23:14, 09/09/2022 International Economics Chapter 15

International Economics, 10e (Krugman/Obstfeld/Melitz)

Chapter 15 (4) Money, Interest Rates , and Exchange Rates

15.1 Money Defined: A Brief Review

1) The exchange rate between currencies depends on

A) the interest rate that can be earned on deposits of those currencies.
B) the interest rate that can be earned on depo sits of those currencies and the expected future
exchange rate.
C) the expected future exchange rate.
D) national output.
E) the interest rate that can be earned on deposits of those countries and the national output.
Answer: B
Page Ref: 379-381
Difficulty: Easy

2) Money serves as all of the following EXCEP T

A) a medium of exchange.
B) a unit of account.
C) a store of value.
D) a symbol that is made of or can be redeemed for a fixed amount of precious metal.
E) a highly liquid asset.
Answer: D
Page Ref: 379-381
Difficulty: Easy

3) Money includes
A) currency.
B) checking deposits held by households and firms.
C) deposits in the foreign exchange market s.
D) currency and checking deposits held by hou seholds and firms.
E) futures and depo sits in the foreign exchange ma rket.
Ans wer: D
Page Ref: 379-381
Difficulty: Easy

4) In the United S tates at the end of 2012, the total money supply, M1, amounted to
approximately
A) 16 percent of that year's GNP .
B) 20 percent of that year's GNP.
C) 30 percent of that year's GNP.
D) 40 percent of that year's GNP .
E) 50 percent o f that year's GNP.
Ans wer: A
Page Ref: 379-381
Difficulty: Easy

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5) What are the main functions of money?

Ans wer: Money s erves in general three important functions: a medium of exchange; a unit of
account; and a store of value. As a medium o f exchange, money avoids going back to a barter
economy, with the enormous search cost s connected with it. As a unit of account, the use of
money economizes on the number of prices an individual faces. Consider an economy with N
goods, then one needs only (N - 1) prices. As a s tore of value, the u se of money in general
ensur es that you can transfe r w ealth between periods.
Page Ref: 379-381
Difficulty: Moderate

15.2 The Demand for Money by Individuals

1) Individuals bas e their demand for an ass et on

A) the expected return the asset offers compared with the returns offered by other assets.
B) the riskiness of the asset 's expected return.
C) the asset's liquidity.
D) the expected return, how risky that expected return is, and the asset's liquidity.
E) the aesthetic qualitie s of the asset.
Ans wer: D
Page Ref: 382-383
Difficulty: Easy

2) A family's summer house on Cape Cod pays a return in the form of

A) interest rate.
B) capital gains.
C) the pleasure of vacation s at the beach.
D) stock options.
E) capital gains and pleasure.
Ans wer: E
Page Ref: 382-383
Difficulty: Easy

3) In a world w ith money and bonds only

A) it is not risky to hold money.
B) it is risky to hold money.
C) ris k is an important factor in the demand for money.
D) there is no relations hip between risk and holding money.
E) assets become meaningless.
Ans wer: B
Page Ref: 382-383
Difficulty: Easy

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4) Which one of the following statements i s the M OST accurate?

A) A rise in the ave rage value of transactions carried out by a household or a firm causes its
demand for money to fall.
B) A reduction in the average value of transactions carried out by a household or a firm causes
its demand for money to rise.
C) A rise in the average value of transactions carried out by a household or a firm causes it s
demand for money to ri se.
D) A rise in the ave rage value of transactions carried out by a household or a firm causes its
demand for real money to rise.
E) a decrease in the average value of t ransactions carried out by a household or a firm causes its
demand for real money to rise.
Ans wer: D
Page Ref: 382-383
Difficulty: Easy

5) An individual's need for liquidity would increase if

A) the average value of transactions ca rried out by the individual fell.
B) the average value of transactions ca rried out by the individual rose.
C) the individual got a raise.
D) the individual received a new ATM card.
E) the individual wanted to avoid risks .
Ans wer: B
Page Ref: 382-383
Difficulty: Easy

