Deck 13: The Open Economy Revisited: the Mundellfleming Model and the Exchange-Rate Regime

Question 1

Exhibit: IS*-LM* A small open economy with a floating exchange rate is initially at equilibrium A with equilibrium exchange rate e₂, and equilibrium output Y₁. If there is a monetary expansion to the new equilibrium will be at _____, holding everything else constant.

A)A
B)B
C)C
D)D

Answer 1

D

Question 2

In the Mundell-Fleming model:

A)the exchange-rate system must have a floating exchange rate.
B)the exchange-rate system must have a fixed exchange rate.
C)it makes no difference whether the exchange-rate system has a floating or a fixed exchange rate.
D)the behaviour of the economy depends on whether the exchange-rate system has a floating or fixed exchange rate.

Answer 2

the behaviour of the economy depends on whether the exchange-rate system has a floating or fixed exchange rate.

Question 3

The Mundell-Fleming model is a _____ model for a _____ open economy.

A)short-run; small
B)short-run; large
C)long-run; large
D)long-run; small

Answer 3

short-run; small

Question 4

Compared to a closed economy, an open economy is one that:

A)allows the exchange rate to float.
B)fixes the exchange rate.
C)trades with other countries.
D)does not trade with other countries.

Question 5

In a small open economy a decrease in the exchange rate will _____ net exports and shift the _____ curve.

A)increase; IS
B)decrease; IS
C)increase; LM
D)decrease; LM

Question 6

Exhibit: IS*-LM* A small open economy with a floating exchange rate is initially at equilibrium A with IS*₁, LM*₁, equilibrium exchange rate e₂, and equilibrium output Y₁. If there is an increase in government spending to IS*₂, the new equilibrium will be at _____, holding everything else constant.

A)A
B)B
C)C
D)D

Question 7

In a small open economy with perfect capital mobility, if the domestic interest rate were to rise above the world interest rate, then _____ would drive the domestic interest rate back to the level of the world interest rate.

A)capital inflow
B)capital outflow
C)the central bank
D)a decline in domestic saving

Question 8

In a small open economy with a floating exchange rate, if the government adopts an expansionary fiscal policy, in the new short-run equilibrium:

A)income and the exchange rate will both rise.
B)the exchange rate will rise, but income will remain unchanged.
C)income will rise, but the exchange rate will remain unchanged.
D)both income and the interest rate will rise.

Question 9

In a small open economy with a floating exchange rate, an effective policy to increase equilibrium output is to:

A)increase government spending.
B)increase taxes.
C)increase the money supply.
D)decrease the money supply.

Question 10

In a small open economy with a floating exchange rate, if the government increases the money supply, then in the new short-run equilibrium, the:

A)interest rate falls and the level of investment rises.
B)exchange rate falls and net exports increase.
C)interest rate falls but the level of investment does not rise.
D)exchange rate falls but net exports do not increase.

Question 11

In the Mundell-Fleming model, the exogenous variables are the:

A)world interest rate, the price level, and the exchange rate.
B)level of government spending, taxes, and income.
C)exchange rate and level of income.
D)price level, world interest rate, monetary policy, and fiscal policy.

Question 12

Under a floating system, the exchange rate:

A)fluctuates in response to changing economic conditions.
B)is maintained at a predetermined level by the central bank.
C)is changed at regular intervals by the central bank.
D)fluctuates in response to changes in the price of gold.

Question 13

In a small open economy with a floating exchange rate, the exchange rate will appreciate if:

A)the money supply is increased.
B)the money supply is decreased.
C)government spending is decreased.
D)taxes are increased.

Question 14

In a small open economy with a floating exchange rate, the supply of real money balances is fixed, and a rise in government spending:

A)raises the interest rate so that income must rise to maintain equilibrium in the money market.
B)raises the interest rate so that net exports must fall to maintain equilibrium in the goods market.
C)cannot change the interest rate so that net exports must fall to maintain equilibrium in the goods market.
D)cannot change the interest rate, so income must rise to maintain equilibrium in the money market.

