AP Macroeconomics Open Economy: International Trade and Finance — Worked Answer Explanations

Unit 6 · 12 questions explained

Below is a complete answer key for our AP Macroeconomics Open Economy: International Trade and Finance practice questions. For each question you'll find the correct choice, a full written explanation of how to get there, and — for every wrong answer — a short note on exactly why it's tempting and where it goes wrong. Reading these straight through is one of the fastest ways to find the gaps in a unit before exam day.

Prefer to test yourself first? Take the timed Open Economy: International Trade and Finance practice test and come back here to review, or head back to the Open Economy: International Trade and Finance unit overview.

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Question 1 · Easy
The current account of the balance of payments records which of the following?
- A
  A U.S. firm purchasing a factory in Mexico.
  Why not A: Purchases of foreign physical assets (foreign direct investment) are recorded in the capital/financial account, not the current account.
- B
  A foreign investor buying U.S. Treasury bonds.
  Why not B: Financial asset purchases (bonds, stocks) are recorded in the financial account, not the current account.
- C
  U.S. exports of goods and services to foreign countries.Correct
- D
  Changes in official reserve assets held by the Federal Reserve.
  Why not D: Changes in official reserves are recorded in the financial account (as official reserve transactions), not the current account.
Explanation
The current account records trade in goods and services (exports and imports), income flows (wages, dividends earned abroad), and transfer payments (foreign aid, remittances). The financial/capital account records purchases and sales of financial and physical assets across borders.

Key takeaway
Current account = trade in goods + services + income + transfers. Financial/capital account = cross-border asset transactions (bonds, stocks, FDI).
Question 2 · Easy
If the U.S. runs a current account deficit, by accounting identity, what must be true?
- A
  The U.S. must also run a financial account deficit.
  Why not A: The balance of payments must sum to zero; a current account deficit is offset by a financial account surplus (net capital inflow), not deficit.
- B
  The U.S. must run a financial account surplus (net capital inflow).Correct
- C
  The U.S. money supply automatically contracts.
  Why not C: A current account deficit does not mechanically contract the money supply; monetary policy and exchange rates mediate any effects.
- D
  The U.S. must reduce government spending to restore balance.
  Why not D: Balance of payments equilibrium is an accounting identity achieved through capital flows, not a policy requirement to cut spending.
Explanation
The balance of payments accounting identity: current account + financial account = 0 (ignoring statistical discrepancy). A current account deficit means imports exceed exports — the economy is paying more to foreigners than it earns. This must be financed by foreigners investing in U.S. assets (financial account surplus / net capital inflow).

Key takeaway
BOP identity: CA + FA = 0. Current account deficit ↔ financial account surplus (net capital inflow). The deficit is 'financed' by foreign purchases of domestic assets.
Question 3 · Easy
In the foreign exchange market for the U.S. dollar, which event would cause the dollar to appreciate?
- A
  U.S. interest rates fall relative to foreign interest rates.
  Why not A: Lower U.S. interest rates make U.S. assets less attractive to foreign investors, reducing demand for dollars and causing depreciation.
- B
  Foreign investors increase demand for U.S. financial assets.Correct
- C
  U.S. consumers significantly increase imports from abroad.
  Why not C: Increased U.S. imports require selling dollars to buy foreign currencies, increasing supply of dollars and causing depreciation, not appreciation.
- D
  The U.S. current account surplus rises.
  Why not D: A rising current account surplus means the U.S. exports more than it imports, which does increase demand for dollars — but the question asks what causes appreciation, not what results from it; the mechanism in choice B is more direct.
Explanation
Appreciation of the dollar requires increased demand for dollars or decreased supply. Foreign investors buying U.S. stocks, bonds, or other assets must first purchase dollars, shifting the demand curve for dollars rightward — the dollar appreciates (its exchange rate rises). Lower U.S. rates, higher U.S. imports, or capital outflows all depreciate the dollar.

