International Economics, 10e (Krugman/Obstfeld/Melitz) Chapter 21 (10) Optimum Currency Areas and the Euro



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International Economics, 10e (Krugman/Obstfeld/Melitz)

Chapter 21 (10) Optimum Currency Areas and the Euro
21.1 How the European Single Currency Evolved
1) The European Economic and Monetary Union

A) set up a single currency and sole bank for European economic monetary policy.

B) eliminated all barriers to trade such as tax differentials between borders.

C) produced a single government for handling European affairs.

D) created the Common Agricultural Pact.

E) eliminated all local currencies in Western Europe.

Answer: A

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Difficulty: Easy
2) The birth of the Euro

A) resulted in fixed exchange rates between all EMU member countries.

B) resulted in flexible exchange rates between all EMU member countries.

C) resulted in crawling-peg exchange rates between all EMU member countries.

D) resulted in non currency board exchange rates between all EMU member countries.

E) resulted in floating exchange rates between all EMU member countries.

Answer: A

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Difficulty: Easy
3) Which of the following is TRUE?

A) All European countries are part of the EMU.

B) All Western European countries are part of the EMU.

C) Originally, 20 countries joined the EMU on January 1999.

D) No Western European countries are part of the EMU.

E) Not all Western European countries are part of the EMU.

Answer: E

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Difficulty: Easy
4) The EMU created a currency area with more than

A) 200 million consumers.

B) 250 million consumers.

C) about a billion.

D) 500 million consumers.

E) 300 million consumers.

Answer: E

Page Ref: 634-641

Difficulty: Easy

5) The EU countries were prompted to seek closer coordination of monetary policies and greater exchange rate stability in order

A) to enhance Europe's role in the world monetary system.

B) to turn the European Union into a truly unified market.

C) both to enhance Europe's role in the world monetary system and to turn the European Union into a truly unified market.

D) both to turn the European Union into a truly unified market and to counter the rise of Japan in international financial markets.

E) to homogenize all European cultures.

Answer: C

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Difficulty: Easy


6) Which of the following statements is TRUE?

A) The 1957 Treaty of Rome founded the EU and created a custom union.

B) The 1957 Treaty of Rome founded the EU.

C) The 1957 Treaty of Rome founded the euro.

D) The 1957 Treaty of Rome founded the European Central Bank.

E) The 1957 Treaty of Rome founded the Stability and Growth Pact. known as SGP.

Answer: A

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Difficulty: Easy
7) The credibility theory of the EMS implies in effect that the political costs of violating international exchange rate agreements

A) cannot restrain governments from depreciating their currency.

B) can restrain governments from depreciating their currency.

C) cannot restrain governments from depreciating their currency in the short run.

D) cannot restrain governments from depreciating their currency in the long run.

E) can control the political policies of member nations.

Answer: B

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Difficulty: Easy
8) The credibility theory of the EMS implies in effect that the political costs of violating international exchange rate agreements

A) cannot restrain governments from depreciating their currency to gain the short-term advantage of an economic boom at the long-term cost of higher inflation.

B) can restrain governments from depreciating their currency to gain the short-term advantage of an economic boom at the long-term cost of higher inflation.

C) cannot restrain governments from depreciating their currency in the short run.

D) cannot restrain governments from depreciating their currency in the long run.

E) cannot restrain governments from depreciating their currency to gain the long-term advantage of an economic boom.

Answer: B

Page Ref: 634-641

Difficulty: Easy

9) Under the EMS, Germany set the system's

A) monetary policy while the other European countries pegged their currencies to the DM.

B) fiscal policy while the other European countries pegged their currencies to the DM.

C) monetary policy while the other European countries kept their currencies fluctuating relative to the DM.

D) fiscal policy while the other European countries kept their currencies fluctuating relative to the DM.

E) monetary policy, while other European countries maintained their traditional policies.

Answer: A

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Difficulty: Easy


10) An inflation-prone country

A) gains from vesting its monetary policy decisions with a "conservative" central bank.

B) loses from vesting its monetary policy decisions with a "conservative" central bank.

C) gains from vesting its fiscal policy decisions with a "conservative" central bank.

D) loses from vesting its fiscal policy decisions with a "conservative" central bank.

E) remains constant when vesting its fiscal policy decisions with a "conservative" central bank.

Answer: A

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Difficulty: Easy
11) The most important feature of the Single European Act of 1986, which amended the founding Treaty of Rome, was dropping the requirement of

A) unanimous consent for measures related to market completion and making it a decision that only Germany and France agreed about.

B) unanimous consent for measures related to market completion.

C) majority consent for measures related to market completion and making it a decision that only Germany and France agreed about.

D) unanimous consent for measures related to agricultural policies only.

E) unanimous consent for measures related only to fiscal policies.

Answer: B

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Difficulty: Easy
12) The 1991 Maastricht Treaty can be best described as

A) a peace treaty between Europe and the United States.

B) an agreement for the accession of the Netherlands into the EU.

C) an agreement for the creation of a free trade area.

D) a provision for the introduction of a single European currency and European central bank.

E) the beginning of a floating exchange rate European monetary system.

Answer: D

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Difficulty: Easy

13) During the period from 1978-2012, the difference between annual inflation rates of EU countries and the German inflation rate

A) grew at an accelerating rate.

B) remained fairly constant.

C) largely disappeared.

D) went through periods of hyperinflation.

E) trended upward at a declining rate.

Answer: C

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Difficulty: Easy


14) How many countries are in the EU as of January 1, 2014?

A) 9


B) 15

C) 17


D) 18

E) 25


Answer: D

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Difficulty: Easy
15) Did the 1957 Treaty of Rome turn the EU into a truly unified market?

A) Yes, it paved the way for the current EMU.

B) No, although it established a customs union, it failed to remove barriers to the movement of goods and factors within Europe.

C) No, it was only after the German unification and locating the ECB in Frankfurt that unity was achieved.

