National Income Accounting and the Balance of Payments PDF

Chapter 12: National Income Accounting and the Balance of Payments Multiple Choice Questions 3. 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....

Chapter 12: National Income Accounting and the Balance of Payments Multiple Choice Questions 3. 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 4. 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 are equal to national output accounts. E. None of the above. Answer: A 5. 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 equals gross national product. E. None of the above. Answer: A 6. The highest component of GNP is A. the current account. B. investment. C. government purchases. 147 D. consumption. E. None of the above. Answer: D 148 10. 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. None of the above. Answer: C 11. 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. None of the above. Answer: B 12. 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. Answers A and C are both correct. E. None of the above. Answer: B 13. 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 15. 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. None of the above. 149  Answer: A 16. 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. None of the above. Answer: D 18. 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. None of the above. Answer: C 20. 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. None of the above. Answer: B 21. 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. None of the above. Answer: A 22. Any goods 150  A. purchased by federal, state, or local governments are classified as government purchases. B. and services purchased only by federal government are classified as government purchases. C. and services purchased only by federal or state governments are classified as government purchases. D. and services purchased by federal, state, or local governments are classified as government purchases. E. None of the above. Answer: D 23. Government transfer payments such as 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. None of the above. Answer: B 151 26. 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. None of the above. Answer: A 27. 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. None of the above. Answer: A 28. 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) = -CA, (i.e., minus the CA). Answer: C 31. 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. None of the above. Answer: B 32. For open economies, A. S = I. B. S = I +CA. C. S = I – CA. D. S > I + CA. E. S < I + CA. Answer: B 152 33. 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. None of the above. Answer: D 34. 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. None of the above. Answer: B 36. 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 households and 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 37. Government savings, Sg, is equal to A. T – G. B. T + G. C. T = G. D. T + G – I. E. None of the above. Answer: A 38. In a closed economy, private saving, Sp, is equal to A. I - (G – T). B. I + (G – T). C. I + (G + T). D. I - (G + T). E. I + (G – T) + C. 153  Answer: B 39. In an open economy, private saving, Sp, is equal to 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 40. 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 receive better 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 lowing future taxes. E. None of the above. Answer: C 41. 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 154 42. 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. None of the above. Answer: B Essay Questions 1. 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. 2. What is the national income identity for a closed economy? Answer: Y = C + I + G. 3. What is the national income identity for an open economy? Answer: Y = C + I + G + EX – IM. 4. Discuss the values of private saving in closed and open economies. Answer: In a closed economy, private saving, Sp, is equal to I + (G – T). In an open economy, private saving, Sp, is equal to I + CA + (G - T). An open economy helps in extending the opportunities for private saving or dis-saving, or borrowing. 5. Discuss the effects of government deficits on the current account. Answer: See pages 306 – 307 A hard and difficult issue. During the Reagan administration, the creation of twin deficits, whereby slashing taxes, government deficits increased, which was accompanied with increased current account deficits. Using the identity CA = Private Saving - I - (G – T), one can see that if private savings and I are constants, an increase in the deficit, namely an increase in (G – T), necessarily increases the CA deficits by the same magnitude. 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 155 increase. This has never happened. The main reason was sharp reduction in private saving rates. A good answer should discuss Ricardian equivalence, which 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. 