Chapter 6 The Open Economy PDF

1. An “open” economy is one in which: A) the level of output is fixed. B) government spending exceeds revenues. C) the national interest rate equals the world interest rate. D) there is trade in goods and services with the rest of the world. 2. A country's exports may be written as equa...

1. An “open” economy is one in which: A) the level of output is fixed. B) government spending exceeds revenues. C) the national interest rate equals the world interest rate. D) there is trade in goods and services with the rest of the world. 2. A country's exports may be written as equal to: A) GDP minus consumption minus investment minus government spending. B) GDP minus consumption of domestic goods and services minus investment of domestic goods and services minus government purchases of domestic goods and services. C) imports. D) GDP minus imports. 3. Net exports equal GDP minus domestic spending on: A) all goods and services. B) all goods and services plus foreign spending on domestic goods and services. C) domestic goods and services. D) domestic goods and services minus foreign spending on domestic goods and services. 4. If domestic spending exceeds output, we ______ the difference—net exports are ______. A) import; negative B) export; positive C) import; positive D) export; negative 5. The value of net exports is also the value of: A) net investment. B) net saving. C) national saving. D) the excess of national saving over domestic investment. 6. If net capital outflow is positive, then: A) exports must be positive. B) exports must be negative. C) the trade balance must be positive. D) the trade balance must be negative. Page 1  7. Net capital outflow is equal to: A) national saving minus the trade balance. B) domestic investment plus the trade balance. C) domestic investment minus national saving. D) national saving minus domestic investment. 8. Net capital outflow is equal to the amount that: A) foreign investors lend here. B) domestic investors lend abroad. C) foreign investors lend here minus the amount domestic investors lend abroad. D) domestic investors lend abroad minus the amount that foreign investors lend here. 9. If domestic saving exceeds domestic investment, then net exports are ______ and net capital outflows are ______. A) positive; positive B) positive; negative C) negative; negative D) negative; positive 10. In a small, open economy if net exports are negative, then: A) domestic spending is greater than output. B) saving is greater than investment. C) net capital outflows are positive. D) imports are less than exports. 11. If domestic saving is less than domestic investment, then net exports are ______ and net capital outflows are ______. A) positive; positive B) positive; negative C) negative; negative D) negative; positive 12. When exports exceed imports, all of the following are true except: A) net capital outflows are positive. B) net exports are positive. C) domestic investment exceeds domestic saving. D) domestic output exceeds domestic spending. Page 2 13. In a small open economy, if exports equal $20 billion, imports equal $30 billion, and domestic national saving equals $25 billion, then net capital outflow equals: A) –$25 billion. B) –$10 billion. C) $10 billion. D) $25 billion. 14. In a small open economy, if exports equal $5 billion and imports equal $7 billion, then there is a trade ______ and ______ net capital outflow. A) deficit; negative B) surplus; negative C) deficit; positive D) surplus; positive 15. In a small open economy, if exports equal $15 billion and imports equal $8 billion, then there is a trade ______ and ______ net capital outflow. A) deficit; negative B) surplus; negative C) deficit; positive D) surplus; positive 16. In a small open economy, if domestic saving equals $50 billion and domestic investment equals $50 billion, then there is ______ and net capital outflow equals ______. A) a trade deficit; $100 billion B) balanced trade; $0 C) a trade surplus; $100 billion D) balanced trade; $100 billion 17. In a small open economy, if domestic investment exceeds domestic saving, then the extra investment will be financed by: A) borrowing from abroad. B) borrowing from domestic banks. C) the domestic government. D) the World Bank. Page 3 18. In a small open economy, if domestic saving exceeds domestic investment, then the extra saving will be used to: A) make loans to the domestic government. B) make loans to foreigners. C) repay the national debt. D) repay loans to the Federal Reserve. 19. A trade deficit can be financed in all of the following ways except by: A) borrowing from foreigners. B) selling domestic assets to foreigners. C) selling foreign assets owned by domestic residents to foreigners. D) borrowing from domestic lenders. 20. If a U.S. corporation sells a product in Europe and uses the proceeds to purchase shares in a European corporation, then U.S. net exports ______ and net capital outflows ______. A) increase; increase B) increase; decrease C) decrease; increase D) decrease; decrease 21. If a U.S. corporation purchases a product made in Europe and the European producer uses the proceeds to purchase a U.S. government bond, then U.S. net exports ______ and net capital outflows ______. A) increase; increase B) increase; decrease C) decrease; increase D) decrease; decrease 22. If a U.S. corporation sells a product in Canada and uses the proceeds to purchase a product manufactured in Canada, then U.S. net exports ______ and net capital outflows ______. A) increase; increase B) decrease; decrease C) do not change; do not change D) do not change; increase Page 4 23. A “small” economy is one in which the: A) level of output is fixed. B) price level is fixed. C) domestic interest rate equals the world interest rate. D) domestic saving is less than domestic investment. 24. The world interest rate: A) is equal to the domestic interest rate. B) makes domestic saving equal to domestic investment. C) is the interest rate charged on loans by the World Bank. D) is the interest rate prevailing in world financial markets. 25. In a small open economy with perfect capital mobility, the real interest rate will always be: A) above the world real interest rate. B) below the world real interest rate. C) equal to the world real interest rate. D) equal to the world nominal interest rate. 26. A small open economy with perfect capital mobility is characterized by all of the following except that: A) its domestic interest rate always exceeds the world interest rate. B) it engages in international trade. C) its net capital outflows always equal the trade balance. D) its government does not impede international borrowing or lending. 