Question 1

Use the following to answer questions :
Exhibit: IS*-LM* and AD 
-(Exhibit: IS*-LM* and AD) A small open economy with a floating exchange rate is initially in equilibrium at A with $I S _ { 1 } ^ { * }$ $L M _ { 1 } ^ { * } .$ Holding all else constant, if the domestic price level decreases, then the _____ curve will shift to _____.

Accepted Answer

A decrease in the domestic price level will increase the real money supply, shifting the LM curve to the right.

Question 2

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

Accepted Answer

In the short-run, a monetary contraction in a large open economy with a floating exchange rate leads to an increase in interest rate, which lowers investment and income. Additionally, it also leads to an increase in exchange rate, which in turn reduces net exports and further lowers income. Therefore, the best choice is D: raises the interest rate and lowers investment and income, but also raises the exchange rate and lowers net exports.

Question 3

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

Accepted Answer

Free capital flows and an independent monetary policy mean that the country's central bank can adjust interest rates to stabilize the domestic economy. However, this may lead to fluctuations in the exchange rate as investors react to these changes in interest rates. Therefore, the country must be willing to live with exchange-rate volatility. Choice B is incorrect because free capital flows mean that citizens can participate in world financial markets. Choice C is incorrect because independent monetary policy allows the country to use monetary policy for domestic stabilization. Choice D is incorrect because having a fixed exchange rate would require giving up the freedom of capital flows or an independent monetary policy.

Question 4

Use the following to answer questions :
Exhibit: IS*-LM* and AD 
-(Exhibit: IS*-LM* and AD) A small open economy with a floating exchange rate is initially in equilibrium at A with $I S _ { 1 } ^ { * }$ $L M _ { 1 } ^ { * } .$ Holding all else constant, if the domestic price level increases, then the _____ curve will shift to _____.

Accepted Answer

An increase in the domestic price level will cause the LM curve to shift up and to the left, as the higher prices will increase the demand for money, pushing up interest rates. This will lead to a decrease in investment spending and a contraction of output, shifting the IS curve to the left. The intersection of the new IS and LM curves will be at point B with the new equilibrium at $L M _ { 3 } ^ { * }$.

Question 5

In a short-run model of a large open economy with a floating exchange rate, a monetary expansion causes a decrease in the interest rate and:

Accepted Answer

According to the short-run model of a large open economy with a floating exchange rate, a monetary expansion causes a decrease in the interest rate, which leads to an increase in investment and aggregate demand. This increase in demand causes an increase in output and prices, which, in turn, leads to an increase in imports and a decrease in net exports. The decrease in net exports causes a decrease in the demand for the domestic currency, which leads to a depreciation of the currency. This depreciation of the currency makes the country's goods and services cheaper for foreign buyers, which increases net exports. Thus, a monetary expansion causes an increase in income, net exports, and net capital outflow, and a decrease in the exchange rate. Choice B is the only option that includes all these effects.

Question 6

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:

Accepted Answer

In the Mundell-Fleming model with fixed exchange rates, a fall in consumer confidence reduces consumption, leading to a decrease in aggregate demand and income. The fixed exchange rate prevents currency depreciation, so net exports do not rise to offset the fall in income.

Question 7

In the Mundell-Fleming model, if the price level falls, then the equilibrium income

Accepted Answer

According to the Mundell-Fleming model, a fall in the price level increases the real money supply, which in turn reduces interest rates and leads to an increase in investment and consumption. This increase in aggregate demand causes an increase in output and income, which leads to an appreciation of the real exchange rate. Therefore, the correct answer is B – equilibrium income rises and the real exchange rate depreciates.

Question 8

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

Accepted Answer

To maintain a fixed exchange rate while restricting international capital flows, a country must control its citizens' access to world financial markets to prevent capital movements that could destabilize the fixed exchange rate.

Question 9

In a short-run model of a large open economy, after net capital outflow is substituted for net exports in the IS curve:

Accepted Answer

When net capital outflow is substituted for net exports in the IS equation, the interest responsiveness of net capital outflow affects the slope of the IS curve. Specifically, the larger the absolute value of the responsiveness of net capital outflow with respect to the interest rate, the flatter the IS curve. This is because a higher interest rate leads to a greater outflow of capital, reducing the supply of loanable funds and causing a decrease in investment and consumption, which in turn leads to a decrease in output and an increase in the interest rate. Therefore, a more responsive net capital outflow curve will flatten the IS curve.

