Extra End of Chapter Questions

EXTRA END OF CHAPTER QUESTIONS

McConnell 10E Macroeconomics

Chapter One

1. Is rational self-interest the same thing as selfishness? Explain.

No, they are not the same. Selfishness means that a person is only concerned with himself or herself to the exclusion of others. Rational self-interest simply means that people strive to achieve personal satisfaction. This personal satisfaction can be achieved in many ways, from both selfish and unselfish acts. For example, a person may be unselfish and volunteer time to help other people or make donations to charities because the person derives personal satisfaction from doing so. In this case the person is not being selfish, but is acting to maximize the person’s well-being by helping others.

2. Why are economic theories and principles imprecise? Shouldn’t they apply to everyone?

The main reason is that they are generalizations relating to economic behaviour or the economy. The economic facts used to develop the theories and principles differ from person to person or economic institution to institution. They reflect tendencies or averages across large groups that may not apply to a particular individual. For example, if the price of a product drops significantly, the quantity demanded among consumers as a group is expected to increase, but some consumers may not increase their purchases.

3. Explain the economic fallacy in the statement: “If the Jones family would just cut up their credit cards and live within their means, they’d be better off. And if consumers in this nation cut up their credit cards and lived within their means, the nation would be better off.”

This is an example of the fallacy of composition. Cutting up credit cards may be good for the Jones family depending on their circumstances. If they have taken on too much debt and are in financial trouble, then cutting up credit cards would reduce their impulses to spend money. But if all consumers cut up their credit cards this action would reduce consumer spending in the economy because there would be fewer transactions and it would make the economy less efficient. Economic growth would decline because of the reduced consumer spending. Chapter Two

1 “The two cornerstones of economics are the scarcity of resources and the multiplicity of wants. True economy consists of deriving maximum want satisfaction from available resources.” Explain.

The first statement refers to the basic economic problem: that society’s wants are unlimited relative to the limited supply of productive resources. The second part of the statement refers to the concept of efficiency, both allocative and productive. Since resources are scarce, it is desirable to achieve the most output from those available. Otherwise we waste resources and will not satisfy as many wants as we could from the resources that we have available, which would mean not achieving productive efficiency. Allocative efficiency means the maximum satisfaction of wants with these resources.

2 How are tradeoffs illustrated by the production possibilities curve? Consider the case of federal government spending on national defence and spending on social programs.

In the production possibilities model, an increase in government spending on national defence will come at the expense of government spending on social programs. If the nation wants to be more secure then it will have to give up the opportunities to use its scarce budget resources for social programs. Conversely, if there is more spending on social programs, there will have to be cuts to national defence, assuming that there is a fixed budget constraint. Moving in either direction on the production possibilities curve will involve trading off one desirable public good for another.

3. Explain the relationship between the increase in women in the labour force over the last forty years in Canada and the production possibilities for the economy.

The increase in women in the labour force represents a shift outward in the production possibilities curve. The reason for the shift is that there are now greater labour resources available for production than there were in past decades.

Chapter Three

1. What effect should each of the following have on the demand for gasoline in a competitive market? State what happens to demand. Explain your reasoning in each case and relate it to a demand determinant.

(a) an increase in the number of cars (b) the economy moves into a recession (c) an increase in the price of car insurance, taxes, maintenance (d) consumer expectations of substantial price increases in gasoline

(a) Demand would increase because there would be more buyers of gasoline. The additional buyers would come from the additional cars and trucks. (b) Demand would decrease because consumer and business incomes would fall. Consumer and businesses would have less money to spend on gasoline. (c)Demand would decrease because of increase in the price of complementary goods. Car insurance, car taxes, and car maintenance expenses are complements to gasoline. (d) Current demand for gasoline would increase because expectations about the future have changed and may prompt consumers to “buy now” to beat the future price increases.

