Chapter 8

1. How can trade liberalization exist on a nondiscriminatory basis

versus a discriminatory basis? What are some actual examples of
each?
The General Agreements on Tariffs and Trade represent trade
liberalization on a nondiscriminatory basis.
Participating nations
acknowledge that tariff reductions agreed to by any two nations will be
extended to all other members. Trade liberalization on a discriminatory
basis occurs when nations form preferential trading arrangements in
which tariff reductions are limited to member nations.
2.

What is meant by the term economic integration? What are the

various stages that economic integration can take?
Economic integration refers to the process of eliminating restrictions
on international trade, payments, and factor mobility. The stages of
economic integration include free trade area, customs union, common
market, economic union, and monetary union.

3.

How do the static welfare effects of trade creation and trade

diversion relate to a nations decision to form a customs union?
Of what importance to this decision are the dynamic welfare
effects?
The formation of a customs union results in static, or once-and-for-all,
welfare effects. Included is a welfare-increasing trade creation effect and
a welfare-reducing trade diversion effect.
A country's decision to
participate in the customs union depends on which of these effects is the
most significant. Over the long run, the formation of a customs union
affects national welfare via economies of scale, investment incentives,
and the level of competition.

4. Why has the so called common agricultural policy been a

controversial issue for the European Union?
One major problem confronting the CAP is that agricultural
efficiencies differ among members of the European Community. This has
led to internal disputes over the level of support provided to member
farmers. The export subsidies of the CAP have also been criticized by
nonmember countries.
5. What are the welfare effects of trade creation and trade diversion
for the European Union, as determined by empirical studies?

Empirical studies suggest that the static welfare effects of the EU's
formation have generally been favorable for member countries. The
benefits associated with trade creation appear to offset the losses
associated with trade diversion.

Chapter 9
1.

Multinational enterprises may diversify their operations along

vertical, horizontal, and conglomerate lines within the host and
source countries. Distinguish among these diversification
approaches.
Vertical integration generally results in the establishment of foreign
subsidiaries that supply inputs going into the finished good. Horizontal
integration occurs when the parent firm sets up a subsidiary to produce
an identical product overseas. Conglomerate integration results in a
firm's diversification into nonrelated markets.

2.

What are the major foreign industries in which U.S businesses

have chosen to place direct investments? What are the major
industries in the U.S. in which foreigners place direct
investments?
The manufacturing sector has dominated in both cases.

3.

Why is it that the rate or return on U.S. direct investments in

the developing nations often exceeds the rate of return on its
investments in industrial nations?
That rates of return on investments in developing countries exceed those
on investments in industrial countries in part reflects political risks and
fears of expropriation often associated with the developing countries.

4.

What are the most important decisions behind an enterprises

decision to undertake foreign direct investment?
Demand and cost factors tend to underlie a firm's decision to undergo
direct foreign investment.

5.

What is meant by the term multinational enterprise?

There is no exact definition of a multinational enterprise. However, it is
generally recognized that multinational firms operate in more than one
country, conduct research and development activities in addition to
manufacturing, and have stock ownership and management which is
multinational in character.

6.

Under what conditions would a business wish to enter foreign

markets by extending licenses or franchises to local businesses
to produce its goods?
The decision to undergo direct foreign investment or licensing is based on
several criteria: (1) import tariff structures; (2) the size of the foreign
market in relation to the firm's most efficient plant size; (3) comparative
labor productivities and wage levels; and (4) the amount of capital used in
the production process.

7.

What are the major issues involving MNEs as a source of

conflict for source and host countries?
As a source of conflict, multinational enterprises involve issues pertaining
to employment, national sovereignty, the balance of payments, and
taxation.

8.

Is the theory of MNE essentially consistent or inconsistent with

the traditional model of comparative advantage?
The traditional trade model involves the movement of finished products
among nations, while multinational enterprise analysis stresses
movements of factor inputs. Both models are based on the principle of
comparative advantage.

9.

What are some examples of welfare gains and welfare losses

that can result from the formation of international joint ventures
among competing businesses?
A joint venture leads to welfare gains when the newly established firm
adds to productive capacity and fosters competition, enters markets that
the parent firms could not enter, and yields cost reductions unavailable to
the parent firms. Welfare losses occur if the formation of a joint venture
results in greater amounts of market power so that output is restricted
and price is raised.

