Macroeconomics, 6e (Blanchard/Johnson)

Chapter 18: Openness in Goods and Financial Markets

18.1 Multiple Choice Questions

1) A tariff is
A) a foreign bond.
B) an order for foreign goods that have not yet been delivered.
C) a barter arrangement between importers and exporters.
D) a tax on imported goods.
E) a restriction on the quantity of imported goods allowed into the country.
Answer: D
Diff: 1

2) In the U.S., over the past forty years,

A) exports as a percentage of GDP have increased, while imports has a percentage of GDP have
decreased.
B) exports as a percentage of GDP have decreased, while imports has a percentage of GDP have
increased.
C) both exports and imports as a percentage of GDP have decreased.
D) both exports and imports as a percentage of GDP have increased.
E) both exports and imports as a percentage of GDP have remained constant.
Answer: D
Diff: 1

3) In 2010, which of the following countries had the highest ratio of exports to GDP?
A) Germany
B) Belgium
C) Japan
D) United States
E) Austria
Answer: B
Diff: 1

4) The ratio of a country's exports to its GDP must

A) be greater than one.
B) be less than one.
C) equal the ratio of imports to GDP.
D) be larger than the ratio of imports to GDP.
E) none of the above
Answer: E
Diff: 1

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5) Which of the following best defines the real exchange rate?
A) the price of foreign bonds in terms of domestic bonds
B) the price of foreign currency in terms of domestic currency
C) the price of domestic goods in terms of foreign goods
D) the price of domestic currency in terms of foreign currency
E) none of the above
Answer: C
Diff: 1

6) Which of the following, all else fixed, will cause the real exchange rate to increase?
A) a nominal depreciation
B) a reduction in the foreign price level
C) a reduction in the domestic price level
D) all of the above
E) none of the above
Answer: B
Diff: 2

7) From the perspective of the United States, an increase in the nominal exchange rate will cause
which of the following?
A) the dollar becomes less expensive to foreigners
B) foreign goods are more expensive to Americans
C) foreign currency is more expensive to Americans
D) American goods are more expensive to foreigners
E) none of the above
Answer: D
Diff: 1

8) When the dollar appreciates relative to the pound, the pound price of the dollar
A) increases.
B) decreases.
C) does not change.
D) increases or decreases, depending on the amount of the depreciation.
E) changes in the next period.
Answer: A
Diff: 1

9) Suppose there is a real depreciation of the dollar. Which of the following may have occurred?
A) foreign currency has become more expensive in dollars.
B) foreign goods have become more expensive to Americans.
C) the foreign price level has increased relative to the U.S. price level.
D) all of the above
E) none of the above
Answer: D
Diff: 1

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10) Suppose that over the past decade, U.S. inflation is less than that in Mexico. Further assume
that during this same period, the dollar depreciates relative to the Mexican peso. Given this
information,
A) the real exchange rate remains unchanged.
B) the real exchange rate must decrease.
C) the real exchange rate must increase.
D) the real exchange rate can increase or remain the same, but not decrease.
E) the real exchange rate can decrease or remain the same, but not increase.
Answer: B
Diff: 2

11) America's largest trading partner is

A) Canada.
B) Japan.
C) Mexico.
D) European Union.
E) none of the above
Answer: D
Diff: 1

12) Another name for "current account transactions" is

A) "capital account transactions."
B) "investment income."
C) "net transfers received."
D) "checking account transactions"
E) "transactions above the line."
Answer: E
Diff: 1

13) Because the U.S. traditionally gives more foreign aid than it receives, the U.S. traditionally
has a negative value for
A) the capital account balance.
B) the trade balance.
C) investment income.
D) net transfers received.
E) all of the above
Answer: D
Diff: 1

14) When the U.S. has a current account surplus, we know that it is also
A) running a balanced trade account.
B) lending to the rest of the world.
C) borrowing from the rest of the world.
D) suffering from negative investment income.
E) none of the above
Answer: B
Diff: 1
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15) The difference between net capital flows and the current account deficit is called the
A) capital account surplus.
B) capital account deficit.
C) international error.
D) missing number.
E) statistical discrepancy.
Answer: E
Diff: 1