2. What effect will each of the following most likely have on the supply of corn in a competitive market? State what happens to supply. Explain your reasoning in each case and relate it to a supply determinant.

(a) the development of an improved corn seed that resists drought conditions (b) an increase in the price of soybeans which can also be planted on land used for growing corn (c) an increase in government payments for growing corn (d) an increase in the price of fertilizer

(a)The supply of corn will increase because of an improvement in the technology of corn production. More bushels of corn will be produced at each and every price. (b) The supply of corn will decrease because of a change in the price of another good that can be produced. Some farmers will no longer use their land to grow corn, but instead will grow soybeans. (c) The supply of corn will increase because of a government subsidy. The government payment reduces the costs of corn production at each and every price. (d) The supply curve for corn will decrease because of a change in the price of a resource. Fertilizer is used to grow corn and it is now more costly to grow corn at each and every price.

3. (Consider This) Is demand more important than supply in determining equilibrium price and quantity in a competitive market? Explain.

Demand and supply are equally important. It is the intersection of the demand and supply curve that determines equilibrium price and quantity. Without demand or without supply there would be no intersection and no price determination. Alfred Marshall likened supply and demand to a pair of scissors. Each blade is needed for the scissors to operate properly and make a cut.

Chapter Four 1. Describe the three major virtues of a market system.

First, the market system promotes efficient use of scarce resources. Products are produced in the least costly way and the products most desired by society get produced. Second, the market system provides incentives for continual improvement and innovation. Rewards are given to entrepreneurs, workers, and consumers who attempt to make the best use of scarce resources. Third, the market system gives great support to individual freedom for producers, consumers, and workers. Each group is able to pursue their own self-interest and thus promote the social interest.

2. Why is there a free-rider problem with public goods?

Most private goods and services are subject to the exclusion principle which is the idea that those who pay for the product are the ones who get it, but those who don’t pay for it are excluded from the benefits provided by that product.

The free-rider problem exists when it is not possible to exclude a person from the benefit of a good even if the person did not pay for its costs. Such is the case with a public good. Once a public good is provided, it is available to all people regardless of whether or not they pay for its cost.

Chapter Five

1. What is the value added by all the firms A–E from the production of a product as described below? What did each firm add separately in value and what does it total?

Stage of production Sales value of product Firm A $4,500 Firm B 8,600 Firm C 14,700 Firm D 20,100 Firm E 32,300

The value added by all firms is $32,300, or the final sales value. Firm A: added $4,500. Firm B: added $4,100. Firm C: added $6,100. Firm D: added: $5,400. Firm E: added $12,200. The value added by all firms totals $32,300 and equals the final sales value by Firm E ($32,300).

2. Which of the following are included and which are excluded in calculating this year’s GDP? Explain in each instance.

(a) A monthly scholarship cheque received by an economics student (b) The purchase of a new truck by a trucking company (c) Government purchase of computers from a private business (d) The purchase of a used tractor by a farmer (e) The value of the purchase of shares of Bombardier by an individual

(a)Scholarships are not included in GDP. They are viewed as financial transactions and would be either a public or private transfer payment depending on the source of funds. They are awards for past performance and would not be included in current production. They don’t represent income earned by providing a productive resource as defined in the GDP accounts. (b) The truck is included because it represents investment. It is a final good that was produced in the current year. (c)The computer purchase is included as part of government spending on goods and services. (d) The used tractor is not included because it was counted when it was new. (e)The value of a stock purchase is not included because it is just a swap of paper assets.

3. (Consider This) Explain how a reservoir can serve as an analogy for thinking about a nation’s capital stock, investment, and depreciation.

The amount of water in a reservoir is a “stock.” It is similar to the stock of capital goods in an economy. The inflow of water to the reservoir is a “flow” and would be similar to gross investment. The outflow of water from the reservoir is also a “flow” and it is similar to depreciation. If the inflow is greater than the outflow, then gross investment is greater than depreciation so there is an addition to the capital stock, or net investment. If the inflow of gross investment is less than depreciation, there is a decline in the capital stock, or negative net investment.

