Unit 6 · 10 to 13% of the exam

Unit 6 practice test: Open Economy

twelve questions, every option explained

12 exam-style questions from the unit, free, with an explanation for every option. Most are multiple choice, as on the real exam; a few ask for a number or have you shift a curve on a graph, and sets share one data table, graph or scenario. Covers: Balance of Payments Accounts; Exchange Rates; The Foreign Exchange Market; Effect of Changes in Policies and Economic Conditions on the Foreign Exchange Market; Changes in the Foreign Exchange Market and Net Exports; Real Interest Rates and International Capital Flows.

Start at question 1

Scenario

Five transactions for Belvia

Belvia is an invented country. During one year these transactions happen between its residents and the rest of the world:

  1. A Belvian winery ships wine to a store abroad and is paid for it.
  2. A Belvian family sends part of its wages to relatives who live abroad.
  3. A pension fund abroad buys Belvian government bonds.
  4. Belvian tourists pay for hotels during a vacation abroad.
  5. A Belvian carmaker buys a factory in another country.

1. How is transaction 3, the pension fund buying Belvian government bonds, recorded in Belvia's balance of payments?

  1. As a credit (+) in the capital and financial account
  2. As a credit (+) in the current account, like an export
  3. As a debit (-) in the capital and financial account
  4. It is left out, since a bond is not a good or a service
Show the answer

A foreign purchase of a Belvian asset brings money in: a credit in the capital and financial account.

  • Correct: As a credit (+) in the capital and financial account: Right: a foreigner is buying a Belvian asset, so money flows into Belvia and the purchase is a credit in the capital and financial account.
  • As a credit (+) in the current account, like an export: A bond is a financial asset, not a good or service. Asset purchases go in the capital and financial account.
  • As a debit (-) in the capital and financial account: Money comes into Belvia when a foreigner pays for a Belvian bond, so it is a credit, not a debit.
  • It is left out, since a bond is not a good or a service: The balance of payments records every transaction with the rest of the world, asset sales included.

2. How is transaction 5, the carmaker buying a factory abroad, recorded?

  1. As an import of goods, a debit in the current account
  2. As a debit (-) in the capital and financial account
  3. As a credit (+) in the capital and financial account
  4. As income received from abroad in the current account
Show the answer

A resident buying a foreign asset sends money out: a debit in the capital and financial account.

  • As an import of goods, a debit in the current account: A factory is an asset that will produce for years, not a good bought for use now; its purchase is a capital and financial account entry.
  • Correct: As a debit (-) in the capital and financial account: Right: a Belvian resident buys a foreign asset, so money flows out of Belvia, a debit in the capital and financial account.
  • As a credit (+) in the capital and financial account: Money leaves Belvia to pay for the factory, so this is a debit, not a credit.
  • As income received from abroad in the current account: The factory may earn income later, and that income would go in the current account, but buying it is an asset purchase.

3. Suppose transactions 2 and 4 grow larger while nothing else in Belvia's current account changes. What must happen to Belvia's capital and financial account balance?

  1. It rises by the same amount the current account falls
  2. It falls by the same amount as the current account
  3. It stays the same, since transfers and travel are not trade in assets
  4. Belvia's government budget deficit rises by the same amount
Show the answer

Larger debits in the current account lower its balance; since the two accounts sum to zero, the capital and financial account balance rises by the same amount.

  • Correct: It rises by the same amount the current account falls: Right: Belvia pays for the extra transfers and imports by selling more assets to foreigners or borrowing more from them, so the capital and financial account balance rises by the same amount.
  • It falls by the same amount as the current account: The two balances sum to zero, so when one falls the other rises; they cannot fall together.
  • It stays the same, since transfers and travel are not trade in assets: They are not asset trades, but they change the current account, and the capital and financial account must move by the opposite amount to keep the sum at zero.
  • Belvia's government budget deficit rises by the same amount: The budget balance is the government's revenue minus its outlays; it is not part of the balance of payments.

Graph

The market for arls after a change

Quantity of arlsPrice of the arl (bels per arl)D1D2SQXR

4. What happened to the international value of the arl?

  1. It depreciated: each arl buys fewer bels
  2. It appreciated: each arl buys more bels
  3. It did not change, because supply did not shift
  4. It is unclear without the bel market graph
Show the answer

Demand right: the price of the arl rises, so the arl appreciates.

  • It depreciated: each arl buys fewer bels: The new crossing is higher on the vertical axis, so each arl now costs (and buys) more bels.
  • Correct: It appreciated: each arl buys more bels: Right: demand for arls rose, so the price of the arl in bels rose. The arl appreciated.
  • It did not change, because supply did not shift: A shift in demand alone moves the equilibrium price along the supply curve.
  • It is unclear without the bel market graph: This graph shows the price of the arl directly on its vertical axis.

5. What is the matching change in the market for bels?

  1. The supply of bels increases, and the bel depreciates
  2. The demand for bels increases, and the bel appreciates
  3. The supply of bels decreases, and the bel appreciates
  4. Nothing changes, since the shift was in the arl market
Show the answer

More demand for arls is more supply of bels: the arl appreciates as the bel depreciates.

  • Correct: The supply of bels increases, and the bel depreciates: Right: Belvians who want more arls pay for them with bels, so the supply of bels rises and the price of the bel in arls falls.
  • The demand for bels increases, and the bel appreciates: More Belvians selling bels for arls adds to the supply of bels, not the demand.
  • The supply of bels decreases, and the bel appreciates: Belvians are offering more bels, not fewer, to get the arls they want.
  • Nothing changes, since the shift was in the arl market: Every trade of bels for arls shows up in both markets; the bel market shows the mirror change.