Key takeaway
Dollar appreciates when demand for dollars rises (e.g., foreign capital inflows, higher U.S. interest rates, increased U.S. export demand) or supply of dollars falls.
Question 4 · Easy
The exchange rate is 0.90 euros per dollar. If the dollar appreciates to 1.05 euros per dollar, what happens to U.S. exports and imports?
- A
  U.S. exports increase and imports decrease.
  Why not A: A stronger dollar makes U.S. goods more expensive abroad (exports fall) and foreign goods cheaper in the U.S. (imports rise) — the opposite of this choice.
- B
  U.S. exports decrease and imports increase.Correct
- C
  Both exports and imports increase.
  Why not C: Exchange rate changes have opposite directional effects on exports and imports; they cannot both move in the same direction from a single exchange rate change.
- D
  Net exports are unchanged because trade volumes adjust proportionally.
  Why not D: There is no automatic proportional adjustment; a stronger dollar definitively raises the relative price of U.S. goods abroad and lowers the price of foreign goods in the U.S.
Explanation
A stronger dollar (from €0.90/ $t o €1.05/$ ) means: U.S. goods now cost more euros for European buyers → U.S. exports fall. Foreign goods cost fewer dollars for U.S. buyers → U.S. imports rise. Net exports (NX = exports − imports) decrease, reducing AD. This is the J-curve and exchange rate transmission mechanism.

Key takeaway
Dollar appreciates → U.S. exports become more expensive abroad (↓ exports) and foreign goods become cheaper in the U.S. (↑ imports) → NX falls → AD decreases.
Question 5 · Easy
Country A has a trade surplus with Country B. Which of the following is a likely explanation, all else equal?
- A
  Country A's currency is overvalued relative to Country B's.
  Why not A: An overvalued currency makes Country A's exports expensive for Country B → Country A exports less, reducing the surplus.
- B
  Country A's interest rates are much higher than Country B's, attracting large capital inflows.
  Why not B: Large capital inflows appreciate Country A's currency, which would hurt exports and reduce the trade surplus.
- C
  Country A's currency is undervalued, making its exports cheap for Country B.Correct
- D
  Country A imposes no trade restrictions, allowing free imports from Country B.
  Why not D: Free imports from Country B would increase A's imports, reducing or eliminating A's trade surplus with B.
Explanation
An undervalued currency makes a country's goods relatively inexpensive for foreign buyers, boosting exports. Simultaneously, foreign goods appear expensive to domestic consumers, reducing imports. Both effects contribute to a trade surplus. This is the logic behind currency manipulation concerns — countries may keep their currencies undervalued to maintain export advantages.

Key takeaway
Undervalued currency → cheap exports abroad + expensive imports domestically → trade surplus. Overvalued currency → expensive exports + cheap imports → trade deficit.
Question 6 · Easy
In the foreign exchange market, which of the following causes the supply of dollars to increase (shift right)?
- A
  U.S. residents increase purchases of foreign goods and assets.Correct
- B
  Foreign tourists increase spending in the United States.
  Why not B: Foreign tourists spending in the U.S. buy dollars, increasing the demand for dollars — not the supply of dollars.
- C
  Foreign companies increase direct investment in U.S. factories.
  Why not C: Foreign FDI into the U.S. requires purchasing dollars — this is increased demand for dollars, not increased supply.
- D
  The U.S. Federal Reserve raises interest rates.
  Why not D: Higher U.S. rates attract foreign capital, increasing the demand for dollars; the supply of dollars does not automatically rise when rates rise.
Explanation
The supply of dollars in the foreign exchange market comes from U.S. residents needing to exchange dollars for foreign currency: to buy imported goods, to invest abroad, or to travel overseas. When U.S. residents increase purchases of foreign goods or assets, they sell (supply) more dollars to obtain foreign currency, shifting dollar supply rightward and causing the dollar to depreciate.

