Name: __________________________ Date: _____________

1. Compared with a closed economy, an open economy:

A) allows the exchange rate to float.
B) fixes the exchange rate.
C) trades with other countries.
D) does not trade with other countries.

2. The MundellFleming model assumes that:

A) prices are flexible, whereas the ISLM model assumes that prices are fixed.
B) prices are fixed, whereas the ISLM model assumes that prices are flexible.
C) as in the ISLM model, prices are fixed.
D) as in the ISLM model, prices are flexible.

3. The MundellFleming model is a ______ model for a ______ open economy.

A) short-run; small
B) short-run; large
C) long-run; large
D) long-run; small

4. In the MundellFleming model:

A) the exchange rate system must have a floating exchange rate.
B) the exchange rate system must have a fixed exchange rate.
C) it makes no difference whether the exchange rate system has a floating or a fixed
exchange rate.
D) the behaviour of the economy depends on whether the exchange rate system has a
floating or fixed exchange rate.

5. In the MundellFleming model, the domestic interest rate is determined by the:

A) intersection of the LM and IS curves.
B) domestic rate of inflation.
C) world rate of inflation.
D) world interest rate.

6. In a small open economy with perfect capital mobility, if the domestic interest rate were
to rise above the world interest rate, then ______ would drive the domestic interest rate
back to the level of the world interest rate.
A) capital inflow
B) capital outflow
C) the central bank

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D) a decline in domestic saving

7. Assuming there is perfect capital mobility, compared to a large open economy, a small
open economy is one in which the:
A) exchange rate is fixed.
B) exchange rate is floating.
C) domestic interest rate equals the world interest rate.
D) domestic interest rate is not equal to the world interest rate.

8. In a small open economy, net exports depend ______ on the exchange rate, where the
exchange rate is defined as the amount of ______ currency per unit of ______ currency.
A) negatively; foreign; domestic
B) negatively; domestic; foreign
C) positively; domestic; foreign
D) positively; foreign; domestic

9. If short-run equilibrium in the MundellFleming model is represented by a graph with Y

along the horizontal axis and the exchange rate (defined as the value of the domestic
currency) along the vertical axis, then the IS* curve:
A) slopes downward and to the right because the higher the exchange rate, the lower
the level of net exports and, therefore, of short-run equilibrium income in the goods
market.
B) is vertical because there is only one investment level that is consistent with the
world interest rate.
C) is vertical because the exchange rate does not enter into the IS* equation.
D) slopes downward and to the right because the higher the exchange rate, the higher
the level of net exports and, therefore, of short-run equilibrium income in the goods
market.

10. In the MundellFleming model on a Y e graph, the curves labeled IS* and LM* are
labeled that way as a reminder that:
A) the price level is held constant at the world price level p*.
B) the interest rate is held constant at the world interest rate r*.
C) the exchange rate is held constant at the world exchange rate e*.
D) output is held constant at the full employment level.

11. If short-run equilibrium in the MundellFleming model is represented by a graph with Y

along the horizontal axis and the exchange rate (defined as the value of the domestic
currency) along the vertical axis, then the LM* curve:
A) slopes upward and to the right because at a higher income a higher interest rate is
needed to increase velocity.

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B) is vertical because monetary velocity is independent of the interest rate.
C) is vertical because the exchange rate does not enter into the LM* equation.
D) slopes upward and to the right because a higher exchange rate leads to a higher
income.

12. In the MundellFleming model, the exogenous variables are the:

A) world interest rate, the price level, and the exchange rate.
B) level of government spending, taxes, and income.
C) exchange rate and level of income.
D) price level, world interest rate, monetary policy, and fiscal policy.

13. The intersection of the IS* and LM* curves shows the ______ and the ______ at which
both the goods market and the money market are in equilibrium.
A) interest rate; price level
B) price level; exchange rate
C) level of output; exchange rate
D) level of output; price level

14. Under a floating system, the exchange rate:

A) fluctuates in response to changing economic conditions.
B) is maintained at a predetermined level by the central bank.
C) is changed at regular intervals by the central bank.
D) fluctuates in response to changes in the price of gold.

15. In a small open economy with a floating exchange rate, an effective policy to increase
equilibrium output is to:
A) increase government spending.
B) increase taxes.
C) increase the money supply.
D) decrease the money supply.

16. In a small open economy with a floating exchange rate, an effective policy to decrease
equilibrium output is to:
A) decrease government spending.
B) decrease taxes.
C) increase the money supply.
D) decrease the money supply.

17. In a small open economy with a floating exchange rate, the exchange rate (defined as
the value of the domestic currency) will appreciate if:

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A) the money supply is increased.
B) the money supply is decreased.
C) government spending is decreased.
D) taxes are decreased.

18. In a small open economy with a floating exchange rate, the exchange rate (defined as
the value of the domestic currency) will depreciate if:
A) the money supply is decreased.
B) import quotas are imposed.
C) government spending is increased.
D) taxes are decreased.