27. Building an economic model based on the assumption of a small open economy is useful because: A) it accurately describes the U.S. economy. B) it is more complicated and realistic than a model based on the assumption of a large open economy. C) this simplifying assumption can assist our understanding and intuition of open economy macroeconomics. D) it is not possible to build models of large open economies. Page 5  28. In a small open economy, if the world real interest rate is above the rate at which national saving equals domestic investment, then there will be a trade ______ and ______ net capital outflow. A) surplus; negative B) deficit; positive C) surplus; positive D) deficit; negative Use the following to answer questions 29-30: Exhibit: Saving and Investment in a Small Open Economy 29. (Exhibit: Saving and Investment in a Small Open Economy) In a small open economy, if the world interest rate is r1, then the economy has: A) a trade surplus. B) balanced trade. C) a trade deficit. D) negative capital outflows. 30. (Exhibit: Saving and Investment in a Small Open Economy) In a small open economy, if the world interest rate is r3, then the economy has: A) a trade surplus. B) balanced trade. C) a trade deficit. D) positive capital outflows. Page 6 31. An increase in the trade deficit of a small open economy could be the result of: A) an increase in taxes. B) an increase in government spending. C) an increase in the world interest rate. D) the expiration of an investment tax-credit provision. 32. An increase in the trade surplus of a small open economy could be the result of: A) a domestic tax cut. B) an increase in government spending. C) an increase in the world interest rate. D) the implementation of an investment tax-credit provision. 33. In a small open economy, starting from a position of balanced trade, if the government increases domestic government purchases, this produces a tendency toward a trade ______ and ______ net capital outflow. A) deficit; negative B) surplus; positive C) deficit; positive D) surplus; negative 34. In a small open economy, starting from a position of balanced trade, if the government increases the income tax, this produces a tendency toward a trade ______ and ______ net capital outflow. A) deficit; negative B) surplus; positive C) deficit; positive D) surplus; negative 35. Holding other factors constant, legislation to cut taxes in an open economy will: A) increase national saving and lead to a trade surplus. B) increase national saving and lead to a trade deficit. C) reduce national saving and lead to a trade surplus. D) reduce national saving and lead to a trade deficit. 36. Starting from a small open economy with balanced trade, if large foreign countries increase their domestic government purchases, this policy will tend to increase: A) investment in the small open economy. B) saving in the small open economy. C) exports by the small open economy. D) imports by the small open economy. Page 7 37. Starting from a trade balance, if the world interest rate falls, then, holding other factors constant, in a small open economy the amount of domestic investment will _____ and net exports will _____. A) increase; increase B) increase; decrease C) increase, not change D) decrease; increase 38. If the government of a small open economy wishes to reduce a trade deficit, which policy action will be successful in achieving this goal? A) increasing taxes B) increasing government spending C) increasing investment tax credits D) imposing protectionist trade policies 39. The adoption of an investment tax credit in a small open economy is likely to lead to: A) no change in either domestic investment or domestic saving in the small open economy. B) an increase in both domestic investment and domestic saving in the small open economy. C) an increase in domestic saving but no change in domestic investment in the small open economy. D) an increase in domestic investment but no change in domestic saving in the small open economy. 40. In a small open economy, policies that increase: A) investment tend to cause a trade surplus. B) investment tend to cause a trade deficit. C) saving do not affect the trade balance. D) saving tend to cause a trade deficit. 41. In an open economy: A) a trade deficit is always good. B) a trade deficit is always bad. C) a trade deficit may be good or bad. D) a trade surplus is always bad. Page 8 42. A shrinking U.S. budget deficit in the 1990s coincided with a ______ U.S. trade deficit. A) shrinking B) continuing C) nonexistent D) stable 43. As the U.S. budget deficit shrank in the 1990s, the increase in U.S. national saving was ______ than the expansionary shift in the U.S. investment function, resulting in a trade ______. A) stronger; deficit B) stronger; surplus C) weaker; deficit D) weaker; surplus 44. Two reasons why capital may not flow to poor countries are that the poorer countries may: A) have economies unlike those described by a Cobb–Douglas production function and not be subject to diminishing returns to capital. B) have already accumulated high levels of capital relative to labor and may already have access to advanced technologies. C) legally prevent the inflow of foreign capital and provide strong legal protection of private property. D) have inferior production capabilities and not enforce property rights. 45. Based on a Cobb–Douglas production function and perfect capital mobility, capital should flow to economies in which: A) capital is relatively scarce. B) capital is relatively abundant. C) technological production capabilities are inferior. D) labor is relatively scarce. 46. The nominal exchange rate between the U.S. dollar and the Japanese yen is the: A) number of yen you can get for lending one dollar in Japan for one year. B) number of yen you can get for one dollar. C) price of U.S. goods divided by the price of Japanese goods. D) price of Japanese goods divided by the price of U.S. goods. Page 9 47. The real exchange rate: A) measures how many Japanese yen one really gets for a U.S. dollar. B) is equal to the nominal exchange rate multiplied by the domestic price level divided by the foreign price level. C) is equal to the nominal exchange rate multiplied by the foreign price level divided by the domestic price level. D) is the price of a domestic car divided by the price of a foreign car. 48. If the number of dollars per yen rises, this is called a(n): A) appreciation of the dollar. B) appreciation of the yen. C) increase in the terms of trade. D) decrease in the terms of trade. 