Chapter 18: The International Monetary System, 1870 1973 Multiple Choice Questions 1.

. Under the price-specie-flow mechanism, what happens when Germanys current account surplus is greater than its non-reserve capital account deficits? A. German loans will finance all foreign net imports. B. here will !e an automatic drop in German domestic prices and a rise in foreign prices. ". Gold reserves will flow into Germany. #. Gold reserves will flow out of Germany. $. %one of the a!ove. Answer& " '. he (rules of the game) under the gold standard can !est !e descri!ed as which of the following? A. *elling domestic assets in a deficit and !uying assets in a surplus B. *lowing down the automatic ad+ustments processes inherent in the gold standard ". *elling domestic assets in order to accumulate gold #. *elling foreign assets in a deficit and !uying foreign assets in a surplus $. %one of the a!ove. Answer& A ,. A country see-ing to maintain internal !alance would !e most concerned with A. attaining low levels of unemployment. B. ensuring that savings is weighted more toward domestic investment than the current account. ". large fluctuations in output. #. an ade.uate stoc- of gold reserves. $. %one of the a!ove. Answer& " /. By internal !alance, most economists mean A. only full employment. B. only price sta!ility. ". full employment and price sta!ility. #. full employment and moderate increase in prices. $. %one of the a!ove. Answer& "

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By e1ternal !alance, most economists mean A. avoiding e1cessive im!alances in international payments. B. a !alance !etween e1ports and imports. ". a !alance !etween trade account and service account. #. a fi1ed e1change rate. $. %one of the a!ove. Answer& A

2.

3hich one of the following statements is true? A. 4nflation !ut not deflation can occur even under conditions of full employment. B. #eflation !ut not inflation can occur even under conditions of full employment. ". 4nflation or deflation can occur even under conditions of full employment. #. 4nflation can occur even under conditions of full employment only in the long run $. %one of the a!ove. Answer& "

5.

3hich one of the following statements is true? A. 4nflation can occur even under conditions of full employment only if the central !an- continues to in+ect money into the economy. B. 4nflation can occur even under conditions of full employment only if the central !an- continues to withdraw money from the economy. ". #eflation can occur even under conditions of full employment only if the central !an- continues to in+ect money into the economy. #. 4nflation cannot occur even under conditions of full employment if the central !an- continues to in+ect money into the economy. $. %one of the a!ove. Answer& A

6.

A sudden increase in the U.*. price level A. ma-es those with dollar de!ts worse off. B. ma-es those with dollar de!ts !etter off. ". does not affect those with dollar de!ts. #. ma-es those with #7 de!t !etter off. $. %one of the a!ove. Answer& B

8.

A sudden increase in the U.*. price level

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A. B. ". #. $.

ma-es creditors in dollars !etter off. ma-es creditors in dollars worse off. does not affect creditors in dollars. ma-es creditors in #7 worse off. %one of the a!ove.

Answer& B 19. A sudden decrease in the U.*. price level A. ma-es those with dollar de!ts worse off. B. ma-es those with dollar de!ts !etter off. ". does not affect those with dollar de!ts. #. ma-es those with #7 worse off. $. %one of the a!ove. Answer& A 11. A sudden decrease in the U.*. price level A. ma-es creditors in dollars !etter off. B. ma-es creditors in dollars worse off. ". do not affect creditors in dollars. #. ma-es creditors in #7 !etter off. $. %one of the a!ove. Answer& A 1'. he costs of inflation have !een most apparent in the post-war period in countries such as A. Argentina. B. Belgium. ". he United *tates. #. "anada. $. :apan. Answer& A 1,. he costs of inflation have !een most apparent in the post-war period in countries such as A. Bra;il. B. Belgium. ". he United *tates. #. "anada. $. :apan. Answer& A

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he costs of inflation have !een most apparent in the post-war period in countries such as A. <ussia. B. Belgium. ". he United *tates. #. "anada. $. :apan. Answer& A

10.

$1ternal !alance means A. !alance in the countrys current account. B. !alance in the countrys service account. ". !alance in the countrys capital account. #. !alance in the countrys trade account. $. %one of the a!ove. Answer& $

12.