16) In a country like Saudi Arabia, which earns substantial income from holding the stocks and
bonds of other countries, we would expect
A) GNP to be larger than GDP.
B) a current account deficit.
C) a current account surplus larger than GNP.
D) a current account surplus larger than GDP.
E) GDP to be larger than GNP.
Answer: A
Diff: 1

17) If the exchange rate between the dollar and the pound (the pound price of the dollar) is
currently 1.50, and is expected to be 1.35 in one year, then the expected rate of
A) depreciation of the dollar is 10%.
B) depreciation of the dollar is 15%.
C) appreciation of the dollar is 10%.
D) appreciation of the dollar is 15%.
E) none of the above
Answer: A
Diff: 2

18) Assume that the uncovered interest parity condition holds. Also assume that the U.S. interest
rate is less than the U.K. interest rate. Given this information, we know that investors expect
A) the pound to depreciate.
B) the pound to appreciate.
C) the dollar-pound exchange rate to remain fixed.
D) the U.S. interest rate to fall.
E) none of the above
Answer: A
Diff: 2

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19) Assume that the interest rate in a foreign country is 7% and that the foreign currency is
expected to depreciate by 3% during the year. For each dollar that a U.S. resident invests in
foreign bonds, he/she can expect to get back an approximate total of
A) $.93.
B) $.96.
C) $1.04.
D) $1.07.
E) $1.10.
Answer: C
Diff: 2

20) Suppose two countries make a credible commitment to fix their bilateral exchange rate. In
such a situation, we know that
A) the uncovered interest parity condition no longer holds.
B) the real exchange rate must be constant as well.
C) each country can freely allow its interest rate to diverge from that of the other country.
D) the interest rate in the two countries must be equal.
E) neither country will run a trade deficit.
Answer: D
Diff: 1

21) In 2010, exports as a percentage of GDP for the United States are approximately
A) between 1% and 5%
B) between 10% and 20%
C) between 20% and 40%
D) between 40% and 75%
E) between 75% and 90%
Answer: B
Diff: 1

22) As of 2010, the ratio of exports to GDP for Belgium was approximately equal to
A) 20%.
B) 40%.
C) 60%.
D) 81%.
Answer: D
Diff: 1

23) If the price level in Japan is 1.0, the price level in the U.S. is 2.0, and it costs 100 Yen to buy
one dollar, then the real exchange rate between the U.S. and Japan is
A) 2.
B) 10.
C) 50.
D) 100.
E) 200.
Answer: E
Diff: 2
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24) Year-to-year movements in real exchange rates between industrialized countries like the U.S.
and Canada are caused mostly by
A) changes in relative rates of inflation.
B) changes in relative growth rates of output.
C) changes in quotas or tariffs.
D) changes in capital controls.
E) changes in nominal exchange rates.
Answer: E
Diff: 1

25) Suppose the U.S. one-year interest rate is 3% per year, while a foreign country has a
one-year interest rate of 5% per year. Ignoring risk and transaction costs, a U.S. investor should
invest in foreign bonds as long as the expected yearly rate of depreciation of the foreign currency
is
A) less than 5%.
B) greater than 5%.
C) greater than 2%.
D) less than 2%.
E) less than 1%.
Answer: D
Diff: 2

26) Which of the following has occurred for the United States since 1960?
A) the ratio of exports to GDP (X/Y) and the ratio of imports to GDP (IM/Y) have both
increased.
B) X/Y has increased while IM/Y has decreased.
C) X/Y has decreased and IM/Y has increased.
D) X/Y has decreased and IM/Y has decreased.
Answer: A
Diff: 1

27) Which of the following has occurred for the United States since 1960?
A) the ratio of exports to GDP (X/Y) and the ratio of imports to GDP (IM/Y) have both
decreased
B) X/Y has increased while IM/Y has decreased
C) X/Y has decreased and IM/Y has increased
D) X/Y and IM/Y have stayed relatively constant
E) none of the above
Answer: E
Diff: 1

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28) The ratio of exports to GDP for the United States in 2010 is approximately equal to
A) 6%.
B) 13%.
C) 21%.
D) 31%.
Answer: B
Diff: 1

29) Estimates are that tradable goods in the U.S. account for approximately what share of GDP
in the U.S.?
A) 10%
B) 16%
C) 25%
D) none of the above
Answer: D
Diff: 1