Key takeaway
Supply of dollars ↑ when U.S. residents buy more foreign goods, invest abroad, or travel. This causes dollar depreciation. Demand for dollars ↑ from reverse flows.
Question 7 · Easy
If the U.S. dollar–euro exchange rate changes from $1.20/€ to \$ 1.40/€, what has happened to the dollar and how does this affect a U.S. tourist in Europe?
- A
  Dollar appreciated; the tourist's dollars buy more euros, so European travel is cheaper.
  Why not A: If it now costs $1.40 t o b u y o n ee u r o (u p f r o m$ 1.20), each dollar buys fewer euros — the dollar has depreciated, not appreciated.
- B
  Dollar depreciated; the tourist needs more dollars per euro, so European travel is more expensive.Correct
- C
  Dollar appreciated; the tourist needs more dollars per euro, making travel more expensive.
  Why not C: A more expensive euro (more $ needed per €) means the dollar has weakened (depreciated), not appreciated.
- D
  Dollar depreciated; U.S. exports become more expensive for Europeans.
  Why not D: Dollar depreciation actually makes U.S. exports cheaper for Europeans, not more expensive.
Explanation
The exchange rate rose from $1.20/€ to \$ 1.40/€ — meaning a euro now costs more dollars. The dollar can buy fewer euros: $1/\$ 1.20 = 0.83 $€/\$ vs. $1/\$ 1.40 = 0.71 $€/\$ . The dollar depreciated. A U.S. tourist must spend more dollars for the same euro-priced goods in Europe — travel becomes more expensive.

Key takeaway
↑ $/€ rate = more dollars per euro = dollar depreciated (weaker dollar). Depreciation makes foreign travel more expensive for U.S. residents and U.S. exports cheaper for foreigners.
Question 8 · Medium
In a flexible (floating) exchange rate system, a U.S. current account deficit tends to be self-correcting because:
- A
  The government automatically raises tariffs to reduce imports.
  Why not A: Automatic tariff adjustments do not occur in a floating rate system; that would be a discretionary trade policy response.
- B
  The excess supply of dollars in foreign exchange markets causes the dollar to depreciate, making exports cheaper and imports more expensive.Correct
- C
  The central bank raises interest rates, reducing domestic spending and imports.
  Why not C: Central bank rate hikes can reduce imports but are discretionary policy actions, not the automatic self-correction mechanism of floating rates.
- D
  Foreign countries reduce exports to the U.S. to balance bilateral trade.
  Why not D: Foreign export decisions are driven by profit, not bilateral balance goals; they do not automatically adjust to correct the U.S. deficit.
Explanation
A current account deficit means the U.S. is selling more dollars than foreigners want to hold (excess supply). In a floating rate system, the dollar depreciates. A weaker dollar makes U.S. exports cheaper for foreigners (exports rise) and foreign goods more expensive for Americans (imports fall). Net exports improve, reducing the deficit — automatic adjustment without government intervention.

Key takeaway
Floating exchange rates self-correct current account imbalances: deficit → excess dollar supply → depreciation → cheaper exports / pricier imports → NX improves.
Question 9 · Medium
The U.S. Federal Reserve raises interest rates. Tracing the effects through the foreign exchange market: which of the following best describes the full chain of effects on net exports?
- A
  ↑ U.S. interest rates → capital inflow → dollar appreciates → exports ↓, imports ↑ → NX decreases.Correct
- B
  ↑ U.S. interest rates → capital outflow → dollar depreciates → exports ↑, imports ↓ → NX increases.
  Why not B: Higher U.S. rates attract foreign capital (inflow), not outflow; the resulting appreciation reduces NX, not increases it.
- C
  ↑ U.S. interest rates → lower AD → imports decrease → NX increases.
  Why not C: While lower AD may reduce imports somewhat, this omits the dominant exchange-rate channel; the full chain must include capital flows and exchange rate effects.
- D
  ↑ U.S. interest rates → dollar depreciates → exports ↑ → NX increases.
  Why not D: Higher interest rates attract foreign capital and cause appreciation (not depreciation) of the dollar.
Explanation
Fed raises rates → U.S. assets offer higher returns → foreign investors buy U.S. assets → demand for dollars increases → dollar appreciates → U.S. exports become more expensive abroad (fall) → foreign goods become cheaper in the U.S. (imports rise) → NX decreases. This open-economy transmission offsets some of the contractionary domestic impact of higher rates.

