EconS 327 Review for Test 2

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1 Test 2 is scheduled for Friday, April 23 rd. Test 2 has 40 multiple choice questions. Test 2 will cover the material assigned during weeks This includes o Text: Chapters 10, 12, 13, 14, 15, and 16. o Aplia assignments 9-14 Suggested Study Plan o The Aplia assignment 14 is a graded review intended to help students prepare for test 2. Pay particular attention to this assignment. o Review the concepts listed below to make sure you haven t missed something. o Go through the sample multiple choice questions listed below. Here is a list of concepts that students need to understand Balance of payments (BOP) Credit on BOP Debit on BOP Double Entry Accounting (BOP) Current Account Income Account Goods and Services Account Trade Balance Financial (and Capital) Account Net Debtor and Net Creditor Unilateral Transfers Official Reserves Nominal Exchange Rate Real Exchange Rate Law of One Price Big Mac Index Purchasing Power Parity Asset Market Approach Real Interest Rate Exchange Rates in the Short Run Exchange Rates in the Long Run Exchange Rate Overshooting Quantity Theory of Money 1 Gold Standard Foreign Repercussion Effect Exchange rate pass through J curve effect Automatic Adjustment to Balance of Payment Imbalances Impossible Trinity Pegged (Fixed) Exchange Rates Exchange Rate Stabilization Fund Bretton Woods Adjustable Pegs Floating (flexible) Exchange Rate Managed Exchange Rate Exchange (Capital) Controls Stablization fund Currency Board Dollarization Siegniorage Fiscal policy with fixed and floating exchange rates Monetary policy with fixed and floating exchange rates International Reserves

2 Here are a few sample multiple choice questions for practice. 1. In a country s balance of payments, which of the following transactions are debits (minuses)? a. Domestic bank balances owned by foreigners are decreased b. Foreign bank balances owned by domestic residents are decreased c. Assets owned by domestic residents are sold to nonresidents d. Securities are sold by domestic residents to nonresidents 2. The net value of flows of goods, services, income, and unilateral transfers is called the: a. Capital account. b. Current account. c. Trade balance. d. Official reserve balance 3. A country experiencing a current account surplus: a. Needs to borrow internationally. b. Is able to lend internationally. c. Must also have had a surplus in its capital account. d. Spent more than it earned on its merchandise and service trade, international income payments and receipts and international transfers. 4. From 1985 to 1988, the US $ depreciated by over 50% against the Japanese Yen. During this period Japanese products sold in the US increased by about 20%. This is best explained by a. The J curve effect b. Partial currency pass through c. The Bretton Woods agreement d. High rates of US inflation 5. Suppose the exchange rate between the Japanese yen and the U.S. dollar is initially 100 yen per dollar and then falls to 80 yen per dollar. As a result the Yen price of a product that the US exports for $5 will a. Increase from 500 Yen to 540 Yen b. Decrease from 500 Yen to 400 yen c. Increase from 400 Yen to 500 Yen d. Decrease from 540 Yen to 500 Yen 6. A decrease in German residents' willingness to invest in dollar-denominated assets will shift the demand curve for: a. Euros to the left b. Dollars to the right c. Dollars to the left 2

3 S D s (millions) 7. The figure above shows the current demand and supply of the British pound. If the British government wants to peg the exchange rate of the pound at $2.50 per pound, what action would British monetary authorities have to undertake? a. Sell 1 million pounds and buy 2.5 million dollars. b. Buy 1 million pounds and sell 1 million dollars. c. Buy 1 million pounds and sell 2.5 million dollars. d. Buy 5.5 million pounds and sell 11 million dollars. 8. The figure above shows the current demand and supply of the British pound. If the British pound is pegged at $2.50 per pound the pound will be: a. Overvalued b. Undervalued c. Devalued d. In equilibrium 9. In the short run, a drop in short run European interests rates will lead to: a. An inflow of capital to Europe. b. An increase in the demand for euro-denominated financial assets. c. A decrease in the demand for euro-denominated financial assets. 10. states that a bundle of tradable products will have the same cost in different countries if the cost is stated in the same currency. a. Covered interest rate equilibrium b. Trade equilibrium c. The law of comparative advantage d. Purchasing power parity 3

