier to the currency depreciation this would cause. E) and wished to increase output, there would no longer be a legal barrier to the currency appreciation this would cause. Answer: B Page Ref: 568-576 Difficulty: Easy 12) Advocates of flexible exchange rates claim that under flexible exchange rates, a currency A) appreciation caused by increasing the money supply would reduce unemployment by lowering the relative price of domestic products. B) depreciation caused by increasing the money supply would increase unemployment by lowering the relative price of domestic products. C) depreciation caused by increasing the money supply would reduce unemployment by lowering the relative price of domestic products. D) depreciation caused by increasing the money supply would reduce unemployment by increasing the relative price of domestic products. E) depreciation cause by decreasing the money supply would not effect unemployment, but would increase the relative price of domestic products. Answer: C Page Ref: 568-576 Difficulty: Easy 13) Advocates of flexible exchange rates claim that under flexible exchange rates, a currency A) depreciation caused by increasing the money supply would reduce unemployment by increasing world demand for them. B) appreciation caused by increasing the money supply would reduce unemployment by increasing world demand for them. C) appreciation caused by decreasing the money supply would reduce unemployment by increasing world demand for them. D) appreciation caused by increasing the money supply would increase unemployment by increasing world demand for them. E) appreciation caused by increasing the money supply would increase unemployment by decreasing world demand for them. Answer: A Page Ref: 568-576 Difficulty: Easy

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14) Advocates of flexible exchange rates claim that under flexible exchange rates, a currency A) depreciation caused by increasing the money supply would reduce unemployment by lowering the relative price of domestic products and increasing the world demand for them. B) appreciation caused by increasing the money supply would reduce unemployment by lowering the relative price of domestic products and increasing world demand for them. C) appreciation caused by decreasing the money supply would reduce unemployment by lowering the relative price of domestic products and increasing world demand for them. D) appreciation caused by increasing the money supply would increase unemployment by lowering the relative price of domestic products and increasing world demand for them. E) appreciation caused by increasing the money supply would increase unemployment by lowering the relative price of domestic products and by decreasing world demand for them. Answer: A Page Ref: 568-576 Difficulty: Easy 15) Advocates of flexible exchange rates claim that under flexible exchange rates, the central bank of A) an overheated economy could cool down activity by increasing the money supply without worrying that undesired reserve inflow would undermine its stabilization effort. B) a cooled economy could cool down activity by contracting the money supply without worrying that undesired reserve inflow would undermine its stabilization effort. C) an overheated economy could cool down activity by contracting the money supply without worrying that undesired reserve inflow would undermine its stabilization effort. D) an overheated economy could cool down activity by contracting the money supply without worrying that undesired reserve outflow would undermine its stabilization effort. E) an overheated economy could cool down activity by decreasing employment and increasing output without worrying that this would undermine its stabilization effort. Answer: C Page Ref: 568-576 Difficulty: Easy 16) Advocates of flexible exchange rates claim that under flexible exchange rates A) enhanced control over fiscal policy would allow countries to dismantle their distorting barriers to international payments. B) reduced control over monetary policy would allow countries to dismantle their distorting barriers to international payments. C) enhanced control over monetary policy would allow countries to increase their distorting barriers to international payments. D) enhanced control over monetary policy would allow countries to dismantle their distorting barriers to international payments. E) enhanced control over monetary policy would destabilize exchange rates. Answer: D Page Ref: 568-576 Difficulty: Easy

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17) By the end of the 1960s, many countries felt that they were importing inflation from A) the United States. B) Germany. C) France. D) Japan. E) the United Kingdom. Answer: A Page Ref: 568-576 Difficulty: Easy 18) Which one of the following statements is TRUE? A) By devaluing its currency, that is, by lowering the domestic currency price of foreign currency, a country can insulate itself completely from an inflationary increase in foreign prices. B) By revaluing its currency, that is, by increasing the domestic currency price of foreign currency, a country can insulate itself completely from an inflationary increase in foreign prices. C) By revaluing its currency, that is, by lowering the domestic currency price of foreign currency, a country cannot insulate itself completely from an inflationary increase in foreign prices. D) By revaluing its currency, that is, by lowering the domestic currency price of foreign currency, a country can insulate itself completely from an inflationary increase in foreign prices. E) By revaluing its currency, that is, by lowering the domestic currency price of foreign currency, a country cannot insulate itself completely from a harmful decrease in foreign prices. Answer: D Page Ref: 568-576 Difficulty: Easy 19) When all changes in the world are due to A) fiscal policy, purchasing power parity holds true in the long run. B) monetary policy, purchasing power parity does not hold true in the long run. C) monetary policy, purchasing power parity holds true in the long run. D) monetary policy, purchasing power parity holds true even in the short run. E) fiscal and monetary policy, purchasing power parity holds true in the long run. Answer: C Page Ref: 568-576 Difficulty: Easy 20) Federal Reserve Chairman Volcker's policy to fight inflation A) led to the 1981-1983 recession, but was ultimately successful. B) led to the 1981-1983 recession, but did not end high inflation due to beggar-thy-neighbor effects. C) was perfectly complemented by Reagan's decrease in fiscal spending. D) led to the 1981-1983 recession and foretold the economic downturn in the mid-1990s. E) led to an immediate depreciation of the dollar. Answer: A Page Ref: 568-576 Difficulty: Easy 38 .

21) Under purchasing power parity (PPP), if U.S. monetary growth leads to a long run doubling of the U.S. price level, while Germany's price level remains constant, PPP predicts that the A) long-run DM price of the dollar will be doubled. B) long-run DM price of the dollar will be halved. C) long-run DM price of the dollar will remain the same. D) short-run DM price of the dollar will be halved. E) short-run DM price of the dollar will be doubled. Answer: B Page Ref: 568-576 Difficulty: Easy 22) Under flexible exchange rate regime, a money-induced A) decrease in U.S. prices causes an immediate appreciation of the foreign currencies against the dollar. B) increase in U.S. prices causes an immediate appreciation of the foreign currencies against the dollar. C) increase in U.S. prices causes an eventual appreciation of the foreign currencies against the dollar. D) increase in U.S. prices causes an eventual depreciation of the foreign currencies against the dollar. E) decrease in U.S. prices causes no change in foreign exchange rate. Answer: B Page Ref: 568-576 Difficulty: Easy 23) Under Bretton Woods, A) any foreign country cannot devalue its currency against the dollar in conditions of "fundamental disequilibrium." B) any foreign country could devalue its currency against the dollar in conditions of "fundamental disequilibrium," but the system's rules did not give the United States the option of devaluing against foreign currencies. C) any foreign country could devalue its currency against the dollar in conditions of "fundamental disequilibrium," and the system's rules did give the United States the same option of devaluing against foreign currencies. D) the U.S. could devalue its currency against the foreign currencies in conditions of "fundamental disequilibrium." E) any foreign country can revalue its currency against the dollar in conditions of "fundamental disequilibrium." Answer: B Page Ref: 568-576 Difficulty: Easy

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24) The DD schedule shows A) interest rate and output pairs for which aggregate demand equals aggregate output. B) exchange rate and output pairs for which aggregate demand equals aggregate output. C) exchange rate and output pairs for which aggregate supply equals aggregate output. D) interest rate and output pairs for which aggregate supply equals aggregate output. E) exchange rate and output pairs for which aggregate demand is greater than aggregate output. Answer: B Page Ref: 568-576 Difficulty: Easy 25) The AA schedule shows A) Interest rate and output pairs at which the foreign exchange market and the domestic money market are in equilibrium. B) Exchange rate and output pairs at which the foreign exchange market and the domestic money market are in equilibrium. C) Interest rate and output pairs at which only the foreign exchange market is in equilibrium. D) Exchange rate and output pairs at which only the foreign exchange market is in equilibrium. E) Exchange rate and output pairs at which only the domestic money market are in equilibrium. Answer: B Page Ref: 568-576 Difficulty: Easy 26) Under flexible exchange rate, the response of an economy to a temporary fall in foreign demand for its exports is A) the currency appreciates, and output falls. B) the currency depreciates, and output falls. C) the currency depreciates, and output increases. D) the currency depreciates, and output remains constant. E) the currency appreciates, and output increases. Answer: B Page Ref: 568-576 Difficulty: Easy 27) Under fixed exchange rate, the response of an economy to a temporary fall in foreign demand for its exports is A) the currency appreciates, and output falls. B) the currency depreciates, and output falls. C) the currency remains the same, and output decreases. D) the currency depreciates, and output remains constant. E) the currency appreciates, and output remains the same. Answer: C Page Ref: 568-576 Difficulty: Easy

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28) Comparing fixed to flexible exchange rate, the response of an economy to a temporary fall in foreign demand for its exports is A) output actually falls less under fixed rate than under floating rate. B) output actually falls more under fixed rate than under floating rate. C) output actually remains the same under fixed rate than under floating rate. D) the currency value grows in a fixed rate system and falls in a flexible system. E) output grows in a fixed rate system and falls in a flexible system. Answer: B Page Ref: 568-576 Difficulty: Easy 29) The effects of a decrease in export demand A) is a powerful argument in favor of fixed rates. B) is a powerful argument in favor of flexible rates. C) shows the difficulties in determining which exchange rate is better. D) is a powerful argument in favor of fixed rates only in the short run. E) is a powerful argument in favor of fixed rates only in the long run. Answer: B Page Ref: 568-576 Difficulty: Easy 30) Under the fixed rate regime foreign countries could hold their dollar exchange rates constant by A) using tight monetary policy. B) using expansionary fiscal policy. C) negotiating with the central bank of the United States. D) setting their domestic interest rate equal to the U.S. interest rate. E) holding their exchange rates constantly pegged to the euro and yen. Answer: D Page Ref: 568-576 Difficulty: Easy 31) Under the flexible exchange rate, lowering the price of a foreign currency will A) allow the expansion of monetary policy without causing inflation. B) decrease the foreign country's output. C) prevent a foreign price increase from causing deflation at home. D) cause a home price increase to be exported to the foreign markets. E) cause a "beggar-thy-neighbor" effect. Answer: A Page Ref: 568-576 Difficulty: Easy

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32) Supporters of a floating exchange rate cited all of the following as advantages over the Bretton Woods system EXCEPT A) each country would be able to choose its own long run inflation rate. B) parity changes and speculative attacks would no longer be possible. C) countries would be forced to work cooperatively in deciding monetary policy. D) exchange rates would be set symmetrically in foreign markets rather than by government decision. E) governments would not need to export inflation to decrease domestic unemployment. Answer: C Page Ref: 568-576 Difficulty: Easy 33) The mechanism behind the inflation insulation provided by a floating exchange rate is A) Purchasing Power Parity. B) a fixed AA curve. C) market speculation. D) tight monetary policy. E) symmetry. Answer: A Page Ref: 568-576 Difficulty: Easy 34) If the demand for Home exports decreased abroad, the Home fall in output would be greatest A) if the decrease was temporary and the exchange rate was fixed. B) if the decrease was temporary and the exchange rate was floating. C) if the decrease was permanent and the exchange rate was fixed. D) if the decrease was permanent and the exchange rate was floating. E) if the decrease was permanent and the exchange rate was high. Answer: C Page Ref: 568-576 Difficulty: Easy 35) Present the case for floating exchange rates. Answer: (1) Monetary policy autonomy — Governments would be able to use monetary policy to reach internal and external balance. No country would be forced to import inflation and deflation from abroad. (2) Symmetry — The United States would no longer be able to set world monetary conditions all by itself. The United States would have the same opportunity as other countries to influence its exchange rate against foreign currencies. (3) Exchange rates as automatic stabilizers — The long and agonizing periods of speculation preceding exchange rate realignments would not occur under floating. Page Ref: 568-576 Difficulty: Moderate

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36) "No central bank can be indifferent to its currency's value in the foreign exchange market." Discuss. Answer: — despite the "Monetary Policy Autonomy" theory of the original supporters of floating exchange rates — exchange rate's role in inflation — prices are sticky in the short run, so foreign developments can affect real interest rates and real exchange rates at home — don't want their exchange rate to be too volatile as it affects the demand for their domestic products — appreciation or depreciation can cause inflation that is difficult to counter — banks intervene on a discretionary basis so it is still necessary for them to continue to hold foreign reserves — "dirty floats" stabilize output and price level after shocks that affect exchange rates — empirically: after 1973 countries have continued to intervene to affect exchange rates Page Ref: 568-576 Difficulty: Moderate

37) Refer to the above figure. Use the DD-AA model to examine and compare the response of an economy under fixed and floating exchange rate to a temporary fall in foreign demand for its exports. Answer: The DD curve shifts to the left. When the exchange rate floats, because the demand shift is assumed to be temporary, it does not change the long-run expected exchange rate and so does not move the asset market equilibrium schedule AA. Thus, E rises, i.e. the currency depreciates and output falls. Under fixed exchange rate, the central bank must prevent the currency depreciation that occurs under a floating rate; thus, it buys domestic money with foreign currency, reducing the domestic money supply and shifting the AA to the left and down. E will remain constant and output will fall. Page Ref: 568-576 Difficulty: Moderate 43 .

38) Refer to the above figure. Use the DD-AA model to examine and compare the response of an economy under fixed and floating exchange rate to a permanent fall in foreign demand for its exports. Answer: The DD curve shifts to the left. Under flexible exchange rate, the expected exchange rate Ee also rises and AA shifts upward and to the right. Thus, a permanent shock causes a greater depreciation than a temporary one. Under fixed exchange rate, the central bank must prevent the currency depreciation that occurs under a floating rate; thus, it buys domestic money with foreign currency, reducing the domestic money supply and shifting the AA to the left and down. E will remain constant and output will fall. Under fixed exchange rate, a fall in export demand if permanent have led to a situation of "fundamental disequilibrium" calling for a devaluation of the currency or a long period of domestic unemployment as export prices fell. Uncertainty about the government's intention would have encouraged speculative capital outflows, further worsening the situation by depleting central bank reserves and contracting the domestic money supply at a time of unemployment. Page Ref: 568-576 Difficulty: Moderate 39) Use the DD-AA model to compare the domestic economic response under flexible and fixed exchange rate regimes to a temporary rise in export demand from foreign countries. Answer: Under floating rate: The DD curve shifts right. AA does not change because the temporary increase will not affect the long run expected exchange rate. Output rises and E falls (depreciates). Under fixed rate: The DD curve shifts right. The central bank intervenes to prevent a change in the exchange rate. By selling domestic currency they expand the domestic supply and the AA curve shifts right, keeping E constant. Output however will rise due to the new equilibrium of the DD and AA curves to the right of its former location. Page Ref: 568-576 Difficulty: Moderate 40) The reason that the claim that floating exchange rates result in greater economic autonomy for individual countries may not be entirely accurate is that A) empirical research finds no supporting data. B) policy makers are influenced by the effect of domestic policies on the exchange rate. C) there is no generally satisfactory method for measuring economic autonomy. D) it is based on the assumption of a gold standard. E) countries that run large trade deficits must increase exports to balance trade. Answer: B Page Ref: 568-576 Difficulty: Easy

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41) Under a flexible exchange rate regime, an increase in real money demand A) moves the AA curve to the right. B) moves the AA curve to the left. C) leaves the AA curve unchanged. D) moves the DD curve to the right. E) moves the DD curve to the left. Answer: B Page Ref: 568-576 Difficulty: Easy 42) The effects of an increase in real money demand on an economy A) is an argument against flexible exchange rates. B) is an argument in favor of flexible exchange rates. C) shows the difficulties in determining which exchange rate regime is better. D) is an argument in favor of flexible exchange rates only in the short run. E) is an argument against flexible exchange rates only in the short run. Answer: A Page Ref: 568-576 Difficulty: Easy 43) If most of the shocks that buffet the economy come from the output market shocks, then A) fixed exchange rates are better than flexible exchange rates. B) flexible exchange rates are better than fixed exchange rates. C) which system is chosen is not important. D) fixed exchange rates are better than flexible exchange rates only in the short run. E) flexible exchange rates are better than fixed exchange rates only in the short-run. Answer: B Page Ref: 568-576 Difficulty: Easy 44) One should expect the forward exchange market to flourish A) under a fixed exchange rate regime. B) under a flexible exchange rate regime. C) under neither fixed nor flexible exchange rate regimes. D) under both fixed and flexible exchange rate regimes. E) only under a gold standard. Answer: B Page Ref: 568-576 Difficulty: Easy

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45) In the case of a domestic monetary shock, floating exchange rates A) make the home economy less vulnerable. B) make the home economy more vulnerable. C) make the foreign economy more vulnerable. D) would not affect the foreign economy. E) would not affect the home economy. Answer: B Page Ref: 568-576 Difficulty: Easy 46) "Under floating rates, the economy is more vulnerable to shocks coming from the domestic money market." Discuss. Answer: The statement is true. Under floating rates, a rise in real domestic money demand causes income to fall and to an appreciation of the domestic currency. If the rise in real domestic money supply is permanent, it will lead eventually to a fall in the home price level. Under a fixed exchange rate, the change in real money demand does not affect the economy at all. To prevent the home currency from appreciating, the central bank buys foreign reserves with domestic money until the real money supply rises by an amount equal to the rise in real money demand. This intervention has the effect of preventing any change in output or the price level. Page Ref: 568-576 Difficulty: Moderate 19.9 Macroeconomic Interdependence under a Floating Rate 1) Due to macroeconomics interdependence between large countries, the effect of a permanent monetary policy expansion by Home is as follows: Home output A) rises, Home's currency depreciates, and Foreign output may rise or fall. B) falls, Home's currency depreciates, and Foreign output may rise or fall. C) rises, Home's currency appreciates, and Foreign output may rise or fall. D) rises, Home's currency depreciates, and Foreign output rises. E) falls, Home's currency appreciates, and Foreign output may rise or fall. Answer: A Page Ref: 576-583 Difficulty: Easy 2) Due to macroeconomics interdependence between large countries, the effect of a permanent fiscal expansion by Home is as follows: Home output A) falls, Home's currency appreciates, Foreign output rises. B) rises, Home's currency appreciates, Foreign output rises. C) rises, Home's currency depreciates, Foreign output rises. D) rises, Home's currency appreciates, Foreign output decreases. E) falls, Homes currency depreciates, Foreign output rises. Answer: B Page Ref: 576-583 Difficulty: Easy

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3) Which of the following does NOT occur if Home starts a policy of permanent fiscal expansion: A) Home's exchange rate increases. B) Foreign's interest rate rises. C) Home output rises. D) Foreign output rises. E) Current Account Balance increases. Answer: E Page Ref: 576-583 Difficulty: Easy 4) The Plaza Accord of 1985 announces that the A) G-5 countries will intervene in the foreign exchange market to bring about a dollar appreciation. B) G-7 countries will intervene in the foreign exchange market to bring about a dollar depreciation. C) G-5 countries will intervene in the foreign exchange market to bring about a dollar depreciation. D) G-7 countries will intervene in the foreign exchange market to bring about a DM depreciation. E) G-5 countries will not intervene in the foreign exchange market unless the dollar needs to appreciate. Answer: C Page Ref: 576-583 Difficulty: Easy