Question 15

The Mundell-Fleming model assumes that:

A)prices are flexible, whereas the IS-LM model assumes that prices are fixed.
B)prices are fixed, whereas the IS-LM model assumes that prices are flexible.
C)as in the IS-LM model, prices are fixed.
D)as in the IS-LM model, prices are flexible.

Question 16

In the Mundell-Fleming model, the domestic interest rate is determined by the:

A)intersection of the LM and IS curves.
B)domestic rate of inflation.
C)world rate of inflation.
D)world interest rate.

Question 17

If short-run equilibrium in the Mundell-Fleming model is represented by a graph with Y along the horizontal axis and the exchange rate along the vertical axis, then the LM^* curve:

A)slopes upward and to the right because at a higher income a higher interest rate is needed to increase velocity.
B)is vertical because monetary velocity is independent of the interest rate.
C)is vertical because the exchange rate does not enter into the LM^* equation.
D)slopes upward and to the right because a higher exchange rate leads to a higher income.

Question 18

The intersection of the IS^* and LM^* curves shows the _____ and the _____ at which both the goods market and the money market are in equilibrium.

A)interest rate; price level
B)price level; exchange rate
C)level of output; exchange rate
D)level of output; price level

Question 19

If short-run equilibrium in the Mundell-Fleming model is represented by a graph with Y along the horizontal axis and the exchange rate along the vertical axis, then the IS^* curve:

A)slopes downward and to the right because the higher the exchange rate, the lower the level of net exports and, therefore, of short-run equilibrium income in the goods market.
B)is vertical because there is only one investment level that is consistent with the world interest rate.
C)is vertical because the exchange rate does not enter into the IS^* equation.
D)slopes downward and to the right because the higher the exchange rate, the higher the level of net exports and, therefore, of short-run equilibrium income in the goods market.

Question 20

In a small open economy with a floating exchange rate, a rise in government spending in the new short-run equilibrium:

A)chokes off investment but not by as much as the new government spending.
B)chokes off an amount of investment just equal to the new government spending.
C)attracts foreign capital, thus raising the exchange rate and reducing net exports, but not by as much as the new government spending.
D)attracts foreign capital, thus raising the exchange rate and reducing net exports by an amount just equal to the new government spending.

Question 21

Exhibit: Shifting IS* and LM* A small open economy with a floating exchange rate is initially in equilibrium at A with Holding all else constant, if domestic consumers develop greater preferences for imported goods, then the _____ curve will shift to _____.

A)LM₁*; LM₂*
B)LM₁*; LM₃*
C)IS₁*; IS₂*
D)IS₁*; IS₃*

Question 22

To maintain a fixed-exchange-rate system, if the exchange rate (foreign currency/local currency) moves below the fixed-exchange-rate level, then the central bank must:

A)buy foreign currency.
B)sell foreign currency from reserves.
C)raise taxes.
D)decrease government spending.

Question 23

In the Mundell-Fleming model with fixed exchange rates, attempts by the central bank to increase the money supply lead the exchange rate to fall, giving arbitrageurs the incentive to _____ the central bank, which causes the money supply to _____.

A)sell domestic currency to; increase
B)sell domestic currency to; decrease
C)buy domestic currency from; increase
D)buy domestic currency from; decrease

Question 24

In a small open economy with a fixed exchange rate, if the government increases government purchases, then in the new short-run equilibrium:

A)the exchange rate rises, but income does not rise.
B)income rises, but the exchange rate does not rise.
C)both income and the exchange rate rise.
D)neither income nor the exchange rate rises, as the money supply contracts.

Question 25

During the Great Depression, countries that devalued their currencies generally _____, whereas countries that maintained the old exchange rate _____.

A)suffered longer; experienced no depression
B)recovered relatively quickly; experienced no depression
C)suffered longer; recovered relatively quickly
D)recovered relatively quickly; suffered longer

Question 26

Exhibit: IS*-LM* A small open economy with a fixed exchange rate e₂ is initially at equilibrium A with IS₁*, LM₁* and equilibrium output Y₁. If there is a monetary expansion, the new equilibrium will be at _____, holding everything else constant.

A)A
B)B
C)C
D)D

Question 27

Under a fixed system, the exchange rate:

A)fluctuates in response to changing economic conditions.
B)is maintained at a predetermined level by the central bank.
C)is changed at regular intervals by the central bank.
D)fluctuates in response to changes in the price of gold.

