Chapter 7: Quiz Answers -- Foreign Exchange and the Balance of Payments

1. Suppose that one British pound buys two U.S. dollars. From the U.S. point of view, the exchange rate is
   2.0. The exchange rate (as defined is this chapter) is the amount of dollars that it takes to purchase one unit of foreign exchange. It takes two dollars to purchase one pound, so e=2.

2. From the first question above, if the pound can now purchase 1.5 dollars instead of 2 dollars, then the dollar has
   appreciated. The pound has weakened relative to the dollar, so the dollar has appreciated relative to the pound.

3. The U.S. has run a trade deficit with Japan for some time. To eliminate this gap, it is necessary for the dollar to _______ against the yen.
   weaken When the dollar weakens against the yen, U.S. exports to Japan will increase because export prices will fall in Japan. Simultaneously, import prices of Japanese products will increase in the U.S. Both of these changes reduce the U.S. trade deficit.

4. Suppose the U.S. has a negative balance on goods and services (i.e. it imports more than it exports), and the exchange rate decreases. This will have the effect of
   increasing the deficit on goods and services. A lower exchange rate translates into a stronger dollar, which means that, all else equal, U.S. exports fall and U.S. imports rise.

5. Under a flexible exchange rate system, if the current account deficit is $100 billion, then the capital account balance must be
   a surplus of $100 billion. With flexible exchange rates, the balance of payments must sum to zero.

6. All the following are examples of a U.S. capital outflow except
   Microsoft opens a new office in Hawaii. Capital must leave the country to be a capital outflow. The new office in Hawaii is domestic investment.

7. In 2005, the value of U.S. exports as a percentage of GDP was approximately
   10%.

8. Other things equal, an increase in capital inflows into the U.S. will
   all of the above. More capital inflows means higher demand for the dollar, which lowers the exchange rate, strengthens the dollar, and reduces net exports.

9. From the U.S. perspective, a capital outflow occurs when a German investor, for example, buys a portion of the U.S. government debt.
   False. This example is a capital inflow, not an outflow.

10. The U.S. has imported more than it has exported every year for the last couple of decades. The U.S. has been able to run persistent trade deficits because the U.S. has a persistent surplus in the capital account.
    True. A trade deficit can be sustained over the long term only if foreigners are willing to purchase more domestic assets than domestic citizens purchase of foreign assets.