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ECN209 International Finance - 2018
Section A
Question 1
Under the Bretton Woods System, an individual country (other than the United States) with
underemployment and excessive current account deficit could achieve both internal balance and
external balance only by implementing expansionary fiscal policy. [Diagrams required] [10 marks]
FALSE.
Internal balance in economics is a state in which a country maintains full employment and price level
stability. It is a function of a country's total output. The condition for internal balance is that full-
employment output equals aggregate demand, which itself is a function of government spending.
The government can directly influence total spending through fiscal policy. Fiscal expansion (a rise in
government spending or a fall in taxation) stimulates aggregate demand and causes output to rise,
even though a fraction of the additional spending goes toward import purchases. Similarly, a
devaluation of the currency (a rise in ) makes domestic goods and services cheaper relative to those
sold abroad and thereby increases demand and output.
External balance signifies a condition in which the country's current account, its exports minus
imports, is neither too far in surplus nor in deficit. It is signified by a level of the current account
which is consistent with the maintenance of existing (or growing) levels of consumption,
employment and national output over the long term. Supposing that the government has a target
value, X, for the current account surplus then the goal of achieving external balance is that it
requires the government to manage domestic spending (through fiscal policy) and the exchange rate
so that the current account equals X.
The II schedule in the diagram below shows combinations of exchange rates and domestic spending
that hold output constant at full employment, and thus maintain internal balance. Along the XX
schedule external balance holds.
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Under the Bretton Woods rules, exchange rate changes (expenditure-switching policy) were
supposed to be infrequent. This left fiscal policy as the main policy tool for moving the economy
toward internal and external balance. But as the figure above shows just fiscal policy is generally
insufficient to attain the two goals of internal and external balance. Only if the economy had been
displaced horizontally from point 1 would fiscal policy be able to do the job alone. Therefore, an
individual currency may not be able to achieve internal and external balance using expansionary
fiscal policy alone.
Question 2. Central banks can only influence the exchange rate by altering the nominal money
supply. [10 marks]
TRUE.
There are a number of key factors which influence the exchange rate.
1. Differentials in Inflation: Typically, a country with a consistently lower inflation rate exhibits
a rising currency value, as its purchasing power increases relative to other currencies.
2. Differentials in Interest Rates: By manipulating interest rates, central banks exert influence
over both inflation and exchange rates, and changing interest rates impact inflation and
ECONOMICS HELP, visit LondonEconomicsTutors.co.uk.
Discounted prices compared to all other websites
ECN209 International Finance - 2018
Section A
Question 1
Under the Bretton Woods System, an individual country (other than the United States) with
underemployment and excessive current account deficit could achieve both internal balance and
external balance only by implementing expansionary fiscal policy. [Diagrams required] [10 marks]
FALSE.
Internal balance in economics is a state in which a country maintains full employment and price level
stability. It is a function of a country's total output. The condition for internal balance is that full-
employment output equals aggregate demand, which itself is a function of government spending.
The government can directly influence total spending through fiscal policy. Fiscal expansion (a rise in
government spending or a fall in taxation) stimulates aggregate demand and causes output to rise,
even though a fraction of the additional spending goes toward import purchases. Similarly, a
devaluation of the currency (a rise in ) makes domestic goods and services cheaper relative to those
sold abroad and thereby increases demand and output.
External balance signifies a condition in which the country's current account, its exports minus
imports, is neither too far in surplus nor in deficit. It is signified by a level of the current account
which is consistent with the maintenance of existing (or growing) levels of consumption,
employment and national output over the long term. Supposing that the government has a target
value, X, for the current account surplus then the goal of achieving external balance is that it
requires the government to manage domestic spending (through fiscal policy) and the exchange rate
so that the current account equals X.
The II schedule in the diagram below shows combinations of exchange rates and domestic spending
that hold output constant at full employment, and thus maintain internal balance. Along the XX
schedule external balance holds.
, FOR MORE HIGH-QUALITY PAST PAPER MODEL ANSWERS, ONLINE TUTORING AND
ECONOMICS HELP, visit LondonEconomicsTutors.co.uk.
Discounted prices compared to all other websites
Under the Bretton Woods rules, exchange rate changes (expenditure-switching policy) were
supposed to be infrequent. This left fiscal policy as the main policy tool for moving the economy
toward internal and external balance. But as the figure above shows just fiscal policy is generally
insufficient to attain the two goals of internal and external balance. Only if the economy had been
displaced horizontally from point 1 would fiscal policy be able to do the job alone. Therefore, an
individual currency may not be able to achieve internal and external balance using expansionary
fiscal policy alone.
Question 2. Central banks can only influence the exchange rate by altering the nominal money
supply. [10 marks]
TRUE.
There are a number of key factors which influence the exchange rate.
1. Differentials in Inflation: Typically, a country with a consistently lower inflation rate exhibits
a rising currency value, as its purchasing power increases relative to other currencies.
2. Differentials in Interest Rates: By manipulating interest rates, central banks exert influence
over both inflation and exchange rates, and changing interest rates impact inflation and