Question 28

If the Bank of Canada announces that it will fix the exchange rate at 100 yen per Canadian dollar, but with the current money supply the equilibrium exchange rate is 150 yen per dollar, then:

A)arbitrageurs will sell yen in the marketplace.
B)arbitrageurs will buy yen from the Bank of Canada.
C)the money supply will fall until the market exchange rate is 100 yen per dollar.
D)the money supply will rise until the market exchange rate is 100 yen per dollar.

Question 29

A revaluation of a currency under a fixed-exchange-rate system occurs when the level at which the currency is fixed is:

A)increased.
B)decreased.
C)allowed to float.
D)kept fixed within a band.

Question 30

In a small open economy with a fixed exchange rate, if the country devalues its currency, then in the new short-run equilibrium the exchange rate _____, and the LM* curve shifts to the _____.

A)decreases; left
B)increases; left
C)decreases; right
D)increases; right

Question 31

If there is a fixed-exchange-rate system, then in the long run:

A)the nominal exchange rate is fixed, but the real exchange rate is free to vary.
B)the real exchange rate is fixed, but the nominal exchange rate is free to vary.
C)both the nominal and real exchange rates are fixed.
D)the nominal and real exchange rates vary by a fixed amount.

Question 32

Exhibit: IS*-LM* A small open economy with a fixed exchange rate e₂ is initially at equilibrium A with and equilibrium output Y₁. If there is an increase in government spending to the new equilibrium will be at _____, holding everything else constant.

A)A
B)B
C)C
D)D

Question 33

In a small open economy with a floating exchange rate, if the government imposes an import quota, then in the new short-run equilibrium the IS^* curve shifts to the right, raising the exchange rate:

A)but not raising net exports or income.
B)and net exports but not income.
C)and income but not net exports.
D)net exports and income.

Question 34

If there is a fixed-exchange-rate system, then in the short run described by the Mundell-Fleming model:

A)the nominal exchange rate is fixed, but the real exchange rate is free to vary.
B)the real exchange rate is fixed, but the nominal exchange rate is free to vary.
C)both the nominal and real exchange rates are fixed.
D)the nominal exchange rate is fixed, but whether the real exchange rate is fixed depends on whether the central bank follows a rule of constant growth of the money supply.

Question 35

In a small open economy with a fixed exchange rate, if the government imposes an import quota, then net exports:

A)decrease, but the money supply falls and income falls.
B)increase, the money supply increases, and income increases.
C)are unchanged, but the money supply falls and income falls.
D)are unchanged, the money supply is unchanged, and income is unchanged.

Question 36

Exhibit: Shifting IS* and LM* A small open economy with a floating exchange rate is initially in equilibrium at A with Holding all else constant, if the government imposes a tariff on imports in order to protect domestic jobs, then the _____ curve will shift to _____.

A)LM₁*; LM₂*
B)LM₁*; LM₃*
C)IS₁*; IS₂*
D)IS₁*; IS₃*

Question 37

According to the Mundell-Fleming model for a small open economy with flexible exchange rates, if the Bank of Canada cannot alter domestic interest rates, changes in the money supply could still influence aggregate income through changes in the:

A)exchange rate.
B)price level.
C)level of government spending.
D)tax rates.

Question 38

In a small open economy with a fixed exchange rate, if the government increases government purchases, then in the process of adjusting to the new short-run equilibrium, the money supply:

A)increases to keep the exchange rate unchanged, thus augmenting the effect of government spending on income.
B)decreases to keep the exchange rate unchanged, thus offsetting the effect of government spending on income.
C)remains unchanged, and there is no effect of government spending on income.
D)remains unchanged to keep the interest rate at the world interest rate, so that government spending reduces income.

Question 39

In a small open economy with a floating exchange rate, if the government imposes a tariff on foreign goods, then in the new short-run equilibrium:

A)imports will decrease while exports remain constant, leading to a rise in net exports.
B)imports will decrease and exports will increase, leading to a rise in net exports.
C)imports will decrease and exports will decrease by an equal amount.
D)both imports and exports will remain unchanged.