49. If the real exchange rate is high, foreign goods: A) and domestic goods are both relatively expensive. B) and domestic goods are both relatively cheap. C) are relatively expensive and domestic goods are relatively cheap. D) are relatively cheap and domestic goods are relatively expensive. 50. If 5 Swiss francs trade for $1, the U.S. price level equals $1 per good, and the Swiss price level equals 2 francs per good, then the real exchange rate between Swiss goods and U.S. goods is ______ Swiss good(s) per U.S. good. A) 0.5 B) 2.5 C) 5 D) 10 51. When the real exchange rate rises: A) exports will decrease but imports will be unaffected. B) imports will decrease but exports will be unaffected. C) exports will increase and imports will decrease. D) exports will decrease and imports will increase. 52. If the real exchange rate depreciates from 1 Japanese good per U.S. good to 0.5 Japanese good per U.S. good, then U.S. exports ______ and U.S. imports ______. A) increase; increase B) decrease; decrease C) increase; decrease D) decrease; increase Page 10 53. If the real exchange rate decreases, then net exports will _____. A) be positive. B) be negative. C) increase. D) decrease. 54. The lower the real exchange rate is, the ______ expensive domestic goods are relative to foreign goods, and the ______ the demand is for net exports. A) more; greater B) more; smaller C) less; greater D) less; smaller 55. In the small open economy in equilibrium: A) saving is fixed, and investment is determined by the investment function and the world interest rate. B) investment is fixed, and saving is determined by the saving function and the world interest rate. C) saving is fixed, and investment is determined by the trade balance. D) investment is fixed, and saving is determined by the trade balance. 56. If a graph is drawn with net exports on the horizontal axis and the real exchange rate on the vertical axis, then the real exchange rate is determined by the intersection of the ______ net-exports schedule and the ______ line representing saving minus investment. A) downward-sloping; vertical B) upward-sloping; vertical C) downward-sloping; upward-sloping D) upward-sloping; downward-sloping 57. The real exchange rate is determined by the equality of: A) saving and the demand for net exports. B) investment and the demand for net exports. C) net capital outflow and the demand for net exports. D) the negative value of net capital outflow and the demand for net exports. Page 11 58. In a small open economy, when the government reduces national saving, the equilibrium real exchange rate: A) rises and net exports fall. B) rises and net exports rise. C) falls and net exports fall. D) falls and net exports rise. 59. In a small open economy with perfect capital mobility, a reduction in the government's budget deficit ______ net exports and the real exchange rate ______. A) increases; appreciates B) increases; depreciates C) decreases; appreciates D) decreases; depreciates 60. In a small open economy, when foreign governments reduce national saving in their countries, the equilibrium real exchange rate: A) rises and net exports fall. B) rises and net exports rise. C) falls and net exports fall. D) falls and net exports rise. 61. In a small open economy, if the world interest rate falls, then domestic investment will _____ and the real exchange rate will _____, holding all else constant. A) decrease; decrease B) decrease; increase C) increase; decrease D) increase; increase 62. In a small open economy, if the world interest rate increases, then the supply of domestic currency on the foreign exchange market will _____ and the real exchange rate will _____, holding all else constant. A) decrease; decrease B) decrease; increase C) increase; decrease D) increase; increase Page 12 63. In a small open economy, if the government encourages investment, through, say, an investment tax credit, investment: A) increases and is financed through an increase in national saving. B) increases and is financed through an increase in exports. C) increases and is financed through an inflow of foreign capital. D) does not increase; the interest rate rises instead. 64. If the information technology boom increases investment demand in a small open economy, then net exports ______ and the real exchange rate ______. A) increase; appreciates B) increase; depreciates C) decrease; appreciates D) decrease; depreciates 65. An appreciation of the real exchange rate in a small open economy could be the result of: A) an increase in government spending. B) an increase in taxes. C) a decrease in the world interest rate. D) the expiration of an investment tax-credit provision. 66. A depreciation of the real exchange rate in a small open economy could be the result of: A) a domestic tax cut. B) an increase in government spending. C) a decrease in the world interest rate. D) the expiration of an investment tax-credit provision. 67. In a small open economy, if the government adopts a policy that lowers imports, then that policy: A) raises the real exchange rate and increases net exports. B) raises the real exchange rate and does not change net exports. C) raises the real exchange rate and decreases net exports. D) lowers the real exchange rate. 68. In a small open economy, if the government adopts a policy that lowers imports, then the quantity of exports: A) remains unchanged. B) decreases but not as much as the quantity of imports decreases. C) decreases by exactly the same amount as the quantity of imports decreases. D) decreases by more than the quantity of imports decreases. Page 13 69. An effective policy to reduce a trade deficit in a small open economy would be to: A) increase tariffs on imports. B) impose stricter quotas on imported goods. C) increase government spending. D) increase taxes. 