D) No, since the Northern members of the EU had larger endowments of capital and skilled labor.

E) No, the Treaty of Rome created more trade barriers between European countries.

Answer: B

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Difficulty: Easy
16) The German central bank in the European Monetary System, 1979-1998

A) was very inflation-averse.

B) was moderately inflation-averse.

C) was willing to accept inflation.

D) lacked control over inflation since it had fixed its exchange rate.

E) lacked sufficient reserves.

Answer: A

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Difficulty: Easy

17) The result of the reunification of eastern and western Germany in 1990

A) was a boom in Germany and higher inflation, with no effect on nearby countries.

B) was a recession in Germany and lower inflation, with no effect on nearby countries.

C) was a boom in Germany and higher inflation, and, with other EMS countries' commitment to fixed exchange rates, a deep recession in nearby countries.

D) was a recession in Germany and lower inflation, and, with other EMS countries' commitment to fixed exchange rates, a deep recession in nearby countries.

E) was a recession in Germany and lower inflation, causing a boom in nearby countries.

Answer: C

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Difficulty: Easy


18) The credibility theory of EMS had as an effect

A) the inflation rates of member countries converging to the low German levels, a result that was not matched by similar countries who did not fix their exchange rates.

B) the inflation rates of member countries failing to converge to the low German levels.

C) the inflation rates of member countries converging to the low German levels, but other countries including U.S. and Britain also reduced inflation in this time period without fixing exchange rates.

D) the inflation rate in Germany rose to match the inflation rates of other member countries.

E) the inflation rate in the U.S. dropped to the low German levels.

Answer: C

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Difficulty: Easy
19) How and why did Europe set up its single currency?

Answer: The why part is because large fluctuations in the exchange rates among the European countries disturbed trade. Also, one of the main reasons was to design a way to prevent future world war. The how part of the question is related to the collapse of Bretton Woods and the European Currency reform of 1969-1978. The Werner Report of 1971 establishes three-phase program to lead to the EMU.

Page Ref: 634-641

Difficulty: Moderate


20) How did the European single currency evolved?

Answer: The answer is related to the collapse of Bretton Woods and the European Currency reform of 1969-1978. The Werner Report of 1971 establishes three-phase program to lead to the EMU.

Page Ref: 634-641

Difficulty: Moderate


21) What prompted the EU countries to seek closer coordination of monetary policies and greater exchange rate stability in the late 1960s?

Answer: (1) To enhance Europe's role in the world monetary system

(2) To turn the European Union into a truly unified market

Page Ref: 634-641

Difficulty: Moderate

22) Discuss the effects of the reunification of eastern and western Germany in 1990 on both Germany and its neighboring European countries.

Answer: Germany: boom, high interest rates to fight inflation. Other European countries: France, Italy and UK in recession, trying to match the high German interest rates to hold their currencies fixed against Germany's, thereby pushing their economies into deep recession. Other European countries tried to continue the fixed exchange rate in order not to lose the credibility they had build up since 1985. The policy conflict between Germany and the other European countries led to a series of fierce speculative attacks on the EMS exchange parities starting in September 1992. By august 1993, the EMS was forced to retreat to very wide (± 10 percent) bands, which is kept in force until the introduction of the euro in 1993.

Page Ref: 634-641

Difficulty: Difficult
23) Explain why the EMS countries decided to fix their exchange rates against the German DM.

Answer: In this way, the other EMS countries in effect imported the credibility of the German central bank in fighting inflation, thus discouraging the development of inflationary pressures at home.

Page Ref: 634-641

Difficulty: Moderate


24) Explain the credibility theory of the EMS.

Answer: In this way, the other EMS countries in effect imported the credibility of the German central bank in fighting inflation, thus discouraging the development of inflationary pressures at home. This is known as the credibility theory of the EMS.

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Difficulty: Moderate


25) Explain how the German Bundesbank gained its low-inflation reputation.

Answer: Mainly, Germany's experience with hyperinflation on the 1920s and again after World War II left the German electorate with a deeply rooted fear of inflation. The law establishing the Bundesbank singled out the defense of the DM's real value as the primary goal of the German central bank.

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Difficulty: Moderate


26) Describe the main provisions of the Maastricht Treaty of 1991.

Answer: Called for a single currency by January 1, 1999, harmonizing social security policy within the European Union, and centralizing foreign and defense policy decisions.

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Difficulty: Easy


27) Why did the EU countries move away from the EMS toward the goal of a single shared currency?

Answer:


(1) To produce a greater degree of European market integration by removing the threat of EMS currency realignments.

(2) Reduce German dominance of the EMS monetary policy.

(3) Given the move to complete freedom of capital movements within the EU, fixed but adjustable currency parities, may lead to ferociously speculative attacks, as in 1992-1993.

(4) To guarantee the political stability of Europe.

Page Ref: 634-641

Difficulty: Moderate

28) Describe the effects of the reunification of eastern and western Germany in 1990 on both Germany and its neighboring European countries using the AA-DD framework.

Answer: As for Germany a period of boom with high interest rates to fight inflation.

Other European countries: France, Italy and UK in recession, trying to match the high German interest rates to hold their currencies fixed against Germany's, thereby pushing their economies into deep recession. Other European countries tried to continue the fixed exchange rate in order not to lose the credibility they had build up since 1985. The policy conflict between Germany and the other European countries led to a series of fierce speculative attacks on the EMS exchange parities starting in September 1992. By August 1993, the EMS was forced to retreat to very wide (± 10 percent) bands, which was kept in force until the introduction of the euro in 1993.

Page Ref: 634-641



Difficulty: Moderate
29) What is the purpose of the following figure?

Answer: The purpose of the figure is to show the inflation convergence within the six original EMS members. The figure shows the difference between domestic inflation and German inflation for six of the original EMS members. As of 1997 all national inflation rates were very close to the German levels. See Figure 20 in the textbook for a more updated figure.