Question 40

Under a fixed-exchange-rate system, the central bank of a small open economy must:

A)have a reserve of its own currency, which it must have accumulated in past transactions.
B)have a reserve of foreign currency, which it can print.
C)allow the money supply to adjust to whatever level will ensure that the equilibrium exchange rate equals the announced exchange rate.
D)follow a rule specifying a constant growth rate for the money supply.

Question 41

If the exchange rate of currency A is fixed to a unit of currency B, then a potential problem for the central bank in charge of currency A is:

A)running out of currency A.
B)running out of currency B.
C)generating excessive revenue from seigniorage.
D)ineffective fiscal policy.

Question 42

According to the Mundell-Fleming model, import restrictions in an economy with flexible exchange rates cause net exports to _____, and in an economy with fixed exchange rates, import restrictions cause net exports to _____.

A)increase; increase
B)increase; remain unchanged
C)remain unchanged; remain unchanged
D)remain unchanged; increase

Question 43

Exhibit: Risk Premium A small open economy with a floating exchange rate is initially in equilibrium at A with IS₁*; LM₁*. If there is an increase in the risk premium, then LM₁* will shift to _____ and IS₁* will shift to _____.

A)LM₂* ; IS₂*
B)LM₂* ; IS₃*
C)LM₃* ; IS₂*
D)LM₃* ; IS₃*

Question 44

Country risk included in the risk premium in interest rates refers to the:

A)additional costs incurred when loans are made in currencies other than the domestic currency.
B)possibility that loans in some countries may not be repaid because of political upheaval.
C)expectation that the exchange rate may change in the future.
D)potential change in the terms of trade between countries.

Question 45

A monetary union with a common currency is an example of a:

A)fixed-exchange-rate system.
B)flexible-exchange-rate system.
C)small open economy.
D)large open economy.

Question 46

According to the Mundell-Fleming model, in an economy with flexible exchange rates, expansionary fiscal policy causes the exchange rate to _____, and expansionary monetary policy causes the exchange rate to _____.

A)rise; rise
B)rise; fall
C)fall; fall
D)fall; rise

Question 47

Some economists argue that monetary union does not work as well in Europe as it does in Canada and the United States for all of the following reasons except:

A)labour is not as mobile in Europe as it is in Canada and the United States.
B)there is no strong central government that can use fiscal policy in Europe as there is in Canada and the United States.
C)there is no common language in Europe as there is in Canada and the United States.
D)there is no European central bank as there is in Canada and the United States.

Question 48

One argument favouring a fixed-exchange-rate system is that it:

A)allows monetary policy to be used for stabilizing output and prices.
B)reduces exchange-rate uncertainty, thereby promoting more international trade.
C)leads to excessive growth of the money supply.
D)requires no actions on the part of the central bank to implement.

Question 49

According to the Mundell-Fleming model, under flexible exchange rates, expansionary monetary policy _____ increase income, and under fixed exchange rates, expansionary monetary policy _____ increase income.

A)can; can
B)can; cannot
C)cannot; can
D)cannot; cannot

Question 50

A speculative attack on a currency occurs when:

A)a central bank switches from a floating to a fixed exchange rate.
B)investors' perceptions change, making a fixed exchange rate untenable.
C)a country accepts dollarization.
D)a central bank adopts a currency board to back the domestic currency with a foreign currency.

Question 51

According to the Mundell-Fleming model, under:

A)floating exchange rates, a monetary expansion raises income, whereas a fiscal expansion does not, but under fixed exchange rates, a fiscal expansion raises income, whereas a monetary expansion does not.
B)both floating and fixed exchange rates, a monetary expansion raises income, but a fiscal expansion does not.
C)both floating and fixed exchange rates, a fiscal expansion raises income, but a monetary expansion does not.
D)floating exchange rates, a fiscal expansion raises income whereas a monetary expansion does not; but under a fixed exchange rate, a monetary expansion raises income whereas a fiscal expansion does not.

Question 52

The risk premium included in the interest rate of small open economies incorporates:

A)country risk and expectations of future exchange-rate changes.
B)the law of one price.
C)inefficient activity by arbitrageurs.
D)capital mobility.

