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After you have read Chapter 29 in your text and completed the exercises in this Study Guide chapter, you
should be able to:
1. Discuss some of the recent trends in foreign trade and understand the economic factors that lie behind
international trade patterns.
2. Define what is meant by a foreign exchange rate, and describe the supply-and-demand framework
through which exchange rates are determined.
3. Differentiate between the terms depreciation and devaluation and between appreciation and
revaluation.
4. Explain the purchasing-power-parity theory of exchange rates.
5. Outline the basic accounting procedure that is used to keep track of the international balance of
payments. Define the four components of balance-of-payments accounting.
6. Trace the evolution from young debtor nation to mature creditor nation.
7. Contrast the fixed-exchange-rate system of the gold standard with the pure floating of a flexible-
exchange-rate system. Describe the intermediate managed float that characterizes the contemporary
international system.
8. Explain David Hume’s gold-flow equilibrating mechanism.
9. Sketch a brief chronology of the evolution of the international financial system from the Bretton
Woods fixed-rate system that was created following World War II, through today’s managed-float system.
10. Describe the crisis in the European monetary system and the creation of the monetary and economic
union in Europe.
Match the following terms from column A with their definitions in column B.
A B
__ Open economy 1. Program and policies that make it difficult for a country to change its exchange
rate.
__ Foreign exchange 2. Contains data on a nation’s exports and imports of goods and services.
rate
__ Depreciation 3. Item in a country’s international balance-of-payments account that involves
spending foreign currency.
__ Appreciation 4. Item recorded in the balance-of-payments accounts when a country intervenes in
the foreign exchange market.
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__ Devaluation 5. Systematic statement of all economic transactions between a country and the rest
of the world.
__ Revaluation 6. Contains data on financial flows (lendings and borrowings) into and out of a
country.
__ Purchasing-power 7. An economy that engages in international trade.
parity theory
exchange rates
__ Balance of 8. Item in a country’s international balance-of-payments account that earns foreign
international currency.
payments
__ Credit 9. Deals with the official lowering of a country’s foreign exchange rate in terms of
other currencies or gold.
__ Debit 10. The price of a unit of foreign currency in terms of the domestic currency.
__ Current account 11. Monetary institution that only issues currency that is fully backed by foreign
assets in a key foreign currency.
__ Financial account 12. A market-determined rise in the price of one currency in terms of others.
__ Official 13. A market-determined fall in the price of one currency in terms of others.
settlements
__ Hard fix 14. Deals with the official raising of a country’s foreign exchange rate in terms of
other currencies or gold.
__ Currency board 15. In the long run, exchange rates tend to move with changes in relative prices of
different countries. This doctrine also holds that countries with high inflation rates
will tend to have depreciating currencies.
__ Floating exchange 16. Occurs when a government buys or sells its own or foreign currencies to affect
rates exchange rates.
__ Fixed exchange 17. Exchange rates are completely flexible and move purely under the influence of
rates supply and demand.
__ Gold standard 18. Exchange rates are basically determined by market forces, but governments
intervene to affect exchange rates.
__ Four-pronged 19. The government specifies the rate at which its currency can be exchanged into
mechanism other nation’s currencies.
__ Managed 20. Established a system of exchange rates that were fixed but adjustable. Also laid
exchange rates foundations for the International Monetary Fund, the World Bank, and the General
Agreement on Tariffs and Trade.
__ Intervention 21. Part of Hume’s explanation of international payments equilibrium.
__ Bretton Woods 22. Administers the international monetary system and operates as a central bank for
system the central banks of member countries.
__ International 23. Fixed-exchange-rate system in which a country defines the value of its currency
Monetary Fund in terms of a fixed amount of gold.
__ World Bank 24. Industrialized nations lend money to this institution, which then makes low-
interest loans to countries for projects which are economically sound but which
cannot get private-sector financing.
__ Monetary union 25. The decision of the countries in Europe to adopt a common currency.
Any transaction that requires foreign currency (e.g., the purchase of a commodity produced in another country)
is recorded as a debit; any transaction that generates foreign currency (e.g., the sale of a domestic product in a
foreign country) is recorded as a credit.
2. Countries usually evolve through several stages in their balance-of-payments histories:
a. young debtor nation
b. mature debtor nation
c. new creditor nation
d. mature creditor nation
A less developed nation is typically one which borrows abroad to the full extent of its line of credit. A mature,
developed nation is typically one which lends to other countries. As a nation develops over a long time period,
it may change from borrower to lender, and this shift will affect its balance-of-payments position. The four-
stage sequence, outlined above, is an attempt to describe the likely balance-of-payments changes involved.
