ANSWERS:

1. D

Ø The principle on comparative advantage states that it pays for someone (or some country) to specialize/trade even if that person is more productive than the trading partners in all activities. Thus, as long as there are relative cost differences in the production of different items (a comparative advantage), specialization should take place.

2. E

Ø From the data, the U.S. must give up 3 pounds of cheese for 1 bottle of soda. On the other hand, France must give up 4 pounds of cheese for 1 bottle of soda. Since the opportunity cost (in terms of cheese) is less for the U.S., the U.S. should produce soda because they have a comparative advantage in its production. In addition, the U.S. can produce more soda and cheese than France if there was no trade. This tells us that the U.S. has an absolute advantage in the production of both of these goods.

3. B

Ø Remember a contractionary fiscal policy consists of ↑ taxes and/or ↓ government spending. This also means that the government will be running on a budget surplus since our revenues will be greater than our expenditures. As a result, the government won’t need to demand money to finance its budget and the demand for loanable funds will decrease (shift left). This, in turn, causes interest rates to ↓. Lower interest rates cause foreigners to demand fewer dollars and, therefore, the value of the dollar ↓. It now takes more dollars to buy another country’s currency. So, our exports will ↑ and our imports will ↓.

4. D

Ø An increase in our demand for French wine would increase our demand for French francs. If the Fed buys securities, the money supply will increase and interest rates will fall. Lower rates result in a decreased demand for dollars and, thus, the value of the dollar declines. If prices rise faster in the U.S. than in France, Americans will look to buy more French goods and, therefore, the demand for French francs will increase. Likewise, if Americans decide to visit France, they are going to demand more French francs. Therefore, the correct answer is D simply because if there is an increased demand in France for our products, they will demand more dollars causing the value of the dollar to rise!

5. B

Ø An import quota will cause the world price to rise simply because we are restricting the most efficient producers from selling their product in the U.S. However, with the higher price, there will be an increase in the domestic production of commodity Y.

6. C

Ø Willie’s conversion of ₤ 100,000 on Monday resulted in ₤ 100,000 x $1.50 per ₤ = $150,000. Now, when he changed the dollars back to pounds, Willie ended up with $150,000 x (₤ 1 / $2) = ₤ 75,000. Thus, Willie would be demoted for losing ₤ 25,000 of the company’s money.

7. D

Ø If our imports increase, that means the world’s supply of dollars is increasing. As the supply of dollars increases (shifts to the right), the value of the dollar declines (or depreciates).

8. A

Ø Tariffs are excise taxes on imports. Tariffs result in higher than world prices and, therefore, cause domestic consumption to decrease. Imports also fall, yet domestic production increases since the price is now higher. Thus, a tariff will hurt the consumers of a product most if the product has several complementary goods. If the product is used with several other goods, in essence, the tariff is also raising the cost of using those goods since the product in question must be used with them.

9. B

Ø If the demand for Japanese yen increases (shifts to the right), the value of the yen has appreciated. This means that it’ll take more U.S. dollars to buy Japanese yen and, therefore, their products. As the yen appreciates relative to the dollar, this also means that the dollar has depreciated relative to the yen. Either way you look at it, American goods will appear less expensive to the Japanese. Thus, our exports will actually increase and our imports will decrease (resulting in a trade surplus).

10. B

Ø If a nation devalued its currency, the people of that nation would no longer be able to purchase foreign goods since that currency would have little value to the foreigners. Likewise, a person from this nation would find it difficult to travel abroad simply because he or she would get little foreign currency for his or her traveler’s checks. In addition, since the people of this nation want other forms of currency, they would be willing to accept almost anything for their goods, thereby making them less expensive for foreigners than before the devaluation. So, this nation’s exports would increase simply because that is the only way for their people to gain currency that has some value.

11. B

Ø An increase in the demand for French wine would increase our demand for French francs. If France expects higher inflation in the U.S., the demand for francs will increase since people will soon be demanding more French products because they will cost less relative to American goods. Likewise, if the French expect a decline in the value of the dollar, the demand for the dollar will decrease (or depreciate). The correct answer is B simply because a tight money policy in the U.S. causes the money supply to decrease and interest rates to increase. As interest rates in the U.S. increase, the demand for dollars increases, and, therefore, the value of the dollar rises (or appreciates).

12. A

Ø Relative cost differences in the production of different items is what makes it beneficial for people or nations to trade. This is the idea of comparative advantage. If you have a comparative advantage in the production of a good, you can produce that good at a lower domestic opportunity cost than can someone else. Thus, these comparative advantages are critical in predicting trade patterns.

13. C

Ø In order to produce one flint, you must give up some of the resources devoted to producing roots. By looking at the data, if you produce 1 flint, you go from producing 6 roots to 5 roots. Thus, the cost of producing that first flint is 1 root. It is what you must give up in order to produce that first flint!

14. B

Ø Flexible exchange rates have the ability to automatically correct any imbalance in the B.O.P.

15. A

Ø From the data, India must give up 1 bushel of wheat for 1 bushel of rice. On the other hand, Canada must give up 2 bushels of wheat for 1 bushel of rice. Since the opportunity cost (in terms of wheat) is less for India (1 as compared to 2 bushels of wheat), India should produce rice because they have a comparative advantage in its production. And, Canada should produce wheat since it only has to give up ½ bushel of rice for 1 bushel of wheat, whereas India would have to give up 1 bushel of rice for 1 bushel of wheat. Remember, you have a comparative advantage if you can produce a product at a lower domestic opportunity cost.

