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Econ 442 – Problem Set 3

Directions: This problem set consists of a mix of multiple-choice questions and short answer questions (60 pts. total).
Mark all responses clearly on your problem set. Be clear and legible.

Multiple Choice Section, choose the single best answer (1 pt each)

1. A central bank's international reserves consists of its holdings of

a. domestic currency holdings
b. foreign assets and gold
c. silver
d. domestic assets

2. Which one of the following statements is the MOST accurate?

a. Under a fixed exchange rate, central bank monetary tools are powerless to affect the economy's
output
b. Under a fixed exchange rate, fiscal policy tools are powerless to affect the economy's output.
c. Under a flexible exchange rate, central bank monetary tools are powerless to affect the economy's
output.

3. Which of the following best describes a deliberate government decision to lower their nominal exchange rate?
a. appreciation
b. depreciation
c. revaluation
d. devaluation
e. accumulation

4. Under fixed rates, which one of the following statements is the MOST accurate?
a. Fiscal policy can affect only employment.
b. Fiscal policy can affect only international reserves.
c. Fiscal policy can affect only output and employment.
d. Fiscal policy can affect output, employment and international reserves at the same time.

5. Under fixed exchange rates, which one of the following statements is the MOST accurate?
a. Devaluation causes a decrease in output.
b. Devaluation has no effect on output.
c. Devaluation causes a rise in output.
d. Devaluation causes a rise in output and a decrease in official reserves.
e. Devaluation causes a decrease in output and in official reserves.

6. Imperfect asset substitutability assumes

a. the risks of holding foreign and domestic currency are unrelated to returns.
b. the risks of holding foreign and domestic currency are identical.
c. the returns on foreign and domestic currency differ and are influenced by risk.
d. the returns on foreign and domestic currency bonds are identical.
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7. Under a fixed exchange rate, in the short-run, fiscal expansion _______ the current account _____ than under
a floating exchange rate.
a. decreases; less
b. decreases; more
c. increases; less
d. increases; more

8. Countries with
a. strong investment opportunities should invest little at home and channel their savings into investment
activity abroad.
b. strong investment opportunities should invest more at home and less abroad.
c. weak investment opportunities should invest more at home.
d. weak investment opportunities should invest little abroad.

9. By internal balance, most economists mean

a. full employment
b. price stability
c. full employment and price stability
d. full employment and high disposable income

10. By external balance, most economists mean

a. avoiding excessive imbalances in international payments
b. balance between exports and imports
c. balance between the trade and service accounts
d. fixed exchange rates

11. A current account surplus

a. poses no problem if domestic savings are being invested less profitably abroad than they would be at
home
b. there is no relation between current account surplus and savings and investment
c. may pose a problem if domestic savings are being invested less profitably abroad than they would be
at home

12. Countries with large current account surpluses might be viewed by the market as candidates for
a. devaluation.
b. revaluation.
c. bankruptcy.
d. depreciation.
e. investment.

13. Which component of the monetary trilemma is given up under the gold standard?
a. exchange rate stability
b. freedom of international capital movements
c. monetary policy oriented towards domestic goals
d. symmetry

14. Countries which stayed on the gold standard until 1936 experienced the
a. biggest deflations and output contractions
b. biggest deflations and output increases
c. lowest deflations and output contractions
d. biggest inflations and output contractions
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15. Under the Gold standard, a country is said to be in balance of payments equilibrium when the current account
balance is
a. equal to zero
b. financed entirely by international lending and past gold reserves
c. financed entirely by international lending without reserve movements
d. financed by international lending and with reserve movements
e. financed entirely by gold reserves

16. Under Bretton Woods,

a. any foreign country cannot devalue its currency against the dollar in conditions of "fundamental
disequilibrium."
b. any foreign country could devalue its currency against the dollar in conditions of "fundamental
disequilibrium," but the system's rules did not give the United States the option of devaluing against
foreign currencies.
c. the U.S. could devalue its currency against the foreign currencies in conditions of "fundamental
disequilibrium."