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Difficulty: Moderate

21.2 The Euro and Economic Policy in the Euro Zone


1) To join the EMU, a country should have no more than

A) 1.5 percent inflation rate above the average of the three EU member states with the highest inflation.

B) 3 percent inflation rate above the average of the three EU member states with the lowest inflation.

C) 4 percent inflation rate above the average of the three EU member states with the lowest inflation.

D) 1.5 percent inflation rate above the average of the three EU member states with the lowest inflation.

E) 2 percent inflation rate above the average of the three EU member states with the lowest inflation.

Answer: D

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Difficulty: Easy
2) To join the EMU, a country must have

A) a public-sector deficit no higher than 3 percent of its GDP in general.

B) a public-sector deficit no higher than 2 percent of its GDP in general.

C) a public-sector deficit no higher than 1 percent of its GDP in general.

D) a zero public-sector deficit.

E) a public-sector deficit no higher than 4 percent of its GDP in general.

Answer: A

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Difficulty: Easy
3) To join the EMU, a country must have a public debt below or approaching a reference level of

A) 50 percent of its GDP.

B) 10 percent of its GDP.

C) 60 percent of its GDP.

D) 100 percent of its GDP.

E) 5 percent of its GDP.

Answer: C

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Difficulty: Easy
4) The European Central Bank has its headquarter in

A) London.

B) Berlin.

C) Frankfurt.

D) Paris.

E) Brussels.

Answer: C

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Difficulty: Easy

5) Under ERM 2 rules, the national central bank of an EU member with its own currency can suspend euro intervention operations

A) if there is a civil war.

B) if they result in money supply changes that threaten to destabilize the domestic price level.

C) if there is a current account deficit.

D) if there is a current account surplus.

E) if they result in a weakened current account.

Answer: B

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Difficulty: Easy


6) The main function of the 1997 Stability and Growth Pact (SGP) was to

A) exclude a highly indebted EMU country

B) enhance cooperation between France and Germany.

C) make the Euro a weak currency.

D) distribute the Euro banknote among European central banks and to create a timetable for the imposition of financial penalties on countries that fail to correct situations of "excessive" deficits and debt promptly enough.

E) determine specialized penalties for each member nation.

Answer: C

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Difficulty: Easy
7) How were the initial members of EMU chosen? How will new members be admitted? What is the structure of the complex of financial and political institutions that govern economic policy in the euro zone?

Answer: EU countries should satisfy:

(1) Low inflation rate (no more than 1.5 percent above the average of the three EU member states with the lowest inflation).

(2) A stable exchange rate within the ERM.

(3) Public-sector deficit no higher than 3 percent of its GDP in general.

(4) A public debt below or approaching a reference level of 60 percent of its GDP.

Page Ref: 641-643

Difficulty: Difficult


21.3 The Theory of Optimum Currency Areas
1) What are the biggest advantages the U.S. has over the EU in terms of being an Optimum Currency Area?

A) low mobility of labor, higher labor productivity, lower level of intra-regional trade

B) high unionization of U.S. Labor force

C) high mobility of labor force, more transfer payments between regions

D) higher uniformity of population's taste in consumption

E) more specialized labor force and natural resource advantages

Answer: C

Page Ref: 643-654

Difficulty: Easy

2) A major economic

A) benefit of fixed exchange rates is that they simplify economic calculations and provide a more predictable basis for decisions that involve international transactions than do floating rates.

B) benefit of floating exchange rates it that they simplify economic calculations and provide a more predictable basis for decisions that involve international transactions than do fixed rates.

C) cost of fixed exchange rates it that they simplify economic calculations and provide a more predictable basis for decisions that involve international transactions than do currency board rates.

D) benefit of flexible exchange rates it that they simplify economic calculations and provide a more predictable basis for decisions that involve international transactions than do crawling peg rates.

E) benefit of fixed exchange rates is that the value of goods will remain constant across a large region of consumers.

Answer: A

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Difficulty: Easy


3) The efficiency

A) gain from a fixed exchange rate with the euro is smaller when trade between say, Norway and the euro zone, is extensive than when it is small.

B) gain from a fixed exchange rate with euro is greater when trade between say, Norway and the euro zone, is extensive than when it is small.

C) loss from a fixed exchange rate with the euro is smaller when trade between say, Norway and the euro zone, is extensive than when it is small.

D) gain from a fixed exchange rate with euro is the same as when trade between say, Norway and the euro zone, is extensive than when it is small.

E) gain from a fixed exchange rate with euro is the same as when trade between say, Norway and the euro zone, is small than when it is small.

Answer: B

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Difficulty: Easy
4) The monetary efficiency

A) loss from pegging the Norwegian krone to the euro (for example) will be higher if factors of production can migrate freely between Norway and the euro area.

B) gain from pegging the Norwegian krone to the euro (for example) will be lower if factors of production can migrate freely between Norway and the euro area.

C) gain from pegging the Norwegian krone to the euro (for example) will be higher if factors of production can not migrate freely between Norway and the euro area.

D) gain from pegging say the Norwegian krone to the euro (for example) will be higher if factors of production can migrate freely between Norway and the euro area.

E) gain or loss from pegging the Norwegian krone to the Euro cannot be predicted using the available information.

Answer: D

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Difficulty: Easy

5) Which one of the following statements is TRUE?

A) The less extensive are cross-border trade and factor movements, the greater is the gain from a fixed cross-border exchange rate.

B) The more extensive are cross-border trade and factor movements, the greater is the loss from a fixed cross-border exchange rate.

C) The more extensive are cross-border trade and factor movements, the greater is the gain from a fixed cross-border exchange rate.

D) The more extensive are cross-border trade, the greater is the loss from a fixed cross-border exchange rate.

E) The more extensive are factor movements, the greater is the loss from a fixed cross-border exchange rate.