A current account surplus A. poses a pro!lem if domestic savings are !eing invested more profita!ly a!road than they would !e at home. B. may pose no pro!lem if domestic savings are !eing invested more profita!ly a!road than they would !e at home. ". may pose no pro!lem if domestic savings are !eing invested less profita!ly a!road than they would !e at home. #. there is no relation !etween current account surplus and !etween savings and investment. $. %one of the a!ove. Answer& B

15.

A current account deficit A. poses a pro!lem if domestic savings are !eing invested more profita!ly a!road than they would !e at home. B. may pose a pro!lem if domestic savings are !eing invested more profita!ly a!road than they would !e at home. ". may pose no pro!lem if domestic savings are !eing invested less profita!ly a!road than they would !e at home. #. here is no relation !etween the current account surplus and !etween savings and investment. $. %one of the a!ove. Answer& B

16.

3hich one of the following statements is true?

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A. B. ". #. $.

"ountries with strong investment opportunities should invest little at home and channel their savings into more productive investment activity a!road. "ountries with wea- investment opportunities should invest little at home and channel their savings into more productive investment activity a!road. "ountries with wea- investment opportunities should invest more at home. "ountries with wea- investment opportunities should invest little a!road. %one of the a!ove.

Answer& B 18. "ountries with A. strong investment opportunities should invest little at home and channel their savings into more productive investment activity a!road. B. strong investment opportunities should invest more at home and less a!road. ". wea- investment opportunities should invest more at home. #. wea- investment opportunities should invest little a!road. $. %one of the a!ove. Answer& B '9. "ountries where investment is relatively A. productive should !e net e1porters of currently availa!le output. B. unproductive should !e net importers of currently availa!le output. ". unproductive should !e net e1porters of currently availa!le output. #. unproductive should !e net e1porters of future availa!le output. $. %one of the a!ove. Answer& " '1. "ountries where investment is relatively A. productive should have current account deficits. B. productive should have current account surpluses. ". unproductive should have current account surpluses. #. productive should !alanced current account surpluses. $. %one of the a!ove. Answer& B

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3hich one of the following statements is true?

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A. B. ". #. $.

"ountries where investment is relatively productive should !e net importers of current output. "ountries where investment is relatively unproductive should !e net importers of current output. "ountries where investment is relatively productive should !e net e1porters of current output. "ountries where investment is relatively productive should not e1port or import current output. %one of the a!ove.

Answer& A ',. "ountries where investment is A. relatively unproductive should have current account deficits. B. relatively productive should have current account surpluses. ". relatively productive should have current account deficits. #. relatively productive should have !alanced current accounts. $. %one of the a!ove. Answer& " '/. Governments prefer to avoid e1cessive current account surpluses !ecause A. the returns to domestic savings may !e easier to ta1 than those on assets a!road. B. an addition to the home capital stoc- may reduce domestic unemployment and therefore lead to higher national income. ". domestic investment !y one firm may have !eneficial technological spillover effects on other domestic producers that the investing firm does not capture. #. All of the a!ove. $. %one of the a!ove. Answer& # '0. Under the gold standard era of 1659 = 181/, A. o-yo was the center of the international monetary system. B. >aris was the center of the international monetary system. ". Berlin the center of the international monetary system. #. %ew ?or- was the center of the international monetary system. $. @ondon was the center of the international monetary system. Answer& $

'2.

Under the gold standard era of 1659 = 181/,

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A. B. ". #. $.

central !an-s tried to have sharp fluctuations in the !alance of payments. central !an-s tried to avoid sharp fluctuations in the current account of the !alance of payments. central !an-s tried to avoid sharp fluctuations in the trade account of the !alance of payments. central !an-s tried to avoid sharp fluctuations in the capital account of the !alance of payments. central !an-s tried to avoid sharp fluctuations in the !alance of payments.

Answer& $ '5. A country is said to !e in !alance of payments e.uili!rium when the sum of its current and its A. non-reserved capital accounts e.uals ;ero. B. reserved capital accounts e.uals ;ero. ". non-reserved capital accounts e.uals to the surplus in the capital account. #. non-reserved capital accounts e.uals to the deficit in the capital account. $. %one of the a!ove. Answer& A '6. Under the gold standard, a country is said to !e in !alance of payments e.uili!rium when the current account !alance is A. financed entirely !y international lending without reserve movements. B. financed !y international lending and with reserve movements. ". e.ual to ;ero. #. financed entirely !y international lending and past gold reserves. $. %one of the a!ove. Answer& A '8. 7ercantilism held that A. silver alone was the mainstay of national wealth. B. gold alone was the mainstay of national wealth. ". silver and gold were the mainstays of national wealth. #. silver and gold are not important for the national wealth of a country. $. %one of the a!ove. Answer& "

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he main policy goal for a country, according to the mercantilists,is

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A. B. ". #. $.

to create a one-time deficit in the !alance of payments. to create a continuing deficit in the !alance of payments. to create a one-time surplus in the !alance of payments. to create a continuing surplus in the !alance of payments. %one of the a!ove.