19. In a small open economy with a floating exchange rate, if the government adopts an
expansionary fiscal policy, in the new short-run equilibrium:
A) income and the exchange rate will both rise.
B) the exchange rate will rise, but income will remain unchanged.
C) income will rise, but the exchange rate will remain unchanged.
D) both income and the interest rate will rise.

20. In a small open economy with a floating exchange rate, a rise in government spending in
the new short-run equilibrium:
A) chokes off investment, but not by as much as the new government spending.
B) chokes off an amount of investment just equal to the new government spending.
C) attracts foreign capital, thus raising the exchange rate and reducing net exports, but
not by as much as the new government spending.
D) attracts foreign capital, thus raising the exchange rate and reducing net exports by
an amount just equal to the new government spending.

21. In a small open economy with a floating exchange rate, the supply of real money
balances is fixed and a rise in government spending:
A) raises the interest rate, so income must rise to maintain equilibrium in the money
market.
B) raises the interest rate, so net exports must fall to maintain equilibrium in the goods
market.
C) cannot change the interest rate, so net exports must fall to maintain equilibrium in
the goods market.
D) cannot change the interest rate, so income must rise to maintain equilibrium in the
money market.

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Use the following to answer questions 22-23:

22. (Exhibit: IS*LM*) A small open economy with a floating exchange rate is initially at
equilibrium A with IS*1, LM*1, equilibrium exchange rate e2, and equilibrium output Y1.
If there is an increase in government spending to IS*2, the new equilibrium will be at
______, holding everything else constant.
A) A
B) B
C) C
D) D

23. (Exhibit: IS*LM*) A small open economy with a floating exchange rate is initially at
equilibrium A with IS*1, LM*1, equilibrium exchange rate e2, and equilibrium output Y1.
If there is a monetary expansion to LM*2, the new equilibrium will be at ______,
holding everything else constant.
A) A
B) B
C) C
D) D

24. In a small open economy with a floating exchange rate, if the government decreases the
money supply, then in the new short-run equilibrium:
A) income falls and the exchange rate rises.
B) the exchange rate falls and income rises.
C) income remains unchanged but the exchange rate rises.
D) the exchange rate remains unchanged but income falls.

25. In a small open economy with a floating exchange rate, if the government increases the

Page 5
 money supply, then in the new short-run equilibrium the:
A) interest rate falls and the level of investment rises.
B) exchange rate falls and net exports increase.
C) interest rate falls but the level of investment does not rise.
D) exchange rate falls but net exports do not increase.

26. According to the MundellFleming model for a small open economy with flexible
exchange rates, if the Bank of Canada cannot alter domestic interest rates, changes in
the money supply could still influence aggregate income through changes in the:
A) exchange rate.
B) price level.
C) level of government spending.
D) tax rates.

27. In a small open economy with a floating exchange rate, if the government imposes an
import quota, then in the new short-run equilibrium the IS* curve shifts to the right,
raising the exchange rate:
A) but not raising net exports or income.
B) and net exports but not income.
C) and income but not net exports.
D) net exports and income.

28. In a small open economy with a floating exchange rate, if the government imposes a
tariff on foreign goods, then in the new short-run equilibrium:
A) imports will decrease while exports remain constant, leading to a rise in net
exports.
B) imports will decrease and exports will increase, leading to a rise in net exports.
C) imports will decrease and exports will decrease by an equal amount.
D) both imports and exports will remain unchanged.

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Use the following to answer questions 29-30:

29. (Exhibit: Risk Premium) A small open economy with a floating exchange rate is initially
in equilibrium at A with IS*1, LM*1. Holding all else constant, if the government
imposes a tariff on imports in order to protect domestic jobs, then the ______ curve will
shift to ______.
A) LM*; LM*2
B) LM*; LM*3
C) IS*; IS*2
D) IS*; IS*3

30. (Exhibit: Risk Premium) A small open economy with a floating exchange rate is initially
in equilibrium at A with IS*1, LM*1. Holding all else constant, if domestic consumers
develop greater preferences for imported goods, then the _____ curve will shift to
_____.
A) LM*; LM*2
B) LM*; LM*3
C) IS*; IS*2
D) IS*; IS*3

31. Under a fixed system, the exchange rate:

A) fluctuates in response to changing economic conditions.
B) is maintained at a predetermined level by the central bank.
C) is changed at regular intervals by the central bank.
D) fluctuates in response to changes in the price of gold.

32. To maintain a fixed-exchange-rate system, if the exchange rate moves below the fixed-
exchange-rate level, then the central bank must:

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A) buy foreign currency.
B) sell foreign currency from reserves.
C) raise taxes.
D) decrease government spending.

33. If the Bank of Canada announced it would fix the exchange rate at 100 yen per dollar,
but with the current money supply the equilibrium exchange rate was 150 yen per dollar,
then:
A) arbitrageurs would sell yen in the marketplace.
B) arbitrageurs would buy yen from the Bank of Canada.
C) the money supply would fall until the market exchange rate was 100 yen per dollar.
D) the money supply would rise until the market exchange rate was 100 yen per dollar.