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5) Imagine a world with two large countries, Home and Foreign. Evaluate how Home's macroeconomic policies affect Foreign. Compare the small and the large country cases; consider both permanent monetary and fiscal policies. Answer: Note that since the two countries are large, neither country can be thought of any longer as facing a fixed external interest rate or a fixed level of foreign export demand. Consider only permanent shifts. A permanent monetary expansion by Home, in the small country's case, would lead to currency depreciation and increase in output, interest rates also falling. When the Home economy is large, the same would happen, but now the rest of the world is affected too. Because Home is facing real currency depreciation, Foreign must be experiencing a real currency appreciation. This makes foreign goods relatively expensive and thus reduces its output. However, this increases Homes output, since Home's imports will rise. Thus, it is not clear what will happen to Foreign output. Note that Foreign output can rise only if the Foreign nominal interest rate rises too and can fall only if Foreign nominal interest rate falls. This is because the foreign market equilibrium is: M /P = L(R , Y ). Because in this exercise M is not changing and P is sticky by assumption and thus fixed in the short run. Consider now, a permanent expansionary fiscal policy in Home. In the small country case, a permanent fiscal expansion would cause a real currency appreciation and a current account deterioration that would fully nullify any positive effect on aggregate demand. In effect, the expansionary impact of the Home fiscal ease would leak entirely abroad. This is because the counterpart of Home's lower current account balance must be higher current account balance abroad. In the large country case, Foreign output still rises since Foreign's exports become relatively cheaper when Home's currency appreciates. In addition, now some of Foreign's increased spending increases Home exports, so Home's output actually increases along with the output of Foreign. Home's nominal interest rate must rise and Foreign's interest rate rises at the same time as well. Page Ref: 576-583 Difficulty: Moderate 6) "Even under flexible exchange rate regime, governments could not be indifferent to the behavior of exchange rates and inevitably surrendered some of their policy autonomy in other areas to prevent exchange rate movements they viewed as harmful to their economies." Discuss. Answer: True. One example is Volcker in October 1979 decreasing the U.S. money supply to halt further weakening of the dollar. Page Ref: 576-583 Difficulty: Moderate

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7) Which system of interest rates is theoretically worst for policy coordination among the industrial countries of the world? How has this played out since the 1980s? Answer: — pro-fixed rate theorists predicted that with floating rates, countries would only make policies that helped themselves at the expense of the world economy (although it has been empirically proven that in the short run policy decisions are exported, requiring the "dirty float") — pro-floaters rebutted that the fixed rate system provided coordination only by giving the U.S. a dominant position — during the 1980s industrial countries could have collectively reduced the effects of recession by coordinating their policies much more effectively, that is floating rates have not provided more coordination as predicted Page Ref: 576-583 Difficulty: Moderate 8) Use the following table to illustrate the importance of macroeconomic policy coordination. Show that the two governments would have been happier if the two of them had adopted looser monetary policies, but given the policies that the other government did adopt, it is not in the interest of any individual government to change its course. Assume that each country wishes to get the biggest reduction in inflation rate at the lowest cost in terms of unemployment. This means that each country maximizes-ΔΠ/ΔU, the inflation reduction per point of increased unemployment.

Answer: One needs to translate the outcomes of the table above into policy payoffs. Assume that each country wishes to get the biggest reduction in inflation rate at the lowest cost in terms of unemployment. This means that each country maximizes -ΔΠ/ΔU, the inflation reduction per point of increased unemployment. This leads to the following table. The outcome of this game is on the lower right hand side of the table, where the two countries use very restrictive monetary policies rather than cooperating and using the better somewhat restrictive policies for both of them. Page Ref: 576-583 Difficulty: Moderate 49 .

9) What are the outcomes of the following games, assuming the max-min criteria is used?

Answer: There are two equilibria in this game, in which one regime uses a "somewhat restrictive" policy, while the other uses a "very restrictive" policy. Page Ref: 576-583 Difficulty: Moderate 19.10 What Has Been Learned Since 1973? 1) Since 1973 "dirty floats" have been required because A) PPP has not held. B) high inflation countries have stronger currencies than countries with low inflation. C) countries are not cooperating as much as original theorists predicted. D) in the short run, monetary and fiscal policy only affects the autonomous home economy. E) countries with a floating exchange rate have laissez-faire economies. Answer: A Page Ref: 583-586 Difficulty: Easy

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2) What has been learned since 1973 with regards to the experience with floating exchange rate regime? Answer: (1) Monetary policy autonomy: Yes, however, floating rate did not insulate countries completely from foreign policy shock. In addition, no central bank can be indifferent to its currency's value in the foreign exchange market, thus the name "dirty float" rather than "clean float." (2) Symmetry: No, the dollar remains an important currency; the DM and the yen have gained importance; the British pound declines in importance. (3) The exchange rate as an automatic stabilizer: Good performance of the flexible regimes; many believe that, otherwise, major realignments of exchange rates should have taken place. However, some sectors suffered, such as agriculture. (4) Discipline: Did countries abuse the autonomy afforded by floating rates? Inflation rates did accelerate after 1973. (5) Destabilizing Speculation: Floating exchange rates have exhibited much more day-to-day volatility than the early advocates of floating would have predicted. However, exchange rates are assets prices and so considerable volatility is to be expected. Over the long run, they do not seem to support the notion of destabilizing speculation. (6) International trade and investment: Critics of floating claimed that international trade and investment would suffer as a result of the increased uncertainty. This prediction was certainly wrong. The use of forward markets and other derivatives expanded dramatically. Still, some economists disagree about the benefit to international trade. (7) Policy coordination: Floating exchange rates have not promoted policy coordination. Page Ref: 583-586 Difficulty: Moderate 3) Economic theory and experience since 1973 indicate that, under floating exchange rates, a country's fiscal and monetary policies in the short-run and the long-run can A) have both domestic and foreign economic impact. B) have domestic or foreign economic impact, but not both. C) have domestic but not foreign economic impact. D) have foreign but not domestic economic impact. E) have neither domestic nor foreign economic impact. Answer: A Page Ref: 583-586 Difficulty: Easy 4) Economic experience since 1973 indicate that, under floating exchange rates, symmetry A) was not attained. B) was attained almost immediately. C) was attained over time as central banks held more U.S. dollars as a reserve currency. D) has been difficult to measure and no consensus has emerged. E) has been attained in foreign countries, but not domestically. Answer: A Page Ref: 583-586 Difficulty: Easy

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5) Economic experience since 1973 indicate that, under floating exchange rates A) large and persistent departures from external balance were not prevented. B) large and persistent departures from external balance were prevented. C) changes in exchange rates failed to act as automatic stabilizers. D) reduced monetary policy autonomy. E) monetary policy autonomy was protected. Answer: A Page Ref: 583-586 Difficulty: Easy 19.11 Are Fixed Exchange Rates Even an Option for Most Countries? 1) Maintaining a fixed exchange rate over the long run is today A) virtually impossible. B) more vulnerable to speculative attacks than in the past. C) preferable. D) possible only in special cases such as maintaining strict capital controls. E) aided by technology which allows instant movement of money between financial markets in different countries. Answer: D Page Ref: 586-587 Difficulty: Easy 2) The focus of policy in the 1990s was A) increasing trade. B) increasing employment. C) maintaining stable exchange rates. D) holding down inflation and increasing domestic output. E) levying beggar-thy-neighbor tariffs. Answer: D Page Ref: 586-587 Difficulty: Easy 3) "Fixed exchange rates are not even an option for most countries." Discuss. Answer: Durable fixed exchange rate arrangements may not even be possible unless countries are willing to maintain strict controls over capital movements (as China does), or, at the other extreme, move to a shared single currency with their monetary partners (as in Europe). Even a country following prudent monetary and fiscal policies is not safe from speculative attacks on its fixed exchange rate. Page Ref: 586-587 Difficulty: Moderate

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4) "No central bank can be indifferent to its currency's value in the foreign exchange market." Discuss. Answer: — despite the "Monetary Policy Autonomy" theory of the original supporters of floating exchange rates — exchange rate's role in inflation — prices are sticky in the short run, so foreign developments can affect real interest rates and real exchange rates at home — don't want their exchange rate to be too volatile as it affects the demand for their domestic products — appreciation or depreciation can cause inflation that is difficult to counter — banks intervene on a discretionary basis so it is still necessary for them to continue to hold foreign reserves — "dirty floats" stabilize output and price level after shocks that affect exchange rates — empirically: after 1973 countries have continued to intervene to affect exchange rates Page Ref: 586-587 Difficulty: Moderate 19.12 Appendix to Chapter 19: International Policy Coordination Failures 1) Coordination of economic policies among nations is a prisoner's ________ because all countries will be better off if they ________. A) dilemma; cooperate B) conundrum; cooperate C) sentence; compete D) screed; compete E) quandary; collude Answer: A Page Ref: 594-596 Difficulty: Easy 2) Coordination of economic policies among nations is a prisoner's ________ because if all countries go it alone, they will choose to ________. A) dilemma; compete B) conundrum; cooperate C) sentence; compete D) dilemma; cooperate E) quandary; collude Answer: A Page Ref: 594-596 Difficulty: Easy

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3) Refer to the payoff matrix below, which ________ a prisoner's dilemma. If both countries go it alone, Home will choose Policy ________ and Foreign will choose Policy ________.

A) is; 1; A B) is; 2; B C) is; 1; B D) is not; 2; B E) is not; 1; A Answer: A Page Ref: 594-596 Difficulty: Easy 4) Refer to the payoff matrix below, which ________ a prisoner's dilemma. If both countries cooperate, Home will choose Policy ________ and Foreign will choose Policy ________.

A) is; 1; A B) is; 2; B C) is; 1; B D) is not; 2; B E) is not; 1; A Answer: B Page Ref: 594-596 Difficulty: Easy

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International Economics, 10e (Krugman/Obstfeld/Melitz) Chapter 20 (9) Financial Globalization: Opportunity and Crisis 20.1 The International Capital Market and the Gains from Trade 1) If you are offered a gamble in which you win 500 dollars 3/8 of the time and you lose 500 dollars 5/8 of the time, what is your expected payoff and your behavior given that you are a risklover? A) $500, take the gamble B) -$125, take the gamble C) -$125, it is unclear what you would do without further information D) $500, decline the gamble E) -$125, decline the gamble Answer: C Page Ref: 597-602 Difficulty: Easy 2) The two types of trade, intertemporal and pure asset swap ________ perfect substitutes, because ________. A) are; they both offer considerable payoff and are equal in the long run B) are; they both involve the smoothing out of now and future consumption C) are not; asset swapping is immediate and involves only assets, while intertemporal trade takes two time periods and involves both assets and goods/services D) could possibly be; different economic states occur at different points in time E) are not; asset swapping never relates to intertemporal trade Answer: D Page Ref: 597-602 Difficulty: Easy

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3) For the following question assume the following facts: (1) Balance of Payments = 0 prior to the transactions. (2) Person A (who lives in the United States) purchases an airplane from British Airways for $150,000. (3) Person A pays with a check from his account at First Union Bank in the United States. (4) British airways, since it will need dollars in 1 month, deposits the check at the Bank of England. (5) Bank of England deposits the $150,000 at Commonwealth bank, which is located in the United States. Due to the transactions above, what are the effects on the balance of payments? A) -$150,000 due to import of good (current account debit) B) +$150,000 due to import of good (current account credit) C) -$150,000 due to deposit of Bank of England (capital account debit) D) +$150,000 due to deposit of Bank of England (capital account credit) E) No effect (150,000 current account debit and 150,000 capital account credit) Answer: E Page Ref: 597-602 Difficulty: Easy 4) For the following questions assume the following facts: (1) Balance of Payments = 0 prior to the transactions. (2) Person A (who lives in the United States) purchases an airplane from British Airways for $150,000. (3) Person A pays with a check from his account at First Union Bank in the United States. (4) British airways, since it will need dollars in 1 month, deposits the check at the Bank of England. (5) Bank of England deposits the $150,000 at Commonwealth bank, which is located in the United States. Due to the transactions above, what are the effects on the reserve at the Fed? A) Fact 2 is a decrease of $150,000, fact 5 is a decrease of $150,000, a net effect of -$300,000. B) Fact 3 is a decrease of $150,000, fact 5 is an increase of $150,000, a net effect of 0. C) Fact 3 is an increase of $150,000, fact 5 is a decrease of $150,000, a net effect of 0. D) Both fact 3 and fact 5 result in increases of $150,000, a net effect of +$300,000. E) Both fact 3 and fact 5 result in decrease of $150,000, a net effect of -$300,000. Answer: B Page Ref: 597-602 Difficulty: Easy

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5) Suppose one is offered a gamble in which you win $1,000 half the time but lose $1,000 half the time. Since in this case one is as likely to win as to lose the $1,000, the average payoff on this gamble—its expected value—is: 0.5 ∗ $1,000 + 0.5 ∗ (-$1,000) = 0. Under such circumstances: A) no one will take the gamble. B) risk averse individuals will take the gamble. C) risk lovers individuals will not take the gamble. D) risk neutral individuals will not take the gamble. E) risk lovers and risk neutral individuals may take the gamble. Answer: E Page Ref: 597-602 Difficulty: Easy 6) For most practical matters, economists assume that A) individuals are risk neutral. B) individuals are risk lovers. C) individuals are risk averse. D) most individuals are risk lovers. E) most individuals are risk neutral. Answer: C Page Ref: 597-602 Difficulty: Easy 7) People who are risk averse A) value a collection of assets only on the basis of its expected returns. B) value a collection of assets only on the basis of the risk of that return. C) value a collection of assets not only on the basis of its expected returns but also on the basis of the risk of that return. D) are less likely to invest in life insurance. E) are less likely to have a diverse portfolio. Answer: C Page Ref: 597-602 Difficulty: Easy 8) The idea of risk aversion A) is at odds with the idea of insurance. B) help explain the profitability of insurance companies. C) has nothing to do with insurance companies. D) help explain the losses suffers by the insurance industry. E) help explain why insurance companies in the long run are zero profit companies. Answer: B Page Ref: 597-602 Difficulty: Easy

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9) Risk averse people A) will never hold bonds denominated in several different currencies because of transaction costs. B) will always hold bonds denominated in several different currencies because of transaction costs. C) may hold bonds denominated in several different currencies. D) may hold bonds denominated in several different currencies only if satisfying the well known interest party condition. E) will hold only domestic bonds because of the home bias effect. Answer: C Page Ref: 597-602 Difficulty: Easy 10) Imagine that there are two countries, Home and Far Far Away, and that residents of each own only one asset, domestic land yielding an annual harvest of mangoes. Assume that the yield on the land is uncertain. Half the time, Home's land yields a harvest of 5,000 tons of mangoes at the same time as Far Far Away's land yields a harvest of 2,500 tons. The other half of the time the outcomes are reversed. The average for each country mango harvest is A) 2500. B) 2750. C) 3500. D) 3750. E) 3000. Answer: D Page Ref: 597-602 Difficulty: Easy 11) Equity Instruments include A) stocks. B) bonds. C) banks deposits. D) receipts. E) bank statements. Answer: A Page Ref: 597-602 Difficulty: Easy 12) What would best describe the international capital markets? A) the market of exchange of bonds B) the market of exchange of stocks C) the market of exchange of real-estate D) the market in which residents of different countries trade assets E) the currency market Answer: D Page Ref: 597-602 Difficulty: Easy 4 .

13) Describe three types of gains from trades? A) trades of exchange rates for goods or services, trades of goods or services for property, and trades of gold for textiles B) trades of goods or services for goods or services, trades of goods or services for assets, and trades of assets for assets C) trades of imports for exports, trades of exports for imports, and trades of natural resources for financial assets D) trades of services for goods, trades of currency for services, and trades of one type of currency for another E) trades of current goods for future services, trades of currency for gold, and trades of one type of currency for another Answer: B Page Ref: 597-602 Difficulty: Easy 14) Asset trades that deal with debt instruments are best described as A) share of stock. B) exchange rate. C) receipts. D) factors. E) bonds or bank deposits. Answer: E Page Ref: 597-602 Difficulty: Easy 15) Asset trades that deal with equity instruments are best described as A) share of stock. B) exchange rate. C) bonds. D) bank deposits. E) factors. Answer: A Page Ref: 597-602 Difficulty: Easy 16) The international capital market is: A) the international currency exchange. B) a market in which capital assets are exchanged for services. C) the market that is subject to intense regulation and must file a report to the Basel committee on a biannual basis. D) not really a single market, but a group of closely interconnected markets in which asset exchanges with some international dimension take place. E) an organization of fiscal policies that dictate international trade. Answer: D Page Ref: 597-602 Difficulty: Easy 5 .

17) Intertemporal trade is A) the exchange of goods but not services for claims to future goods. B) the exchange of services but not goods for claims to future services. C) the exchange of good and services for claims to future goods and services. D) the exchange of domestic goods and services for foreign goods and services. E) the type of trade that the U.S. government focuses most upon. Answer: C Page Ref: 597-602 Difficulty: Easy 18) What is the basic motive for asset trade? A) the belief that large risks will lead to large returns B) restoration of the balance of payments C) portfolio unification D) economic stability E) increase expected returns and reduced risk Answer: E Page Ref: 597-602 Difficulty: Easy 19) Using international asset trade, countries can A) never really eliminate all risk. B) eliminate all risk. C) actually increase their risk in some cases. D) eliminate all their risk except for emerging markets. E) never really diversify their holdings. Answer: A Page Ref: 597-602 Difficulty: Easy 20) What are the three types of transactions between the residents of different countries? Answer: The three types are: (1) Trades of goods and services for goods or services (2) Trades of goods and services for assets, and (3) Trades of assets for assets. Page Ref: 597-602 Difficulty: Moderate

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21) What are the three types of gains from international transactions between the residents of different countries? Answer: The three types are: (1) Gains due to comparative advantage and economies of scale. (2) Gains due to inter-temporal trade, which is the exchange of goods and services for claims to future goods and services, which is for assets. (3) Gains due to trades of assets for assets, such as the exchange of real estate located in London for U.S. Treasury bonds. Page Ref: 597-602 Difficulty: Moderate 22) How international trade in assets can make both countries better off? Answer: By allowing them to reduce the riskiness of the return on their wealth and by allowing the two parties to diversify their portfolios, i.e., to divide their wealth among a wider spectrum of assets, and thus reduce the amount of money placed on one specific asset. Page Ref: 597-602 Difficulty: Moderate 23) Explain Tobin's idea of "Don't put all your eggs in one basket." Answer: Trade in assets can make both parties better off by allowing them to reduce the riskiness of the return on their wealth. Portfolio diversification occurs when the wealth is divided among a wide spectrum of assets, so the amount of money riding on each individual asset is reduced. Obviously, this diversification needs to be contrasted against the expected returns of the new assets that you are acquiring. Page Ref: 597-602 Difficulty: Moderate 24) Why is it useful to make a distinction between debt and equity instruments? Answer: Debt instruments such as bonds and bank deposits are repaid regardless of economic circumstances. Equity instruments, like a share of stock, have a payoff that is linked to economic performances. However, remember the possibility of bankruptcy and the real return, which is subject to domestic currency fluctuations. Page Ref: 597-602 Difficulty: Moderate 25) Define risk aversion and give an example of a risk-averse person? Answer: Risk aversion is a characteristic of a person that dislikes risk. An example of this is someone who takes out rental or home insurance to reduce the risk of some kind of catastrophe from happening. Page Ref: 597-602 Difficulty: Moderate

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26) Why is portfolio diversification so important in international trade? Answer: Portfolio diversification is important in international trade because parties of the trade are better off by allowing themselves to reduce the risk of the return on their wealth. Traders can divide their wealth among wider amounts of assets in turn reducing the amount of money they have riding on each individual asset. Page Ref: 597-602 Difficulty: Moderate 27) What is the difference between equity instruments and debt instruments? Answer: Equity instruments are share of stocks. It is defined as a claim to the firm's profit. Debt instrument are bonds and bank deposits. They specify that the issuer of the instrument must repay a fixed value. Page Ref: 597-602 Difficulty: Moderate 28) Why is the foreign exchange market so vital? Answer: The foreign exchange market is the central component of the international capital market. The exchange rates it sets help determine the profitability of international transactions of all type. The exchange rates show valuable economic signals to households and firms involved in international trade and investment. Page Ref: 597-602 Difficulty: Moderate 29) Suppose you are offered a gamble in which you win $1,000 half the time but lose $1,000 half the time. If you are risk averter will you take the gamble? Answer: Since you are as likely to win as to lose the $1,000, the average payoff on this gamble—its expected value— is: 0.5 ∗ $1,000 + 0.5 ∗ (-$1,000) = 0. If you are risk averse, you will not take the gamble because, for you, the possibility of losing $1000 outweighs the possibility that you will win, although both outcomes are equally likely. Page Ref: 597-602 Difficulty: Moderate 30) Suppose you are offered a gamble in which you win $1,000 1/3 half the time but lose $800 2/3 half the time. If you are risk lover will you take the gamble? What will your expected payoff be? Answer: The expected payoff would be: 1/3 (+$1,000) + 2/3 (-$800) = -$200. From this calculation, we know that risk-neutral individuals would not take the gamble, but it is not clear what a risk-loving individual would do. Page Ref: 597-602 Difficulty: Moderate

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31) Calculate the expected payoff for the following cases, where q1 and q2 are the probabilities of state 1 and 2, respectively.

