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chp 3 - End-of-Chapter Question Solutions 1 CHAPTER 2 THE...

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End-of-Chapter Question Solutions ____________________________________________________________________________________________ 1 C HAPTER 2: T HE I NTERNATIONAL M ONETARY S YSTEM 1. The gold standard and the money supply. Under the gold standard all national governments promised to follow the “rules of the game”. This meant defending a fixed exchange rate. What did this promise imply about a country’s money supply? A country’s money supply was limited to the amount of gold held by its central bank or treasury. For example, if a country had 1,000,000 ounces of gold and its fixed rate of exchange was 100 local currency units per ounce of gold, that country could have 100,000,000 local currency units outstanding. Any change in its holdings of gold needed to be matched by a change in the number of local currency units outstanding. 2. Causes of devaluation. If a country follows a fixed exchange rate regime, what macroeconomic variables could cause the fixed exchange rate to be devalued? The following macroeconomic variables could cause the fixed exchange rate to be devalued: C An interest rate that is too low compared to other competing currencies C A continuing balance of payments deficit C An inflation rate consistently higher than in other countries 3. Fixed versus flexible exchange rates. What are the advantages and disadvantages of fixed exchange rates? C Fixed rates provide stability in international prices for the conduct of trade. Stable prices aid in the growth of international trade and lessen risks for all businesses. C Fixed exchange rates are inherently anti-inflationary, requiring the country to follow restrictive monetary and fiscal policies. This restrictiveness, however, can often be a burden to a country wishing to pursue policies that alleviate continuing internal economic problems, such as high unemployment or slow economic growth. C Fixed exchange rate regimes necessitate that central banks maintain large quantities of international reserves (hard currencies and gold) for use in the occasional defense of the fixed rate. As international currency markets have grown rapidly in size and volume, increasing reserve holdings has become a significant burden to many nations. C Fixed rates, once in place, may be maintained at rates that are inconsistent with economic fundamentals. As the structure of a nation’s economy changes, and as its trade relationships and balances evolve, the exchange rate itself should change. Flexible exchange rates allow this to happen gradually and efficiently, but fixed rates must be changed administratively—usually too late, too highly publicized, and at too large a one-time cost to the nation’s economic health. 4. The Impossible Trinity. Explain what is meant by the term “Impossible Trinity” and why it is true. C Countries with floating rate regimes can maintain monetary independence and financial integration but must sacrifice exchange rate stability.
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