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Chapter 13 – Automatic Adjustment Under Flexible and Fixed Exchange Rates (Answers at end) 1. A depreciation of the US dollar makes US products __________________ for European residents, because European residents need _______ euros to purchase each dollar. a. cheaper, more b. cheaper, fewer c. more expensive, more d. more expensive, fewer 2. The more elastic is a nation's demand and supply of foreign exchange the: a. larger is the depreciation required to correct a deficit of a given size in the nation's balance of payments *b. smaller is the depreciation required to correct a deficit of a given size in the nation's balance of payments c. less feasible is a flexible exchange rate system d. none of the above 3. A nation's demand curve for foreign exchange is derived from the: a. foreign demand curve for the nations' exports b. nation's supply curve of exports *c. demand and supply curves for the nation’s imports in terms of the foreign currency d. demand and supply curves for the nations’ exports in terms of the foreign currency 4. The price elasticity of the US demand for imports in euros is given by: a. the percentage change in the quantity demanded of imports by US consumers divided by the percentage change in the quantity demanded of US exports by European consumers b. *the percentage change in the quantity demanded of imports by US consumers divided by the percentage change in the price of the US imports in euros c. the percentage change in the quantity demanded of US exports by European consumers divided by the percentage change in the quantity demanded of imports by US consumers d. the percentage change in the price of European exports divided by the percentage change in the price of the US imports in euros. 5. The price elasticity of the US demand for imports and the price elasticity of the foreign demand for US exports in euros have what type of relationship? a. positive b. *negative c. constant d. there is no relationship 6. If the US currency pass-through is 60 percent, what will occur as a result of a 15 percent depreciation in the value of the dollar? a. import prices fall by 9 percent b. import prices fall by 15 percent c. *import prices rise by 9 percent d. import prices rise by 15 percent 7. The US demand for euros is always___________. a. *negatively sloped b. positively sloped c. perfectly elastic d. perfectly inelastic 8. The US supply curve may be vertical or negatively sloped if the foreign demand for US exports in terms of euros is sufficiently __________. a. elastic b. *inelastic c. unit elastic d. none of the above 9. When a(n) ___________________ condition is present, a disturbance from the equilibrium exchange rate gives rise to automatic forces that push the exchange rate back toward the equilibrium rate. a. unstable foreign exchange market b. Marshall-Lerner condition c. J-curve effect d. *stable foreign exchange market 10. When a(n) _____________condition is present, a disturbance from the equilibrium exchange rate pushes the exchange rate farther away from equilibrium. a. *unstable foreign exchange market b. Marshall-Lerner condition c. J-curve effect d. stable foreign exchange market 11. The foreign exchange market is stable when: The demand curve of foreign exchange is negatively inclined and the supply curve of a. foreign exchange is positively inclined b. the supply curve of foreign exchange is negatively inclined and less elastic than the demand curve c. the sum of the absolute values of the elasticity of the nation's demand of imports and the foreign demand for the nation's exports is greater than one *d. all of the above 12. The _______________states that the foreign exchange market is stable when the sum of the price elasticities of demands for imports and exports is greater than one. a. J-curve effect b. Pass-through condition c. *Marshall-Lerner condition d. Stable market theory 13. The ________________ explains why it may take up to two years for a currency depreciation to make significant reductions in a nation’s trade deficit. a. *J-curve effect b. Pass-through c. Marshall-Lerner condition d. Multiplier effect 14. In a stable foreign exchange market, a nation can correct a deficit in its balance of payments by allowing its currency to __________. a. appreciate b. *depreciate c. remain constant d. none of the above 15. In an unstable foreign exchange market, a nation with a deficit in its balance of payments will find that depreciation of its currency will __________. a. eliminate the deficit b. *cause the deficit to get larger c. not effect the deficit