Answer:

Page Ref: 597-602 Difficulty: Moderate 32) Calculate the expected payoff for the following cases, where q1 and q2 are the probabilities of state 1 and 2, respectively.

Answer:

Page Ref: 597-602 Difficulty: Moderate

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33) Complete the following table.

Answer:

Page Ref: 597-602 Difficulty: Moderate 34) Complete the following table.

Answer:

Page Ref: 597-602 Difficulty: Moderate

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The following simple two-country question illustrates how countries are made better off by trade in assets. Imagine that there are two countries, Home and Foreign, and that residents of each own only one asset, domestic land yielding an annual harvest of kiwi fruit. Assume that the yield on the land is uncertain. Half the time, Home's land yields a harvest of 100 tons of kiwi fruit at the same time as Foreign's land yields a harvest of 50 tons. The other half of the time the outcomes are reversed. The Foreign's harvest is 100 tons, but the Home harvest is only 50. 35) Calculate the average, for each country of kiwi harvest. Answer: The average for each country of kiwi harvest is: 0.5 ∗ 100 + 0.5 ∗ 50 = 75 tons of kiwi fruit. However, note that the inhabitants of the two countries never know in advance whether the next year will bring feast or famine. Page Ref: 597-602 Difficulty: Difficult 36) Suppose the two countries can trade shares in the ownership of their perspective assets. Further, assume that a Home owner of a 10 percent share in Foreign land. He will receive 10 percent share in Foreign land, and thus receives 10 percent of the annual Foreign kiwi fruit harvest. Further assume that a Foreign owner of a 10 percent share in Home land is permitted. In this case, a Foreigner is entitled to 10 percent of the Home harvest. Calculate the expected value of kiwi fruit for each investor. Is the investor better off? Answer: Good year at Home: the farmer will get 90 toms of kiwi from home and 5 tons of kiwi from Foreign. Bad years at home: he will get 45 tons of kiwi from his Home and 10 tons from the Foreign country, namely 55 tons. The probability for a good or a bad year is 0.5. Thus the expected returns will now be: 0.5 ∗ 95 + 0.5 ∗ 55 = 75 It is not clear whether the investor is better off or not. If he likes to smooth his consumption, he may be better off. Otherwise, it is impossible to tell without a particular utility function. Page Ref: 597-602 Difficulty: Difficult 37) Suppose the two countries can trade shares in the ownership of their perspective assets. Further assume that a Home owner of a 25 percent share in Foreign land. He will receive 25 percent share in Foreign land and thus receives 25 percent of the annual Foreign kiwi fruit harvest. Further assume that also that a Foreign owner of a 25 percent share in Home land is permitted. In this case, a Foreigner is entitled to 25 percent of the Home harvest. Calculate the expected value of kiwi fruit for each investor. Answer: Good year at Home: 75 + 12.5 = 87.5 tons with probability 0.5 Bad year at Home: 37.5 from Home and 25 from Foreign = 62.5 with probability 0.5. The expected return is: 0.5 ∗ 87.5 + 0.5 ∗ 62.5 = 75. Page Ref: 597-602 Difficulty: Difficult

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38) Suppose the two countries can trade shares in the ownership of their perspective assets without any restrictions. Assume that the consumers in both countries would like to totally smooth their consumption. Describe the outcomes. Answer: In this case, Home residents will buy a 50 percent share of the land in Foreign, and they will pay for it by giving Foreign residents a 50 percent share in Home land. Explain why. To understand why, think about the returns to the Home and Foreign portfolios when both are equally divided between titles to Home and Foreign land. When times are good at Home (and therefore bad in Foreign), each country earns the same return harvest, which is 75 every year with certainty. Half of the Home harvest (100 ton of kiwi fruit) plus half of the Foreign harvest (50 tons of kiwi fruit) or 75 tons of fruit. 0.5 ∗ 100 + 0.5 ∗ 500 = 75. In the opposite case-bad times in Home, good time in Foreign-each country still earns 75 tons of fruit. Thus, we have shown that if the countries hold portfolios equally divided between the two assets, each country earns a certain return of 75 tons of kiwi fruit. This certain return is exactly the same as the average harvest each faced before international asset trade was allowed. This trade completely eliminates the risk faced by both countries without changing average returns. Assuming risk-averse individuals in both countries, the two countries are better off as a result of asset trade. Page Ref: 597-602 Difficulty: Difficult 39) Suppose that trade in asset is not allowed but the two countries sign a treaty that guarantee the sending of 25 tons of kiwi in good time by the high output country in that season. What will the outcome of such a treaty? Explain why. Answer: The outcomes will be exactly the same as in Case D above. In other words, rather than signing a treaty, just leaving the financial markets to function will lead us to the desirable results. Page Ref: 597-602 Difficulty: Difficult

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40) Calculate the expected payoff for the following cases with the formula: (P1) * (payoff if state 1) + (P2) * (payoff if state 2), where P1 and P2 are the probabilities of state 1 and 2, respectively.

Answer:

Page Ref: 597-602 Difficulty: Moderate 41) Complete the following table with the formula (P1) * (payoff if state 1) + (P2)* (payoff if state 2), where P1 and P2 are the probabilities of state 1 and 2, respectively.

Answer:

Page Ref: 597-602 Difficulty: Moderate 13 .

20.2 International Banking and the International Capital Market 1) As a country begins to liberalize its capital account, what would you expect to happen to the difference between the interest rates for similar assets in this country and another country with open capital markets? A) get larger B) get smaller C) stay the same D) it depends on the existing exchange rate. E) exponential divergence Answer: B Page Ref: 602-605 Difficulty: Easy 2) Investment banks in the U.S. are A) regular banks specializing in investment projects. B) not banks at all but institutions which specialize in underwriting sales of stocks and bonds. C) special arm of the U.S. government for U.S. banks operating outside the U.S. D) regular banks specializing in investment projects, but allowed to offer limited domestic transactions. E) international banks that are heavily invest in the U.S. Answer: B Page Ref: 602-605 Difficulty: Easy 3) Credit Suisse, Goldman Sachs, and Lazard Freres are examples of A) commercial banks. B) corporations. C) non-bank financial institutions, such as insurance companies, pension funds, and mutual funds. This includes investment banks, which specialize in underwriting sales of stocks and bonds by corporations and in some cases governments. D) central banks and other government agencies. E) non-profit organizations. Answer: C Page Ref: 602-605 Difficulty: Easy 4) A country can control A) its flexible exchange rate. B) monetary policy oriented toward domestic goals. C) international capital movements. D) foreign inflationary policies. E) and avoid risks in international trade. Answer: B Page Ref: 602-605 Difficulty: Easy 14 .

5) Under a gold standard, countries control A) its flexible exchange rate. B) monetary policy oriented toward domestic goals. C) international capital movements. D) foreign inflationary policies. E) and avoid risks in international trade. Answer: B Page Ref: 602-605 Difficulty: Easy 6) After Bretton Woods period, countries chose to control A) fixed exchange rate only. B) monetary policy oriented toward domestic goals only. C) freedom of international capital movements only. D) fixed exchange rate and freedom of international capital movements. E) fixed exchange rate and monetary policy oriented toward domestic goals. Answer: D Page Ref: 602-605 Difficulty: Easy 7) Under the unified Euro regime, the European countries control A) fixed exchange rate only. B) monetary policy oriented toward domestic goals only. C) freedom of international capital movements only. D) monetary policy oriented toward domestic goals and freedom of international capital movements. E) fixed exchange rate and freedom of international capital movements. Answer: E Page Ref: 602-605 Difficulty: Easy 8) Which one of the following possibilities is TRUE? A) Much of eurocurrency trading occurs in Europe. B) Much of eurocurrency trading occurs in the United States. C) Eurocurrencies trading occurs everywhere except the United States. D) Eurocurrencies trading occurs everywhere except Europe. E) Eurocurrencies trading occurs everywhere except China. Answer: C Page Ref: 602-605 Difficulty: Easy

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9) Eurodollars are A) dollar deposits located in the United States. B) dollar deposits located in Europe. C) dollar deposits located outside Europe. D) dollar deposits located outside the United States. E) dollar deposits located outside both Europe and the United States. Answer: D Page Ref: 602-605 Difficulty: Easy 10) Eurobanks are A) all European Banks. B) all non American banks. C) banks that accept deposits denominated in Eurocurrencies excluding Eurodollars. D) banks that accept deposits denominated in Eurocurrencies including Eurodollars. E) banks that do not take U.S. dollars. Answer: D Page Ref: 602-605 Difficulty: Easy 11) The leading center of Eurocurrency trading is A) New York City. B) Chicago. C) London. D) Paris. E) Frankfurt. Answer: C Page Ref: 602-605 Difficulty: Easy 12) The Fed's Regulation Q A) placed a ceiling on the interest rates U.S. banks could pay on time deposits to foreigners. B) placed a ceiling on the interest rates U.S. banks could pay on time deposits. C) placed a ceiling on the amount U.S. residents can deposits in Euro banks. D) placed a ceiling on the amount foreign residents can deposits in domestic American banks. E) placed a ceiling on the amount foreign banks can pay on time deposits. Answer: B Page Ref: 602-605 Difficulty: Easy

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13) Which type of main institution in the international capital market most often is involved in foreign exchange intervention? A) central banks B) non-bank financial institutions C) insurance companies D) corporations E) commercial banks Answer: A Page Ref: 602-605 Difficulty: Easy 14) The difference between an agency office located abroad and a subsidiary bank located abroad is A) an agency office is just a home bank in another country while a subsidiary bank is controlled by a foreign bank and subject to the same regulations as local banks. B) an agency office is just a home bank in another country while a subsidiary bank arranges loans and transfers funds but does not accept deposits. C) an agency office arranges loans and transfers funds but does not accept deposits while a subsidiary bank is controlled by a foreign bank and subject to the same regulations as local banks. D) an agency office arranges loans and transfers funds but does not accept deposits while a subsidiary bank is just a home bank in a foreign country. E) an agency office is controlled by a foreign bank and subject to the same regulations as local banks while a subsidiary bank arranges loans and transfers funds but does not accept deposits. Answer: C Page Ref: 602-605 Difficulty: Easy 15) Besides world trade growth, what can explain the growth of international banking since the 1960s? A) war in the Middle East B) government focus on banking regulation. C) an increase in world travel. D) the emergence of developing countries like China. E) desire of depositors to hold currencies outside the jurisdiction of the countries that issue them Answer: E Page Ref: 602-605 Difficulty: Easy

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16) The Eurodollar market's early growth was stimulated by the Cold War between the United States and U.S.S.R. Why? A) Soviets feared the U.S. might confiscate dollars place in American banks if conditions of Cold War were to worsen. B) The United States didn't feel safe holding as many dollars in American banks. C) The Cold War did not stimulate the Eurodollar market's early growth. D) Developing technologies required larger money transfers than central banks could handle. E) Soviets developed a new banking system with new allies developed during the tension. Answer: A Page Ref: 602-605 Difficulty: Easy 17) Rising inflationary pressure caused the U.S. to tighten its monetary policy at the end of the 1960s. As a result, market interest rates rose above the Regulation Q ceiling and American banks found it impossible to attract time deposits for re-lending. How did the banks get around this problem? A) by setting their own interest rates and then using better business as compensation for government regulations B) by borrowing funds from European branches, which faced no restriction on the interest they could pay on Eurodollar deposits C) by pushing through new legislation that nullified Regulation Q D) by creating subsidiary branches in foreign countries E) by waiting to trade time deposits until Regulation Q no longer applied Answer: B Page Ref: 602-605 Difficulty: Easy 18) What structures make up the international capital markets? A) stock market, IFM, and the World bank B) bond market, foreign exchange rates, IFM, and the World bank C) commercial banks, corporations, non-bank financial institutions, the central banks, and other government agencies D) commercial banks and corporations E) the central banks and non-bank financial institutions Answer: C Page Ref: 602-605 Difficulty: Easy 19) What are the types of institution banks used to conduct foreign business? A) corporations B) central banks C) commercial banks D) agency offices, subsidiary banks, and foreign branches E) state-owned enterprises Answer: D Page Ref: 602-605 Difficulty: Easy 18 .

20) A business's use of a bank located outside of the home country is called A) Swiss banking. B) offshore banking. C) international banking. D) domestic banking. E) international swapping. Answer: B Page Ref: 602-605 Difficulty: Easy 21) The scale of transactions in the international capital market has A) grown more quickly than world GDP since the early 1970s. B) grown less quickly than world GDP since the early 1970s. C) grown about the same rate as the world GDP since the early 1970s. D) been fixed by international regulations. E) decreased more quickly than world GDP since the early 1970s. Answer: A Page Ref: 602-605 Difficulty: Easy 22) If a country chooses to have a monetary policy oriented toward domestic goals and a fixed exchange rate, then A) it can have the freedom of international capital movements. B) it cannot have the freedom of international capital movements. C) it cannot balance its current account. D) it cannot have fiscal policy oriented toward domestic goals. E) it cannot control money supply growth. Answer: B Page Ref: 602-605 Difficulty: Easy 23) If a country chooses to have a monetary policy oriented toward domestic goals and the freedom of international capital movements, then A) it can have a fixed exchange rate. B) it cannot have a fixed exchange rate. C) it cannot balance its current account. D) it cannot have a fiscal policy oriented toward domestic goals. E) it cannot control money supply growth. Answer: B Page Ref: 602-605 Difficulty: Easy

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24) Offshore banking can take place at which institution? A) agency office only B) subsidiary bank only C) foreign bank only D) subsidiary bank and foreign bank E) agency office, subsidiary bank, and foreign bank Answer: E Page Ref: 602-605 Difficulty: Easy 25) The fact that assets of the political opponents of the U.S. were frozen in U.S. banks A) was challenged as unconstitutional. B) lead to an increased amount of funds being placed in Eurobanks. C) lead to a violation of the Law of One Price. D) lead to the Cold War. E) lead to a violation of Regulation Q. Answer: B Page Ref: 602-605 Difficulty: Easy 26) Regulatory asymmetries can explain why the following places have become main Eurocurrency centers A) the United States. B) Germany. C) Zurich, Somalia, and Mozambique. D) London, Luxembourg, and The United States. E) London, Luxembourg, and Hong Kong. Answer: E Page Ref: 602-605 Difficulty: Easy 27) Who are the main actors in the international capital market? Answer: (1) Commercial banks (2) Corporations (3) Non-bank financial institutions, such as insurance companies, pension funds, and mutual funds. This includes investment banks, which specialize in underwriting sales of stocks and bonds by corporations and in some cases governments. (4) Central banks and other government agencies Page Ref: 602-605 Difficulty: Moderate

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28) Describe the role of offshore banking and of offshore currency (eurocurrencies) trading Answer: Both have mushroomed due to increased international trade, increased multinational corporations and globalization. Students should also emphasize banks' desire to escape domestic government regulations and taxes on financial activities and political concerns from holding deposits in the country that issued them, which increases default concerns on the part of the foreign investors, etc. Page Ref: 602-605 Difficulty: Moderate 29) What do you expect would be the effects of 9/11 on the size of the Eurocurrency markets? Answer: Will increase due to fear that foreign deposits in the U.S. will be frozen unless coordinated efforts by all countries. Page Ref: 602-605 Difficulty: Moderate 30) Explain why a London Eurobank has a competitive advantage over a bank in New York in attracting dollar deposits. Answer: It can pay more because the London bank is not subject to any reserve requirements (neither American nor British), whereas the New York bank is subject to U.S. reserve requirements. Page Ref: 602-605 Difficulty: Moderate 31) Explain how Eurobanks played a role in the Iranian Hostage Crisis in 1979. Answer: When American hostages were taken by Iranians at the American embassy in Tehran, President Carter froze all Iranian assets in U.S. banks as well as in their European branches. Page Ref: 602-605 Difficulty: Moderate 32) Describe how the Eurodollar market's early growth was spawned by the Cold War between the United States and the U.S.S.R. Answer: During the Cold War, the Soviets feared the United States might confiscate dollars placed in American banks if the events were to escalate. So, Soviet dollars were placed in Europeans banks, outside the jurisdiction of the United States. Page Ref: 602-605 Difficulty: Moderate 33) Explain what Eurocurrencies are and why they are significant. Answer: Eurocurrencies are offshore currency deposits denominated in a currency other than that of the country in which the bank resides. This currency is significant because of the rapid expansion of international trade and increased multinational nature of corporations' activities. Page Ref: 602-605 Difficulty: Moderate

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20.3 Banking and Financial Fragility 1) For the following question, assume the following facts: (1) Chase (which is located in the United States) has a 20% reserve requirement imposed by the government. (2) Bank of Germany has no reserve requirements. (3) Both banks may invest at an 8% interest rate. (4) Both banks have fixed costs of $3 per deposit made. What is the difference between the minimum interest rates each bank can offer and still make a profit if the deposit is $500 for 1 year? A) 0 - Both banks can offer the same rate. B) 1% C) 1.6% D) 0.4% E) 20% Answer: C Page Ref: 605-612 Difficulty: Moderate 2) Which of the following statements is TRUE? A) Bank failure is limited to banks that have mismanaged their assets. B) Bank failure is limited to banks that have invested in real estate. C) Bank failure is limited to banks that have invested in government bonds. D) Bank failure is limited to a few banks. E) Bank failure is NOT limited to banks that have mismanaged their assets. Answer: E Page Ref: 605-612 Difficulty: Easy 3) Which of the following statements is TRUE? A) Bank failures inflict serious financial harm on individual depositors. B) Bank failures do not inflict serious financial harm on individual depositors. C) Bank failures inflict not only serious financial harm on individual depositors, but also harm the macroeconomic stability of the economy. D) Bank failures inflict serious financial harm on individual depositors, but fortunately do not harm the macroeconomic stability of the economy. E) Bank failures only inflict serious financial harm on the macroeconomic stability of the economy. Answer: C Page Ref: 605-612 Difficulty: Easy