34. Under a fixed-exchange-rate system, the central bank of a small open economy must:
A) have a reserve of its own currency, which it must have accumulated in past
transactions.
B) have a reserve of foreign currency, which it can print.
C) allow the money supply to adjust to whatever level will ensure that the equilibrium
exchange rate equals the announced exchange rate.
D) follow a rule specifying a constant growth rate for the money supply.

35. If there is a fixed-exchange-rate system, then in the short run described by the Mundell
Fleming model:
A) the nominal exchange rate is fixed, but the real exchange rate is free to vary.
B) the real exchange rate is fixed, but the nominal exchange rate is free to vary.
C) both the nominal and real exchange rates are fixed.
D) the nominal exchange rate is fixed, but whether the real exchange rate is fixed
depends on whether the central bank follows a rule of constant growth of the
money supply.

36. If there is a fixed-exchange-rate system, then in the long run:

A) the nominal exchange rate is fixed, but the real exchange rate is free to vary.
B) the real exchange rate is fixed, but the nominal exchange rate is free to vary.
C) both the nominal and real exchange rates are fixed.
D) the nominal and real exchange rates vary by a fixed amount.

37. During the era of the gold standard, the price of gold in England:
A) was always equal to the price of gold in the United States.
B) was always a little higher than the price of gold in the United States, but it could
not be higher by more than the cost of transporting gold from the United States to
England.

Page 8
C) was always a little lower than the price of gold in the United States, but it could not
be lower than the cost of transporting gold from England to the United States.
D) could be higher or lower than the price of gold in the United States, but not by
more than the cost of transporting gold between the two countries.

38. In a small open economy with a fixed exchange rate, if the government increases
government purchases, then in the new short-run equilibrium:
A) the exchange rate rises but income does not rise.
B) income rises but the exchange rate does not rise.
C) both income and the exchange rate rise.
D) neither income nor the exchange rate rises, as the money supply contracts.

39. In a small, open economy with a fixed exchange rate, if the government increases
government purchases, then in the process of adjusting to the new short-run equilibrium
the money supply:
A) increases to keep the exchange rate unchanged, thus augmenting the effect of
government spending on income.
B) decreases to keep the exchange rate unchanged, thus offsetting the effect of
government spending on income.
C) remains unchanged, and there is no effect of government spending on income.
D) remains unchanged to keep the interest rate at the world interest, so that
government spending reduces income.

40. In a small, open economy with a fixed exchange rate, an effective policy to increase
equilibrium output is to:
A) decrease government spending.
B) decrease taxes.
C) increase the money supply.
D) decrease the money supply.

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Use the following to answer questions 41-42:

41. (Exhibit: IS*LM*) A small open economy with a fixed exchange rate, e2, is initially at
equilibrium A with IS*1, LM*1, and equilibrium output Y1. If there is an increase in
government spending to IS*2, the new equilibrium will be at ______, holding everything
else constant.
A) A
B) B
C) C
D) D

42. (Exhibit: IS*LM*) A small open economy with a fixed exchange rate, e2, is initially at
equilibrium A with IS*1, LM*1, and equilibrium output Y1. If there is a monetary
expansion to LM*2, the new equilibrium will be at ______, holding everything else
constant.
A) A
B) B
C) C
D) D

43. In a small open economy with a fixed exchange rate, if the central bank tries to increase
the money supply, then in the new short-run equilibrium:
A) income rises.
B) income falls.
C) the exchange rate falls.
D) income remains constant.

44. In a small open economy with a fixed exchange rate, if the country devalues its

Page 10
 currency, then in the new short-run equilibrium the exchange rate ______, and the LM*
curve shifts to the ______.
A) decreases; left
B) increases; left
C) decreases; right
D) increases; right

45. In the MundellFleming model with fixed exchange rates, attempts by the central bank
to decrease the money supply:
A) lead to a lower equilibrium level of income.
B) lead to a higher equilibrium level of income.
C) must be abandoned in order to maintain the fixed exchange rate.
D) must be offset by expansionary fiscal policy.

46. A revaluation of a currency under a fixed-exchange-rate system occurs when the level at
which the currency is fixed is:
A) increased.
B) decreased.
C) allowed to float.
D) kept fixed within a band.

47. A devaluation of a currency under a fixed-exchange-rate system occurs when the level
at which the currency is fixed is:
A) increased.
B) decreased.
C) allowed to float.
D) kept fixed within a band.

48. During the Great Depression, countries that devalued their currencies generally ______,
whereas countries that maintained the old exchange rate ______.
A) suffered longer; experienced no depression
B) recovered relatively quickly; experienced no depression
C) suffered longer; recovered relatively quickly
D) recovered relatively quickly; suffered longer

49. In a small open economy with a fixed exchange rate, if the government imposes an
import quota, then net exports:
A) decrease but the money supply falls and income falls.
B) increase, the money supply increases, and income increases.
C) are unchanged but the money supply falls and income falls.
D) are unchanged, the money supply is unchanged, and income is unchanged.