Answer: C

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Difficulty: Easy


6) A country that joins an exchange rate area

A) gives up its ability to use the exchange rate for the purpose of stabilizing output and employment.

B) does not give up its ability to use the exchange rate and monetary policy for the purpose of stabilizing output and employment.

C) gives up its ability to use the exchange rate and monetary policy for the purpose of stabilizing output and employment.

D) gives up its ability to use only monetary policy for the purpose of stabilizing output and employment.

E) does not gives up its ability to use only monetary policy for the purpose of stabilizing output and employment.

Answer: C

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Difficulty: Easy
7) When the economy is disturbed by a change in the output market

A) a fixed exchange rate has an advantage over a flexible rate.

B) a floating exchange rate has an advantage over a fixed rate.

C) a crawling peg exchange rate has an advantage over a flexible rate.

D) a floating exchange rate has the same effect as fixed rate.

E) a flexible exchange rate is not as effective as a fixed exchange rate.

Answer: B

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Difficulty: Easy

8) Which one of the following statements is TRUE?

A) A fixed exchange rate automatically cushions the economy's output and employment by allowing an immediate change in the relative price of domestic and foreign goods.

B) A flexible exchange rate does not automatically cushions the economy's output and employment by allowing an immediate change in the relative price of domestic and foreign goods.

C) A flexible exchange rate automatically cushions the economy's output and employment by allowing an immediate change in the relative price of domestic and foreign goods.

D) A flexible exchange rate automatically cushions the economy's output and employment by allowing an immediate change in the absolute price of domestic and foreign goods.

E) A fixed exchange rate automatically cushions the economy's output and employment by allowing an immediate change in the absolute price of domestic and foreign goods.

Answer: C

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Difficulty: Easy


9) When the exchange rate is

A) flexible, purposeful stabilization is more difficult because monetary policy has no power at all to affect domestic output and employment.

B) fixed, purposeful stabilization is less difficult because monetary policy has no power at all to affect domestic output and employment.

C) fixed, purposeful stabilization is more difficult because monetary policy has no power at all to affect domestic output and employment.

D) a crawling peg, rather than fixed, purposeful stabilization is more difficult because monetary policy has no power at all to affect domestic output and employment.

E) fixed rather than crawling peg purposeful stabilization is more difficult because fiscal policy has no power at all to affect domestic output and employment.

Answer: C

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Difficulty: Easy
10) When Norway unilaterally fixes its exchange rate against the euro and leaves the krone

A) free to float against the non-euro currencies, it is able to keep at least some monetary independence.

B) free to float against the non-euro currencies, it is unable to keep at least some monetary independence.

C) free to float against the non-euro currencies, it is able to keep its monetary independence.

D) run by crawling peg against the non-euro currencies, it is able to keep at least some monetary independence.

E) fixed against the non-euro currencies, it is unable to keep its monetary independence.

Answer: B

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Difficulty: Easy

11) After Norway unilaterally pegs the krone to the euro, domestic money market disturbances will

A) no longer affect domestic output despite the continuation of float-rate regime against non-euro currencies.

B) now have major effect on domestic output despite the continuation of float-rate regime against non-euro currencies.

C) have some effect on domestic output despite the continuation of float-rate regime against non-euro currencies.

D) have major effect on domestic employment despite the continuation of float-rate regime against non-euro currencies.

E) no longer affect foreign imports despite the continuation of float-rate regime against non-euro currencies.

Answer: A

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Difficulty: Easy


12) A krone/euro peg alone is

A) not enough to provide automatic stability in the face of any monetary shocks that shift the AA schedule.

B) enough to provide automatic stability in the face of any monetary shocks that shift the AA schedule.

C) not enough to provide automatic stability in the face of any monetary shocks that shift the AA schedule, provided fiscal policy will be used as well.

D) enough to provide automatic stability in the face of any monetary shocks that shift the AA schedule, provided the government runs a budget deficit.

E) enough to provide partial stability in the face of smaller monetary shocks that shift the AA schedule.

Answer: B

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Difficulty: Easy
13) Since Norway has close trading links with the euro zone

A) a small reduction in its price will lead to an increase in euro zone demand for Norwegian goods that is large relative to Norway's output. Thus, full employment can be restored fairly quickly.

B) a small reduction in its price will lead to a decrease in euro zone demand for Norwegian goods that is large relative to Norway's output. Thus, full employment can be restored fairly quickly.

C) a small reduction in its price will lead to an increase in euro zone demand for Norwegian goods that is small relative to Norway's output. Thus, full employment can be restored fairly quickly.

D) a big reduction in its price will lead to an increase in euro zone demand for Norwegian goods that is large relative to Norway's output. Thus, full employment can be restored fairly quickly.

E) a big reduction in its price will lead to a decrease in euro zone demand for Norwegian goods that is small relative to Norway's output. Thus, full employment can be restored fairly quickly.

Answer: A

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Difficulty: Easy

14) If Norway's labor and capital markets are highly correlated with those of its euro zone neighbors

A) unemployed workers can easily move abroad to find work and domestic capital can be shifted to more profitable uses in other countries.

B) unemployed workers cannot easily move abroad to find work and domestic capital cannot be shifted to more profitable uses in other countries.

C) while unemployed workers can easily move abroad to find work, domestic capital cannot be shifted to more profitable uses in other countries.

D) while capital can easily move abroad to be put to a more profitable use, unemployed workers cannot easily move abroad to find work.

E) unemployment will rise, thanks to competition from foreign labor.

Answer: A

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Difficulty: Easy


15) The ability of factors to migrate abroad

A) reduces the severity of unemployment and the fall in the rate of return available to investors.

B) increases the severity of unemployment and the fall in the rate of return available to investors.

C) reduces the severity of unemployment but increases the fall in the rate of return available to investors.

D) cannot change the severity of unemployment and the constant rate of return available to investors.

E) reduces the migration of highly-skilled workers.