Key takeaway
Higher U.S. interest rates → capital inflow → dollar appreciates → NX falls. This open-economy channel partially offsets domestic monetary policy: tight money also reduces NX.
Question 10 · Medium
A country pegs its currency to the U.S. dollar at an overvalued rate. To maintain this peg, the central bank must:
- A
  Buy its own currency using foreign reserves, reducing domestic money supply.Correct
- B
  Print more of its own currency to satisfy excess demand.
  Why not B: An overvalued currency creates excess supply (people want to sell it for dollars); printing more would worsen the oversupply, not help maintain the peg.
- C
  Lower interest rates to attract capital inflows.
  Why not C: Lower interest rates reduce capital inflows and cause further pressure on the currency to depreciate, undermining the overvalued peg.
- D
  Raise tariffs on imports to reduce demand for foreign currency.
  Why not D: Tariffs are a trade policy tool; while they reduce import demand, they are not the standard mechanism for maintaining a currency peg, which operates through foreign reserve transactions.
Explanation
An overvalued peg means the domestic currency is worth more than the market equilibrium rate. In the free market, excess supply of the domestic currency would drive it down. To prevent this, the central bank must purchase (buy back) its own currency using its foreign currency reserves, absorbing the excess supply. This action reduces the domestic money supply and depletes reserves.

Key takeaway
Overvalued peg: excess supply of domestic currency → central bank buys own currency (sells foreign reserves) to maintain the peg. Depletes reserves; unsustainable long-term.
Question 11 · Medium
Net capital outflows from the U.S. increase. What is the direct effect on the U.S. exchange rate and current account?
- A
  Dollar appreciates; current account surplus increases.
  Why not A: Capital outflows supply dollars in FX markets, depreciating the dollar (not appreciating); a depreciated dollar improves NX, tending to balance or create a current account surplus — but the direction of the exchange rate change is wrong.
- B
  Dollar depreciates; net exports and the current account tend to improve.Correct
- C
  Dollar depreciates; current account deficit widens.
  Why not C: A depreciating dollar makes exports cheaper and imports more expensive, which improves (not worsens) the current account.
- D
  Dollar appreciates; net exports decrease.
  Why not D: Capital outflows increase the supply of dollars, causing depreciation (not appreciation); this then improves, not decreases, net exports.
Explanation
Net capital outflows mean U.S. residents are sending more capital abroad than foreigners are investing in the U.S. This increases the supply of dollars in FX markets → dollar depreciates. A weaker dollar makes U.S. exports cheaper for foreigners (exports rise) and foreign goods more expensive in the U.S. (imports fall) → NX improves → current account moves toward surplus.

Key takeaway
Capital outflows → ↑ dollar supply → dollar depreciates → exports ↑, imports ↓ → current account improves. BOP accounting: financial account deficit → current account surplus.
Question 12 · Medium
A nation runs a large government budget deficit. Using the open-economy loanable funds framework, what is the likely effect on the nation's current account?
- A
  Current account surplus, because government borrowing reduces domestic consumption and thus imports.
  Why not A: Government borrowing raises interest rates, attracting foreign capital inflows, which appreciate the currency and reduce NX — leading to a current account deficit, not surplus.
- B
  Current account deficit, because higher real interest rates attract foreign capital, appreciate the currency, and reduce net exports.Correct
- C
  No change to the current account, because domestic saving adjusts to finance the deficit.
  Why not C: This would be true only in a closed economy; in an open economy, foreign capital also responds to higher interest rates, causing exchange rate effects.
- D
  Current account surplus, because the deficit reduces domestic investment, freeing up goods for export.
  Why not D: Reduced domestic investment (crowding out) frees up loanable funds but does not automatically free up goods for export; the currency appreciation channel dominates, reducing NX.
Explanation
This is the 'twin deficits' hypothesis: $Budget deficit \Rightarrow↑$ demand for loanable funds $\Rightarrow↑$ real interest rate $\Rightarrow$ foreign capital inflow $\Rightarrow$ dollar appreciates $\Rightarrow↓$ exports, $↑$ imports $\Rightarrow$ current account deficit. The budget deficit and current account deficit are linked through the interest rate–exchange rate–trade channel.

Key takeaway
Twin deficits: budget deficit → ↑ real interest rates → capital inflows → currency appreciation → ↓ NX → current account deficit.