30) In 2010, which of the following countries had the lowest ratio of exports to GDP?
A) Japan
B) Switzerland
C) Austria
D) Netherlands
E) United States
Answer: E
Diff: 1

31) In 2010, which of the following countries had the highest ratio of exports to GDP?
A) United States
B) Germany
C) Japan
D) Belgium
Answer: D
Diff: 1

32) The differences in the ratios of exports to GDP across countries are believed to be caused
primarily by
A) trade barriers.
B) each country's size.
C) monetary policy.
D) fiscal policy.
E) inflation in the domestic country.
Answer: B
Diff: 1

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33) The differences in the ratios of exports to GDP across countries are believed to be caused
primarily by
A) trade barriers.
B) each country's size.
C) geography.
D) all of the above
E) both B and C
Answer: E
Diff: 1

34) The nominal exchange rate (E) as defined in the text represents
A) the number of units of foreign currency you can obtain with one unit of domestic currency.
B) the number of units of domestic goods you can obtain with one unit of foreign goods.
C) the price of domestic currency in terms of foreign currency.
D) none of the above
E) both A and C
Answer: E
Diff: 1

35) When E increases by 5%, we know that

A) a real appreciation will occur if P decreases by 5%.
B) a real depreciation will occur if P also increases by 5%.
C) a nominal appreciation will occur.
D) a nominal depreciation will occur.
Answer: C
Diff: 2

36) When E decreases by 3%, we know that

A) a real appreciation will occur if P also falls by 3%.
B) a real depreciation will occur if P increases by 3%.
C) nominal appreciation.
D) nominal depreciation.
Answer: D
Diff: 2

37) A nominal depreciation of the Mexican peso (against all currencies) indicates that
A) the peso price of foreign currency has fallen.
B) the Mexican real exchange rate will not change if the price level in Mexico falls.
C) the peso price of, for example, the U.K. pound has increased.
D) the number of units of foreign currency that one can obtain with one peso has decreased.
Answer: C
Diff: 2

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38) A nominal appreciation of the Japanese yen (against all currencies) indicates that
A) the yen price of the U.S. dollar has increased.
B) the yen price of the U.K. pound has increased.
C) the number of units of foreign currency that one can obtain with one yen has increased.
D) all of the above
Answer: D
Diff: 2

39) Which of the following expressions represents the real exchange rate (ε)?
A) E/P.
B) EP*/P.
C) EP*.
D) EP/P*.
E) none of the above
Answer: D
Diff: 2

40) Which of the following expressions represents the dollar price of foreign currency?
A) EP*/P
B) EP/P*
C) 1/E
D) E
E) none of the above
Answer: C
Diff: 1

41) Assume that the nominal exchange rate decreases by 4%. If prices (both domestic and
foreign do not change), we know that
A) foreign goods are now relatively cheaper.
B) foreign goods are now relatively more expensive.
C) domestic goods are now relatively more expensive.
D) both A and C
Answer: B
Diff: 2

42) Assume that the nominal exchange rate increases by 2%. If prices (both domestic and foreign
do not change), we know that
A) domestic goods are now relatively cheaper.
B) domestic goods are now relatively more expensive.
C) foreign goods are now relatively cheaper.
D) both B and C
Answer: D
Diff: 2

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43) A reduction in the real exchange rate indicates that
A) foreign goods are now relatively cheaper.
B) foreign goods are now relatively more expensive.
C) domestic goods are now relatively more expensive.
D) both A and C
Answer: B
Diff: 1

44) An increase in the real exchange rate indicates that

A) domestic goods are now relatively cheaper.
B) domestic goods are now relatively more expensive.
C) foreign goods are now relatively cheaper.
D) both B and C
Answer: D
Diff: 1

45) Which of the following will cause a real appreciation?

A) a reduction in E
B) a decrease in P
C) an increase in P*
D) none of the above
Answer: D
Diff: 2

46) Which of the following will cause a real depreciation?