Chapter Six

1. In the table below are statistics showing the civilian non-institutional population, the civilian labour force and total employment in year 1 and year 2. Make the computations necessary to complete the table. (Number of persons is in thousands.)

Year 1 Year 5 Civilian non-institutional population 209,699 211,864 Civilian labour force 140,862 141,815 Employed 135,208 135,973 Unemployed ______Unemployment rate ______(to one decimal place)

Year 1 Year 5 Unemployed 5,654 6742 Unemployment rate 4.0% 4.8% 2. Answer the next four questions based on the following data using year 1 as the base year. All dollars are in billions. Calculate to one decimal place.

Year CPI 1 160 2 165 3 170 4 177

(a)What was the percentage rise in prices between years 1 and 2? (b) What was the percentage rise in prices between years 2 and 3? (c)What was the percentage rise in prices between years 3 and 4?

(a) 3.1% (165 minus 160 divided by 160 equals .031. 0.031 x 100 = 3.1% (b) 3.0% (170 minus 165) divided by 165 equals 0.030. 0.030 x 100 = 3.0% (c) 3.0% (177 minus 170) divided by 170 equals 0.041. 0.041 x 100 = 4.1%

3. (Consider This) How was the practice of clipping coins during feudalism contributing to inflation? Who benefited from this inflation?

As peasants paid their taxes in gold coin, the prince would clip off some of the coin and use the clipping to mint new coins. The additional coins increase the money supply, but the output in the economy was essentially constant. The price level rose because there was “too much money chasing too few goods.” In this case, the inflation benefited the issuers of the coin (the feudal lords) and hurt the peasants.

Chapter Seven

1. Define the multiplier. How is it related to real GDP and the initial change in spending? How can the multiplier have a negative effect?

The multiplier is simply the ratio of the change in real GDP to the initial change in spending. Multiplying the initial change in spending by the multiplier gives you the amount of change in real GDP. The multiplier effect can work in a positive or a negative direction. An initial increase in spending will result in a larger increase in real GDP, and an initial decrease in spending will result in a larger decrease in real GDP.

2. What is the relationship between the multiplier and the marginal propensities?

The multiplier is directly related to the marginal propensities. By definition, the multiplier is related to the marginal propensity to save because it equals 1/MPS. Thus, the multiplier and the MPS are inversely related. The multiplier is also related to the marginal propensity to consume because it also equals 1/ (1–MPC).

3. Explain why saving equals planned investment at equilibrium GDP. It is based on the fact that saving is income not consumed. Saving therefore represents a “leakage” or diversion of potential spending from the income- expenditures stream. Consumption falls short of total output by the amount of saving. However, investment spending can be viewed as an “injection” into this income-expenditures stream. If planned investment is equal to the amount of saving at a particular level of GDP, then leakages equal injections and GDP will be in equilibrium.

4. (Last Word) Explain Say’s law.

Say’s law, attributed to the 19th-century French economist, is that “supply creates its own demand.” Essentially, this theory states that people engage in production in order to be able to buy or demand other things. Whatever one earns from production, one expects to spend on goods and services of equivalent value. Thus, supply (production) has created its own demand. Chapter Eight

1. Define aggregate supply. Describe the characteristics of the aggregate supply curve from long-run and short-run perspectives.

The aggregate supply is a curve that shows the total quantity of goods and services that will be produced (supplied) at different price levels. In the long run, the aggregate supply curve is vertical at the full-employment level of output for the economy because the rise in wages and other inputs will match changes in the price level. In the short run, the aggregate supply curve is upsloping because nominal wages and input prices adjust only slowly to changes in the price level. With this curve, an increase in the price level increases real output and a decrease in the price level reduces real output.