6) What are the factors that determine the amount of money an individual desires to hold?
Ans wer: Three main factors: firs t, the expected return the asset offers compared with the returns
offered by other assets; second, the riskiness of the asset's expected return; and thi rd, the asset's
liquidity.
Page Ref: 382-383
Difficulty: Moderate

15.3 Aggregate Money D emand

1) The aggregate money demand depends on

A) the interest rate.
B) the price level.
C) real national income.
D) the interest rate, price level, and real national income.
E) the price level and the liquidity of the asset.
Ans wer: D
Page Ref: 383-385
Difficulty: Easy

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2) If there is initially an
A) excess demand for money, the inter est rate will fall, and the supply of money it will ris e.
B) excess supply of money, the interest rate will fall, and if there is initially an excess demand, it
will rise.
C) excess supply of money, the interest rate will rise, and if there i s initially an excess demand, it
will fall.
D) excess supply o f money, the interest rate will fall, and if there is als o an excess demand, it
will fall rapidly.
E) excess supply of money, the interest rate w ill ris e, and if there is al so an excess demand, it
will rise rapidly.
Ans wer: B
Page Ref: 383-385
Difficulty: Easy

3) Which one of the following statements i s the M OST accurate?

A) A decrease in the money supply lowers the interes t rate while an increa se in the money
supply rais es the interest rate, given the price level and output.
B) An increase in the money supply lowers the interes t rate while a fall in the money supply
raises the interest rate, given the price level.
C) An increase in the money supply lowers the interes t rate while a fall in the money supply
raises the interest rate, given the output level.
D) An inc rease in the money supply low ers the intere st rate while a fall in the money supply
raises the interest rate, given the price level and output.
E) An increase in the money supply does not usually affect the interest rate.
Ans wer: D
Page Ref: 383-385
Difficulty: Easy

4) An increase in
A) nominal output rai ses the inte res t rate while a fall in real output lowers the interest rate, given
the price level and the money supply.
B) real output decreases the interest rate while a fall in real output increas es the interest rate,
given the price level.
C) real output raises the interest rate while a fall in real output low ers the interest rate, given the
money supply.
D) nominal output rai ses the inte res t rate while a fall in real output low ers the interest rate, given
the price level.
E) real output rais es the interest rate while a fall in r eal output lowers the interest rate, given the
price level and the money supply.
Ans wer: E
Page Ref: 383-385
Difficulty: Easy

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5) The aggregate demand for money can be exp ress ed by

A) M d = P × L(R,Y).
B) Md = L × P(R,Y).
C) Md = P × Y(R, L).
D) M d = R × L(P,Y).
E) Md = R × L(R, P).
Ans wer: A
Page Ref: 383-385
Difficulty: Easy

6) What are the main factors that determine agg regate money demand?
Ans wer: The three main factors are interest rate, the price level and real national income. A rise
in the interes t rate causes individuals in the economy to reduce their demand for money. If the
price level rises, individual households and firms will spend more money than before. When real
national income (GNP) rises the demand for money will also rise.
Page Ref: 383-385
Difficulty: Moderate

7) Explain w hy one can write the demand for money as the price level times a function of the
interest rate and real income as follows:
= PxL (R, Y)
Ans wer: The aggregate money demand is proportional to the price level. Imagine that all prices
in an economy doubled, but the interest rate and everyone's real incomes remained unchanged.
Then, the money value of each individual 's ave rage daily transactions would simply double, as
would the amount of money each wishes to hold.
Page Ref: 383-385
Difficulty: Moderate

15.4 The Equilibrium Interest Rate: The Interaction of Money Supply and Demand

1) The aggregate real money demand schedule L (R,Y)

A) slopes upward becaus e a fall in the interes t rate raises the des ired real money holdings of each
household and firm in the economy.
B) s lopes dow nward because a fall in the inte rest rate reduces the desired real money holdings of
each household and firm in the economy.
C) ha s a zero slope because a fall in the interest rate keeps constant the desired real money
holdings of each hou sehold and firm in the economy.
D) slopes downward because a fall in the interest rate rai ses the desired real money holdings of
each household and firm in the economy.
E) slopes downward because a rise in the interest rate makes consume rs less focused on the
liquidity of their assets.
Ans wer: D
Page Ref: 385-388
Difficulty: Easy