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 50. According to the MundellFleming model, under:
A) floating exchange rates, a monetary expansion raises income whereas a fiscal
expansion does not, but under fixed exchange rates, a fiscal expansion raises
income whereas a monetary expansion does not.
B) both floating and fixed exchange rates, a monetary expansion raises income, but a
fiscal expansion does not.
C) both floating and fixed exchange rates, a fiscal expansion raises income, but a
monetary expansion does not.
D) floating exchange rates, a fiscal expansion raises income whereas a monetary
expansion does not; but under a fixed exchange rate, a monetary expansion raises
income whereas a fiscal expansion does not.

51. According to the MundellFleming model, under floating exchange rates a fiscal
expansion:
A) lowers the exchange rate, but a monetary expansion raises it.
B) raises the exchange rate, but a monetary expansion or an import restriction lowers
it.
C) or an import restriction lowers the exchange rate, but a monetary expansion raises
it.
D) or an import restriction raises the exchange rate, but a monetary expansion lowers
it.

52. According to the MundellFleming model, under fixed exchange rates expansionary
fiscal policy causes income to ______, and under flexible exchange rates expansionary
fiscal policy causes income to ______.
A) increase; increase
B) increase; remain unchanged
C) remain unchanged; remain unchanged
D) remain unchanged; increase

53. According to the MundellFleming model, in an economy with flexible exchange rates,
expansionary fiscal policy causes the exchange rate (defined as the value of the
domestic currency) to ______ and expansionary monetary policy causes the exchange
rate to ______.
A) rise; rise
B) rise; fall
C) fall; fall
D) fall; rise

54. According to the MundellFleming model, in an economy with flexible exchange rates,

Page 12
 expansionary fiscal policy causes net exports to ______ and expansionary monetary
policy causes net exports to ______.
A) increase; increase
B) increase; decrease
C) decrease; decrease
D) decrease; increase

55. According to the MundellFleming model, import restrictions in an economy with

flexible exchange rates cause net exports to ______ and in an economy with fixed
exchange rates import restrictions cause net exports to ______.
A) increase; increase
B) increase; remain unchanged
C) remain unchanged; remain unchanged
D) remain unchanged; increase

56. According to the MundellFleming model, under flexible exchange rates expansionary
monetary policy ______ increase income and under fixed exchange rates expansionary
monetary policy ______ increase income.
A) can; can
B) can; cannot
C) cannot; can
D) cannot; cannot

57. The risk premium included in the interest rate of small open economies incorporates:
A) country risk and expectations of future exchange-rate changes.
B) the law of one price.
C) inefficient activity by arbitrageurs.
D) capital mobility.

58. Country risk included in the risk premium in interest rates refers to the:
A) additional costs incurred when loans are made in currencies other than the domestic
currency.
B) possibility that loans in some countries may not be repaid because of political
upheaval.
C) expectation that the exchange rate may change in the future.
D) potential change in the terms of trade between countries.

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Use the following to answer questions 59-60:

Exhibit: Risk Premium

59. (Exhibit: Risk Premium) A small open economy with a floating exchange rate is initially
in equilibrium at A with IS*1, LM*1. If there is an increase in the risk premium, then
LM*1 will shift to ______ and IS*1 will shift to ______.
A) LM*2; IS*2
B) LM*2; IS*3
C) LM*3; IS*2
D) LM*3; IS*3

60. (Exhibit: Risk Premium) A small open economy with a floating exchange rate is initially
in equilibrium at A with IS*1, LM*1. If the establishment of a new government in the
country decreases the risk premium, then LM*1 will shift to ______ and IS*1 will shift to
______.
A) LM*2; IS*2
B) LM*2; IS*3
C) LM*3; IS*2
D) LM*3; IS*3

61. To compensate for an expected future decline in the Japanese yen relative to the U.S.
dollar, the interest rate in Japan must be ______ the interest rate in the United States.
A) higher than
B) lower than
C) equal to
D) fixed relative to

62. In the MundellFleming model, if political turmoil raises the risk premium in a
country's interest rate, then the exchange rate will:

Page 14
A) increase.
B) decrease.
C) remain constant.
D) either increase or decrease, depending on whether the IS* or LM* curve shifts more.

63. In the MundellFleming model, expectations that a currency will lose value in the future
will cause the current exchange rate to:
A) increase in the present.
B) decrease in the present.
C) remain constant in the present.
D) decrease only in the future.

64. An increase in income generated by an increase in the country risk premium will not
occur if there is a(n) ______ sufficient to offset the decline in the demand for money
caused by the higher risk premium.
A) decrease in the money supply
B) increase in the money supply
C) decrease in government spending
D) fall in the price level

65. An increase in income generated by an increase in the country risk premium will not
occur if there is a(n) ______ sufficient to offset the decline in the demand for money
caused by the higher risk premium.
A) increase in the money supply
B) decrease in government spending
C) increase in the price level caused by more expensive imports
D) fall in the price level caused by less expensive imports

66. According to the MundellFleming model with floating exchange rates, political
uncertainty in Mexico in 1994 caused the risk premium on Mexican interest rates to
______ and the Mexican exchange rate to ______.
A) increase; increase
B) increase; decrease
C) decrease; increase
D) decrease; decrease

67. At the end of 1994 the Mexican government was unable to maintain a fixed exchange
rate because it:
A) ran out of foreign-currency reserves.
B) was unable to increase the supply of Mexican pesos.
C) was forced by the IMF to let the peso float.