Question 53

An increase in income generated by an increase in the country risk premium will not occur if there is a(n) _____ sufficient to offset the decline in the demand for money caused by the higher risk premium.

A)decrease in the money supply
B)increase in the money supply
C)decrease in government spending
D)fall in the price level

Question 54

"Crony capitalism" refers to situations in which banks make loans to those borrowers with the most:

A)profitable investment projects.
B)political clout.
C)ability to repay the loans.
D)creditworthy borrowers.

Question 55

An increase in income generated by an increase in the country risk premium will not occur if there is a(n) _____ sufficient to offset the decline in the demand for money caused by the higher risk premium.

A)increase in the money supply
B)decrease in government spending
C)increase in the price level caused by more expensive imports
D)fall in the price level caused by less expensive imports

Question 56

In the Mundell-Fleming model with fixed exchange rates, the imposition of trade restrictions results in an increase in net exports because:

A)investment increases.
B)investment decreases.
C)saving increases.
D)saving decreases.

Question 57

In order to compensate for an expected future decline in the Japanese yen relative to the dollar, the interest rate in Japan must be _____ the interest rate in Canada.

A)higher than
B)lower than
C)equal to
D)fixed relative to

Question 58

In the Mundell-Fleming model, expectations that a currency will lose value in the future will cause the current exchange rate to:

A)increase in the present.
B)decrease in the present.
C)remain constant in the present.
D)decrease only in the future.

Question 59

One argument favouring a floating-exchange-rate system is that it:

A)makes international trade less difficult.
B)minimizes destabilizing speculation by international investors.
C)allows monetary policy to be used for other purposes.
D)helps prevent excessive growth in the money supply.

Question 60

According to the Mundell-Fleming model, under fixed exchange rates, expansionary fiscal policy causes income to _____, and under flexible exchange rates expansionary fiscal policy causes income to _____.

A)increase; increase
B)increase; remain unchanged
C)remain unchanged; remain unchanged
D)remain unchanged; increase

Question 61

If domestic prices are assumed to be endogenous in the Mundell-Fleming model, then a fall in government spending leads to:

A)a larger decline in the level of output under a flexible exchange rate compared to a fixed exchange rate regime.
B)a larger decline in the level of output under a fixed exchange rate compared to a flexible exchange rate regime.
C)a decline in the level of output under a fixed exchange rate regime, but no change under a flexible exchange rate regime.
D)a similar decline in the level of output under a fixed exchange rate and a flexible exchange rate regime.

Question 62

Which of the following would be evidence that a country with a fixed exchange rate has an undervalued currency?

A)The government has a budget surplus.
B)The government has a budget deficit.
C)The central bank's foreign-currency reserves are increasing.
D)The central bank's foreign-currency reserves are decreasing.

Question 63

In the Mundell-Fleming model with flexible exchange rates, an increase in the price level results in a(n) _____ in the real exchange rate and a(n) _____ in net exports.

A)increase; increase
B)increase; decrease
C)decrease; decrease
D)decrease; increase

Question 64

The principal economic loss when a country dollarizes is the loss of:

A)seigniorage revenue.
B)income tax revenue.
C)monetary stability.
D)a fixed exchange rate with the dollar.

Question 65

If the exchange rate is allowed to have a direct effect on the consumer price index, then a drop in government spending leads to:

A)a larger fall in the level of output under a flexible exchange rate than under a fixed exchange rate regime.
B)a larger fall in the level of output under a fixed exchange rate than under a flexible exchange rate regime.
C)an increase in the level of output under a flexible exchange rate regime.
D)an increase in the level of output under a fixed exchange rate regime.

Question 66

When a country abandons its national currency and adopts the currency of the United States, this is known as:

A)a floating exchange-rate system.
B)dollarization.
C)a speculative attack on the United States.
D)a currency board.

Question 67

If a country chooses to restrict international capital flows and to maintain a fixed exchange rate, then it must:

A)live with exchange-rate volatility.
B)control its citizens' access to world financial markets.
C)give up the use of monetary policy for purposes of domestic stabilization.
D)give up the use of fiscal policy for purposes of domestic stabilization.

