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Answers to Pause-for-Thought Questions
Chapter 12
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p465 
Where would interest payments on short-term foreign deposits in UK banks be entered on the
balance of payments account?
As a debit on the investment income part of the current account. Payments of interest, profits and
dividends are all elements in this part of the balance of payments account.
p466 
How did the pound ‘fare’ compared with the dollar, the (former) lira and the yen from 1980 to
2001? What conclusions can be drawn about the relative movements of these three currencies?
Taking the period as a whole, the pound depreciated against the US dollar and substantially against
the Japanese yen, but appreciated against the Italian lira. There were, however, fluctuations around
this trend. There was, for example, an appreciation against the dollar between 1993 and 1998 and
against the yen between 1995 and 1998.
The movements mean that over the period as a whole there was a decrease in demand for the
pound relative to the dollar and yen, but an increase in demand for the pound relative to the lira. This
in turn would suggest, other things being equal, that the rate of inflation was higher in the UK than in
Japan and the USA but lower than in Italy. There are, however, other possible explanations for
currency demand and supply shifts: these are examined in the text.
p470 
Go through each of the above reasons for shifts in the demand for and supply of sterling and
consider what would cause an appreciation of the pound.
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p473 
A rise in UK interest rates relative to those abroad.
A lower rate of inflation in the UK than abroad.
A fall in UK incomes relative to those abroad.
Better investment prospects in the UK than abroad.
Speculators believe that the rate of exchange will appreciate.
UK goods become more competitive (in terms of quality, etc.) than imported goods.
What problems might arise if the government were to adopt this third method of maintaining a fixed
exchange rate?
It could invite retaliation from other countries, whereby they imposed restrictions on UK exports to
them. By reducing the total amount of international trade, it would reduce the benefits that flow from
it. (For a discussion of the benefits of trade and of the advantages and disadvantages of trade
restrictions, see Chapter 11, sections 11.1 and 11.2.)
p476 
If speculators on average gain from their speculation, who loses?
People buying or selling internationally traded goods who are not themselves speculating. For
example, if speculation drives the exchange rate below what it would otherwise have been, then
purchasers of imports will be paying a higher price than they otherwise would.
Answers to pause-for-thought questions in Essentials of Economics (3rd edition), John Sloman
p482 
Under what circumstances may a currency bloc like the ERM (a) help to prevent speculation;
(b) aggravate the problem of speculation?
(a) By its persuading speculators that the combined strength of the countries’ reserves and their
combined monetary policies would guarantee that rates of exchange could be maintained within
their bands. Under these circumstances speculation would be pointless.
(b) If exchange rates were being maintained at clearly disequilibrium levels. The longer devaluation
or revaluation were put off, and the more inevitable speculators believed the devaluation or
revaluation would eventually be, the more would speculation take place.
p486 
How might multiplier effects (the principle of cumulative causation) lead to prosperous regions
becoming more prosperous and less prosperous regions falling even further behind?
The prosperous regions, by expanding faster, would attract more capital and labour to the regions.
The extra capital would help to expand capacity and lead to faster growth. The increased labour
would increase consumption in the region. This, along with the higher investment, would lead to a
multiplied rise in income within the region.
As people left the less prosperous regions, consumption would fall. A decline in demand
would not attract capital to these regions. This could all lead to a spiralling downwards as the fall
in consumption and investment led to a multiplied fall in regional income.
p490 
What will be the effect on the UK economy if the European Central Bank cuts interest rates?
There will an outflow of funds from the euro-zone and the euro will probably depreciate. Funds will
flow to the UK and sterling will probably appreciate. UK exports will become less competitive and
there will probably be a rise in imports. UK aggregate demand will fall. This will put downward
pressure on inflation. (To some extent the downward pressure on aggregate demand in the UK will
be offset by a rise in aggregate demand in the euro-zone and hence a boost to the UK economy via
the international trade multiplier.)
The net result of a forecast of lower inflation in the UK and a worsening balance of trade may
encourage the Monetary Policy Committee to lower the rate of interest. If this happened, it could
neutralise the balance of payments effect of the ECB’s interest rate cut. In fact, if rates of interest in
the UK fell by the same amount as in the euro-zone, the UK’s balance of trade would probably
improve, as sterling depreciates against the dollar, the yen and other currencies other than the euro.
p494 
What are the relative advantages and disadvantages to a developing country of rescheduling its
debts compared with simply defaulting on them (either temporarily or permanently)?
Default is a high-risk strategy. The benefits are an immediate wiping out of debt. The potential costs
are great, however. Its assets in foreign institutions may be confiscated, as too may its ships and
merchandise in transit. Once having defaulted, it will be virtually impossible to raise future loans to
rebuild the economy. The threat of default, however, especially if made by several debtor countries
acting together, could force creditor institutions to offer lower interest rates or more generous
rescheduling programmes, or even to write off a certain portion of the debt.
p496 
Should rich countries cancel all debts owed to them by developing countries?
From the perspective of a rich donor country, there might be a political gain from the welcome
this would receive from debtor countries. There might also be some spin-off economic gain if it
encouraged developing countries to buy its exports.
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Answers to pause-for-thought questions in Essentials of Economics (3rd edition), John Sloman
From the debtor country’s perspective there is the immediate benefit of no longer having to
spend large amounts of precious foreign exchange servicing its debts. This would lead to a direct
increase in living standards within the country. There is, however, the longer-term problem of
whether the cancellation of debts would encourage debtor countries to be wasteful with foreign
exchange and to begin building up debts again. It is for this reason that many of the creditor
countries and international agencies, such as the IMF and World Bank, argue that cancellation of
debt should be combined with requirements that the money saved on debt servicing should be
channelled into socially beneficial projects, such as health and education. They also require such
countries to undertake various economic reforms, such as cutting government budget deficits and
liberalising markets.
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