Page 15
D) joined an exchange-rate union.

68. Crony capitalism refers to situations in which banks make loans to those borrowers
with the most:
A) profitable investment projects.
B) political clout.
C) ability to repay the loans.
D) creditworthy borrowers.

69. One argument favouring a floating-exchange-rate system is that it:

A) makes international trade less difficult.
B) minimizes destabilizing speculation by international investors.
C) allows monetary policy to be used for other purposes.
D) helps prevent excessive growth in the money supply.

70. One argument favouring a fixed-exchange-rate system is that it:

A) allows monetary policy to be used for stabilizing output and prices.
B) reduces exchange-rate uncertainty, thereby promoting more international trade.
C) leads to excessive growth of the money supply.
D) requires no actions on the part of the central bank to implement.

71. A monetary union with a common currency is an example of a:

A) fixed-exchange-rate system.
B) flexible-exchange-rate system.
C) small open economy.
D) large open economy.

72. Some economists argue that monetary union will not work as well in Europe as it does
in Canada for all of the following reasons except:
A) labour is not as mobile in Europe as it is in Canada.
B) there is no strong central government that can use fiscal policy in Europe as there is
in Canada.
C) there is no common language in Europe as there is in Canada.
D) there is no European central bank as there is in Canada.

73. If the exchange rate of currency A is fixed to a unit of currency B, then a potential
problem for the central bank in charge of currency A is:
A) running out of currency A.
B) running out of currency B.
C) generating excessive revenue from seigniorage.

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D) ineffective fiscal policy.

74. A speculative attack on a currency occurs when:

A) a central bank switches from a floating to a fixed exchange rate.
B) investors' perceptions change, making a fixed exchange rate untenable.
C) a country accepts dollarization.
D) a central bank adopts a currency board to back the domestic currency with a
foreign currency.

75. A change in investors' perceptions that make a fixed exchange rate untenable is known
as:
A) a speculative attack.
B) dollarization.
C) seigniorage.
D) a floating currency board.

76. An arrangement by which a central bank holds enough foreign currency to back each
unit of the domestic currency is called a:
A) floating exchange rate.
B) dollarization.
C) monetization.
D) currency board.

77. When a country abandons its national currency and adopts the currency of the United
States, this is known as:
A) a floating exchange rate system.
B) dollarization.
C) a speculative attack on the United States.
D) a currency board.

78. One economic loss that occurs when a country dollarizes is the loss of:
A) seigniorage revenue.
B) income tax revenue.
C) sales tax revenue.
D) a fixed exchange rate with the dollar.

79. The impossible trinity refers to the idea that it is impossible for a country to
simultaneously have:
A) low inflation, low unemployment, and a rapid rate of GDP growth.
B) free capital flows, a fixed exchange rate, and an independent monetary policy.

Page 17
C) high interest rates, a budget deficit, and a trade deficit.
D) an expansionary fiscal policy, a contractionary monetary policy, and a flexible
exchange rate.

80. If a country chooses to have free capital flows and to conduct an independent monetary
policy, then it must:
A) live with exchange-rate volatility.
B) restrict its citizens from participating in world financial markets.
C) give up the use of monetary policy for purposes of domestic stabilization.
D) have a fixed exchange rate.

81. If a country chooses to have free capital flows and to maintain a fixed exchange rate,
then it must:
A) live with exchange-rate volatility.
B) restrict its citizens from participating in world financial markets.
C) give up the use of monetary policy for purposes of domestic stabilization.
D) give up the use of fiscal policy for purposes of domestic stabilization.

82. If a country chooses to restrict international capital flows and to maintain a fixed
exchange rate, then it must:
A) live with exchange-rate volatility.
B) control its citizen's access to world financial markets.
C) give up the use of monetary policy for purposes of domestic stabilization.
D) give up the use of fiscal policy for purposes of domestic stabilization.

83. Between 1995 and 2005, China chose to:

A) conduct independent monetary policy, allow free international-capital flows, and
maintain a fixed exchange rate.
B) maintain a fixed exchange rate, allow free international-capital flows, and give up
the use of monetary policy for domestic stabilization.
C) conduct an independent monetary policy, restrict international-capital flows, and
maintain a fixed exchange rate.
D) allow a flexible exchange rate, conduct an independent monetary policy, and allow
free international-capital flows.

84. Which of the following would be evidence that a country with a fixed exchange rate has
an undervalued currency?
A) The government has a budget surplus.
B) The government has a budget deficit.
C) The central bank's foreign-currency reserves are increasing.
D) The central bank's foreign-currency reserves are decreasing.

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 85. In the MundellFleming model, if the price level falls, then the equilibrium income:
A) rises and the real exchange rate appreciates.
B) rises and the real exchange rate depreciates.
C) falls and the real exchange rate appreciates.
D) falls and the real exchange rate depreciates.