Answer& # ,1. he view of mercantilists can !e summari;ed 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. ". to consume more of theirs in value than we sell to strangers. #. to consume the same amount as theirs in value as we sell to strangers. $. %one of the a!ove. Answer& B ,'. Under the gold standard, A. a perpetual surplus is possi!le. B. a perpetual deficit is possi!le. ". a perpetual surplus is impossi!le, !ut a perpetual deficit is possi!le. #. a perpetual deficit is impossi!le, !ut a perpetual surplus is possi!le. $. a perpetual surplus is impossi!le. Answer& $ ,,. 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. ". a shortage of currency leads to low domestic prices and a foreign payments deficit. #. a shortage of currency leads to low domestic prices !ut leaves the foreign !alance of payments at e.uili!rium $. %one of the a!ove. Answer& A

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Until the United *tates "ivil 3ar, he Unites *tates had a

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A. B. ". #. $.

gold-!ased monetary standard. silver-!ased monetary standard. !imetallic monetary standard consisting of silver and gold. !imetallic monetary standard consisting of copper and silver. !imetallic monetary standard consisting of copper and gold.

Answer& " ,0. Ance the United *tates "ivil 3ar !ro-e out, the United *tates moved to a A. gold standard. B. silver standard. ". !imetallic monetary standard consisting of silver and gold. #. !imetallic monetary standard consisting of copper and gold. $. paper currency, called the (green!ac-.) Answer& $ ,2. @. Bran- Baums classic 1899 childrens !oo-, The Wonderful Wizard of Oz, is A. an allegorical rendition of the U.*. political struggle over silver. B. an allegorical rendition of the U.*. political struggle over copper. ". an allegorical rendition of the U.*. political struggle over !oth silver and gold. #. %one of the statements is true. $. an allegorical rendition of the U.*. political struggle over gold. Answer& $ ,5. 4n @. Bran- Baums classic 1899 childrens !oo-, The Wonderful Wizard of Oz, the name (A;) is a reference to A. an ounce Co;.D of gold. B. an ounce Co;.D of silver. ". an ounce Co;.D of copper. #. an ounce Co;.D of either gold or silver. $. %one of the a!ove. Answer& A ,6. A policy of (!eggar-thy-neigh!or) is a policy that A. often !enefits the home country in the long run. B. often !enefits the foreign country in the long run. ". often !enefits the foreign country in the short run. #. does not often !enefit any country in the long run. $. %one of the a!ove. Answer& # ,8. he Great #epression that started in 18'8 was

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A. B. ". #. $.

confined only to the United *tates. confined only to the United *tates and Britain. confined only to the United *tates and $urope. a glo!al phenomenon. %one of the a!ove.

Answer& # /9. 3hich one of the following statements is the most accurate? By the year 18,', the United *tates A. and "anada alone held more than 59 percent of the worlds monetary gold. B. and Germany alone held more than 59 percent of the worlds monetary gold. ". and Britain alone held more than 59 percent of the worlds monetary gold. #. Britain, and Brance alone held more than 59 percent of the worlds monetary gold. $. and Brance alone held more than 59 percent of the worlds monetary gold. Answer& $ /1. "ountries with the A. !iggest deflations and output contractions are countries which were not on the gold standard until 18,2. B. !iggest inflations and output contractions are countries which were on the gold standard until 18,2. ". lowest deflations and output contractions are countries which were on the gold standard until 18,2. #. !iggest deflations and output increases are countries which were on the gold standard until 18,2. $. !iggest deflations and output contractions are countries which stayed on the gold standard until 18,2. Answer& $ /'. A converti!le currency is a currency that may !e freely e1changed for A. gold or silver. B. only silver. ". only copper. #. national currency. $. foreign currencies. Answer& $

