Questions for Review. CHAPTER 5 The Open Economy

Transcription

1 Questions fo Review 1. By ewiting the national income accounts identity, we show in the text that I =. This fom of the national income accounts identity shows the elationship between the intenational flow of funds fo capital accumulation, I, and the intenational flow of goods and sevices,. Net capital outflow efes to the ( I) pat of this identity: it is the excess of domestic saving ove domestic investment. In an open economy, domestic saving need not equal domestic investment, because investos can boow and lend in wold financial makets. The tade balance efes to the () pat of the identity: it is the diffeence between what we expot and what we impot. Thus, the national accounts identity shows that the intenational flow of funds to finance capital accumulation and the intenational flow of goods and sevices ae two sides of the same coin. 2. The nominal exchange ate is the elative pice of the cuency of two counties. The eal exchange ate, sometimes called the tems of tade, is the elative pice of the goods of two counties. It tells us the ate at which we can tade the goods of one county fo the goods of anothe. 3. A cut in defense spending inceases govenment saving and, hence, inceases national saving. Investment depends on the wold ate and is unaffected. Hence, the incease in saving causes the ( I) schedule to shift to the ight, as in Figue 5 1. The tade balance ises, and the eal exchange ate falls. () CHAPTER 5 The Open Economy 1 I 2 I Figue 5 1 Real exchange ate 1 2 A B 1 2 Net expots 30

2 Chapte 5 The Open Economy If a small open economy bans the impot of Japanese DVD playes, then fo any given eal exchange ate, impots ae lowe, so that net expots ae highe. Hence, the net expot schedule shifts out, as in Figue I Figue 5 2 Real exchange ate 2 1 B A 2 ( ) 1 ( ) Net expots The potectionist policy of banning DVD playes does not affect saving, investment, o the wold inteest ate, so the I schedule does not change. Because potectionist policies do not alte eithe saving o investment in the model of this chapte, they cannot alte the tade balance. Instead, a potectionist policy dives the eal exchange ate highe. 5. We can elate the eal and nominal exchange ates by the expession Nominal Real Ratio of Exchange = Exchange Pice Rate Rate Levels e = (P * /P). Let P * be the Mexican pice level and P be the Japanese pice level. The nominal exchange ate e is the numbe of Mexican pesos pe Japanese yen (this is as if we take Japan to be the domestic county). We can expess this in tems of pecentage changes ove time as % Change in e = % Change in + (π * π), whee π * is the Mexican inflation ate and π is the Japanese inflation ate. If Mexican inflation is highe than Japanese inflation, then this equation tells us that a yen buys an inceasing amount of pesos ove time: the yen ises elative to the peso. Altenatively, viewed fom the Mexican pespective, the exchange ate in tems of yen pe peso falls.

3 32 Answes to Textbook Questions and Poblems Poblems and Applications 1. a. An incease in saving shifts the ( I) schedule to the ight, inceasing the supply of dollas available to be invested aboad, as in Figue 5 3. The inceased supply of dollas causes the equilibium eal exchange ate to fall fom 1 to 2. Because the dolla becomes less valuable, domestic goods become less expensive elative to foeign goods, so expots ise and impots fall. This means that the tade balance inceases. The nominal exchange ate falls following the movement of the eal exchange ate, because pices do not change in esponse to this shock. ( 1 I) ( 2 I) Figue 5 3 Real exchange ate 1 2 A B ( ) 1 2 Net expots b. The intoduction of a stylish line of Toyotas that makes some consumes pefe foeign cas ove domestic cas has no effect on saving o investment, but it shifts the ( ) schedule inwad, as in Figue 5 4. The tade balance does not change, but the eal exchange ate falls fom 1 to 2. Because pices ae not affected, the nominal exchange ate follows the eal exchange ate. ( I) Figue 5 4 Real exchange ate 1 2 A B 1 ( ) 2 ( ) Net expots

