TEST YOURSELF

2.  Items a and c would add to the U.S. deficit. Item b would add to the surplus, as would item e if the proceeds from the sale are brought home.  Item d would not affect the balance of payments because the car is produced and sold in the United States.

DISCUSSION QUESTIONS

2.   As the dollar appreciates, less dollars have to be given up in exchange for a given quantity of euros, and therefore in dollar terms the German camera becomes less expensive. Consequently, Americans buy more German cameras and they therefore demand more euros. Remember that an appreciation of the dollar is equivalent to a depreciation of the euro. Therefore, the American demand curve for the euro slopes downward; as the euro becomes less expensive, Americans demand more of them.

3.   The purchasing-power parity theory predicts that the dollar would depreciate relative to the mark, because of the higher U.S. inflation rate. In fact, however, between 1980 and 1985, the dollar appreciated considerably in comparison to the mark.

6.   The Bretton Woods conference established a system of fixed exchange rates in order to restore confidence in the international economic system and promote trade, after the volume of international trade had collapsed in the 1930s. It was thought that fixed rates would reduce the risks inherent in international trade, and consequently encourage more of it. The flaw that led to the collapse of the system in 1971 was that the United States was running massive balance of payments deficits but could not devalue because the dollar was tied to gold, and the surplus nations refused to revalue. Eventually, President Nixon cut the tie of gold to the dollar, and this left exchange rates free to float.

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