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4) Which of the following statements is TRUE for the U.S.? A) The Federal Deposit Insurance Corporation (FDIC) insures bank deposits against losses up to $250,000. B) The Federal Deposit Insurance Corporation (FDIC) insures bank deposits against losses up to $100,000. C) The Federal Deposit Insurance Corporation (FDIC) insures bank deposits against losses up to $10,000. D) The Federal Deposit Insurance Corporation (FDIC) insures bank deposits against natural disaster up to $100,000. E) The Federal Deposit Insurance Corporation (FDIC) insures bank deposits against floods up to $100,000. Answer: A Page Ref: 605-612 Difficulty: Easy 5) Which of the following statements is TRUE for the U.S.? A) Federally chartered banks are required to make contributions to the FDIC to cover the cost of bank deposits insurance. B) Federally chartered banks are not required to make contributions to the FDIC to cover the cost of bank deposits insurance. C) The States are not required to make contributions to the FDIC to cover the cost of bank deposits insurance for banks with their main branch in that State. D) The States are required to make contributions to the FDIC to cover the cost of bank deposits insurance for banks with their main branch in that State. E) The specific municipality where the main branch of the bank is located is required to make contributions to the FDIC to cover the cost of bank deposits insurance. Answer: A Page Ref: 605-612 Difficulty: Easy 6) Which of the following statements is TRUE for the U.S.? A) The FDIC does not provide insurance for deposits for Savings and Loans (S&L) associations. B) The FDIC does provide insurance for deposits for Savings and Loans (S&L) associations, but only up to $50,000. C) The FDIC does provide insurance for deposits for Savings and Loans (S&L) associations up to $250,000. D) The FDIC does provide insurance for deposits for Savings and Loans (S&L) associations up to $150,000. E) The FDIC does provide insurance for deposits for Savings and Loans (S&L) associations up to $100,000. Answer: C Page Ref: 605-612 Difficulty: Easy

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7) Banks in the U.S. A) face rules against lending too large a fraction of their assets to a single private customer only. B) face rules against lending too large a fraction of their assets to a single private customer or to a single foreign government borrower. C) face rules against lending too large a fraction of their assets to a single foreign government borrower only. D) face rules against lending to too many foreign organizations and corporations. E) face rules against lending to other banks. Answer: B Page Ref: 605-612 Difficulty: Easy 8) Banks in the U.S. A) cannot hold common stocks. B) can hold common stocks. C) cannot hold common stocks of companies they do business with. D) cannot hold common stocks of companies that have their headquarters in the same state. E) can hold risky assets. Answer: A Page Ref: 605-612 Difficulty: Easy 9) Banks in the U.S. A) are prevented from holding assets that are "too risky." B) are not prevented from holding assets that are "too risky." C) are encouraged not to hold assets that are "too risky." D) are not encouraged not to hold assets that are "too risky." E) are encouraged to lend to a single private customer. Answer: A Page Ref: 605-612 Difficulty: Easy 10) In the U.S., the following agencies have the right to examine the bank's books A) Fed and the FDIC. B) FDIC and the Office of the Comptroller of the Currency. C) Fed and the Department of Commerce D) FDIC, Fed and the Office of the Comptroller of the Currency. E) Only the Fed. Answer: D Page Ref: 605-612 Difficulty: Easy

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11) In the U.S., banks A) cannot be forced to sell assets that the bank examiner deems too risky. B) can be forced to sell assets that the bank examiner deems too risky. C) can be forced to sell assets that the bank examiner deems too risky only after a court order. D) can be forced to sell assets that the bank examiner deems too risky only after both examiners from the Fed and from the FDIC agree. E) can be forced to trade assets that the bank examiner deems too risky. Answer: B Page Ref: 605-612 Difficulty: Easy 12) In the U.S., banks A) may not be forced by bank examiner to adjust their balance sheets by writing off loans the examiner thinks will not be repaid. B) may be forced by bank examiner to adjust their balance sheets by writing off loans the examiner thinks will not be repaid. C) may be forced by bank examiner to adjust their balance sheets by writing off loans the examiner thinks will not be repaid only if the Fed and the FDIC examiners agree. D) may be forced by bank examiner to adjust their balance sheets by writing off loans the examiner thinks will not be repaid only if the Fed and the Office of the Comptroller of the Currency examiners agree. E) may be forced by bank examiner to adjust their balance sheets by paying off loans the examiner thinks will not be repaid. Answer: B Page Ref: 605-612 Difficulty: Easy 13) A bank faced with the wholesale loss of deposits is likely to shut down despite fundamentally sound balance sheet. Why could this be? A) Banks have accountants that are too optimistic. B) Banks purposely lie about their balance sheets in order to attract more clients. C) Many bank assets are illiquid and cannot be sold quickly to meet deposit obligations without substantial loss to the bank. D) Many banks operate on a budget that exceeds their actual reserves. E) Many banks will shut down to preserve their interest profits. Answer: C Page Ref: 605-612 Difficulty: Easy

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14) Which statement is NOT true regarding emerging markets? A) Emerging market financial institutions have generally proven to be weaker than those in industrialized countries. B) Emerging markets are the capital markets of poorer, developing countries that have liberalized their financial system to allow private asset trade with foreigners. C) Countries with emerging markets include Brazil, Mexico, and Thailand. D) Countries with emerging markets have been unable to liberalize their financial systems to allow private trade with foreigners. E) Emerging market financial institutions contributed to the financial crisis of 1997-1999. Answer: D Page Ref: 605-612 Difficulty: Easy 15) The main problem with securitization is that A) governments are no longer able to repackage bank assets. B) securitized banks grow too large and create oligopolies. C) There is no problem. Governments can still get an accurate picture of global financial flows by simply examining bank balance sheets. D) governments are not able to monitor bank assets or to asses a bank's risk to the soundness of the international banking system. E) the bank assets are not marketable. Answer: D Page Ref: 605-612 Difficulty: Easy 16) In the United States, which of the following safety precautions has the government NOT taken to reduce Bank failures? A) implemented deposits insurance B) bank reserve requirements C) capital requirements and asset restrictions D) required bank examination E) forcibly closing poorly run banks Answer: E Page Ref: 605-612 Difficulty: Easy 17) The purpose of the Basel Committee was to A) achieve a better coordination of the surveillance exercised by national authorities over the international banking system. B) achieve a better coordination of domestic banking systems. C) achieve a better coordination between brokers and investment bankers. D) achieve a better coordination between bond holder and bon issuers. E) manipulate bank rates for more leverage profits. Answer: A Page Ref: 605-612 Difficulty: Easy 26 .

18) The case where people purposely act in a careless way, for example, driving recklessly because they are insured, is called A) asymmetric information. B) risk aversion. C) moral hazard. D) bounded rationality. E) thrill-seeking. Answer: C Page Ref: 605-612 Difficulty: Easy 19) Capital markets of poor developing countries that liberalized their financial systems to allow private asset trade with foreigners are called A) direct foreign markets. B) foreign exchange markets. C) stock & bond markets. D) emerging markets. E) fledgling financial markets. Answer: D Page Ref: 605-612 Difficulty: Easy 20) U.S. reserve requirements A) are rejected by half the banks operating in the United States. B) show how regulatory asymmetries can operate to enhance the profitability of Eurocurrency trading. C) tend to harm the bank's business and decrease monetary aggregates. D) force banks to hold a portion of its assets in a liquid form easily mobilized to meet sudden deposit outflows. E) remain in place, but capital requirements have begin defaulting. Answer: D Page Ref: 605-612 Difficulty: Easy 21) What is a difficulty encountered in regulating international banking? A) excessive deposit insurance rates on international banks B) absence of reserve requirements C) oppressive regulatory controls that reduce competitiveness D) lack of funds and incentive to secure payments E) variability in exchange rates Answer: B Page Ref: 605-612 Difficulty: Easy

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22) The Basel committee A) takes advantages of loopholes in multinational banks B) does not support regulatory agencies that monitor the assets of banks' foreign subsidiaries. C) submitted its Concordat in 1975 and was then disbanded. D) continues to be the major forum for cooperation in the regulation of international banking. E) met for the first time in 1975. Answer: D Page Ref: 605-612 Difficulty: Easy 23) What is an appropriate definition for "securitization"? A) the repackaging of bank assets into readily marketable forms B) the promise of a secure return on deposits in FDIC-banks C) the simplification of interest-bearing assets into their simplest derivative form D) the unloading of derivative securities in response to a bank run E) the reinforcement of an asset's worth through official certification Answer: A Page Ref: 605-612 Difficulty: Easy 24) What caused a major economic shock in August 2007? A) U.S. mortgage market B) war in Iraq C) U.S. bond market D) technology stocks E) misreporting from Asian markets Answer: A Page Ref: 605-612 Difficulty: Easy 25) The first run on a British bank since 1866 occurred in August 2007 at which bank? A) Liberty Mutual B) Liberty Rock C) Northern Rock D) Bank of England E) First Savings and Loan Answer: C Page Ref: 605-612 Difficulty: Easy

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26) Did the Bank of England intervene and perform its Lender of Last Resort responsibility to end the panic in August 2007? A) yes B) no C) yes, only after a bank run and under pressure from the British financial industry D) no, since such support would present a moral hazard problem E) no, despite intense pressure from the chancellor of the exchequer Answer: C Page Ref: 605-612 Difficulty: Easy 27) Many observers believe that the largely unregulated nature of global banking activity leaves the world financial system vulnerable to bank failure on a massive scale. Is this a real threat? If so, what measures have governments taken to reduce it? Answer: Yes, this is a real threat. A high level of inter-bank depositing implies that problems affecting a single could be highly contagious and could spread quickly to banks with which it is thought to do business. In response to this threat, the Basel Committee was created in 1974 to coordinate the surveillance and regulation among bank regulators from different countries. Page Ref: 605-612 Difficulty: Moderate 28) "Bank failure may not be limited to banks that have mismanaged their assets." Explain why? Answer: A sound bank faced with the wholesale loss of deposits is likely to close its door even if the asset side of its balance sheet is fundamentally sound because many bank assets are illiquid and cannot be sold quickly to meet deposit obligations without substantial loss to the bank. Students should stress the atmosphere of financial panic, which will lead to self-fulfilling expectations. Page Ref: 605-612 Difficulty: Moderate 29) "It is in the interest of each depositor to withdraw her money from a bank if all other depositors are doing the same, even when the bank's assets are sound." Discuss. As part of your answer clearly state whether the statement is true or false. Answer: True. Students should elaborate on bank run and stress the atmosphere of financial panic, which will lead to self-fulfilling expectations. Page Ref: 605-612 Difficulty: Moderate

29 .

30) "There is evidence that the string of U.S. bank closings in the early 1930s helped start and worsen the Great Depression." Discuss. Answer: Bank Failure can harm the economy's macroeconomic stability (keep in mind that safeguards intended to reduce the risk of bank failure were put in place after the Great Depression). One bank's problems may spread to sounder banks if they are suspected of having lent to the bank in trouble. This leads to a drastic reduction in the banking system's ability to finance investment and consumer-durable expenditure, so the economy slips into recession (or worse in the case of the Great Depression). Page Ref: 605-612 Difficulty: Moderate 31) Describe the extensive "safety net" that has been set up in the United States in order to reduce the risk of bank failure. Answer: (1) Deposit insurance (2) Reserve requirements (3) Capital requirements and asset restrictions (4) Bank examination (5) Lender of last resort facilities Page Ref: 605-612 Difficulty: Moderate 32) Explain why the FDIC is following a "too-big-to-fail" policy of fully protecting all depositors at the largest banks. Answer: A tricky question. The FDIC does that although, officially, it still applies only to the $100,000 limit. Probably, the idea is that the cost to one depositor is unbearable relative to the small cost we all need to pay as a collective. Also, there are the issues of political pressure and avoiding blaming the government for mismanaging the safe guards. Page Ref: 605-612 Difficulty: Moderate 33) Explain the issues involved with the Fed acting as a lender of Last Resort (LLR). Answer: On the one hand, LLR enables the Fed to avoid panic and disturbance to proper functioning of financial markets. On the other hand, using the policy may cause problems of moral hazard. Page Ref: 605-612 Difficulty: Moderate 34) Explain the causes of the U.S. Savings and Loans crisis of the early 1980s. Answer: On the one hand, allowing S&L to make much riskier loans, for example, loans on commercial real estate. On the other hand, inadequate examination for the new situation and depositors, together with increase in interest rate due to increased inflation rate. Page Ref: 605-612 Difficulty: Moderate

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35) Explain the difficulties in regulating international banking. Answer: (1) No deposit insurance, in particular, inter-bank deposits are unprotected (2) Absence of reserve requirements (3) bank examination more difficult to enforce (4) not clear which group of regulators has responsibility for monitoring a given bank's assets (5) not clear which central bank, if any, is responsible for providing Lender of Last Resort assistance. Page Ref: 605-612 Difficulty: Moderate 36) "The internationalization of banking has weakened national safeguards against banking collapse, but at the same time it has made the need for effective safeguards more urgent." Discuss. Answer: True. Students should elaborate on: (1) No deposit insurance, in particular, inter-bank deposits are unprotected (2) Absence of reserve requirements (3) Bank examination more difficult to enforce (4) Not clear which group of regulators has responsibility for monitoring a given bank's assets (5) Not clear which central bank, if any, is responsible for providing Lender of Last Resort assistance. Page Ref: 605-612 Difficulty: Moderate 37) Why did the Fed step in to organize a rescue for Long Term Capital Management (LTCM) in September, 1998, rather than simply letting the trouble fund fail? Was the Fed's action necessary or advisable? Answer: To avoid what the Fed perceived as a possible meltdown of international banking caused by the crisis in Russia and when Asia and Latin American economies were already facing a steep economic slowdown. The problem is moral hazard. Page Ref: 605-612 Difficulty: Moderate 38) What is securitization? Answer: The term refers to financial instrument in which bank assets are repackaged in readily marketable forms. This kind of "derivatives," although useful for the international investors and the banks that underwrite them, causes huge problems in government abilities to monitor bank assets and independently assess their risk to the soundness of the international banking system. Page Ref: 605-612 Difficulty: Moderate

31 .

39) Who is the Basel Committee? Discuss both their involvement in the Concordat as well the role of the Concordat in international banking. Answer: In 1975, the Basel Committee reached an agreement, called the Concordat, which allocated responsibility for supervising multinational banking establishments. In addition, the Concordat called for the sharing of information about banks and the granting of permission to inspect any such banks. Page Ref: 605-612 Difficulty: Moderate 20.4 How Well Have International Financial Markets Allocated Capital and Risk? 1) What are three things to measure for in evaluating the performance of the capital markets? A) level of intertemporal trade, international trade, portfolio diversification B) level of portfolio diversification, balanced capital accounts, global inflation C) level of portfolio diversification, intertemporal trade, efficiency of foreign exchange D) onshore-offshore interest rate parity, level of portfolio diversification, stability of eurocurrency market E) onshore-offshore interest rate parity, interest parity and foreign exchange, balanced capital accounts Answer: C Page Ref: 608-615 Difficulty: Easy 2) In the Interest Parity Condition, Rt - R t = ( rate differential and (

- Et)/Et + xt, where Rt - R t is the interest

- Et)/Et is the expected change in the exchange rate, what does xt

stand for if it potentially is a market efficient difference between the two? A) market inefficiency B) risk premium C) forecast error D) tracking error E) excessive volatility Answer: B Page Ref: 608-615 Difficulty: Easy 3) Why might a country's savings rate have a high positive correlation to its investment rate? A) A country's gains from intertemporal trade may have been large. B) governments' regulation to avoid inflation C) A country's savings rate and investment rate are generally not positively correlated but rather have negative correlation. D) governments' regulation to avoid large current account balances E) A government has not practiced sufficient fiscal regulation. Answer: D Page Ref: 608-615 Difficulty: Easy 32 .

4) Large differences in interest rates between countries would indicate that A) the global market is thriving. B) there is good communication between countries about potential global investment opportunities. C) there are unrealized gains from trade. D) the market is in danger of collapse. E) the supply growth exceeds the aggregate demand. Answer: C Page Ref: 608-615 Difficulty: Easy 5) Statistical studies of the relationship between interest rates and later depreciation rates show that A) the interest difference has been a very bad predictor in the large swings of exchange rates. B) the interest difference has been an accurate predictor in the large swings of exchange rates. C) the interest difference has correctly predicted the direction in which exchange rates would change. D) the interest difference has not yet been studied as a predictor in the large swings of exchange rates. E) the interest difference is unrelated to the large swings of exchange rates. Answer: A Page Ref: 608-615 Difficulty: Easy 6) Which of the following is TRUE about exchange rates? A) They should not be volatile because they will determine the economic climate. B) They are generally more volatile than stock prices. C) They are more volatile than several underlying factors that move them such as money supplies and fiscal variables. D) They should be volatile because to correct price signals they adjust quickly in response to economic news, but they are generally less volatile than stock prices. E) They never overreact to economic news. Answer: D Page Ref: 608-615 Difficulty: Easy 7) Departures from interest parity A) can be explained using theories of risk premium. B) cannot be explained using theories of risk premium. C) may or may not be able to be explained using theories of risk premium, more research is needed. D) are completely unrelated to risk premium. E) occur when risk premium is over calculated. Answer: C Page Ref: 608-615 Difficulty: Easy 33 .

8) A random walk model can more accurately predict exchange rates as compared to a sophisticated forecast A) always. B) for forecasts up to a year away. C) for forecasts longer than a year away. D) never. E) because of the predictability of exchange rates. Answer: B Page Ref: 608-615 Difficulty: Easy 9) How well has the international capital market perform? Answer: International portfolio diversification has increased. Page Ref: 608-615 Difficulty: Moderate 10) Explain why, according to Feldstein and Horioka, one should expect that domestic investment rates diverge widely from saving rates. Answer: The decisions of corporations to invest and for households to save are different. Thus globalization means more and different ways to save and invest and increasing the differences between the two ratios. Page Ref: 608-615 Difficulty: Moderate 11) Explain why large interest rate differences would be strong evidence of unrealized gains from trade. Answer: The difference between onshore and offshore interest rates on similar assets denominated in the same currency should be small if information about global investment opportunities is transmitted efficiently. Data show that this is the case for the U.S., Germany, Japan and the Netherlands. Page Ref: 608-615 Difficulty: Moderate 12) Discuss studies based on the interest parity conditions. Answer: In general, the formula does not hold and is not a good predictor of future devaluations. Even worse, it failed to predict correctly even the direction in which the spot exchange rate would change. Page Ref: 608-615 Difficulty: Moderate

34 .