3. Some economists suggest that during the 1980s the United States may have entered a fifth stage of
development, namely that of “senile debtor nation.” Greatly diminished saving has caused heavy U.S.
borrowing and turned the world’s biggest creditor into the world’s biggest debtor.
3. In a system of managed exchange rates, market forces determine exchange rates, but governments or
central banks may intervene when they want to influence the market exchange rate. Intervention occurs when
the government buys or sells its own or foreign currencies, or changes its monetary policy with the goal of
affecting exchange rates. For example, if a currency is appreciating in value, and the government has some
holdings of this currency, it may sell this currency in the foreign exchange market. This action would increase
the supply and, everything else held constant, tend to lower its price. Alternatively, the central bank could, via
monetary policy, lower interest rates. This action would decrease the demand for the nation’s currency by
foreigners looking for high-interest investment opportunities.
4. At the end of World War II the nations of the world recognized the need to coordinate economic policies
and seek common solutions to their problems. The discussions held at Bretton Woods, New Hampshire, led to
the creation of the International Monetary Fund (IMF), the World Bank, and the General Agreement on
Tariffs and Trade (GATT). According to the Bretton Woods system, exchange rates would be fixed but
adjustable.
The intended goal behind the IMF’s formation was to maintain, to the extent possible, stable exchange
rates. No nation would have to push itself deliberately into recession or depression just to maintain a steady
international value for its currency, but each participating nation did deposit a supply of its own currency (and,
in some cases, gold) with the IMF. These deposits established a “lending pool” from which any nation could
borrow if it found itself temporarily losing reserves in its maintenance of a fixed rate. It was of course
understood that persistent losses of reserves indicated some form of “fundamental disequilibrium” which could
not be sustained by continual borrowing. A nation could then devalue its currency value by up to 10 percent if
it wished. Further devaluation required “consultation with the fund”—in effect, international approval.
5. Although the old international gold standard and Bretton Woods system are both gone, their influence
persists, particularly in two important respects. First, nations still consider their gold stocks as reserves for
settling international balances. (But now they tend to regard gold as an “Emergency” reserve; they do not part
with gold unless events force them to do so.) Second, the desire for relative stability in exchange rates persists.
The gold standard is not the only possible mechanism to this end. You can hold the price of your currency
steady by simply maintaining a sufficiently large inventory of foreign monies.
V. HELPFUL HINTS
1. As with all diagrams, pay careful attention to how the axes are labeled when working with diagrams
depicting foreign exchange markets. Like any supply-and-demand diagram, price is measured on the vertical
axis and quantity on the horizontal axis. In this case, the quantity will always be the amount of some currency:
French francs, German deutsche marks, Japanese yen, whatever. If we are considering the cost of these
currencies from the U.S. perspective, the price (on the vertical axis) will measure how many dollars are needed
to purchase each unit of the foreign currency. So in the foreign exchange market for Japanese yen, the price
would be dollars per yen, or $/Y. (Note: Regardless of which currency market you are studying, the currency
which is measured on the horizontal axis will always be in the denominator of the price on the vertical axis.)
Figure 29-1
Consider Figure 29-1. Panel (a) illustrates the market for yen. Note how the axes are labeled. When
people demand yen, they will pay for them with dollars. The suppliers of yen will sell them for dollars.
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Panel (b) illustrates the mirror image of panel (a). The suppliers of yen (from panel [a]) are now the
demanders of dollars, and the folks supplying dollars are demanding yen for dollars back in panel (a).
2. Samuelson and Nordhaus point out that “a rise in the price of a currency in terms of another currency is
called an ‘appreciation.’” The key phrase here is “in terms of.” Suppose that a dollar, in terms of deutsche
marks (DM), costs 2 DM. For purposes of example, assume that a year later that same dollar now costs 3 DM.
In terms of DM, the dollar is now more expensive—it costs more DM to get dollars. We would say that, at
least relative to DM, the dollar has appreciated in value.
3. A devaluation occurs when a country or government intervenes in the foreign exchange market to lower
the value of its currency vis-à-vis other currencies. The result is similar to a depreciation, but that comes
about via the forces of supply and demand in the market place.
4. In the balance-of-payments account, the current account refers to the difference between exported and
imported goods and services. This is the trade deficit that in recent years has been mentioned frequently on
U.S. television news. Keep in mind that balance-of-payments accounts are only half the picture. Equally
important are the flows of financial capital that are measured in the financial account.
5. If a transaction earns foreign currency, it is called a credit. Exports earn foreign currency because foreigners
who want to purchase goods and services from county A must sell their currency to buy some of Country A’s
currency. Borrowings, in the capital account, are also counted as credits, because when a country lends to
Country A, it gives up some of its currency, again through the foreign exchange market, to Country A.
6. Surpluses or deficits that exist in the current account must be financed or offset by lendings or borrowings
in the financial account.
7. The PPP exchange rate calculations, illustrated in Figure 29-6 in your text make China’s GDP, and that of
other low-income countries, much higher. Many of the products that are not traded internationally are labor-
intensive services. These are very inexpensive, even in low-income countries. Therefore, when market
exchange rates are used to evaluate output, GDP in low-income countries tends to be underestimated. Keep in
mind, however, that the numbers in this table are “gross” and not “per capita.” China remains the most
populated nation on the earth.
These questions are organized by topic from the chapter outline. Choose the best answer from the options
available.
a. its imports will seem cheaper (from the viewpoint of its own citizens), and its exports will seem more
expensive (from the viewpoint of foreigners).
b. its imports will seem more expensive (from the viewpoint of its own citizens), and its exports will
seem cheaper (from the viewpoint of foreigners).
c. both its imports and its exports will seem cheaper (from the viewpoint of both its own citizens and
foreigners).
d. both its imports and its exports will seem more expensive (from the viewpoint of both its own
citizens and foreigners).
e. none of the above will occur, since there is no reason why the prices of either imports or exports
should be affected.
13. According to the purchasing-power-parity (PPP) theory of exchange rates:
a. exchange rates tend to move with changes in relative price level of different countries.
b. applies better to the long run than the short run.
c. applies better to the short run than the long run.
d. a and b.
e. a and c.
b. a government may purchase its own currency in the foreign exchange market.
c. monetary policy may be used to influence exchange rates.
d. all the above.
e. none of the above.
20. If GDP falls in the United States and exchange rates are floating, then:
a. imports will tend to decrease and the price of the U.S. dollar will tend to increase.
b. imports will tend to decrease and the price of the U.S. dollar will tend to decrease.
c. imports will tend to increase and the price of the U.S. dollar will tend to increase.
d. imports will tend to increase and the price of the U.S. dollar will tend to decrease.
e. none of the preceding statements will be true.
21. One of the principal tasks of the International Monetary Fund is to:
a. serve as a partial substitute for the gold standard in maintaining stable exchange rates.
b. help countries with short-term balance-of-payment difficulties.
c. make loans to private companies in any country where the funds could not otherwise be borrowed at
any reasonable interest rate.
d. facilitate the development of free-trade “regions” similar to the European Common Market.
e. coordinate the views of the larger and more developed nations concerning exchange-rate and trade
problems.
22. It could also be said that a principal task assigned to the International Monetary Fund is to:
a. act as the world’s banker in matters of both short-term and long-term credit.
b. make direct long-term loans to less developed nations when necessary, so as to assist in their
economic development.
c. control international credit sufficiently to enable member nations to maintain their price levels at
reasonably noninflationary levels.
d. work toward the gradual reduction of tariffs and the elimination of protectionist policies among
nations.
e. none of the above.
23. Which alternative in question 9 would be correct had that question referred to the World Bank rather than
the International Monetary Fund?
a. there are now more pesos to the pound.
b. there are now fewer pounds to the peso.
c. other things held constant, British goods now cost more in Mexico.
d. all the above.
e. a and c only.
24. A disturbance in its balance of payments may cause any nation to lose gold or foreign exchange reserves.
This danger of loss is most acute whenever that nation:
a. increases its exports.
b. seeks to maintain a flexible exchange rate.
c. seeks to maintain a fixed exchange rate.
d. increases its borrowing from other nations.
e. experiences a drop in GDP—i.e., whenever a recession occurs.
25. A “managed float” means:
a. an increase in the protectionist policies by some device other than a tariff increase.
b. refusal by a nation to allow its currency to appreciate even though its reserves are large and increasing.
c. a beggar-thy-neighbor policy.
d. introduction of a split exchange rate—a fixed rate for some transactions, a floating rate for others.
e. periodic intervention by a central bank to check excessive fluctuation in an otherwise floating exchange
rate.
26. As part of the Bretton Woods system:
a. the industrialized economies adopted a system of floating exchange rates.
b. the ideas of John Maynard Keynes were widely discredited.
c. the U.S. dollar was recognized as the preeminent currency of the world.
d. all the above.
e. none of the above.
27. Which of the following is typically expected to have the largest influence on the rate of investment in a
country?
a. The policies of the World Bank.