4. 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 that are recorded in the capital account. 7. “The balance of payments is always balanced.” 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 8. “The balance of payments accounts seldom 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 as reliable as data from the financial account. Moreover, accurate measurements of international interest and dividend receipts are particularly difficult. 9. What are the reasons for the world as a whole running a substantial current account deficit? Answer: (See pages 314 – 315.) This deficit increased sharply in the early 1980s and has remained high. The main reasons are statistical discrepancies of national accounts, timing factors, while the main factor is the systematic misreporting of international interest income flows. Since the world interest rates rose sharply after 1980, the size of the world interest payment discrepancy increased with them. In addition, much of the world’s merchant shipping fleet is registered in countries that do not report maritime freight earnings to the IMF, which collects these data. 156 Quantitative/Graphing Problems 5. Assume C = 40 + 0.8(Y – T) G = 10 I = 20 T = 0, where T are taxes. A. Calculate Y at equilibrium. Answer: Y=C+I+G Y = 350 B. Calculate C, I, and G at equilibrium. Answer: C = 40 + 0.8 Y = 320 I = 20 G = 10 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: Y = 269.1667 157 2. Fill in the following table: GNP Consumption Investment Government Exports Imports Investment Total Output Purchases Consumption 100 25 10 10 20 115 75 12 14 16 120 70 25 20 30 69 58 10 10 32 135 75 30 35 25 140 140 140 140 140 940 140 200 300 200 1150 600 300 200 150 1250 700 200 200 150 Answer GNP Consumption Investment Government Exports Imports Investment Total Output Purchases Consumption 100 75 25 10 10 20 115 75 30 12 14 16 120 70 25 35 20 30 69 58 10 10 23 32 135 75 30 35 25 30 420 140 140 140 140 140 940 500 140 200 300 200 1150 600 200 300 200 150 1250 700 200 300 200 150 158 3. What can you learn from the figure below, which depicts the US GNP and its components for the year 1997? Answer: The figure shows the US GNP and its components for the year 1997. The U.S. GNP is about 8 trillion, consumption represents about 6 trillion, etc. The current account is in a small deficit, smaller than the one from 2000 that the students see in the Sixth Edition. 159 4. What can one learn from the following figure? Answer: The figure shows the U.S. current account and net foreign wealth from 1977 until 1996. It shows that a string of current account deficits in the 1980s reduced America’s net foreign wealth until, by the end 1996, 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. 160 5. 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 billion dollar entry in the capital account. The associated credit is in the financial account, in the form of a two billion dollar reduction in U.S. assets held abroad, i.e., a net asset “export,” and therefore a positive balance of payments entry. 161 Chapter 13: Exchange Rates and the Foreign Exchange Market: An Asset Approach Multiple Choice Questions 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 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 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 4. The German currency is called the A. Euro B. DM C. Yen D. Dollar E. Pound Answer: A 164 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 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 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 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 165 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 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 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. None of the above. Answer: E 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. None of the above. Answer: D 166 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. None of the above. Answer: A 14. By early 2002, A. A Canadian dollar was worth only about 15 United States cents. B. A Canadian dollar was worth only about 20 United States cents. C. A Canadian dollar was worth only about 65 United States cents. D. A Canadian dollar was worth only about 100 United States cents. E. A Canadian dollar was worth only about 5 United States cents. Answer: C 15. The largest trading of foreign exchange occurs in A. New York. B. London. C. Tokyo. D. Frankfurt. E. Singapore. Answer: B 16. In 2001, 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. 