13) Explain the forecast error, ut+1, in terms of: (1) Its equation (what it is equal to) (2) How it is used (3) Its accuracy Answer: (Et+1 - Et)/Et - (

- Et)/Et this equation represents actual minus expected

depreciation, where ut+1 is the forecast error made in predicting future depreciation. Under interest parity the equation ((Et+1 - Et)/Et - (Rt - Rt ) would also be correct, this equation represents the actual currency depreciation minus the interest difference Statistical methods have been used to see if the forecast error is predictable through the use of past information. Indeed, a number of researchers have found that ut+1 CAN be predicted. Page Ref: 608-615 Difficulty: Difficult

35 .

14) Does the interest rate parity hold in each of the following cases? In case it does not hold, calculate the risk premium. A. Rt = 5,

= 3, Et = 5,

=7

B. Rt = 6,

= 3, Et = 5,

=7

C. Rt = 7,

= 3, Et = 5,

=7

D. Rt = 8,

= 3, Et = 5,

=7

E. Rt = 5,

= 4, Et = 5,

=7

F. Rt = 5,

= 5, Et = 5,

=7

G. Rt = 5,

= 6, Et = 5,

=7

H. Rt = 5,

= 3, Et = 6,

=7

I.

Rt = 5,

= 3, Et = 7,

=7

J.

Rt = 5,

= 3, Et = 8,

=7

K. Rt = 5,

= 3, Et = 5,

=8

L. Rt = 5,

= 3, Et = 5,

=9

M. Rt = 5,

= 3, Et = 5,

= 10

36 .

Answer:

Page Ref: 608-615 Difficulty: Moderate

37 .

15) Does the interest rate parity hold in each of the following cases? In case it does not hold, calculate the risk premium. N. Rt = 8,

= 3, Et = 5,

=7

O. Rt = 7,

= 4, Et = 6,

=8

P. Rt = 6,

= 5, Et = 5,

=7

Q. Rt = 5,

= 4, Et = 6,

=8

R. Rt = 8,

= 6, Et = 5,

=7

S. Rt = 7,

= 5, Et = 6,

=8

T. Rt = 6,

= 4, Et = 5,

=7

U. Rt = 5,

= 3, Et = 6,

=8

V. Rt = 8,

= 5, Et = 6,

=8

W. Rt = 7,

= 3, Et = 8,

=9

X. Rt = 6,

= 7, Et = 7,

=8

Y. Rt = 5,

= 6, Et = 5,

=9

Z. Rt = 4,

= 3, Et = 5,

= 10

38 .

Answer:

Page Ref: 608-615 Difficulty: Difficult 16) Assume interest parity holds. Calculate

for each of the following cases.

Answer:

Page Ref: 608-615 Difficulty: Moderate

39 .

17) Assume interest parity holds. Calculate

for each of the following cases.

Answer:

Page Ref: 608-615 Difficulty: Moderate

40 .

18) Does the interest rate parity hold in each of the following cases by using the formula Rt - Rt = (Ee+1 - Et)/Et ? In case it does not hold, calculate the risk premium. 1. Rt = 5,

= 3, Et = 5,

= 17

2. Rt = 6,

= 4, Et = 5,

=5

3. Rt = 7,

= 5, Et = 5,

=8

4. Rt = 8,

= 3, Et = 5,

= 15

5. Rt = 5,

= 4, Et = 6,

=6

6. Rt = 5,

= 5, Et = 3,

= 10

7. Rt = 5,

= 6, Et = 2,

=8

8. Rt = 5,

= 3, Et = 0,

= 20

9. Rt = 5,

= 9, Et = 7,

=3

10. Rt = 5,

= 10, Et = 8,

=7

41 .

Answer:

Page Ref: 608-615 Difficulty: Difficult

42 .

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. Answer: A Page Ref: 634-641 Difficulty: Easy 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. Answer: A Page Ref: 634-641 Difficulty: Easy 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. Answer: E Page Ref: 634-641 Difficulty: Easy 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. Answer: E Page Ref: 634-641 Difficulty: Easy

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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. Answer: C Page Ref: 634-641 Difficulty: Easy 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. Answer: A Page Ref: 634-641 Difficulty: Easy 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. Answer: B Page Ref: 634-641 Difficulty: Easy 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. Answer: B Page Ref: 634-641 Difficulty: Easy 2 .

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. Answer: A Page Ref: 634-641 Difficulty: Easy 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. Answer: A Page Ref: 634-641 Difficulty: Easy 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. Answer: B Page Ref: 634-641 Difficulty: Easy 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. Answer: D Page Ref: 634-641 Difficulty: Easy

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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. Answer: C Page Ref: 634-641 Difficulty: Easy 14) How many countries are in the EU as of January 1, 2014? A) 9 B) 15 C) 17 D) 18 E) 25 Answer: D Page Ref: 634-641 Difficulty: Easy 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. Answer: B Page Ref: 634-641 Difficulty: Easy 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. Answer: A Page Ref: 634-641 Difficulty: Easy

4 .

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. Answer: C Page Ref: 634-641 Difficulty: Easy 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. Answer: C Page Ref: 634-641 Difficulty: Easy 19) How and why did Europe set up its single currency? Answer: The why part is because large fluctuations in the exchange rates among the European countries disturbed trade. Also, one of the main reasons was to design a way to prevent future world war. The how part of the question is related to the collapse of Bretton Woods and the European Currency reform of 1969-1978. The Werner Report of 1971 establishes three-phase program to lead to the EMU. Page Ref: 634-641 Difficulty: Moderate 20) How did the European single currency evolved? Answer: The answer is related to the collapse of Bretton Woods and the European Currency reform of 1969-1978. The Werner Report of 1971 establishes three-phase program to lead to the EMU. Page Ref: 634-641 Difficulty: Moderate 21) What prompted the EU countries to seek closer coordination of monetary policies and greater exchange rate stability in the late 1960s? Answer: (1) To enhance Europe's role in the world monetary system (2) To turn the European Union into a truly unified market Page Ref: 634-641 Difficulty: Moderate 5 .

22) Discuss the effects of the reunification of eastern and western Germany in 1990 on both Germany and its neighboring European countries. Answer: Germany: boom, high interest rates to fight inflation. Other European countries: France, Italy and UK in recession, trying to match the high German interest rates to hold their currencies fixed against Germany's, thereby pushing their economies into deep recession. Other European countries tried to continue the fixed exchange rate in order not to lose the credibility they had build up since 1985. The policy conflict between Germany and the other European countries led to a series of fierce speculative attacks on the EMS exchange parities starting in September 1992. By august 1993, the EMS was forced to retreat to very wide (± 10 percent) bands, which is kept in force until the introduction of the euro in 1993. Page Ref: 634-641 Difficulty: Difficult 23) Explain why the EMS countries decided to fix their exchange rates against the German DM. Answer: In this way, the other EMS countries in effect imported the credibility of the German central bank in fighting inflation, thus discouraging the development of inflationary pressures at home. Page Ref: 634-641 Difficulty: Moderate 24) Explain the credibility theory of the EMS. Answer: In this way, the other EMS countries in effect imported the credibility of the German central bank in fighting inflation, thus discouraging the development of inflationary pressures at home. This is known as the credibility theory of the EMS. Page Ref: 634-641 Difficulty: Moderate 25) Explain how the German Bundesbank gained its low-inflation reputation. Answer: Mainly, Germany's experience with hyperinflation on the 1920s and again after World War II left the German electorate with a deeply rooted fear of inflation. The law establishing the Bundesbank singled out the defense of the DM's real value as the primary goal of the German central bank. Page Ref: 634-641 Difficulty: Moderate 26) Describe the main provisions of the Maastricht Treaty of 1991. Answer: Called for a single currency by January 1, 1999, harmonizing social security policy within the European Union, and centralizing foreign and defense policy decisions. Page Ref: 634-641 Difficulty: Easy

6 .

27) Why did the EU countries move away from the EMS toward the goal of a single shared currency? Answer: (1) To produce a greater degree of European market integration by removing the threat of EMS currency realignments. (2) Reduce German dominance of the EMS monetary policy. (3) Given the move to complete freedom of capital movements within the EU, fixed but adjustable currency parities, may lead to ferociously speculative attacks, as in 1992-1993. (4) To guarantee the political stability of Europe. Page Ref: 634-641 Difficulty: Moderate 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. Answer: As for Germany a period of boom with high interest rates to fight inflation. Other European countries: France, Italy and UK in recession, trying to match the high German interest rates to hold their currencies fixed against Germany's, thereby pushing their economies into deep recession. Other European countries tried to continue the fixed exchange rate in order not to lose the credibility they had build up since 1985. The policy conflict between Germany and the other European countries led to a series of fierce speculative attacks on the EMS exchange parities starting in September 1992. By August 1993, the EMS was forced to retreat to very wide (± 10 percent) bands, which was kept in force until the introduction of the euro in 1993. Page Ref: 634-641 Difficulty: Moderate

7 .

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 EMS members. The figure shows the difference between domestic inflation and German inflation for six of the original EMS members. As of 1997 all national inflation rates were very close to the German levels. See Figure 20 in the textbook for a more updated figure. Page Ref: 634-641 Difficulty: Moderate 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. Answer: D Page Ref: 641-643 Difficulty: Easy

8 .

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. Answer: A Page Ref: 641-643 Difficulty: Easy 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. Answer: C Page Ref: 641-643 Difficulty: Easy 4) The European Central Bank has its headquarter in A) London. B) Berlin. C) Frankfurt. D) Paris. E) Brussels. Answer: C Page Ref: 641-643 Difficulty: Easy 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. Answer: B Page Ref: 641-643 Difficulty: Easy

9 .

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. Answer: C Page Ref: 641-643 Difficulty: Easy 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? Answer: EU countries should satisfy: (1) Low inflation rate (no more than 1.5 percent above the average of the three EU member states with the lowest inflation). (2) A stable exchange rate within the ERM. (3) Public-sector deficit no higher than 3 percent of its GDP in general. (4) A public debt below or approaching a reference level of 60 percent of its GDP. Page Ref: 641-643 Difficulty: Difficult 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 Answer: C Page Ref: 643-654 Difficulty: Easy

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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. Answer: A Page Ref: 643-654 Difficulty: Easy 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. Answer: B Page Ref: 643-654 Difficulty: Easy 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. Answer: D Page Ref: 643-654 Difficulty: Easy 11 .

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. Answer: C Page Ref: 643-654 Difficulty: Easy 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. Answer: C Page Ref: 643-654 Difficulty: Easy 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. Answer: B Page Ref: 643-654 Difficulty: Easy

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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. Answer: C Page Ref: 643-654 Difficulty: Easy 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. Answer: C Page Ref: 643-654 Difficulty: Easy 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. Answer: B Page Ref: 643-654 Difficulty: Easy

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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 noneuro 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 noneuro 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. Answer: A Page Ref: 643-654 Difficulty: Easy 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. Answer: B Page Ref: 643-654 Difficulty: Easy

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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. Answer: A Page Ref: 643-654 Difficulty: Easy 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. Answer: A Page Ref: 643-654 Difficulty: Easy 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. Answer: A Page Ref: 643-654 Difficulty: Easy

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16) Which one of the following statements is TRUE for Norway, a non-euro country? A) Of course, owners of capital that cannot be moved cannot avoid more of the economic stability loss due to fixed exchange rates when Norway's economy is open to capital flows. B) Even owners of capital that cannot be moved can avoid more of the economic stability loss due to fixed exchange rates when Norway's economy is open to capital flows. C) Owners of capital that cannot be moved can avoid more of the economic stability loss due to fixed exchange rates when Norway's economy is closed to capital flows. D) Even owners of capital that can be moved can avoid more of the economic stability loss due to fixed exchange rates when Norway's economy is closed to capital flows. E) Only owners of capital that can be moved can avoid more of the economic stability loss due to fixed exchange rates when Norway's economy is open to capital flows. Answer: B Page Ref: 643-654 Difficulty: Easy 17) The intersection of GG and LL determines A) the optimal level of integration desired by Norway. B) the maximum integration level desired by Norway. C) the minimum level of integration that will cause Norway to join the fixed exchange rate regime. D) the maximum level of integration that will cause Norway to join the fixed exchange rate regime. E) the maximum level of integration that can aid Norway if it joins the fixed exchange rate regime. Answer: C Page Ref: 643-654 Difficulty: Easy 18) The level of fiscal federalism in the European Union is A) too big to cushion member countries from adverse economic events. B) too small to cushion member countries from adverse economic events. C) appropriate to cushion member countries from adverse economic events. D) too big relative to the one in the U.S. E) similar in its level to that of the U.S. Answer: B Page Ref: 643-654 Difficulty: Easy

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19) A good measure of a country's level of economic integration with a currency area is A) the intersection of DD and GG. B) the country's price level. C) the compatibility of economic policies. D) the intersection of AA and GG. E) the extent of trade between the joining country and the currency area and the ease with which labor and capital can migrate between the joining country and the currency area. Answer: E Page Ref: 643-654 Difficulty: Easy 20) A key barrier to labor mobility within Europe is A) the laziness of Germans. B) full employment in most European countries. C) differences in language and culture. D) lack of transportation. E) the physical barriers in the landscape. Answer: C Page Ref: 643-654 Difficulty: Easy 21) Which of the following statements is MOST accurate? A) The countries of southern Europe are better endowed with capital and skilled labor than the countries of northern Europe. B) The countries of northern Europe are better endowed with capital and skilled labor than the countries of southern Europe. C) EU products that make intensive use of high-skill labor are most likely to come from Portugal. D) EU products that make intensive use of low-skill labor are most likely to come from Great Britain. E) The countries of eastern Europe are better endowed with capital and skilled labor than the countries of western Europe. Answer: B Page Ref: 643-654 Difficulty: Easy 22) A recent study by Andrew Rose of the University of California showed that, on average, two countries that are members of the same currency union A) trade three times as much with each other as countries that do not share a currency. B) trade twenty times as much with each other as countries that do not share a currency. C) trade ten times as much with each other as countries that do not share a currency. D) trade six times as much with each other as countries that do not share a currency. E) trade twice as much with each other as countries that do not share a currency. Answer: A Page Ref: 643-654 Difficulty: Easy 17 .

23) Fiscal federalism in the EU refers to A) one nation's control of the monetary policy of all the other nations. B) freedom of member countries to leave the EU at any time. C) the transfer of economic resources from members with healthy economies to those suffering economic setbacks. D) one nation's freedom to abandon the Euro and use its own currency. E) the transfer of economic resources between members with healthy economies. Answer: C Page Ref: 643-654 Difficulty: Easy 24) Shortly after their admission into the EMU, Ireland and the Netherlands A) both seceded from the EMU. B) were expelled due to high levels of debt. C) breached the inflation convergence criterion that had qualified them for admission to the EMU in the first place. D) achieved inflation rates of zero percent. E) abandoned the Euro as their national currency. Answer: C Page Ref: 643-654 Difficulty: Easy 25) Which of the following best defines an optimum currency area? A) a group of nations sharing the same currency B) a group of regions in close proximity to each other. C) a group of regions who operate under similar economic policies. D) a group of regions with economies closely linked by factor mobility and by trade in goods and services E) a group of nations that engage in free trade with each other Answer: D Page Ref: 643-654 Difficulty: Easy

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26) Which of the following statements is MOST accurate? A) A rise in the size and frequency of country-specific disturbances to the joining country's product markets raises the critical level of economic integration at which the exchange rate area is joined. B) A rise in the size and frequency of country-specific disturbances to the joining country's product markets lowers the critical level of economic integration at which the exchange rate area is joined. C) A decline in the size and frequency of country-specific disturbances to the joining country's product markets raises the critical level of economic integration at which the exchange rate area is joined. D) A rise in the size and frequency of country-specific disturbances to the joining country's product markets has no effect on the critical level of economic integration at which the exchange rate area is joined. E) A decline in the size and frequency of country-specific disturbances to the joining country's product markets does not affect the level of economic integration at which the exchange rate area is joined. Answer: A Page Ref: 643-654 Difficulty: Easy 27) Which of the following statements is MOST accurate? A) A low degree of economic integration between a country and the fixed exchange rate area that it joins reduces the resulting economic stability loss due to output market disturbances. B) A high degree of economic integration between a country and the fixed exchange rate area that it joins reduces the resulting economic stability loss due to output market disturbances. C) A high degree of economic integration between a country and the fixed exchange rate area that it joins increases the resulting economic stability loss due to output market disturbances. D) A complete lack of economic integration between a country and the fixed exchange rate area that it joins reduces the resulting economic stability loss due to output market disturbances. E) A low degree of economic integration between a country and the fixed exchange rate area that it joins increases the resulting economic stability loss due to output market disturbances. Answer: B Page Ref: 643-654 Difficulty: Easy 28) The theory of optimum currency areas predicts that A) floating exchange rates are most appropriate for areas closely integrated through international trade and factor movements. B) fixed exchange rates are most appropriate for areas that are loosely integrated through international trade and factor movements. C) fixed exchange rates are most appropriate for areas closely integrated through international trade and factor movements. D) floating exchange rates are most appropriate for all countries in Europe. E) fixed exchange rates are most appropriate for all countries in Europe. Answer: C Page Ref: 643-654 Difficulty: Easy 19 .