A) an increase in E
B) a reduction in P*
C) a reduction in P
D) all of the above
E) none of the above
Answer: A
Diff: 1

47) Which of the following events will cause the smallest change in the real exchange rate (ε)?
A) a 6% drop in E and a 6% increase in the foreign price level (P*)
B) a 6% increase in the domestic price level (P) and a 6% reduction in P*
C) a 6% drop in E and a 6% reduction in P*
D) a 3% increase in E
E) a 2% increase in E and a 2% increase in P
Answer: C
Diff: 2

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48) Which of the following events will cause the largest real depreciation for the domestic
economy?
A) a 6% reduction in E and a 6% increase in the foreign price level (P*)
B) a 6% increase in the domestic price level (P) and a 6% reduction in P*
C) a 6% reduction in E and a 6% reduction in P*
D) a 3% increase in E
E) a 2% increase in E and a 2% increase in P
Answer: A
Diff: 2

49) Suppose you have one U.S. dollar with which you wish to purchase U.K. (one-year) bonds in
period t. Which of the following expressions represents the amount of U.S. dollars you will
receive in one year (i.e., period t+1) from purchasing U.K. bonds in period t?
A) i
B) 1 + i*
C) (1 + i*)Eet+1/Et
D) (1 + i*)Et/Eet+1
E) none of the above
Answer: D
Diff: 2

50) Suppose you have one U.S. dollar with which you wish to purchase U.K. (one-year) bonds in
period t. Which of the following expressions represents the amount of U.K. pounds you will
receive in one year (i.e., period t+1) from purchasing U.K. bonds in period t?
A) i
B) 1 + i*
C) (1 + i*)Eet+1/Et
D) (1 + i*)Et/Eet+1
E) none of the above
Answer: B
Diff: 2

51) Which of the following expressions represents the amount of foreign currency you can obtain
with one U.S. dollar?
A) Et
B) Eet+1
C) 1/ Eet+1
D) εt
E) none of the above
Answer: A
Diff: 2

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52) For this question, assume the interest parity conditions holds. Also assume that the domestic
interest rate is 9% and that the foreign interest rate is 5%. Given this information, we would
expect that
A) individuals will only hold foreign bonds.
B) individuals will only hold domestic bonds.
C) the domestic currency is expected to appreciate by 4%.
D) the domestic currency is expected to depreciate by 4%.
Answer: D
Diff: 2

53) For this question, assume the interest parity conditions holds. Also assume that the domestic
interest rate is 10% and that the foreign interest rate is 7%. Given this information, we would
expect that
A) individuals will only hold foreign bonds.
B) individuals will only hold domestic bonds.
C) the domestic currency is expected to appreciate by 3%.
D) the domestic currency is expected to depreciate by 3%.
Answer: D
Diff: 2

54) Assume the interest parity condition holds and that individuals expect the dollar to appreciate
by 5% during the coming year. Given this information, we know that
A) the interest rate differential between the two countries is less than 5%.
B) i < i*.
C) i = i*.
D) individuals will only hold foreign bonds.
E) none of the above
Answer: B
Diff: 2

55) Which of the following conditions will occur when two countries are engaged in a credible,
fixed exchange rate regime?
A) E = 1
B) E > 1
C) i = i*
D) E < 1
Answer: C
Diff: 2

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56) For this question, assume that the domestic interest rate is 8% and that the foreign interest
rate is 6%. And finally, assume that the domestic currency is expected to depreciate by 3%
during the coming year. Given this information, we know that
A) individuals will only hold domestic bonds.
B) individuals will only hold foreign bonds.
C) individuals will be indifferent about holding domestic or foreign bonds.
D) the interest parity condition holds.
Answer: B
Diff: 2

57) For this question, assume that the domestic interest rate is 6% and that the foreign interest
rate 4%. And finally, assume that the domestic currency is expected to appreciate by 3% during
the coming year. Given this information, we know that
A) individuals will only hold domestic bonds.
B) individuals will only hold foreign bonds.
C) individuals will be indifferent about holding domestic or foreign bonds.
D) the interest parity condition holds.
Answer: A
Diff: 2

58) For this question, suppose the domestic interest rate is 4% and that the foreign interest rate is
7%. And finally, assume that the domestic currency is expected to depreciate by 3% during the
coming year. Given this information, we know that
A) individuals will only hold domestic bonds.
B) individuals will only hold foreign bonds.
C) individuals will be indifferent about holding domestic or foreign bonds.
D) the interest parity condition holds.
Answer: B
Diff: 2