70. Protectionist policies implemented in a small open economy with a trade deficit have the effect of ______ the trade deficit and ______ the quantity of imports and exports. A) decreasing; decreasing B) not changing; decreasing C) decreasing; not changing D) not changing; not changing 71. Protectionist policies in a small open economy do not alter the trade balance because the: A) quantity of imports and exports is fixed. B) interest rate adjusts to offset any reductions in imports. C) exchange rate appreciates to offset the increase in net exports. D) level of net capital outflow is fixed by the world interest rate. 72. Which of the following would decrease the real exchange rate in a small open economy in the long run? A) a personal income tax cut B) a reduction in government spending C) a tariff on imports D) an increase in investment Page 14 Use the following to answer questions 73-77: Exhibit: Policies Influence Real Exchange Rate 73. (Exhibit: Policies Influence Real Exchange Rate) Which of the panels illustrates the impact on the real exchange rate of contractionary fiscal policies at home? A) (A) B) (B) C) (C) D) (D) Page 15 74. (Exhibit: Policies Influence Real Exchange Rate) Which of the panels illustrates the impact on the real exchange rate of contractionary fiscal policies abroad? A) (A) B) (B) C) (C) D) (D) 75. (Exhibit: Policies Influence Real Exchange Rate) Which of the panels illustrates the impact on the real exchange rate of an increase in investment demand? A) (A) B) (B) C) (C) D) (D) 76. (Exhibit: Policies Influence Real Exchange Rate) Which of the panels illustrates the impact on the real exchange rate of protectionist trade policies? A) (A) B) (B) C) (C) D) (D) 77. (Exhibit: Policies Influence Real Exchange Rate) Which of the panels illustrates the impact on the real exchange rate of an increase in household saving? A) (A) B) (B) C) (C) D) (D) 78. The percentage change in the nominal exchange rate equals the percentage change in the real exchange rate plus the: A) foreign inflation rate minus the domestic inflation rate. B) domestic inflation rate minus the foreign inflation rate. C) foreign exchange rate minus the domestic exchange rate. D) domestic interest rate minus the foreign interest rate. 79. If a country has a high rate of inflation relative to the United States, the dollar will buy: A) less of the foreign currency over time. B) more of the foreign currency over time. C) the same amount of the foreign currency over time. D) an amount of foreign currency determined by the real exchange rate. Page 16 80. One consequence of high inflation is a(n): A) appreciating nominal exchange rate. B) decrease in the price of goods measured in terms of money. C) depreciating nominal exchange rate. D) decrease in the price of foreign currencies measured in terms of the domestic currency. 81. If the real exchange rate between the United States and Japan remains unchanged, and the inflation rate in the United States is 6 percent and the inflation rate in Japan is 3 percent, the: A) dollar will appreciate by 3 percent against the yen. B) yen will appreciate by 3 percent against the dollar. C) yen will appreciate by 6 percent against the dollar. D) yen will appreciate by 9 percent against the dollar. 82. If the nominal exchange rate falls 10 percent, the domestic price level rises 4 percent, and the foreign price level rises 6 percent, the real exchange rate will fall: A) 0 percent. B) 8 percent. C) 10 percent. D) 12 percent. 83. The U.S. dollar exchange rate (units of foreign currency per U.S. dollar) for currencies of countries with high inflation rates relative to the United States has tended to ______, and the U.S. dollar exchange rate (units of foreign currency per U.S. dollar) for currencies of countries with low inflation rates relative to the United States has tended to ______. A) appreciate; appreciate B) appreciate; depreciate C) depreciate; depreciate D) depreciate; appreciate 84. If the purchasing-power parity theory is true, then: A) the net exports schedule is very steep. B) all changes in the real exchange rate result from changes in price levels. C) all changes in the nominal exchange rate result from changes in price levels. D) changes in saving or investment influence only the real exchange rate. Page 17 85. The idea that the amount of any currency that can buy a particular good in one country should be able to buy (after being exchanged for the local currency) the same quantity of the same good anywhere in the world is called: A) the theory of the real exchange rate. B) equal currency conversion. C) international monetary exchange. D) purchasing-power parity. 86. If purchasing-power parity holds, then changes in domestic saving will _____ the real exchange rate. A) increase B) decrease C) not change D) either increase or decrease 87. According to purchasing-power parity, if the dollar price of oil is higher in New York than in London, arbitrageurs will ___ oil in New York and _____ oil in London to drive _____ the price of oil in New York. A) buy; sell; up B) buy; sell; down C) sell; buy; up D) sell; buy; down 88. The law of one price is enforced by: A) governments. B) producers. C) consumers. D) arbitrageurs. 89. The doctrine of purchasing-power parity: A) is a completely accurate description of the real world. B) would be entirely accurate if only goods were traded. C) would be entirely accurate if all consumers had the same preferences. D) provides a reason to expect that movements in the real exchange rate will typically be small or temporary. Page 18 90. If purchasing-power parity held, if a Big Mac costs $2 in the United States, and if 10 Mexican pesos trade for $1 dollar, then a Big Mac in Cancun, Mexico, should cost: A) 2 pesos. B) 5 pesos. C) 10 pesos. D) 20 pesos. 91. In a large but open economy, when a fiscal expansion takes place, the interest rate goes up and some investment is crowded out; the expansion also causes a trade: A) surplus and a fall in the real exchange rate. B) deficit and a rise in the real exchange rate. C) surplus and a rise in the real exchange rate. D) deficit and a fall in the real exchange rate. 92. Net capital outflow in a large country: A) rises as the real domestic interest rate rises. B) declines as the domestic interest rate rises. C) depends on the foreign interest rate. D) depends only on domestic saving. 93. For a closed economy, when net capital outflow is measured along the horizontal axis and the real interest rate is measured along the vertical axis, net capital outflow is drawn as a: A) vertical line at 0. B) horizontal line at the world real interest rate. C) line that slopes up and to the right. D) line that slopes down and to the right. 