Answer: A

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Difficulty: Easy
16) Which one of the following statements is TRUE for Norway, a non-euro country?

A) Of course, owners of capital that cannot be moved cannot avoid more of the economic stability loss due to fixed exchange rates when Norway's economy is open to capital flows.

B) Even owners of capital that cannot be moved can avoid more of the economic stability loss due to fixed exchange rates when Norway's economy is open to capital flows.

C) Owners of capital that cannot be moved can avoid more of the economic stability loss due to fixed exchange rates when Norway's economy is closed to capital flows.

D) Even owners of capital that can be moved can avoid more of the economic stability loss due to fixed exchange rates when Norway's economy is closed to capital flows.

E) Only owners of capital that can be moved can avoid more of the economic stability loss due to fixed exchange rates when Norway's economy is open to capital flows.

Answer: B

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17) The intersection of GG and LL determines

A) the optimal level of integration desired by Norway.

B) the maximum integration level desired by Norway.

C) the minimum level of integration that will cause Norway to join the fixed exchange rate regime.

D) the maximum level of integration that will cause Norway to join the fixed exchange rate regime.

E) the maximum level of integration that can aid Norway if it joins the fixed exchange rate regime.

Answer: C

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Difficulty: Easy


18) The level of fiscal federalism in the European Union is

A) too big to cushion member countries from adverse economic events.

B) too small to cushion member countries from adverse economic events.

C) appropriate to cushion member countries from adverse economic events.

D) too big relative to the one in the U.S.

E) similar in its level to that of the U.S.

Answer: B

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Difficulty: Easy
19) A good measure of a country's level of economic integration with a currency area is

A) the intersection of DD and GG.

B) the country's price level.

C) the compatibility of economic policies.

D) the intersection of AA and GG.

E) the extent of trade between the joining country and the currency area and the ease with which labor and capital can migrate between the joining country and the currency area.

Answer: E

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Difficulty: Easy
20) A key barrier to labor mobility within Europe is

A) the laziness of Germans.

B) full employment in most European countries.

C) differences in language and culture.

D) lack of transportation.

E) the physical barriers in the landscape.

Answer: C

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Difficulty: Easy

21) Which of the following statements is MOST accurate?

A) The countries of southern Europe are better endowed with capital and skilled labor than the countries of northern Europe.

B) The countries of northern Europe are better endowed with capital and skilled labor than the countries of southern Europe.

C) EU products that make intensive use of high-skill labor are most likely to come from Portugal.

D) EU products that make intensive use of low-skill labor are most likely to come from Great Britain.

E) The countries of eastern Europe are better endowed with capital and skilled labor than the countries of western Europe.

Answer: B

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22) A recent study by Andrew Rose of the University of California showed that, on average, two countries that are members of the same currency union

A) trade three times as much with each other as countries that do not share a currency.

B) trade twenty times as much with each other as countries that do not share a currency.

C) trade ten times as much with each other as countries that do not share a currency.

D) trade six times as much with each other as countries that do not share a currency.

E) trade twice as much with each other as countries that do not share a currency.

Answer: A

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Difficulty: Easy
23) Fiscal federalism in the EU refers to

A) one nation's control of the monetary policy of all the other nations.

B) freedom of member countries to leave the EU at any time.

C) the transfer of economic resources from members with healthy economies to those suffering economic setbacks.

D) one nation's freedom to abandon the Euro and use its own currency.

E) the transfer of economic resources between members with healthy economies.

Answer: C

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Difficulty: Easy
24) Shortly after their admission into the EMU, Ireland and the Netherlands

A) both seceded from the EMU.

B) were expelled due to high levels of debt.

C) breached the inflation convergence criterion that had qualified them for admission to the EMU in the first place.

D) achieved inflation rates of zero percent.

E) abandoned the Euro as their national currency.

Answer: C

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Difficulty: Easy

25) Which of the following best defines an optimum currency area?

A) a group of nations sharing the same currency

B) a group of regions in close proximity to each other.

C) a group of regions who operate under similar economic policies.

D) a group of regions with economies closely linked by factor mobility and by trade in goods and services

E) a group of nations that engage in free trade with each other

Answer: D

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26) Which of the following statements is MOST accurate?

A) A rise in the size and frequency of country-specific disturbances to the joining country's product markets raises the critical level of economic integration at which the exchange rate area is joined.

B) A rise in the size and frequency of country-specific disturbances to the joining country's product markets lowers the critical level of economic integration at which the exchange rate area is joined.

C) A decline in the size and frequency of country-specific disturbances to the joining country's product markets raises the critical level of economic integration at which the exchange rate area is joined.

D) A rise in the size and frequency of country-specific disturbances to the joining country's product markets has no effect on the critical level of economic integration at which the exchange rate area is joined.

E) A decline in the size and frequency of country-specific disturbances to the joining country's product markets does not affect the level of economic integration at which the exchange rate area is joined.

Answer: A

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27) Which of the following statements is MOST accurate?

A) A low degree of economic integration between a country and the fixed exchange rate area that it joins reduces the resulting economic stability loss due to output market disturbances.

B) A high degree of economic integration between a country and the fixed exchange rate area that it joins reduces the resulting economic stability loss due to output market disturbances.

C) A high degree of economic integration between a country and the fixed exchange rate area that it joins increases the resulting economic stability loss due to output market disturbances.

D) A complete lack of economic integration between a country and the fixed exchange rate area that it joins reduces the resulting economic stability loss due to output market disturbances.

E) A low degree of economic integration between a country and the fixed exchange rate area that it joins increases the resulting economic stability loss due to output market disturbances.

Answer: B

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28) The theory of optimum currency areas predicts that

A) floating exchange rates are most appropriate for areas closely integrated through international trade and factor movements.

B) fixed exchange rates are most appropriate for areas that are loosely integrated through international trade and factor movements.

C) fixed exchange rates are most appropriate for areas closely integrated through international trade and factor movements.