Question 10

Between 1995 and 2005, China chose to:

Accepted Answer

China, between 1995 and 2005, chose to maintain a fixed exchange rate, restrict international-capital flows, and conduct an independent monetary policy. This approach allowed China to control its domestic economy while managing the value of its currency against the dollar.

Question 11

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:

Accepted Answer

In the Mundell-Fleming model with floating exchange rates, a fall in consumer confidence that leads to increased savings and reduced spending results in lower domestic interest rates. This, in turn, causes the domestic currency to depreciate, making exports cheaper and imports more expensive. As a result, net exports increase, offsetting the initial fall in consumption, thus leaving overall income unchanged.

Question 12

In a short-run model of a large open economy with a floating exchange rate:

Accepted Answer

In a short-run model of a large open economy with a floating exchange rate, the interest rate is determined within the IS-LM framework, which in turn determines net capital outflow. Net exports are also affected by the exchange rate, which adjusts to make net exports equal to net capital outflow. Therefore, choice C is the correct option.

Question 13

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.

Accepted Answer

According to the Mundell-Fleming model, if the economy is operating at or below the natural level in the short run, then the exchange rate will depreciate to stimulate net exports and increase aggregate demand. This will result in an increase in output and employment in the short run. However, in the long run, the price level will fall to restore the economy to its natural rate. Therefore, the correct choice is C: depreciate; increase net exports.

Question 14

In a short-run model of a large open economy with a floating exchange rate, a fiscal expansion causes an increase in:

Accepted Answer

According to the short-run model of a large open economy with a floating exchange rate, a fiscal expansion results in an increase in income due to increased government spending, which then leads to an increase in the interest rate. This increase in interest rate causes an appreciation of the domestic currency, leading to a decrease in net exports. The decrease in net exports and the increase in the interest rate together cause a decrease in investment, leading to an overall decrease in investment and net exports. Therefore, income, the interest rate, and the exchange rate all increase, while investment and net exports decrease.

Question 15

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

Accepted Answer

If the central bank's foreign-currency reserves are increasing, it means that the central bank is buying foreign currency to maintain the fixed exchange rate. This results in a higher demand for foreign currency and a lower supply of the country's currency, causing the currency to be undervalued. A budget surplus or deficit is not necessarily indicative of the currency's value.

Question 16

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

Accepted Answer

The impossible trinity, also known as the "trilemma," states that a country cannot simultaneously have free capital flows, a fixed exchange rate, and an independent monetary policy. If a country wants to maintain a fixed exchange rate, it must give up control over its monetary policy to prevent capital outflows. On the other hand, if a country wants to maintain control over its monetary policy and have free capital flows, it must allow its exchange rate to float. Therefore, it is impossible for a country to have all three at the same time.

Question 17

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.

Accepted Answer

In the Mundell-Fleming model with flexible exchange rates, an increase in the price level leads to a decrease in the real exchange rate (making domestic goods more expensive relative to foreign goods) and consequently a decrease in net exports (as domestic goods become less competitive internationally).

Question 18

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

Accepted Answer

When a country chooses to have free capital flows and maintain a fixed exchange rate, it cannot use monetary policy to stabilize the domestic economy. This is because changes in the demand for money influence the exchange rate, which, in turn, reflects the balance of payments. If a central bank attempts to offset these changes by changing the money supply, this can create inconsistencies that undermine the fixed exchange rate. As a result, countries pursuing this policy may be forced to accept exchange rate volatility, particularly in response to changes in the business cycle. However, this does not require restricting citizens from participating in world financial markets or giving up fiscal policy.

Question 19

In a short-run model of a large open economy with a floating exchange rate, net capital outflow ______ as the domestic interest rate increases and is just equal to ______.

Accepted Answer

In a large open economy with a floating exchange rate, an increase in the domestic interest rate makes domestic assets more attractive, leading to a decrease in net capital outflow. This decrease in net capital outflow corresponds to a decrease in net exports, as the currency appreciates, making exports more expensive and imports cheaper.

Question 20

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:

Accepted Answer

The answer of The introduction of a stylish new line...

Quiz 13: The Open Economy Revisited: the Mundell-Fleming Model and the Exchange-Rate Regime