EXTRA END OF CHAPTER QUESTIONS
McConnell 10E Macroeconomics
Chapter One
1.
Is rational self-interest the same thing as selfishness? Explain.
No, they are not the same. Selfishness means that a person is only concerned
with himself or herself to the exclusion of others. Rational self-interest
simply means that people strive to achieve personal satisfaction. This
personal satisfaction can be achieved in many ways, from both selfish and
unselfish acts. For example, a person may be unselfish and volunteer time to
help other people or make donations to charities because the person derives
personal satisfaction from doing so. In this case the person is not being
selfish, but is acting to maximize the person’s well-being by helping others.
2.
Why are economic theories and principles imprecise? Shouldn’t they apply
to everyone?
The main reason is that they are generalizations relating to economic
behaviour or the economy. The economic facts used to develop the theories
and principles differ from person to person or economic institution to
institution. They reflect tendencies or averages across large groups that may
not apply to a particular individual. For example, if the price of a product
drops significantly, the quantity demanded among consumers as a group is
expected to increase, but some consumers may not increase their purchases.
3.
Explain the economic fallacy in the statement: “If the Jones family would
just cut up their credit cards and live within their means, they’d be better off.
And if consumers in this nation cut up their credit cards and lived within their
means, the nation would be better off.”
This is an example of the fallacy of composition. Cutting up credit cards may
be good for the Jones family depending on their circumstances. If they have
taken on too much debt and are in financial trouble, then cutting up credit
cards would reduce their impulses to spend money. But if all consumers cut
up their credit cards this action would reduce consumer spending in the
economy because there would be fewer transactions and it would make the
economy less efficient. Economic growth would decline because of the
reduced consumer spending.
Chapter Two
1
“The two cornerstones of economics are the scarcity of resources and the
multiplicity of wants. True economy consists of deriving maximum want
satisfaction from available resources.” Explain.
The first statement refers to the basic economic problem: that society’s wants
are unlimited relative to the limited supply of productive resources. The
second part of the statement refers to the concept of efficiency, both
allocative and productive. Since resources are scarce, it is desirable to
achieve the most output from those available. Otherwise we waste resources
and will not satisfy as many wants as we could from the resources that we
have available, which would mean not achieving productive efficiency.
Allocative efficiency means the maximum satisfaction of wants with these
resources.
2
How are tradeoffs illustrated by the production possibilities curve? Consider
the case of federal government spending on national defence and spending on
social programs.
In the production possibilities model, an increase in government spending on
national defence will come at the expense of government spending on social
programs. If the nation wants to be more secure then it will have to give up
the opportunities to use its scarce budget resources for social programs.
Conversely, if there is more spending on social programs, there will have to
be cuts to national defence, assuming that there is a fixed budget constraint.
Moving in either direction on the production possibilities curve will involve
trading off one desirable public good for another.
3.
Explain the relationship between the increase in women in the labour force
over the last forty years in Canada and the production possibilities for the
economy.
The increase in women in the labour force represents a shift outward in the
production possibilities curve. The reason for the shift is that there are now
greater labour resources available for production than there were in past
decades.
Chapter Three
1.
What effect should each of the following have on the demand for gasoline in
a competitive market? State what happens to demand. Explain your
reasoning in each case and relate it to a demand determinant.
(a)
(b)
(c)
an increase in the number of cars
the economy moves into a recession
an increase in the price of car insurance, taxes, maintenance
(d)
consumer expectations of substantial price increases in gasoline
(a)
Demand would increase because there would be more buyers of
gasoline. The additional buyers would come from the additional cars and
trucks.
(b) Demand would decrease because consumer and business incomes
would fall. Consumer and businesses would have less money to spend on
gasoline.
(c)Demand would decrease because of increase in the price of
complementary goods. Car insurance, car taxes, and car maintenance
expenses are complements to gasoline.
(d) Current demand for gasoline would increase because expectations
about the future have changed and may prompt consumers to “buy now” to
beat the future price increases.
2.
