Question

In this section, describe each statement as true, false or uncertain and explain your answer. Each question is worth X marks: all of the marks are for explanation, none, for the true, false or uncertain. Answers should be brief.

a) If a country has a floating exchange rate, then the fact that it has a high nominal interest rate (relative to world nominal interest rates) will make it attractive to international investors seeking high returns.

b) A country with a negative trade balance and no official exchange intervention must necessarily have a surplus in the financial account.

c) A country can have an absolute advantage in the production of a good, but not have a comparative advantage.

d) If a country unilaterally reduces the tariff rate on an imported good, this will necessarily lead to an improvement in domestic welfare.

e) If country A’s ten-year sovereign bonds have a higher yield than those of country B’s, even though the exchange rate between the two country’s is fixed, this indicates that market participants do not believe that the exchange rate will remain fixed.

Answer 1

A).

The given statement is FALSE. As we know according to the “UIP” under the flexible exchange rate regime the rate of return should be same in same currency. Now, if the “home country” has higher rate of return compare to the foreign country then “exchange rate” will adjust in such a way that the rate of return will be same in same currency, => home country may have higher nominal interest rate in local currency but that will be in common currency system.

B).

The given statement is TRUE. Now, under the flexible exchange rate the “BoP” will be always in balance, => if trade balance will be in deficit, => the financial account should be in surplus and vice versa, => the above statement is TRUE.

C).

The given statement is FALSE. The “absolute advantage” depends on the productivity of two or different goods and the comparative advantage depends on the opportunity cost. So, it may happen that a country have absolute advantage in all goods or don’t have any absolute advantage but it should have comparative advantage in at least one goods because it take into account the opportunity cost.

D).

Here the result will be uncertain. Increase in tariff will increase welfare if the “TOT effect” of tariff out weight the “dead weight loss” created by tariff. Similarly decrease in tariff will also increase the welfare if “TOT effect” is lower than the “dead weight loss” effect. So, here the effect is completely uncertain.