Questions and Problems (Chapter 7)

1. Why do governments prefer to avoid current account deficits that are too large?
A current account deficit may pose no problem if the borrowed funds are
channeled into productive domestic investment projects that pay for themselves
with the revenue they generate in the future.
2. Why do governments prefer to avoid excessive current account surpluses? Or, why are
growing domestic claims to foreign wealth ever a problem?
For a given level of national saving, an increased current account surplus implies lower
investment in domestic plant and equipment. A few reasons why: first, the returns to
domestic savings may be easier to tax than those on assets abroad; second, an addition
to the home capital stock may reduce domestic unemployment and therefore lead to
higher national income; third, domestic investment by one firm may have beneficial
technological spillover effects on other domestic producers that the investing firm does
not capture. In addition, the country may in the future find itself unable to collect the
money it is owed. Furthermore, countries with large surpluses can become targets for
discriminatory protectionist measures by trading partners with external deficits.

3. Explain why under the gold standard a perpetual surplus or a perpetual deficit is impossible.
Since specie inflows drive up domestic prices and restore equilibrium in the balance of
payments, any surplus eventually eliminates itself. A shortage of currency leads to low
domestic prices and a foreign payments surplus, and any deficit eventually eliminates
itself.

4. Explain why the monetary policy is not a policy tool under fixed exchange rates.
If a country adopts a fixed exchange rate policy, the exchange rate is the target of
monetary policy. Monetary policy cannot pursue an inflation target or an output target
at the same time as it pursues an exchange rate target. Nor can it set either interest
rates or money supply growth rates independently.

5. What policy tools are available in the Bretton –Woods fixed exchange rate system
Under the fixed exchange rates of the Bretton Woods system, fiscal policy was supposed
to be the main policy tool to achieve both internal and external balance. In general,
fiscal policy can not attain both internal balance and external balance at the same time,
so they used devaluation as an alternative tool.
6. Explain why fiscal policies cannot be used to achieve both the internal balance and external
balance under the fixed exchange rate system

Fiscal policy that results in internal or external balance: by

reducing demand for imports and output or increasing demand for
imports and output.

7. What are the impacts of policy tools are available in the Bretton –Woods fixed exchange rate
system