86. In the MundellFleming model, if the economy is operating at or below the natural level
in the short run, then in the long run the price level will fall, the exchange rate (defined
as the value of the domestic currency) will ______, and net exports will ______ to
restore the economy to its natural rate.
A) appreciate; increase
B) appreciate; decrease
C) depreciate; increase
D) depreciate; decrease

87. In the MundellFleming model with flexible exchange rates, an increase in the price
level results in a(n) ______ in the real exchange rate and a(n) ______ in net exports.
A) increase; increase
B) increase; decrease
C) decrease; decrease
D) decrease; increase

Use the following to answer questions 88-89:

88. (Exhibit: Risk Premium) A small open economy with a floating exchange rate is initially
in equilibrium at A with IS*1, LM*1. Holding all else constant, if the domestic price level

Page 19
 increases then the ______ curve will shift to ______.
A) LM*; LM*2
B) LM*; LM*3
C) IS*; IS*2
D) IS*; IS*3

89. (Exhibit: Risk Premium) A small open economy with a floating exchange rate is initially
in equilibrium at A with IS*1, LM*1. Holding all else constant, if the domestic price level
decreases then the ______ curve will shift to ______.
A) LM*; LM*2
B) LM*; LM*3
C) IS*; IS*2
D) IS*; IS*3

90. A fall in consumer confidence about the future, which induces consumers to spend less
and save more, will, according to the MundellFleming model with floating exchange
rates, lead to:
A) a fall in consumption and income.
B) no change in consumption or income.
C) no change in income but a rise in net exports.
D) no change in income or net exports.

91. A fall in consumer confidence about the future, which induces consumers to spend less
and save more, will, according to the MundellFleming model, with fixed exchange
rates, lead to:
A) a fall in consumption and income.
B) no change in consumption or income.
C) no change in income but a rise in net exports.
D) a fall in income but a rise in net exports.

92. The introduction of a stylish new line of cars made in Europe, which makes some
consumers prefer foreign cars over domestic cars, will, according to the Mundell
Fleming model with floating exchange rates, lead to:
A) a fall in income and net exports.
B) no change in income or net exports.
C) a fall in income but no change in net exports.
D) no change in income but a fall in net exports.

93. The introduction of a stylish new line of cars made in Europe, which makes some
consumers prefer foreign cars over domestic cars, will, according to the Mundell
Fleming model with fixed exchange rates, lead to:

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A) a fall in income and net exports.
B) no change in income or net exports.
C) a fall in income but no change in net exports.
D) no change in income but a fall in net exports.

94. The introduction of automatic teller machines, which reduces the demand for money,
will, according to the MundellFleming model with floating exchange rates, lead to:
A) no change in income and net exports.
B) no change in income but a rise in net exports.
C) a rise in income but no change in net exports.
D) a rise in both income and net exports.

95. The introduction of automatic teller machines, which reduces the demand for money,
will, according to the MundellFleming model with fixed exchange rates, lead to:
A) a rise in income and net exports.
B) no change in income or net exports.
C) no change in income but a rise in net exports.
D) a rise in income but no change in net exports.

96. In the MundellFleming model with a floating exchange rate, a rise in the world interest
rate will lead income:
A) and net exports both to fall.
B) to rise and net exports to fall.
C) to fall and net exports to rise.
D) and net exports both to rise.

97. In the MundellFleming model with a fixed exchange rate, a rise in the world interest
rate will lead income:
A) and net exports both to fall.
B) to fall while net exports are unchanged.
C) to be unchanged and net exports to fall.
D) and net exports to both be unchanged.

98. The goods produced in Canadian industry may be made more competitive in world
markets by:
A) appreciating the Canadian currency.
B) depreciating the Canadian currency.
C) keeping the exchange rate fixed.
D) expanding the money supply.

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 99. When the MundellFleming model is extended to allow the consumer price index to
depend directly on the exchange rate, the IS* locus is ___________ and the LM* locus
is _________.
A) negatively sloped; positively sloped
B) negatively sloped; vertical
C) vertical; positively sloped
D) negatively sloped; horizontal

100. Consider a small open economy with a flexible exchange rate.

I: According to the MundellFleming model, the imposition of a tariff by the domestic
government raises domestic output.
II: When the MundellFleming model is extended to allow the consumer price index to
depend directly on the domestic cost of imports, the imposition of that tariff has no
effect on domestic output.
A) I is true; II is not.
B) II is true; I is not.
C) Both I and II are true.
D) Neither I nor II is true.

101. In the MundellFleming model of a small open economy

I: an increase in foreign interest rates must cause a recession whether or not the
exchange rate is flexible.
II: an increase in foreign interest rates involves no clear prediction for the effect on real
output in the flexible exchange rate case if the model is extended to allow the consumer
price index to depend on the exchange rate.
A) I is true; II is not.
B) II is true; I is not
C) Both I and II are true.
D) Neither I nor II is true.

