AP_Krugman_Textbook

module 43 Exchange Rate Policy 435

Section 8 The Open Economy: International Trade and Finance

Module 43 AP Review

Check Your Understanding

1. Draw a diagram, similar to Figure 43.1, representing the foreign
   exchange situation of China when it kept the exchange rate
   fixed at a target rate of $0.121 per yuan and the market
   equilibrium rate was higher than the target rate. Then show
   with a diagram how each of the following policy changes might
   eliminate the disequilibrium in the market.

a. allowing the exchange rate to float more freely

b. placing restrictions on foreigners who want to invest

in China

c. removing restrictions on Chinese who want to

invest abroad

d. imposing taxes on Chinese exports, such as clothing

Solutions appear at the back of the book.

Tackle the Test: Multiple-Choice Questions

1. Which of the following methods can be used to fix a country’s
   exchange rate at a predetermined level?
   I. using foreign exchange reserves to buy its own currency
   II. using monetary policy to change interest rates
   III. implementing foreign exchange controls
   a. I only
   b. II only
   c. III only
   d. I and II only
   e. I, II, and III


2. Changes in exchange rates affect which of the following?
   a. the price of imports
   b. the price of exports
   c. aggregate demand
   d. aggregate output
   e. all of the above


3. The United States has which of the following exchange
   rate regimes?
   a. fixed
   b. floating
   c. fixed, but adjusted frequently

d. fixed, but managed

e. floating within a target zone

4. Which of the following interventions would be required to
   keep a country’s exchange rate fixed if the equilibrium
   exchange rate in the foreign exchange market were below
   the fixed exchange rate (measured as units of foreign
   currency per unit of domestic currency)? The government/
   central bank
   a. buys the domestic currency.
   b. sells the domestic currency.
   c. buys the foreign currency.
   d. lowers domestic interest rates.
   e. removes foreign exchange controls.


5. Which of the following is a benefit of a fixed exchange
   rate regime?
   a. certainty about the value of domestic currency
   b. commitment to inflationary policies
   c. no need for foreign exchange reserves
   d. allows unrestricted use of monetary policy
   e. all of the above

Tackle the Test: Free-Response Questions

1. Suppose the United States and India were the only two
   countries in the world.
   a. Draw a correctly labeled graph of the foreign exchange
   market for U.S. dollars showing the equilibrium in
   the market.
   b. On your graph, indicate a fixed exchange rate set above the
   equilibrium exchange rate. Does the fixed exchange rate lead
   to a surplus or shortage of U.S. dollars? Explain and show
   the amount of the surplus/shortage on your graph.

c. To bring the foreign exchange market back to an

equilibrium at the fixed exchange rate, would the U.S.

government need to buy or sell dollars? On your graph,

illustrate how the government’s buying or selling of dollars

would bring the equilibrium exchange rate back to the

desired fixed rate.