4 11. Suppose the average price of a Big Mac in the United States is $3.50 while in Japan the average price is 500 yen. If the price of a dollar is 100 yen per dollar, the purchasing power parity model of exchange rate determination suggests: a. Compared to the US$, the yen is overvalued. b. Compared to the US$, the yen is undervalued. c. The price of a Big Mac in Japan will rise. d. The price of a Big Mac in the US will decrease 12. Suppose Canada has a trade deficit and imports rice. Assume the Canadian demand elasticity for imports = Also assume the foreign demand for Canadian exports = If the Canadian currency depreciates by 10%, then in the short run a. The Canadian trade balance will become more negative ( larger deficit ). b. The Canadian trade balance will remain unchanged c. The quantity of rice imported by Canada will increase d. Prices of imported products will not change. 13. Exchange rates are determined in the long-run by: a. Interest rate differentials. b. Purchasing power parity. c. Financial asset pricing. 14. Pressures in the foreign exchange rate market are such as to cause the British pound to depreciate with respect to the U.S. dollar. If Britain is trying to maintain a fixed exchange rate with respect to the U.S. dollar, which of the following interventions will stem the pressures for depreciation of the pound? a. Britain should sell pounds and buy dollars. b. Britain should do nothing as a fixed rate will not change. c. Britain should buy pounds and sell dollars. d. Britain should increase their money supply to create domestic inflation. 4

5 $/ S (spring - summer) $2.20 S (autumn - winter) $1.90 $ D (Billions) 15. Referring to the figure above, assuming that the British government is committed to maintaining a fixed exchange rate at $1.90 per pound. In the spring-summer period, what type of intervention must British monetary authorities engage in? a. Sell 20 billion pounds at $1.60. b. Sell 20 billion pounds at $1.90. c. Sell 10 billion pounds at $2.20. d. Buy 20 billion pounds at $

6 16. The table below shows balances for the US balance of payments in the years 2000 and From these data we see that, in the year 2006 US Imports of goods and services was -$2.204 trillion. In the context of the US Balance of Payments this means a. US imports were $2.204 trillion in 2006 b. The US decreased its imports by $2.204 trillion in 2006 c. The US increased its imports by $2.204 trillion in 2006 d. The US trade deficit was $2.204 in The table below shows balances for the US balance of payments in the years 2000 and From these data we see that, in the year 2006 Foreign-owned assets in the United States was +$1.859 trillion. In the context of the US Balance of payments this means a. Foreigners increased their asset holdings in the US by +$1.859 in 2006 b. Foreigners decreased their asset holdings in the US by +$1.859 in 2006 c. Foreign owned assets in the US totaled +$1.859 in 2006 d. The US trade deficit was +$1.859 in 2006 US Balance of Payments (Credits +; debits -) Exports of goods and services and income receipts Exports of goods and services Income receipts Imports of goods and services and income payments Imports of goods and services Income payments Unilateral current transfers, net U.S.-owned assets abroad (increase/financial outflow (-)) Foreign-owned assets in the United States Financial derivatives, net n.a Statistical discrepancy Memoranda: Balance on goods and services Balance on income Unilateral current transfers, net Balance on current account Suppose, these are the market prices Today s price of the : $2.00 per pound 90 day interest rate in US 4% 90 day interest rate in UK 4% The US Federal Reserve then announced (unexpectedly) that it would raise US interest rates to 6%. As a result the for the would increase and the price of the pound would $2.00 per pound. a. Demand; Dollar; fall below b. Demand; Pound; fall below c. Demand; Dollar; rise above d. Supply; Pound; rise above 6