d. any of the above answers 16. The ________________ operated from about 1880 until the outbreak of World War I in 1914. a. *gold standard b. silver standard c. stable foreign exchange market d. Marshall-Lerner condition 17. Under the gold standard: a. each nations defines the price of gold in terms of its currency and then stands ready to buy and sell any amount of gold at that price b. there is a fixed relationship between any two currencies called the mint parity c. the exchange rate is determined by demand and supply between the gold points and is prevented from moving outside the gold points by gold shipments *d. all of the above 18._____________ represents the fixed exchange rates defined by the gold content of each nation’s currency. a. Purchaing power parity b. Pass through c. *Mint parity d. Price-specie-flow 19. Suppose a £1 gold coin in the UK contained 115 grains of pure gold, while a $1 gold coin in the US contained 25 grains. What is the mint parity exchange rate between pounds and dollars? a. £4.87 per dollar b. *$4.87 per pound c. $.22 per pound d. £0.22 per dollar 20. Assume ₣1 (French franc) gold coin in France contains 445.824 grains of pure gold, while the $1 gold coin in the US contains 23.22 grains. If the cost of shipping ₣1 from Paris to New York was 4 cents, the gold export point of the French franc is _____, and the gold import point is ________. a. $103.56, $103.48 b. *$19.24, $19.16 c. $19.16, $19.24 d. Cannot be determined from information given 21. The ________________ served as the automatic adjustment mechanism under the gold standard exchange system. a. mint parity b. gold import point c. *price-specie-flow mechanism d. purchasing power parity model 22. In a closed economy without a government sector, the equilibrium level of income is found where income is equal to___________________. a. planned consumption expenditures divided by planned business investment b. the ratio of planned business investment to planned consumption expenditures c. planned consumption expenditures plus planned business investment plus planned net exports d. *planned consumption expenditures plus planned business investment. 23. If for every one dollar increase in income, savings increases by 25 cents, the marginal propensity to save is _________ and the closed economy multiplier is ______. a.*.25, 4 b..75, 4 c. .25, .04 d. .75, 1.333 24. The increase in imports induced per dollar increase in income is called the________________. a. import elasticity of demand b. *marginal propensity to import c. income elasticity of imports d. none of the above 25. The equilibrium level of income in an open economy is where: a. Savings + Investment = Imports + Exports b. Consumption + Savings = Imports + Exports c. Savings + Exports = Investment + Imports d. *Savings + imports = Investment + Exports 26. The ratio of the change in income to the change in exports and/or investments is: a. the multiplier b. *the foreign trade multiplier c. equilibrium level of income d. the marginal propensity to save 27. If MPS=0.2 and MPM=0.3, the foreign trade multiplier is: a. 5 b. 3.3 c. 3 *d. 2 28. The S-I function rises because: a. rising I are subtracted from constant S *b. constant I are subtracted from rising S c. rising I are subtracted from rising S d. constant I are added to falling S Figure 13.2. Australian Economy Under a System of Fixed Exchange Rates 29. Refer to Figure 13.2. The slope of the (X – M) schedule and (S – I) schedule indicates that Australia’s foreign trade multiplier is: a. 0.5 b. 1.0 c. 1.5 d. 2.0 30. Refer to Figure 13.2. Starting at equilibrium income $50 billion, where (S – I)0 intersects (X – M)0, suppose that improving economic conditions abroad lead to an autonomous increase in Australian exports of $5 billion. Australian income thus ________, which leads to Australia’s trade account moving to a ________. a. Rises to $60 billion, surplus of $2.5 billion b. Rises to $60 billion, surplus of $5 billion c. Falls to $40 billion, deficit of $2.5 billion d. Falls to $40 billion, deficit of $5 billion 31 Refer to Figure 13.2. Starting at equilibrium income $50 billion, where (S – I)0 intersects (X – M)0, suppose that worsening profit expectations lead to an autonomous decrease in Australian investment of $5 billion. Australian income thus ________, which leads to Australia’s trade account moving to a ________. a. Rises to $60 billion, deficit of $2.5 billion b. Rises to $60 billion, deficit of $5 billion c. Falls to $40 billion, surplus of $2.5 billion d. Falls to $40 billion, surplus of $5 billion 32. Refer to Figure 13.2. Starting at