D) floating exchange rates are most appropriate for all countries in Europe.

E) fixed exchange rates are most appropriate for all countries in Europe.

Answer: C

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29) Why does the GG schedule have a positive slope?

A) The monetary efficiency gain a country gets by joining a fixed exchange rate area falls as its economic integration with the area increases.

B) The monetary efficiency gain a country gets by joining a fixed exchange rate area rises as its economic integration with the area decreases.

C) The monetary efficiency gain a country gets by joining a fixed exchange rate area rises as its economic integration with the area increases.

D) The monetary efficiency gain a country gets by joining a floating exchange rate area rises as its economic integration with the area increases.

E) The monetary efficiency gain a country gets by joining a fixed exchange rate area is constant after their integration into the area.

Answer: C

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30) Why does the LL schedule have a negative slope?

A) The economic stability loss from pegging to the area's currencies rises as the degree of economic interdependence rises.

B) The economic stability loss from pegging to the area's currencies falls as the degree of economic interdependence rises.

C) The economic stability loss from pegging to the area's currencies falls as the degree of economic interdependence falls.

D) The economic stability loss from pegging to the area's currencies rises as the degree of economic activity increases.

E) The economic stability loss from pegging to the area's currencies is constant, even as the degree of economic activity increases.

Answer: B

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31) Compared with inter-regional trade in the he United States, intra-EU trade

A) is far greater.

B) is greater.

C) is about the same.

D) is less.

E) is far less.

Answer: D

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32) When did the UK decide to adopt the Euro?

A) 1999

B) 2001


C) 2008

D) The UK has not adopted the Euro.

E) 2010

Answer: D

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33) Which of the following statements is the MOST accurate?

A) Trade of EU countries with other EU countries has increased since the euro was introduced.

B) Trade of EU countries with other EU countries has decreased since the euro was introduced.

C) Trade of EU countries with other EU countries has increased in some years and decreased in other years since the euro was introduced.

D) Trade of EU countries with other EU countries can no longer be measured since both trading parties have the same currency.

E) Trade of EU countries with North American countries has decreased since the euro was introduced.

Answer: A

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34) Richard Baldwin's estimate was that the euro increased the trade level of its users by

A) only 5 percent.

B) only 9 percent.

C) over 30 percent.

D) over 50 percent.

E) only 12 percent.

Answer: B

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35) "The costs and benefits for a country from joining a fixed-exchange rate area such as the EMS depend on how well-integrated its economy is with those of its potential partners." Discuss.

Answer: We will expand on this idea, which is roughly the theory of an optimum currency area as developed by Mundell. A major economic benefit of fixed exchange rates is that they simplify economic calculations and provide a more predictable basis for decisions that involve international transactions than do floating rates. This gain in monetary efficiency would be even higher if the factors of production could migrate freely. The costs of joining a fixed-exchange rate area is that a country gives up the ability to use the exchange rate and monetary policy to stabilize the domestic economy. So, if a country has a well-integrated economy with those in the fixed-exchange rate area, then the benefits would likely outweigh the costs.

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36) Discuss the benefits and costs of joining a fixed-exchange area.

Answer: Benefits: In general, gains from the stability of the area and reduced uncertainty. The efficiency gain from a fixed exchange rate with euro is greater when trade between, say Norway and the euro zone, is extensive than when it is small. A major economic benefit of fixed exchange rates it that they simplify economic calculations and provide a more predictable basis for decisions that involve international transactions than do floating rates. The monetary efficiency gain from pegging, say the Norwegian krone to the euro, will be higher if factors of production can migrate freely between Norway and the euro area. The more extensive are cross-border trade and factor movements, the greater is the gain from a fixed cross-border exchange rate.

Costs: A country that joins an exchange rate area gives up its ability to use the exchange rate and monetary policy for the purpose of stabilizing output and employment. When the economy is disturbed by a change in the output market, a floating exchange rate has an advantage over a fixed rate. A flexible exchange rate automatically cushions the economy's output and employment by allowing an immediate change in the relative price of domestic and foreign goods. When the exchange rate is fixed, purposeful stabilization is more difficult because monetary policy has no power at all to affect domestic output and employment.

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37) Explain why when Norway unilaterally fixes its exchange rate against the euro but leaves the krone free to float against the non-euro currencies, it is unable to keep at least some monetary independence.

Answer: Any independent money supply change in Norway would put pressure on krone interest rates and thus on the krone/euro exchange rate. So by pegging the krone even to a single foreign currency, Norway completely surrenders its domestic monetary control.

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38) Explain why after, say Norway unilaterally pegs the krone to the euro, domestic money market disturbances will no longer affect domestic output despite the continuation of float-rate regime against non-euro currencies.

Answer: Because Norway's interest rate must equal the euro interest rate, any pure shifts in the AA curve (see chapter 19) will result in immediate reserve inflows or outflows that leave Norway's interest rate unchanged.

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39) Explain why even owners of capital that cannot be moved can avoid more of the economic stability loss due to fixed exchange rates when Norway's economy is open to capital flows.

Answer: The main reason is through diversification. If Norway's capital market is integrated with those of the EMU neighbors, Norwegians will invest some of their wealth in other countries while at the same time part of Norway's capital stock will be owned by foreigners.

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40) Explain why the oil price shocks after 1973 made countries unwilling to revive the Bretton Woods system of fixed exchange rates. See also Chapter 19.

Answer: Using the GG-LL framework will help solve this question. The oil price shock of 1973 pushes the LL curve upward and to the right. Thus, the level of economic integration at which it becomes worthwhile to join the currency rises. In general, increase variability in the product markets makes countries less willing to enter fixed exchange rate areas. This prediction helps explain why the oil price shocks after 1973 made countries unwilling to revive the Bretton Woods system of fixed exchange rates.

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41) Explain why it may make sense for the United States, Japan, and Europe to allow their mutual exchange rate to float?