90 percent of foreign exchange transactions involved exchanges of foreign currencies for U.S. dollars. Answer: E 167 17. Which one of the following statements is the most accurate? The term spot exchange rate is A. misleading because even spot exchanges usually become effective only three days after a deal is struck. B. misleading because even spot exchanges usually become effective only four days after a deal is struck. C. misleading because even spot exchanges usually become effective only five days after a deal is struck. D. misleading because even spot exchanges usually become effective only six days after a deal is struck. E. misleading because even spot exchanges usually become effective only two days after a deal is struck. Answer: E 18. Which one of the following statements is the most accurate? Trades of U.S. dollars for Canadian dollars in New York are executed with A. a one-day lag. B. a two-day lag. C. a three-day lag. D. a four-day lag. E. a zero-day lag. Answer: A 19. Forward and spot exchange rates A. are necessarily equal B. do not move closely together C. The forward exchange rate is always above the spot exchange rate. D. while not necessarily equal, do move closely together. E. None of the above. Answer: D 20. 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. None of the above. Answer: C 168 21. An American put option on foreign exchange A. gives the buyer the right to sell the foreign currency at a known exchange rate at any time during the period of the option. B. gives the seller the right to sell the foreign currency at a known exchange rate at any time during the period of the option. C. gives the buyer the right to sell the foreign currency at a known exchange rate at a specific time in the future. D. obligates the buyer to sell the foreign currency at a known exchange rate at any time during the period of the option. E. None of the above. Answer: A 22. An American call option on foreign exchange A. obligates you to buy foreign currency at a known price at any time during the period of the option. B. gives you the right to buy foreign currency at a known price at any time during the period of the option. C. gives you the right to buy foreign currency at a known price at a specific day in the future. D. gives you the right to sell foreign currency at a known price at any time during the period of the option. E. None of the above. Answer: B 23. The exchange rate between currencies depends on A. the interest rate that can be earned on deposits of those currencies. B. the expected future exchange rate. C. the interest rate that can be earned on deposits of those currencies and the expected future exchange rate. D. national output. E. None of the above. Answer: B 24. Which one of the following statements is the most accurate? Countries in the euro zone include A. Austria, Australia, and Belgium. B. Austria, Belgium, and Finland. C. Austria and Finland. D. Austria, Belgium, Finland, and France. E. Austria, Belgium, Finland, France, and Germany. Answer: E 169 25. Which one of the following statements is the most accurate? A. Because dollar and DM interest rates are measured in comparable terms, they can move quite differently over time. B. Because dollar and DM interest rates are not measured in comparable terms, they can move quite differently over time. C. Because dollar and DM interest rates are measured in comparable terms, they move quite the same over time. D. Because dollar and DM interest rates are measured in comparable terms, they still move quite differently over time. E. None of the above. Answer: B 26. Which one of the following statements is the most accurate? Countries in the euro zone include A. Austria, Belgium, Finland, France, and Germany. B. Austria, Belgium, Finland, France, Germany, and Greece. C. Austria, Belgium, Finland, France, Germany, and Ireland. D. Austria, Belgium, Finland, France, Germany, and Italy. E. All of the above statements are correct. Answer: E 27. Which one of the following statements is the most accurate? Countries in the euro zone include A. Austria, Belgium, Finland, France, Germany, and Greece. B. Austria, Belgium, Finland, France, Germany, and Luxembourg. C. Austria, Belgium, Finland, France, Germany, Portugal, and Ireland. D. Austria, Belgium, Finland, France, Germany, Spain, and Italy. E. All of the above statements are correct. Answer: E 28. Which one of the following statements is the most accurate? Countries in the euro zone include A. Austria, Belgium, Finland, France, Germany, Greece, Luxemburg, and Ireland. B. Austria, Belgium, Finland, France, Germany, Luxembourg, Portugal, and Poland. C. Austria, Belgium, Finland, France, Germany, Portugal, Ireland, and the Czeck Republic. D. Austria, Belgium, Finland, France, Germany, Spain, Italy, and Ukraine. E. All of the above statements are correct. Answer: A 170 29. Which one of the following statements is the most accurate? A. The dollar rate of return on euro deposits is the euro interest rate plus the rate of depreciation of the dollar against the euro. B. The dollar rate of return on euro deposits is approximately the euro interest rate minus the rate of depreciation of the dollar against the euro. C. The dollar rate of return on euro deposits is the euro interest rate minus the rate of depreciation of the dollar against the euro. D. The dollar rate of return on euro deposits is approximately the euro interest rate plus the rate of appreciation of the dollar against the euro. E. The dollar rate of return on euro deposits is approximately the euro interest rate plus the rate of depreciation of the dollar against the euro. Answer: E 30. 