Introduction to Economics

Exercise 10

1. State which of the following is true or false and give reasons for your answer.

(a) When a UK citizen stays in a hotel in France, the UK is exporting a service.

(b) The sale of Scotch whisky to the US is recorded in the current account of the balance
of payments.

(c) The import of a capital good like a tractor is recorded in the capital account of the
balance of payments.

(d) The official settlements account balance must always be zero under a fixed
exchange rate regime.

(e) A larger government sector deficit always leads to a higher current account
deficit.

(f) If the exchange rate between the UK pound and the Japanese yen rises from 130 yen
per pound to 140 yen per pound, the UK pound has appreciated.

2. In the Balance of Payments Accounts, the addition to the Central Bank’s stock of official
foreign reserves enters as a debit (or minus) item. Why?

3. Suppose the Bank of England decides to pursue a very restrictive monetary policy to rid
the UK economy of inflation, by raising interest rates.

(a) What do you expect the implications of this policy to be on the value of the
pound sterling (£) if it is freely floating?
(b) What do expect to happen to the UK trade balance?
(c) Suppose the authorities were committed to keep the exchange rate fixed. What would
have to happen to foreign reserves of the Central Bank?

4. Assume in a hypothetical economy that government purchases of goods and services

are £400 billion, tax revenues are £300 billion, private savings are £300 billion, and private
investment is £250 billion. What is the balance of trade on current account (X-M)?

5. In September 2000, the average prices for a ‘Big-Mac’ in Britain and the Euro-11
area were £1.90 and 2.56 Euros respectively. On the basis of the relevant exchange rates, a
pound sterling buys 1.67 Euros. On the basis of this information, is the pound sterling over-
valued or under-valued relative to the Euro.