ch12 - CHAPTER 12 INTERNATIONAL LINKAGES Solutions to the...

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CHAPTER 12 INTERNATIONAL LINKAGES Solutions to the Problems in the Textbook : Conceptual Problems: 1. A country with a balance-of-payments deficit has made more payments of currency to foreigners than it receives and the country’s central bank generally provides the needed funds. If the central bank refuses to do so, the country will experience a decrease in money supply, which will eventually lead to a recession. As domestic income goes down, less will be spent on imports. Since the domestic price level is likely to decrease in a recession, people from abroad will begin to demand more of the country’s goods and exports will increase, ultimately leading to a new equilibrium in the external balance. 2.a. A decrease in exports leads to a decrease in income and to a trade deficit. This situation cannot be remedied with standard demand-side stabilization policy. The most appropriate policy response would be protectionist measures (tariffs) or export subsidies combined with expansionary fiscal policy. 2.b. A decrease in private domestic saving and a corresponding increase in the level of domestic consumption will lead to an increase in national income. If only more domestic goods are demanded, then no trade deficit will occur. But if consumers also demand more foreign goods, then a trade deficit will occur. In either case, a cut in government spending is the most appropriate policy response. 2.c. An increase in government spending will increase national income and lead to a trade deficit. A subsequent cut in spending is the most appropriate policy response. 2.d. A shift from imports to domestic goods will increase national income and lead to a trade surplus. This situation cannot be remedied with standard demand-side stabilization policy. A cut in government spending combined with lower tariffs is the most appropriate policy response. 2.e. A reduction in imports combined with a corresponding increase in saving will lead to a trade surplus but no change in national income. A cut in income taxes combined with lower tariffs is the most appropriate policy response. 3. Expansionary monetary policy lowers the interest rate, which stimulates the level of investment spending and therefore aggregate demand. If there is perfect capital mobility, lower interest rates will also lead to a capital outflow, which will result in a depreciation of the currency. Export goods will be cheaper for foreigners, so more of them will be demanded. The increase in net exports will lead to an even higher level of aggregate demand and therefore national income. 182
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4.a. An increase in the dollar/pound exchange rate means that now more U.S. dollars are required to buy one British pound. Therefore the U.S. dollar has depreciated in value.
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This note was uploaded on 12/18/2010 for the course SOES 2003 taught by Professor Jian during the Fall '10 term at Uni. Southampton.

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ch12 - CHAPTER 12 INTERNATIONAL LINKAGES Solutions to the...

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