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he 47B articles of 18// A. called for converti!ility on current account transactions only. B. called for converti!ility on capital account transactions only. ". called for converti!ility on current and capital account transactions. #. did not call for converti!ility on current account transactions. $. did not call for converti!ility on current and capital account transactions. Answer& A

//.

he dollar of the United *tates !ecame the postwar worlds -ey currency !ecause A. of the early converti!ility of the U.*. dollar in 18/0. B. of the special position of the dollar under the Bretton 3oods system. ". of the strength of the American economy relative to the devastated economies of $urope and :apan. #. "entral !an-s naturally found it advantageous to hold their international reserves in the form of interest-!earing dollar assets.. $. All of the a!ove. Answer& $

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he 7arshall >lan was a program of A. dollar grants from the United *tates to $uropean countries initiated in 18/6. B. dollar grants from the United *tates to $uropean countries initiated in 18/0. ". British pound grants from the $uropean countries to the United *tates initiated in 18/6. #. British pound grants from the $uropean countries to the United *tates initiated in 18/6. $. dollar grants from the United *tates to Germany only initiated after 3orld 3ar 44. Answer& A

/2.

he current account surplus is A. an increasing function of disposa!le income and an increasing function of the real e1change rate. B. a decreasing function of disposa!le income and a decreasing function of the real e1change rate. ". a decreasing function of disposa!le income and an increasing function of the real e1change rate. #. only a decreasing function of disposa!le income. $. only an increasing function of the real e1change rate.

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Answer& " /5. Under fi1ed e1change rates, A. monetary policy is not an effective policy. B. fiscal policy is not an effective policy. ". monetary policy and fiscal policy are not effective. #. !oth monetary and fiscal policies are effective. $. %one of the a!ove. Answer& A /6. Under fi1ed e1change rates, domestic asset transactions !y the central !anA. can !e used to alter the level of foreign reserves !ut not to affect the state of employment and output. B. cannot !e used to alter the level of foreign reserves or to affect the state of employment and output. ". can !e used to alter the level of foreign reserves and to affect the state of employment and output. #. cannot !e used. $. %one of the a!ove. Answer& A /8. he EE schedule shows how much A. fiscal e1pansion is needed to hold the current account surplus at E as the currency is devalued !y a given amount. B. monetary e1pansion is needed to hold the current account surplus at E as the currency is devalued !y a given amount. ". fiscal e1pansion is needed to hold the current account surplus at E as the currency is evaluated !y a given amount. #. fiscal and monetary e1pansions are needed to hold the current account surplus at E as the currency is devalued !y a given amount. $. %one of the a!ove. Answer& A

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ssay Questions 1. Fow did the international monetary system influence macroeconomic policy-ma-ing and performance during the gold standard era C1659 = 181/D?

Answer& @ondon was the center of the international monetary system. he primary responsi!ility of the central !an- was to preserve the official parity !etween its currency and gold. o maintain this price, the central !an- needed an ade.uate stoc- of gold reserves. "entral !an-s tried to avoid sharp fluctuations in the !alance of payments. Burther details are in pages 0,5 = 0/,. '. Fow did the international monetary system influence macroeconomic policy-ma-ing and performance during the interwar period C1816 = 18,8D?

Answer& Governments effectively suspended the gold standard during 3orld 3ar 4 and financed part of their massive military e1penditures !y printing money. Burther, la!or forces and productivity capacity had !een reduced sharply through war losses. As a result, price levels were higher everywhere at the conclusion of the war in 1816. Af special note is the German hyperinflation that occurred when prices in Germany increased !y a factor of /61.0 !illionG he United *tates returned to gold in 1818. 4n 18'', at a conference in Genoa, 4taly, a group of countries including Britain, Brance, 4taly and :apan agreed on a program of a partial gold e1change standard in which smaller countries could hold as reserves the currencies of several large countries whose own international reserves would consist entirely of gold. 4n 18'0, Britain returned to the gold standard !y pegging the pound to gold at the prewar price. hus, the Ban- of $ngland was therefore forced to follow contractionary monetary policies that contri!uted to severe unemployment and to the decline of @ondon as the leading financial center. he world economy disintegrated into increasingly autar-ic Cself-sufficientD national units in the early 18,9s. *ee also pages 0/, = 0/2. ,. Fow did the international monetary system influence macroeconomic policy-ma-ing and performance during the post-3orld 3ar 44 years during which e1change rates were fi1ed under the Bretton 3oods agreement C18/2 = 185,D?