2. Use this aggregate demand–aggregate supply schedule for a hypothetical economy to answer the following questions.

Real domestic Real domestic output demanded output supplied (in billions) Price level (in billions)

$3000 350 $9000 $4000 300 $8000 $5000 250 $7000 $6000 200 $6000 $7000 150 $5000 $8000 100 $4000

(a)What will be the equilibrium price level and quantity of real domestic output? (b) If the quantity of real domestic output demanded increased by $2000 at each price level, what will be the new equilibrium price level and quantity of real domestic output? (c)Using the original data from the table, if the quantity of real domestic output demanded increased by $5000 and the quantity of real domestic output supplied increased by $1000 at each price level, what would the new equilibrium price level and quantity of real domestic output be?

(a) 200 and $6000 (b) 250 and $7000 (c)300 and $9000

Chapter Nine

1. Comment on the statement: “Increasing government spending is preferred to a cut in taxes when the Canadian government seeks to fight a recession.” The statement is a normative one. Either action, increased government spending or taxation, can be use to fight a recession. The policy choice will depend on the preferences of the individual. Those individuals who want to fight a recession with an increase in government spending may want to preserve the size of government in the economy and have specific government programs they would like to see funded. Those individuals who prefer a tax cut may want to reduce the size of government and give people more money and the freedom to spend it as they chose.

2. Explain the problems giving rise to this statement: “You would think the government would want to do something to improve economic conditions when the economy is in trouble, but the government is slow to act.”

Fiscal policy is subject to timing problems. There are three timing lags that limit the speed with which fiscal policy can be enacted and effective. First, there is a lag in recognizing the phase of the business cycle to determine when the government might want to provide help. Second, there is an administrative lag in decision-making that involves deciding which specific policies should be adopted. Third, there is an operational lag because the adoption of policies takes time to have an effect on output and employment.

3. How do expectations about the future by households and businesses affect the effectiveness of fiscal policy? Cite examples.

If households or businesses expect that the fiscal policy changes are only temporary, they may not change their behaviour in the expected way. For example, if tax cuts are enacted to stimulate consumer spending, some consumers may not change their spending habits if they think the tax change is only temporary. In the future, they will have to pay more in taxes, so they might increase their saving. Similarly, businesses may not invest in new plants and equipment if they get a tax cut, if they expect taxes in the future to rise or the fiscal policy to be ineffective.

Chapter 10

1. The following table shows government spending and tax revenue for a hypothetical economy over a five-year period. All figures are in billions.

Year Government Spending Tax Revenues 1 $ 1100 $1050 2 1150 1100 3 1250 1150 4 1250 1300 5 1300 1250

(a)In what years were there budget deficits and what were the amounts? (b) In what year was there a budget surplus and what was the amount? (c)What is the public debt in this economy over the five years? (d) If the size of the economy (GDP) was $6,000 billion what would the public debt in year 5 as a percentage of GDP.

(a)There were budget deficits in year 1 (–$50 billion), year 2 (-$50 billion), year 3 (-$100) and year 5 (-$50) billion. (b) There was budget surplus in year 4 ($50 billion). (c)The public debt was $200 billion. (-$50 -$50 billion -$100 billion +$50 billion –$50 billion) (d) 3.3% ($200 billion/ $6000 billion x 100 = 3.3%)

2. What information would be important for assessing the size of the public debt beside the absolute amount of the public debt?

When the public debt is stated as an absolute amount, the numbers can often be staggering and misleading. The absolute amount, however, needs to be viewed in relation to the size of the economy (its GDP). If GDP is large relative to the public debt, then the nation has the capacity to service that debt. Also, as the economy grows, the debt as a percentage of GDP will tend to fall unless the economy continues to add substantially to the public debt each year with large budget deficits.

Chapter Eleven

1. (Consider This) Are credit cards money? Explain.

Credit cards represent the ability to get an instant loan that can be exchanged for goods or services. At some point, however, that loan must be paid with money (checks or currency). So credit card transactions are short-term loans that must be repaid with money.