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2) F or a given level of
A) nominal GNP , changes in interest rates cause movements along the L( R,Y) schedule.
B) real GNP, changes in interest rates caus e a decrease of the L(R,Y) schedule.
C) real GNP, changes in interest rates caus e an increase of the L(R,Y) schedule.
D) nominal GNP , changes in interest rates cause an increase in the L(R,Y ) schedule.
E) real GNP, changes in interes t rates cau se movements along the L(R,Y ) schedule.
Ans wer: E
Page Ref: 385-388
Difficulty: Easy

3) The money supply s chedule is

A) horizontal because is set by the central bank w hile P is taken as given.
B) horizontal because is set by the central bank.
C) ve rtical becaus e is set by the households and fi rms while P is taken as given.
D) vertical because and P are set by the central bank.
E) ver tical becaus e is set by the central bank while P is taken as given.
Ans wer: E
Page Ref: 385-388
Difficulty: Easy

4) If individuals are holding more money than they desire

A) they w ill attempt to reduce their liquidity by us ing money to purchas e goods .
B) they will attempt to reduce thei r liquidity by using money to purchase interest-bearing assets.
C) they will attempt to reduce thei r liquidity by converting real money holdings into nominal
money holdings.
D) they w ill keep their holdings cons tant.
Ans wer: B
Page Ref: 385-388
Difficulty: Easy

5) If there is an excess supply of money

A) the interest rate falls .
B) the interest rate rises.
C) the real money supply shifts left to make an equilibrium.
D) the real money supply shifts right to make an equilibrium.
E) the interest rate stay s constant, but con sumer confidence falters.
Ans wer: A
Page Ref: 385-388
Difficulty: Easy

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6) A reduction in a country's money supply causes
A) its currency to depreciate in the foreign exchange market.
B) its currency to appreciate in the foreign exchange market.
C) does not affect its currency in the foreign market.
D) does affect its currency in the foreign market in an ambiguous manor.
E) affects other countries currency in the foreign market.
Ans wer: B
Page Ref: 385-388
Difficulty: Easy

7) What will be the effects of an increase in the money supply on the interest rate?
Ans wer: An increase in the money supply w ill caus e interest rate to decrease. This should
increa se investment and possibly consumption of durable goods. The reduction in the inter est
rate w ill cause a depreciation o f the dollar.
Page Ref: 385-388
Difficulty: Moderate

8) What will be the effects of an increase in real output on the interest rate?
Ans wer: An increase in real output will inc reas e the interest rate. If inves tment depends only on
interest rate, this will cause inves tment to go down. The increases interest rate will cause an
appreciation of the dollar.
Page Ref: 385-388
Difficulty: Moderate

15.5 The Money Supply and the Exchange Rate in the S hort Run

1) An increase in a count ry's money supply causes

A) its currency to appreciate in the foreign exchange market while a reduction in the money
supply causes its currency to depreciate.
B) its currency to depreciate in the foreign exchange market while a reduction in the money
supply causes its currency to appreciate.
C) no effect on the values of it currency in international markets.
D) its currency to depreciate in the foreign exchange market while a reduction in the money
supply causes its currency to further depreciate.
E) its currency to depreciate in the domestic market and appreciate in the foreign market.
Ans wer: B
Page Ref: 389-394
Difficulty: Easy

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2) Which one of the following statements i s the M OST accurate?