59) Suppose the domestic interest rate is 3% and that the foreign interest rate is 6%. And finally,
assume that the domestic currency is expected to appreciate by 4% during the coming year.
Given this information, we know that
A) individuals will only hold domestic bonds.
B) individuals will only hold foreign bonds.
C) individuals will be indifferent about holding domestic or foreign bonds.
D) the interest parity condition holds.
Answer: A
Diff: 2

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60) Which of the following, all else fixed, will cause the real exchange rate to decrease?
A) a nominal appreciation
B) an increase in the foreign price level
C) an increase in the domestic price level
D) all of the above
E) none of the above
Answer: B
Diff: 2

61) From the perspective of the United States, a reduction in the nominal exchange rate will
cause which of the following?
A) the dollar becomes more expensive to foreigners.
B) foreign goods are less expensive to Americans
C) foreign currency is less expensive to Americans.
D) American goods are less expensive to foreigners.
E) none of the above
Answer: D
Diff: 1

62) When the dollar depreciates relative to the pound, the pound price of the dollar
A) increases.
B) decreases.
C) does not change.
D) increases or decreases, depending on the amount of the depreciation.
E) changes in the next period.
Answer: B
Diff: 1

63) Suppose that over the past decade, U.S. inflation is greater than that in Mexico. Further
assume that during this same period, the dollar appreciates relative to the Mexican peso. Given
this information,
A) the real exchange rate remains unchanged.
B) the real exchange rate must decrease.
C) the real exchange rate must increase.
D) the real exchange rate can increase or remain the same, but not decrease.
E) the real exchange rate can decrease or remain the same, but not increase.
Answer: C
Diff: 2

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64) Assume that the uncovered interest parity condition holds. Also assume that the U.S. interest
rate is greater than the U.K. interest rate. Given this information, we know that investors expect
A) the pound to depreciate.
B) the pound to appreciate.
C) the dollar-pound exchange rate to remain fixed.
D) the U.S. interest rate to fall.
E) none of the above
Answer: B
Diff: 2

65) A nominal appreciation of the Mexican peso (against all currencies) indicates that
A) the peso price of foreign currency has risen.
B) the Mexican real exchange rate will not change if the price level in Mexico falls.
C) the peso price of, for example, the U.K. pound has decreased.
D) the number of units of foreign currency that one can obtain with one peso has increased.
Answer: C
Diff: 2

18.2 Essay Questions

1) Explain the three distinct notions of openness.

Answer: There are three notions of openness. First, there is openness in the goods market where
agents buy domestic and foreign goods and domestic firms sell goods abroad. Second, there is
openness in financial markets where individuals can purchase, for example, domestic or foreign
bonds. And third, there is openness in factor markets where firms can locate either domestically
or in other countries. Workers can also move between countries.

2) First, write out the expression/equation for the real exchange rate. Second, explain all factors
that determine the real exchange rate.
Answer: The real exchange rate is the price of domestic goods in terms of foreign goods. It is
represented as EP/P*. An increase in E, a nominal appreciation, raises the pound price of the
dollar. This will also raise the relative price of domestic goods. An increase in P*, the foreign
price level, reflects an increase in the foreign currency price of foreign goods. This will reduce
the relative price of domestic goods. And finally, an increase in P, the domestic price level,
reflects an increase in the dollar price of domestic goods. This will increase the relative price of
domestic goods in terms of foreign goods.

3) What are the differences between the real exchange rate and nominal exchange rate? Explain.
Answer: The real exchange rate, EP/P*, represents the relative price of domestic goods in terms
of foreign goods. The nominal exchange rate, E, is the pound price of domestic currency or,
equivalently, the relative price of domestic currency in terms of foreign currency.

4) Discuss what factors could cause a real depreciation.

Answer: Decrease in E; increase in P*; and decrease in P.

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5) Explain the difference between gross domestic product and gross national product.
Answer: GDP represents the market value of all final goods and services produced IN a country
during a given period. GNP is the market value of all final goods and services produced by
domestically owned factors of production in a given period.