10. What effect does labor migration have on the country of

migration? The country of emigration? The world as a whole?
In response to higher U.S. wage rates, labor migration from Mexico to the
United States results in a reduction in the Mexican labor supply and an
increase in the U.S. labor supply. Wage rates tend to rise in Mexico and
fall in the United States until they equalize. The labor migration hurts
native U.S. workers, but helps U.S. owners of capital; the opposite occurs

in Mexico. Since migrant workers flow from uses of lower productivity to

higher productivity, the world's output potential expands.

Chapter 10
1.

What is meant by balance of payments?

The balance of payments is a record of the monetary transactions
between residents of one country and the rest of the world that occur
over the course of a one-year period.

2.

What economic transactions give rise to the receipt of dollars

from foreigners? What transactions give rise to payments to
foreigners?
The receipt of dollars from foreigners, results from the following
transactions: (1) merchandise exports, (2) transportation-travel receipts,
(3) income received from foreign investments abroad, (4) gifts received
from foreign residents, (5) aid received from foreign governments, and (6)
investments in the U.S. by overseas residents. The payment of dollars to
foreigners would suggest the opposite for the above transactions.

3.

Why does the balance-of-payments statement Balance?

Because the balance-of-payments statement utilizes a double-entry
booking system, in which each credit entry is balanced by a debit entry,
the overall balance of payments must numerically balance.

4.

From a functional viewpoint, a nations balance of payments

can be grouped into several categories. What are these
categories?

Balance-of-payments transactions are grouped into two categories: (1)

the current account which refers to the monetary value of international
flows associated with flows in goods, services, income, and unilateral
transfers; and (2) the capital account which includes all international
purchases and sales of assets.
5.

What financial assets are categorized as official reserve assets

for the United States?
Official reserve assets consist of gold, Special Drawing Rights, reserve
positions in the International Monetary Fund, and convertible currencies.

6.

What is the meaning of a surplus (deficit) on (a) merchandise

trade balance, (b) goods and services balance, and (c) current
account balance?
A merchandise trade surplus suggests that the home country is a net
exporter of merchandise. A goods and services surplus suggests that the
home country transfers more real resources (goods and services) to other
countries than it receives from them. A current account surplus means an
excess of exports over imports of goods, services, income, and unilateral
transfers.

7.

Why has goods and services balance sometimes shown a

surplus while the merchandise trade balance shows a deficit?
If the surplus balance on the service account exceeds the deficit balance
on the merchandise (goods) account, the goods and services balance will
be in surplus.

8.

What does the balance of international indebtedness measure?

How does this statement differ from the balance-of-payments?
The balance of international indebtedness indicates the international
investment position of a country at one moment in time. The balance of
payments indicates all of the international monetary transactions of a
country over a one-year period.

9.

Indicate whether each of the following represents a debit or a

credit on the U.S. balance-of-payments:
a. A U.S. importer purchases a shipload of French wine.
b. A Japanese automobile firm builds an assembly plant in Kentucky.
c. A British manufacturer exports machinery to Taiwan on a U.S. vessel.

d. A U.S. college student spends a year studying in Switzerland.

e. American charities donate food to people in drought plagued Africa.
f. Japanese investors collect interest income on their holdings of U.S.
government securities.
g. A German resident sends money to her relatives in the United States.
h. Lloyds of London sells an insurance policy to a U.S. business firm.
i. A Swiss resident receives dividends on her IBM stock.
Answer: a-debit; b-credit; c-credit; d-debit; e-debit; f-debit; g-credit; hdebit; i-debit.

Chapter 11
1. What is meant by the foreign exchange market? Where is it
located?
The foreign exchange market refers to the organizational setting within
which individuals, firms, and banks buy and sell foreign currencies.
The two largest foreign exchange markets are located in New York and
London.
2. What is meant by the forward market? How does it differ from
the spot market?
The spot market permits the buying and selling of foreign exchange for
immediate delivery. Future contracts are made by those who will make
or receive foreign exchange payments in the weeks or months ahead.
3. The supply and demand for foreign exchange are considered to
be derived schedules. Explain.

