Question 1

In the "gold standard" framework of the period 1880-1914, suppose that the par value exchange rate is $2.00/£1. If the market exchange rate rises to $2.12/£1 because of a rise in U.S. demand for British goods, and if it costs $0.05 to ship gold between the two countries, there would be __________. Then, if the "rules of the game" were being followed, the money supply in the United States would __________ after this movement of gold.

Accepted Answer

An increase in the market exchange rate to $2.12/£1 indicates that the dollar has depreciated relative to the pound, making British goods more expensive for Americans and American goods cheaper for the British. This situation would typically lead to an outflow of gold from the U.S. to Britain to pay for the increased demand for British goods. According to the "gold standard" rules, when gold flows out of a country, its money supply would decrease, as the gold reserves backing the currency are reduced.

Question 2

If, under the gold standard, the par value of the Swiss franc in terms of the dollar is $0)80, and if it costs $0.01 to move one franc's worth of gold between the countries, then The "gold export point" from the United States is at __________, and the "gold import
Point" into the United States is at __________.

Accepted Answer

The gold export point is determined by adding the cost of shipping gold ($0.01) to the par value of the Swiss franc ($0.80), which equals $0.81. The gold import point is determined by subtracting the cost of shipping gold ($0.01) from the par value of the Swiss franc ($0.80), which equals $0.79. Therefore, the answer is B.

Question 3

Is the Marshall-Lerner condition of any relevance for the successful operation of the gold standard adjustment mechanism? Explain.

Accepted Answer

The Marshall-Lerner condition is an economic theory that pertains to the responsiveness of trade balances to changes in exchange rates. According to this condition, a devaluation (or depreciation) of a country's currency will only improve its trade balance if the sum of the price elasticities of demand for exports and imports is greater than one. In other words, the quantities of exports and imports must respond sufficiently to the change in exchange rates to offset the changes in prices and lead to an improved trade balance.

The gold standard, on the other hand, was a monetary system in which the value of a country's currency was directly linked to a specified amount of gold. Countries that operated under the gold standard would fix their currencies to a set amount of gold and would adjust the flow of gold to maintain this fixed exchange rate. The adjustment mechanism of the gold standard worked through the balance of payments: if a country had a trade deficit, gold would flow out of the country, leading to a reduction in the money supply, deflation, and an eventual restoration of balance as goods became cheaper and more competitive internationally.

Now, to address the relevance of the Marshall-Lerner condition to the gold standard adjustment mechanism:

The Marshall-Lerner condition is not directly applicable to the gold standard because the gold standard operates on a fixed exchange rate system, where the value of the currency is pegged to gold, and not subject to frequent changes in response to trade imbalances. Under the gold standard, exchange rates do not fluctuate in the same way they do under a floating exchange rate system, where the Marshall-Lerner condition would be more relevant.

However, the underlying principle of the Marshall-Lerner condition—that the responsiveness of trade flows to price changes (in this case, due to deflation) is crucial for correcting trade imbalances—does have some relevance. Under the gold standard, when a country experienced a trade deficit, the outflow of gold would lead to a contraction in the money supply, which in turn would cause prices and wages to fall (deflation). This deflation would theoretically make the country's exports cheaper and imports more expensive, thus correcting the trade imbalance, similar to a currency devaluation in a floating exchange rate system.

For the gold standard adjustment mechanism to work successfully, it was necessary for the prices of goods and services to be flexible and for the economy to respond to these price changes. If the economy was not responsive—if the price elasticity of demand for exports and imports was low—the deflation caused by the gold outflow would not lead to a significant increase in exports or decrease in imports, and the trade imbalance would persist. This is analogous to the requirement in the Marshall-Lerner condition that the price elasticity of demand for exports and imports must be sufficiently high for a devaluation to improve the trade balance.

In conclusion, while the Marshall-Lerner condition is not directly applicable to the gold standard due to the fixed nature of exchange rates under that system, the principle that trade balances are influenced by the responsiveness of trade flows to price changes is relevant. For the gold standard adjustment mechanism to function effectively, economies needed to be flexible and responsive to the deflationary pressures that arose from gold outflows, similar to how economies must be responsive to exchange rate changes for the Marshall-Lerner condition to hold true in a floating exchange rate system.

