Page 484 - Krugmans Economics for AP Text Book_Neat

2. Devaluation of a currency will lead to which of the following? 4. Monetary policy that reduces the interest rate will do which of
a. appreciation of the currency the following?
b. an increase in exports a. appreciate the domestic currency
c. an increase in imports b. decrease exports
d. a decrease in exports c. increase imports
e. floating exchange rates d. depreciate the domestic currency
e. prevent inflation
3. Devaluation of a currency is used to achieve which of the
following? 5. Which of the following will happen in a country if a trading
a. an elimination of a surplus in the foreign exchange market partner’s economy experiences a recession?
b. an elimination of a shortage in the foreign exchange market a. It will experience an expansion.
c. a reduction in aggregate demand b. Exports will decrease.
d. a lower inflation rate c. The demand for the country’s currency will increase.
e. a floating exchange rate d. The country’s currency will appreciate.
e. All of the above will occur.

Tackle the Test: Free-Response Questions
1. Suppose the United States and Australia were the only two
1 point: The equilibrium exchange rate and equilibrium quantity of dollars are
countries in the world, and that both countries pursued a
labeled on the axes at the point where the supply and demand curves
floating exchange rate regime. Note that the currency in
intersect.
Australia is the Australian dollar.
a. Draw a correctly labeled graph showing equilibrium in the 1 point: The U.S. interest rate falls.
foreign exchange market for U.S. dollars.
1 point: There is an increase in the capital flow into Australia and an increase
b. If the Federal Reserve pursues expansionary monetary in the capital flow out of the United States.
policy, what will happen to the U.S. interest rate and
1 point: The lower interest rate in the United States reduces the incentive to
international capital flows? Explain.
invest in the United States and increases the incentive to invest in Australia.
c. On your graph of the foreign exchange market, illustrate
the effect of the Fed’s policy on the supply of U.S. dollars, 1 point: The supply of U.S. dollars increases.
the demand for U.S. dollars, and the equilibrium exchange
1 point: The demand for U.S. dollars decreases.
rate.
d. How does the Fed’s monetary policy affect U.S. aggregate 1 point: The exchange rate falls (the U.S. dollar depreciates).
demand? Explain. 1 point: The lower exchange rate leads to more exports from the United
States to Australia (they are cheaper now) and fewer imports into the United
States from Australia (they are more expensive now). When exports increase
Answer (10 points)
and imports decrease, U.S. aggregate demand increases.
Exchange rate
(Australian 1. After the U.S. interest rate 2. Explain how a floating exchange rate system can help insulate
dollars per falls, U.S. investors sell more
U.S. dollar) U.S. dollars in exchange for a country from recessions abroad.
Australian dollars…
S 1
S 2
E 1
XR 1 2. …and Australians
demand fewer U.S.
E 2 dollars with which to
XR 2 invest in the U.S. …
D 1
3. …leading to
a depreciation of D 2
the U.S. dollar.
Q Quantity of U.S. dollars
1 point: The vertical axis is labeled “Exchange rate (Australian dollars per U.S.
dollar)” and the horizontal axis is labeled “Quantity of U.S. dollars.”

1 point: Demand is downward sloping and labeled; supply is upward sloping
and labeled.

442 section 8 The Open Economy: Inter national Trade and Finance