Question 68

The "impossible trinity" refers to the idea that it is impossible for a country to simultaneously have:

A)low inflation, low unemployment, and a rapid rate of GDP growth.
B)free capital flows, a fixed exchange rate, and an independent monetary policy.
C)high interest rates, a budget deficit, and a trade deficit.
D)an expansionary fiscal policy, a contractionary monetary policy, and a flexible exchange rate.

Question 69

If a country chooses to have free capital flows and to conduct an independent monetary policy, then it must:

A)live with exchange-rate volatility.
B)restrict its citizens from participating in world financial markets.
C)give up the use of monetary policy for purposes of domestic stabilization.
D)have a fixed exchange rate.

Question 70

In a large open economy with a floating exchange rate, such as in the United States, in the short run a monetary contraction:

A)raises the interest rate and lowers investment and income, but does not affect the exchange rate.
B)raises the exchange rate and lowers net exports and income, but does not affect the interest rate.
C)initially raises the exchange rate, causing arbitrageurs to sell dollars and return the money supply to its initial level.
D)raises the interest rate and lowers investment and income, but also raises the exchange rate and lowers net exports.

Question 71

A fall in consumer confidence about the future, which induces consumers to spend less and save more, will, according to the Mundell-Fleming model, with fixed exchange rates, lead to:

A)a fall in consumption and income.
B)no change in consumption or income.
C)no change in income, but a rise in net exports.
D)a fall in income, but a rise in net exports.

Question 72

In the Mundell-Fleming model, if the price level falls, then the equilibrium income _____ and the real exchange rate _____.

A)rises; appreciates
B)rises; depreciates
C)falls; appreciates
D)falls; depreciates

Question 73

If a country chooses to have free capital flows and to maintain a fixed exchange rate, then it must:

A)live with exchange-rate volatility.
B)restrict its citizens from participating in world financial markets.
C)give up the use of monetary policy for purposes of domestic stabilization.
D)give up the use of fiscal policy for purposes of domestic stabilization.

Question 74

If the exchange rate is allowed to have a direct effect on the consumer price index, under a flexible exchange rate a fall in government spending causes:

A)a fall in the level of output and an increase in the consumer price index.
B)a fall in the level of output and a decrease in the consumer price index.
C)an increase in the level of output and a decrease in the consumer price index.
D)an increase in the level of output and an increase in the consumer price index.

Question 75

In the Mundell-Fleming model, if the economy is operating at or below the natural level in the short run, then in the long run the price level will fall, the exchange rate will _____, and net exports will _____ to restore the economy to its natural rate.

A)appreciate; increase
B)appreciate; decrease
C)depreciate; increase
D)depreciate; decrease

Question 76

The introduction of a stylish new line of Toyotas, which makes some consumers prefer foreign cars over domestic cars, will, according to the Mundell-Fleming model with floating exchange rates, lead to:

A)a fall in income and net exports.
B)no change in income or net exports.
C)a fall in income but no change in net exports.
D)no change in income but a fall in net exports.

Question 77

If domestic prices are assumed to be endogenous in the Mundell-Fleming model, the IS curve in this model is:

A)downward sloping.
B)upward sloping.
C)vertical.
D)horizontal.

Question 78

If the Mundell-Fleming model is modified to allow the exchange rate to have a direct effect on the consumer price index, then an appreciation of the currency will lead to:

A)an increase in the overall cost of living.
B)a decrease in the overall cost of living.
C)no change in the overall cost of living.
D)an increase in the price of imported goods only.

Question 79

Exhibit: IS*-LM* and AD ​ A small open economy with a floating exchange rate is initially in equilibrium at A with IS₁*; LM₁*. Holding all else constant, if the domestic price level increases, then the _____ curve will shift to _____.

A)LM₁*; LM₂*
B)LM₁*; LM₃*
C)IS₁*; IS₂*
D)IS₁*; IS₃*

Question 80

A fall in consumer confidence about the future, which induces consumers to spend less and save more, will, according to the Mundell-Fleming model with floating exchange rates, lead to:

A)a fall in consumption and income.
B)no change in consumption or income.
C)no change in income but a rise in net exports.
D)no change in income or net exports.