94. For an open economy with perfect capital mobility, when net capital outflow is measured along the horizontal axis and the real interest rate is measured along the vertical axis, net capital outflow is drawn as a: A) vertical line at 0. B) horizontal line at the world real interest rate. C) line that slopes up and to the right. D) line that slopes down and to the right. Page 19  95. A statement that is generally true about capital in a large open economy is that it is: A) perfectly mobile, and the country does not influence world financial markets. B) perfectly mobile, and the country influences world financial markets. C) not perfectly mobile, but the country does not influence world financial markets. D) not perfectly mobile, but the country influences world financial markets. 96. In a large open economy, the real interest rate is determined by: A) national saving, the domestic investment function, and the net capital outflow function. B) national saving, the domestic investment function, and the net exports function. C) the domestic investment function, the net capital outflow function, and the net exports function. D) national saving, the domestic investment function, the net capital outflow function, and the net exports function. 97. In a large open economy, the interest rate adjusts so that domestic saving equals: A) domestic investment. B) net exports. C) net capital outflow. D) domestic investment plus net capital outflow. 98. In a large open economy, the exchange rate adjusts so that net exports equal: A) domestic saving. B) domestic investment. C) net capital outflow. D) domestic investment plus net capital outflow. 99. Expansionary fiscal policy in a large open economy ______ the real interest rate and ______ the real exchange rate. A) does not change; increases B) increases; increases C) increases; decreases D) decreases; increases 100. In a large open economy, an investment tax credit raises the real interest rate, ______ the trade balance, and ______ net capital outflow. A) decreases; decreases B) increases; increases C) decreases; increases D) increases; decreases Page 20 101. In a large open economy, if an import quota is adopted, then: A) net exports remain unchanged, as imports and exports decrease by equal amounts, while the real exchange rate rises. B) net exports remain unchanged, as imports and exports decrease by equal amounts, while the real exchange rate falls. C) net exports rise and the real exchange rate rises. D) net exports rise and the real exchange rate falls. 102. In a large open economy, if political instability abroad lowers the net capital outflow function, then the real interest rate: A) rises, while the real exchange rate rises and net exports fall. B) rises, while the real exchange rate falls and net exports rise. C) falls, while the real exchange rate rises and net exports rise. D) falls, while the real exchange rate rises and net exports fall. 103. In a small open economy, if consumer confidence falls and consumers decide to save more, then the real exchange rate: A) rises and net exports fall. B) and net exports both rise. C) falls and net exports rise. D) and net exports both fall. 104. In a small open economy, if consumers shift their preference toward Japanese cars, then net exports: A) fall and the real exchange rate falls. B) fall but the real exchange rate remains unchanged. C) remain unchanged but the real exchange rate falls. D) and the real exchange rate remains unchanged. 105. In a small open economy, if the introduction of automatic-teller machines reduces the demand for money, then net exports: A) fall and the real exchange rate falls. B) fall but the real exchange rate remains unchanged. C) remain unchanged but the real exchange rate falls. D) and the real exchange rate remain unchanged. Page 21 106. Assume that a small open economy gets involved in a global war, in which its government purchases increase and the rest of the world's government purchases also increase. Then, for the small country, net exports: A) will certainly decrease. B) will certainly increase. C) may increase or decrease. D) will remain the same. 107. Assume that some large foreign countries begin to subsidize investment by instituting an investment tax credit. Then, if world saving does not depend on the interest rate, world investment: A) will rise and small country investment will fall. B) will rise and small country investment will remain unchanged. C) will remain unchanged and small country investment will fall. D) and small country investment will both remain unchanged. 108. Assume that some large foreign countries decide to subsidize investment by instituting an investment tax credit. Then a small country's real exchange rate: A) will fall and its net exports will rise. B) will rise and its net exports will fall. C) and net exports will both fall. D) and exports will both rise. 109. If a dollar bought 1,000 Chilean pesos ten years ago and 1,500 lire now, and inflation for that period was 25 percent in the United States and 100 percent in Chile, then: A) the purchasing-power parity theory is correct. B) traveling in Chile today costs about the same as it did ten years ago. C) traveling in Chile is cheaper now than it was ten years ago. D) traveling in Chile is more expensive now than it was ten years ago. 110. If the nominal interest rates in the United States and Canada are 8 percent and 12 percent, respectively, the real interest rates are the same, and the real exchange rate is fixed, then the market's expectation about the number of Canadian dollars to be received for a U.S. dollar a year from now will be that it will: A) decrease by 8 percent. B) decrease by 4 percent. C) increase by 4 percent. D) increase by 5 percent. Page 22 111. Assume that a war breaks out abroad, and foreign investors choose to invest more in a large safe country, the United States. Then, the U.S. real interest rate: A) and net exports will both fall. B) will fall and net exports will rise. C) will rise and net exports will fall. D) and net exports will both rise. 112. Assume that in a small open economy where full employment always prevails, national saving is 300. a. If domestic investment is given by I = 400 – 20r, where r is the real interest rate in percent, what would the equilibrium interest rate be if the economy were closed? b. If the economy is open and the world interest rate is 10 percent, what will investment be? c. What will the current account surplus or deficit be? What will net capital outflow be? 113. Assume that in a small open economy with full employment, consumption depends only on disposable income. National saving is 300, investment is given by I = 400 – 20r, where r is the real interest rate in percent, and the world interest rate is 10 percent. a. If government spending rises by 100, does