CEA International Trade and Finance 5 — Questions and Answers
Question 1: The 'gravity model' of international trade predicts that bilateral trade flows are:
- Inversely related to both country GDPs and directly related to distance
- Directly related to both country GDPs and inversely related to distance (Correct answer)
- Unrelated to geographic distance in a globalized economy
- Determined solely by comparative advantage and factor endowments
Correct answer: Directly related to both country GDPs and inversely related to distance
The gravity model shows that trade between two countries increases with their economic sizes (GDPs) and decreases with the distance between them, analogous to Newton's law of gravity.
Question 2: Trade diversion, a potential cost of a preferential trade agreement, occurs when:
- A customs union creates new trade between member countries
- Import sourcing shifts from an efficient non-member to a less efficient member due to tariff preferences (Correct answer)
- A free trade area diverts trade away from services toward goods
- Countries divert export subsidies from domestic to international markets
Correct answer: Import sourcing shifts from an efficient non-member to a less efficient member due to tariff preferences
Trade diversion reduces welfare by shifting purchases from the lowest-cost global producer to a higher-cost partner that benefits from preferential tariff treatment.
Question 3: A country's terms of trade improve when:
- The price of its imports rises relative to its exports
- The price of its exports rises relative to its imports (Correct answer)
- It devalues its currency to boost export volumes
- Import tariffs are raised, reducing import volumes
Correct answer: The price of its exports rises relative to its imports
Terms of trade equal export prices divided by import prices; an increase means the country can buy more imports per unit of exports, improving welfare.
Question 4: The WTO's Most Favored Nation (MFN) principle requires that:
- Developing countries receive preferential market access from all members
- Any trade advantage granted to one member must be extended to all WTO members (Correct answer)
- Countries must liberalize services trade before goods trade
- Trade remedies can only be applied to non-WTO members
Correct answer: Any trade advantage granted to one member must be extended to all WTO members
MFN is the cornerstone of the WTO system, requiring non-discrimination: a tariff concession offered to any one WTO member must be applied equally to all members.
Question 5: Foreign exchange reserves held by a central bank primarily serve to:
- Finance fiscal deficits when tax revenues are insufficient
- Intervene in currency markets and service external debt obligations (Correct answer)
- Back domestic money supply under a fiat currency regime
- Fund sovereign wealth fund investments in foreign equities
Correct answer: Intervene in currency markets and service external debt obligations
Foreign reserves allow central banks to defend the exchange rate through market intervention and provide liquidity to meet external debt obligations during stress.
Question 6: The 'Triffin Dilemma' identified a fundamental problem with which international monetary system?
- The European Exchange Rate Mechanism (ERM)
- The gold standard fixed exchange rate regime
- The Bretton Woods dollar-gold standard (Correct answer)
- The current flexible exchange rate system
Correct answer: The Bretton Woods dollar-gold standard
Triffin showed that under Bretton Woods, the US had to run current account deficits to supply global liquidity, but this would eventually undermine confidence in dollar-gold convertibility.
Question 7: A real effective exchange rate (REER) index is most useful for measuring:
- The bilateral nominal exchange rate between two trading partners
- A country's overall external price competitiveness adjusted for inflation differentials (Correct answer)
- The purchasing power of a currency in a single foreign market
- The forward premium on a currency relative to the US dollar
Correct answer: A country's overall external price competitiveness adjusted for inflation differentials
REER is a trade-weighted average of a country's nominal exchange rates adjusted for relative price levels, making it the standard measure of international competitiveness.
CEA International Trade and Finance 5
The 'gravity model' of international trade predicts that bilateral trade flows are: