Practice Questions on Chapter 5: The Open Economy Assume that all questions are about the long run.

Name: __________________________ Date: _____________ 1. An open economy is one in which: A) the level of output is fixed. B) government spending exceeds revenues. C) the national interest rate equals the world interest rate. D) there is trade in goods and services with the rest of the world. 2. The value of net exports is also the value of: net investment. net saving. national saving. the excess of national saving over domestic investment.

A) B) C) D)

3. If domestic investment (I) exceeds domestic saving (S), then the extra investment will be financed by: A) borrowing from abroad. B) lending from abroad. C) the domestic government. D) the World Bank. 4. If domestic saving exceeds domestic investment, then the extra saving will be used to: A) make loans to the government. B) make loans to foreigners. C) repay the national debt. D) repay loans to the Federal Reserve. 5. The world real interest rate (r*): A) is defined as the domestic real interest rate. B) makes domestic saving equal to domestic investment. C) is the interest rate charged on loans by the World Bank. D) is defined as the real interest rate prevailing in world financial markets. 6. In a country with a "small open economy", the real interest rate will always be: above the world real interest rate. below the world real interest rate. equal to the world real interest rate. equal to the world nominal interest rate.

A) B) C) D)

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Use the following to answer questions 7-8: Exhibit: Saving and Investment in a Small Open Economy

7. (Exhibit: Saving and Investment in a Small Open Economy) In a small open economy, if the world interest rate is r1, then the economy has: A) a trade surplus. B) balanced trade. C) a trade deficit. D) negative capital outflows. 8. (Exhibit: Saving and Investment in a Small Open Economy) In a small open economy, if the world interest rate is r3, then the economy has: A) a trade surplus. B) balanced trade. C) a trade deficit. D) positive capital outflows. 9. An increase in the trade deficit of a small open economy could be the result of: A) an increase in taxes. B) an increase in government spending. C) a decrease in the world interest rate. D) the expiration of an investment tax-credit provision.

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10. An increase in the trade surplus of a small open economy could be the result of: A) a domestic tax cut. B) an increase in government spending. C) an increase in the world interest rate. D) the implementation of an investment tax-credit provision. 11. Holding other factors constant, legislation to cut taxes in an open economy will: A) increase national saving and lead to a trade surplus. B) increase national saving and lead to a trade deficit. C) reduce national saving and lead to a trade surplus. D) reduce national saving and lead to a trade deficit. 12. Consider a small open economy. If large foreign countries increase their domestic government purchases, this policy will tend to increase: A) investment in the small open economy. B) saving in the small open economy. C) net exports by the small open economy. D) imports by the small open economy. 13. Starting from trade balance, if the world interest rate falls, then, in a small open economy, the amount of domestic investment will _____ and net exports will _____. A) increase; increase B) increase; decrease C) increase, not change D) decrease; increase 14. If the government of a small open economy wishes to reduce its trade deficit, which policy action will be successful in achieving this goal? A) increasing taxes B) increasing government spending C) increasing investment tax credits D) imposing protectionist trade policies 15. The adoption of an investment tax credit in a small open economy is likely to lead to: A) no change in either domestic investment or domestic saving. B) an increase in both domestic investment and domestic saving. C) an increase in domestic saving but no change in domestic investment. D) an increase in domestic investment but no change in domestic saving.

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16. In a small open economy, policies that increase: A) investment tend to cause a trade surplus. B) investment tend to cause a trade deficit. C) saving do not affect the trade balance. D) saving tend to cause a trade deficit. 17. The nominal exchange rate between the U.S. dollar and the Japanese yen (e) is the: A) number of yen you can get for lending one dollar in Japan for one year. B) number of yen you can get for one dollar. C) price of U.S. goods divided by the price of Japanese goods. D) price of Japanese goods divided by the price of U.S. goods.

18. The real exchange rate (): A) measures how many Japanese yen one really gets for a U.S. dollar. B) is equal to the nominal exchange rate multiplied by the domestic price level divided by the foreign price level (eP/P*). C) is equal to the nominal exchange rate multiplied by the foreign price level divided by the domestic price level (eP*/P). D) is the price of a domestic car divided by the price of a foreign car.
19. If the price of a yen (dollars per yen) rises, this is called a(n): A) appreciation of the dollar. B) appreciation of the yen. C) increase in the terms of trade. D) decrease in the terms of trade.

20. If the real exchange rate () is high, foreign goods: A) and domestic goods are both relatively expensive. B) and domestic goods are both relatively cheap. C) are relatively expensive and domestic goods are relatively cheap. D) are relatively cheap and domestic goods are relatively expensive.
21. If 5 Swiss francs trade for $1, the U.S. price level equals $1 per good, and the Swiss price level equals 2 francs per good, then the real exchange rate is ______ Swiss goods per U.S. good. A) 0.5 B) 2.5 C) 5 D) 10

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22. When the real exchange rate rises: A) exports will decrease but imports will be unaffected. B) imports will decrease but exports will be unaffected. C) exports will increase and imports will decrease. D) exports will decrease and imports will increase. 23. If the real exchange rate depreciates (or, decreases) from 1 Japanese good per U.S. good to 0.5 Japanese good per U.S. good, then U.S. exports ______ and U.S. imports ______. A) increase; increase B) decrease; decrease C) increase; decrease D) decrease; increase 24. In a small open economy, when the government reduces taxes, domestic demand increase but domestic production remains unchanged. Therefore, the price of domestic goods relative to foreign goods (which is the equilibrium real exchange rate): A) rises and net exports fall. B) rises and net exports rise. C) falls and net exports fall. D) falls and net exports rise. 25. In a small open economy with perfect capital mobility, a reduction in the government's budget deficit (G - T) ______ net exports and the real exchange rate ______. A) increases; appreciates B) increases; depreciates C) decreases; appreciates D) decreases; depreciates 26. In a small open economy, when foreign governments reduce national saving in their countries, the equilibrium real exchange rate: A) rises and net exports fall. B) rises and net exports rise. C) falls and net exports fall. D) falls and net exports rise. 27. In a small open economy, if the world real interest rate (r*) falls, domestic investment will _____ and the real exchange rate will _____, holding all else constant. A) decrease; decrease B) decrease; increase C) increase; decrease

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D)

increase; increase

28. If the information technology boom increases investment demand in a small open economy (for example, from I = 10 - 5r to I = 17 - 5r), then net exports ______ and the real exchange rate ______. A) increase; appreciates B) increase; depreciates C) decrease; appreciates D) decrease; depreciates

An appreciation of the real exchange rate () in a small open economy could be the 29. result of: A) an increase in government spending. B) an increase in taxes. C) a decrease in the world interest rate. D) the expiration of an investment tax-credit provision.
30. In a small open economy, if the government adopts a policy that lowers imports (for example, the government might impose a tariff or a quota limit on imported goods), then that policy: A) raises the real exchange rate and increases net exports. B) raises the real exchange rate and does not change net exports. C) raises the real exchange rate and decreases net exports. D) lowers the real exchange rate. 31. In a small open economy, if the government adopts a policy that lowers imports, then the quantity of exports: A) remains unchanged. B) decreases, but not as much as the quantity of imports decreases. C) decreases by exactly the same amount as the quantity of imports decreases. D) decreases by more than the quantity of imports decreases. 32. An effective policy to reduce a trade deficit in a small open economy would be to: A) increase tariffs on imports. B) impose stricter quotas on imported goods. C) increase government spending. D) increase taxes. 33. Protectionist policies (these are policies that unfairly discourage imports) implemented in a small open economy with a trade deficit have the effect of ______ the trade deficit

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A) B) C) D)

and ______ the quantity of imports and exports. decreasing; decreasing not changing; decreasing decreasing; not changing not changing; not changing

34. Which of the following would decrease the real exchange rate in a small open economy in the long run? A) a personal income tax cut B) a reduction in government spending C) a tariff on imports D) an increase in investment 35. The percentage change in the nominal exchange rate equals the percentage change in the real exchange rate plus the: A) foreign inflation rate minus the domestic inflation rate. B) domestic inflation rate minus the foreign inflation rate. C) foreign exchange rate minus the domestic exchange rate. D) domestic interest rate minus the foreign interest rate. 36. If a country has a high rate of inflation relative to the United States, the dollar will buy: A) less of the foreign currency over time. B) more of the foreign currency over time. C) the same amount of the foreign currency over time. D) an amount of foreign currency determined by the real exchange rate. 37. One consequence of high inflation is a(n): A) appreciating nominal exchange rate (that is, increasing price of the country's currency). B) appreciating real exchange rate (that is, increasing relative price of the country's goods). C) depreciating nominal exchange rate. D) depreciating real exchange rate. 38. If the real exchange rate between the United States and Japan remains unchanged, and the inflation rate in the United States is 6 percent and the inflation rate in Japan is 3 percent, the: A) dollar will appreciate by 3 percent against the yen. B) yen will appreciate by 3 percent against the dollar. C) yen will appreciate by 6 percent against the dollar. D) yen will appreciate by 9 percent against the dollar.

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39. If the nominal exchange rate falls 10 percent, the domestic price level rises 4 percent, and the foreign price level rises 6 percent, the real exchange rate will fall: A) 0 percent. B) 8 percent. C) 10 percent. D) 12 percent. 40. The currencies of countries with high inflation rates relative to the United States have tended to ______, and the currencies of countries with low inflation rates relative to the United States have tended to ______. A) appreciate; appreciate B) appreciate; depreciate C) depreciate; depreciate D) depreciate; appreciate 41. If the purchasing-power parity theory is true, then: A) the net exports schedule is very steep. B) all changes in the real exchange rate result from changes in price levels. C) all changes in the nominal exchange rate result from changes in price levels. D) changes in saving or investment influence only the real exchange rate. 42. If purchasing-power parity holds, then changes in domestic saving will _____ the real exchange rate. A) increase B) decrease C) not change D) either increase or decrease 43. According to purchasing power-parity, if the dollar price of oil is higher in New York than in London, arbitrageurs (traders who buy something and then sell it at a higher price) will _____ oil in New York and _____ oil in London to drive _____ the price of oil in New York. A) buy; sell; up B) buy; sell; down C) sell; buy; up D) sell; buy; down 44. The doctrine of purchasing-power parity: A) is a completely accurate description of the real world.

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B) C) D)

would be entirely accurate if only goods were traded. would be entirely accurate if all consumers had the same preferences. provides a reason to expect that movements in the real exchange rate will typically be small or temporary.

45. Assume purchasing-power parity is true. If a Big Mac costs $2 in the United States, and if 10 Mexican pesos trade for $1 dollar, then a Big Mac in Cancun, Mexico, should cost: A) 2 pesos. B) 5 pesos. C) 10 pesos. D) 20 pesos. 46. In a small open economy, if consumer confidence falls (for example, C = 10 + 0.85(Y T) becomes C = 8 + 0.85(Y - T)) and consumers decide to save more, then the real exchange rate: A) rises and net exports fall. B) and net exports both rise. C) falls and net exports rise. D) and net exports both fall. 47. In a small open economy, if consumers shift their preferences toward Japanese cars, then net exports: A) fall and the real exchange rate falls. B) fall but the real exchange rate remains unchanged. C) remain unchanged but the real exchange rate falls. D) and the real exchange rate remain unchanged. 48. If a dollar bought 1,000 Chilean pesos ten years ago and 1,500 pesos now, and inflation for that period was 25 percent in the United States and 100 percent in Chile, then: A) the purchasing-power parity theory is correct. B) traveling in Chile today costs about the same as it did ten years ago. C) traveling in Chile is cheaper now than it was ten years ago. D) traveling in Chile is more expensive now than it was ten years ago.

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Answer Key
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44. D D A B D C A C B C D C B A D B B B B D B D C A B D D C A B C D B B A B C B D D C C D D

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45. 46. 47. 48.

D C C D

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