A) Given PUS, when the money supply ris es, the dollar interest rate declines and the dollar
depreciates against the euro.
B) Given YUS, w hen the money supply rises , the dollar interest rate declines and the dolla r
depreciates against the euro.
C) Given PUS and YUS, w hen the money supply dec reas es, the dollar interest rate declines and
the dollar depreciates against the euro.
D) Given PUS and YU S, when the money supply rises, the dollar interes t rate declines and the
dollar appreciates against the euro.
E) Given PU S and YUS, w hen the money supply rises, the dolla r interest rate declines and the
dollar depreciates against the euro.
Ans wer: E
Page Ref: 389-394
Difficulty: Easy

3) Given PUS and YUS

A) An inc rease in the European money supply causes the euro to appreciate agains t the dollar,
but it does not disturb the U.S. money market equilibrium.
B) An increase in the European money supply caus es the euro to appreciate agains t the dollar,
and it creates excess demand for dollars in the U .S. money market.
C) An increase in the European money supply caus es the euro to depreciate agains t the dollar,
and it creates excess demand for dollars in the U .S. money market.
D) An inc rease in the European money supply causes the euro to depreciate agains t the dollar,
but it does not disturb the U.S. money market equilibrium.
E) An increase in the European money supply causes the euro to depreciate against the dolla r,
and disturbing the U.S. money mar ket equilibrium.
Ans wer: D
Page Ref: 389-394
Difficulty: Easy

4) Analyze the effects of an increase in the European money supply on the dolla r/euro exchange
rate.
Ans wer: The main points a re: An increase in the European money supply w ill reduce the interest
rate on the euro, and thu s causes the euro to depreciates against the dollar . The U.S. money
demand and money supply are not going to be affected, and thu s the interest rate in the U.S. will
remain the same.
Page Ref: 389-394
Difficulty: Moderate

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5) Explain how the money markets of two countries are linked th rough the foreign exchange
market.
Ans wer: The monetary policy actions by the F ed affect the U.S. interest rate, changing the
dollar/euro exchange rate that clears the foreign exchange market. The European System of
Central Banks (ESCB) can affect the exchange rate by changing the European money supply and
interest rate.
Page Ref: 389-394
Difficulty: Moderate

6) What would be the effect of an increase in the European Money Supply in the Dollar Euro
Exchange Rate?
Ans wer: An increase in the European money supply lowers the dolla r return on Euro deposits,
i.e. the dollar appreciates against the Euro. There is no change in the US money market.
Page Ref: 389-394
Difficulty: Moderate

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7) Us ing a figure describing both the U.S. money market and the foreign exchange market,
analyze the effects of a temporary increase in the European money s upply on the dollar/euro
exchange rate.
Ans wer: An increase in the European money supply w ill reduce the interest rate on the euro and
thus will cause the schedule of the expected euro return expresses in dolla rs to shift down,
causing a reduction in the dollar/euro exchange rate, i.e., an appreciation of the U .S. Dollar. The
euro depreciates against the dollar. The U.S . money demand and money s upply are not going to
be affected, and thus the interest rate in the U .S. will remain the same.

Page Ref: 389-394

Difficulty: Moderate

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8) Us ing a figure describing both the U.S. money market and the foreign exchange market,
analyze the effects of an increase in the U.S. money supply on the dollar/euro exchange rate.
Ans wer: An increase in the U.S. money supply will cause interest rate to decreas e. This should
increa se investment and possibly consumption of durable goods. The reduction in the interest
rate w ill cause a movement to the left along the schedule depicting the expected euro return
expressed in dollar. The result is an increase in E or a depreciation of the dollar.

Page Ref: 389-394

Difficulty: Moderate

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9) Explain the following figure.

Ans wer: The figure explains how the money markets of t wo countries are linked through the
foreign exchange market. The monetary policy action s by the Fed affect the U.S. interest rate,
changing the dollar/euro exchange rate that clears the foreign exchange market. The European
System of Central Banks (ESCB) can affect the exchange rate by changing the European money
supply and interest rate.
Page Ref: 389-394
Difficulty: Moderate

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10) Combine a graph showing the interest parity condition and one show ing money demand and
supply to demonstrate simultaneous equilibrium in the money market and the foreign exchange
market.
How would an increas e in the U.S. money supply affect the Dollar/Euro exchange rate and the
U.S. interest rate? Illustrate your answer graphically and explain.
Ans wer: Above the axis is depicted the foreign exchange ma rket, where changes in the rate of
return on the dollar are mapped into changes in the exchange rate. Below the axis is depicted the
U.S. money market and shows the relation between the rate of return on the dollar and U.S. real
money holdings. The mechanism works as follows. Consider an increase in the U.S . real money
holdings. Supply and demand dictate that the demand for money must increase, so the rate of
return must lower to equilibrate at point 2. The lower rate of return on the dollar w ill cause the
dollar to depreciate (exchange rate moves to point ).