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. B. an investor should invest only in euros. C. an investor should be indifferent between dollars and euros. D. it is impossible to tell given the information. E. All of the above. Answer: D 31. If the dollar interest rate is 10 percent, the euro interest rate is 6 percent, and the expected return on dollar depreciation against the euro is zero 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. It is impossible to tell given the information. E. All of the above. Answer: A 32. If the dollar interest rate is 10 percent, the euro interest rate is 6 percent, and the expected return on dollar depreciation against the euro is 4 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. It is impossible to tell given the information. E. All of the above. Answer: C 171 33. If the dollar interest rate is 10 percent and the euro interest rate is 6 percent, and the expected return on dollar depreciation against the euro is 8 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. It is impossible to tell given the information. E. All of the above. Answer: B 34. If the dollar interest rate is 10 percent, the euro interest rate is 12 percent, and the expected return on dollar depreciation against the euro is negative 4 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. It is impossible to tell given the information. E. All of the above. Answer: A 35. Which 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. None of the above. Answer: D 36. Which of the following statements is the most accurate? A. For a given U.S. interest rate and a given expectation with regard to the future exchange rate, a rise in the interest rate paid by euro deposits causes the dollar to depreciate. B. For a given U.S. interest rate and a given expectation with regard to the future exchange rate, a rise in the interest rate paid by euro deposits causes the dollar to appreciate. C. A rise in the interest rate paid by euro deposits does not affect the value of the dollar. D. A rise in the interest rate paid by euro deposits causes the dollar to depreciate. E. None of the above. 172  Answer: A 37. 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 euros it is 4 percent. What is the rate of return on a covered euro deposit? A. 0.10 B. 0.101 C. 0.102 D. 0.103 E. 0.104 Answer: D 38. 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 euros it is 4 percent. Under these assumptions, A. covered interest parity does hold. B. covered interest parity does not hold. C. It is hard to tell whether covered interest parity does or does not hold. D. Not enough information is given to answer the question. E. None of the above. Answer: B 173 Essay Questions 1. In the year 2000, Americans flocked to Paris. What economic forces made French goods appear so cheap to residents of the United States? Answer: One major factor was a sharp fall in the dollar price of France’s currency. 2. Who are the major participants in the foreign exchange market? Answer: 1. Commercial banks 2. Corporations 3. Nonblank financial institutions 4. Central banks 3. Based on the case study, “A Tale of Two Dollars,” explain why errors in the currency market can be more costly to the Toronto Blue Jays baseball team than errors in the field. Answer: See page 329. The Toronto team has 80 percent of its revenue paid in Canadian dollars and 80 percent of its expenses set in U.S. dollars. Since the Canadian dollar has depreciated substantially, it causes big losses for the team by raising its expenses relative to its receipts. To protect itself from the vagaries of the exchange rate, the team tries to predict its need for U.S. dollars ahead of time so that it can sell Canadian dollars and purchase the American currency in advance to lock in the exchange rate. Errors in the currency market can thus be more costly to the team than on the field. 4. Explain what a “vehicle currency” is. 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 2001, ninety percent of foreign exchange transactions involve exchanges of foreign currencies for U.S. dollars; therefore, the dollar is considered a vehicle currency. 5. 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. 174 6. 