Unit 5: International Economics

Answer: A — The correct answer is A because when countries trade based on comparative advantage, they export goods they can produce at a lower opportunity cost and import goods that would be more costly to produce domestically. In this scenario, the country has a comparative advantage in wheat, so it will export wheat, and it has a comparative disadvantage in textiles, so it will import textiles. Options B, C, and D are incorrect because they do not align with the principles of comparative advantage and international trade.

Answer: A — When a currency depreciates (decreases in value), it takes more of that currency to buy foreign goods, but foreign buyers need less of their currency to buy exports from that country. Therefore, when the euro depreciates against the dollar, European goods become cheaper for American and other international buyers, making European exports more competitive. Option B is incorrect because depreciation makes imports MORE expensive, not cheaper—European consumers would need more euros to buy American goods. Option C is incorrect because currency depreciation does not automatically trigger central bank policy responses; policy decisions are made independently based on various economic factors. Option D is incorrect because currency depreciation alone does not motivate relocation of manufacturing facilities; other factors like labor costs and infrastructure matter more. This question tests understanding of how exchange rates affect international trade competitiveness.

Answer: A — The correct answer is A. Country Z has a balance of payments surplus of $5 billion ($50B current account surplus minus $45B capital account deficit). This surplus means more foreign currency is flowing into the country than leaving it, creating excess demand for Country Z's currency. Without central bank intervention, this excess demand will cause the currency to appreciate. A stronger currency makes the country's exports more expensive for foreign buyers and imports cheaper for domestic consumers, which predictably reduces the current account surplus over time—this is the automatic adjustment mechanism in flexible exchange rate systems. Option B is incorrect because a currency appreciation (not depreciation) is what occurs with a balance of payments surplus. Additionally, the relationship between currency movement and the capital account is more complex than stated. Option C is misleading. While the balance of payments does sum to zero by accounting identity, this is only true when including the official reserve account (central bank interventions). Without intervention, temporary imbalances occur that cause currency movements. Option D is partially correct in identifying appreciation but incorrectly suggests the currency will then depreciate solely due to the capital account deficit. The capital account deficit is already reflected in the current $5 billion surplus. The currency appreciation itself will be the primary mechanism causing the current account to adjust downward over time.

Answer: A — The correct answer is A. When U.S. interest rates rise relative to other countries, foreign investors are attracted to dollar-denominated assets offering higher returns. This increased demand for dollars causes the dollar to appreciate. A stronger dollar makes U.S. goods more expensive for foreign buyers (fewer yen, euros, etc. needed to purchase each dollar), reducing export competitiveness and worsening the trade deficit. This represents a real understanding of the interest rate-exchange rate-trade balance transmission mechanism. Option B is incorrect because it describes the opposite effect—higher U.S. rates actually attract capital inflows, not outflows. Option C is partially correct in identifying dollar appreciation but incorrectly suggests this improves the trade deficit; appreciation actually worsens it by making exports less competitive (though it does make imports cheaper). Option D is incorrect because interest rate differentials are a primary driver of capital flows and exchange rate movements in modern financial markets. This question requires students to trace through multiple economic relationships rather than apply a single concept.

Answer: A — This question requires understanding the interaction between tariff policy, capital flows, and exchange rate dynamics under a flexible exchange rate system. Option A is correct because it accurately traces the causal chain: (1) tariffs reduce imports, improving the current account; (2) FDI inflows represent capital account surpluses that increase demand for the domestic currency; (3) this increased demand appreciates the exchange rate; (4) the appreciation makes exports more expensive for foreign buyers, creating an offsetting negative effect on the current account. This is the "impossible trinity" problem in modified form—the nation cannot simultaneously maintain import protection, attract foreign investment, and preserve export competitiveness under flexible rates. Option B is incorrect because capital inflows appreciate (not depreciate) the currency, a fundamental error about exchange rate mechanics. Option C is incorrect because FDI is not necessarily discouraged by tariffs on imports; tariffs often attract FDI as foreign firms establish production within the tariff wall. Option D is incorrect because it ignores exchange rate mechanics entirely and falsely assumes the currency won't respond to capital flows. A well-prepared student must understand balance of payments accounting and how flexible exchange rates clear imbalances through price adjustments.