What effect will each of the following most likely have on the supply of corn
in a competitive market? State what happens to supply. Explain your
reasoning in each case and relate it to a supply determinant.
(a) the development of an improved corn seed that resists drought conditions
(b) an increase in the price of soybeans which can also be planted on land
used for growing corn
(c) an increase in government payments for growing corn
(d) an increase in the price of fertilizer
(a)The supply of corn will increase because of an improvement in the
technology of corn production. More bushels of corn will be produced at
each and every price.
(b) The supply of corn will decrease because of a change in the price of
another good that can be produced. Some farmers will no longer use their
land to grow corn, but instead will grow soybeans.
(c) The supply of corn will increase because of a government subsidy. The
government payment reduces the costs of corn production at each and every
price.
(d) The supply curve for corn will decrease because of a change in the price
of a resource. Fertilizer is used to grow corn and it is now more costly to
grow corn at each and every price.
3.
(Consider This) Is demand more important than supply in determining
equilibrium price and quantity in a competitive market? Explain.
Demand and supply are equally important. It is the intersection of the
demand and supply curve that determines equilibrium price and quantity.
Without demand or without supply there would be no intersection and no
price determination. Alfred Marshall likened supply and demand to a pair of
scissors. Each blade is needed for the scissors to operate properly and make a
cut.
Chapter Four
1.
Describe the three major virtues of a market system.
First, the market system promotes efficient use of scarce resources. Products
are produced in the least costly way and the products most desired by society
get produced. Second, the market system provides incentives for continual
improvement and innovation. Rewards are given to entrepreneurs, workers,
and consumers who attempt to make the best use of scarce resources. Third,
the market system gives great support to individual freedom for producers,
consumers, and workers. Each group is able to pursue their own self-interest
and thus promote the social interest.
2.
Why is there a free-rider problem with public goods?
Most private goods and services are subject to the exclusion principle which
is the idea that those who pay for the product are the ones who get it, but
those who don’t pay for it are excluded from the benefits provided by that
product.
The free-rider problem exists when it is not possible to exclude a person from
the benefit of a good even if the person did not pay for its costs. Such is the
case with a public good. Once a public good is provided, it is available to all
people regardless of whether or not they pay for its cost.
Chapter Five
1.
What is the value added by all the firms A–E from the production of a
product as described below? What did each firm add separately in value and
what does it total?
Stage of production
Firm A
Firm B
Firm C
Firm D
Firm E
Sales value of product
$4,500
8,600
14,700
20,100
32,300
The value added by all firms is $32,300, or the final sales value. Firm A:
added $4,500. Firm B: added $4,100. Firm C: added $6,100. Firm D:
added: $5,400. Firm E: added $12,200. The value added by all firms totals
$32,300 and equals the final sales value by Firm E ($32,300).
2.
Which of the following are included and which are excluded in calculating
this year’s GDP? Explain in each instance.
(a) A monthly scholarship cheque received by an economics student
(b) The purchase of a new truck by a trucking company
(c) Government purchase of computers from a private business
(d) The purchase of a used tractor by a farmer
(e) The value of the purchase of shares of Bombardier by an individual
(a)Scholarships are not included in GDP. They are viewed as financial
transactions and would be either a public or private transfer payment
depending on the source of funds. They are awards for past performance and
would not be included in current production. They don’t represent income
earned by providing a productive resource as defined in the GDP accounts.
(b) The truck is included because it represents investment. It is a final
good that was produced in the current year.
(c)The computer purchase is included as part of government spending on
goods and services.
(d) The used tractor is not included because it was counted when it was
new.
(e)The value of a stock purchase is not included because it is just a swap of
paper assets.
3.
(Consider This) Explain how a reservoir can serve as an analogy for thinking
about a nation’s capital stock, investment, and depreciation.
The amount of water in a reservoir is a “stock.” It is similar to the stock of
capital goods in an economy. The inflow of water to the reservoir is a “flow”
and would be similar to gross investment. The outflow of water from the
reservoir is also a “flow” and it is similar to depreciation. If the inflow is
greater than the outflow, then gross investment is greater than depreciation so
there is an addition to the capital stock, or net investment. If the inflow of
gross investment is less than depreciation, there is a decline in the capital
stock, or negative net investment.
