Question 1

Which of the following methods can a country use to accumulate precautionary savings?

Accepted Answer

Accumulating foreign exchange reserves is a common method used by countries to accumulate precautionary savings. This involves building up a stockpile of foreign currencies, which can be used to help support the domestic currency in times of economic volatility. This can provide a source of stability and confidence for investors, and can help to prevent financial crises from spiraling out of control. Options A, B, and D are not effective ways of accumulating precautionary savings, as they involve reducing government revenue or expenditure, which can in turn reduce the country's capacity to respond to economic fluctuations.

Question 2

In an open economy, as long as the long-run budget constraint is upheld, a nation may:

Accepted Answer

Running a trade deficit during temporary shocks and running a trade surplus during temporary gains in output allows a nation to keep consumption stable while still maintaining the long-run budget constraint. This approach allows for flexibility in responding to economic shocks and fluctuations, without sacrificing financial stability in the long term. Options B, C, and D are not necessarily mutually exclusive with option A, but option A is the most directly related to the concept of an open economy and the long-run budget constraint.

Question 3

If the percentage of change in total spending (C + G ) is lower than the percentage change in income, an economy has some degree of:

Accepted Answer

If the percentage change in income is higher than the percentage change in total spending (C+G), it suggests that individuals are saving a higher percentage of their income instead of spending it all. This behavior is indicative of consumption smoothing, where individuals tend to save money during high-income periods to be able to maintain their consumption levels during low-income periods. This behavior helps to stabilize the economy during fluctuations in income or other economic shocks.

Question 4

Events such as wars not financed by increases in taxes, such as the U.S. Afghanistan and Iraq wars:

Accepted Answer

Typically, wars that are not financed by increases in taxes involve the government borrowing money internationally, which increases the country's external debt. This can have negative effects on the country's credit rating and ability to borrow money in the future.

Question 5

When there is a temporary shock to output (positive or negative), what happens to consumption in an open economy?

Accepted Answer

In an open economy, when there is a temporary shock to output, consumption tends to be smoother than output due to the ability to borrow from or lend to the rest of the world. This means that consumption changes by less than the temporary output gain or loss, as individuals spread the impact of the shock over time. The specific factor provided in option D suggests a mathematical relationship that captures this smoothing effect, where r, S1, U1, P1, and P0 represent various economic parameters and variables.

Question 6

If a nation experiences an output shock and wishes to borrow to smooth consumption, how much of the loss is the nation able to borrow and still maintain the long-run budget constraint?

Accepted Answer

The percentage of the shock to GDP that a nation can borrow and still maintain the long-run budget constraint is given by the formula 1/(1 + r^*), where r^* is the world long-run real interest rate. This result is derived from the intertemporal budget constraint, which states that a country's current consumption plus its net borrowing must equal its current output plus the change in its debt level. The long-run budget constraint requires that the present value of future primary surpluses is equal to the present value of future debt service payments. The formula above reflects the fact that the more a country borrows, the higher its debt service payments will be in the future, reducing the amount of future surpluses available to pay them. Thus, a country must balance the benefits of increased consumption smoothing against the costs of reduced future surpluses.

Question 7

Sovereign wealth funds are created for all of the following reasons, EXCEPT:

Accepted Answer

Sovereign wealth funds are typically created to achieve a better return on assets, save windfall from natural resource exports, and invest bank reserves and state revenue/savings. The purpose is primarily to provide a long-term savings vehicle for a nation's wealth and to use that wealth for future generations. It is not intended to discourage foreign investment in the domestic economy. In fact, many sovereign wealth funds invest in foreign companies and assets to diversify their holdings and improve returns.

Question 8

International firms have begun to offer a new product based on the need for nations to put their savings into productive and high-return assets. It is called:

Accepted Answer

The product described is commonly known as a sovereign wealth fund, which is essentially a state-owned investment fund that accumulates and manages surplus funds from a country's budget or trade. This allows nations to invest in a diversified range of assets with the goal of generating long-term returns, and to establish a buffer against economic shocks or challenges. Option A, external wealth funds, is not a commonly used term in finance and does not accurately describe the product. Option C, automatic withdrawals, is not related to investment strategies or funds. Option D, sovereign debt accounts, refers to a different type of financial instrument focused on government borrowing and debt management, and is therefore not the correct answer.

Question 9

A nation that engages in precautionary savings is:

Accepted Answer

Precautionary savings involve setting aside money or assets as a contingency plan for future events such as an economic downturn or emergency. Storing foreign currency reserves, bonds, or deposits to use in case of persistent deficits is a form of precautionary savings. A is incorrect because it refers to a specific purpose for savings rather than a general approach. C is incorrect because saving is a necessary component of investment, and investing without saving first can result in financial instability. D is incorrect because it refers to a specific policy rather than a general approach.