Answer& 4n :uly 18//, representatives of // countries met in Bretton 3oods, %ew Fampshire, and drafted and signed the Articles of Agreement of the 4nternational 7onetary Bund C47BD and of the 3orld Ban-. he agreement esta!lished fi1ed e1change rates against the U.*. dollar and an unvarying dollar price of gold - H,0 an ounce.

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he dollar of the United *tates !ecame the postwar worlds -ey currency !ecause of a few factors& 1. he early converti!ility of the U.*. dollar in 18/0. '. he special position of the dollar under the Bretton 3oods system. ,. he strength of the American economy relative to the devastated economies of $urope and :apan. /. "entral !an-s naturally found it advantageous to hold their international reserves in the form of interest-!earing dollar assets. he 7arshall >lan, a program of dollar grants from the United *tates to $uropean countries, was initiated in 18/6. 7ost countries in $urope did not restore converti!ility until the end of 1806, with :apan following in 182/. *ee also pages 0/2 = 021. /. ( he line distinguishing !etween e1ternal and internal goals can !e fu;;y.) #iscuss.

Answer& rue. Bor e1ample, employment target for e1port industries when e1port growth influences the a!ility of the economy to repay its foreign de!ts. 0. 3hy do governments prefer to avoid current account deficits that are too large?

Answer& A current account deficit may pose no pro!lem if the !orrowed funds are channeled into productive domestic investment pro+ects that pay for themselves with the revenue they generate in the future. Fowever, sometimes, large current account deficits represent temporarily high consumption resulting from misguided government policies or some other malfunctioning of the economy. *ometimes, the investment pro+ects that draw on foreign funds may !e !adly planned, etc. 4n such cases, the government might wish to reduce the current account deficit immediately rather than face pro!lems in repaying its foreign de!t in the future. 2. 3hy do governments prefer to avoid e1cessive current account surpluses? Ar, why are growing domestic claims to foreign wealth ever a pro!lem?

Answer& Bor a given level of national saving, an increased current account surplus implies lower investment in domestic plant and e.uipment. A few reasons why& first, the returns to domestic savings may !e easier to ta1 than those on assets a!roadI second, an addition to the home capital stoc- may reduce domestic unemployment and therefore lead to higher national incomeI third, domestic investment !y one firm may have !eneficial technological spillover effects on other domestic producers that the investing firm does not capture. 4n addition, the

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country may in the future find itself una!le to collect the money it is owed. Burthermore, countries with large surpluses can !ecome targets for discriminatory protectionist measures !y trading partners with e1ternal deficits. 5. <efute the claim !y mercantilists who claimed that without severe restrictions on international trade and payments, a country might find itself impoverished and without an ade.uate supply of circulating monetary gold as a result of !alance of payments deficits.

Answer& he !alance of payments would automatically regulate itself to ensure an ade.uate supply of money in every country. 6. $1plain why under the gold standard a perpetual surplus or a perpetual deficit is impossi!le.

Answer& *ince specie inflows drive up domestic prices and restore e.uili!rium in the !alance 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. 8. 4t is claimed that @. Bran- Baums classic 1899 childrens !oo-, The Wonderful Wizard of Oz, is an allegorical rendition of the U.*. political struggle over gold. #iscuss.

Answer& rue. 4n @. Bran- Baums classic 1899 childrens !oo-, The Wonderful Wizard of Oz, the name (o;) is a reference to an ounce Co;.D of gold, and the yellow !ric- road represents the false promise of gold. he story represents the struggle of farmers in the western United *tates who were heavily inde!ted. 19. #escri!e the effects of the *moot-Fawley tariff imposed !y the United *tates in 18,9.

Answer& 4t had a damaging effect on employment a!road. he foreign response involved retaliatory trade restrictions and preferential trading arrangements among a group of countries. his is an e1ample of a (!eggar-thy-neigh!or) policy, meaning a policy that !enefits the home country only !ecause it worsens economic conditions a!road. 11. 3hat e1plains the nearly universal scope of the Great #epression?

Answer& he international gold standard played a central role in starting, deepening, and spreading the Great #epression. 1'. 3hat is a converti!le currency?

Answer& A converti!le currency is a currency that may !e freely e1changed for foreign currencies.

