Deck 25: Economic Policy in the Open Economy Under Fixed Exchange Rates

Question 1

In the diagram below, under fixed exchange rates, the automatic adjustment mechanism will lead to

A) a fall in the money supply, a fall in income, and a fall in the interest rate.
B) a rise in the money supply, a fall in income, and a fall in the interest rate.
C) a fall in the money supply, a rise in income, and a rise in the interest rate.
D) a fall in the money supply, a fall in income, and a rise in the interest rate.

Answer 1

D

Question 2

In the ordinary analysis of IS and LM curves (ignoring the BP curve),

A) expansionary fiscal policy shifts the IS curve to the left.
B) expansionary monetary policy shifts the LM curve to the left.
C) expansionary fiscal and expansionary monetary policy undertaken at the same time
Will lead to an increase in the level of equilibrium income.
D) expansionary fiscal policy and contractionary monetary policy acting together will
Lead to a decline in the equilibrium interest rate.

Answer 2

C

Question 3

"A country that must adopt foreign exchange controls because of a misaligned exchange rate sacrifices the use of both monetary and fiscal policy instruments to influence domestic income and the interest rate." Explain.

Answer 3

not answered

Question 4

In a closed economy, an increase in the demand for money shifts the LM curve to the
__________; other things equal, this will lead to __________ in national income.

A) right; an increase
B) right; a decrease
C) left; an increase
D) left; a decrease

Question 5

In a system of fixed exchange rates, the automatic balance-of-payments adjustment process for a country with a balance-of-payments deficit would theoretically involve, among other things, __________ in the interest rate and __________ in national income.

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

Question 6

Under a fixed exchange rate, a balance-of-payments surplus for a country will lead to a
__________ in the money supply as the country's central bank __________ in order to maintain the fixed exchange rate.

A) rise; purchases domestic currency
B) rise; purchases foreign exchange
C) fall; sells domestic currency
D) fall; sells foreign exchange

Question 7

Under fixed exchange rates and a constant price level, the automatic adjustment process produces balance-of-payments equilibrium as

A) the LM curve shifts along the fixed IS and BP curves.
B) the IS curve shifts along the fixed LM and BP curves.
C) the IS, LM, and BP curves all shift.
D) the BP curve shifts to the point where the IS and LM curves intersect.

Question 8

Explain, in the IS/LM/BP framework with fixed exchange rates, the impact of an autonomous increase in foreign demand for a country's exports upon the country's national income, money supply, and balance of payments. If there is no impact on a variable, explain why.

Question 9

A general rule is that, as international capital mobility for a country increases, the
Country's BP curve __________.

A) becomes steeper (less elastic)
B) maintains the same slope (or elasticity)
C) becomes flatter (more elastic)
D) eventually will become downward-sloping

Question 10

Under fixed exchange rates,

A) fiscal policy is ineffective in influencing national income with all degrees of
International capital mobility.
B) fiscal policy is most effective in influencing national income when capital is perfectly
Mobile internationally.
C) monetary policy is very effective in influencing national income if capital is perfectly
Immobile internationally.
D) monetary policy is more effective when capital is perfectly mobile internationally than when capital is perfectly immobile internationally.

Question 11

In the Mundell analysis in which, in a situation of fixed exchange rates, a country is using monetary and fiscal policy to attain "external balance" (i.e., balance-of-payments equilibrium) and "internal balance" (i.e., full employment without inflation), the country __________. In this context, if the country has a balance-of-payments surplus at the same time that it has inflation, the country should engage in __________.

A) should assign monetary policy to the attainment of internal balance and fiscal policy
To the attainment of external balance; expansionary ("easy") monetary policy and contractionary ("tight") fiscal policy
B) should assign monetary policy to the attainment of internal balance and fiscal policy to the attainment of external balance; contractionary ("tight") monetary policy
And expansionary ("easy") fiscal policy
C) should assign monetary policy to the attainment of external balance and fiscal policy
To the attainment of internal balance; expansionary ("easy") monetary policy
And contractionary ("tight") fiscal policy
D) should assign monetary policy to the attainment of external balance and fiscal policy
To the attainment of internal balance; contractionary ("tight") monetary policy
And expansionary ("easy") fiscal policy

Question 12

Since under a fixed exchange rate system the exchange rate does not change, does this mean that the BP curve never shifts? Why or why not? If it in fact does shift, what effects do such movements have on the equilibrium interest rate and equilibrium income if financial capital is imperfectly mobile? Briefly explain.

Question 13

The use of expansionary or "easy" fiscal policy by a country's government in a situation of fixed exchange rates will, other things equal, initially lead to __________ of the country's current account balance (or trade balance); if short-term financial capital is relatively mobile between countries (i.e., the BP curve is flatter than the LM curve), the policy initially __________ of the country's capital/financial account balance.

A) an improvement; also leads to an improvement
B) an improvement; leads to a deterioration (or worsening)
C) a deterioration (or worsening); leads to an improvement
D) a deterioration (or worsening); also leads to a deterioration (or worsening)

Question 14

"Attempts to stimulate an economy with expansionary monetary policy will lead only to a loss of some of the country's international reserves and to no permanent change in income under a fixed-rate system." Agree? Disagree? Explain.