Question 10

If a nation experiences an output shock and wishes to borrow to smooth consumption, how much of consumer spending must it forgo each year to achieve consumption smoothing and maintain the long-run budget constraint?

Accepted Answer

The amount that a nation must forgo each year to achieve consumption smoothing and maintain the long-run budget constraint is calculated using the permanent income hypothesis. According to the permanent income hypothesis, a nation can smooth its consumption by borrowing an amount equal to r^**S1P0/(1 + r^*), where r is the interest rate, ^{is the shock to output,} is the elasticity of output with respect to permanent income, and S1P0 is the initial level of permanent income. This formula calculates the amount that a nation can borrow in the first year. In subsequent years, the nation must repay the principal and pay interest. To determine the amount that the nation must forgo each year, the formula is simplified to r^**S1P0/(1 + r^*). Therefore, the answer is A.

Question 11

In an open economy, in the long run, permanent shocks to GDP:

Accepted Answer

Permanent shocks to GDP in an open economy necessitate adjustments in various economic variables, including consumption. In the long run, economies adjust to new levels of output, and this often involves changes in consumption patterns to align with the new economic reality.

Question 12

If, in an open economy with a real world interest rate of 5%, an output shock (decline) of 21% occurs followed by a recovery the next year:

Accepted Answer

With a 21% decline in output, it is not possible to fully smooth consumption. However, the nation can borrow up to 20% of GDP in the first year and pay back 1% of GDP each year from then on. This strategy ensures that consumption is not overly disrupted in the short term, while still adhering to the long-run budget constraint. Option A is incorrect because some consumption smoothing is possible. Option C is incorrect because the proposed borrowing plan does not exceed the long-run budget constraint. Option D is incorrect because there is no indication that the shock would require the economy to give up international trade and financial flows.

Question 13

An open economy has:

Accepted Answer

An open economy has access to international borrowing which provides it with greater ability to smooth its consumption. This is because it can borrow from other countries during periods of economic downturns or when faced with domestic shocks.

Question 14

In a closed economy, what happens to the present value of GDP (discounted at 5%) following an output shock (decline) of 21% recovered the following year?

Accepted Answer

The present value of GDP is the sum of the discounted future values of GDP. An output shock that is recovered the following year will have no long-run effect on the present value of GDP. However, the output shock will cause a one-year drop in GDP in the first year, which will reduce the present value of GDP by 1%.

Question 15

If an economy is closed and has no internal shocks, its consumption will:

Accepted Answer

If an economy is closed and has no internal shocks, there are no sudden changes in income or prices to disrupt consumption patterns. Therefore, consumption would be perfectly smooth.

Question 16

If low-income nations purchase sovereign wealth funds, in effect they are:

Accepted Answer

Purchasing sovereign wealth funds means that low-income nations are investing their scarce resources into the wealth funds of other nations, essentially transferring wealth from the poor country to the richer country. This does not address the fundamental issues of poverty and inequality within the low-income nation, and it may even worsen the situation by draining their already limited resources.

Question 17

Low-income nations with poor credit ratings are often dependent on commodity sales as a major portion of income. To insure against the effects of a fall in the prices of commodities, the nation could:

Accepted Answer

Saving as a precaution and purchasing sovereign wealth funds with that money can provide the low-income nation with a buffer to mitigate the impact of a fall in commodity prices. This strategy also avoids the risks associated with borrowing internationally or entering into a commodity cartel. Asking for debt reduction and forgiveness may not always be a viable option, and entering a commodity cartel may not be legal or feasible for all commodities.

Question 18

Consumption smoothing is possible as long as the output shock is:

Accepted Answer

Consumption smoothing is a technique people use to maintain roughly the same level of consumption despite changes in their income. In order to do this, the change in income needs to be temporary. If it is permanent, then consumption smoothing will not work and people will need to adjust their spending habits to match their new income level. The other options (less than 10% and more than the rate of interest) are not relevant to the question of whether consumption smoothing is possible.

Question 19

Which of the following statements is NOT correct?

Accepted Answer

The statement that is not correct is D, as poor nations often face significant challenges in benefiting from globalization due to factors such as lack of access to foreign investments, inadequate financial markets, and capital flight. While globalization has the potential to offer benefits, the extent to which poor nations can leverage these benefits is limited by various structural and economic barriers.

Question 20

If the United States were a closed instead of an open economy, the economic effects of the Iraq War would be felt:

Accepted Answer

In a closed economy, the United States would not engage in international trade, meaning the economic impacts of events like the Iraq War would be absorbed internally. This would lead to U.S. consumers feeling the effects more directly, as the economy would not have the buffer of international trade to mitigate impacts.

Quiz 17: Balance of Payments I: the Gains From Financial Globalization