2. Explain what policies are used to stabilize the value of money.

Monetary policy is used to regulate the money supply in the economy. If too much money is available for the given level of production of goods and services, this situation can lead to inflation and reduce the value of money. Fiscal policy can also be used to help maintain the value of money. The Canadian government needs to be prudent in its spending and taxing actions (fiscal policy) so that it does not reduce the value of money by running large deficits when the economy is at full-employment.

3. Suppose that a bond having no expiration date has a face value of $5,000 and pays a fixed amount of interest of $500 annually. Compute and enter in the spaces provided the effective interest rate (to one decimal place) that a bond buyer could receive at the new bond price.

Bond price Interest rate (%) $ 3,750 ____ 4,250 ____ 5,750 ____ 6,500 ____

Bond price Interest rate (%) $ 3,750 13.3 4,250 11.8 5,750 8.7 6,500 7.7

Chapter Twelve

1. Using the balance sheet below and assuming a desired reserve ratio of 33%, answer the following: (a) What is the amount of excess reserves? (b) This bank can safely expand its loans by what amount? (c) By expanding its loans by this amount in part (b), its demand deposits would expand to what amount (if all loans were made to cheque account customers)? (d) If cheques clear against the bank equal to the amount loaned in (b), how much would remain in reserves and in checkable deposits?

Assets Liabilities Reserves $ 60,000 Demand Deposits$150,000 Loans 60,000 Capital Stock 300,000 Securities 40,000 Property 290,000

(a) $10,000 because desired reserves are $50,000 (1/3 of $150,000) while actual reserves are $60,000. (b) $10,000 (= $60,000 – 50,000). (c) $160,000 (= $150,000 + 10,000). (d) $50,000 in reserves, $150,000 in demand deposits.

2. Using the balance sheet below and assuming a desired reserve ratio of 20%, answer the following: (a) What is the amount of excess reserves? (b) This bank can safely expand its loans by what amount? (c) By expanding its loans by this amount in part (b), its demand deposits would expand to what amount (if all loans were made to chequing account customers)? (d) If cheques clear against the bank equal to the amount loaned in (b), how much would remain in reserves and in checkable deposits?

Assets Liabilities Reserves $ 40,000 Demand Deposits$100,000 Loans 70,000 Capital Stock 460,000 Securities 50,000 Property 400,000

(a)$20,000 because desired reserves are $20000 (20% of $100,000) while actual reserves are $40,000. (b) $20,000 (= $40,000 – 20,000). (c) $120,000 (= $100,000 + 20,000). (d) $20,000 in reserves, $100,000 in chequable deposits.

Chapter Thirteen

1. One of the advantages of monetary policy is its speed and flexibility, but there are limitations. Explain.

Monetary policy is not subject to an administration lag because once the decision is made action can be taken quickly. The major timing problems are recognition lags that occur because it sometimes take time to recognize or understand that there is a problem that needs to be addressed by a change in monetary policy. Also, there is an operational lag that occurs between the time that the problem is recognized and the monetary policy takes effect. It may take 3 to 6 months for interest rate changes to have the anticipated effect on the economy.

2. Explain the debate over whether monetary policy should be conducted by “artful management” or inflation targeting.

The term “artful management” refers to a discretionary approach to monetary policy to allow policymakers the discretion to set the course of monetary policy based on what they think works best. This discretion permits The Bank of Canada officials to change policy to address price stability, economic growth, unemployment, or other major economic variables. By contrast, inflation targeting would be a more restrictive approach to monetary policy that would set numerical targets for the acceptable range for inflation and then adjust policy to achieve those targets. It is argued that this approach would increase the transparency of monetary policy because one objective would be the focus and it would make Bank of Canada officials more accountable. In this view, achieving the inflation target would be the best way for the Bank of Canada to also achieve full employment and healthy economic growth. Critics of this approach argue that it gives too limited or restrictive of a role to the Bank of Canada and it has not been well-tested as an approach to monetary policy.