Page Ref: 389-394

Difficulty: Moderate

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15.6 Money, the P rice Level, and the Exchange Rate in the Long Run

1) An economy's long-run equilibrium is

A) the equilibrium that would occur if prices were perfectly flexible.
B) the equilibrium that would occu r if prices were perfectly flexible and always adjusted
immediately.
C) the equilibrium that would occu r if prices were perfectly flexible and always adjusted
immediately to preserve full employment.
D) the equilibrium that would occur if prices were perfectly fixed to preserve full employment.
E) the equilibrium that would occur if prices were perfectly fixed at the full employment point.
Ans wer: C
Page Ref: 394-397
Difficulty: Easy

2) A permanent increase in a country's money supply

A) causes a more than proportional increase in its price level.
B) causes a less than proportional increase in its price level.
C) causes a proportional increase in its price level.
D) leaves its price level con stant in long-run equilibrium.
E) causes an inversely proportional fall in its price level.
Ans wer: C
Page Ref: 394-397
Difficulty: Easy

3) A change in the level of the supply of money

A) increa ses the long-run values of the interest rate and real output.
B) decreases the long-run values of the interest rate and real output.
C) ha s no effect on the long-run values of the interest rate, but may affect real output.
D) has no effect on the long-run values of real output, but may a ffect the interest rate.
E) has no effect on the long -run values of the interest rate and real output.
Ans wer: E
Page Ref: 394-397
Difficulty: Easy

4) Changes in the money supply growth rate

A) are neutral in the short run.
B) need not be neutral in the short run.
C) are neutral in the long run.
D) need not be neutral in the long run.
E) affect the real output of the economy.
Ans wer: D
Page Ref: 394-397
Difficulty: Easy

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5) A s ustained change in the monetary growth rate will

A) immediately affect equilibrium real money balances by raising the money interest rate.
B) eventually affect equilibrium nominal money balances by rais ing the money interest rate.
C) eventually affect equilibrium real money balances by reducing the money interest rate.
D) eventually affect equilibrium real money balances by rais ing the real interest rate.
E) eventually affect equilibrium real money balances by raising the money interest rate.
Ans wer: E
Page Ref: 394-397
Difficulty: Easy

6) Money demand behavior may

A) change as a result of demographic trends or financial innovations such as electr onic cash-
transfer facilities.
B) change only as a re sult of demographic trends.
C) change only as a re sult of financial innovations such as electr onic cash-transfer facilities.
D) not change as a result of demographic trends or financial innovations such as electronic cash-
transfer facilities.
E) change as a res ult of demographic trends but not as a result of financial innovations such as
electronic cash-transfer facilities.
Ans wer: A
Page Ref: 394-397
Difficulty: Easy

7) Us ing year-by-year data from 1987-2007 s hows that

A) there is a strong positive relation between average Latin American money-supply growth and
inflation.
B) the re is a strong negative relation between average Latin A merican money-supply growth and
inflation.
C) the re is a strong positive relation between average Latin A merican money-s upply growth and
deflation.
D) it is difficult to find a strong positive relation between average Latin American money-supply
growth and inflation.
E) there is a weak positive relation between average Latin Amer ican money-supply grow th and
inflation.
Ans wer: A
Page Ref: 394-397
Difficulty: Easy

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8) Which one of the follo wing statements i s the M OST accurate?