4 Chapte 5 The Open Economy 33 c. In the model we consideed in this chapte, the intoduction of ATMs has no effect on any eal vaiables. The amounts of capital and labo detemine output Y. The wold inteest ate * detemines investment I( * ). The diffeence between domestic saving and domestic investment ( I) detemines net expots. Finally, the intesection of the ( ) schedule and the ( I) schedule detemines the eal exchange ate, as in Figue 5 5. I Figue 5 5 Real exchange ate ( ) Net expots The intoduction of ATMs, by educing money demand, does affect the nominal exchange ate though its effect on the domestic pice level. The pice level adjusts to equilibate the demand and supply of eal balances, so that M/P = (M/P) d. If M is fixed, then a fall in (M/P) d causes an incease in the pice level: this educes the supply of eal balances M/P and estoes equilibium in the money maket. Now ecall the fomula fo the nominal exchange ate: e = (P * /P). We know that the eal exchange ate emains constant, and we assume that the foeign pice level P * is fixed. When the domestic pice level P inceases, the nominal exchange ate e depeciates.

5 34 Answes to Textbook Questions and Poblems 2. a. National saving is the amount of output that is not puchased fo cuent consumption by households o the govenment. We know output and govenment spending, and the consumption function allows us to solve fo consumption. Hence, national saving is given by: = Y C G = 5,000 ( (5,000 1,000)) 1,000 = 750. Investment depends negatively on the inteest ate, which equals the wold ate * of 5. Thus, I = 1, = 750. Net expots equals the diffeence between saving and investment. Thus, = I = = 0. Having solved fo net expots, we can now find the exchange ate that cleas the foeign-exchange maket: = ε 0 = ε ε = 1. b. Doing the same analysis with the new value of govenment spending we find: = Y C G = 5,000 ( (5,000 1,000)) 1,250 = 500 I = 1, = 750 = I = = 250 = ε 250 = ε ε = 1.5. The incease in govenment spending educes national saving, but with an unchanged wold eal inteest ate, investment emains the same. Theefoe, domestic investment now exceeds domestic saving, so some of this investment must be financed by boowing fom aboad. This capital inflow is accomplished by educing net expots, which equies that the cuency appeciate.

6 Chapte 5 The Open Economy 35 c. Repeating the same steps with the new inteest ate, = Y C G = 5,000 ( (5,000 1,000)) 1,000 = 750 I = 1, = 500 = I = = 250 = ε 250 = ε ε = 0.5. aving is unchanged fom pat (a), but the highe wold inteest ate lowes investment. This capital outflow is accomplished by unning a tade suplus, which equies that the cuency depeciate. 3. a. When Leveett s expots become less popula, its domestic saving Y C G does not change. This is because we assume that Y is detemined by the amount of capital and labo, consumption depends only on disposable income, and govenment spending is a fixed exogenous vaiable. Investment also does not change, since investment depends on the inteest ate, and Leveett is a small open economy that takes the wold inteest ate as given. Because neithe saving no investment changes, net expots, which equal I, do not change eithe. This is shown in Figue 5 6 as the unmoving I cuve. The deceased populaity of Leveett s expots leads to a shift inwad of the net expots cuve, as shown in Figue 5 6. At the new equilibium, net expots ae unchanged but the cuency has depeciated. ε I Figue 5 6 Real exchange ate ε 2 ε 1 (ε) 1 (ε) 2 { 1 = 2 Net expots Even though Leveett s expots ae less popula, its tade balance has emained the same. The eason fo this is that the depeciated cuency povides a stimulus to net expots, which ovecomes the unpopulaity of its expots by making them cheape.