The supply and demand for foreign exchange is derived from the credit
(debit) items on the balance of payments, such as exports or
investment flows.
4. Explain why exchange rate quotations stated in different
financial centers tend to be consistent with one another.
Exchange-rate quotations throughout the world are brought into
harmony via exchange arbitrage.
5. Who are the participants in the forward exchange market?
What advantages does this market offer these participants?
Traders and investors often participate in the forward market to protect
their expected profits from the risk of exchange rate fluctuations.
Speculators also participate in the forward market.
6. What explains the relationship between the spot rate and the
forward rate?
The relation between the spot rate and forward rate is a reflection of
the interest rate differential between countries.
Currencies of
countries whose interest rates are relatively low tend to sell at a
premium over the spot rate in the forward market. Currencies of
countries where interest rates are relatively high tend to sell at a
forward discount relative to the spot rate.
7. What is the strategy of speculating in the forward market? In
what other ways can one speculate on exchange rate changes?
Exchange market speculators deliberately assume foreign exchange
risk with the hope of profiting from exchange rate fluctuations over
time. Most speculation is conducted in the forward market.
8. Distinguish between stabilizing speculation and destabilizing
speculation.
Stabilizing speculation refers to the purchase of a foreign currency with
the domestic currency when there occurs a fall in the foreign exchange
rate. The anticipation is that the exchange rate will soon rise and thus
generate a profit. Stabilizing speculation moderates a fall (rise) in the
exchange rate. Destabilizing speculation reinforces fluctuations in
exchange rates.
9. If the exchange rate changes from $1.7=1 to $1.68 =1, what
does this mean for the dollar? For the pound? What if the
exchange rate changes from $1.7=1 to $1.72=1?

The dollar appreciates against the pound; the pound depreciates

against the dollar. The dollar depreciates against the pound; the
pound appreciates against the dollar.
10.
Suppose $1.69=1 in New York and $1.71=1 in London.
How can foreign exchange arbitragers profit from these
exchange rates?
Arbitragers will buy pounds in New York, at $1.69 per pound, and sell
pounds in London, at $1.71 per pound, thus making a profit of 2 cents
on each pound. As pounds are bought in New York, their prices rises;
as pounds are sold in London, their price falls. When the dollar price of
the pound equalizes in the financial centers, the profitability of
arbitrage ceases and the practice stops.
12. Suppose the spot rate of the pound today is $1.70 and the
three-month forward rate is $1.75.
a) How can a U.S. importer who has to pay 20,000 pounds in
three months hedge the foreign exchange risk?
The U.S. importer can cover her foreign exchange risk by purchasing
20,000 pounds for three-month delivery at today's three-month
forward rate of $1.75 per pound. The importer is willing to pay 5 cents
more per pound (or $1000 more for the 20,000 pounds) than today's
spot rate to guard against the possibility that the spot rate in three
months will exceed $1.70 per pound. In three months, when her
payments are due, the importer will pay $35,000 and get the 20,000
pounds needed for payment, irrespective of what the pound's spot rate
is at that time.
b) What occurs if the U.S. importer does not hedge and the spot
rate of the pound in three months is $1.80?
If the spot rate of the pound in three months is $1.80 per pound, and
the U.S. importer does not obtain forward cover, she must pay $36,000
for the 20,000 pounds; this amount exceeds by $1000 the cost of the
pounds she incurs by hedging.

15. Assume a speculator anticipates that the spot rate of the

franc in three months will be lower than todays three-month
forward rate of the franc, $0.50=1 franc.
a. How can this speculator use $1 million to speculate in the
forward market?

The U.S. speculator should sell francs today for delivery in 6 months at
today's forward rate of the franc, which equals $0.50.
b. What occurs if the francs spot rate in three months is $0.40,
$0.60, $0.50?
After 6 months, if the franc's spot rate is $0.40, the speculator can
purchase francs at the price of $0.40 each and deliver them for the
previously contracted rate of $0.50 per franc; the speculator realizes a
profit of $0.10 on each franc which the forward contract specifies. If
the franc's spot rate after 6 months is $0.60, the speculator must
purchase francs at a price of $0.60 per franc and resell them at a price
of $0.50 per franc; the speculator would suffer losses of $0.10 on each
franc specified in the forward contract. If the franc's spot rate after 6
months is $0.50, the speculator realizes neither a profit nor a loss on
the transaction.
16. You are given the following spot exchange rates: $1=3
francs, $1=4 schillings, and 1 franc=2 schillings. Ignoring
transaction costs, how much profit could a person make via
three-point arbitrage?
An arbitrager could purchase 3 francs for $1, purchase 6 schilling with
3 francs, and sell 6 schilling for $1.50. Ignoring transaction costs, the
arbitrager realizes a $0.50 profit on the transactions.

Chapter 12

1.In a free market, what factors underlie currency exchange values?