29) Why does the GG schedule have a positive slope? A) The monetary efficiency gain a country gets by joining a fixed exchange rate area falls as its economic integration with the area increases. B) The monetary efficiency gain a country gets by joining a fixed exchange rate area rises as its economic integration with the area decreases. C) The monetary efficiency gain a country gets by joining a fixed exchange rate area rises as its economic integration with the area increases. D) The monetary efficiency gain a country gets by joining a floating exchange rate area rises as its economic integration with the area increases. E) The monetary efficiency gain a country gets by joining a fixed exchange rate area is constant after their integration into the area. Answer: C Page Ref: 643-654 Difficulty: Easy 30) Why does the LL schedule have a negative slope? A) The economic stability loss from pegging to the area's currencies rises as the degree of economic interdependence rises. B) The economic stability loss from pegging to the area's currencies falls as the degree of economic interdependence rises. C) The economic stability loss from pegging to the area's currencies falls as the degree of economic interdependence falls. D) The economic stability loss from pegging to the area's currencies rises as the degree of economic activity increases. E) The economic stability loss from pegging to the area's currencies is constant, even as the degree of economic activity increases. Answer: B Page Ref: 643-654 Difficulty: Easy 31) Compared with inter-regional trade in the he United States, intra-EU trade A) is far greater. B) is greater. C) is about the same. D) is less. E) is far less. Answer: D Page Ref: 643-654 Difficulty: Easy

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32) When did the UK decide to adopt the Euro? A) 1999 B) 2001 C) 2008 D) The UK has not adopted the Euro. E) 2010 Answer: D Page Ref: 643-654 Difficulty: Easy 33) Which of the following statements is the MOST accurate? A) Trade of EU countries with other EU countries has increased since the euro was introduced. B) Trade of EU countries with other EU countries has decreased since the euro was introduced. C) Trade of EU countries with other EU countries has increased in some years and decreased in other years since the euro was introduced. D) Trade of EU countries with other EU countries can no longer be measured since both trading parties have the same currency. E) Trade of EU countries with North American countries has decreased since the euro was introduced. Answer: A Page Ref: 643-654 Difficulty: Easy 34) Richard Baldwin's estimate was that the euro increased the trade level of its users by A) only 5 percent. B) only 9 percent. C) over 30 percent. D) over 50 percent. E) only 12 percent. Answer: B Page Ref: 643-654 Difficulty: Easy 35) "The costs and benefits for a country from joining a fixed-exchange rate area such as the EMS depend on how well-integrated its economy is with those of its potential partners." Discuss. Answer: We will expand on this idea, which is roughly the theory of an optimum currency area as developed by Mundell. A major economic 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. This gain in monetary efficiency would be even higher if the factors of production could migrate freely. The costs of joining a fixed-exchange rate area is that a country gives up the ability to use the exchange rate and monetary policy to stabilize the domestic economy. So, if a country has a well-integrated economy with those in the fixed-exchange rate area, then the benefits would likely outweigh the costs. Page Ref: 643-654 Difficulty: Easy

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36) Discuss the benefits and costs of joining a fixed-exchange area. Answer: Benefits: In general, gains from the stability of the area and reduced uncertainty. The efficiency 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. A major economic benefit of fixed exchange rates it that they simplify economic calculations and provide a more predictable basis for decisions that involve international transactions than do floating rates. The monetary efficiency gain from pegging, say the Norwegian krone to the euro, will be higher if factors of production can migrate freely between Norway and the euro area. The more extensive are crossborder trade and factor movements, the greater is the gain from a fixed cross-border exchange rate. Costs: A country that joins an exchange rate area gives up its ability to use the exchange rate and monetary policy for the purpose of stabilizing output and employment. When the economy is disturbed by a change in the output market, a floating exchange rate has an advantage over a fixed rate. 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. When the exchange rate is fixed, purposeful stabilization is more difficult because monetary policy has no power at all to affect domestic output and employment. Page Ref: 643-654 Difficulty: Difficult 37) Explain why when Norway unilaterally fixes its exchange rate against the euro but leaves the krone free to float against the non-euro currencies, it is unable to keep at least some monetary independence. Answer: Any independent money supply change in Norway would put pressure on krone interest rates and thus on the krone/euro exchange rate. So by pegging the krone even to a single foreign currency, Norway completely surrenders its domestic monetary control. Page Ref: 643-654 Difficulty: Moderate 38) Explain why after, say Norway unilaterally pegs the krone to the euro, domestic money market disturbances will no longer affect domestic output despite the continuation of float-rate regime against non-euro currencies. Answer: Because Norway's interest rate must equal the euro interest rate, any pure shifts in the AA curve (see chapter 19) will result in immediate reserve inflows or outflows that leave Norway's interest rate unchanged. Page Ref: 643-654 Difficulty: Moderate 39) Explain why even owners of capital that cannot be moved can avoid more of the economic stability loss due to fixed exchange rates when Norway's economy is open to capital flows. Answer: The main reason is through diversification. If Norway's capital market is integrated with those of the EMU neighbors, Norwegians will invest some of their wealth in other countries while at the same time part of Norway's capital stock will be owned by foreigners. Page Ref: 643-654 Difficulty: Moderate

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40) Explain why the oil price shocks after 1973 made countries unwilling to revive the Bretton Woods system of fixed exchange rates. See also Chapter 19. Answer: Using the GG-LL framework will help solve this question. The oil price shock of 1973 pushes the LL curve upward and to the right. Thus, the level of economic integration at which it becomes worthwhile to join the currency rises. In general, increase variability in the product markets makes countries less willing to enter fixed exchange rate areas. This prediction helps explain why the oil price shocks after 1973 made countries unwilling to revive the Bretton Woods system of fixed exchange rates. Page Ref: 643-654 Difficulty: Moderate 41) Explain why it may make sense for the United States, Japan, and Europe to allow their mutual exchange rate to float? Answer: Even though these regions trade with each other, the extent of that trade is modest compared with regional GDPs and interregional labor mobility is low. Page Ref: 643-654 Difficulty: Moderate 42) Is Europe an optimum currency area? Answer: An open question. I think yes, the area's economy is closely integrated with its own: most EU members export from 10 to 20 percent of their output to other EU members. But still, the law of one price does not apply to many products such as the auto market. In 1998, prices for the BMW 520i varied by as much as 29.5 percent between the United Kingdom and the Netherlands. Prices for the Ford Fiesta varied as much as 43.5 percent between the United Kingdom and Portugal! The text is more critical, claiming: "The extent of intra-European trade is not large enough, however, to give us an overwhelming reason for believing the European Union itself is an optimum currency area." Also, the text cites the fact that may be price convergence has more to do with Internet marketing than optimum currency area. The book concludes that on balance, it seems doubtful that the 1992 measures have yet pushed Europe dramatically closer to being an optimum currency area. Page Ref: 643-654 Difficulty: Difficult 43) How mobile is Europe's labor force? Answer: Differences in language and cultural discourage labor movements between European countries. Differences in regional unemployment rates are smaller and less persistent in the United States than are differences between national unemployment rates in the European Union. Even, within European countries, labor mobility appears limited, partly because of government regulations. For example, the requirement in some countries that worker establish residence before receiving unemployment benefits makes it harder for unemployed workers to seek jobs in regions that are far from their current homes. Page Ref: 643-654 Difficulty: Moderate

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44) How much trade do currency unions create? Answer: The main result is that currency unions promote trade. One study found that on average, two countries that are members of the same currency union trade three times as much with each other as countries that do not share a currency. Even if the euro were to raise trade within the euro zone by 50 percent, the positive effect on people's welfare could be immense, as another study has shown. However, some challenge the conclusion. Some claim the results would not be duplicated when applied to large countries such as the members of the EU; another study found out that leaving a common currency area as Ireland did has not caused reduction in UK-Ireland trade. Page Ref: 643-654 Difficulty: Moderate 45) Explain why the European Union's current combination of rapid capital migration with limited labor migration may actually raise the cost of adjusting to product market shocks without exchange rate change? Answer: If the Netherlands suffers an unfavorable shift in output demand, Dutch capital can flee abroad, leaving even more unemployed Dutch workers behind than in the case of government regulations that were to hinder the movement of capital outside the Netherlands. Severe and persistent regional depressions could result, worsened by the likelihood that the relatively few workers who did successfully emigrate would be precisely those who are most skilled, reliable, and enterprising. This is another example of the theory of the second best. Page Ref: 643-654 Difficulty: Moderate 46) "Given that labor remains relatively immobile within Europe, the European Union's success in liberalizing its capital flows may have worked perversely to worsen the economic stability loss due to the process of monetary unification." Discuss. Answer: Probably right. This is another example of the theory of the second best. If the Netherlands suffers an unfavorable shift in output demand, Dutch capital can flee abroad, leaving even more unemployed Dutch workers behind than in the case of government regulations that were to hinder the movement of capital outside the Netherlands. Severe and persistent regional depressions could result, worsened by the likelihood that the relatively few workers who did successfully emigrate would be precisely those who are most skilled, reliable, and enterprising. Page Ref: 643-654 Difficulty: Moderate

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47) Explain what the GG-LL model tells us about the benefits of extensive trade between EU member states and comment on the significance of similarity of economic structure in this framework. Answer: The GG-LL model shows that extensive trade with the rest of the euro zone makes it easier for a member to adjust to output market disturbances that affect it and its currency partners differently. A key element in minimizing such disturbances is similarity in economic structure, especially in the types of products produced. Euro zone countries are, in fact, not entirely dissimilar in the manufacturing structure, as evidenced by the very high volume of intraindustry trade. The hope is that any difference in EU member country factor endowments will be minimized by the completion of a single European market and the redistribution of capital and labor across Europe. This will bring about the desired similarity of economic structure. Page Ref: 643-654 Difficulty: Difficult 48) Explain the theory of optimum currency areas. Answer: The theory implies that countries will wish to join fixed exchange rate areas closely linked to their own economies through trade and factor mobility. This decision to join is, in turn, determined by the difference between the monetary efficiency gain from joining and the economic stability loss from joining. These factors are both related to the degree of economic integration between the joining country and the larger fixed exchange rate zone. Only when economic integration passes a critical level is it beneficial to join. Page Ref: 643-654 Difficulty: Difficult 49) What is one way to offset the economic stability loss due to fixed exchange rates? Answer: Fiscal federalism is one solution in which the EU transfers economic resources from members with healthy economies to those suffering economic setbacks. These transfer payments come in the form of welfare benefits, and they are usually financed by the taxes that other member states pay. Ultimately, the extent of fiscal federalism is limited by the EU's restricted taxation powers. Page Ref: 643-654 Difficulty: Moderate 50) Using the GG-LL framework, analyze the effect of an increase in the size and frequency of sudden shifts in the demand for a country's exports. Answer: Such a change pushes LL upward and to the right. Thus, the level of economic integration at which it becomes worthwhile to join the currency rises. In general, increased variability in the product markets makes countries less willing to enter fixed exchange rate areas. This prediction helps explain why the oil price shocks after 1973 made countries unwilling to revive the Bretton Woods system of fixed exchange rates. See also Chapter 19. Page Ref: 643-654 Difficulty: Difficult

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51) Using the GG-LL framework, analyze the effect of Libya subsidizing the Pakistani Nuclear programs. Answer: This will shift the GG curve upward and to the left causing the two countries to trade more, thus reducing the minimum value for the two countries to cooperate under a fixed exchange rate regime. Page Ref: 643-654 Difficulty: Difficult 52) Draw the graph of the GG and LL schedules and explain the logic behind the slopes of each of the schedules. Answer: The correct graph has "degree of economic integration between the joining country and the exchange rate area" on the x-axis, and "gains and losses for the joining country" on the yaxis. The GG curve has a positive slope since the monetary efficiency gain a country gets by joining a fixed exchange rate area rises as its economic integration with the area increases. The LL curve has a negative slope because the economic stability loss from pegging to the area's currencies falls as the degree of economic interdependence rises. The two curves cross at a point that determines the critical level of economic integration (1 between the fixed exchange rate area and the country considering joining. In other words, it is the minimum integration level at which the country will join. (See Figure 20-5 in the text.)

Page Ref: 643-654 Difficulty: Difficult

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53) Discuss the trends and implications of the following graph, especially with respect to the official start of the EMU on January 1, 1999.

Answer: The extent of intra-EU country trade has fluctuated since the mid-1980s, but the pronounced growth of this trade after the start of the EMU suggests that the adoption of the single euro currency may have encouraged commerce among EU countries, moving them closer to forming an optimum currency area. Page Ref: 643-654 Difficulty: Easy 21.4 The Euro Crisis and the Future of EMU 1) Discuss the problems that the EMU will continue to experience in the coming years. Answer: (1) Europe is not an optimum currency area; therefore asymmetric economic developments within different countries of the euro zone that call for different interest rates cannot be implements. (2) The political part of the unification is much weaker and may limit the political legitimacy of the economic unification. (3) On the one hand, labor markets remain highly unionized and subject to high government unemployment taxes and other regulations impeding labor mobility. On the other hand, capital has high incentive to migrate to the EMU countries with the lowest wages. (4) Constraints on national fiscal policy are likely to be painful due to the absence of substantial fiscal federalism (fiscal transfer of resources from the rich to the less rich countries within the European Union) within the EU. (5) The EU is considering a largescale expansion of its membership into Eastern Europe and the Mediterranean. This will cause many coordination costs and also the issue of representation of small and big countries. Page Ref: 655-665 Difficulty: Difficult

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2) Which one of the following countries was the "spark" that ignited the 2009 euro crisis? A) China B) Greece C) England D) Spain E) Germany Answer: B Page Ref: 655-665 Difficulty: Easy 3) Which one of the following unexpected events ignited the 2009 euro crisis? A) Accelerating hyperinflation and political upheaval. B) The prospect of a sovereign default by one or more euro zone countries. C) Rising oil prices. D) Revolutions in Switzerland and Belgium. E) A Chinese boycott of European products. Answer: B Page Ref: 655-665 Difficulty: Easy 4) What behavior by central and private banks in euro zone countries created the conditions for the 2009 euro crisis? Answer: Assets were accumulated by the banks through the purchase of US financial products and through lending to other euro zone countries. Easy credit led to a European housing boom. Following the global financial crisis and the consequent recession, some European countries such as Greece Ireland Portugal Italy and Spain were found to have unsustainable levels of debt relative to national GDP. This raised the specter of a sovereign default by one or more euro zone countries and the crisis was on. Page Ref: 655-665 Difficulty: Moderate 5) During the 2009 euro crisis, a number of countries had private banks that had become too "big to save." Explain. Answer: A private bank is too big to save if the resources available to the home government through the central bank are insufficient to prevent bank failure. Essentially, saving the private bank would lead to a sovereign default by a countries government and so was not feasible. Page Ref: 655-665 Difficulty: Moderate

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6) What led to the over-extension of credit by some private banks and central banks in the euro zone prior to the 2009 euro crisis? Answer: Differences in interest rates in euro zone countries did not accurately represent differences in risk and inflation. Consequently banks were able to borrow at very low real interest rates while assuming relatively high levels of default risk. Once it became apparent that sovereign default and private bank failures were not only possible but likely in some countries, borrowing costs skyrocketed in those countries. In some cases, credit was cut off entirely. Page Ref: 655-665 Difficulty: Moderate 7) What event in 2009 ignited the euro crisis? Answer: Greece elected a new government in 2009 which found that the previous government had been misreporting economic statistics for years and the public debt amounted to more than 100% of GDP. It became apparent that Greece would experience a sovereign default unless bailed out by the European Central Bank or some other source of credit. Page Ref: 655-665 Difficulty: Moderate 8) Is the United States in danger of a sovereign default because, like countries in the euro zone, it has high current account deficits and levels of public debt? Answer: No. The United States has a central bank that can print money as needed to service its debt. It is in no danger of default. Euro zone countries, on the other hand, do not have individual central banks capable of printing money to pay off debt. Instead the European Central Bank and all member countries must collectively agree on monetary policy. Countries that have managed their affairs prudently are understandably unwilling to support the profligate behavior of other countries. Page Ref: 655-665 Difficulty: Moderate 9) How do constraints on monetary policy in the United States differ from those experienced by euro zone countries? Answer: United States monetary policy constraints are quite different from those encountered by countries in the euro zone. The US can print dollars to pay off debts as necessary and, while the result might be a higher rate of inflation, it makes it virtually impossible for the US to default on its public debts. Euro countries have a European Central Bank that must make decisions regarding monetary policy that will affect all of the euro zone countries. One possibility that has been discussed is to make it possible to conditionally remove countries from the euro zone to prevent the destruction of the monetary union. Note that this would be equivalent to the United States deciding to remove a state from the union if the state threatened bankruptcy. Page Ref: 655-665 Difficulty: Moderate

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10) What is the "doom loop" responsible for the rapid development and severity of the 2009 euro crisis? Answer: The "doom loop" refers to the feedback loop that runs from private bank distress to central bank distress to further private bank distress and so on, increasing in magnitude as it goes. During the euro crisis this process was evident in several euro zone countries. Page Ref: 655-665 Difficulty: Moderate 11) What is the "three-pronged approach" to organizing a banking union? Answer: Centralize financial supervision, create a deposit insurance fund, and provide mechanisms for the resolution of insolvent banks within the euro area. Page Ref: 655-665 Difficulty: Moderate 12) What is fiscal federalism? Answer: Fiscal federalism in the euro zone involves establishing a larger centralized budget managed by a central fiscal authority with the capability to tax, spend, and issue euro bonds. Page Ref: 655-665 Difficulty: Moderate 13) Describe the single supervisory mechanism or SSM proposed by EU leaders in June of 2012. Answer: The SSM involved granting the European Central Bank the power to police banks throughout the euro zone and the ability to re-capitalize banks directly if needed. Page Ref: 655-665 Difficulty: Moderate 14) Describe the policy of "outright monetary transactions" or 0MT presented by the president of the European Central Bank in 2012. Answer: The ECB is now committed to purchase sovereign bonds of euro zone countries, potentially without limit, in order to control interest rates in the euro zone. Page Ref: 655-665 Difficulty: Moderate 15) Is the EU an optimum currency area? Why or why not? Answer: Europe is not an optimum currency area. Labor mobility is highly limited. Economic and political conflicts within the euro zone have been persistent and they continue to result in questions regarding the ability of the euro zone to survive going forward. Page Ref: 655-665 Difficulty: Moderate

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International Economics, 10e (Krugman/Obstfeld/Melitz) Chapter 22 (11) Developing Countries: Growth, Crisis, and Reform 22.1 Income, Wealth, and Growth in the World Economy 1) The world's economies can be divided into four main categories according to their annual percapita income levels. Which one of the following is NOT one of the categories? A) low-income B) upper middle-income C) high-income D) lower middle-income E) middle-income Answer: E Page Ref: 670-674 Difficulty: Easy 2) Average per-capita GDP in the richest, most prosperous economies is ________ times that of the average in the ________ economies. A) 95, low (poorest) income B) 95, lower-middle income C) 73, lower-middle income D) 44, low (poorest) income E) 69, low (poorest) income Answer: E Page Ref: 670-674 Difficulty: Easy 3) Compared with industrialized economies, most developing countries are poor in the factors of production essential to modern industry: These factors are A) capital and skilled labor. B) capital and unskilled labor. C) fertile land and unskilled labor. D) fertile land and skilled labor. E) water and capital. Answer: A Page Ref: 670-674 Difficulty: Easy 4) The main factors that discourage investment in capital and skills in developing countries are A) political instability, insecure property rights. B) political instability, insecure property rights, misguided economic policies. C) political instability, misguided economic policies. D) political instability. E) insecure property rights, misguided economic policies. Answer: B Page Ref: 670-674 Difficulty: Easy 1 .