7 36 Answes to Textbook Questions and Poblems b. Leveett s cuency now buys less foeign cuency, so taveling aboad is moe expensive. This is an example of the fact that impots (including foeign tavel) have become moe expensive as equied to keep net expots unchanged in the face of deceased demand fo expots. c. If the govenment educes taxes, then disposable income and consumption ise. Hence, saving falls so that net expots also fall. In Figue 5-6, the I cuve shifts to the left, loweing net expots until the exchange ate is again equal to its initial value. This fall in net expots puts upwad pessue on the exchange ate that offsets the deceased wold demand. Investment and the inteest ate would be unaffected by this policy since Leveett takes the wold inteest ate as given. 4. Goveno Benanke s statement is consistent with the models in the chapte. uppose we conside the United tates as a small open economy, fo example. The incease in the global supply of saving pushes the global inteest ate down, which encouages U.. investment. If we assume that this is pimaily non-u.. saving, then fo the United tates, the saving cuve doesn t shift but we get a movement along the investment cuve fom point A to point B in Figue 5 7. The inteest ate falls, and the tade deficit ises (-I falls). Figue 5 7 Real inteest ate 1 2 Tade deficit I Investment, aving I, 5. The incease in govenment spending deceases govenment saving and, thus, deceases national saving; this shifts the saving schedule to the left, as in Figue 5 8. Given the wold inteest ate *, the decease in domestic saving causes the tade balance to fall. Figue 5 8 Real inteest ate * Tade deficit I Investment, aving I,

8 Chapte 5 The Open Economy 37 Figue 5 9 shows the impact of this incease in govenment puchases on the eal exchange ate. The decease in national saving causes the ( I) schedule to shift to the left, loweing the supply of dollas to be invested aboad. The lowe supply of dollas causes the equilibium eal exchange ate to ise. As a esult, domestic goods become moe expensive elative to foeign goods, which causes expots to fall and impots to ise. In othe wods, as we detemined in Figue 5 8, the tade balance falls. ( 2 I ) ( 1 I ) Figue 5 9 B Real exchange ate 2 1 Change in the cuent tade balance account A ( ) 2 1 Net Net expots expots

9 38 Answes to Textbook Questions and Poblems The answe to this question does depend on whethe this is a local wa o a wold wa. A wold wa causes many govenments to incease expenditues; this inceases the wold inteest ate *. The effect on a county s extenal accounts depends on the size of the change in the wold inteest ate elative to the size of the decease in saving. Fo example, an incease in the wold inteest ate could cause a county to have a smalle tade deficit, as in Figue 5 10, o even a tade suplus, as in Figue Figue 5 10 Real inteest ate 2 * 1 * Tade deficit I() Investment, aving I, Tade suplus 2 1 Figue * Real inteest ate 1 * I () Investment, aving I,

10 Chapte 5 The Open Economy a. If poo nations offeed bette poduction efficiency and legal potections, then the maginal poduct of capital would ise. To incease the amount of capital that they have, fims need to incease the amount of investment. Hence, thei investment demand cuve shifts out at any given inteest ate, fims have a highe level of investment spending than they did peviously. b. Assuming that togethe, the poo nations account fo a noticeable shae of wold demand fo investment, the demand fo loanable funds in wold financial makets ises. Fo the wold oveall, the pictue looks like Figue 5 12, which follows. Global Figue 5 12 Wold eal inteest ate I () 1 I () 2 Wold investment, Wold saving I, c. In global financial makets, the incease in demand fo loanable funds aises the inteest ate. d. Fo ich counties, the incease in global inteest ates educes desied investment. Hence, I() ises, which means that the tade balance ises. 7. The taiff on luxuy cas would not affect net expots because it does not affect national saving (because it would not affect Y, C, o G) o investment. It would, howeve, shift the cuve by deceasing U.. demand fo Japanese auto impots. This shift of the cuve, shown in Figue 5 13, would aise the exchange ate. Although net expots would not change, the volume of both impots and expots would fall by the same amount. ε I Figue 5 13 Real exchange ate ε 2 ε 1 (ε) 2 (ε) 1 { 1 = 2 Net expots