investment change? What is the level of investment after the change? b. Does the trade balance change if G rises by 100? If it changes, does it increase or decrease, and by how much? c. Does net capital outflow change if G rises by 100? If it changes, does it increase or decrease, and by how much? d. Will the real exchange rate rise, fall, or remain constant as a result of the change in G 114. Assume that the following equations characterize a large open economy: (1) Y = 5,000 (2) Y = C + I + G + NX (3) C = 1/2(Y – T) (4) I = 2,000 – 100r (5) NX = 500 – 500 (6) CF = –100r (7) CF = NX (8) G = 1,500 (9) T = 1,000. Where NX is net exports, CF is net capital outflow, and  is the real exchange rate. Solve these equations for the equilibrium values of C, I, NX, CF, r, and . (Hint: Substitute equations (9) and (1) into (3), then substitute (1), (3), (4), (8), and (5) into (2). Then substitute (5) and (6) into (7). Now you have two equations in r and . Check your work by seeing that all of these equations balance given your answers.) Page 23 115. a. In April 1995, Michel Camdessus, managing director of the International Monetary Fund (IMF), criticized U.S. economic policy for allowing the dollar exchange rate to fall too low. He recommended that the United States reduce its budget deficit in order to raise the exchange rate. Use the long-run model of a small open economy to illustrate graphically the impact of reducing the government's budget deficit on the exchange rate and the trade balance. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the new long-run equilibrium values. b. Based on your graphical analysis, explain whether Mr. Camdessus's policy recommendation will work. Specifically state what happens to the exchange rate and the trade balance as a result of the government budget deficit reduction. 116. a. In September 1995, Patrick Buchanan, a Republican candidate for president, proposed a 10 percent tariff on Japanese imports to the United States, a 20 percent tariff on Chinese imports to the United States, and an unspecified “social” tariff on imports from third-world countries. Use the long-run model of a small open economy to illustrate graphically the impact of these trade policies on the U.S. exchange rate and the trade balance. Assume that the country starts from a position of trade balance, i.e., exports equal imports. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the new long-run equilibrium values. b. Based on your graphical analysis, explain the predicted impact of Mr. Buchanan's proposed policies. Specifically state what happens to the exchange rate, the trade balance, the volume of imports, and the volume of exports. 117. a. Suppose that governments around the world begin to engage in expansionary fiscal policy (run large budget deficits) in order to stimulate economic activity in their countries. Use the long-run model of a small open economy to illustrate graphically the impact of this expansionary fiscal policy by foreigners on the U.S. exchange rate and the trade balance. Assume that the country starts from a position of trade balance, i.e., exports equal imports. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the new long-run equilibrium values. b. Based on your graphical analysis, explain the predicted impact of the foreign expansionary fiscal policy on the U.S. exchange rate and the U.S. trade balance. 118. a. If corporate downsizing and lack of job security cause consumers to spend less and save more, what will be the impact on the exchange rate and trade balance? Use the long-run model of a small open economy to illustrate graphically the impact of this decline in consumer confidence on the exchange rate and the trade balance. Assume the country starts from a position of trade balance, i.e., exports equal imports. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the new long-run equilibrium values. b. Based on your graphical analysis, explain the predicted impact of a decline in consumer confidence on the exchange rate and the U.S. trade balance. Page 24 119. Suppose that the large industrial countries of the world are concerned about the depreciating currencies of a number of small open economies. a. What type of fiscal policies must the large industrial countries undertake in order to promote currency appreciation in the small open economies? b. Illustrate graphically the impact of the industrial countries' policies on the exchange rate of the small open economies. c. What will happen to the trade balance of the typical small open economy, assuming that it starts from a position of balanced trade? 120. Suppose that the International Monetary Fund (IMF) is concerned about currency depreciation in a small open economy. a. What type of fiscal policy should the IMF propose to the government of the small open economy to generate a currency appreciation? b. Illustrate graphically the impact of the IMF proposal on the exchange rate of the small open economy. c. What will happen to the trade balance of the small open economy, assuming that it started from a position of balanced trade? 121. The government of a small open economy wishes to promote trade policies that will result in currency appreciation. a. Would protectionist policies (higher tariffs and more quotas) or freer trade policies (tariff reductions and quota eliminations) be more effective in generating currency appreciation? b. Illustrate graphically the impact of the trade policy on the exchange rate of the small open economy. c. What will happen to the trade balance of the small open economy as a result of the trade policies, assuming that the country started from a position of free trade? d. What will happen to the quantity of exports and imports as a result of the trade policies? 122. Compare the impact of an increase in the government's budget deficit on investment spending in a small open economy with an otherwise comparable closed economy. Assume prices are flexible and that factors of production are fully employed in both economies. Assume there is perfect capital mobility for the small open economy. 123. Explain why government budget deficits crowd out private investment spending in a closed economy, but crowd out net exports in a small open economy. Assume prices are flexible and that factors of production are fully employed in both economies. Assume there is perfect capital mobility for the small open economy. Page 25 124. What determines the real exchange rate and what determines the nominal exchange rate in a small open economy with perfect capital mobility, fully employed factors of production, and flexible prices? 