7 19. In Country A, the government has a government budget deficit (tax revenues < government expenditures). Country A has a surplus on its current account. {Note: Country A s situation is similar to Japan during the last decade.} Country A will have a in its capital account. a. Deficit b. Depreciation c. Lag d. Balance 20. Country A has a currency called the Alpha. A s government manages the Alpha/US$ exchange rate. Currently, the exchange rate is 7 Alphas/$. Analysts suggest that the market equilibrium exchange rate is 4 Alphas/$. Which of the following is correct? a. At the 7 Alpha/$ exchange rate there is an excess supply of Alphas in the market b. To maintain the 7 Alpha/$ exchange rate the A s central bank must sell Alphas and buy dollars c. If the exchange rate fell to 4 Alphas/$, A s exports to the US would less expensive to US consumers d. A s central bank can maintain the 7 Alpha/$ exchange rate by raising country A s interest rates 21. Which of the following terms describes an exchange rate regime in which the government intervenes in the foreign exchange market in order to influence the market determined exchange rate? a. Fully convertible b. Currency control c. Managed float d. Clean float 22. Hong Kong has a currency board. Under this exchange rate regime a. The Hong Kong $ floats b. The Hong Kong $ follows an adjustable peg to market basket of currencies c. The Hong Kong $ is managed so that Hong Kong s current account must balance d. The Hong Kong $ is fixed against the US $ 23. Ecuador has dollarized. This means that Ecuador a. Has no ability to set domestic monetary policy and interest rates b. Every Ecuadorian dollar is backed by 7.75 US dollars c. Ecuador gains from seigniorage d. Gets a free, interest rate loan from the US 24. According to the Impossible Trinity, it is impossible to do 3 Things at the same time. These 3 Things are a. Free capital flows, free immigration flows, and free trade flows b. Government budget deficit, current account deficit, and negative personal savings c. Free capital flows, independent monetary policy, and fixed exchange rates d. Democracy, economic growth, and low corruption 25. Exchange rate stabilization requires that a country s central bank a. Use an expansionary monetary policy to offset a depreciation of its currency b. Raise interest rates to offset a depreciation of its currency c. Raise taxes to offset a depreciation of its currency d. Raise import tariffs to offset a depreciation of its currency 26. Refer to Figure 12.6 above. Suppose the British unexpectedly raised British interest rates. This caused the short run demand for the pound to increase from D0 to D1. According to the 7

8 phenomena of exchange rate overshooting, the reason that the short term exchange rate (US $ per pound) will initially rise "too much" to $2.20 and subsequently fell to $2.10 is that the supply of British pounds became more elastic (S1 instead of S0). The reason the supply of pounds became more elastic is that a. the US would be expected to raise US interests rates as well b. over time the British will adjust to the pound appreciation and import more US goods c. British exports would gradually increase following the pound appreciation 27. According to the quantity theory of money with output fixed at the full employment level, a change in the domestic money supply will bring about: a. Inverse and proportionate changes in the price level b. Inverse and less-than-proportionate changes in the price level c. Direct and proportionate changes in the price level d. Direct and less-than-proportionate changes in the price level 28. Suppose Country A has a current account deficit with the ROW (rest of the world). Country A's exchange rate is fixed. This means that A's current account deficit will not affect their exchange rate. Which of the following are automatic adjustments that could occur as a result of Country A's current account deficit? a. interest rates in Country A could fall b. prices in Country A could fall c. Country A's capital and financial account surplus could increase d. prices in the ROW could fall 29. Under the gold standard, a surplus nation facing a gold inflow and an increase in its money supply would also experience a: a. Rise in its interest rate and a short-term financial inflow b. Rise in its interest rate and a short-term financial outflow c. Fall in its interest rate and a short-term financial inflow d. Fall in its interest rate and a short-term financial outflow 30. Suppose Japan increases its imports from Sweden, leading to a rise in Sweden's exports and income level. With a higher income level, Sweden imports more goods from Japan. Thus a change in imports in Japan results in a feedback effect on its exports. This process is best referred to as the: a. Monetary approach to balance-of-payments adjustment b. Discretionary income adjustment process c. Foreign repercussion effect d. Price-specie flow mechanism 8

9 31. Suppose there are only two countries in the world; Country A and Country B. These countries are on the gold standard and everything is priced in terms of units of gold. There are no exchange rates and each economy is described fully by the quantity theory MV=PQ. The time period is set so that the velocity of money is one (V=1.0) and V doesn t change over time. In year 0 the world starts with each country having official gold reserves (G). The money supply in each country is equal to its gold reserves. The two countries don't trade in year 0. In year 1, A and B trade and this results in trade imbalances. There are no exchange rates and so something else has to give in order to reach a new equilibrium without trade imbalances. At the end of a period, balance of payments imbalances result in inflows or outflows of gold. After the gold flows in and out, in year 2, domestic prices then adjust according to the quantity theory. In Year 0, for Country A the money (gold) supply is 1000, the quantity of output (Q) is 1000 units and the price level is 1.00 (MV=PQ. 1000(1) = (1.00)(1000). In this model Q is assumed to be constant at the full employment level of Country A. Note that Y is also = PQ. In Year 0, for Country B, the money (gold) supply is 300, the quantity of output (Q) is 300 units and the price level is 2.00 (MV=PQ. 300(1)=(2.00)(300). In this model Q is assumed to be constant at the full employment level of Country A. For Country A at the end of year 1 a. C+I+G=1000 b. C+S+T=1000 c. NX=S-I d. NX=G-T 32. For Country B at the end of year 1 a. Domestic consumption (C+I+G) is less than domestic production (Y) b. Domestic savings is less than domestic investment c. The government budget has a deficit d. Net exports are negative 9