Chapter Fourteen

1. Contrast “supply-side” economics with “demand-side” fiscal policy.

“Supply-side” economics advocates the use of government tax or spending policies to alter the supply schedule, that is, the production side of the economy. Tax reductions may have an expansionary effect on aggregate supply as well as aggregate demand. Some economists argue that as taxes are cut, savings and investment will increase. Also tax cuts could be aimed specifically at encouraging business investment such as investment tax credits. “Supply-side” economists also argue that tax increases can reduce tax revenues rather than increasing them due to a leftward shift in the aggregate supply curve which causes a decrease in domestic output.

2. What is supply-side economics? What is the rationale for it? Is it effective?

Some economists argue that a reduction in taxes will expand aggregate supply. From this perspective, fiscal policy can be used to increase real GDP with little or no rise in the price level, as would be the case if tax cuts expanded aggregate demand.

There are three possible reasons for the supply-side effect of tax cuts. First, lower taxes increase disposable income that may increase household saving. They may also stimulate businesses’ investments because they increase the after-tax profitability of businesses. Second, lower taxes also give people more incentive to work because they keep more of their income. Third, lower taxes will encourage more risk-taking and entrepreneurship in society because the after-tax reward has been increased.

Many economists are sceptical about the supply-side effect of tax cuts. The positive effects on incentives to save, invest, or work may not be very large, and therefore the stimulus to the supply-side may be minor. In other words, the demand-side effects of tax cuts appear to be far greater, and more immediate than any of the supply-side effects.

Chapter Fifteen

1. (Consider This) Why do small differences in the rate of economic growth produce large differences in the size of the economy over time? Illustrate with an example.

Small changes in the rate of growth can be very important. Over a period of time small changes are cumulative in the same way that compound interest payments are cumulative in a bank account. Using the rule of 70 to estimate the time it takes to double GDP, we can see that Nation A, whose growth rate is 3 percent takes 23 years to double its GDP, but Nation B whose growth rate is only 2% may take nearly 35 years to double its GDP.

2. Discuss the meaning of the statement: “Human history teaches us that economic growth springs from better recipes, not just more cooking.”

Economic growth arises largely from increases in labour productivity (“better recipes”) rather than increases in the quantity of labour inputs (“more cooking”). Among the most important factors increasing labour productivity, accounting for some 40 percent of this factor, is technological advance. It includes not only new innovations in production but also better managerial techniques that improve the process of production.

3. How does investment in capital goods and infrastructure contribute to economic growth? Capital goods (plant, equipment, tools) are needed by workers to be more productive. New investment in capital goods helps workers produce more goods and services per work hour, thus increasing labour productivity. Labour productivity is a key factor of economic growth. Infrastructure is also important because there is a need for public capital goods (highways, harbours, bridges, educational facilities) that help businesses and their workers get the job done sooner. For example, if the highway infrastructure is poor, it will be more difficult for businesses to get their products to market and it will require more work time on the part of their workers, thus reducing labour productivity.

Chapter Sixteen

1. Suppose that by devoting all of its resources to the production of rice (R), Japan can produce 40 units. By devoting all of its resources to corn (C), it can produce 20 units. Comparable figures for Mexico are 15 units of rice (R) and 15 units of corn (C). Explain why each nation will specialize in which product. What are the limits to the terms of trade?

In Japan, the cost of producing 1 C is 2 R (20 C = 40 R) given the stated cost conditions. In Mexico, the cost of producing 1 C is only 1 R. Thus, in terms of opportunity costs or the amount of R that must be given up to get each C, Mexico can produce units of C more cheaply. Therefore, Mexico should produce Cs and Japan should produce units of R, and Mexico should trade away some of its C to Japan for some of the units of R produced in Japan.