125. Suppose a new technology is developed that increases investment demand in both a closed economy and in a small open economy that are in other ways identical. Holding other factors constant, will the quantity of investment spending increase more in the closed economy or in the small open economy? Explain. Assume prices are flexible and that factors of production are fully employed in both economies. Assume there is perfect capital mobility for the small open economy. 126. The real interest rates and real exchanges rates are constant and equal in North Country and South Country. The Fisher equation and purchasing-power parity hold in both countries. If the nominal interest rate is 8 percent in North Country and 10 percent in South Country, do you expect North Country's nominal exchange rate to appreciate, depreciate, or remain the same? Explain. 127. In the 2008 global financial crisis, many investors considered the U.S. economy a safe place to move their assets. What is the predicted impact of this inflow of financial capital to the United States, which is a large open economy, on the U.S. interest rate and the U.S. exchange rate, holding other factors constant? Illustrate your answer graphically and explain in words. 128. In times of great economic uncertainty and potential job loss, many consumers may increase their saving as a precautionary measure. What is the predicted impact of an increase in national saving on the domestic interest rate and exchange rate in a large open economy, holding other factors constant? Illustrate your answer graphically and explain in words. 129. Major improvements in computer information technology and communications in the late 1990s fueled an increase in investment demand in the United States, which is a large open economy. What is the predicted impact of this increased investment demand in the United States on the U.S. interest rate, the U.S. exchange rate, and U.S. net exports, holding other factors constant? Illustrate your answer graphically and explain in words. Page 26  130. If the money supply in Mexico is increasing much more rapidly than the money supply in the United States, holding other factors constant, what would you predict will happen to the nominal exchange rate between the Mexican peso and the United States dollar? Explain. 131. Compare the impact of an increase in investment demand in a small open economy and a large open economy. Assume prices are flexible, factors of production are fully employed in both countries and there is perfect capital mobility in the small open economy. 132. Why is the domestic output not equal to domestic spending in an open economy? Explain. 133. Fill in the blanks: According to the national income accounts identity, an economy’s ______________ must always equal the difference between its ____________and its _____________. 134. What is the difference between trade surplus and trade deficit? Explain. Use the following to answer question 135: Page 27 135. From the following graph, find the world interest rate at which there will be equilibrium in the capital market of small open economy? 136. What will be the effect of increase in fiscal expansion abroad (by a large economy) on the trade balance of a small open economy? 137. What is the difference between the strengthening and weakening of domestic currency? Explain. 138. Illustrate with a graph the real exchange rate trend along with net exports. 139. Why is purchasing power parity called “the law of one price”? Explain. 140. What is the effect of investment enhancement measures on the trade balance of a small open economy? Page 28 Answer Key 1. D 2. B 3. A 4. A 5. D 6. C 7. D 8. D 9. A 10. A 11. C 12. C 13. B 14. A 15. D 16. B 17. A 18. B 19. D 20. A 21. D 22. C 23. C 24. D 25. C 26. A 27. C 28. C 29. A 30. C 31. B 32. C 33. A 34. B 35. D 36. C 37. B 38. A 39. D 40. B 41. C 42. B 43. C 44. D Page 29 45. A 46. B 47. B 48. B 49. D 50. B 51. D 52. C 53. C 54. C 55. A 56. A 57. C 58. A 59. B 60. D 61. D 62. C 63. C 64. C 65. A 66. D 67. B 68. C 69. D 70. B 71. C 72. B 73. A 74. B 75. C 76. D 77. A 78. A 79. B 80. C 81. B 82. B 83. D 84. C 85. D 86. C 87. D 88. D 89. D 90. D Page 30  91. B 92. B 93. A 94. B 95. D 96. A 97. D 98. C 99. B 100. A 101. A 102. D 103. C 104. C 105. D 106. C 107. C 108. A 109. D 110. C 111. A 112. a. 5 percent b. 200 c. The trade surplus will be 100. 113. a. No. 200 b. Yes. It decreases by 100. c. Yes. It decreases by 100. d. It will rise. 114. c = 2,000; I = 1,750; NX = –250; CF = –250; r = 2.5 percent;  = 1.5 115. a. b. Mr. Camdessus's policy will not have the intended effect. The dollar exchange rate will decline and the trade balance will move toward surplus. 116. a. Page 31  b. Under Mr. Buchanan's policy, the dollar exchange rate would appreciate but the trade balance would remain unchanged. However, the volume of imports will decrease (because of the tariffs) and the volume of exports will decrease by the same amount (because of the appreciation of the exchange rate). 117. a. b. The fiscal expansion in the rest of the world would raise the world interest rate and lower domestic investment. As a result, the U.S. exchange rate will depreciate and the trade balance will move toward surplus. 118. a. Page 32  b. The increase in private saving caused by the loss of consumer confidence will lower the exchange rate and move the trade balance toward surplus. 119. a. The large economies must execute contractionary fiscal policy (decreasing government spending and/or increasing taxes) to generate a lower world interest rate. b. The lower world interest rate increases investment in the small open economy, which reduces the supply of currency going into the foreign exchange market and increases the exchange rate of the small open economies. The trade balance of the small open economy will move into deficit. c. 120. a. The IMF must propose expansionary fiscal policy, i.e., increasing government spending and/or cutting taxes. This will decrease saving in the small open economy. b. The decrease in domestic saving will reduce the supply of currency to the foreign exchange market, resulting in currency appreciation. The trade balance of the small open economy will move into deficit. c. Page 33 121. a. Protectionist policies will result in currency appreciation. b. The protectionist policies increase the demand for net exports. The trade balance will remain unchanged—still balanced. c. d. The volume of exports will decrease (as a result of the currency appreciation), and the volume of imports will decrease (as a result of the protectionist policies and currency appreciation). 