Question 4

Given the following table showing various $/£ exchange rates and the respective
Quantities of pounds demanded by U.S. buyers:
$\begin{array} { c c } 
\$ / £ & \text { pounds demanded } \
\hline \$ 2.50 / £ 1 & £ 1,000 \
\$ 2.00 / £ 1 & £ 1,500 \
\$ 1.50 / £ 1 & £ 1,800
\end{array}$
The demand for pounds between $2.00/£1 and $1.50/£1 is

Accepted Answer

The demand for pounds is inelastic as the quantity demanded does not change much despite a significant change in the exchange rate.

Question 5

Under either a gold standard or a pegged-rate system, what changes in the money supply are necessary in order for effective adjustment to take place? Why are these changes necessary?

Accepted Answer

The answer of Under either a gold standard or a...

Question 6

In which of the following cases can we conclude, without any further information, that a depreciation of a country's currency will worsen the country's trade balance (or current account balance).

Accepted Answer

When the demand curve for exports is vertical and the demand curve for imports is also vertical, a depreciation of the country's currency will make its exports more expensive and its imports cheaper, thus reducing the quantity of exports demanded and increasing the quantity of imports demanded. This will result in a worsening of the country's trade balance (or current account balance). In the other choices, the effects of a depreciation on the trade balance depend on the slopes and positions of the curves.

Question 7

Using the information in the table in Question #10 above, the arc elasticity of demand for Pounds between the $2.50/£1 exchange rate and the $2.00/£1 exchange rate is (ignoring The negative sign) __________.

Accepted Answer

The answer of Using the information in the table in...

Question 8

If depreciation of a home currency occurs, foreign exporters to the home country could offset some of the impact of the depreciation by __________ the price/cost ratio on goods sent to the home country; such a change in the price/cost ratio would mean that there was _________ "pass-through" of the exchange rate change to foreign export prices.

Accepted Answer

If the foreign exporters decrease the price/cost ratio on goods sent to the home country, it means that they are absorbing some of the impact of the depreciation. However, this does not mean that there is complete pass-through of the exchange rate change to foreign export prices because the foreign exporters are reducing their profit margins in doing so. Therefore, the best choice is B, which states that the foreign exporters could offset some of the impact of the depreciation by decreasing the price/cost ratio on goods sent to the home country, and that there would be less-than-complete pass-through of the exchange rate change to foreign export prices.

Question 9

If, in a demand curve/supply curve graph with the quantity of U.S. imports plotted on the horizontal axis and the price of U.S. imports in dollars plotted on the vertical axis, suppose that, from an initial equilibrium position, there is now a depreciation of the U.S. dollar relative to other currencies. (Assume that the supply curve is horizontal.) Other things equal, this depreciation of the dollar would cause the __________.

Accepted Answer

The answer of If, in a demand curve/supply curve graph...

Question 10

The simple Marshall-Lerner condition would suggest that one of the following cases would produce a worsening of the trade balance if the country's currency depreciated. Which one? (The negative sign on elasticities is being ignored; also, assume that trade is initially balanced.)

Accepted Answer

The Marshall-Lerner condition states that the sum of the absolute values of the elasticities of demand for exports and imports must be greater than one for a depreciation to improve the trade balance. In case D, the sum of the absolute values of the elasticities is 0.8 + 0.1 = 0.9, which is less than one. Therefore, a depreciation would worsen the trade balance in this case.

Question 11

Suppose that there is an increase in the supply of foreign exchange due to an inflow of foreign investment in a flexible-rate system. Explain how this would affect the balance on current account, being careful to explain any assumptions about the foreign exchange market that are critical to your discussion.

Accepted Answer

The answer of Suppose that there is an increase in...

Question 12

"The J curve occurs because of differences of short-run elasticities from long-run elasticities." Explain the reasoning behind this statement.

Accepted Answer

The answer of "The J curve occurs because of differences...

Question 13

Assume a two-country world containing country A (whose currency is the dollar) and country B (whose currency is the peso). In this context, and using relevant graphs, explain how a depreciation of the dollar against the peso (for example, a 10% depreciation) conceptually affects the quantity of A's exports to B and the quantity of A's imports from B. (You can use either dollars or pesos on the vertical axes of your graphs. Also, assume that "pass-through" is complete.) Then carefully explain why economists say that such a depreciation could actually worsen the trade balance (or current account balance) of country A and indicate the Marshall-Lerner condition. Finally, define the "J curve" and give a very brief explanation of why it has the shape that it does.