A) A permanent increa se in a country's money supply causes a proportional long-run
depreciation of it s currency against foreign currencies.
B) A temporary increas e in a country's money supply causes a proportional long-run depreciation
of its currency against foreign currencies.
C) A permanent increase in a country's money s upply caus es a proportional long-run
appreciation of it s currency against foreign currencies.
D) A permanent increa se in a country's money supply causes a proportional short-run
depreciation of it s currency against foreign currencies.
E) A permanent inc rease in a country's money s upply causes a proportional short-run
appreciation of it s currency against foreign currencies.
Ans wer: A
Page Ref: 394-397
Difficulty: Easy

9) The long run effects of money supply change

A) ambiguous effect on the long-run values of the interest rate or real output, a proportional
change in the price level's long-run value in the opposite direction.
B) proportional effect on the long-run values of the interest rate or real output, a proportional
change in the price level's long-run value in the same direction.
C) no effect on the long-run values of the interest rate or real output, a proportional change in the
price level's long-run value in the same direction.
D) no effect on the long-run values of the intere st rate or real output, no change in the price
level's long-run value.
E) ambiguous effect on the long-run values of the interest rate or real output, A disproportional
change in the price level's long-run value in the same direction.
Ans wer: C
Page Ref: 394-397
Difficulty: Easy

15.7 Inflation and Exchange Rate Dynamics

1) What term means an explosive and seemingly uncontrollable inflation in which money loses
value rapidly and may even go out of use?
A) superinflation
B) s tagflation
C) hyperinflation
D) maginflation
E) def lation
Ans wer: C
Page Ref: 398-405
Difficulty: Easy

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2) The most extreme inflationa ry conditions occurred

A) in Zimbabwe in 2008.
B) in Chile in 2012.
C) in Eas tern Europe in the 1990s.
D) in Western Europe in the 1980s.
E) in Germany in 20013.
Ans wer: A
Page Ref: 398-405
Difficulty: Easy

3) F or main industrial countries s uch as Japan and the U .S.

A) there is much less month-to -month variability of the exchange rate, suggesting that price
levels are relatively sticky in the short run.
B) the re is much more month-to-month variability of the exchange rate, suggesting that price
levels are relatively sticky in the short run.
C) the re is almost the same month-to-month variability of the exchange rate and price levels.
D) it is hard to tell whether month-to-month variability of the exchange rate is s imilar to changes
in price levels.
E) there is much more month-to-month variability of the exchange rate, suggesting that p rice
levels are relatively sticky in the long run.
Ans wer: B
Page Ref: 398-405
Difficulty: Easy

4) Which one of the follo wing statements i s the M OST accurate?

A) There is a lively academic debate over the possibility that s eemingly s ticky wages and prices
are in reality quite fixed.
B) There is a lively academic debate over the poss ibility that seemingly sticky wages and prices
are in reality much more sticky than theory assumes .
C) There is a lively academic debate over the poss ibility that seemingly sticky wages and prices
are in reality quite flexible.
D) There is no debate over the possibility that wages and prices are sticky in the long run.
E) There is no debate over the possibility that wages and prices a re sticky in the short run.
Ans wer: C
Page Ref: 398-405
Difficulty: Easy

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5) During hyperinflation, exploding inflation causes real money demand to

A) fall over time, and this additional monetary change makes money prices rise even more
quickly than the money s upply itself ris es.
B) inc rease over time, and this additional monetary change make s money prices rise even more
quickly than the money s upply itself ris es.
C) fall over time, and this additional monetary change makes money prices decreas e even more
quickly than the money s upply itself ris es.
D) increa se over time, and this additional monetary change makes money prices decrease even
more quickly than the money supply itself rises.
E) fall over time, and this additional monetar y change makes money prices decrease even less
quickly than the money s upply itself ris es.
Ans wer: A
Page Ref: 398-405
Difficulty: Easy

6) In a classic paper, Columbia University economist Phillip Cagan drew the line between
inflation and hyperinflation at an inflation rate of
A) 50 percent per month.
B) 10 percent per month.
C) 20 percent per month.
D) 5 percent per month.
E) 25 percent per month.
Ans wer: A
Page Ref: 398-405
Difficulty: Easy