Chapter Six
1.
In the table below are statistics showing the civilian non-institutional
population, the civilian labour force and total employment in year 1 and year
2. Make the computations necessary to complete the table. (Number of
persons is in thousands.)
Civilian non-institutional population
Civilian labour force
Employed
Unemployed
Unemployment rate
(to one decimal place)
Unemployed
Unemployment rate
Year 1
5,654
4.0%
Year 1
209,699
140,862
135,208
______
______
Year 5
6742
4.8%
Year 5
211,864
141,815
135,973
______
______
2.
Answer the next four questions based on the following data using year 1 as
the base year. All dollars are in billions. Calculate to one decimal place.
Year
1
2
3
4
CPI
160
165
170
177
(a)What was the percentage rise in prices between years 1 and 2?
(b) What was the percentage rise in prices between years 2 and 3?
(c)What was the percentage rise in prices between years 3 and 4?
(a) 3.1% (165 minus 160 divided by 160 equals .031. 0.031 x 100 = 3.1%
(b) 3.0% (170 minus 165) divided by 165 equals 0.030. 0.030 x 100 = 3.0%
(c) 3.0% (177 minus 170) divided by 170 equals 0.041. 0.041 x 100 = 4.1%
3.
(Consider This) How was the practice of clipping coins during feudalism
contributing to inflation? Who benefited from this inflation?
As peasants paid their taxes in gold coin, the prince would clip off some of
the coin and use the clipping to mint new coins. The additional coins
increase the money supply, but the output in the economy was essentially
constant. The price level rose because there was “too much money chasing
too few goods.” In this case, the inflation benefited the issuers of the coin
(the feudal lords) and hurt the peasants.
Chapter Seven
1.
Define the multiplier. How is it related to real GDP and the initial change in
spending? How can the multiplier have a negative effect?
The multiplier is simply the ratio of the change in real GDP to the initial
change in spending. Multiplying the initial change in spending by the
multiplier gives you the amount of change in real GDP. The multiplier effect
can work in a positive or a negative direction. An initial increase in spending
will result in a larger increase in real GDP, and an initial decrease in spending
will result in a larger decrease in real GDP.
2.
What is the relationship between the multiplier and the marginal
propensities?
The multiplier is directly related to the marginal propensities. By definition,
the multiplier is related to the marginal propensity to save because it equals
1/MPS. Thus, the multiplier and the MPS are inversely related. The
multiplier is also related to the marginal propensity to consume because it
also equals 1/ (1–MPC).
3.
Explain why saving equals planned investment at equilibrium GDP.
It is based on the fact that saving is income not consumed. Saving therefore
represents a “leakage” or diversion of potential spending from the incomeexpenditures stream. Consumption falls short of total output by the amount
of saving. However, investment spending can be viewed as an “injection”
into this income-expenditures stream. If planned investment is equal to the
amount of saving at a particular level of GDP, then leakages equal injections
and GDP will be in equilibrium.
4.
(Last Word) Explain Say’s law.
Say’s law, attributed to the 19th-century French economist, is that “supply
creates its own demand.” Essentially, this theory states that people engage in
production in order to be able to buy or demand other things. Whatever one
earns from production, one expects to spend on goods and services of
equivalent value. Thus, supply (production) has created its own demand.
Chapter Eight
1.
Define aggregate supply. Describe the characteristics of the aggregate supply
curve from long-run and short-run perspectives.
The aggregate supply is a curve that shows the total quantity of goods and
services that will be produced (supplied) at different price levels. In the long
run, the aggregate supply curve is vertical at the full-employment level of
output for the economy because the rise in wages and other inputs will match
changes in the price level. In the short run, the aggregate supply curve is
upsloping because nominal wages and input prices adjust only slowly to
changes in the price level. With this curve, an increase in the price level
increases real output and a decrease in the price level reduces real output.
2.