5) The per-capita GNP of the industrial group is about ________ times that of the upper middleincome countries. A) 6 B) 10 C) 15 D) 19 E) 2 Answer: A Page Ref: 670-674 Difficulty: Easy 6) When one compares per-capital output growth rates among countries A) one needs to correct the data to account for departures from purchasing power parity. B) such corrections are often not necessary. C) such corrections are sometimes necessary. D) the evidence whether such corrections are necessary are vague. E) such corrections are not necessary. Answer: A Page Ref: 670-674 Difficulty: Easy 7) Over the period 1960-2010, the United States economy grew at roughly A) 2.1 percent. B) 3 percent. C) 4 percent. D) one percent. E) 3.5 percent. Answer: A Page Ref: 670-674 Difficulty: Easy 8) Over the period 1960-2000, France grew ________ than the United States economy A) 2 % slower. B) 2% faster. C) more than 2% slower. D) less than 2% faster. E) more than 2% faster. Answer: D Page Ref: 670-674 Difficulty: Easy

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9) Over the post-war era, the gaps between industrial countries' living standards A) disappeared. B) stayed the same. C) increased. D) decreased. E) fluctuated. Answer: D Page Ref: 670-674 Difficulty: Easy 10) Over the post-war era, the gaps between countries' living standards A) disappeared. B) stayed the same. C) increased. D) decreased. E) changed inconsistently. Answer: E Page Ref: 670-674 Difficulty: Easy 11) Over the post-war era, poorer countries grew A) faster. B) slower. C) stayed the same. D) grew faster, then grew slower. E) No general tendency can be found. Answer: E Page Ref: 670-674 Difficulty: Easy 12) Since 1960, countries in Africa have grown at rates ________ those of the main industrial countries. A) far below B) far above C) about the same D) slightly below E) slightly above Answer: A Page Ref: 670-674 Difficulty: Easy

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13) Since 1960, South Korea and Singapore enjoyed an average per-capita growth rates ________ the average industrialized world. A) far below B) far above C) about the same D) slightly below E) slightly above Answer: B Page Ref: 670-674 Difficulty: Easy 14) Until recently, per-capita income increased in East Asian countries such as Hong Kong, Singapore, South Korea, and Taiwan by ________-fold every generation A) 2 B) 3 C) 4 D) 5 E) 1 Answer: D Page Ref: 670-674 Difficulty: Easy 15) Between 1960 and 2010, the annual growth rate in percent per year was the highest in A) China. B) United States. C) Brazil. D) Singapore. E) South Korea. Answer: A Page Ref: 670-674 Difficulty: Easy 16) What is the basic problem of developing countries? A) corruption B) murder C) poverty D) stock market E) natural resources Answer: C Page Ref: 670-674 Difficulty: Easy

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17) How would you describe the world distribution of income? A) persistently unequal B) temporarily unequal C) converging D) fairly equal E) completely unpredictable Answer: A Page Ref: 670-674 Difficulty: Easy 18) How would you define convergence? A) tendency for gaps between industrial countries' per-capital incomes to narrow B) tendency for gaps between all countries' per-capital incomes to narrow C) the theory that a crisis in a low-income country will spread to all countries, regardless of debt structure D) the theory that a crisis in a low-income country will spread to only those countries which had lent money to the original country E) tendency for the world distribution of income to be persistently unequal Answer: A Page Ref: 670-674 Difficulty: Easy 19) Which of the following countries had a larger growth rate since 1960? A) U.S. B) Senegal C) South Korea D) Kamul E) Colombia Answer: C Page Ref: 670-674 Difficulty: Easy 20) What explains the sharply divergent long-run growth patterns? Answer: The answer lies in the economic and political features of developing countries and the way these have changed over time in response to both world events and internal pressures. Page Ref: 670-674 Difficulty: Moderate 21) Explain the theory behind convergence and why it is a "deceptively simple" theory. Answer: Convergence is the tendency for gaps between industrialized countries' living standards (i.e. per capita income) to narrow. If trade is free, if capital can move to countries offering the highest returns, and if knowledge itself moves across political borders so that countries always have access to new production technologies, then there is no reason for international income differences to persist for long. Some differences, however, do exist because of policy differences across industrial countries. Page Ref: 670-674 Difficulty: Moderate 5 .

22) Explain what the four main categories of world economies are and give examples? Answer: The four main categories of the world economies are categorized by annual per-capita income levels. Low-income economies which include India, Pakistan, and much of the subSaharan Africa. Lower middle income includes most Middle Eastern Countries, Latin American, Caribbean countries, the former Soviet countries and the most of the African countries. The upper middle income economies which are Latin American countries, Saudi Arabia, Malaysia, South Africa, Poland, Hungary, Czech and the Slovak Republic. The last category is the highincome economies such as Korea, Israel, Kuwait, Singapore and the United states. Page Ref: 670-674 Difficulty: Moderate

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23) Please consider Table 22-2 below.

Assuming constant Annual Average Growth Rate in the future, calculate the output per capita for the United States and South Korea for the year 2040. Answer: Since 2040 - 2000 = 2000 - 1960, then output per capita for U.S. = 34365 * (34365 / 1544) = 90,633 output per capita for South Korea = 15702 * (15702 / 1544) = 159,685 Page Ref: 670-674 Difficulty: Moderate

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24) Please consider Table 22-2 below.

At that Annual Average Growth Rate, how many years does it take for the output per capita to double in both the United States and South Korea.

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Answer: United States (1 + 0.025)t = 2 t = ln(2) / ln(1.025) = 28 years South Korea (1 + 0.06)t = 2 t = ln(2) / ln(1.06) = 12 years (short-cut-rule of 69) United States t ≈ 69 / 2.5 = 28 years South Korea t ≈ 69 / 6 = 12 years Page Ref: 670-674 Difficulty: Moderate

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25) Please consider Table 22-2 below.

Assuming constant Annual Average Growth Rate in the future, determine the year in which the United States will have the same output per capita as South Korea? Answer: (34,365) (1 + 0.025)t-2000 = (15,702) (1 + 0.06)t-2000 (34,365) / (15,702) = [(1.06) / (1.025)]t-2000 t - 2000 = ln[(34,365) / (15,702)] / ln[(1.06) / (1.025)] t = 2023 Page Ref: 670-674 Difficulty: Moderate

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22.2 Structural Features of Developing Countries 1) While many developing countries have reformed their economies in order to imitate the success of the successful industrial economies, the process remains incomplete and most developing countries tend to be characterized by all of the following EXCEPT A) seigniorage. B) control of capital movements by limiting foreign exchange transactions connected with trade in assets. C) use of natural resources or agricultural commodities as an important share of exports. D) a worse job of directing savings toward their most efficient investment uses. E) reduced corruption and poverty due to limited underground markets. Answer: E Page Ref: 674-677 Difficulty: Easy 2) In general, one would expect that life expectancies reflect international differences in income levels. Do the data support such a claim? A) Average life span falls as relative poverty falls. B) Average life span increases as relative poverty falls. C) There is no statistically significant relationship between the two. D) The relation is not very strong. E) The relationship looks more like a U-shape. Answer: B Page Ref: 674-677 Difficulty: Easy 3) Seigniorage refers to A) real resources a government earns when it prints money to use for spending on goods and services. B) nominal resources a government earns when it prints money to use for spending on goods and services. C) real resources a government earns when it prints money. D) nominal resources a government earns when it prints money. E) real resources a government earns when it issues bonds to use for spending on goods and services. Answer: A Page Ref: 674-677 Difficulty: Easy

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4) In developing countries, exchange rates tend to be A) floating with some government intervention. B) pegged. C) hard to tell from the data. D) run by currency boards. E) flexible. Answer: B Page Ref: 674-677 Difficulty: Easy 5) Most developing countries have tried to A) liberalize capital movement. B) control capital movements. C) Hard to tell from the data. D) in the 1960s and 1970s control, now to liberalize. E) in the 1960s and 1970s liberalize, now to control. Answer: B Page Ref: 674-677 Difficulty: Easy 6) For many developing countries, natural resources or agricultural commodities make up ________ share of exports A) close to no B) an unimportant C) an important D) close a to 5 percent E) close to a 10 percent Answer: C Page Ref: 674-677 Difficulty: Easy 7) In general, the development of underground economic activity ________ economic efficiency A) hinders B) has no effect C) aides D) hard to tell, sometime hinders, sometimes aides E) spikes Answer: A Page Ref: 674-677 Difficulty: Easy

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8) One should expect ________ relationship between annual per-capita GDP and an inverse index of corruption A) a weak and negative B) a weak and positive C) a strong and negative D) a strong and positive E) an unpredictable Answer: D Page Ref: 674-677 Difficulty: Easy 9) Which of the following is NOT a common characteristic of a developing country? A) extensive direct government control of the economy B) history of low inflation C) many weak credit institutions D) "pegged" exchange rates E) Agricultural commodities make up a large share of its exports. Answer: B Page Ref: 674-677 Difficulty: Easy 10) The relationship between annual real per-capita GDP and corruption across countries has been found to be A) negative. B) positive. C) The relationship was negative in the late 1960s but is now positive. D) The relationship was in the late 1960s but is now negative. E) There is no relationship between these two variables. Answer: A Page Ref: 674-677 Difficulty: Easy 11) Which of the following does NOT explain why developing countries encouraged new manufacturing industries of their own in the mid 20th century? A) They were cut off from traditional suppliers of manufactures during WWII. B) Former colonial areas had something to prove; they wanted to attain the same income levels as their former rulers. C) Leaders of these countries feared that their efforts to escape poverty would be doomed if they continues to specialize in primary commodity exports. D) There was political pressure to protect these industries. E) Developing countries ran out of the natural resources that traditionally made up the majority of their trade. Answer: E Page Ref: 674-677 Difficulty: Easy

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12) Which of the following are characteristic of a developing country? A) extensive embrace of free trade policies B) low inflation C) high national savings D) a current account deficit and low national savings E) strong credit institutions Answer: D Page Ref: 674-677 Difficulty: Easy 13) The real resource a government earns when it prints money and spends it on goods and services is called A) seigniorage. B) control of capital movements by limiting foreign exchange transactions. C) pure profits. D) inflation profits. E) greenback. Answer: A Page Ref: 674-677 Difficulty: Easy 14) For many developing countries, natural resources or agricultural commodities make up a ________ share of exports. A) large B) moderate C) nonexistent D) small E) insubstantial Answer: A Page Ref: 674-677 Difficulty: Easy 15) Which of the following countries is the most corrupt? A) U.S. B) Iceland C) Finland D) New Zealand E) Greenland Answer: A Page Ref: 674-677 Difficulty: Easy

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16) Describe some of the features hindering developing countries from growing faster. Answer: One of the features that can be hold developing countries from growing faster is corruption. The way governments control the economy by developing restrictions that would not allow international trade among other countries; knowing that by having the doors open for international trading the country can be better off. More over, governments also owning or controlling the largest industries, that produce more in the countries, and controlling international transactions, they do not led new opportunities to come into their society. These governments also do tax evasion, which must of the time in some countries it's been out of control. Basically, developing countries have been managed by corrupt and inexperience peoples that just want to disturbed instead of encouraging new opportunities for a better future. Page Ref: 674-677 Difficulty: Moderate 17) Explain the extensive economic role of government within a developing country. Answer: An open question. Students should include 2 of the following in their answer along with discussion: (1) Restrictions on international trade (2) Government control over large industrial firms (3) High level of government consumption as a share of GNP (4) Strict management of exchange rates; limit exchange rate flexibility Page Ref: 674-677 Difficulty: Moderate 22.3 Developing-Country Borrowing and Debt 1) In developing economies, national saving is often ________ relative to developed economies. A) high B) the same C) hard to tell D) low E) low for the very poor countries and high for the more developed Answer: D Page Ref: 677-688 Difficulty: Easy 2) The Convertibility Law of April 1991 in Argentina A) pegged the Argentinean currency to the US dollar at a ratio of one to one. B) pegged the Argentinean currency to the US dollar at a ratio of one to two. C) pegged the Argentinean currency to the US dollar at a ratio of one to 0.5. D) represents an era of floating exchange rate in Argentina. E) pegged the Argentinean currency to the British pound at a ratio of one to one. Answer: A Page Ref: 677-688 Difficulty: Easy

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3) The $50 billion emergency loan orchestrated by the U.S. Treasury and the IMF to Mexico in 1994 A) was a disastrous policy for Mexico. B) avoided a disaster to the Mexican economy. C) did not affect Mexico in the short run. D) did not affect Mexico in the long run. E) was ineffective both in the short and long runs. Answer: B Page Ref: 677-688 Difficulty: Easy 4) Brazil's 1999 crisis was relatively short lived because A) Brazil's financial institutions had avoided borrowing all together. B) Brazil's financial institutions had avoided heavy borrowing in local currency. C) Brazil's financial institutions had avoided heavy borrowing in dollars. D) Brazil's financial institutions had extended low-interest loans. E) Brazil's financial institutions had extended high-interest loans. Answer: C Page Ref: 677-688 Difficulty: Easy 5) What does it mean for a loan to be in default? A) when the borrower of the a loan fails to repay on schedule according to a loan contract, without the agreement of the lender B) when the borrower of a loan fails to repay on schedule according to a loan contract, with the agreement of the lender C) when the lender of a loan fails to supplies the full amount of a loan to the borrower D) when the lender of a loan supplies the full amount of a loan to a borrower without any promise of being repaid E) when the lender of a loan fails to offer the promised sum Answer: A Page Ref: 677-688 Difficulty: Easy 6) A trend that has been reinforced by many developing countries is privatization. Privatization refers to A) purchasing large companies and turning them into state-owned enterprises. B) investing government money in large, privately-owned companies. C) exchanging bonds for shares in state-owned enterprises. D) selling large state-owned enterprises to private owners in the financial sector. E) selling large state-owned enterprises to private owners in key areas such as electricity, telecommunications, or petroleum. Answer: E Page Ref: 677-688 Difficulty: Easy

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7) A considerable advantage that richer countries have over poorer ones is exemplified by the fact that A) richer countries do not have to denominate their foreign debts in their own currencies. B) richer countries have the ability to denominate their foreign debts in foreign currencies. C) when demand falls for a poorer country's goods, this leads to a significant wealth transfer from foreigners to the poorer country, a kind of international insurance payment. D) richer countries have the ability to denominate their foreign debts in their own currencies. E) richer countries can extract trade advantages by using military power. Answer: D Page Ref: 677-688 Difficulty: Easy 8) In 1981-1983, the world economy suffered a steep recession. Naturally, the fall in industrial countries' aggregate demand had a direct negative impact on the developing countries. What other mechanism was an even more important contributor to this event? A) the immediate steep inflation that followed the recession B) the dollar's sharp depreciation in the foreign exchange market C) the increase in primary commodity prices, increasing terms of trade in many poor countries D) the collapse in primary commodity prices and the immediate, large rise in the interest burden that debtors had to pay E) the influx of defaulting credit Answer: D Page Ref: 677-688 Difficulty: Easy 9) With which country did the Debt Crisis of the early 1980s begin? A) France B) Mexico C) Argentina D) Japan E) Germany Answer: B Page Ref: 677-688 Difficulty: Easy 10) In 1991, Argentina established a radical institutional reform after experiencing a decade marked by financial instability. This program was called the new Convertibility Law. What did this law do? A) made Argentina's currency fully convertible into Eurocurrency at a fixed rate B) required that the monetary base be backed completely by U.S. dollars C) placed limits on exports of commodities D) made Argentina's currency fully convertible into U.S. dollars at a fixed rate and required that the monetary base be backed completely by gold or foreign currency E) restricted risky international trade activity Answer: D Page Ref: 677-688 Difficulty: Easy 17 .

11) In the instances where a loan has been issued under certain terms and has to be repaid, what happens when the borrower does not uphold these stipulations? A) call B) option C) payment D) default E) fraud Answer: D Page Ref: 677-688 Difficulty: Easy 12) There are many ways developing countries finance their external deficits EXCEPT A) bank finance. B) portfolio investment in ownership of firms. C) bond finance. D) official lending. E) foreign exchange rates. Answer: E Page Ref: 677-688 Difficulty: Easy 13) During the time period of 1981-1983 what dramatic world issue happened? A) political instability, insecure property rights B) stock market crashed C) world wide hyperinflation D) the collapse of the U.S. mortgages market E) A world economic recession caused developing countries to not be able to make payments on foreign loans, in turn causing a universal default. Answer: E Page Ref: 677-688 Difficulty: Easy 14) The term Original Sin by two economists Barry Eichengreen and Ricardo Hausmann is used to describe what? A) low-income economy B) developing countries' inability to borrow in their own currencies C) a sin that is part of the Ten Commandments D) borrows not able to receive loans E) not diversifying economies portfolios Answer: B Page Ref: 677-688 Difficulty: Easy

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15) How would you define exchange control? A) The government allocates foreign exchange through decree rather than through the market. B) a country NOT pegging its exchange rate C) a country pegging its exchange rate D) a country buying up excess current account so that CA=0 E) a country restricting all foreign exchange Answer: A Page Ref: 677-688 Difficulty: Easy 16) As of 2013, how large is the debt of developing countries to the rest of the world? A) $350 million B) $350 billion C) $7 trillion D) $35 trillion E) $3.5 trillion Answer: C Page Ref: 677-688 Difficulty: Easy 17) Which of the following is a reason that developing countries are running large surpluses? A) They are required to do so by IMF. B) They have defaulted on international loans. C) They have pegged exchange rates and thus the growth of exports must drive surplus up. D) They have a strong desire to accumulate international reserves to protect against a sudden stop of capital inflows. E) They don't know how to manage their surpluses. Answer: D Page Ref: 677-688 Difficulty: Easy 18) Which Latin American country defaulted on loans in 2005 and paid off their creditors at only 1/3 value? A) Argentina B) Brazil C) Chile D) Colombia E) Mexico Answer: A Page Ref: 677-688 Difficulty: Easy

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19) When a government defaults on its obligations, the event is called a A) sovereign default. B) magisterial default. C) private default. D) sudden stop default. E) national default. Answer: A Page Ref: 677-688 Difficulty: Easy 20) The following are all the forms of debt finance. A) bond, bank, and official finance B) bond and bank finance C) bond, bank, and portfolio finance D) foreign direct and portfolio investment E) direct investment, stock, and dividends Answer: A Page Ref: 677-688 Difficulty: Easy 21) Why may equity finance be preferred to debt finance for developing countries? A) A fall in domestic income automatically reduces the earnings of foreign shareholders without violating any loan agreement. B) There are laws insuring against any default with equity finance. C) The risk is shared between debtor and creditor with debt finance. D) The tax structure leaves equity finance unconstrained. E) Repayments are unaffected by falls in real income. Answer: A Page Ref: 677-688 Difficulty: Easy 22) Since foreign credit dries up in crises when it is most needed, developing countries can protect themselves from default by A) cutting off imports of goods. B) allowing the exchange rate to float. C) using equity finance only. D) accumulating high levels of international reserves. E) avoiding the international capital market. Answer: D Page Ref: 677-688 Difficulty: Easy

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23) What factors lie behind capital inflows to the developing world? Answer: Many developing countries have received a lot of capital inflows that lead them to a huge debt to foreigners. These debts are been produced because the economy of the developing world is very small compared to the economy of the industrial world. Since developing countries face a lot of poverty and poor financial institutions, national savings is often low and because of that, they are always facing current account deficit. Even though, these countries are very poor in capital, there are opportunities for profitable introduction or expansion of firms and equipments, and these opportunities give good reason for a high level of investment. However, because these countries always have deficits in their current account, a country can obtain resources from abroad to invest even if its domestic savings level is low. This means that the country is going to have to borrow money from a foreign country. These ways of production are the one that lie behind capital inflows because by helping these countries to grow and expand, the price to be pay is a big debt which they know based on their circumstances its going to be hard to repaid. Page Ref: 677-688 Difficulty: Moderate 24) Describe alternative forms of capital inflow to finance external deficits and explain why these methods were used in different times? Answer: The capital inflows that finance developing countries' deficits are: Bond finance in which developing countries sell bonds to private foreign citizens to finance their deficits. At that time bond finance is a key to get money to solve the deficit of the country. Bank finance, which help developing countries to borrow widely from commercial banks. At that time banks provide more or less a quarter of developing country external finance. Official lending, this is use because developing countries sometimes borrow from official foreign agencies such as the World Bank or Inter American Development Bank. They like to take advantage of these banks because they to lend at interest rates below market level or on a market basis that allows the lender to earn the market rate of return. Direct foreign investment, which allows a foreign largest firm owned by foreigner's residents, acquires or expands a subsidiary firm or factory domestically. Since WWII, direct investment has been a consistently important source of developing country's capital. Page Ref: 677-688 Difficulty: Moderate 25) Explain why the distinction between debt and equity finance is useful in analyzing the response of developing countries to unforeseen events such as recession or terms of trade change? Answer: When a country's liabilities are in the form of debt, its fixed scheduled payments to creditors do not fall when its real income falls. This makes it difficult to honor the developing country's foreign obligations and may lead to default. Page Ref: 677-688 Difficulty: Moderate