Question 15

Fiscal policy is most effective in a fixed-rate system when capital is perfectly mobile because there is no domestic "crowding out." Explain what is meant by the term "crowding out," and then critically evaluate the previous statement using the IS/LM/BP model.

Question 16

In the situation pictured in Question #13 above, during the automatic adjustment process to the disequilibrium in the balance of payments,

A) the BP curve will shift to the left (or vertically upward).
B) the IS curve will shift to the left (or vertically downward).
C) the LM curve will shift to the right (or vertically downward).
D) the IS curve will shift to the right (or vertically upward).

Question 17

In the following diagram, with fixed exchange rates,

The economy is in domestic equilibrium at income level __________ and there is__________.

A) Y₁; a balance-of-payments surplus
B) Y₂; a balance-of-payments deficit
C) Y₂; a balance-of-payments surplus
D) Y₃; equilibrium in the balance of payments

Question 18

In the Mundell prescription for monetary and fiscal policy under fixed exchange rates, expansionary fiscal policy and contractionary monetary policy would be recommended if a country were faced with

A) unemployment and a balance-of-payments deficit.
B) unemployment and a balance-of-payments surplus.
C) inflation and a balance-of-payments deficit.
D) inflation and a balance-of-payments surplus.

Question 19

In the graph below, if point W represents the income and interest rate targets under a
Country's fixed exchange rate system, then the policy combination needed to reach point
W consists of

A) expansionary monetary policy and expansionary fiscal policy.
B) expansionary monetary policy and contractionary fiscal policy.
C) contractionary monetary policy and contractionary fiscal policy.
D) contractionary monetary policy and expansionary fiscal policy.

Question 20

Using the Mundell-Fleming diagram dealing with internal balance (IB) and external balance (EB), explain what is meant by effective policy instrument choice, being careful to identify clearly the critical elements of the diagram. Why is the EB curve postulated to be more interest-elastic than the IB curve? In what ways is the IS/LM/BP model preferable to the simple Mundell-Fleming diagram?

Question 21

Assume an initial equilibrium position for the economy (at the three-way intersection of
The IS, LM, and BP curves), and also assume that the BP curve is vertical. This situation
Is one where there is __________ of financial capital internationally, and, from this initial equilibrium, expansionary fiscal policy would initially lead to a balance-of-payments
__________.

A) perfect immobility; surplus
B) perfect immobility; deficit
C) perfect mobility; surplus
D) perfect mobility; deficit

Question 22

Other things equal, a fall in the marginal propensity to save will make the IS curve
__________, and a rise in the responsiveness of short-term international financial capital
To changes in the interest rate will make the BP curve __________.

A) flatter of more elastic; flatter or more elastic
B) flatter or more elastic; steeper or less elastic
C) steeper or less elastic; flatter or more elastic
D) steeper or less elastic; steeper or less elastic

Question 23

Suppose, in the basic Mundell-Fleming diagram that plots the internal balance (IB) and external balance (EB) schedules against the interest rate (i) and government spending minus taxes (G - T), that the economy is located at a point that is above (or to the left) of the IB schedule and also above (or to the left) of the EB schedule. In this situation the economy is experiencing

A) unacceptably high unemployment and a balance-of-payments deficit.
B) unacceptably high unemployment and a balance-of-payments surplus.
C) unacceptably rapid inflation and a balance-of-payments deficit.
D) unacceptably rapid inflation and a balance-of-payments surplus.

Question 24

Other things equal, a rise in income in a country will lead to __________ in the demand for money in the country and consequently to __________ in the country's LM curve.

A) an increase; a leftward (or vertically upward) shift
B) an increase; a rightward (or vertically downward) shift
C) a decrease; a leftward (or vertically upward) shift
D) a decrease; a rightward (or vertically downward) shift

Question 25

In the IS-LM analysis (and ignoring the BP curve), if the economy is located at a point that is to the left (or below) the IS curve and also to the left (or above) the LM curve, there is __________ pressure in the real sector of the economy as well as an excess __________ money.

A) expansionary; demand for
B) expansionary; supply of
C) contractionary; demand for
D) contractionary; supply of

Question 26

With imperfect capital mobility, the BP curve slopes upward because, starting from a
Given balance-of-payments equilibrium position, a rise in national income will tend to
Cause a __________, which must be counteracted by a rise in the interest rate in order to
Cause a __________ that will restore BOP equilibrium.

A) BOP deficit; short-term financial capital inflow
B) BOP deficit; short-term financial capital outflow
C) BOP surplus; short-term financial capital inflow
D) BOP surplus; short-term financial capital outflow

Question 27

Other things equal, if the if the demand for money becomes more elastic, then the LM
Curve will become __________, i.e., a given rise in the interest rate will, in order for
Money market equilibrium to be preserved, be associated with a __________ rise in
Income.

A) less elastic; smaller
B) less elastic; larger
C) more elastic; smaller
D) more elastic; larger

Question 28

From an initial equilibrium position for the economy (at the three-way intersection of the IS, LM, and BP curves), and if the LM curve is steeper than the BP curve, expansionary fiscal policy initially leads to a balance-of-payments (BOP) __________, and expansionary monetary policy __________.

A) deficit; also initially leads to a BOP deficit
B) deficit; initially leads to a BOP surplus
C) surplus; initially leads to a BOP deficit
D) surplus; also initially leads to a BOP surplus