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 + (Ee$/E – E$/E) / E$/E. 7. Discusses the effects of a rise in the dollar interest rate on the exchanger rate. Answer: 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. 175 8. Discusses the effects of a rise in the interest rate paid by euro deposits on the exchanger rate. Answer: For a given U.S. interest rate and a given expectation with regard to the future exchange rate, a rise in the interest rate paid by euro deposits causes the dollar to depreciate. 176 9. Explain the purpose of the following figure. Show the effects of German unification on Germany’s interest rate. Answer: The main purpose is to show that different interest rates exist for different assets since foreign currencies are different assets. From 1990 to 1995, the DM interest rate is higher than that of the United States. Excluding this period, the dollar rates are higher reflecting higher inflation in the United States and depreciating of the dollar versus the German currency. 177 10. Explain the purpose of the following figure. Answer: To show that spot and forward exchange rates are in general close to each other. 178 Quantitative/Graphing Problems 1. Compute how many dollars it would cost to buy an Edinburgh Woolen Mill sweater costing 50 British pounds for the following exchange rates: Exchange Rate Price of a sweater in British pounds Price in dollars Number of dollars per one British pound 1 50 1.1 50 1.2 50 1.25 50 1.3 50 1.4 50 1.5 50 1.6 50 1.7 50 1.75 50 1.8 50 1.9 50 2 50 Answer: Exchange Rate Price of a sweater in British pounds Price in dollars Number of dollars per one British pound 1 50 $ 50.00 1.1 50 $ 55.00 1.2 50 $ 60.00 1.25 50 $ 62.50 1.3 50 $ 65.00 1.4 50 $ 70.00 1.5 50 $ 75.00 1.6 50 $ 80.00 1.7 50 $ 85.00 1.75 50 $ 87.50 1.8 50 $ 90.00 1.9 50 $ 95.00 2 50 $ 100.00 179 2. Compute how many British pounds it would cost to buy a pair of American designer jeans costing $45: Price of a pair of American designer Exchange Rate jeans Price in British pounds Number of dollars per one British pound 1 45 1.1 45 1.2 45 1.25 45 1.3 45 1.4 45 1.5 45 1.6 45 1.7 45 1.75 45 1.8 45 1.9 45 2 45 Answer: Price of a pair of American designer Exchange Rate jeans Price in British pounds Number of dollars per one British pound 1 45 45 1.1 45 40.90909091 1.2 45 37.5 1.25 45 36 1.3 45 34.61538462 1.4 45 32.14285714 1.5 45 30 1.6 45 28.125 1.7 45 26.47058824 1.75 45 25.71428571 1.8 45 25 1.9 45 23.68421053 2 45 22.5 180 3. Find the exchange rate between the dollar and the British pound for the following cases: Price of a pair of American designer jeans Price in British pounds Exchange Rate Number of dollars per one British pound 45 10 45 20 45 30 45 40 45 50 45 60 45 70 45 80 45 90 45 100 45 110 45 120 45 130 45 140 Answer: Price of a pair of American designer jeans Price in British pounds Exchange Rate Number of dollars per one British pound 45 10 4.5 45 20 2.25 45 30 1.5 45 40 1.125 45 50 0.9 45 60 0.75 45 70 0.642857143 45 80 0.5625 45 90 0.5 45 100 0.45 45 110 0.409090909 45 120 0.375 45 130 0.346153846 45 140 0.321428571 181 4. For the following 15 cases, compare the dollar rates of return on dollar and euro deposits: Rate of Return Difference Expected between Rate of Dollar and Dollar Euro Dollar Euro Interest Interest Depreciation Deposits Case Rate, R$ Rate, RE against Euro 1 0.1 0.06 0 2 0.1 0.06 0.04 3 0.1 0.06 0.08 4 0.1 0.12 -0.04 5 0.1 0.18 0 6 0.15 0.06 0 7 0.15 0.06 0.04 8 0.15 0.06 0.08 9 0.15 0.12 -0.04 10 0.15 0.18 0 11 0.2 0.06 0 12 0.2 0.06 0.04 13 0.2 0.06 0.08 14 0.2 0.12 -0.04 15 0.2 0.18 0 Answer: Rate of Return Difference Expected between Rate of Dollar and Dollar Euro Dollar Euro Interest Interest Depreciation Deposits Case Rate, R$ Rate, RE against Euro 1 0.1 0.06 0 0.04 2 0.1 0.06 0.04 0 3 0.1 0.06 0.08 -0.04 4 0.1 0.12 -0.04 0.02 5 0.1 0.18 0 -0.08 6 0.15 0.06 0 0.09 7 0.15 0.06 0.04 0.05 8 0.15 0.06 0.08 0.01 9 0.15 0.12 -0.04 0.07 10 0.15 0.18 0 -0.03 11 0.2 0.06 0 0.14 12 0.2 0.06 0.04 0.1 13 0.2 0.06 0.08 0.06 14 0.2 0.12 -0.04 0.12 15 0.2 0.18 0 0.02 182 5. For the table below, calculate the EXACT relationship. Expected Rate of Rate of Return Dollar Difference Depreciation between against Euro Dollar and Euro Exact Case R$ RE E Deposits formula 1 0.1 0.06 0 0.04 2 0.1 0.06 0.04 0 3 0.1 0.06 0.08 -0.04 4 0.1 0.12 -0.04 0.02 5 0.1 0.18 0 -0.08 6 0.15 0.06 0 0.09 7 0.15 0.06 0.04 0.05 8 0.15 0.06 0.08 0.01 9 0.15 0.12 -0.04 0.07 10 0.15 0.18 0 -0.03 11 0.2 0.06 0 0.14 12 0.2 0.06 0.04 0.1 13 0.2 0.06 0.08 0.06 14 0.2 0.12 -0.04 0.12 15 0.2 0.18 0 0.02 Answer: Expected Rate of Rate of Return Dollar Difference Depreciation between against Euro Dollar and Euro Exact Case R$ RE E Deposits formula 1 0.1 0.06 0 0.04 0.04 2 0.1 0.06 0.04 0 -0.0024 3 0.1 0.06 0.08 -0.04 -0.0448 4 0.1 0.12 -0.04 0.02 0.0248 5 0.1 0.18 0 -0.08 -0.08 6 0.15 0.06 0 0.09 0.09 7 0.15 0.06 0.04 0.05 0.0476 8 0.15 0.06 0.08 0.01 0.0052 9 0.15 