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26) Explain why despite enormous natural resources, much of Latin America's population remains in poverty and the region has been repeatedly experiencing financial crises. Answer: Most Latin America population remains in poverty because bad advise and inefficient proliferated about investment decisions having taken. At the same time, the revenues available to those able to exploit limited domestic markets inspired lobbying for imports licenses and expanding the market as well as corruption. Discrimination in the import that alternates financial system and poverty at the lowest income levels grew over time. Government corruption and bad administration of money have been one of the factors that enable Latin America population from growing. Since the 1950s and 1960s many of the Latin America countries in the region were able to attain amazing growth rates by exploiting the initially high returns from moving resources in to industrial uses from inefficient agricultural activities. Instead of using the growth to get rid of debts and decrease the deficit of the country, governments along with corrupt people wasted for getting about the debt that the country was facing. Page Ref: 677-688 Difficulty: Moderate 27) Explain why a exchange rate-based stabilization plan may result in a real appreciation? Answer: Real appreciation may result for any of three reasons: first, persistent inflation due to say lagged wage indexation; second, lack of credibility of the policy; and third, productivity shifts due to inflation reduction or efficient reforms. See also Figure 22-3 for illustration in the case of Argentina, Chile, Brazil and Mexico. See also Chapter 15. Page Ref: 677-688 Difficulty: Moderate 28) Write an essay on the importance of a sound banking system in developing countries. Answer: See for example the vivid example of Chile in 1981-1982 experience. Students should explain the phenomena of moral hazard as a part of their answer. Page Ref: 677-688 Difficulty: Moderate 29) Explain why Argentina, one of the world's richest countries at the start of the twentieth century, has become progressively poorer relative to the industrial countries. [An alternative question: What explains Argentina's regress from riches to rags?] Answer: As usual, the answer is complex, but the country's inward orientation and macroeconomic instability appear to be the major culprits. Page Ref: 677-688 Difficulty: Moderate

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30) The 1980s are considered as the "lost decade" of Latin American growth. Explain why? Answer: Just as the Great Depression made it hard for developing countries to make payments on their foreign loans, the great recession of the 1980s also sparked a crisis over developing country debt. The fall in the industrial countries' aggregate demand had a direct negative impact on the developing countries. The problem was make worse by the dollar's sharp appreciation in the foreign exchange market, which raised the real value of the dollar debt burden substantially. The crisis began in August 1982 when Mexico announced that its central bank had run out of foreign reserves and that it could no longer meet payments on its $80 billion in foreign debt. Seeing potential similarities between Mexico and other large Latin American debtors such as Argentina, Brazil, and Chile, banks in the industrial countries, the largest private lenders to Latin America scrambled to reduce their risks by cutting off new credits and demanding repayment on earlier loans. The result was a widespread inability of developing countries to meet prior debt obligations, and a rapid move to the edge of a generalized default. Latin America was perhaps hardest hit, but so were soviet bloc countries like Poland that had borrowed from the European banks. Nonetheless, by the end of 1986 more than 40 countries had encountered severe financing problems. Growth had slowed sharply in much of the developing countries because they have to stop producing in order to pay the debtors. Page Ref: 677-688 Difficulty: Moderate 31) Evaluate the Argentinean Convertibility Law of April, 1991. Answer: Good idea in the short run, catastrophic idea in the long run. The law was abandoned only in January 2002. Page Ref: 677-688 Difficulty: Moderate 32) Explain how Brazil was able to reduce the rate of inflation from 2,669 percent in 1994 to less than 10 percent in 1997? Answer: By introducing a new currency and initially pegging it to the dollar. At the cost of widespread bank failures, high interest rates in 1995 and the shift to a fixed upwardly crawling peg and a substantial real appreciation of the local currency. Page Ref: 677-688 Difficulty: Moderate 33) Some economists claim that the Chilean experience during the 1990s was much more successful than its Latin American neighbors. Evaluate the Chilean policies during that decade. Answer: Students should refer to the democratic nature of the regime, and the fact that the policies specifically targeted corruption. Page Ref: 677-688 Difficulty: Moderate

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34) The main reason for the crisis in Argentina in 2001 and 2002, as to do with exchange rate policy, i.e., the continued peg of the exchange rate to the dollar. Discuss. Answer: Student should emphasize that the quote is mainly true. Students should compare Argentina in those years with the better experience of Chile and Mexico with flexible exchange rates and emphasize the appreciation of the dollar. Page Ref: 677-688 Difficulty: Moderate 35) Should the IMF be abolished? Discuss. Answer: An open answer. Arguments for abolishing the IMF should mention moral hazard, insistence on high interest rates, hasty structural reforms, etc. Arguments against abolishing will stress more coordination, more credit lines, transparency, etc. Page Ref: 677-688 Difficulty: Moderate 36) What do you think about international "Chapter 11"? Answer: A formal procedure whereby a country can seek international legal authorization to temporarily stop paying its debt and then negotiate a settlement that gives it more time to repay, or in extreme cases, actually writes off part of its obligations. The answer is that such an idea is probably a good idea, but again more moral hazard. Page Ref: 677-688 Difficulty: Moderate 37) "Sharp contractions in a country's output and employment invariably result from a crisis in which the country suddenly loses access to all foreign sources of funds." Explain how the current account identity necessitates these contractions. Answer: S - I = CA (Current Account Identity) Imagine that a country is running a current account deficit (i.e. borrowing from abroad) a certain amount of its GNP when foreign lenders suddenly become scared of default and cut off all new loans. This action causes the current account balance to be at least 0 due to either a rise in saving or a fall in investment (or a combination of both). The required sharp fall in aggregate demand necessarily depresses the country's output dramatically. Page Ref: 677-688 Difficulty: Moderate 38) List and explain 3 major channels through which developing countries have financed their external deficits. Answer: Any of the 3 below along with clear explanation will suffice: (1) Bond Finance (2) Bank Finance (3) Official Lending (4) Foreign Direct Investment (5) Portfolio investment in ownership of firms Page Ref: 677-688 Difficulty: Moderate

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39) Economists Eichengreen and Hausmann coined the phrase original sin to describe developing countries inability to borrow in their own currencies. Where do they believe that this inability comes from? What are other beliefs on this topic? Answer: Eichengreen and Hausmann believe that this inability is a structural problem of poor countries caused by features of the global capital market such as limited additional diversification potential. For the second part of the question, students discussion may include but is not limited to the following: (1) Bad history of economic policies (2) Problems arise with debt finance in international markets for developing countries Page Ref: 677-688 Difficulty: Moderate 40) What are the five major channels, which developing countries use to finance their external deficit? Answer: The five major channels are bonds finance, bank finance, official lending, foreign investment, and portfolio investment. Page Ref: 677-688 Difficulty: Moderate 41) What is Argentina's Convertibility Law of April 1991? Explain. Answer: The convertibility law is the law that made Argentina currency fully convertible into U.S. dollars at a fixed rate of exactly one peso per dollar. The law also required that the monetary base be backed entirely by gold or foreign currency. Page Ref: 677-688 Difficulty: Moderate 42) During 1991, Argentina's monetary law had a currency board. Explain and give an example. Answer: The currency board is monetary base backed entirely by foreign currency and the central bank therefore held no domestic assets. An example of currency board is 100% foreign exchange backing for monetary base. Page Ref: 677-688 Difficulty: Moderate 22.4 East Asia: Success and Crisis 1) East Asia's crisis was relatively long lived because A) East Asia's financial institutions had encouraged borrowing all together. B) East Asia's financial institutions had encouraged heavy borrowing in local currency. C) East Asia's financial institutions had extended low-interest loans. D) East Asia's financial institutions had extended high-interest loans. E) East Asia's financial institutions had encouraged heavy borrowing in dollars. Answer: E Page Ref: 688-694 Difficulty: Easy

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2) In the early 1960s South Korea was an extremely poor country. However, in 1963, the country began a remarkable economic ascent. What was a direct cause of this? A) a shift in strategy that emphasized exports rather than imports B) an increase in wages C) an increase in the labor force D) an increase in the money supply E) an emphasis on education, leading to a highly productive labor force Answer: A Page Ref: 688-694 Difficulty: Easy 3) What weakness in the economic structures of Asian countries contributed to the severe financial crisis that Asian economies experienced in 1997? A) Productivity: It increased rapidly and the countries were victims of their own success B) Banking regulation: Banks were excessively regulated, which reduced profits. C) Legal Framework: The system dealt unsuccessfully with companies in financial trouble D) Natural Resources: Countries' lack of natural resources and failure to explore developing industries accumulated and led to the crisis. E) High Taxes: High rates of taxation resulted in a reliance on imports. Answer: C Page Ref: 688-694 Difficulty: Easy 4) What event started the Asian financial crisis in 1997? A) Indonesia's inability to pay its debts B) devaluation of Indonesia's currency C) Thailand's inability to pay its debts D) devaluation of Thailand's currency E) devaluation of Malaysia's currency Answer: D Page Ref: 688-694 Difficulty: Easy 5) The problem of moral hazard has led A) the governments of many developing countries to guarantee repayment of all loans. B) to higher growth rates in Latin America. C) to excessively speculative investment. D) to both privilege and responsibility of creditors. E) to stable investments with small and steady expected gains. Answer: C Page Ref: 688-694 Difficulty: Easy

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6) How would you define a currency board? A) the process by which non-pegged interest rates are allowed to fluctuate B) the stockpiling of international reserves by developing countries C) using the dollar to carry out all domestic transactions, making the domestic currency a currency in name alone D) a constraint placed on monetary policy E) The monetary bases is backed entirely by foreign currency and the central bank holds no domestic assets. Answer: E Page Ref: 688-694 Difficulty: Easy 7) If a developing country institutes a currency board, it relinquishes control over having A) monetary policy autonomy. B) exchange rate stability. C) freedom of capital movement. D) freedom of labor movement. E) all of its funds. Answer: A Page Ref: 688-694 Difficulty: Easy 8) A currency board can ________ a country's ability to act as a lender of last resort. A) aggrandize B) limit C) enhance D) offset E) not affect Answer: B Page Ref: 688-694 Difficulty: Easy 9) Explain why East Asian countries have done so well relative to South American countries. Answer: Mainly, the reasons are: less moral hazard, less government debt to foreigners and smaller budget deficits in East Asian countries. Page Ref: 688-694 Difficulty: Moderate 10) Explain the reasons for the economic "miracle" of the East Asian countries between 1960 and 1997. Is it only because of the common Asian practice of industrial policy and businessgovernment cooperation? Answer: Students should emphasize high rates of savings and investment, rapidly improving educational levels among the work force, and a high degree of openness to and integration with world markets. Page Ref: 688-694 Difficulty: Moderate 27 .

11) Based on the 1997 Crisis and your own experience, what are the main weaknesses of the East Asian economies? Answer: The textbook raised mainly three issues. The first weakness is little productivity increase, most of the growth due to capital and labor inputs increase, eventually leading to diminishing returns. The second weakness is the poor state of banking regulation in most of the Asian economies. The third reason is inadequate legal framework for dealing with companies in trouble. Page Ref: 688-694 Difficulty: Moderate 12) Describe the Asian financial crisis as it unfolds beginning with the devaluation of the Thai currency in July 1997, followed by the Malaysian, Indonesian and South Korean crises. As part of your answer, elaborate on the Malaysian response to the crisis versus its troubled neighbors responses. Answer: Students should emphasize the relation to the slowdown in their largest industrial neighbor, Japan, and the reliability on large debts denominated in dollars. Malaysia did not turn to the IMF with its austerity plans. Malaysia imposed extensive foreign exchange controls on capital movements. Page Ref: 688-694 Difficulty: Moderate 13) Describe the crisis in Russia starting from 1989. Explain why? Answer: Students should emphasize lack of legal system, tax collection, corruption, organized crime, inflation, seigniorage financing, inability to reduce spending, reduction in oil prices, gold prices, world's recession etc. high and unsustainable interest rates, and continued support from the IMF for fear of collapse of the regime, including a possible nuclear threat if Russia decided to sell off its arsenal. Page Ref: 688-694 Difficulty: Moderate 14) Contrast the crisis in Poland and Russia. Explain why the Polish economy has done better? Answer: By the end of the 1990s, a handful of East European economies including Poland, Hungary, and the Czech Republic had made successful transitions to the entrepreneur order. Not surprisingly each of these countries was geographically close to the European Union (EU) and had a recent tradition, of industrial capitalism, including a body of contract and property law. In regards to Russia, by 1990 the Russia's government was unable to collect taxes or even to enforce basic laws; the country was riddled with corruption and organized crime. That is why the measured output got smaller progressively and the inflation was hard to control, so at the end of the 1990s most Russians were substantially worse off than under the old Soviet regime. As we can see, Poland's economy started producing more money to growth and decrease inflation because they were having business with potential firms. Page Ref: 688-694 Difficulty: Moderate

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15) Does it appear that currency boards make fixed exchange rates credible? Answer: No, because is prohibited by law from acquiring any domestic assets, so all the currency it issues automatically is fully backed by foreign reserves. Also countries that adopt currency board, do it because one of the mayor advantage aside from the constrain it places on fiscal policy, central bank can never run out of foreign exchange reserves in the face of a speculative attack on the exchange rate. So the currency board cannot fix exchange rates. Page Ref: 688-694 Difficulty: Moderate 16) Does it appear that currency boards make low-inflation policies credible? Answer: Currency boards have the power to bring in anti-inflation credibility from the country to which the domestic currency is hook. Currency boards typically may not acquire government debt, but it can discourage fiscal deficits leading to reduce a major cause of inflation and devaluation. In order for a currency board to be successful is by increasing the banking sector and that can get the government under pressure to abandon the currency board. Moreover if the markets anticipate that the government is leaving the currency boar, the country may not benefit from the potential of a currency board. Page Ref: 688-694 Difficulty: Moderate 17) Compare currency board to conventional fixed exchange rate. Answer: Currency board may not acquire domestic assets and thus cannot lend currency freely to domestic banks in time of financial crisis. Also, limit government ability to "surprise" the market and have real devaluation. Page Ref: 688-694 Difficulty: Moderate 18) What do you think about dollarization? Answer: This is an open question. The answer is probably a bad idea unless in the very short run. Students should talk about the loss of seigniorage and the gain in credibility against devaluation, which should lead to lower domestic interest rates. Students should mention the importance of political will to repair the fundamental economic weaknesses of the country. Page Ref: 688-694 Difficulty: Moderate 19) Compare the macroeconomic performances in the 1990s of the following countries under the following exchange-rate regimes: floating exchange rates, Mexico and Brazil; capital control, China and Malaysia; and currency boards, Estonia and Hong Kong; dollarization, Argentina. Answer: An open question. Students should use the IMF web site to discuss the issue, and to obtain data. Page Ref: 688-694 Difficulty: Moderate

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20) How was South Korea able to become one of the East Asian Economic Miracles? Answer: South Korea was able to become one of the East Asian Economic Miracle by launching a series of economic reforms, shifting from an inward-looking, import-substitution development strategy to one that emphasized exports. Page Ref: 688-694 Difficulty: Moderate 22.5 Lessons of Developing-Country Crises 1) Which of the following economic lessons should we take from developing country crises in Latin America (and elsewhere)? A) Only that it is important to choose the right exchange rate regime. B) Only that banking is of central importance in any government. C) The order in which reform measures are implemented are irrelevant. D) It is important to choose the right exchange rate regime and banking is of central importance in any government. E) The order in which reform measures are implemented are irrelevant and banking is of central importance in any government. Answer: D Page Ref: 694-696 Difficulty: Easy 2) The term contagion refers to A) a government's complete control over it's banking system. B) a drop in interest rates across industrialized countries. C) the vulnerability of healthy economies to crises generated by events elsewhere. D) a directed attack on one market by a foreign market. E) a side effect of international trade. Answer: C Page Ref: 694-696 Difficulty: Easy 3) What are the three main lessons on crisis learned from early developing countries in Latin America? A) choosing the right exchange rate regime, the importance of contagion and the importance of the banking system B) choosing the right real rate, the importance of following exchange rates, and keeping prices high to make the most profit C) pegging exchange rates with Euros, keeping labor cost and wages low D) maintaining money supply, avoiding tariffs, and increasing output E) maintaining money supply, avoiding inflation, and increasing production Answer: A Page Ref: 694-696 Difficulty: Easy

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4) What are the main lessons economists learned from the developing country crisis? Answer: (1) Choosing the right exchange rate regime (2) The central importance of sound banking system (3) The proper sequence of reform measures (4) The importance of contagion Page Ref: 694-696 Difficulty: Moderate 5) What is the theory of Second Best? Answer: The principal of the second best tells us that when an economy suffers from multiple distortions, the removal of only a few may make matters worse, not better. Page Ref: 694-696 Difficulty: Moderate 6) "Developing countries should delay opening the capital account until the domestic financial system is strong enough to withstand the sometimes violent ebb and flow of world capital." Discuss. Answer: Probably true. The issue is related to the theory of second best and the proper sequence of reform measures. Of course, students may argue against such step-by-step measures. Page Ref: 694-696 Difficulty: Moderate 7) "Trade liberalization should precede capital account liberalization." Discuss. Answer: The answer is probably true. The issue is related to the theory of second best and the proper sequence of reform measures. Of course, students may argue against such step-by-step measures. Page Ref: 694-696 Difficulty: Moderate 8) What is the domino effect or contagion? Answer: The definition is the vulnerability of even seemingly healthy economies to crisis of confidence generated by events elsewhere in the world. Students should provide examples like the Thai crisis, which provoked another crisis in South Korea, a much larger economy some 7,000 miles away. Or the Russian crisis sparking massive speculation against the Brazil's real. Page Ref: 694-696 Difficulty: Moderate

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22.6 Reforming the World's Financial "Architecture" 1) Why is China's currency undervalued? A) The Asian miracle is over. B) They do not trade with the U.S. C) They do not allow their currency to appreciate despite large external surpluses. D) They are stockpiling international reserves to protect against the next East Asian crisis. E) They are not aware of the real value of their currency. Answer: C Page Ref: 696-702 Difficulty: Easy 2) Explain the basic macroeconomic policy trilemma for open economies. Answer: Of three goals most countries share—independence in monetary policy, stability in the exchange rate, and the free movement of capital—only two can be reached simultaneously. Page Ref: 696-702 Difficulty: Moderate 3) Discuss the role of more "transparency" in reducing the risk of financial crisis. Answer: Students should discuss the Asian crisis where foreign banks lent money to Asian enterprises without any clear idea of what the risks were, and then pulled their money out equally blindly when it became clear those risks were larger than they anticipated. Page Ref: 696-702 Difficulty: Moderate 22.7 Understanding Global Capital Flows and the Global Distribution of Income: Is Geography Destiny? 1) Which theory best explains the wealth inequalities amongst nations? A) weather B) government institutions C) natural selection D) factors outside of any human control E) levels of corruption Answer: B Page Ref: 703-708 Difficulty: Easy

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