102. When the MundellFleming model is extended to allow the consumer price index to
depend on the exchange rate and to allow for real wage rigidity, the IS* locus is
___________ and the LM* locus is __________.
A) negatively sloped; positively sloped
B) negatively sloped; vertical
C) vertical; positively sloped
D) negatively sloped; horizontal

103. A flexible exchange rate acts as an automatic stabilizer when the economy is hit with a
drop in export sales
I: in the basic MundellFleming model.
II: in the MundellFleming model when it is extended to allow for direct CPI effects of

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 the exchange rate, flexible domestic prices and real wage rigidity.
A) I is true; II is not.
B) II is true; I is not
C) Both I and II are true.
D) Neither I nor II is true.

104. In a small open economy with a flexible exchange rate

I: monetary policy has no effect on real output if the consumer price index is fixed.
II: monetary policy does affect real output if the real wage is fixed.
A) I is true; II is not.
B) II is true; I is not
C) Both I and II are true.
D) Neither I nor II is true.

105. With exchange rate expectations added to the MundellFleming model, a flexible
exchange rate acts _________ as an automatic stabilizer. If the central bank smooths the
exchange rate, participants in the foreign exchange market may react by putting more
weight on recent past values of the exchange rate when forming a forecast of the
exchange rate. This response will _________ exchange-rate volatility.
A) more efficiently; increase
B) less efficiently; increase
C) more efficiently; decrease
D) less efficiently; decrease

106. In a small open economy with a flexible exchange rate, fiscal policy has a smaller effect
on domestic output the ________ the country represents an optimum currency area, and
the __________ rigid are the country's real wages.
A) more; more
B) more; less
C) less; more
D) less; less

107. Assume that the LM curve for a small open economy with a floating exchange rate is
given by Y = 200r 200 + 2(M/P), while the IS curve is Y = 400 + 3G 2T + 3NX
200r. The function for NX is NX = 200 100e, where e is the exchange rate. The price
level (P) is fixed at 1.0. The international interest rate is r* = 2.5 percent.

a. Using the LM curve, find the equilibrium level of Y in the small open
economy, if M = 100.
b. Given this value of Y, if G = 100 and T = 100, what must be the
equilibrium value of NX?

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 c. If this value of NX is to be achieved, what must be the equilibrium
exchange rate, e?

108. Assume that the LM curve for a small open economy with a fixed exchange rate is given
by Y = 200r 200 + 2(M/P). This IS curve is given by Y = 400 + 3G 2T + 3NX 200r.
The function for the net exports is NX = 200 100e, where e is the exchange rate. The
price level is fixed at 1.0, the world interest rate is r* = 2.0 percent, and the exchange
rate is initially 1.0.

a. If M = 100, G = 100, and T = 100, solve for the equilibrium short-run

values of Y and NX. Is the initially given exchange rate equal to the
equilibrium exchange rate?
b. If the central bank buys bonds in order to raise the money supply, will
equilibrium Y increase?

109. Suppose Parliament cuts government spending in order to balance the budget. Use the
MundellFleming model with floating exchange rates to illustrate graphically the short-
run impact of the cuts in government spending on the dollar exchange rate and output in
Canada. Be sure to label:
i. the axes
ii. the curves
iii. the initial equilibrium levels
iv. the direction the curves shift
v. the new short-run equilibrium.

110. Suppose the government of a small open economy with a floating exchange rate
imposes
50 percent tariffs on all imports. Use the MundellFleming model to illustrate
graphically the short-run impact of the tariffs of the exchange rate and output in the
country. Be sure to label:
i. the axes
ii. the curves
iii. the initial equilibrium levels
iv. the direction the curves shift
v. the new short-run equilibrium.

111. In early 1994, Mexico was adhering to a fixed-exchange-rate system. Use the Mundell
Fleming model to illustrate graphically the short-run impact on the exchange rate and
level of output of increased country risk caused by the Chiapas uprising and the
assassination of presidential candidate Colosio. Be sure to label:
i. the axes
ii. the curves

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 iii. the initial equilibrium levels
iv. the direction the curves shift
v. the new short-run equilibrium.

112. a. You are the chief economic adviser in a small open economy with a
floating-exchange-rate system. Your boss, the president of the country,
wishes to increase the level of output in the short run in order to win
reelection. Do you recommend using expansionary or contractionary,
monetary or fiscal policy?
b. Use the MundellFleming model to illustrate graphically your proposed
policy. Be sure to label:
i. the axes
ii. the curves
iii. the initial equilibrium levels
iv. the direction the curves shift
v. the new short-run equilibrium.

113. Economic expansion throughout the rest of the world raises the world interest rate. Use
the MundellFleming model to illustrate graphically the impact of an increase in the
world interest rate on the exchange rate and level of output in a small open economy
with a floating-exchange-rate system. Be sure to label:
i. the axes
ii. the curves
iii. the initial equilibrium levels
iv. the direction the curves shift
v. the new short-run equilibrium.

114. Two small open economies, Fixed and Flex, can be described by the MundellFleming
model. The countries are otherwise identical except that Fixed maintains a fixed
exchange rate, while Flex maintains a flexible exchange-rate regime. The governments
of both countries increase spending by the same amount. Compare what happens in the
two countries to:

a. the exchange rate

b. equilibrium output
c. net exports

115. Macroland is a small open economy with perfect capital mobility and a flexible
exchange-rate system. Macroland is initially in equilibrium at the natural level of output
with balanced trade. Compare the impact of a tax cut in the short run (when prices are
fixed) and in the long run (when prices are flexible) on:

Page 25
 a. output
b. consumption
c. investment
d. net exports
e. the exchange rate.