0.12 -0.04 0.07 0.0748 10 0.15 0.18 0 -0.03 -0.03 11 0.2 0.06 0 0.14 0.14 12 0.2 0.06 0.04 0.1 0.0976 13 0.2 0.06 0.08 0.06 0.0552 14 0.2 0.12 -0.04 0.12 0.1248 15 0.2 0.18 0 0.02 0.02 183 6. Calculate the interest rate in the United States, if interest parity condition holds, for the following 15 cases: Expected Rate of Dollar Depreciation against Euro Case RE E R$ 1 0.06 0 2 0.06 0.04 3 0.06 0.08 4 0.12 -0.04 5 0.18 0 6 0.06 0 7 0.06 0.04 8 0.06 0.08 9 0.12 -0.04 10 0.18 0 11 0.06 0 12 0.06 0.04 13 0.06 0.08 14 0.12 -0.04 15 0.18 0 Answer: Expected Rate of Dollar Depreciation against Euro Case RE E R$ 1 0.06 0 0.06 2 0.06 0.04 0.1 3 0.06 0.08 0.14 4 0.12 -0.04 0.08 5 0.18 0 0.18 6 0.06 0 0.06 7 0.06 0.04 0.1 8 0.06 0.08 0.14 9 0.12 -0.04 0.08 10 0.18 0 0.18 11 0.06 0 0.06 12 0.06 0.04 0.1 13 0.06 0.08 0.14 14 0.12 -0.04 0.08 15 0.18 0 0.18 184 7. Calculate the interest rate in the euro zone if interest parity condition holds, for the following 15 cases: Expected Rate of Dollar Depreciation against Euro Case RE E R$ 1 0 0.06 2 0.04 0.11 3 0.08 0.16 4 -0.04 0.05 5 0 0.1 6 0 0.11 7 0.04 0.16 8 0.08 0.21 9 -0.04 0.1 10 0 0.15 11 0 0.16 12 0.04 0.21 13 0.08 0.26 14 -0.04 0.15 15 0 0.2 Answer: Case RE E R$ 1 0.06 0 0.06 2 0.07 0.04 0.11 3 0.08 0.08 0.16 4 0.09 -0.04 0.05 5 0.1 0 0.1 6 0.11 0 0.11 7 0.12 0.04 0.16 8 0.13 0.08 0.21 9 0.14 -0.04 0.1 10 0.15 0 0.15 11 0.16 0 0.16 12 0.17 0.04 0.21 13 0.18 0.08 0.26 14 0.19 -0.04 0.15 15 0.2 0 0.2 185 8. 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: Expected Dollar Depreciation Today’s Interest Rate Expected Dollar Dollar/Euro Rate on Against Return on Euro Exchange Euro Euro Deposits Case Rate Deposits (1.05 - E)/E Re + (1.05 - E)/E 1 1.07 2 1.06 3 1.05 4 1.04 5 1.03 6 1.02 7 1.01 8 1 9 0.99 10 0.98 Answer: Expected Dollar Depreciation Today’s Interest Rate Expected Dollar Dollar/Euro Rate on Against Return on Euro Exchange Euro Euro Deposits Case Rate Deposits (1.05 - E)/E Re + (1.05 - E)/E 1 1.07 0.05 -0.0186916 0.031308411 2 1.06 0.05 -0.009434 0.040566038 3 1.05 0.05 0 0.05 4 1.04 0.05 0.0096154 0.059615385 5 1.03 0.05 0.0194175 0.069417476 6 1.02 0.05 0.0294118 0.079411765 7 1.01 0.05 0.039604 0.08960396 8 1 0.05 0.05 0.1 9 0.99 0.05 0.0606061 0.110606061 10 0.98 0.05 0.0714286 0.121428571 186 9. For the data in Question 8, plot today’s dollar/euro exchange rate against the expected dollar return on euro deposits. Answer: 1.08 1.06 1.04 1.02 1 0.98 0.96 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 10. Using the data from Question 8 and the plot in Question 9, show that if the interest rate in the United States is 10 percent, the exchange rate will be 1, and if the interest rate in the United States is 12 percent, the exchange rate will be 0.98 dollars per euro. Answer: Points 1 and 2 in the figure below correspond to these two equilibrium points. 1.08 1.06 1.04 1.02 1 1 2 0.98 0.96 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 187 11. 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. Today’s Dollar/Euro Exchange Forward Rate Exchange Rate E$/E F$/E 1 1.05 1.1 1.2 1.3 Answer: Using the covered interest rate parity will yield the second column in the table: F$/E = (R$ - RE) E$/E + E$/E Today’s Dollar/Euro Exchange Forward Rate Exchange Rate E$/E F$/E 1 1.05 1.05 1.1025 1.1 1.155 1.2 1.26 1.3 1.365 188 Chapter 14: Money, Interest Rates, and Exchange Rates Multiple Choice Questions 1. The exchange rate between currencies depends on A. the interest rate that can be earned on deposits of those currencies. B. the expected future exchange rate. C. the interest rate that can be earned on deposits of those currencies and the expected future exchange rate. D. national output. E. None of the above. Answer: B 2. Money serves as A. a medium of exchange. B. a unit of account. C. a store of value. D. All of the above. E. Only A and B Answer: D 3. Money includes A. currency. B. bank deposits on which check may be written. C. both A and B. D. travelers’ checks. E. A, B and D. Answer: E 4. In the United States at the end of 2000, the total money supply, M1, amounted to approximately A. 10 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 189 5. 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. All of the above. E. Only A and B. Answer: D 6. The family summer house on Cape Code pays a return in the form of A. interest rate. B. capital gains. C. the pleasure of vacations at the beach. D. A, B and C. E. B and C only. Answer: E 7. In a world with money and bonds only, A. it is risky to hold money. B. it is not risky to hold money. C. risk does affect the demand for money. D. there is no relationship between risk and holding money. E. None of the above. Answer: A 8. 