11 40 Answes to Textbook Questions and Poblems Thee ae also impotant compositional effects of this policy. On the poduction side, the highe exchange ate inceases impots and puts pessue on the sales of Ameican companies with the exception of Ameican luxuy ca poduction, which is shielded by the taiff. Also Ameican expotes will be hut by the highe exchange ate, which makes thei impoted goods moe expensive to foeign counties. Consumes of Japanese luxuy cas will be hut by the taiffs while all othe consumes will benefit fom the appeciated dolla, which allows them to puchase goods moe cheaply. In sum, the policy would shift demand to Ameican luxuy ca poduces at the expense of the est of Ameican poduction and also shift consumption fom Japanese luxuy cas to all othe impots. 8. The eal exchange ate measues the ate at which the goods of one county can be taded fo the goods of the othe county. In this case, the eal exchange ate measues the numbe of bottles of vodka that must be exchanged fo one TV. If Russia is expeiencing no technological pogess in vodka poduction, then the numbe of bottles poduced is fixed. ince China is expeiencing positive technological pogess in TV poduction, the numbe of TVs poduced will be inceasing. Given that TVs ae elatively moe abundant and vodka is elatively moe scace, we would expect the eal exchange ate to decease that is, it takes fewe bottles of vodka to buy one TV. The nominal exchange ate (e), measued as ubles pe yuan, is detemined by the following equation: P e = Ê Ë Á * e ˆ P whee ε. measues the eal exchange ate, P* measues the pice level in Russia, and P measues the pice level in China. Given China has stable money gowth and Russia has apid money gowth, Russia s pice level will be inceasing at a faste ate than the pice level in China. The effect on the nominal exchange ate is ambiguous. The decline in the eal exchange ate will push the nominal exchange ate down, but the apidly ising pice level in Russia elative to China will push the nominal exchange ate up. 9. a. If the counties that institute an investment tax cedit ae lage enough to shift the wold investment demand schedule, then the tax cedits shift the wold investment demand schedule upwad, as in Figue Figue 5 14 Real inteest ate 2 * 1 * B A I 2 () I 1 () Wold investment, Wold saving I, b. The wold inteest ate inceases fom * 1 to * 2 because of the incease in wold investment demand; this is shown in Figue (Remembe that the wold is a closed economy.)

12 Chapte 5 The Open Economy 41 c. The incease in the wold inteest ate inceases the equied ate of etun on investments in ou county. Because the investment schedule slopes downwad, we know that a highe wold inteest ate means lowe investment, as in Figue Figue 5 15 Real inteest ate 2 * 1 * I() I 2 I 1 Investment I d. Given that ou saving has not changed, the highe wold inteest ate means that ou tade balance inceases, as in Figue Tade suplus Figue * Real inteest ate 1 * I () Investment, aving I,

13 42 Answes to Textbook Questions and Poblems e. To bing about the equied incease in the tade balance, the eal exchange ate must fall. Ou goods become less expensive elative to foeign goods, so that expots incease and impots decease, as in Figue ( I) 1 ( I) 2 Figue 5 17 Real exchange ate 1 2 A B ( ) 1 2 Net expots 10. The easiest way to tell if you fiend is ight o wong is to conside an example. uppose that ten yeas ago, an Ameican hot dog cost $1, while a Mexican taco cost 10 pesos. ince $1 bought 10 pesos ten yeas ago, it cost the same amount of money to buy a hot dog as to buy a taco. ince total U.. inflation has been 25 pecent, the Ameican hot dog now costs $1.25. Total Mexican inflation has been 100 pecent, so the Mexican taco now costs 20 pesos. This yea, $1 buys 15 pesos, so that the taco costs 20 pesos [15 pesos/dolla] = $1.33. This means that it is now moe expensive to puchase a Mexican taco than a U.. hot dog. Thus, you fiend is simply wong to conclude that it is cheape to tavel in Mexico. Even though the dolla buys moe pesos than it used to, the elatively apid inflation in Mexico means that pesos buy fewe goods than they used to it is moe expensive now fo an Ameican to tavel thee. 11. a. The Fishe equation says that whee i = + π e i = the nominal inteest ate = the eal inteest ate (same in both counties) π e = the expected inflation ate. Plugging in the values given in the question fo the nominal inteest ates fo each county, we find: 12 = + π e Can 8 = + π e U This implies that π e = 4. Can πe U Because we know that the eal inteest ate is the same in both counties, we conclude that expected inflation in Canada is fou pecentage points highe than in the United tates.