Use this aggregate demand–aggregate supply schedule for a hypothetical
economy to answer the following questions.
Real domestic
output demanded
(in billions) Price level
$3000
$4000
$5000
$6000
$7000
$8000
350
300
250
200
150
100
Real domestic
output supplied
(in billions)
$9000
$8000
$7000
$6000
$5000
$4000
(a)What will be the equilibrium price level and quantity of real domestic
output?
(b) If the quantity of real domestic output demanded increased by $2000 at
each price level, what will be the new equilibrium price level and quantity of
real domestic output?
(c)Using the original data from the table, if the quantity of real domestic
output demanded increased by $5000 and the quantity of real domestic
output supplied increased by $1000 at each price level, what would the new
equilibrium price level and quantity of real domestic output be?
(a) 200 and $6000
(b) 250 and $7000
(c)300 and $9000
Chapter Nine
1.
Comment on the statement: “Increasing government spending is preferred to
a cut in taxes when the Canadian government seeks to fight a recession.”
The statement is a normative one. Either action, increased government
spending or taxation, can be use to fight a recession. The policy choice will
depend on the preferences of the individual. Those individuals who want to
fight a recession with an increase in government spending may want to
preserve the size of government in the economy and have specific
government programs they would like to see funded. Those individuals who
prefer a tax cut may want to reduce the size of government and give people
more money and the freedom to spend it as they chose.
2.
Explain the problems giving rise to this statement: “You would think the
government would want to do something to improve economic conditions
when the economy is in trouble, but the government is slow to act.”
Fiscal policy is subject to timing problems. There are three timing lags that
limit the speed with which fiscal policy can be enacted and effective. First,
there is a lag in recognizing the phase of the business cycle to determine
when the government might want to provide help. Second, there is an
administrative lag in decision-making that involves deciding which specific
policies should be adopted. Third, there is an operational lag because the
adoption of policies takes time to have an effect on output and employment.
3.
How do expectations about the future by households and businesses affect the
effectiveness of fiscal policy? Cite examples.
If households or businesses expect that the fiscal policy changes are only
temporary, they may not change their behaviour in the expected way. For
example, if tax cuts are enacted to stimulate consumer spending, some
consumers may not change their spending habits if they think the tax change
is only temporary. In the future, they will have to pay more in taxes, so they
might increase their saving. Similarly, businesses may not invest in new
plants and equipment if they get a tax cut, if they expect taxes in the future to
rise or the fiscal policy to be ineffective.
Chapter 10
1.
The following table shows government spending and tax revenue for a
hypothetical economy over a five-year period. All figures are in billions.
Year Government Spending Tax Revenues
1
$ 1100
$1050
2
1150
1100
3
1250
1150
4
1250
1300
5
1300
1250
(a)In what years were there budget deficits and what were the amounts?
(b) In what year was there a budget surplus and what was the amount?
(c)What is the public debt in this economy over the five years?
(d) If the size of the economy (GDP) was $6,000 billion what would the
public debt in year 5 as a percentage of GDP.
(a)There were budget deficits in year 1 (–$50 billion), year 2 (-$50 billion),
year 3 (-$100) and year 5 (-$50) billion.
(b) There was budget surplus in year 4 ($50 billion).
(c)The public debt was $200 billion. (-$50 -$50 billion -$100 billion +$50
billion –$50 billion)
(d) 3.3% ($200 billion/ $6000 billion x 100 = 3.3%)
2.
What information would be important for assessing the size of the public debt
beside the absolute amount of the public debt?
When the public debt is stated as an absolute amount, the numbers can often
be staggering and misleading. The absolute amount, however, needs to be
viewed in relation to the size of the economy (its GDP). If GDP is large
relative to the public debt, then the nation has the capacity to service that
debt. Also, as the economy grows, the debt as a percentage of GDP will tend
to fall unless the economy continues to add substantially to the public debt
each year with large budget deficits.
Chapter Eleven
1.
(Consider This) Are credit cards money? Explain.
Credit cards represent the ability to get an instant loan that can be exchanged
for goods or services. At some point, however, that loan must be paid with
money (checks or currency). So credit card transactions are short-term loans
that must be repaid with money.