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$1plain why the dollar of the United *tates !ecame the postwar worlds -ey currency. 1. '. ,. /. he early converti!ility of the U.*. dollar in 18/0. he special position of the dollar under the Bretton 3oods system. he strength of the American economy relative to the devastated economies of $urope and :apan. "entral !an-s naturally found it advantageous to hold their international reserves in the form of interest-!earing dollar assets.

Answer&

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Fow did the international monetary system created at Bretton 3oods in 18// allow its mem!ers to reconcile their e1ternal commitments with their internal goals of full employment and price sta!ility?

Answer& As the world economy evolved in the years after 3orld 3ar 44, the meaning of (e1ternal !alance) changed and conflicts !etween internal and e1ternal goals increasingly threatened the fi1ed e1change rate system. he United *tates, the issuer of the principal reserve currency, was a ma+or concern, leading to proposals to reform the system. 10. (A monetary policy is not a policy tool under fi1ed e1change rates.) #iscuss.

Answer& rue. Under fi1ed e1change rates, domestic asset transactions !y the central !ancan !e used to alter the level of foreign reserves !ut not to affect the state of employment and output. 12. 3hat is an *#<?

Answer& An *#< is a *pecial #rawing <ight at the 47B and holds a place as a world reserve currency Csome countries, especially those that do not want to peg to the dollar for political reasons, peg to the *#<D. An *#<Js value is determined !y a !as-et of currencies that ma-e up a large portion of the worldJs G%>.

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Quantitati!e"#raphin$ %ro&lems 1. Using an e.uation, e1plain why governments prefer to avoid e1cessive current account surpluses.

Answer& his follows from the national income identity, * K "A L 4., which says that total domestic savings, *, is divided !etween foreign asset accumulation, "A, and domestic investment, 4. '. A. Assume that < denotes the domestic interest rate and <M denotes the foreign interest rate. Under a fi1ed e1change rate, what is the relation !etween < and <M?

Answer& < K <M. B. Assume $ denotes the domestic currency price of the dollar for a country which is not the United *tates. 4f one wants to analy;e only the short-run effects of a policy, what does one assume a!out the Fome and Boreign price levels, > and >M, respectively? Answer& > K >9 and >M K >M9, where !oth >9 and >M9 are constants. ". Assume that there is no ongoing !alance of payment crisis. 3hat does this assumption really assume? Answer& hat $e , the e1pected e1change rate, is e.ual to the e1change rate today, $. 4n other words, $ K $e. #. Assume a fi1ed e1change rate system. 3hat does this tell you a!out $? Answer& $ is constant, i.e., $ K $9. $. Under the a!ove assumptions, what are the conditions for internal !alance? Answer& *ince >M and $ are fi1ed, the e1pected price is fi1edI thus, no inflation is e1pected. hen, internal !alance will re.uire only full employment, aggregate demand e.ualing the full-employment level, ?f. B. Fow would your answer to >art # a!ove change if >M is unsta!le due to foreign inflation? Answer& 4n this case, full employment alone will not guarantee price sta!ility under a fi1ed e1change rate.

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G. Given the definitions a!ove, how does one define the real e1change rate? Answer& he real e1change rate is e.ual to $>MN>. F. 3rite the condition for internal !alance. Answer& ?f K "C?f - D L 4 L G L "AC$>MN>, ?f - D
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4. #efine the varia!le not defined !efore in >art G. Answer& " K consumption, 4 K 4nvestment, C?f - D K disposa!le income, K ta1es.

:. Using the e.uation for internal !alance derived a!ove, and given our assumptions, analy;e the effects of a fiscal e1pansion. Answer& An increase in G or a reduction in output to rise in the short run. will increase aggregate demand and will cause

O. 3hat would happen if the government of that country, which is not the United *tates under Bretton 3oods, decides to devaluate its currency? Answer& A rise in $ ma-es domestic goods and services cheaper relative to those sold a!road, and thus increases demand for output. @. 3hat would happen if the government of that country, which is not the United *tates under Bretton 3oods, decides to use monetary policy rather than fiscal policy? Answer& A monetary policy is not a policy tool under fi1ed e1change rates. Under fi1ed e1change rates, domestic asset transactions !y the central !an- can !e used to alter the level of foreign reserves !ut not to affect the state of employment and output. 7. Given all of the a!ove, what is the relation !etween the e1change rate, $, and fiscal ease, i.e., an increase in G or a reduction in ? Answer& %egative relation. %. Assume that the economy is at internal !alance. 3hat will happen if G goes up for a given level of $? Answer& Aver-employment. A. Assume that the economy is at internal !alance. 3hat will happen if G goes down for a given level of $? Answer& Underemployment.