7) In a classic paper, Columbia University economist Phillip Cagan drew the line between
inflation and hyperinflation at an inflation rate of
A) more than 120 percent per year.
B) more than 100 percent per year.
C) more than 200 percent per year.
D) more than 12,000 percent per year.
E) more than 1,000 percent per year.
Ans wer: D
Page Ref: 400
Difficulty: Easy

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8) In a world where the price level could adjust immediately to its new long-run level after a
money supply increas e
A) The dollar interest rate w ould increase because prices would adjust immediately and prevent
the money s upply from rising.
B) The dollar interest rate would fall becau se prices would adjust immediately and p revent the
money supply from rising.
C) The dollar interest rate would fall becau se prices would adjust immediately and prevent the
money supply from decreas ing.
D) The dollar interest rate w ould decrease because prices would adjust immediately and prevent
the money s upply from decreasing.
E) The dollar interest rate would fall because prices would not be able to prevent the money
supply from ris ing.
Ans wer: B
Page Ref: 398-405
Difficulty: Easy

9) After a permanent increase in the money s upply

A) the exchange rate overshoots in the short run.
B) the exchange rate overshoots in the long run.
C) the exchange rate smoothly depreciates in the short run.
D) the exchange rate s moothly appreciates in the s hort run.
E) the exchange rate remains the same.
Ans wer: A
Page Ref: 398-405
Difficulty: Easy

10) A change in the money supply creates demand and cos t pressures that lead to f uture increas es
in the price level from which main sources?
I. Excess demand for output and labor
II. Inflationary expectation s
III. Raw materials prices
A) I
B) II
C) II and III
D) I and II
E) I, II, and III
Ans wer: E
Page Ref: 398-405
Difficulty: Easy

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11) In Zimbabwe, the government stopped the country's hyperinflation by

A) reducing domestic monetary growth drastically.
B) returning to a gold/silver currency standard.
C) s witching to foreign currencies. that are relatively stable.
D) passing a law making p rice increases illegal.
E) implementing a new currency based on diamonds.
Ans wer: C
Page Ref: 400-401
Difficulty: Easy

12) Which of the following can help to explain why higher inflation may lead to currency
appreciations?
A) The interes t rate is not the prime target of monetary policy.
B) Most central banks adjust their policy inte rest rates expressly so a s to keep inflation in check.
C) Central banks increa se the money supply leading to overshooting of the exchange rate.
D) Inf lation will inc rease the purchasing pow er of a currency.
E) The world market does not adjust their currency trade to reflect inflation.
Ans wer: B
Page Ref: 398-405
Difficulty: Easy

13) Which one of the countries below announces inflation target s?

A) Japan
B) U. S.
C) Canada
D) M exico
E) Nicaragua
Ans wer: C
Page Ref: 398-405
Difficulty: Easy

14) M ichael Woodford says the follo wing is an advantage of interest -rate instruments for central
banks .
A) Conduct monetary policy without inflation.
B) Conduct monetary policy even if checking depos its pay interest at competitive rates.
C) Conduct monetary policy w ithout government approval.
D) Conduct monetary policy with cons umers in mind.
E) Conduct monetary policy with workers in mind.
Ans wer: B
Page Ref: 405
Difficulty: Easy

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15) Inflation targeting was initiated by which central bank in 1989?

A) U.S.
B) J apan
C) Canada
D) Ne w Zealand
E) U. K.
Ans wer: D
Page Ref: 398-405
Difficulty: Easy

16) "A lthough the price levels appear to display short-run stickine ss in many countries, a change
in the money supply creates immediate demand and cost p ressur es that eventually lead to future
increa se in the price level." Discuss.
Ans wer: (See Section 7). The statement is true. The pressures come from three main sources:
excess demand for output and labor; in flationary expectations; and, raw material prices.
Page Ref: 398-405
Difficulty: Moderate