equilibrium income $50 billion, where (S – I)0 intersects (X – M)0, suppose that increased thriftiness leads to an autonomous increase in Australian saving of $5 billion. Australian income thus ________, which leads to Australia’s trade account moving to a ________. a. Rises to $60 billion, deficit of $2.5 billion b. Rises to $60 billion, deficit of $5 billion c. Falls to $40 billion, surplus of $2.5 billion d. Falls to $40 billion, surplus of $5 billion 33 Refer to Figure 13.2. Starting at equilibrium income $50 billion, where (S – I)0 intersects (X – M)0, suppose that changing preferences lead to an autonomous decrease in Australian imports of $5 billion. Australian income thus ________, which leads to Australia’s trade account moving to a ________. a. Rises to $60 billion, surplus of $2.5 billion b. Rises to $60 billion, surplus of $5 billion c. Falls to $40 billion, deficit of $2.5 billion d. Falls to $40 billion, deficit of $5 billion 34. An autonomous fall in M from a condition of equilibrium in national income and in the trade balance results in the nation's income: a. rising and its trade balance turning to deficit b. falling and its trade balance turning into surplus *c. rising and its trade balance turning into surplus d. rising and the trade balance remaining in equilibrium 35. The improvement in a nation's balance of trade and payments resulting from a depreciation of its currency is: a. reinforced by the induced fall in imports *b. partly neutralized by the induced rise in imports c. partly neutralized by the induced fall in imports d. any of the above. 36. A benefit of automatic adjustment mechanisms is that they: a. avoid the possibility of policy mistakes b. avoid the time lags associated with adjustment policies c. begin to operate as soon as balance of payments disequilibria develop *d. all of the above 37__________ account(s) for the impact a change in a large nation’s income and trade has on the rest of the world and which the rest of the world in turn has on a nation. a. *Foreign repercussions b. Absorption c. The synthesis of automatic adjustments d. The foreign multiplier 38. According to the absorption approach (where B = Y – A, derived from Y = C + I + (X-M), where A = C + I, domestic absorption, and B =X - M, the trade balance), currency devaluation improves a nation’s trade balance if: a. Y increases and A increases b. Y decreases and A decreases c. Y increases and/or A decreases d. Y decreases and/or A increases 39. Assume the UK momentarily has a balance of payments deficit. Consider how the deficit is eliminated under flexible and fixed exchange rates. Under flexible exchange rates and stability, the UK currency will depreciate which eliminates the deficit, which has a(n) _________ effect on the economy. Under fixed exchange rates, there will be net UK outpayments to pay for the deficit, its money supply will contract, prices will fall, leading to an increase in UK exports and decrease in imports, which eliminates the deficit, with a(n) ___________ effect on the economy. a. expansionary; expansionary b. contractionary; contractionary c. expansionary; contractionary d. contractionary; expansionary Answers to Chapter 13 1. b To buy US goods, EU folks need to demand dollars by supplying Euros. Thus, a depreciation of the US dollar means dollar is cheaper for EU (EU needs fewer Euros to purchase each dollar), and thus US goods are cheaper for the EU in terms of Euros. 2. b. See Fig. 13.1. Compare equilibrium E (elastic S and D) to equilibrium E* (inelastic S and D). In former case, smaller depreciation of dollar, i.e., appreciation of Euro, needed for adjustment. 3. c. See last paragraph on p. 336. Intuition should be apparent -- to import a foreign good, must first demand the currency of the foreign country. 4. b. Standard definition of price elasticity of demand from Ec 201, here for imports. See p. 337. 5. b. This just follows from the law of demand, i.e., that demand curves are downward sloping. 6. c. With dollar depreciation, one dollar purchases fewer units of foreign exchange, i.e., takes more dollars to purchase a particular foreign good. But 60 percent of this decline (not 100 percent) is passed through in terms of the dollar price of US goods. Thus, a 15 percent depreciation in the dollar means that the dollar price of US imports rises (0.6)(15 %) = 9 %. 7. a. See all three graphs in Fig. 13.2. 8. b. See the middle and the right graphs in Fig. 13.2. This follows from the Marshall- Lerner condition, discussed below. 9. d. This is shown in the left and the middle graphs in Fig. 13.2. 10. a. This is shown in the right graph in Fig. 13.2. 