6. Which event could have caused the shift shown?

  1. Arland consumers buy more cheese imported from Belvia
  2. Belvian tourists stop visiting Arland
  3. Arland residents buy more Belvian bonds
  4. Belvian consumers buy more phones made in Arland
Show the answer

Demand for arls shifts right when Belvians want more Arland goods, services or assets.

  • Arland consumers buy more cheese imported from Belvia: Arland consumers would supply more arls to get bels, shifting the supply of arls right, not demand.
  • Belvian tourists stop visiting Arland: Fewer tourists from Belvia need fewer arls, which would shift demand for arls left.
  • Arland residents buy more Belvian bonds: Arland residents buying Belvian assets supply arls; that shifts supply right.
  • Correct: Belvian consumers buy more phones made in Arland: Right: Belvians need arls to pay for Arland phones, so demand for arls shifts right.

7. What happened to the quantity of arls traded?

  1. It fell, because the arl became more expensive
  2. It stayed the same, since the price did the adjusting
  3. It rose, along the supply curve
  4. It is unclear without knowing the bel price
Show the answer

Demand right: the quantity of arls traded rises.

  • It fell, because the arl became more expensive: A rise in demand moves the crossing up and to the right along supply, so the quantity rises.
  • It stayed the same, since the price did the adjusting: Both the price and the quantity change when demand shifts along an upward-sloping supply curve.
  • Correct: It rose, along the supply curve: Right: demand shifted right along an upward supply curve, so both the price and the quantity of arls rose.
  • It is unclear without knowing the bel price: The horizontal axis shows the quantity of arls directly.

8. The rate is 2.5 bels per arl. A traveler from Belvia trades 1,000 bels for arls. How many arls does the traveler get?

  1. 2,500 arls
  2. 250 arls
  3. 1,000 arls
  4. 400 arls
Show the answer

1,000 bels / 2.5 bels per arl = 400 arls.

  • 2,500 arls: That multiplies by bels per arl. Bels divided by bels per arl gives arls: 1,000 / 2.5 = 400.
  • 250 arls: That divides by 4, not 2.5. 1,000 / 2.5 = 400 arls.
  • 1,000 arls: That treats the two currencies as worth the same; the rate says one arl costs 2.5 bels.
  • Correct: 400 arls: Right: each arl costs 2.5 bels, so 1,000 bels buy 1,000 / 2.5 = 400 arls.

9. Consumers in Belvia lose interest in cars made in Arland and buy fewer of them. What happens in the market for arls?

  1. Demand for arls falls, so the arl depreciates
  2. Supply of arls falls, so the arl appreciates
  3. Demand for arls rises, so the arl appreciates
  4. Supply of arls rises, so the arl depreciates
Show the answer

A change in tastes abroad away from Arland goods lowers demand for arls.

  • Correct: Demand for arls falls, so the arl depreciates: Right: Belvians need fewer arls to pay for Arland cars, so demand for arls shifts left and the price of the arl falls.
  • Supply of arls falls, so the arl appreciates: Belvian buyers are on the demand side of the arl market; the change is in demand.
  • Demand for arls rises, so the arl appreciates: Fewer purchases of Arland cars mean fewer arls wanted, not more.
  • Supply of arls rises, so the arl depreciates: The arl does depreciate, but through lower demand from Belvian buyers, not more supply from Arland residents.

10. A machine made in Arland is priced at 2,000 arls. The exchange rate moves from 3 bels per arl to 4 bels per arl. By how many bels does the price rise for a buyer in Belvia?

Type a number. A four-function calculator is allowed, as on the exam.

Show the answer

Before: 2,000×3=6,0002{,}000 \times 3 = 6{,}000 bels. After: 2,000×4=8,0002{,}000 \times 4 = 8{,}000 bels. The price rises by 8,000−6,000=2,0008{,}000 - 6{,}000 = 2{,}000 bels, though the arl price did not change.

  • Answer: 2000

11. Bonds in Belvia pay a nominal interest rate of 5%, and expected inflation in Belvia is 1%. What is the real interest rate on Belvian bonds, in percent?

Type a number (%). A four-function calculator is allowed, as on the exam.

Show the answer

Real rate = nominal rate - expected inflation: 5−1=45 - 1 = 4 percent.

  • Answer: 4 %

12. A company based abroad builds a new factory in Arland. How does this enter Arland's balance of payments?

  1. As an export of goods, a credit in the current account
  2. As a debit in the current account, because the factory is foreign-owned
  3. As a debit in the capital and financial account
  4. As a credit in the capital and financial account
Show the answer

Foreign purchases of assets in Arland, real or financial, are credits in the capital and financial account.

  • As an export of goods, a credit in the current account: No good is sold to a foreign buyer; a foreign firm is acquiring a real asset in Arland, a capital and financial account entry.
  • As a debit in the current account, because the factory is foreign-owned: Ownership of an asset is recorded in the capital and financial account, and money flows in, so it is not a debit.
  • As a debit in the capital and financial account: Money flows into Arland to pay for the factory, so this is a credit, not a debit.
  • Correct: As a credit in the capital and financial account: Right: a foreigner acquires an asset in Arland and pays for it, so money flows in: a credit in the capital and financial account.