Answer: Even though these regions trade with each other, the extent of that trade is modest compared with regional GDPs and interregional labor mobility is low.

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42) Is Europe an optimum currency area?

Answer: An open question. I think yes, the area's economy is closely integrated with its own: most EU members export from 10 to 20 percent of their output to other EU members. But still, the law of one price does not apply to many products such as the auto market. In 1998, prices for the BMW 520i varied by as much as 29.5 percent between the United Kingdom and the Netherlands. Prices for the Ford Fiesta varied as much as 43.5 percent between the United Kingdom and Portugal!

The text is more critical, claiming: "The extent of intra-European trade is not large enough, however, to give us an overwhelming reason for believing the European Union itself is an optimum currency area." Also, the text cites the fact that may be price convergence has more to do with Internet marketing than optimum currency area. The book concludes that on balance, it seems doubtful that the 1992 measures have yet pushed Europe dramatically closer to being an optimum currency area.

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43) How mobile is Europe's labor force?

Answer: Differences in language and cultural discourage labor movements between European countries. Differences in regional unemployment rates are smaller and less persistent in the United States than are differences between national unemployment rates in the European Union. Even, within European countries, labor mobility appears limited, partly because of government regulations. For example, the requirement in some countries that worker establish residence before receiving unemployment benefits makes it harder for unemployed workers to seek jobs in regions that are far from their current homes.

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44) How much trade do currency unions create?

Answer: The main result is that currency unions promote trade. One study found that on average, two countries that are members of the same currency union trade three times as much with each other as countries that do not share a currency. Even if the euro were to raise trade within the euro zone by 50 percent, the positive effect on people's welfare could be immense, as another study has shown. However, some challenge the conclusion. Some claim the results would not be duplicated when applied to large countries such as the members of the EU; another study found out that leaving a common currency area as Ireland did has not caused reduction in UK-Ireland trade.

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45) Explain why the European Union's current combination of rapid capital migration with limited labor migration may actually raise the cost of adjusting to product market shocks without exchange rate change?

Answer: If the Netherlands suffers an unfavorable shift in output demand, Dutch capital can flee abroad, leaving even more unemployed Dutch workers behind than in the case of government regulations that were to hinder the movement of capital outside the Netherlands. Severe and persistent regional depressions could result, worsened by the likelihood that the relatively few workers who did successfully emigrate would be precisely those who are most skilled, reliable, and enterprising. This is another example of the theory of the second best.

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46) "Given that labor remains relatively immobile within Europe, the European Union's success in liberalizing its capital flows may have worked perversely to worsen the economic stability loss due to the process of monetary unification." Discuss.

Answer: Probably right. This is another example of the theory of the second best. If the Netherlands suffers an unfavorable shift in output demand, Dutch capital can flee abroad, leaving even more unemployed Dutch workers behind than in the case of government regulations that were to hinder the movement of capital outside the Netherlands. Severe and persistent regional depressions could result, worsened by the likelihood that the relatively few workers who did successfully emigrate would be precisely those who are most skilled, reliable, and enterprising.

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47) Explain what the GG-LL model tells us about the benefits of extensive trade between EU member states and comment on the significance of similarity of economic structure in this framework.

Answer: The GG-LL model shows that extensive trade with the rest of the euro zone makes it easier for a member to adjust to output market disturbances that affect it and its currency partners differently. A key element in minimizing such disturbances is similarity in economic structure, especially in the types of products produced. Euro zone countries are, in fact, not entirely dissimilar in the manufacturing structure, as evidenced by the very high volume of intraindustry trade. The hope is that any difference in EU member country factor endowments will be minimized by the completion of a single European market and the redistribution of capital and labor across Europe. This will bring about the desired similarity of economic structure.

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48) Explain the theory of optimum currency areas.

Answer: The theory implies that countries will wish to join fixed exchange rate areas closely linked to their own economies through trade and factor mobility. This decision to join is, in turn, determined by the difference between the monetary efficiency gain from joining and the economic stability loss from joining. These factors are both related to the degree of economic integration between the joining country and the larger fixed exchange rate zone. Only when economic integration passes a critical level is it beneficial to join.

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49) What is one way to offset the economic stability loss due to fixed exchange rates?

Answer: Fiscal federalism is one solution in which the EU transfers economic resources from members with healthy economies to those suffering economic setbacks. These transfer payments come in the form of welfare benefits, and they are usually financed by the taxes that other member states pay. Ultimately, the extent of fiscal federalism is limited by the EU's restricted taxation powers.

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50) Using the GG-LL framework, analyze the effect of an increase in the size and frequency of sudden shifts in the demand for a country's exports.

Answer: Such a change pushes LL upward and to the right. Thus, the level of economic integration at which it becomes worthwhile to join the currency rises. In general, increased variability in the product markets makes countries less willing to enter fixed exchange rate areas. This prediction helps explain why the oil price shocks after 1973 made countries unwilling to revive the Bretton Woods system of fixed exchange rates. See also Chapter 19.

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51) Using the GG-LL framework, analyze the effect of Libya subsidizing the Pakistani Nuclear programs.

Answer: This will shift the GG curve upward and to the left causing the two countries to trade more, thus reducing the minimum value for the two countries to cooperate under a fixed exchange rate regime.

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52) Draw the graph of the GG and LL schedules and explain the logic behind the slopes of each of the schedules.

Answer: The correct graph has "degree of economic integration between the joining country and the exchange rate area" on the x-axis, and "gains and losses for the joining country" on the y-axis. The GG curve has a positive slope since the monetary efficiency gain a country gets by joining a fixed exchange rate area rises as its economic integration with the area increases. The LL curve has a negative slope because the economic stability loss from pegging to the area's currencies falls as the degree of economic interdependence rises. The two curves cross at a point that determines the critical level of economic integration (1 between the fixed exchange rate area and the country considering joining. In other words, it is the minimum integration level at which the country will join. (See Figure 20-5 in the text.)



