Progress Test 3B

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                                                                                      Form B
Introduction to International Economics                                          ECON 321 003

Student’s Name _______________________________________________                      Closed Book

Address __________________________________________________                     Date __________

You are NOT ALLOWED to take this examination, a copy of it, or any scratch paper
used during the examination out of the testing room or area. Violation of this rule will
automatically DISQUALIFY you from receiving credit for the course. You will be given
two hours to complete this test. You may use a calculator and a ruler.

                                        Progress Test 3

Part A: Multiple-Choice (50 points)

On the line to the left, place the letter of the choice that best completes or answers each of the
following statements or questions. Each question is worth one point.

____ 1. One often mentioned downside to international investment is its:
        a. volatility.
        b. profitability.
        c. harmful effect on international trade.
        d. stability.

____ 2. After adjusting for inflation, in 2000, the volume of net foreign assets purchased
        by U.S. investors was:
        a. approaching the volume of U.S. exports.
        b. smaller than it was in 1970.
        c. more than twice as great than it was in 1970.
        d. about equal to what it was in 1970.

____ 3. Intertemporal transactions:
         a. are not normally included among the activities classified as globalization.
         b. are more easily carried out between countries than within countries.
         c. are a part of international trade, not international investment.
         d. involve current payments to acquire something that returns a payment in
            the future.
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Introduction to International Economics                                      ECON 321 003

____ 4. The two-period model of international investment shows that if the interest rate
        r* is lower in the rest of the world than in a small economy and if the small
        economy opens its economy to free trade and investment, then all other things
        equal, that small economy will:
         a. increase its investment in capital in period 1.
         b. run a trade surplus in period 1.
         c. increase its consumption in period 1.
         d. lend to the rest of the world in period 1.

____ 5. According to the two-period model of international investment, differences in
        interest rates between different economies can be the result of, among other
        a. differences in technology.
        b. different tastes.
        c. differences in the relative quantities of labor and capital.
        d. All of the above.
        e. b and c only.

___ 6. The motive for international investment referred to as intertemporal consumption
        smoothing is related to the fact that international investment:
        a. distorts how consumers allocate their consumption expenditures over time.
        b. permits savings to be channeled to the highest return investments wherever
           they may be in the world.
        c. permits investors to reduce risk by pooling assets from different countries,
           which are less closely correlated than assets located within a single country.
        d. permits consumers to more efficiently allocate their consumption
           expenditures over time.

____ 7. Suppose that the return to investment is given by the slope of the standard
        diminishing returns production function that relates the level of output, Y, to
        the stock of capital, K. In this case, all other things equal the slope of the
        production function is steeper the smaller is:
         a. the stock of capital.
         b. the stock of other substitute factors of production.
         c. the level of technology.
         d. All of the above.
         e. None of the above.
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Introduction to International Economics                                     ECON 321 003

____ 8. Martin Feldstein and Charles Horioka found that after the liberalization of
        international investment in the late twentieth century,:
        a. economic growth reduced the amount of international investment.
        b. saving and investment still remained roughly in balance in each of the
            individual countries included in their study.
        c. most developed economies became either large net borrowers or net
        d. nearly all of the countries included in their study began to borrow heavily

____ 9. Creditors can reduce the risk of default by debtors through:
        a. financial repression.
        b. charging higher interest rates.
        c. collateral.
        d. All of the above.
        e. None of the above.

____ 10. A fundamental problem inherent in any intertemporal trade is that:
        a. one party to the agreement has an incentive to accept a payment or good
            now and then not deliver on the future obligation.
        b. one party to the exchange may know more than the other about the
            likelihood of the future payment.
        c. after receiving the initial payment, the party obligated to make the future
            payment becomes less motivated to ensure that the obligation will be met.
        d. All of the above.
        e. None of the above.

____ 11. Adverse selection and moral hazard are likely to be more serious problems in
        an international setting because:
        a. local legal systems may make it difficult for foreign lenders to claim
        b. cultural differences make legal systems incompatible and courts in different
            countries often interpret issues very differently.
        c. in some countries, legal systems are simply corrupt.
        d. All of the above.
        e. None of the above.

____ 12. A multinational enterprise (MNE) is accurately defined as a firm that:
        a. exports more than it imports.
        b. sells in many markets around the globe.
        c. operates and controls production or distribution facilities in more than one
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Introduction to International Economics                                       ECON 321 003

        d. has foreign stockholders.
        e. All of the preceding answers are correct.