122. Investment spending decreases in the closed economy, but does not change in the small open economy. In the closed economy the increase in the budget deficit reduces national saving and increases the interest rate, which decreases private investment spending. In the small open economy the domestic interest rate remains unchanged at the world interest rate. Although national saving also declines in the small open economy, capital inflows make up this shortfall in domestic saving to finance domestic investment. 123. In the closed economy, the increase in the budget deficit reduces national saving and increases the interest rate, which crowds out (decreases) private investment spending. In the small open economy, the budget deficit reduces national saving, which increases the real exchange rate. The increase in the real exchange rate crowds out (decreases) net exports. 124. The real exchange rate adjusts to bring the net exports and net capital outflows into equilibrium. The nominal exchange rate equals the real exchange rate times the ratio of the foreign price level to the domestic price level. 125. Investment spending will not change in the closed economy, but will increase in the small open economy. In the closed economy, there is no change in domestic saving, so the domestic interest rate must rise to keep investment spending equal to the unchanged domestic saving. In the small open economy, the increase in investment demand is financed by net capital inflows (a decrease in net capital outflows) at the unchanged world interest rate. The decrease in net capital outflows raises the real exchange rate and reduces net exports in the small open economy. 126. From the Fisher equation, inflation is expected to be higher in South Country than in North Country, since the nominal interest rate equals the real interest rate plus the expected rate of inflation and the real interest rate is the same in both countries while the nominal interest rate is higher in South Country. According to purchasing-power parity, the change in the North Country's nominal exchange rate equals the change in the real exchange rate (which is constant) plus the difference in inflation rates (foreign inflation minus domestic inflation). Since South Country's expected inflation is higher, then North Country's nominal exchange rate should appreciate, i.e., each unit of North Country's currency should exchange for more units of South Country currency in the future. Page 34 127. The reduction in net capital outflows reduces the demand for loanable funds, which reduces the domestic interest rate. The lower domestic interest rate partially offsets some of the initial decrease in net capital outflows from the U.S., but there is an overall decrease in net capital outflows. The reduction in net capital inflows reduces the supply of dollars in the foreign exchange market and increases the real exchange rate. 128. Page 35  The increase in national saving will decrease the domestic interest rate. The lower interest rate will increase the amount of net capital outflows, which will decrease the domestic exchange rate as the supply of the domestic currency in the foreign exchange market increases. 129. Page 36  The increase in domestic investment demand will increase the U.S. interest rate. The higher domestic interest rate will reduce net capital outflows. The reduced supply of dollars in the foreign exchange market will increase the U.S. exchange rate. The higher real exchange rate makes U.S. exports less competitive and imports more attractive, reducing U.S. net exports. 130. According to the quantity theory, the faster growth rate of money will result in a higher rate of inflation in Mexico than in the United States. If there is purchasing-power parity, then the percentage change in the nominal exchange rate equals the percentage change in the real exchange rate plus the difference in the inflation rates (foreign inflation minus domestic inflation). The higher Mexican inflation will increase the nominal exchange rate (pesos per dollar), holding other factors constant. 131. In the small open economy, the increase in investment demand puts upward pressure on the interest rate which attracts capital inflows to fully finance the increased investment demand at the world interest rate. The increase in capital inflows (decrease in net capital outflows) increases the demand for the domestic currency in the foreign exchange market, which increases the exchange rate and reduces net exports. In the large open economy, the increase in investment demand increases the domestic interest rate, which offsets some of the increase in investment demand. The higher domestic interest rate reduces net capital outflows and drives up the domestic exchange rate, which reduces net exports. In summary, in the small open economy the full increase in domestic investment demand is met at the cost of a reduction in net exports. Page 37  In contrast, in the large open economy, not all of the increase in domestic investment demand is realized because of the increase in the domestic interest rate. The increase in investment demand also leads to a reduction in net exports. 132. In an open economy, domestic output could be exported while foreign output could be imported through international trade. This results in the difference between the domestic spending and domestic output. 133. Net exports; savings; investment 134. When a country is a net exporter of goods (including services) and capital, it has a trade surplus. If it is a net importer of goods and borrower of capital it has a trade deficit. 135. At 7 percent 136. The increase in fiscal expansion abroad will raise the world interest rates, which in turn will lead to the trade surplus in a small open economy. 137. Strengthening of currency is when domestic currency buys more of foreign currency. Weakening of currency is when domestic currency buys less of foreign currency. 138. 139. Purchasing power parity signifies that if there is any change in the price level of a good in different countries, then it will levelled out through international arbitrage. Thus, the currency has the same purchasing power in different countries at the same time. 140. An increased investment demand will lead to trade deficit of a small open economy. Page 38