The Open Economy


Review Questions

1. How are net exports related to net foreign investment? NX = NFI.

 
2. How are national saving, domestic investment, and net foreign investment related to each other?

 

 S = I + NFI.

 
3. How are national saving, domestic investment, and net exports related to each other?

 

 S = I + NX.

 
4. What are the major determinants of the trade balance?

 

 Domestic saving and investment.

 
5. Is a trade deficit necessarily bad for the economy?

 

 No.
6. What is the nominal exchange rate?

 

 The rate of exchange between domestic and foreign currencies.
7. What is the real exchange rate?

 

 The rate of exchange between domestic and foreign goods.
8. How are the two related? e = ePh/Pf

 
9. How does a government budget deficit affect the real exchange rate and the trade balance according to the traditional view? According to the Ricardian view?

 

 

 According to the traditional view, the real exchange rate to appreciates and the trade balance declines (meaning a smaller surplus or a larger deficit). According to the Ricardian view, the real exchange rate and the trade balance are unaffected.
10. What is Purchasing Power Parity (PPP)?

 

 

 A relation between nominal exchange rates and domestic and foreign prices which implies that one unit of a given currency has the same purchasing power when spent on the goods of any country.
11. Is PPP a good description of the short run? Of the long run? No. Yes.

 
12. What is the primary determinant of long-run movements in nominal exchange rates?

 

 Domestic and foreign inflation rates.

 
13. Can two countries have different long-run inflation rates under a system of fixed exchange rates? Under a system of flexible exchange rates?

 

 No. Yes.
14. What is interest rate parity? A relation between nominal exchange rates and domestic and foreign nominal interest rates which implies that the nominal rate of return on domestic assets is the same as the nominal rate of return on foreign assets, after adjusting for foreign exchange gains or losses.

Show review questions without answers


Answers to Selected Textbook Problems

Mankiw, Macroeconomics, fourth edition, chapter 8, problems and applications

1. Assume that we are dealing with a small, open economy.  The analysis can be performed using Figure 8-2 from the text.
a. Because NFI is equal to national saving minus domestic investment, the increase in saving shifts the NFI curve to the right.  The increase in NFI implies an increase in net exports and a reduction in the real exchange rate (i.e., a real depreciation).  There is no reason to expect a change in either domestic or foreign price levels, implying that the nominal and real exchange rates decline in the same proportion (i.e., a nominal depreciation of the domestic currency).
b. This increase in import demand shifts the NX curve to the left, but there is no reason for national saving or domestic investment (and thus NFI) to change.  With no shift in the NFI curve, the actual quantity of net exports remains unchanged.  The leftward shift in the NX curve causes the real exchange rate to fall.  There is no reason to expect a change in either domestic or foreign price levels, implying that the nominal and real exchange rates decline in the same proportion (i.e., a nominal depreciation of the domestic currency).  Thus, the main effect of the increase in import demand is a weakening of the domestic currency, not a change in the trade balance.
c.  A reduction in the domestic demand for money raises the domestic price level (for any given nominal supply of money).  Given that this is a small, open economy, domestic developments should exert no effect on foreign prices.  There should be no effect on the domestic NX or NFI curves, meaning that net exports and the real exchange rate are unchanged.  With a constant real exchange rate, an increase in domestic prices implies a nominal depreciation of the domestic currency.

 
3. a. The NX curve shifts to the left, but there is no reason for national saving or domestic investment (and thus NFI) to change.  With no shift in the NFI curve, the actual quantity of net exports remains unchanged.  The leftward shift in the NX curve causes the real exchange rate to fall.  There is no reason to expect a change in real or nominal interest rates.
b. The real depreciation makes foreign travel more expensive.
c. The initial real exchange rate could be restored if the NFI curve were to shift leftward by the same amount as the NX curve.  Because NFI is equal to national saving minus domestic investment, this requires either a reduction in saving or an increase in investment.  The government could tax domestic saving in an attempt to reduce it.  Alternatively, the government could enact a tax subsidy to domestic investment.  If this leftward shift in the NFI curve is achieved, then net exports will fall.  The real interest rate is set on world markets and is not affected by developments in a small, open economy.

 
4. First consider the case of a local rather than a world war.  This means that the world real interest rate is unchanged.   If the war does not last forever, we are dealing with a temporary increase in government purchases.  This lowers national saving no matter how the spending is financed.  (If the government borrows to pay for its purchases, public saving declines.  If the government temporarily raises taxes to pay for its purchases, households reduce their spending by less than the temporary increase in their tax payments, reducing their saving to smooth consumption.)

The reduction in national saving shifts the NFI curve to the left, reducing net exports and causing the real exchange rate to increase.

If the war is a world war rather than a local one, then the worldwide increase in government purchases would increase the world real interest rate.   A higher world interest rate would reduce domestic investment and raise national saving, shifting the NFI curve back to the right.  This could partially or fully reverse the effects of the leftward shift in the NFI curve discussed above.

 
5. This policy will have no effect on net exports unless it somehow affects either national saving or domestic investment, and there is no reason to expect either of these quantities to change.  The policy shifts the NX curve to the right and increases the real exchange rate.  Domestic makers of luxury cars benefit, because the price of competing products increases.  Domestic consumers of such cars are hurt by this price increase.  Consumers who do not buy luxury cars might benefit, however, because the increase in the real exchange rate increases their purchasing power means that other foreign goods are now less expensive.   Because of competitive pressures, the producers of domestic goods that compete with these cheaper imports are hurt.

 
6. Assume that we are dealing with a small, open economy and that only foreign countries enact the investment tax credit, which does not apply to domestic investment.
a. Worldwide investment demand increases (i.e., the investment demand curve shifts to the right).
b. Because the world is a closed economy, this increase in investment demand drives up the world real ingerest rate.
c. The higher interest rate causes a reduction in domestic investment spending (i.e., a movement along the domestic investment demand curve, but not a shift of the curve).
d.  The higher interest rate may also stimulate national saving.  In any case, NFI (equal to national saving minus domestic investment) declines, implying lower net exports.
e. The new equilibrium occurs at a lower real exchange rate.

 
7. To be concrete, assume that 10 years ago a cup of American coffee cost $1.00 and a cup of Italian espresso cost 1000 lire, also equivalent to $1.00 at the prevailing exchange rate.  Given the information about two rates of inflation, we can calculate that a cup of American coffee now costs $1.25 and a cup of espresso now costs 2000 lire.  At today's exchange rate, the cost of the espresso is now 2000/1500, or $1.67.  So, after adjusting for price level changes, it is now more expensive to travel in Italy, (i.e., the real value of the dollar has declined against the lira).

 
8. a. The expected inflation rate is equal to the nominal interest rate minus the real interest rate.  Given a common real rate in the two countries, we can conclude that expected inflation in Canada is equal to 12% minus the real interest rate and expected inflation in the United States is equal to 8% minus the real rate.  This implies that expected inflation in Canada is 4% higher than in the United States.
b. PPP implies that the change in the nominal exchange rate is equal to the inflation differential between the two countries.   These expected inflation rates imply that the U.S. dollar is expected to appreciate by 4% against the Canadian dollar.
c. This scheme ignores the fact that the Canadian dollar is expected to lose 4% of its value against the U.S. dollar over the next year, so that the return in U.S. dollars is 4% on both investments.  (Note:  This question is of some relevance to the Asian financial crisis, where some investors seemed not to understand the implications of the fact that nominal interest rates were higher in some of the Asian currencies than in U.S. dollars.)