2.
Explain what policies are used to stabilize the value of money.
Monetary policy is used to regulate the money supply in the economy. If too
much money is available for the given level of production of goods and
services, this situation can lead to inflation and reduce the value of money.
Fiscal policy can also be used to help maintain the value of money. The
Canadian government needs to be prudent in its spending and taxing actions
(fiscal policy) so that it does not reduce the value of money by running large
deficits when the economy is at full-employment.
3.
Suppose that a bond having no expiration date has a face value of $5,000 and
pays a fixed amount of interest of $500 annually. Compute and enter in the
spaces provided the effective interest rate (to one decimal place) that a bond
buyer could receive at the new bond price.
Bond price
$ 3,750
4,250
5,750
6,500
Interest rate (%)
____
____
____
____
Bond price
$ 3,750
4,250
5,750
6,500
Interest rate (%)
13.3
11.8
8.7
7.7
Chapter Twelve
1.
Using the balance sheet below and assuming a desired reserve ratio of 33%,
answer the following: (a) What is the amount of excess reserves? (b) This
bank can safely expand its loans by what amount? (c) By expanding its loans
by this amount in part (b), its demand deposits would expand to what amount
(if all loans were made to cheque account customers)? (d) If cheques clear
against the bank equal to the amount loaned in (b), how much would remain
in reserves and in checkable deposits?
Assets
Reserves $ 60,000
Loans
60,000
Securities 40,000
Property 290,000
Liabilities
Demand Deposits$150,000
Capital Stock
300,000
(a) $10,000 because desired reserves are $50,000 (1/3 of $150,000) while
actual reserves are $60,000.
(b) $10,000 (= $60,000 – 50,000).
(c) $160,000 (= $150,000 + 10,000).
(d) $50,000 in reserves, $150,000 in demand deposits.
2.
Using the balance sheet below and assuming a desired reserve ratio of 20%,
answer the following: (a) What is the amount of excess reserves? (b) This
bank can safely expand its loans by what amount? (c) By expanding its loans
by this amount in part (b), its demand deposits would expand to what amount
(if all loans were made to chequing account customers)? (d) If cheques clear
against the bank equal to the amount loaned in (b), how much would remain
in reserves and in checkable deposits?
Assets
Reserves $ 40,000
Loans
70,000
Securities 50,000
Property 400,000
Liabilities
Demand Deposits$100,000
Capital Stock
460,000
(a)$20,000 because desired reserves are $20000 (20% of $100,000) while
actual reserves are $40,000.
(b) $20,000 (= $40,000 – 20,000).
(c) $120,000 (= $100,000 + 20,000).
(d) $20,000 in reserves, $100,000 in chequable deposits.
Chapter Thirteen
1.
One of the advantages of monetary policy is its speed and flexibility, but
there are limitations. Explain.
Monetary policy is not subject to an administration lag because once the
decision is made action can be taken quickly. The major timing problems are
recognition lags that occur because it sometimes take time to recognize or
understand that there is a problem that needs to be addressed by a change in
monetary policy. Also, there is an operational lag that occurs between the
time that the problem is recognized and the monetary policy takes effect. It
may take 3 to 6 months for interest rate changes to have the anticipated effect
on the economy.
2.
Explain the debate over whether monetary policy should be conducted by
“artful management” or inflation targeting.
The term “artful management” refers to a discretionary approach to monetary
policy to allow policymakers the discretion to set the course of monetary
policy based on what they think works best. This discretion permits The
Bank of Canada officials to change policy to address price stability, economic
growth, unemployment, or other major economic variables. By contrast,
inflation targeting would be a more restrictive approach to monetary policy
that would set numerical targets for the acceptable range for inflation and
then adjust policy to achieve those targets. It is argued that this approach
would increase the transparency of monetary policy because one objective
would be the focus and it would make Bank of Canada officials more
accountable. In this view, achieving the inflation target would be the best
way for the Bank of Canada to also achieve full employment and healthy
economic growth. Critics of this approach argue that it gives too limited or
restrictive of a role to the Bank of Canada and it has not been well-tested as
an approach to monetary policy.
