CEA International Trade and Finance 3 — Questions and Answers
Question 1: Which of the following best describes 'Dutch disease' in international economics?
- A contagious financial crisis spreading across borders
- Currency appreciation from a resource boom crowding out manufacturing exports (Correct answer)
- Excessive foreign debt from natural resource imports
- A trade war triggered by commodity subsidies
Correct answer: Currency appreciation from a resource boom crowding out manufacturing exports
Dutch disease refers to the deindustrialization that occurs when a natural resource boom appreciates the exchange rate, making other exports less competitive.
Question 2: The 'impossible trinity' (trilemma) in international finance states that a country cannot simultaneously maintain:
- Low inflation, full employment, and a trade surplus
- A fixed exchange rate, free capital mobility, and independent monetary policy (Correct answer)
- Fiscal balance, current account balance, and stable growth
- A pegged currency, low interest rates, and high reserves
Correct answer: A fixed exchange rate, free capital mobility, and independent monetary policy
The Mundell-Fleming trilemma holds that only two of three goals—fixed exchange rate, capital mobility, and monetary autonomy—can be achieved at the same time.
Question 3: Intra-industry trade is best explained by which theory?
- Heckscher-Ohlin factor endowments
- Ricardian comparative advantage
- New Trade Theory emphasizing economies of scale and product differentiation (Correct answer)
- Classical absolute advantage
Correct answer: New Trade Theory emphasizing economies of scale and product differentiation
New Trade Theory explains intra-industry trade (exporting and importing similar goods) through increasing returns to scale and consumer demand for variety.
Question 4: A country imposes a countervailing duty. This trade measure targets:
- Imports priced below fair market value (dumping)
- Imports subsidized by a foreign government (Correct answer)
- Exports that violate intellectual property rights
- Imports that threaten national security
Correct answer: Imports subsidized by a foreign government
Countervailing duties are imposed to offset the competitive advantage gained by foreign producers who receive government subsidies.
Question 5: Under a currency board arrangement, the domestic money supply is:
- Determined solely by domestic monetary policy
- Fully backed by foreign exchange reserves at a fixed rate (Correct answer)
- Allowed to float within a managed band
- Determined by IMF conditionality requirements
Correct answer: Fully backed by foreign exchange reserves at a fixed rate
A currency board ties the domestic money supply directly to foreign reserve holdings, leaving no discretion for independent monetary policy.
Question 6: The Transfer Pricing problem in multinational corporations arises because MNCs may manipulate prices on intra-firm transactions to:
- Comply with WTO anti-dumping rules
- Shift profits to lower-tax jurisdictions (Correct answer)
- Increase bilateral trade volumes artificially
- Satisfy host country local content requirements
Correct answer: Shift profits to lower-tax jurisdictions
MNCs can manipulate transfer prices on goods and services traded between subsidiaries to shift taxable profits to low-tax countries.
Question 7: The 'home bias' puzzle in international finance refers to the observation that:
- Investors hold far more domestic assets than international diversification theory predicts (Correct answer)
- Countries import more from neighbors than from distant trading partners
- Central banks prefer to hold gold over foreign currency reserves
- Domestic firms prefer domestic suppliers despite higher costs
Correct answer: Investors hold far more domestic assets than international diversification theory predicts
The home bias puzzle is the empirical finding that investors hold a disproportionately large share of domestic assets despite the gains from international portfolio diversification.
CEA International Trade and Finance 3
Which of the following best describes 'Dutch disease' in international economics?