11. d. Answer (a) is shown in the left graph in Fig. 13.2; answer (b) is shown in the middle graph in Fig. 13.2; and answer (c) is a statement of the Marshall-Lerner condition, discussed below. 12. c. The Marshall-Lerner condition is stated on p. 339. If the condition is satisfied, then foreign exchange markets will be stable; if it is not satisfied, then the market is unstable. Given the importance of the foreign exchange market in economics (the largest market in terms of value of transactions per time period), one would hope it is stable! If not, governments simply must fix exchange rates! 13. a. See Fig. 13.1, where the US has a balance of payments deficit in Euros. Appreciation of the Euro, i.e., depreciation of the dollar, will eliminate the problem, i.e., move the US to point E. But the J-Curve refers to the lag before the depreciation of a country's currency will improve its balance of payments position (see bottom of p. 339). The lag is because it takes time to order, ship, receive, and utilize goods, i.e., before the improvement in the balance of payments will occur. 14. b. See left and middle graphs of Fig. 13.2, beginning at 2.0 $/Euro. 15. b. See the right graph of Fig. 13.2, again beginning at 2.0 $/Euro. 16. a. 17. d. Nice question in that the three correct answers contain a lot of good info about Gold Standard, the first traditional fixed exchange rate system. 18. c. 19. d. [115 grains/pound]/[25 grains/$] = $4.6/pound, i.e., 0.22 pounds/dollar 20. b. [445.8 grains/F1]/[23.2 grains/$] = $19.20 is the mint parity fixed rate. With 4 cents the cost of shipping, the export point is $19.24 and the import point is $19.16. 21. c. 22. d See the top half of Fig. 13.4. 23. b. s = change in S/change in Y = $0.25/$1.0 = 0.25. Multiplier = k = 1/s = 4 24. b. 25. d. Equilibrium income is where total leakages (S+M) equals total injections (I+X); see p. 347. 26. b. This is simply the open economy analog to the closed economy multiplier from question 23. 27. d. k' = foreign trade multiplier = 1/(s+m) = 2. See p. 348. 28. b. I is assumed exogenous, i.e., independent of income. S increases as income increases. Thus, S-I increases as income increases. 29. d Note that X and I are viewed as exogenous, independent of income, here. Looking at the slope of X-M, you can see that when M increases by $5 billion, Y increases by $20 billion, implying that m = 0.25. The slope of S-I indicates that as S increase by $5 billion, Y again increases by $20 billion, implying that s = 0.25. Thus, the foreign trade multiplier k' = 1/(m+s) = 1/0.5 = 2.0. 30. a. Shift (X-M)o to the right to (X-M)1. Thus, the new income is $60 billion, with a surplus of $2.5 billion. 31. c. Investment goes down, so minus investment goes up. Thus, shift (S-I)o up to (S-I)2, so the new income is $40 billion, with a surplus of $2.5 billion. 32. c. Increase S by $5 billion; rest identical as question 31. 33. a. Imports go down, so minus imports go up. Thus shift (X-M) up by $5 billion, and income increases to $60 billion, with a surplus of $2.5 billion. 34. c. A fall in M means an increase in minus M, hence an increase in (X-M). Thus, income increases and there is a trade surplus. 35. b. With currency depreciation and assuming stability in the foreign exchange market, the increase in exports and decrease in imports both increase domestic income. But the secondary effect is that the increase in domestic income increases imports some, so that more depreciation is necessary to bring about a given trade improvement. 36. d. All are true. 37. a. 38. c. Given that B = Y - A, an increase in B requires an increase in Y and/or a decrease in A, strictly from the equation. 39. c. Very important to understand all statements in the question as well as the correct answer!! This question summarizes international adjustment under flexible exchange rates and fixed exchange rates, and the impact on the domestic economy of the adjustment. Easy under flexible rates, as currency of the deficit country depreciates, which stimulates exports and reduces imports to eliminate the deficit (see Fig. 13.1), and given the improvement in the trade balance, income increases since Y = C+I+G+X-M, hence expansionary impact domestically. Under fixed rates, deficit means cash flowing out of economy to pay for the deficit, so money supply contracts, prices decline, which stimulates exports and reduces imports. Domestically, first impact and net impact is contraction, with money supply declining. And be able to repeat analysis for a country beginning with a balance of payments surplus instead of a deficit!!