14 Chapte 5 The Open Economy 43 b. As in the text, we can expess the nominal exchange ate as e = ε (P Can /P U ), whee ε = the eal exchange ate P Can = the pice level in Canada P U = the pice level in the United tates. The change in the nominal exchange ate can be witten as: % change in e = % change in ε + (π Can π U ). We know that if puchasing-powe paity holds, then a dolla must have the same puchasing powe in evey county. This implies that the pecent change in the eal exchange ate ε is zeo because puchasing-powe paity implies that the eal exchange ate is fixed. Thus, changes in the nominal exchange ate esult fom diffeences in the inflation ates in the United tates and Canada. In equation fom this says % change in e = (π Can π U ). Because people know that puchasing-powe paity holds, they expect this elationship to hold. In othe wods, the expected change in the nominal exchange ate equals the expected inflation ate in Canada minus the expected inflation ate in the United tates. That is, Expected % change in e = π e Can πe U In pat (a), we found that the diffeence in expected inflation ates is 4 pecent. Theefoe, the expected change in the nominal exchange ate e is 4 pecent. c. The poblem with you fiend s scheme is that it does not take into account the change in the nominal exchange ate e between the U.. and Canadian dollas. Given that the eal inteest ate is fixed and identical in the United tates and Canada, and given puchasing-powe paity, we know that the diffeence in nominal inteest ates accounts fo the expected change in the nominal exchange ate between U.. and Canadian dollas. In this example, the Canadian nominal inteest ate is 12 pecent, while the U.. nominal inteest ate is 8 pecent. We conclude fom this that the expected change in the nominal exchange ate is 4 pecent. Theefoe, e this yea = 1 C$/U$. e next yea = 1.04 C$/U$. Assume that you fiend boows 1 U.. dolla fom an Ameican bank at 8 pecent, exchanges it fo 1 Canadian dolla, and puts it in a Canadian Bank. At the end of the yea you fiend will have $1.12 in Canadian dollas. But to epay the Ameican bank, the Canadian dollas must be conveted back into U.. dollas. The $1.12 (Canadian) becomes $1.08 (Ameican), which is the amount owed to the U.. bank. o in the end, you fiend beaks even. In fact, afte paying fo tansaction costs, you fiend loses money.

15 44 Answes to Textbook Questions and Poblems Moe Poblems and Applications to Chapte 5 1. a. As shown in Figue 5 18, an incease in govenment puchases educes national saving. This educes the supply of loans and aises the equilibium inteest ate. This causes both domestic investment and net capital outflow to fall. The fall in net capital outflow educes the supply of dollas to be exchanged into foeign cuency, so the exchange ate appeciates and the tade balance falls. Figue 5 18 A. The Maket fo Loanable Funds B. Net Capital Outflow Real inteest ate I + CF CF() Loanable funds, I + CF CF Net capital outflow C. The Maket fo Foeign Exchange CF Real exchange ate ( ) Net expots

16 Chapte 5 The Open Economy 45 Figue 5 19 b. As shown in Figue 5 19, the incease in demand fo expots shifts the net expots schedule outwad. ince nothing has changed in the maket fo loanable funds, the inteest ate emains the same, which in tun implies that net capital outflow emains the same. The shift in the net expots schedule causes the exchange ate to appeciate. The ise in the exchange ate makes U.. goods moe expensive elative to foeign goods, which depesses expots and stimulates impots. In the end, the incease in demand fo Ameican goods does not affect the tade balance. A. The Maket fo Loanable Funds B. Net Capital Outflow Real inteest ate I + CF CF() Loanable funds, I + CF Net capital outflow CF C. The Maket fo Foeign Exchange CF Real exchange ate ( ) Net expots