Accepted Answer

The answer of Assume a two-country world containing country A...

Question 14

Briefly compare and contrast the price adjustment mechanism under fixed exchange rates to that under flexible exchange rates. Why is a price adjustment necessary under a fixed-rate system?

Accepted Answer

The answer of Briefly compare and contrast the price adjustment...

Question 15

If a home country depreciates or devalues its currency by 10 percent, and if there is "complete pass-through" as well as horizontal supply curves of exports and imports, then The price of the country's exports in terms of foreign currency will __________ and the Price of the country's imports in terms of home currency will __________.

Accepted Answer

If a country's currency is devalued by 10 percent, then the price of its exports in terms of foreign currency will fall by the same amount (10 percent) since they will now be relatively cheaper. On the other hand, the price of the country's imports in terms of home currency will rise by 10 percent because the imports will now be more expensive to purchase with the devalued currency. This is assuming there is "complete pass-through" (meaning that changes in exchange rates are fully passed on to prices) and horizontal supply curves of exports and imports (meaning that the quantities supplied and demanded are unresponsive to changes in prices).

Question 16

If, in a demand curve/supply curve graph with the quantity of U.S. exports plotted on the horizontal axis and the price of U.S. exports in dollars plotted on the vertical axis, suppose that, from an initial equilibrium position, there is now a depreciation of the U.S. dollar relative to other currencies. (Assume that the supply curve is horizontal.) Other things equal, this depreciation of the dollar would cause the __________.

Accepted Answer

A depreciation of the U.S. dollar relative to other currencies makes U.S. exports cheaper for foreign buyers. As a result, demand for U.S. exports is likely to increase, causing the demand curve to shift to the right (or vertically upward). Since the supply curve is horizontal, it remains in its original position. Therefore, the new equilibrium occurs at a higher quantity and a higher price than before the depreciation of the dollar.

Question 17

The shape of the curve that shows the effect of currency depreciation upon a country's current account balance over time, with the curve itself being known as the __________, reflects the fact that short-run demand elasticities are sufficiently __________ than long- Run elasticities to generate this particular shape. (Ignore the negative sign on the Elasticities.)

Accepted Answer

The J curve is characterized by a short-term increase in the current account deficit after a currency depreciation, followed by a long-term improvement in the current account due to increased exports and decreased imports. This shape is due to short-term demand being relatively inelastic, while long-term demand becomes more elastic as consumers and producers adjust to the new prices. Thus, the short-run demand elasticities are lower than the long-run elasticities, leading to a J-shaped curve.

Question 18

When considering the change in price of a country's imports when foreign currencies depreciate by 10 percent relative to the home country, the "elasticity of exchange rate pass-through" would be equal to

Accepted Answer

The "elasticity of exchange rate pass-through" refers to the extent to which the change in the exchange rate affects the prices of imports. If there is complete "pass-through," it means that a 10 percent depreciation in foreign currencies relative to the home country's currency would lead to a 10 percent change in the price of imports, indicating an elasticity of 1.0.

Question 19

Suppose that a 5% depreciation of the U.S. dollar raises the dollar price of a U.S. import Good by 5%. This situation would be characterized as a situation of __________ "pass- Through" (or "exchange-rate pass-through"), and U.S. consumers of the imported good Would spend a larger dollar amount on the imported good than they did before the Depreciation of the dollar if their demand for the good is __________.

Accepted Answer

A 5% depreciation of the U.S. dollar raising the dollar price of a U.S. import good by 5% indicates a complete pass-through, where the full effect of the exchange rate change is reflected in the import price. If demand is inelastic, consumers will continue to buy the product despite the price increase, leading to a larger dollar expenditure on the imported good.

Question 20

If country A depreciates its currency against country B's currency, then, other things Equal,

Accepted Answer

When country A depreciates its currency against country B's currency, A's goods become cheaper for both A's and B's residents, leading to "expenditure switching" towards A's goods by residents of both countries as they find A's goods more cost-effective compared to B's goods.

Quiz 23: Price Adjustments and Balance-Of-Payments Disequilibrium

If, under the gold standard, the par value of the Swiss franc in terms of the dollar is $0) 80, and if it costs $0.01 to move one franc's worth of gold between the countries, then The "gold export point" from the United States is at , and the "gold import Point" into the United States is at .