6) Suppose you are considering the purchase of a bond issued in another country. What
calculations must you do to calculate the expected return on a foreign bond? Explain.
Answer: You must first determine the amount of foreign currency you can obtain with one unit
of domestic currency (E). You then must determine how much foreign currency you will obtain
in one year after purchasing foreign bonds. And finally, you must then calculate how much
domestic currency you will receive in one year when you convert the foreign currency back to
domestic currency.

7) Explain what factors determine the expected return on a foreign bond.

Answer: The current exchange rate, the current foreign interest rate, and the future expected
exchange rate.

8) Suppose the interest parity condition holds and that the domestic interest rate is greater than
the foreign interest rate. What does this imply about the current versus future expected exchange
rate? Explain.
Answer: If i > i*, we know that the foreign currency must be expected to appreciate to equate
the expected returns on the two bonds.

9) Suppose the interest parity condition holds. Also assume that the one-year interest rate in the
United States is 6% and that the one-year interest rate in Canada is 6%. What does this imply
about the current versus future expected exchange rate (for the U.S. and Canadian dollars)?
Explain.
Answer: This implies that there are no expected exchange gains or losses from holding foreign
currency denominated assets for one year. So, the exchange rate that financial market
participants expect to occur in one year is equal to the current exchange rate.

10) Assuming that the interest parity condition holds, what type of information is contained in
interest rate differentials between domestic and foreign bonds? Explain.
Answer: Given that the domestic rate equals the foreign interest rate minus any expected rate of
appreciation of the domestic currency, any difference in interest rates will reflect this expected
depreciation/appreciation of the domestic currency.

11) Explain why a comparison between the interest rates on domestic and foreign bonds might
provide misleading information about which bonds yield the highest expected returns.
Answer: A simple comparison of interest rates will ignore the expected exchange gains/losses
that can occur from holding assets denominated in a foreign currency. Hence, such a comparison
will likely provide incorrect information about which bonds have a higher expected return.

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12) Suppose the interest parity condition holds and that the domestic interest rate is less than the
foreign interest rate. What does this imply about the current versus future expected exchange
rate? Explain.
Answer: If i < i*, we know that the foreign currency must be expected to depreciate to equate
the expected returns on the two bonds.

13) Suppose the interest parity condition holds. Also assume that the one-year interest rate in the
United States is 5% and that the one-year interest rate in Canada is 6%. What does this imply
about the current versus future expected exchange rate (for the U.S. and Canadian dollars)?
Explain.
Answer: If the interest rate in US is less than the interest rate in Canada, we know that Canadian
dollars must be expected to depreciate to equate the expected returns on the two bonds.

14) Suppose the interest parity condition holds. Also assume that the one-year interest rate in the
United States is 6% and that the one-year interest rate in Canada is 5%. What does this imply
about the current versus future expected exchange rate (for the U.S. and Canadian dollars)?
Explain.
Answer: If the interest rate in US is greater than the interest rate in Canada, we know that
Canadian dollars must be expected to appreciate to equate the expected returns on the two bonds.

15) What is uncovered interest parity? Explain.

Answer: Uncovered interest parity or interest parity, is an arbitrage condition stating that the
expected rates of return in terms of domestic currency on domestic bonds and foreign bonds
must be equal. Interest parity implies that the domestic interest rate approximately equals the
foreign interest rate minus the expected appreciation rate of the domestic currency.

16) Suppose the one-year nominal interest rate is 2.0% in the United States and 5.0% in Canada.
Should you hold Canadian bonds or U.S. bonds? Explain.
Answer: It depends whether you expect the Canadian dollars to depreciate relative to the dollar
over the coming year by more or less than the difference between the U.S. interest rate and the
Canada interest rate, or 3.0% in this case (5.0% - 2.0%). If you expect the Canadian dollars to
depreciate by more than 3.0%, then, despite the fact that the interest rate is higher in Canada than
in the United States, investing in Canadian bonds is less attractive than investing in U.S. bonds.
By holding
Canadian bonds, you will get higher interest payments next year, but the Canadian dollars will be
worth less in terms of dollars next year, making investing in Canada bonds less attractive than
investing in U.S. bonds. If you expect the Canadian dollars to depreciate by less than 3.0% or
even to appreciate, then the reverse holds, and Canadian bonds are more attractive than U.S.
bonds.

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