116. The government of a small open economy with perfect capital mobility wants to
establish a stronger currency by moving its exchange rate higher. Suggest both an
appropriate monetary policy adjustment and an appropriate fiscal policy adjustment that
would allow the economy to move to a higher exchange rate. What are the consequences
of these adjustments on domestic output and net exports?

117. A back-bench MP wants to reduce the Canadian trade deficit by imposing tariffs on
imports. Use a model of a small open economy with a flexible exchange rate to predict
the impact of tariffs on Canadian imports, exports, net exports, the exchange rate, and
the interest rate.

118. The impossible trinity refers to the idea that a country can simultaneously pursue only
two of the three following policies: free international-capital flows, monetary policy for
domestic stabilization, and a fixed exchange rate. For each of the following
combinations indicate what the economy gives up by selecting the combination and why
the omitted policy can not be achieved:

a. a fixed exchange rate and free international-capital flows

b. a monetary policy for domestic stabilization and a fixed exchange rate
c. a monetary policy for domestic stabilization and free international-capital
flows.

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Answer Key

1. C
2. C
3. A
4. D
5. D
6. A
7. C
8. A
9. A
10. B
11. C
12. C
13. C
14. A
15. C
16. D
17. B
18. D
19. B
20. D
21. C
22. B
23. D
24. A
25. B
26. A
27. A
28. C
29. C
30. D
31. B
32. B
33. D
34. C
35. C
36. A
37. D
38. B
39. A
40. B
41. C
42. A
43. D
44. C

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45. D
46. A
47. B
48. D
49. B
50. A
51. D
52. B
53. B
54. D
55. D
56. B
57. A
58. B
59. B
60. C
61. A
62. D
63. B
64. A
65. C
66. B
67. A
68. B
69. C
70. B
71. A
72. D
73. B
74. B
75. A
76. D
77. B
78. A
79. B
80. A
81. C
82. B
83. C
84. C
85. B
86. C
87. B
88. B
89. A
90. C

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 91. A
92. B
93. A
94. D
95. B
96. D
97. B
98. B
99. A
100. D
101. B
102. C
103. A
104. D
105. B
106. B
107. a. equilibrium Y = 500
b. equilibrium NX = 166.67
c. equilibrium e = 1/3
108. a. Equilibrium values are Y = 400 and NX = 100. The initially given
exchange rate is equal to the equilibrium exchange rate.
b. Equilibrium Y will not increase.
109.

110.

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111.

* * * *
The increase in the risk premium shifts IS1 to IS 2 and LM 1 to LM 2 . To maintain the
* *
fixed exchange rate LM 2 must shift to LM 3 .
112. a. expansionary monetary policy
b.

113.

Page 30
114. a. The central bank in Fixed will keep the exchange rate fixed, while the
exchange rate will increase in Flex.
b. Output will increase in Fixed, but will be unchanged in Flex.
c. Net exports will be unchanged in Fixed (because the exchange rate does
not change), but will decrease in Flex (because the exchange rate
increased).
115. a. In both the short run and long run, output is unchanged.
b. Consumption is higher in both the short run and the long run because the
tax cut increases disposable income.
c. Investment is unchanged in the short run and the long run because there
is no change in the world interest rate.
d. In the short run and long run, net exports decrease by the amount that
consumption increases because the exchange rate increases. Starting from
balanced trade, the country will have a trade deficit in the short run and
the long run.
e. In the short run and long run, the exchange rate is higher because the tax
cut puts upward pressure on the domestic interest rate, which attracts
capital inflows and drives up the exchange rate.
116. Contractionary monetary policy would move the economy to a higher exchange rate.
Domestic output would be reduced by the decrease in the money supply, and the higher
exchange rate would reduce net exports.
Expansionary fiscal policy would also move the economy to the higher exchange rate.
The level of domestic output would not change, but the composition of output would
change. The higher exchange rate resulting from either more government spending or
more consumption spending caused by lower taxes would crowd out net exports.
117. The tariffs reduce the demand for imports, raise the demand for net exports, and cause
the exchange rate to appreciate. The higher exchange rate reduces exports by an amount
equal to the decrease in imports, so there is no change in net exports or in the trade
deficit. Since it is a small open economy, there is no change in the interest rate.
118. a. The economy loses the ability to use monetary policy for domestic
stabilization because monetary policy must be used to maintain the fixed
exchange rate.

Page 31
b. The economy must restrict the free flow of international capital to isolate
the determinants of the domestic interest rate from the world interest rate,
so monetary policy can be used to influence the domestic economy and at
the same time fix the exchange rate.
c. The economy can not fix the exchange rate because monetary policy is
used for domestic stabilization rather than to fix the exchange rate. The
free flow of capital ensures that the domestic interest rate is determined
by the world interest rate rather than by domestic monetary policy.

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