____ 13. The prominence of MNEs in the world economy means that:
        a. we must substantially amend our theory of international trade.
        b. we must develop a new theory of international trade.
        c. we can continue to use our existing theory of international trade as it is.
        d. none of our models can correctly explain MNE’s trade and investment

____ 14. Evidence suggests that:
        a. FDI causes greater technology transfers to developing countries than to
           developed countries.
        b. FDI has little effect on technology transfers between countries, unlike other
           forms of international investment.
        c. FDI is more likely to promote economic growth in countries that maintain
           protectionist trade policies because protection increases the competitive
           need to innovate.
        d. FDI causes fewer technology transfers to developing countries than to
           developed countries.

____ 15. U.S. portfolio investment overseas grew very rapidly in the 1980s and 1990s
        a. U.S. stock and bond markets were very large and easy to use.
        b. U.S. wealth contracted rapidly in the 1980s and 1990s.
        c. the U.S. government eliminated restrictions that had limited its citizens’ and
           financial firms’ ability to acquire foreign assets.
        d. numerous countries around the world established stock and bond markets
           or, where such markets already existed, they opened such markets to foreign
           participation for the first time.

____ 16. Foreign aid:
        a. has usually caused economic growth to accelerate in developing countries.
        b. has declined as a proportion of developed country gross domestic products
           over the past three decades.
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Introduction to International Economics                                     ECON 321 003

        c. has increased rapidly in real terms over the past 20 years.
        d. was smaller than any of the major categories of international investment in
           the 1950s but is now larger.

____ 17. Over the past several decades:
        a. international investment has become more one sided, consisting almost
           entirely of foreign direct investment.
        b. international bank lending grew to where it was the largest category of
           international investment by the year 2000.
        c. most international investment has flowed from developed to developing
        d. international investment has come to consist mostly of foreign direct
           investment and portfolio investment.

____ 18. The internal prices that firms use to record exchanges between branches of the
        same firm located in different countries are called:
        a. foreign prices.
        b. intra-industry prices.
        c. transfer prices.
        d. firm prices.

____ 19. The eurocurrency market first appeared in:
        a. London in 2002.
        b. New York after World War II.
        c. London during the 1950s.
        d. Paris during the 1980s.

____ 20. The earliest foreign exchange markets appeared:
        a. some 200 years ago.
        b. in China 1,000 years ago.
        c. in ancient times, over 2,000 years ago.
        d. in Medieval Europe at trade fairs.

____ 21. Fiat money:
        a. is currency that is tender by law but is not redeemable into gold or silver.
        b. makes the job of the money changer easier.
        c. means that future purchasing power of national moneys no longer matters
            for the exchange rate.
        d. All of the above.
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Introduction to International Economics                                          ECON 321 003

____ 22. Arbitrage:
        a. is the simultaneous purchase and sale of goods or assets in two distinct
           markets with different prices.
        b. permits the arbitrageur to profit from a difference in prices for a certain
           commodity or asset across different market segments.
        c. tends to eliminate price differences across different market segments.
        d. All of the above.
        e. a and b only.

____ 23. Triangular arbitrage implies that:
        a. a government need only manipulate supply and demand in the n-1 foreign
            exchange markets where its currency trades to keep its exchange rates fixed.
        b. the exchange rate between any two currencies will be the same in markets
            around the world.
        c. if any one exchange rate changes, other exchange rates will remain
        d. it is not difficult for policy makers to keep exchange rates fixed.

____ 24. Among the forms of arbitrage that characterize unrestricted foreign exchange
        markets is/are:
        a. reverse arbitrage.
        b. market arbitrage.
        c. geographic arbitrage.
        d. All of the above.
        e. None of the above.

____ 25. Denoting the forward exchange rate as ftt+1, the expected future exchange rate
        as Eet+1, the spot exchange rate as et, r as the domestic rate of return on assets,
        and r* as the foreign rate of return on assets, the equations (1) et = [(1 + r*/(1 +
        r)](Eet+1) and (2) et = [(1 + r*)/(1 + r)](ftt+1) represent:
        a. the (1) covered and (2) uncovered interest parity conditions, respectively.
        b. the (1) forward and (2) spot exchange markets, respectively.
        c. the (1) uncovered and (2) covered interest parity conditions, respectively.
        d. the (1) spot and (2) forward exchange markets, respectively.

____ 26. If one U.S dollar costs five Argentinean pesos, what is the U.S. dollar price of a
        a. $5.00.
        b. $.20.
        c. $.05.
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Introduction to International Economics                                        ECON 321 003

         d. $.50.

____ 27. Which of the following statements is false?
        a. The forward market allows cashless speculation.
        b. The forward exchange markets are well developed only for the currencies of
           the major developed countries.
        c. Hedging can only be undertaken using the forward market.
        d. The spot market is often used by speculators.
        e. None of the above; they are all true.

