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

Question 1

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

Answer 1

capital inflow

Question 2

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.

Answer 2

price level, world interest rate, monetary policy, and fiscal policy.

Question 3

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.

Answer 3

is vertical because the exchange rate does not enter into the LM^* equation.

Question 4

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 5

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

Question 6

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 7

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 8

In the Mundell-Fleming model on a Y - e graph, the curves labeled IS^* and LM^* are labeled that way as a reminder that:

A) the price level is held constant at the world price level p*.
B) the interest rate is held constant at the world interest rate r*.
C) the exchange rate is held constant at the world exchange rate e*.
D) output is held constant at the full employment level.

Question 9

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 10

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 11

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 12

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 13

Assuming there is perfect capital mobility, compared to a large open economy, a small open economy is one in which the:

A) exchange rate is fixed.
B) exchange rate is floating.
C) domestic interest rate equals the world interest rate.
D) domestic interest rate is not equal to the world interest rate.

Question 14

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 15

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 16

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 17

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 18

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

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

Question 19

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

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

Question 20

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

Question 21

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 22

Use the following to answer questions :
Exhibit: Shifting IS* and LM*
(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*;
B) LM₁*;
C) IS₁*;
D) IS₁*;

Question 23

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

A) income falls and the exchange rate rises.
B) the exchange rate falls and income rises.
C) income remains unchanged but the exchange rate rises.
D) the exchange rate remains unchanged but income falls.

Question 24

During the era of the gold standard, the price of gold in England:

A) was always equal to the price of gold in the United States.
B) was always a little higher than the price of gold in the United States, but it could not be higher by more than the cost of transporting gold from the United States to England.
C) was always a little lower than the price of gold in the United States, but it could not be lower than the cost of transporting gold from England to the United States.
D) could be higher or lower than the price of gold in the United States, but not by more than the cost of transporting gold between the two countries.

Question 25

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 26

To maintain a fixed-exchange-rate system, if the exchange rate 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 27

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 28

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 29

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 30

If the Fed announced it would fix the exchange rate at 100 yen per dollar, but with the current money supply the equilibrium exchange rate was 150 yen per dollar, then:

A) arbitrageurs would sell yen in the marketplace.
B) arbitrageurs would buy yen from the Fed.
C) the money supply would fall until the market exchange rate was 100 yen per dollar.
D) the money supply would rise until the market exchange rate was 100 yen per dollar.

Question 31

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

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

Question 32

Use the following to answer questions :
Exhibit: Shifting IS* and LM*
(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*;
B) LM₁*;
C) IS₁*;
D) IS₁*;

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

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 35

According to the Mundell-Fleming model for a small open economy with flexible exchange rates, if the Federal Reserve 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 36

Use the following to answer questions :
Exhibit: IS*-LM*
(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 37

Use the following to answer questions :
Exhibit: IS*-LM*
(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

Question 38

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 39

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 40

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 41

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 42

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 43

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 44

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 45

In the Mundell-Fleming model with fixed exchange rates, attempts by the central bank to decrease the money supply:

A) lead to a lower equilibrium level of income.
B) lead to a higher equilibrium level of income.
C) must be abandoned in order to maintain the fixed exchange rate.
D) must be offset by expansionary fiscal policy.

Question 46

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 47

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

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

Question 48

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 49

In a small open economy with a fixed exchange rate, if the central bank tries to increase the money supply, then in the new short-run equilibrium:

A) income rises.
B) income falls.
C) the exchange rate falls.
D) income remains constant.

Question 50

Use the following to answer questions :
Exhibit: IS*-LM*
(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 a monetary expansion to the new equilibrium will be at ____, holding everything else constant.

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

Question 51

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 52

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 53

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 54

According to the Mundell-Fleming model, under floating exchange rates a fiscal expansion:

A) lowers the exchange rate, but a monetary expansion raises it.
B) raises the exchange rate, but a monetary expansion or an import restriction lowers it.
C) or an import restriction lowers the exchange rate, but a monetary expansion raises it.
D) or an import restriction raises the exchange rate, but a monetary expansion lowers it.

Question 55

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 56

A devaluation 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 57

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 58

Use the following to answer questions :
Exhibit: IS*-LM*
(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 59

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 60

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 61

One argument favoring 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 62

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 63

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 64

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 65

A small open economy with a floating exchange rate is initially in equilibrium at A with If the establishment of a new government in the country decreases the risk premium, then will shift to _____ and will shift to _____.

A)
B)
C)
D)

Question 66

"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 67

In the Mundell-Fleming model, if political turmoil raises the risk premium in a country's interest rate, then the exchange rate will ______.

A) increase
B) decrease
C) remain constant
D) either increase or decrease, depending on whether the IS* or LM* curve shifts more.

Question 68

According to the Mundell-Fleming model with floating exchange rates, political uncertainty in Mexico in 1994 caused the risk premium on Mexican interest rates to ______ and the Mexican exchange rate to ______.

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

Question 69

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 70

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

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

Question 71

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 72

At the end of 1994 the Mexican government was unable to maintain a fixed exchange rate because it:

A) ran out of foreign-currency reserves.
B) was unable to increase the supply of Mexican pesos.
C) was forced by the IMF to let the peso float.
D) joined an exchange-rate union.

Question 73

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 74

Use the following to answer questions :
Exhibit: Risk Premium
(Exhibit: Risk Premium) A small open economy with a floating exchange rate is initially in equilibrium at A with If there is an increase in the risk premium, then will shift to _____ and will shift to _____.

A)
B)
C)
D)

Question 75

One argument favoring 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 76

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 77

In order to compensate for an expected future decline in the Japanese yen relative to the U.S. dollar, the interest rate in Japan must be ______ the interest rate in the United States.

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

Question 78

An arrangement by which a central bank holds enough foreign currency to back each unit of the domestic currency is called a:

A) floating exchange rate.
B) dollarization.
C) monetization.
D) currency board.

Question 79

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 80

A change in investors' perceptions that make a fixed exchange rate untenable is known as:

A) a speculative attack.
B) dollarization.
C) seigniorage.
D) a floating currency board.