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The following problems are designed to help you apply the concepts that you learned in the chapter.
g. In the balance-of-payments merchandise account, therefore, there is a surplus of (credits over debits /
debits over credits), and the balance of trade is (favorable / unfavorable).
h. This balance is supported by the (debit / credit) balance in the investment income account.
Figure 29-2
4. A demand schedule for francs, at various dollars-and-cents prices, is outlined in Table 29-1.
TABLE 29-1
P of Franc Q of Francs P of Dollar Q of Dollars
(in $) Demanded (in francs) Supplied
1.00 0 ___ ___
0.90 100 ___ ___
0.80 200 ___ ___
0.70 300 ___ ___
0.60 400 ___ ___
0.50 500 ___ ___
0.40 600 ___ ___
0.30 700 ___ ___
0.20 800 ___ ___
0.10 900 ___ ___
a. Convert the table into a supply schedule for dollars, at various franc prices.
(Hint: A “straight-line” demand schedule results in a supply schedule of quite unexpected shape. Convert in
this way: If the price of 1 franc is 90 cents, then 1 franc = 90 cents, and so $1 = 100/0.90 franc (i.e., the price
of $1 is about 1.1 francs). The schedule in Table 29-1 says that 100 francs will be demanded when the price of
the franc is 90 cents; i.e., $90 will be supplied to buy them. In sum, then, $90 will be supplied when the
dollar’s price is 1.1 francs. Work out other points on the supply schedule similarly.)
b. Plot both curves in the appropriate panels of Figure 29-3. The demand schedule goes in panel (a) and
the mirror-image supply schedule goes in panel (b).
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Figure 29-3
5. What effect, if any, is each of the following events likely to have on the price of the franc in dollars? For
each statement below, put (U) in the blank if the effect should be to push the price of the franc (in terms of
dollars) up, (D) if it should push the price down, and (N) if there is no reason why the price of the franc should
be affected at all.
___ a. French corporations have a large interest payment to make, in dollars, to American bondholders.
___ b. French corporations have a large interest payment to make, in francs, to American bondholders.
___ c. France emerges from a recession, and with this increase in incomes, the French people want to
buy more American merchandise.
___ d. American residents decide to buy French bonds.
___ e. French corporations sell bonds to Americans, borrowing in dollars in New York because the
interest rate is lower there. The proceeds of the bond issue are to be spent on French labor and materials.
___ f. Foreign exchange speculators decide that the price of the dollar in francs is going to fall.
___ g. The taste of American gourmets for French wine is replaced by a taste for California wine.
___ h. The French government decides that American movies are immoral and refuses to admit them into
France.
___ i. An American citizen sends a package of merchandise to her French relatives as a gift.
___ j. An American citizen sends a remittance of dollars to his French relatives as a gift.
___ k. A French bank, in possession of a dollar bank account, decides to convert the dollars into francs.
6. Canada relies heavily on exports to, and imports from, the United States. Suppose that the Canadian
authorities (to whom the exchange rate is consequently important) decide that it would be desirable for trading
purposes to keep the price of the U.S. dollar at $(Can.) 1.15.
a. If the price of the U.S. dollar begins to drift below this figure, then Canada could enter the foreign
exchange market and support the price by (selling / buying) U.S. dollars.
b. It would, for this purpose, supply (sell) (Canadian / American) dollars.
c. If the U.S. dollar’s price started to move above $(Can.) 1.15, on the other hand, Canada could (buy /
sell) U.S. dollars.
Alternatively, Canada might choose a modified version of the same plan, keeping the price of the U.S. dollar
within a “band” of, say, $(Can.) 1.12 and $(Can.) 1.18. Canada could not, of course, keep the exchange rate
indefinitely at a level not justified by supply and demand.
d. If the price of the U.S. dollar kept trying to push above $(Can.) 1.18, then Canada would (accumulate
too many / run out of) U.S. dollars.
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7. The word “devaluation” goes back to the days of the gold standard, in which the currency unit allegedly
had a “gold content” and gold consequently had an “official price” per ounce.
a. Devaluation meant a government-decreed (reduction / increase) in that gold content—i.e., (a
reduction / an increase) in the official price of gold.
b. President Roosevelt’s 1933 declaration that the dollar’s gold content would be reduced from 1/21 to
1/35 of an ounce (was / was not) an instance of devaluation.