____ 28. Rational expectations implies that people set their expectations:
        a. using the best available economic models.
        b. using the best available information.
        c. using their available information in an unbiased fashion.
        d. All of the above.
        e. None of the above.

____ 29. The effective exchange rate:
        a. is the reciprocal of the normal exchange rate.
        b. is no longer published by any country because it is thought to be too
        c. is a weighted average of a set of exchange rates and often provides a better
           indication of the overall value of a currency in the global economy.
        d. is a theoretical concept that is of little practical use.

____ 30. According to the interest parity condition, the spot exchange rate will remain
        constant if:
        a. expectations about future exchange rates change gradually.
        b. rates of return on assets at home and abroad are equal and unchanging.
        c. rates of return on assets are different at home and abroad but remain
        d. policy makers do not alter their policies when expectations or rates of return

____ 31. Exchange rate intervention:
        a. has no domestic effects; it only affects foreign economies.
        b. does not change the money supply and it therefore cannot change exchange
        c. changes a country’s money supply.
        d. is carried out by the International Monetary Fund.

____ 32. If the interest parity condition holds and people rationally use all available
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Introduction to International Economics                                      ECON 321 003

        information to set their expectations about the future, then:
        a. the spot exchange rate is no longer systematically related to future exchange
        b. the spot exchange rate will change whenever news arrives.
        c. it becomes possible to consistently and accurately predict future changes in
            the exchange rate.
        d. forward exchange rates are useless as predictors of future exchange rate

____ 33. If P is the overall price index at home, such as the well-known wholesale price
        index, P* is the general price index overseas, and e is the exchange rate defined
        as the domestic currency price of the foreign currency, then the purchasing
        power parity theory of the exchange rate predicts that the exchange rate must
        a. e = P*/P.
        b. e = P - P*
        c. e = P*
        d. e = P/P*

____ 34. As shown in the textbook, the position of the vertical aggregate supply curve is
         most likely to depend on:
        a. the level of aggregate demand.
        b. the steady state level of output as determined by the aggregate production
           function in the Solow growth model.
        c. the price level.
        d. the exchange rate.

____ 35. According to the aggregate demand/aggregate supply model, all other things
        equal, a decrease in aggregate demand will cause the price level in the economy
        a. rise rapidly.
        b. gradually rise in the long run.
        c. remain the same.
        d. fall.

____ 36. The trilemma states that:
        a. countries can only engage in international investment if they let exchange
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Introduction to International Economics                                      ECON 321 003

           rates float.
        b. open economies must let their exchange rates float if they do not direct their
           economic policies toward domestic economic goals.
        c. countries must abandon globalization if they want to fix their exchange
        d. no country can simultaneously fix its exchange rate, set economic policies
           with only domestic goals in mind, and permit the free flow of goods and
           assets across national borders.

____ 37. The manner in which the European countries have gone about their transition
        towards the single currency shows that they recognize the difficulties of
        maintaining a fixed exchange rate. For example, the twelve European countries
        that agreed to adopt the euro as their currency:
        a. agreed to form a single regional central bank, the European Central Bank.
        b. set very few domestic fiscal policy goals for individual countries in order to
           avoid making any countries ineligible for joining the scheme.
        c. required that each country’s central bank to focus on keeping
           unemployment low.
        d. set inflation targets for each country that reflected each country’s unique
           economic conditions.

____ 38. A country that is a net borrower:
        a. produces more than it absorbs.
        b. absorbs less than it imports.
        c. absorbs more than it produces.
        d. accumulates more than it produces.

____ 39. Contributing to Asia’s 1997 financial crash was:
        a. heavy borrowing overseas in dollars by banks and firms whose earnings
           were in local currency.
        b. the weak balance sheets of many Asian banks, whose customers were often
           not solvent either.
        c. the fact that in Thailand, Malaysia, and Indonesia foreign loans were
           sometimes used to finance real estate speculation.
        d. All of the above.
        e. None of the above.

____ 40. Great Britain ended up with a gold standard in the early nineteenth century
        a. as master of the British mint, Sir Isaac Newton priced silver much higher
           relative to gold than the two precious metals were priced in other European
        b. certain political groups in Parliament wanted a very expansionary monetary
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Introduction to International Economics                                      ECON 321 003

        c. Parliament sought to limit the government’s ability to print money.
        d. most other major economies had already adopted the gold standard.

____ 41. The gold standard:
        a. is a theoretical monetary system that never actually existed.
        b. existed for only a few decades before World War I.
        c. is what lies behind the present international monetary system.
        d. functioned continuously for centuries until 1914.

