EXERCISE 6 

1. The assurance of international payments is one of the leading advantages of a 

fixed exchange rate regime. 
a. TRUE,  certainty  is  one  of  the  advantages  of  a  fixed  exchange  rate  regime 
since  the  price  of  currency  remains  constant.  This  makes  businesses  in 
the  country  more  attractive  to  foreign  direct  investors.  This  certainty  also 
lowers  transaction  costs  because  they  don’t  have  to  buy  insurance  in  the 
market of foreign currency which increases transactions as well.  
 
2. In a flexible exchange rate regime, if the economy is experiencing inflationary 
pressure, contractionary economic policies can lead to BOP surplus. 
a. *understand the graph* 
b. FALSE,​ a contractionary policy would only lead to the appreciation of the 
currency. This would weaken exports and increase imports which would 
not lead to a BOP surplus. 
 
3. There is a need for huge reserves in addressing BOP imbalances under a 
flexible exchange rate regime. 
a. FALSE,​ reserves are kept to serve as a contingency in case there isn’t 
enough money in circulation. Countries do not need huge reserves to 
address a BOP imbalance because a change in the exchange rate or 
monetary policy can be implemented. 
b. A BOP deficit could be solved by a depreciation of the currency or a 
decrease in the money supply. 
c. A BOP surplus could be solved by an appreciation of the currency or an 
increase in the money supply. 
d. Huge reserves are only needed under a fixed exchange rate regime since 
under a flexible exchange rate regime.  
 
4. In a flexible exchange rate regime and perfect capital mobility, an expansionary 
monetary policy can increase national income. 
a. TRUE,​ Expansionary monetary policy increases the money supply which 
would lower the domestic interest rate. A lower domestic interest rate 
would make holding foreign assets more attractive leading to capital 
outflows. Since the demand for foreign currency would increase, the price 
of foreign currency would be more expensive causing a depreciation in 
domestic currency.  
 b. Since there would be a depreciation in domestic currency, the price of 
exports would be cheaper in the international market and exports would 
increase which would increase national income. 
 
5. There is a need for wider trade among countries in a monetary union to reap the 
benefits of an optimal currency area.  
a. TRUE,​ the theory of the optimal currency area is from Robert Mundell. 
b. Basically, an optimal currency area is the geographic area in which having 
a single currency would create the greatest economic benefit. An optimal 
currency area would also mean that the pricing of products and services 
are in one currency so to reap the benefits, there should be a wider trade 
among countries so that citizens can buy products and services from a 
country with lower prices. 
  
6. In the gold standard system, a BOP deficit is addressed by the outflows of gold 
into the country. 
a. FALSE​, in a Gold Standard system, the money of countries can be 
exchanged for gold and there is no limit in the entry and exit of gold, 
making gold a standard for international transactions of private 
companies. Therefore, if there is a BOP deficit, it should be addressed by 
an inflow of gold in the country so that increases its reserves to supply the 
deficit. 
 
7. The demise of the gold reserve standard was caused by the desire of countries 
to hold more foreign currencies as reserves. 
a. FALSE,​ the demise of the gold reserve standard was due to the fact that 
there are limitations to producing gold to supply expanding international 
trade. This is why the gold exchange standard addressed the limitations of 
the gold standard system by including not just gold but also foreign 
currency that may be exchanged with gold to their reserves. 
 
8. Under the Bretton Woods system, the seigniorage enjoyed by the US with the US 
dollar in international transactions led to the huge BOP surplus of the US. 
a. Seigniorage - the difference between the value of money and the cost to 
produce it or the profit made by the government by issuing currency. 
b. One of the benefits the US enjoyed due to seigniorage included a weak 
BOP deficit. Eventually though, the Bretton Woods system led to a huge 
BOP deficit since one of the effects of the seigniorage of the US was the 
collection of dollar reserves of countries. Since the dollar can be traded 
 with gold, countries which had collected many dollar reserves were forced 
to trade their dollar reserves for gold which led to the devaluation of the 
dollar relative to gold to st 
c. In the Bretton Woods system, the dollar reserves can be exchanged for 
gold, and because of this, the countries were forced to trade their dollar 
reserves for gold to stop the devaluation of dollar relative to gold. The 
desire of people to hold gold rather than the dollar reserves caused United 
States to have a huge BOP deficit rather than a surplus. 
d. The reason it fell apart was because the supply of international dollars was 
growing faster than the supply of gold. This happened because of US trade 
deficits, but also because they lent dollars into existence to foreign nations 
to finance development. But as the supply of dollars started to get much 
larger than the stock of gold that the US held, it started to put pressure on 
the dollar exchange rate with gold. When countries started demanding 
payments in gold instead of dollars, Nixon chose to end convertibility into 
gold. This ended the Bretton-Woods system, and began the era of floating 
exchange rates. 
 
9. The creation of euro by the European Monetary Union further strengthens the 
seigniorage enjoyed by the United States. 
a. FALSE,​ during the Bretton Woods System, currencies were based on the 
value of the dollar which expanded: 
i. dollar reserves 
ii. the market for dollars,  
iii. and the US funds. 
Because it was the major currency in trade and movement of capital 
around the world, the United States enjoyed the benefits of seigniorage. 
Following the fall of the Bretton Woods system, the creation of the euro 
would potentially challenge the dollar as the major currency, by lessening 
borrowing from the IMF and widening its currency. This would ​weaken 
United States’ seigniorage as the euro area would lessen its hold of dollars 
which would lessen the United States’ funds and profits from currency 
creation. 
 
10. There is a need for macroeconomic policy coordination among countries 
since expansionary fiscal policy can lead to disequilibrium in the BOP. 
a. TRUE,​ Expansionary fiscal policy involves higher government spending or 
lowered taxes. This increases aggregate demand which would result to 
inflation. Inflation decreases exports which would lead to disequilibrium in 
the BOP which is why there is a need for macroeconomic policy 
coordination among countries for stability.