Chapter Fourteen
1.
Contrast “supply-side” economics with “demand-side” fiscal policy.
“Supply-side” economics advocates the use of government tax or spending
policies to alter the supply schedule, that is, the production side of the
economy. Tax reductions may have an expansionary effect on aggregate
supply as well as aggregate demand. Some economists argue that as taxes are
cut, savings and investment will increase. Also tax cuts could be aimed
specifically at encouraging business investment such as investment tax
credits. “Supply-side” economists also argue that tax increases can reduce
tax revenues rather than increasing them due to a leftward shift in the
aggregate supply curve which causes a decrease in domestic output.
2.
What is supply-side economics? What is the rationale for it? Is it effective?
Some economists argue that a reduction in taxes will expand aggregate
supply. From this perspective, fiscal policy can be used to increase real GDP
with little or no rise in the price level, as would be the case if tax cuts
expanded aggregate demand.
There are three possible reasons for the supply-side effect of tax cuts. First,
lower taxes increase disposable income that may increase household saving.
They may also stimulate businesses’ investments because they increase the
after-tax profitability of businesses. Second, lower taxes also give people
more incentive to work because they keep more of their income. Third,
lower taxes will encourage more risk-taking and entrepreneurship in society
because the after-tax reward has been increased.
Many economists are sceptical about the supply-side effect of tax cuts. The
positive effects on incentives to save, invest, or work may not be very large,
and therefore the stimulus to the supply-side may be minor. In other words,
the demand-side effects of tax cuts appear to be far greater, and more
immediate than any of the supply-side effects.
Chapter Fifteen
1.
(Consider This) Why do small differences in the rate of economic growth
produce large differences in the size of the economy over time? Illustrate with
an example.
Small changes in the rate of growth can be very important. Over a period of
time small changes are cumulative in the same way that compound interest
payments are cumulative in a bank account. Using the rule of 70 to estimate
the time it takes to double GDP, we can see that Nation A, whose growth rate
is 3 percent takes 23 years to double its GDP, but Nation B whose growth rate
is only 2% may take nearly 35 years to double its GDP.
2.
Discuss the meaning of the statement: “Human history teaches us that
economic growth springs from better recipes, not just more cooking.”
Economic growth arises largely from increases in labour productivity (“better
recipes”) rather than increases in the quantity of labour inputs (“more
cooking”). Among the most important factors increasing labour productivity,
accounting for some 40 percent of this factor, is technological advance. It
includes not only new innovations in production but also better managerial
techniques that improve the process of production.
3.
How does investment in capital goods and infrastructure contribute to
economic growth?
Capital goods (plant, equipment, tools) are needed by workers to be more
productive. New investment in capital goods helps workers produce more
goods and services per work hour, thus increasing labour productivity.
Labour productivity is a key factor of economic growth. Infrastructure is also
important because there is a need for public capital goods (highways,
harbours, bridges, educational facilities) that help businesses and their
workers get the job done sooner. For example, if the highway infrastructure
is poor, it will be more difficult for businesses to get their products to market
and it will require more work time on the part of their workers, thus reducing
labour productivity.
Chapter Sixteen
1.
Suppose that by devoting all of its resources to the production of rice (R),
Japan can produce 40 units. By devoting all of its resources to corn (C), it
can produce 20 units. Comparable figures for Mexico are 15 units of rice (R)
and 15 units of corn (C). Explain why each nation will specialize in which
product. What are the limits to the terms of trade?
In Japan, the cost of producing 1 C is 2 R (20 C = 40 R) given the stated cost
conditions. In Mexico, the cost of producing 1 C is only 1 R. Thus, in terms
of opportunity costs or the amount of R that must be given up to get each C,
Mexico can produce units of C more cheaply. Therefore, Mexico should
produce Cs and Japan should produce units of R, and Mexico should trade
away some of its C to Japan for some of the units of R produced in Japan.
