The Open Economy: International Trade and Finance — Hard Practice Quiz
A Macroeconomics cheat sheet for The Open Economy: International Trade and Finance — every key formula with its symbols defined — plus a hard-level practice quiz to test recall.
Formulas & key concepts
A summary of a country's transactions with the rest of the world over a period.
The part of the balance of payments recording trade in goods and services, factor income, and transfers with other countries.
The difference between a country's exports and imports of both goods and services.
The difference between a country's exports and imports of goods alone, ignoring services.
The part of the balance of payments recording sales and purchases of assets between a country and the rest of the world.
The market in which currencies are traded and exchange rates are determined.
The price of one country's currency expressed in terms of another country's currency.
A rise in the value of a currency relative to other currencies.
A fall in the value of a currency relative to other currencies.
The exchange rate at which the quantity of a currency demanded equals the quantity supplied in the foreign exchange market.
The nominal exchange rate adjusted for the two countries' price levels; the current account responds to this, not to the nominal rate.
The exchange rate that would make a basket of goods and services cost the same in two countries; it is a good predictor of changes in the nominal exchange rate.
The set of rules a government follows in managing its currency's exchange rate.
A regime in which the government acts to hold the exchange rate at a target level.
A regime in which the exchange rate is left free to fluctuate with market forces.
Government buying or selling of its own currency to keep a fixed exchange rate, which requires holding foreign exchange reserves.
Stocks of foreign currency a government holds so it can intervene in the foreign exchange market.
Legal restrictions on the buying and selling of foreign currency, sometimes used to defend a fixed exchange rate.
Stable exchange rates bring benefits, but the tools to fix them are costly: intervention ties up reserves, controls distort incentives, and using monetary policy to defend the rate makes it unavailable for domestic goals.
A reduction in the target level of a fixed exchange rate, which eliminates a currency surplus and increases aggregate demand.
An increase in the target level of a fixed exchange rate, which eliminates a currency shortage and reduces aggregate demand.
Expansionary monetary policy lowers interest rates, depreciating the currency, which raises exports and cuts imports and so increases aggregate demand; contractionary policy does the reverse.
Because one country's imports are another's exports, business cycles are linked across countries, though floating exchange rates can weaken that link.
International flows of savings connect countries' loanable funds markets, so capital inflows and outflows help shape domestic interest rates and the balance of payments.
Practice quiz
If a country's financial account surplus increases due to a surge in foreign direct investment, and its merchandise trade balance moves into a larger deficit, what must be true about the overall Balance of Payments Accounts, assuming no other changes and a floating exchange rate regime?
- The current account deficit must have decreased to offset the financial account surplus.
- The current account deficit must have increased, but the overall balance of payments remains zero.
- The financial account surplus must be exactly offset by a current account deficit, maintaining overall balance.
- The country's foreign exchange reserves would increase, indicating a balance of payments surplus.
Answer: The financial account surplus must be exactly offset by a current account deficit, maintaining overall balance.
To improve its Balance of Payments on Goods and Services, a country operating under a floating exchange rate regime decides to implement an expansionary monetary policy. How would this policy likely affect the real exchange rate and subsequently the current account?
- The nominal exchange rate would appreciate, leading to a real appreciation and a worsening of the current account.
- The nominal exchange rate would depreciate, leading to a real depreciation, which would make exports cheaper and imports more expensive, thereby improving the current account.
- The real exchange rate would remain unchanged, as monetary policy only affects nominal variables in the long run, thus having no impact on the current account.
- Interest rates would rise, attracting capital inflows, causing the currency to appreciate and worsening the current account.
Answer: The nominal exchange rate would depreciate, leading to a real depreciation, which would make exports cheaper and imports more expensive, thereby improving the current account.
A country operating under a fixed exchange rate regime is facing a persistent current account deficit and wishes to stimulate its aggregate demand. Which policy action, consistent with its exchange rate regime, would address both issues, and what would be its immediate effect on the exchange rate target?
- A revaluation of its currency, which would increase aggregate demand and reduce the current account deficit.
- An increase in interest rates, which would attract capital inflows and strengthen the currency, but worsen the current account.
- A devaluation of its currency, which would eliminate a currency surplus, increase aggregate demand, and improve the current account.
- Implementing foreign exchange controls to restrict imports, which would improve the current account but not directly affect aggregate demand.
Answer: A devaluation of its currency, which would eliminate a currency surplus, increase aggregate demand, and improve the current account.
Given the nominal exchange rate of $1 \text{ Alpha} = 2 \text{ Beta}$, and a standard basket of goods costing $100 \text{ Alpha}$ in Country A and $180 \text{ Beta}$ in Country B, what is the real exchange rate (expressed as Beta per Alpha) and what does it imply about the Alpha's purchasing power relative to Beta?
- The real exchange rate is $0.9 \text{ Beta/Alpha}$, implying Alpha is undervalued relative to Beta.
- The real exchange rate is $1.11 \text{ Beta/Alpha}$, implying Alpha is overvalued relative to Beta.