17. The collapse of the Bretton Woods system marked

a. the beginning of the gold standard
b. the end of fixed exchange rates and a move to floating exchange rates
c. the end of floating exchange rates and a move to fixed exchange rates

18. Advocates of floating exchange rates suggest it is favorable for economies for all of the following reasons
EXCEPT
a. it helps stabilize unemployment in case of economic shocks such as a fall in export demand
b. stabilizing speculation would prevent current account deficits from growing too large
c. it gives every country the opportunity to guide its own monetary conditions at home
d. it automatically matches the domestic inflation with ongoing foreign inflation

19. Which of the following is NOT a result of a temporary fall in foreign demand on one country's exports under
floating exchange rate?
a. The DD curve shifts to the left due to reduction of aggregate demand.
b. The AA curve shifts downwards due to reduction of money supply.
c. a fall in aggregate output
d. depreciation in home country's currency
e. a fall in the home interest rate

20. Economic experience since 1973 indicate that, under floating exchange rates
a. large and persistent departures from external balance were prevented
b. monetary policy autonomy was reduced
c. large and persistent departures from external balance were not prevented
d. perfect symmetry in monetary policy autonomy exists across countries

21. What would best describe the international capital markets?

a. the market of exchange of bonds
b. the market of exchange of stocks
c. the market in which residents of different countries trade assets
d. the currency market

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22. Eurodollars are dollar deposits located
a. in the United States.
b. in Europe.
c. outside Europe.
d. outside the United States.
e. outside both Europe and the United States.

23. Besides world trade growth, what can most directly explain the growth of international banking since the
1960s?
a. desire of depositors to hold currencies outside the jurisdiction of the countries that issue them.
b. the emergence of developing countries like China.
c. an increase in world travel.

24. For most practical matters, economists assume that

a. individuals are risk neutral.
b. individuals are risk lovers.
c. individuals are risk averse.

25. The case where people purposely act in a careless way, for example, driving recklessly because they are
insured, is called
a. moral hazard.
b. asymmetric information.
c. risk aversion.
d. bounded rationality.

26. What is a difficulty encountered in regulating international banking?

a. excessive deposit insurance rates on international banks
b. variability in exchange rates
c. absence of reserve requirements
d. oppressive regulatory controls that reduce competitiveness

27. The purpose of the Basel Committee was to

a. achieve a better coordination of domestic banking systems.
b. achieve a better coordination between brokers and investment bankers.
c. manipulate bank rates for more leverage profits.
d. achieve a better coordination of the surveillance exercised by national authorities over the
international banking system.

28. A random walk model can more accurately predict exchange rates as compared to a sophisticated forecast
a. for forecasts longer than a year away.
b. for forecasts up to a year away.
c. because of the predictability of exchange rates.
d. always.

29. Statistical studies of the relationship between interest rates and later depreciation rates show that the interest
difference across countries
a. has been an accurate predictor in the large swings of exchange rates.
b. has correctly predicted the direction in which exchange rates would change.
c. has been a very bad predictor in the large swings of exchange rates.
d. has not yet been studied as a predictor in the large swings of exchange rates.
e. is unrelated to the large swings of exchange rates.
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 30. The three types of gains from international transactions between the residents of different countries are
a. trades of exchange rates for goods or services, trades of goods or services for property, and trades of
gold for textiles
b. trades of goods or services for goods or services, trades of goods or services for assets, and trades of
assets for assets
c. trades of imports for exports, trades of exports for imports, and trades of natural resources for
financial assets
d. trades of services for goods, trades of currency for services, and trades of one type of currency for
another
e. trades of current goods for future services, trades of currency for gold, and trades of one type of
currency for another

Short Answer Section (3 questions, 10 pts each)

1. Explain how a balance of payment crisis might arise under a fixed exchange rate regime. Be sure to include the
terms “capital flight”, “expectations”, and “self-fulfilling crisis” in your explanation.

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2. Explain at least 3 drawbacks (problems) of the Gold Standard system.

3. Explain the monetary trilemma for open economies. How did each of the three international monetary systems
we studied (the Gold Standard, Bretton Woods, and floating exchange rates) relate to the monetary trilemma?