10 33. During year 1, trade resulted in a trade imbalance; Country A had a trade deficit and Country B had a trade surplus. Under the fixed exchange rate/ gold standard, there is an automatic adjustment mechanism leading to a new equilibrium with no trade imbalance. This happened in year 2. For Country B this automatic adjustment included a. gold outflow, decrease in money supply, decrease in prices, reduced imports and increased exports b. gold outflow, decrease in money supply, decrease in prices, reduced imports and increased exports c. gold inflow, decrease in money supply, decrease in prices, reduced imports and increased exports d. gold inflow, increase in money supply, increase in prices, increased imports and lower exports 34. Country A has a trade surplus and a floating exchange rate. Financial capital can freely flow in and out of Country A If Country A uses an expansionary fiscal policy to stimulate its economy out of a recession, this policy will also result in a. a decrease in A's trade surplus b. a depreciation in A's currency c. an increase in A's exports d. a decrease in domestic interest rates 35. If a country fixes the exchange rate of its currency to one key currency, it faces the risk that this particular key currency will be unstable in the future. To avoid this risk, countries can fix the exchange rate of their currency to the SDR (special drawing rights). This reduces exchange rate risk because a. The SDR is a composed of several key currencies and fluctuates less than any one of the key currencies b. The value of the SDR is guaranteed by the IMF. c. The SDR provides a lump sum signing bonus for countries that fix their currencies to the SDR. d. The SDR is fully backed by gold reserves. 10

11 36. The currency of Country A is the alpha and it is pegged at a fixed exchange rate = $2.00 per alpha. The Central Bank of Country A currently has foreign exchange reserves of $400. Originally the market equilibrium exchange rate given D0 and S0 is $2.00 per alpha. Then A's exports decreased, and along with the decreased demand for A's exports there was a corresponding decrease in the international demand for the alpha. The demand for the alpha decreased to D1. In order to maintain their peg at $2.00 per alpha, the Central Bank could a. Buy 5 alphas with $10. The Bank s foreign exchange reserves would decrease to $390 b. Sell 2 alphas for $3.40. The Bank s foreign exchange reserves would decrease to $ c. Buy2 alphas for $3.40. The Bank s foreign exchange reserves would increase to $ d. Sell 10 alphas for $5.00. The Bank s foreign exchange reserves would increase to $ A credible currency board must a. have a floating (flexible) exchange rate b. have a balanced government budget (G=T) c. have sufficient foreign reserves to purchase 100% of their domestic money supply at the fixed exchange rate d. fix domestic interest rates 11

12 38. Country A's currency is the Alpha. Country A has a floating (market determined) exchange rate. The Rest of the World's (ROW) currency is the $. The figure above shows the market for Alphas in Year 0. In Year 0 Country A has a current account balance = 0. In the currency markets, the equilibrium price of the Alpha (the exchange rate) is $2.00 per Alpha. a. There is excess demand for the alpha = 5 alphas b. The alpha is overvalued which led to low levels of exports from Country A, high levels of imports into Country A, and a trade deficit c. The surplus of alphas in the foreign exchange market corresponds (roughly) to A's trade surplus d. The shortage of alphas in the foreign exchange market corresponds (roughly) to A's trade surplus 39. Over the past year China has pegged their currency (RMB) to the US $. To maintain this fixed exchange rate, the Chinese monetary authorities have a. filled the excess demand for Chinese currency by increasing the Chinese money supply b. purchased the excess supply of Chinese currency by selling dollars from their foreign reserves c. increased the domestic interest rate d. used the surplus on their capital and financial accounts to reduce government debt 40. Expansionary monetary policy for an open economy with floating exchange rates can be more powerful than in a closed economy because a. A's currency will appreciate b. A's exports will increase c. A's interest rates will increase d. A's price level will decrease Answers on the next page 12

13 1 A 2 B 3 B 4 B 5 B 6 C 7 C 8 A 9 C 10 D 11 A 12 A 13 B 14 C 15 B 16 A 17 A 18 A 19 A 20 B 21 C 22 D 23 A 24 C 25 B 26 B 27 C 28 B 29 D 30 C 31 B 32 A 33 D 34 A 35 A 36 A 37 C 38 B 39 A 40 B Posted Wed.(4/21) at 1:21 13

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