- The real exchange rate is $1.8 \text{ Beta/Alpha}$, implying Alpha is undervalued relative to Beta.
- The real exchange rate is $2.22 \text{ Beta/Alpha}$, implying Alpha is overvalued relative to Beta.
Answer: The real exchange rate is $1.11 \text{ Beta/Alpha}$, implying Alpha is overvalued relative to Beta.
A country committed to a fixed exchange rate regime is experiencing both high inflation and a severe recession. Its central bank wants to use monetary policy to address the recession, but this conflicts with maintaining the fixed exchange rate. Which statement best describes the Exchange Rate Policy Dilemma in this situation?
- Using expansionary monetary policy to combat the recession would lead to currency appreciation, exacerbating inflation.
- Using contractionary monetary policy to combat inflation would lead to currency depreciation, worsening the recession.
- To maintain the fixed exchange rate, the central bank must use its monetary policy to defend the rate, making it unavailable for domestic goals like combating recession or inflation.
- The country should switch to a floating exchange rate regime, as this would resolve the dilemma by allowing independent monetary policy without intervention.
Answer: To maintain the fixed exchange rate, the central bank must use its monetary policy to defend the rate, making it unavailable for domestic goals like combating recession or inflation.
If Country X experiences a sudden and significant increase in its domestic interest rates relative to global rates, how would this likely affect its Financial Account and the equilibrium exchange rate under a floating exchange rate regime?
- Capital outflows would increase, leading to a deficit in the Financial Account and a depreciation of the domestic currency.
- Capital inflows would increase, leading to a surplus in the Financial Account and an appreciation of the domestic currency.
- Capital flows would remain unchanged, as interest rate differentials are only relevant under fixed exchange rates.
- The Financial Account would move into a deficit, but the exchange rate would depreciate due to increased demand for foreign assets.
Answer: Capital inflows would increase, leading to a surplus in the Financial Account and an appreciation of the domestic currency.
If a country's merchandise trade balance improves significantly due to a surge in goods exports, but simultaneously its imports of services increase substantially, what can be definitively concluded about its Balance of Payments on Goods and Services and its Current Account, assuming no changes in factor income or transfers?
- Both the Balance of Payments on Goods and Services and the Current Account must improve.
- The Balance of Payments on Goods and Services will improve, but the Current Account might worsen if the service import increase is large enough.
- The Merchandise Trade Balance improvement guarantees an improvement in the Balance of Payments on Goods and Services, but the Current Account's direction is uncertain.
- The Balance of Payments on Goods and Services could either improve or worsen, and the Current Account's direction is also uncertain.
Answer: The Balance of Payments on Goods and Services could either improve or worsen, and the Current Account's direction is also uncertain.
A country maintaining a fixed exchange rate faces persistent downward pressure on its currency due to a large current account deficit. To defend its fixed exchange rate, what action must its central bank take in the foreign exchange market, and what will be the consequence for its foreign exchange reserves?
- The central bank must sell its domestic currency and buy foreign currency, leading to an increase in its foreign exchange reserves.
- The central bank must buy its domestic currency and sell foreign currency, leading to a decrease in its foreign exchange reserves.
- The central bank must implement foreign exchange controls to reduce demand for foreign currency, which will not affect its reserves.
- The central bank must revalue its currency, which would eliminate the downward pressure and increase reserves.
Answer: The central bank must buy its domestic currency and sell foreign currency, leading to a decrease in its foreign exchange reserves.
Country A, operating under a floating exchange rate, enters a recession and implements expansionary monetary policy. How might this policy affect the international business cycle linkage with Country B, and what is the mechanism?
- The expansionary policy will cause Country A's currency to appreciate, reducing its exports to Country B and strengthening the business cycle linkage.
- The expansionary policy will cause Country A's currency to depreciate, increasing its exports to Country B and weakening the business cycle linkage by stimulating domestic demand.
- The expansionary policy will cause Country A's currency to depreciate, increasing its exports to Country B, thereby transmitting the expansion to Country B and strengthening the business cycle linkage.
- The floating exchange rate regime will completely insulate Country A from Country B's business cycle, making the linkage irrelevant.
Answer: The expansionary policy will cause Country A's currency to depreciate, increasing its exports to Country B and weakening the business cycle linkage by stimulating domestic demand.
Country Z, operating under a fixed exchange rate, is experiencing a significant currency surplus and high inflationary pressures. To address these issues, its government decides to adjust its exchange rate target. What action should it take, and what would be the expected impact on aggregate demand?
- A devaluation, which would eliminate the currency surplus and increase aggregate demand, worsening inflation.
- A revaluation, which would eliminate the currency surplus and reduce aggregate demand, alleviating inflation.
- A devaluation, which would create a currency shortage and reduce aggregate demand, alleviating inflation.
- A revaluation, which would create a currency shortage and increase aggregate demand, worsening inflation.
Answer: A devaluation, which would eliminate the currency surplus and increase aggregate demand, worsening inflation.
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