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Assume that the government has a target value, E, for the current account surplus. A. 3hat is the goal of e1ternal !alance?

Answer& he goal of e1ternal !alance re.uires the government to manage fiscal policy and the e1change rate so that the following e.uation is satisfied& "AC$>MN>, ? = D K E. B. Assuming that we are dealing with only the short run, what are the values of > and >M?

Answer& > K >9, >M K >M9, !oth constants. ". Given fi1ed > and >M, what would happen if $ rises? Answer& An increase in $ ma-es domestic goods cheaper, thus improving the current account. #. Given > and >M, what would happen if fiscal policy? decreases, i.e., an e1pansionary

Answer& A fall in raises output, ?. he resulting increase in output increases disposa!le income and thus leads to increased home spending on foreign goods, worsening the current account. $. Given > and >M, what would happen if G increases, i.e., an e1pansionary fiscal policy? Answer& *imilar to the answer a!ove. A rise in G causes "A to fall !y increasing ?. B. Given all of the a!ove, what is the relation !etween the e1change rate, $, and fiscal ease, i.e., an increase in G or a reduction in ? Answer& >ositive relationship. G. Assume that the economy is in e1ternal !alance. 3hat will happen if the government maintains its current account at E, !ut devaluates the domestic currency? Answer& he government raises $I thus, either G should go up or maintain the e1ternal !alance. should go down to

F. Assume that the economy is at e1ternal !alance. 3hat will happen if the government raises $?

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Answer& An increase in $ raises net e1ports and thus leads to a surplus in the current account higher than the target level of E. his will represent a point a!ove the EE schedule. 4. Assume that the economy is at e1ternal !alance. 3hat will happen if the government lowers $? Answer& A decrease in $ reduces net e1ports and thus leads to a deficit in the current account lower than the target level of E. his will represent a point !elow the EE schedule.

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he following ta!le introduces the relationship !etween industrial production and wholesale price inde1 changes !etween the years 18'8 = 18,0. 3hat is the purpose of the following figure? >lease note that the num!ers should !e starting from the origin with 09 and 09 and increase !y ten units, each time. he num!ers 19, 11, 1' etc. should read 199, 119, 1'9 etc. he num!ers on the ?-a1is !est !e ignored and +ust note that every dash represents a ten !eginning from 09.

Answer& he purpose is to show that countries that left the gold standard early and adopted counter-deflationary monetary policies, such as Australia and the United Oingdom, e1perienced milder declines in output during the Great #epression. "ountries such as Brance and *wit;erland that stuc- to the gold standard longer had greater decline in price level and output. A !etter figure is given on page 0/5 of the te1t!oo-.

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Use the figure !elow to descri!e the four ;ones of economic discomfort. EE C"A K ED Pone 1

$1change <ate, $ Pone ' Pone /

Pone ,

44 C ? K ?fD

Biscal ease CG or QD Answer& he answer is given in the following figure.

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Using the 44 = EE framewor-, show using a figure that fiscal policies !y themselves cannot !ring the economy to !oth internal and e1ternal !alances.

Answer& *tarting at point ', fiscal policy is shown as only hori;ontal movements. his means that the economy can reach either point , Cinternal !alanceD or point / Ce1ternal !alanceD in the figure, !ut not !oth internal and e1ternal !alances. Anly a devaluation of the currency accompanied with an increase in fiscal ease, namely increasing government e1penditures or decreasing ta1es, will move the economy to !oth internal and e1ternal !alances at point 1 in the figure.

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5.

Use the 44 = EE framewor- in order to show graphically how inflation can !e imported from a!road unless e1change rates are ad+usted.

Answer& *uppose that the home economy is faced with foreign inflation, i.e., >M is rising. Bor a given price level at home, i.e., > fi1ed, the increase in >M will lower $, such that $>MN> is unchanged. his implies that the 44 and EE curves will shift downward in such a way that the distance !etween the original $ and the final $ will !e e.ual to $ R>MN>M, i.e., revaluation of the currency.

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