Which factors best apply to long and short run exchange rates?
Market fundamentals and market expectations. Long run exchange rates
are best explained by factors including real income differentials, inflation
rate differentials, productivity changes, and the like. In the short run,
exchange rates respond to real interest rate differentials, news about
market fundamentals, and speculative opinion about future exchange
rates.
2.Why are international investors especially concerned about the
real interest rate as opposed to the nominal rate?
The nominal interest rate refers to the interest rate, unadjusted for
inflation. The real interest rate equals the nominal interest rate minus the
inflation rate. International investors are especially concerned about the
real interest rate.
3.What predictions does the PPP theory make concerning the
impact of domestic inflation on the home countrys exchange
rate? What are some limitations of the PPP?
The purchasing-power-parity theory predicts that a country's currency will
depreciate by an amount equal to the excess of domestic inflation over
foreign inflation. The theory also predicts that a country's exchange rate
will appreciate by an amount equal to the excess of foreign inflation over
domestic inflation.
The theory does not consider the impact of
international capital movements, and it suffers from the choice of an
appropriate price index used in price calculations.
4.If a currency becomes overvalued in the foreign exchange market,
what will be the likely impact on the home countrys trade
balance? What if the home currency becomes overvalued?
An overvalued currency tends to lead to a balance-of-payments deficit for
the home country, while an undervalued currency leads to a
balance-of-payments surplus.
5.Identify the factors that account for changes in a currencys value
over the long run.
In the long run, four key factors account for changes in exchange rates:
relative productivity levels, relative price levels, preferences for domestic
goods and foreign goods, and barriers to trade.
6.What factors underlie changes in a currencys value in the short
run?

In the short run, changes in exchange rates are caused by relative interest
rates and expected changes in exchange rates.
7.Explain how the following factors affect the dollars exchange rate
under a system of market determined exchange rates:
a.A rise in the US price level, with the foreign price level held
constant
b.Tariffs and quotas placed on U.S. imports
c. Increased demand for U.S. exports and decreased U.S. demand for
imports
d.Rising productivity in the U.S. relative to other countries
e.Rising real interest rates overseas relative to U.S. rates
f. An increase in U.S. money growth
g.An increase in U.S. money demand

The dollar's exchange rate will:

a. Depreciate
b. Appreciate
c.Appreciate
d. Appreciate
e. Depreciate
f. Depreciate
g. Appreciate

8.What is meant by exchange rate overshooting?

An exchange rate is said to overshoot when its short-run response
(depreciation/appreciation) to a change in market fundamentals is greater
than its long-run response. Exchange rate overshooting occurs because
exchange rates tend to be more flexible than other prices; exchange rates
often depreciate/appreciate more in the short run than in the long run so
as to compensate for other prices that are slower to adjust to their longrun equilibrium levels.
9.What methods do currency forecasters use to predict future
changes in exchange rates?

Currency forecasters generally use one of three methods to predict

future exchange rates: (1) judgmental analysis,(2) technical analysis, or
(c) fundamental analysis.

10. Assuming market determined exchange rates, use supply and

demand schedules for pounds to analyze the effect on the
exchange rate (dollars per pound) between the U.S. dollar and
the UK pound under each of the following circumstances:
a.Voter polls suggest that the UKs conservative government will be
replaced by radicals who pledge to nationalize all foreign owned
assets.
b.Both UK and U.S. economies slide into recession, but the UK
recession is less severe than the U.S. recession.
c. The Federal Reserve adopts a tight monetary policy that
dramatically increases U.S. interest rates.
d.Britains oil production in the North Sea decreases, and exports to
the U.S. fall.
e.The U.S. unilaterally reduces tariffs on UK products.
f. Britain encounters severe inflation, while price stability exists in
the U.S.
g. Fears of terrorism reduce U.S. tourism in the U.K.
h. The British government invites U.S. firms to invest in British oil
fields.
i. The rate of productivity growth in Britain decreases sharply.
j. An economic boom occurs in the United Kingdom that induces the
UK consumers to purchase more U.S. made autos, trucks and
computers.
k.Ten-percent inflation occurs in both the United States and the
United Kingdom.

a.
b.
c.

Supply of Demand for

Exchange rate
pounds
pounds
($ per pound)
-------decrease
decrease
decrease
increase
increase
increase
decrease
decrease

d.
e.
f.
g.
h.
i.
j.
k.

--------------increase
--------------increase
increase
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decrease
increase
decrease
decrease
increase
decrease
---------------

decrease
increase
decrease
decrease
increase
decrease
decrease
--------