16. E

Ø Remember an expansionary fiscal policy consists of ↑ government spending and/or ↓ taxes. This also means that the government will be running on a budget deficit since our expenditures will be greater than our revenues. As a result, the government will demand money to finance its budget and the demand for loanable funds will increase (shift right). This, in turn, causes interest rates to ↑. Higher interest rates cause foreigners to demand more dollars and, therefore, the value of the dollar ↑. It now takes fewer dollars to buy another country’s currency. So, our imports will ↑ and our exports will ↓.

17.

Ø Since there is demand-pull inflation, we would want to implement a “tight” monetary policy. This may consist of ↑ the reserve requirement, ↑ the discount rate, or having the Fed sell securities on the open market. The result of these actions would be a decrease in the money supply. As the money supply decreases, interest rates will rise, and, therefore, investment will fall. As investment falls, AD decreases (shifts to the left) causing prices to fall (the purpose of this policy).

18.

Ø Since interest rates rise as a result of the “tight” monetary policy, foreigners will demand more dollars because they will now want to invest in our financial markets. As the demand for dollars increases, the value of the dollar appreciates causing a ↓ in U.S. exports and an ↑ in U.S. imports (a trade deficit occurs).

19.

Ø Since there is demand-pull inflation, we would want to implement a contractionary fiscal policy. This may consist of ↑ taxes and/or ↓ government spending. The ↑ taxes will have an indirect effect simply because it ↓ consumption by the (∆ Tax) x (MPC). On the other hand, the ↓ government spending will have a direct effect by causing G to ↓ by that amount. The ↓ in G or the ↓ in C is then multiplied by the spending multiplier [1/MPS or 1/(1-MPC)] to determine the overall impact on GDP. The end result of these fiscal policies is a ↓ in AD (shifts to the left). This, in turn, causes prices to fall (the purpose of this policy).

20.

Ø Remember, the government is using a contractionary fiscal policy. This means that the government will be running on a budget surplus since our revenues will be greater than our expenditures. As a result, the government won’t need to demand money to finance its budget and the demand for loanable funds will decrease (shift left). This, in turn, causes interest rates to ↓. Lower interest rates cause foreigners to demand fewer dollars and, therefore, the value of the dollar ↓. It now takes more dollars to buy another country’s currency. So, our exports will ↑ and our imports will ↓ (a trade surplus occurs).

21.

Ø A strong dollar means that foreign goods will cost Americans less money. This results in an increase in U.S. imports. It also encourages travel and spending abroad. On the other hand, a strong dollar means that it costs foreigners more money to buy our goods. Thus, our exports decline as does tourism and spending by foreigners in the U.S.

22.

Ø A weak dollar means that foreign goods will cost Americans more money. This results in a decrease in U.S. imports. It also discourages travel and spending abroad. On the other hand, a weak dollar means that it costs foreigners less money to buy our goods. Thus, our exports increase as does tourism and spending by foreigners in the U.S.

23.

Ø Trade barriers cause prices to be greater than world prices. Trade barriers also cause the number of imports to decline. In addition, tariffs cause domestic consumption to decline due to the higher prices. An indirect effect of tariffs revolves around the fact that inefficient industries (domestic) are expanding, while relatively efficient industries overseas are being forced to contract.

24.

Ø Free trade allows the world economy to achieve a more efficient allocation of resources and more material goods. Free trade promotes competition. Free trade also increases specialization, which increases the productivity of resources and allows the PPC (production possibilities curve) to expand. Free trade also allows people to obtain imports, which they may prefer over domestic products.

25.

Part A:

Ø In the domestic car market, the supply of cars will increase since the producers are given a subsidy. This increase in supply (rightward shift of the supply curve) causes the price of domestically produced cars to decrease and the quantity to increase.

Ø Since more people are buying domestic cars, the demand for imported cars will decline. This decrease in demand (leftward shift of the demand curve) causes the price and quantity of imported cars to decrease.

Ø The subsidy for domestic car producers causes relatively inefficient industries to expand and it also eventually results in lower prices for imports.

Part B:

Ø A policy that combines tax cuts and increases in government spending is an expansionary fiscal policy. This also means that the government will be running on a budget deficit since our expenditures will be greater than our revenues. As a result, the government will demand money to finance its budget and the demand for loanable funds will increase (shift right). This, in turn, causes interest rates to ↑. Higher interest rates cause foreigners to demand more dollars and, therefore, the value of the dollar ↑.

Part C:

Ø It now takes fewer dollars to buy another country’s currency. So, Multaluna’s imports will ↑ and their exports will ↓.

Ø Thus, the demand for cars in Multaluna’s domestic car market will decrease (since foreigners won’t be able to afford American cars because it will take them more of their currency to buy $1.

Ø Whereas, the demand for cars in the import market will increase since the dollar has appreciated in value (it now takes fewer dollars to buy another currency so imported cars are cheaper).

Ø Multaluna’s GDP will decrease because net exports have decreased (since imports > exports).

Part D:

Ø Those who continue purchase domestic cars will benefit from the previously described change in currency value because the price of domestic cars has decreased (since the demand for domestic cars decreased). In addition, the producers of imported cars will also benefit since the increased demand for their cars will result in higher prices in the end.