The limits to the terms of trade are set by the cost ratio in each country. In other words, it is to Japan’s advantage to trade away units of R for as many units of C as it can get above the lower limit of 0.5 C, which is what each R costs in Japan. However, Mexico will not be willing to trade more than one C for each R since any more than that could be gotten more cheaply by producing them at home. Therefore the limits to the terms of trade will be between 0.5 C and 1 C for each R. And Mexico will be able to get between 1 R and 2 R for each C.

2. (Consider This) Why is a trade war like shooting yourself in the foot?

A trade war between Nation X and Nation Y is destructive to the economies of both nations. If Nation X boycotts or slaps protective tariffs on the imports from Nation Y, then Nation Y will not be able to export as many goods and services. The economy of Nation Y will suffer and there will be less income. As a consequence, Nation Y will not be able to import as many goods and services from Nation X, so the economy of Nation X will suffer. So trade wars hurt both nations by reducing imports and exports of each nation. A trade war has no winners and only losers. It is like shooting yourself in the foot. 3. What five trade liberations is the World Trade Organization seeking to get adopted?

After the 1994 Uruguay “round” of trade agreements, the World Trade Organization was formed by 120 nations to oversee the agreements and get them implemented by 2005. The major provisions of the agreements included: (1) widespread reduction in tariffs worldwide; (2) new rules to promote the growing trade in services; (3) plans to cut subsidies in agriculture; (4) the inclusion of protection for intellectual property rights— patents, trademarks, copyrights—in trade rules; and (5) phased reduction in quotas on textiles and apparel.

Chapter Seventeen

1. How are changes in one currency mirrored in changes in some other foreign currency?

Currencies are linked because an appreciation in the value of one currency means that there has been a depreciation in the value of another currency. Conversely, if there is a depreciation in the value of one currency, then there has been an appreciation in the value of another currency. So if one currency rises in value, the other currency must fall in value and vice versa.

2. Describe how changes in tastes affect the value of a nation’s currency.

If consumer preferences for the products of a foreign nation change, then the demand for and supply of that country’s currency will change. If the demand for British clothing increases, then the demand for British pounds will increase causing the pound to appreciate. If the demand for British clothing declines, then the demand for British pounds will decrease causing the pound to depreciate. Conversely, if British preferences regarding some other country’s products change, then the supply of British pounds will change accordingly.

3. Explain how changes in relative income affect the value of a nation’s currency.

If a foreign nation’s income rises more rapidly than other nations’ incomes, then its expenditures on imports are likely to grow along with expenditures on everything else. This will probably cause the currency to depreciate as other nations are not growing as rapidly, and therefore, their demand for the nation’s currency is not keeping pace with the change in supply. The reverse would be true if the nation’s income grew more slowly than other nations’ incomes.

4. Do changes in relative price-levels affect the value of a nation’s currency?

If prices in one country rise relatively more than in another, the currency in the higher-priced country is likely to depreciate as domestic consumers seek less expensive foreign imports and increase the demand for foreign currency. At the same time demand for domestic currency will fall since foreigners will find it less attractive to buy the higher-priced country’s goods. This, too, adds to the depreciation of the higher-priced country’s currency.

5. Explain how changes in relative real interest rates affect the value of a nation’s currency.

Higher relative real interest rates in one country will cause an increase in demand for the currency of that country or an appreciation of that country’s currency as foreign investors seek higher rates of return. The reverse would be true of lower relative real interest rates.

6. (Consider This) How can the Big Mac index be used to explain purchasing power parity theory?

The index shows the prices of a Big Mac in currencies of other nations. If a Big Mac costs $3.00 in the Canada and 300 yen in Japan, the exchange rate based on Big Mac prices in the two nations should be $1 = 100 yen. If the actual exchange rate was $1.00 equals 110 yen, then the dollar is overvalued and the yen is undervalued. The dollar will depreciate and the yen will appreciate.