17 46 Answes to Textbook Questions and Poblems Figue 5 20 c. As shown in Figue 5 20, the U.. investment demand schedule shifts inwad. The demand fo loans falls, so the equilibium inteest ate falls. The lowe inteest ate inceases net capital outflow. Despite the fall in the inteest ate, domestic investment falls; we know this because I + CF does not change, and CF ises. The ise in net capital outflow inceases the supply of dollas in the maket fo foeign exchange. The exchange ate depeciates, and net expots ise. A. The Maket fo Loanable Funds B. Net Capital Outflow Real inteest ate I + CF CF() Loanable funds, I + CF CF Net capital outflow C. The Maket fo Foeign Exchange CF Real exchange ate ( ) Net expots

18 Chapte 5 The Open Economy 47 d. As shown in Figue 5 21, the incease in saving inceases the supply of loans and lowes the equilibium inteest ate. This causes both domestic investment and net capital outflow to ise. The incease in net capital outflow inceases the supply of dollas to be exchanged into foeign cuency, so the exchange ate depeciates and the tade balance ises. Figue 5 21 A. The Maket fo Loanable Funds B. Net Capital Outflow Real inteest ate I + CF CF() Loanable funds, I + CF CF Net capital outflow C. The Maket fo Foeign Exchange CF Real exchange ate ( ) Net expots

19 48 Answes to Textbook Questions and Poblems Figue 5 22 e. The eduction in the willingness of Ameicans to tavel aboad educes impots, since foeign tavel counts as an impot. As shown in Figue 5 22, this shifts the net expots schedule outwad. ince nothing has changed in the maket fo loanable funds, the inteest ate emains the same, which in tun implies that net capital outflow emains the same. The shift in the net expots schedule causes the exchange ate to appeciate. The ise in the exchange ate makes U.. goods moe expensive elative to foeign goods, which depesses expots and stimulates impots. In the end, the fall in Ameicans desie to tavel aboad does not affect the tade balance. A. The Maket fo Loanable Funds B. Net Capital Outflow Real inteest ate I + CF CF() Loanable funds, I + CF CF Net capital outflow C. The Maket fo Foeign Exchange CF Real exchange ate Net expots ( )

20 Chapte 5 The Open Economy 49 Figue 5 23 f. As shown in Figue 5 23, the net capital outflow schedule shifts in. This educes demand fo loans, so the equilibium inteest ate falls and investment ises. Net capital outflow falls, despite the fall in the inteest ate; we know this because I + CF is unchanged and investment ises. The fall in net foeign investment educes the supply of dollas to be exchanged into foeign cuency, so the exchange ate appeciates and the tade balance falls. A. The Maket fo Loanable Funds B. Net Capital Outflow Real inteest ate Loanable funds I + CF CF(), I + CF Net capital outflow CF C. The Maket fo Foeign Exchange CF Real exchange ate Net expots ( )

21 50 Answes to Textbook Questions and Poblems Figue Gingich s statement has no immediate effect on any of the fundamentals in the economy: consumption, govenment puchases, taxes, and output ae all unchanged. Intenational investos, howeve, will be moe eluctant to invest in the Ameican economy, paticulaly to puchase U.. govenment debt, because of the default isk. As both Ameicans and foeignes move thei money out of the United tates, the CF cuve shifts outwad (thee is moe capital outflow), as shown in Figue 5 24(B). This aises the inteest ate in ode to keep I + CF equal to the unchanged, shown in Figue 5 24(A). The incease in CF aises the supply in the maket fo foeign exchange, which lowes the equilibium exchange ate as shown in Figue 5 24(C). A. The Maket fo Loanable Funds B. Net Capital Outflow Real inteest ate I + CF CF () Loanable funds, I + CF Net capital outflow CF C. The Maket fo Foeign Exchange ε Real exchange ate CF (ε) Net expots