17) Explain the effects of a permanent increase in the U.S . money supply in the short run and in
the long run. Ass ume that the U.S. real national income is constant.
Ans wer: An increase in the nominal money supply raises the real money supply, lowering the
interest rate in the short run. The money supply increase i s considered to continue in the future;
thus, it will affect the exchange rate expectations. This will make the expected return on the euro
more desirable and thus the dollar depreciates. In the case of a permanent inc rease in the U.S .
money supply, the dollar depreciates mo re than under a tempora ry increase in the money supply.
Now, in the long run, prices will rise until the real money balances are the same as be fore the
permanent increase in the money supply. Since the output level is given, the U.S. interest rate,
which decreased before, will start to increase, until it will move back to its original level. The
equilibrium interest rate must be the same as its original long run value. This increase in the
interest rate must caus e the dollar to appreciate against the euro afte r its s har p depreciation as a
res ult of the permanent inc rease in the money supply. So a large depreciation is follo wed by an
appreciation of the dollar. Eventually, the dollar depreciates in proportion to the increase in the
price level, which in turn increas es by the same proportion as the permanent increase in the
money supply. Thus, money is neutral, in the sense that it cannot affect in the long run real
variables, such as output, investment, etc.
Page Ref: 398-405
Difficulty: Difficult

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18) Explain the exchange rate over-shooting hypothesis.

Ans wer: Many prices in the economy are written into long-term contracts and cannot be
changed immediately when changes in the money supply occur. A permanent increase in M,
holding P constant, inc reases the real money supply (M /P) and lowe rs the nominal interest rate
(R). This shifts the dollar return schedule left. A permanent increase in M also creates the
expectation that in the long run all prices including the exchange rate would ri se. A ris e in the
expected exchange rate shifts the ERR( DM) schedule right. Therefore, in the short run
equilibrium is established at point 2 In the long run the price level adjusts and rise s
proportionately with the money s upply. Therefore, M/P and R return to their initial levels in the
long run and the equilibrium exchange rate is determined at point 3. In other w ords, the exchange
rate first overshoots and then returns to its long run level. The refore, the f luctuations in E are
much stronger than those of P.
Page Ref: 398-405
Difficulty: Difficult

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19) Using figures for both the short run and the long run, show the effects of a permanent
increa se in the U.S. money supply. Try to line up your figu res to the short and long run equilibria
side by side. Assume that the U.S. real national income is constant.
Ans wer:

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An increase in the nominal money supply raises the real money supply, lowering the inte rest rate
in the short run (the movement from 1 to 2 on the lower left figure). The money supply increase
is considered to continue in the future, and thus it will affect the exchange rate expectations. This
will make the expected retu rn on the euro more desirable and thus the dolla r depreciates. In the
case o f a permanent inc reas e in the U.S. money supply, the dollar depreciates more than under a
temporary increas e in the money supply (from point to point in the upper left figu re).
Now, in the long run, (the right hand side figure), prices will rise until the real money balances
are the same as before the permanent increa se in the money supply (from point 2 to point 4, in
the lower right figure). Since the output level is given, the U.S . interest rate which decreased
before, will start to increase, until it will move back to its original level (fr om Point 2 to 4 in the
low er left figure). The equilib rium interest rate must be the s ame as its original long run value (at
point 4 in the lower right figure). This inc rease in the interest rate must cause the dollar to
appreciate against the euro after its sharp depreciation as a result o f the permanent increase in the
money supply (this process is depicted in the upper right figure from point to ) . So a large
depreciation (from Point in the left upper figure to pint in both the left and right upper
figures) is followed by an appreciation o f the dollar (the movement from to point in the
upper right hand side figure ). Eventually, the dollar depreciates in p roportion to the increas e in
the price level, which in turn increases by the same proportion as the permanent increase in the
money supply. Thus, money is neutral, in the sense that it cannot affect in the long run real
variables, such as output, investment, etc. Note that points and represent the same exchange
rate.
Page Ref: 398-405
Difficulty: Moderate

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20) Using 4 different figure s, plot the time paths showing the effects of a permanent increase in
the U nited States money supply on:
(a) U.S. Money supply
(b) The dollar interest rate.
(c) The U.S. price level
(d) The dollar/eu ro exchange rate
Ans wer: See below .

Page Ref: 398-405

Difficulty: Difficult

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