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53) Discuss the trends and implications of the following graph, especially with respect to the official start of the EMU on January 1, 1999.

Answer: The extent of intra-EU country trade has fluctuated since the mid-1980s, but the pronounced growth of this trade after the start of the EMU suggests that the adoption of the single euro currency may have encouraged commerce among EU countries, moving them closer to forming an optimum currency area.

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21.4 The Euro Crisis and the Future of EMU
1) Discuss the problems that the EMU will continue to experience in the coming years.

Answer: (1) Europe is not an optimum currency area; therefore asymmetric economic developments within different countries of the euro zone that call for different interest rates cannot be implements. (2) The political part of the unification is much weaker and may limit the political legitimacy of the economic unification. (3) On the one hand, labor markets remain highly unionized and subject to high government unemployment taxes and other regulations impeding labor mobility. On the other hand, capital has high incentive to migrate to the EMU countries with the lowest wages. (4) Constraints on national fiscal policy are likely to be painful due to the absence of substantial fiscal federalism (fiscal transfer of resources from the rich to the less rich countries within the European Union) within the EU. (5) The EU is considering a large-scale expansion of its membership into Eastern Europe and the Mediterranean. This will cause many coordination costs and also the issue of representation of small and big countries.

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2) Which one of the following countries was the "spark" that ignited the 2009 euro crisis?

A) China


B) Greece

C) England

D) Spain

E) Germany

Answer: B

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3) Which one of the following unexpected events ignited the 2009 euro crisis?

A) Accelerating hyperinflation and political upheaval.

B) The prospect of a sovereign default by one or more euro zone countries.

C) Rising oil prices.

D) Revolutions in Switzerland and Belgium.

E) A Chinese boycott of European products.

Answer: B

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Difficulty: Easy
4) What behavior by central and private banks in euro zone countries created the conditions for the 2009 euro crisis?

Answer: Assets were accumulated by the banks through the purchase of US financial products and through lending to other euro zone countries. Easy credit led to a European housing boom. Following the global financial crisis and the consequent recession, some European countries such as Greece Ireland Portugal Italy and Spain were found to have unsustainable levels of debt relative to national GDP. This raised the specter of a sovereign default by one or more euro zone countries and the crisis was on.

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5) During the 2009 euro crisis, a number of countries had private banks that had become too "big to save." Explain.

Answer: A private bank is too big to save if the resources available to the home government through the central bank are insufficient to prevent bank failure. Essentially, saving the private bank would lead to a sovereign default by a countries government and so was not feasible.

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6) What led to the over-extension of credit by some private banks and central banks in the euro zone prior to the 2009 euro crisis?

Answer: Differences in interest rates in euro zone countries did not accurately represent differences in risk and inflation. Consequently banks were able to borrow at very low real interest rates while assuming relatively high levels of default risk. Once it became apparent that sovereign default and private bank failures were not only possible but likely in some countries, borrowing costs skyrocketed in those countries. In some cases, credit was cut off entirely.

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7) What event in 2009 ignited the euro crisis?

Answer: Greece elected a new government in 2009 which found that the previous government had been misreporting economic statistics for years and the public debt amounted to more than 100% of GDP. It became apparent that Greece would experience a sovereign default unless bailed out by the European Central Bank or some other source of credit.

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8) Is the United States in danger of a sovereign default because, like countries in the euro zone, it has high current account deficits and levels of public debt?

Answer: No. The United States has a central bank that can print money as needed to service its debt. It is in no danger of default. Euro zone countries, on the other hand, do not have individual central banks capable of printing money to pay off debt. Instead the European Central Bank and all member countries must collectively agree on monetary policy. Countries that have managed their affairs prudently are understandably unwilling to support the profligate behavior of other countries.

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9) How do constraints on monetary policy in the United States differ from those experienced by euro zone countries?

Answer: United States monetary policy constraints are quite different from those encountered by countries in the euro zone. The US can print dollars to pay off debts as necessary and, while the result might be a higher rate of inflation, it makes it virtually impossible for the US to default on its public debts. Euro countries have a European Central Bank that must make decisions regarding monetary policy that will affect all of the euro zone countries. One possibility that has been discussed is to make it possible to conditionally remove countries from the euro zone to prevent the destruction of the monetary union. Note that this would be equivalent to the United States deciding to remove a state from the union if the state threatened bankruptcy.

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10) What is the "doom loop" responsible for the rapid development and severity of the 2009 euro crisis?

Answer: The "doom loop" refers to the feedback loop that runs from private bank distress to central bank distress to further private bank distress and so on, increasing in magnitude as it goes. During the euro crisis this process was evident in several euro zone countries.

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11) What is the "three-pronged approach" to organizing a banking union?

Answer: Centralize financial supervision, create a deposit insurance fund, and provide mechanisms for the resolution of insolvent banks within the euro area.

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Difficulty: Moderate

12) What is fiscal federalism?

Answer: Fiscal federalism in the euro zone involves establishing a larger centralized budget managed by a central fiscal authority with the capability to tax, spend, and issue euro bonds.

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13) Describe the single supervisory mechanism or SSM proposed by EU leaders in June of 2012.

Answer: The SSM involved granting the European Central Bank the power to police banks throughout the euro zone and the ability to re-capitalize banks directly if needed.

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14) Describe the policy of "outright monetary transactions" or 0MT presented by the president of the European Central Bank in 2012.

Answer: The ECB is now committed to purchase sovereign bonds of euro zone countries, potentially without limit, in order to control interest rates in the euro zone.

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15) Is the EU an optimum currency area? Why or why not?

Answer: Europe is not an optimum currency area. Labor mobility is highly limited. Economic and political conflicts within the euro zone have been persistent and they continue to result in questions regarding the ability of the euro zone to survive going forward.

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Difficulty: Moderate



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