____ 42. The specie flow mechanism described by David Hume implied that a country’s
        balance of trade will:
        a. automatically tend toward equality.
        b. gradually grow more negative.
        c. be consistently positive.
        d. never remain in balance.

____ 43. In terms of the trilemma, the gold standard effectively implied governments’
        choice of:
        a. globalization and policy independence over a fixed exchange rate.
        b. globalization and a fixed exchange rate over policy independence.
        c. policy independence and a fixed exchange rate over globalization.
        d. a fixed exchange rate over globalization and policy independence.

____ 44. Some governments intervene in the foreign exchange markets to intentionally
        suppress the values of their currencies. Among the reasons why a government
        keeps its currency undervalued is:
        a. the desire to help exporters.
        b. the desire to help domestic firms cope with foreign debt.
        c. the desire to make important imports less expensive.
        d. the desire to make it less expensive for domestic citizens to acquire foreign
        e. None of the above.

____ 45. Among the characteristics of the Bretton Woods system was/were:
        a. floating exchange rates.
        b. a return to the gold standard.
        c. the pegging of all currencies to the U.S. dollar.
        d. All of the preceding items were characteristics of the Bretton Woods system.

____ 46. Under the Bretton Woods system, foreign exchange market intervention was
        carried out by:
        a. the Bank of England.
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Introduction to International Economics                                      ECON 321 003

         b.   the Central Bank of France.
         c.   the Japanese Central Bank.
         d.   All of the above.
         e.   None of the above.

____ 47. The exchange rate arrangement agreed to at the Bretton Woods conference is
        known as:
        a. the dirty float.
        b. the adjustable peg.
        c. the bimetallic standard.
        d. the EMS.

____ 48. The Bretton Woods system gave way to floating exchange rates because,
        among other things:
        a. the United States ran persistent large balance of payments surpluses, which
           prevented other countries from accumulating any dollar reserves.
        b. the United States accumulated all the world’s gold.
        c. central bank intervention required to maintain the pegs interfered with
           monetary policy goals.
        d. floating exchange rates would be more stable.

____ 49. The European Monetary System (EMS):
        a. was the first fixed exchange rate system to fail during the twentieth century.
        b. eliminated all exchange rate changes among most European currencies
           between 1979 and 1992.
        c. was abandoned in the early 1990s after several European currencies suffered
           speculative attacks.
        d. was the first fixed exchange rate system to succeed during the twentieth

____ 50. If a country places high tariffs on imports, a multinational enterprise operating
        in the country can avoid paying some of those tariffs by:
        a. raising transfer prices on the components imported from foreign affiliates.
        b. lowering transfer prices on the components imported from foreign affiliates.
        c. shifting production abroad.
        d. charging lower prices for its products in the domestic market.
Progress Test 3-continued                 12      FORM B
Introduction to International Economics        ECON 321 003
Progress Test 3-continued                      13                                    FORM B
Introduction to International Economics                                           ECON 321 003

Part B: Essays/Problems (50 points)

1. (20 pts.) Chapter 10 develops a two-period model of intertemporal trade in which we
suppose that people live for two periods of time, they can only produce output in
period 1, but they must consume in both periods. Period 2 consumption is possible
only if people invest in period 1. Suppose that the home economy has an intertemporal
consumption possibilities frontier as shown on the side, and intertemporal preferences
are represented by the indifference curves I and I’. The slope of the dotted line P
represents the marginal rate of return to period 1 investment at the equilibrium point A.
                          Output in                  Fi gure Q 1
                          Period 2        FP    Intertemporal Equilibrium wit h
                                                Asset Trade

                                 f         A

                                 0             i       1Y           Output in
                                                                    Period 1

Now, suppose that suppose that the return to investment overseas is higher than the
return to investment in the home economy. Illustrate this case of r* > r by drawing a
diagram and explaining precisely what consumption is in each period, what
international trade flows are in each period, and what international borrowing and
lending is in each period. Show also how national welfare is affected.
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Introduction to International Economics                                        ECON 321 003

2. (5 pts.) Suppose that the spot exchange rate between Canadian dollars and U.S.
dollars is equal to e = US$0.50. The current return on high-quality Canadian financial
assets is 13 percent while the interest rate in the U.S. for comparable assets is 9 percent.
Given this information, calculate what the 360-day forward exchange rate must be. Be
sure to explain precisely where you get the equation with which you calculate the
forward rate.

3. (10 pts.) Explain what is meant by central bank exchange market intervention. Is
exchange rate intervention a useful long-run tool for keeping the exchange rate fixed?
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Introduction to International Economics                                 ECON 321 003

4. (15 pts.) Explain the trilemma. Then explain how the trilemma was successfully or
unsuccessfully dealt with during the late 1800s gold standard period.