The limits to the terms of trade are set by the cost ratio in each country. In
other words, it is to Japan’s advantage to trade away units of R for as many
units of C as it can get above the lower limit of 0.5 C, which is what each R
costs in Japan. However, Mexico will not be willing to trade more than one
C for each R since any more than that could be gotten more cheaply by
producing them at home. Therefore the limits to the terms of trade will be
between 0.5 C and 1 C for each R. And Mexico will be able to get between 1
R and 2 R for each C.
2.
(Consider This) Why is a trade war like shooting yourself in the foot?
A trade war between Nation X and Nation Y is destructive to the economies
of both nations. If Nation X boycotts or slaps protective tariffs on the
imports from Nation Y, then Nation Y will not be able to export as many
goods and services. The economy of Nation Y will suffer and there will be
less income. As a consequence, Nation Y will not be able to import as many
goods and services from Nation X, so the economy of Nation X will suffer.
So trade wars hurt both nations by reducing imports and exports of each
nation. A trade war has no winners and only losers. It is like shooting
yourself in the foot.
3.
What five trade liberations is the World Trade Organization seeking to get
adopted?
After the 1994 Uruguay “round” of trade agreements, the World Trade
Organization was formed by 120 nations to oversee the agreements and get
them implemented by 2005. The major provisions of the agreements
included: (1) widespread reduction in tariffs worldwide; (2) new rules to
promote the growing trade in services; (3) plans to cut subsidies in
agriculture; (4) the inclusion of protection for intellectual property rights—
patents, trademarks, copyrights—in trade rules; and (5) phased reduction in
quotas on textiles and apparel.
Chapter Seventeen
1.
How are changes in one currency mirrored in changes in some other foreign
currency?
Currencies are linked because an appreciation in the value of one currency
means that there has been a depreciation in the value of another currency.
Conversely, if there is a depreciation in the value of one currency, then there
has been an appreciation in the value of another currency. So if one currency
rises in value, the other currency must fall in value and vice versa.
2.
Describe how changes in tastes affect the value of a nation’s currency.
If consumer preferences for the products of a foreign nation change, then the
demand for and supply of that country’s currency will change. If the demand
for British clothing increases, then the demand for British pounds will
increase causing the pound to appreciate. If the demand for British clothing
declines, then the demand for British pounds will decrease causing the pound
to depreciate. Conversely, if British preferences regarding some other
country’s products change, then the supply of British pounds will change
accordingly.
3.
Explain how changes in relative income affect the value of a nation’s
currency.
If a foreign nation’s income rises more rapidly than other nations’ incomes,
then its expenditures on imports are likely to grow along with expenditures
on everything else. This will probably cause the currency to depreciate as
other nations are not growing as rapidly, and therefore, their demand for the
nation’s currency is not keeping pace with the change in supply. The reverse
would be true if the nation’s income grew more slowly than other nations’
incomes.
4.
Do changes in relative price-levels affect the value of a nation’s currency?
If prices in one country rise relatively more than in another, the currency in
the higher-priced country is likely to depreciate as domestic consumers seek
less expensive foreign imports and increase the demand for foreign currency.
At the same time demand for domestic currency will fall since foreigners will
find it less attractive to buy the higher-priced country’s goods. This, too,
adds to the depreciation of the higher-priced country’s currency.
5.
Explain how changes in relative real interest rates affect the value of a
nation’s currency.
Higher relative real interest rates in one country will cause an increase in
demand for the currency of that country or an appreciation of that country’s
currency as foreign investors seek higher rates of return. The reverse would
be true of lower relative real interest rates.
6.
(Consider This) How can the Big Mac index be used to explain purchasing
power parity theory?
The index shows the prices of a Big Mac in currencies of other nations. If a
Big Mac costs $3.00 in the Canada and 300 yen in Japan, the exchange rate
based on Big Mac prices in the two nations should be $1 = 100 yen. If the
actual exchange rate was $1.00 equals 110 yen, then the dollar is overvalued
and the yen is undervalued. The dollar will depreciate and the yen will
appreciate.