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 nominal money to rise. E. A rise in the average value of transactions carried out by a household or a firm causes its demand for real money to rise. Answer: E 190 9. The aggregate money demand depends on A. the interest rate. B. the price level. C. real national income. D. All of the above. E. Only A and C. Answer: D 10. 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. None of the above. Answer: D 11. 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 191 12. A rise in A. real GNP decreases aggregate real money demand for a given interest rate, moving the L(R,Y) schedule to the right. B. real GNP raises aggregate real money demand for a given interest rate, moving the L(R,Y) schedule to the left. C. real GNP raises aggregate real money demand for a given interest rate, moving the L(R,Y) schedule to the right. D. nominal GNP raises aggregate real money demand for a given interest rate, moving the L(R,Y) schedule to the right. E. real GNP raises aggregate nominal money demand for a given interest rate, moving the L(R,Y) schedule to the right. Answer: C 13. The money supply schedule is A. horizontal because MS is set by the central bank while P is taken as given. B. vertical because MS is set by the central bank. C. vertical because MS is set by the households and firms while P is taken as given. D. vertical because MS and P are set by the central bank. E. vertical because MS is set by the central bank while P is taken as given. Answer: E 14. If there is initially A. excess demand for money, the interest rate falls, and if there is initially an excess supply, it rises. B. excess supply of money, the interest rate falls, and if there is initially an excess demand, it rises. C. excess supply of money, the interest rate increases, and if there is initially an excess demand, it falls. D. excess supply of money, the interest rate falls, and if there is initially an excess demand, it further falls. E. None of the above. Answer: B 192 15. 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. None of the above. Answer: D 16. 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 17. 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 its 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. None of the above. Answer: B 193 18. 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 19. 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. None of the above statements is true. Answer: D 20. 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 194 21. Which one of the following statements is the most accurate? A. Only the long-run equilibrium price level is the value of P satisfying P=MS/L(R,Y). B. Only the short-run equilibrium price level is the value of P satisfying P=MS/L(R,Y). C. The short and long-run equilibrium price level is the value of P satisfying P=MS/L(R,Y). D. The long-run equilibrium price level is the value of P satisfying P=MD/L(R,Y). E. None of the above. Answer: C 22. An 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. None of the above. Answer: C 23. 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 value of only the interest rate. D. has no effect on the long-run value of only real output. E. has no effect on the long-run values of the interest rate and real output. Answer: E 24. 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 both in the short and long run. D. are neutral in the long run. E. need not be neutral in the long run. Answer: D 195 25. 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 26. Money demand behavior may A. change as a result of demographic trends or financial innovations such as electronic cash-transfer 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 cash-transfer 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 27. Which one of the following statements is the most accurate? In a A. cross-section of countries, long-term changes in money supplies and price levels show a clear negative correlation. B. time series of countries, long-term changes in money supplies and price levels show a clear positive correlation. C. cross-section of countries, short-term changes in money supplies and price levels show a clear negative correlation. D. cross-section of countries, short-term changes in money supplies and price levels show a clear positive correlation. E. cross-section of countries, long-term changes in money supplies and price levels show no clear correlation. Answer: A 196 28. For Germany, long-term changes in money supplies and price levels A. do not show a clear positive correlation. B. show a clear positive correlation. C. do not show a clear negative correlation. D. do show a high and significant positive correlation. E. None of the above. Answer: A 29. Year-by-year data from 1989 – 2000 show that A. there is a strong positive relationship between average Latin American money-supply growth and inflation. B. there is a strong negative relationship between average Latin American money-supply growth and inflation. C. there is a strong positive relationship between average Latin American money-supply growth and deflation. D. it is difficult to find a strong positive relationship between average Latin American money-supply growth and inflation. E. there is a weak positive relationship between average Latin American money- supply growth and inflation. Answer: A 30. 