Depreciation, in the context of foreign exchange, refers to a reduction in the price of a currency relative to other
monies.
c. Suppose that the price of the Canadian dollar is 90 U.S. cents. If this price were to drop to 85 U.S.
cents, then the Canadian dollar would be worth, in U.S. funds, (more / less); this would be an instance of
depreciation.
d. If the price were to rise from 90 U.S. cents to 95 U.S. cents, on the other hand, this would indicate (a
depreciation / an appreciation) of the Canadian dollar.
e. Any depreciation of a foreign currency (relative to the U.S. dollar) makes that foreign country’s goods
appear (cheaper / more expensive) to Americans. To residents in that other country, in terms of their own
currency, American goods appear (cheaper / more expensive).
f. When a country’s currency is depreciated, therefore, this move tends to (increase / decrease) the
volume of its exports and to (increase / decrease) the volume of its imports.
Figure 29-4
11. Assume that Japan and England have agreed to a system of floating exchange rates. Figure 29-5 illustrates
the foreign exchange market between these two countries. Assume that the initial exchange rate is 320 Japanese
yen per English pound.
Figure 29-5
c. Foreign investment therefore flowed (into / out of) the United States, (increasing / decreasing) the
demand for dollars and thus causing the dollar to (appreciate / depreciate) in money markets all around
the world.
d. Exports from the United States therefore became (more / less) expensive, while imports from abroad
became (more / less) costly.
e. Net exports (expanded / contracted) by nearly ($50 / $140 / $250) billion, as a result, and created an
enormous (deficit / surplus) in the current account.
f. This discrepancy was, though, almost canceled by a (deficit / surplus) in the capital account, so the
overvaluation persisted and drove interest rates abroad (up / down).
g. The result was a tendency for foreign economies to move into (recession / boom), and (depressed /
overextended) export- and import-competing industries called for (free trade / protection and subsidy)
in the United States.
Answer the following questions, making sure that you can explain the work you did to arrive at the answers.
1. Why does the use of PPP exchange rates, as opposed to market exchange rates, increase the value of GDP
in low-income countries?
2. According to the PPP doctrine, why do countries with high inflation rates tend to have depreciating
currencies?
3. Briefly explain the four steps in Hume’s gold-flow equilibrating mechanism.
4. Briefly discuss the two main ways in which a country can intervene in the foreign exchange market to
influence the exchange rate of its currency.
5. What factors contributed to the collapse of the Bretton Woods exchange-rate system?
6. Discuss some of the economic considerations that must be addressed before Europe can act as a truly
unified single economy.
Figure 29-2
TABLE 29-1
P of Franc Q of Francs P of Dollar Q of Dollars
(in $) Demanded (In francs) Supplied
1.00 0 1.00 0
0.90 100 1.11 90
0.80 200 1 25 160
0.70 300 1 43 210
0.60 400 1 67 240
0.50 500 2.00 250
0.40 600 2 50 240
0.30 700 3.33 210
0.20 800 5.00 160
0.10 900 10.00 90
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assessing the value of nontraded products. PPP exchange rates may more accurately reflect the true value of a
nation’s output when there are different products and means of production across countries.
2. Countries with relatively high rates of inflation will experience higher prices. Higher prices hurt exports,
and the demand for the nation’s currency on the foreign exchange markets will fall. In other words, the
country’s currency will depreciate in value.
3. a. When a country runs a trade deficit, it must pay for it with gold. The reduction in gold decreases its
money supply and price level. The fall in prices makes imports relatively more expensive, so imports
decrease.
b. Exports will increase due to the fall in prices.
c. The country receiving the gold will experience an increase in its money supply and an increase in
prices. Since prices are higher, exports will decrease.
d. The increase in prices will also encourage citizens to import more goods and services.
4. A country can purchase or sell its own currency or the currency of other nations. A country can also use
monetary policy to change domestic interest rates. This will influence the flow of foreign financial capital and
thereby affect the demand and exchange rate for its currency.
5. As the economies of the world recovered from the Second World War, nations (especially Germany and
Japan) developed trade surpluses with the United States. Trade barriers were lowered, and technological
advances quickened the pace of financial capital flows between countries. Large federal budget deficits in the
United States, which kept upward pressure on interest rates, attracted financial resources from abroad. All these
factors made it more and more difficult for the United States to maintain the exchange-rate parities that were
established at Bretton Woods.
6. Once a common currency is agreed upon, a single central bank needs to be established to create a uniform
monetary policy (no small matter). Price and wage rigidities need to be reduced so that markets can adjust to
shocks and disturbances. For the same reason, labor needs to be mobile between regions and countries! Both
interest rates and the inflation rate need to be similar among the nations—hopefully at a low level. In addition,
participating countries need to control their federal government budget deficits and national debt. A great deal
needs to be accomplished, but the payoff could be enormous!
Figure 29-3
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