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 197 31. Wages A. enter indices of the price level directly. B. do not enter indices of the price level directly, but they make up a small fraction of the cost of producing goods and services. C. do not enter indices of the price level directly, but they make up a negligible fraction of the cost of producing goods and services. D. do not enter indices of the price level directly, but they make up a large fraction of the cost of producing goods and services. E. None of the above. Answer: D 32. For all the main industrial countries in recent years, A. the exchange rate is much more variable than relative price levels. B. the exchange rate is much less variable than relative price levels. C. the exchange rate is as variable as the relative price levels. D. It is hard to tell from the data whether the exchange rate is much more variable than relative price levels. E. None of the above. Answer: A 33. For all the main industrial countries in recent years, 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 198 34. 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 35. 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. fall over time, and this additional monetary change makes money prices rise 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 36. 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 199 37. 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 38. 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. None of the above. Answer: B 39. 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. None of the above. Answer: A 200 Essay Questions 1. 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. 2. 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. 3. What are the main factors determining the aggregate money demand? Answer: Three main factors: interest rate, the price level, and real national income. A rise in the interest rate causes each individual in the economy to reduce her 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 rise. 4. Explain why one can write the demand for money as follows: Md = P L (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 then simply double, as would the amount of money each wishes to hold. 5. 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 the 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. 201 6. What will be the effects of an increase in real national income on the interest rate? Answer: An increase in real national income 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. 7. 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. 8. 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. 9. “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 pages 3479 – 380). The statement is true. The pressures come from three main sources: excess demand for output and labor; inflationary expectations; and raw material prices. 10. 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. 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 202 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. 203 Quantitative/Graphing Problems 1. 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 expressed in dollars to shift down, causing a reduction in the dollar/euro exchange rate, that is, 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. 204 2. 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 the 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 dollars. The result is an increase in E or a depreciation of the dollar. 205 3. 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. 206 4. 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: 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 1’ to point 2’ in the upper left figure). 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 207 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 2’ to 4’). So a large depreciation (from point 1’ in the left upper figure to pint 2’ in both the left and right upper figures) is followed by an appreciation of the dollar (the movement from 2’ to point 4’ 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 3’ and 4’ represent the same exchange rate. 208 5. 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. 209 Chapter 15: Price Levels and the Exchange Rate in the Long Run Multiple Choice Questions 1. In order for the condition E$/HK$ = Pus/PHK to hold, what assumptions does the principle of purchasing power parity make? A. No transportation costs and restrictions on trade; commodity baskets that are a reliable indication of pr