| 1. |
How are net exports related to
net foreign investment? |
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| 2. |
How are national saving, domestic
investment, and net foreign investment related to each other? |
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| 3. |
How are national saving, domestic
investment, and net exports related to each other? |
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| 4. |
What are the major determinants
of the trade balance? |
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| 5. |
Is a trade deficit necessarily
bad for the economy? |
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| 6. |
What is the nominal exchange
rate? |
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Answers |
| 7. |
What is the real exchange rate? |
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| 8. |
How are the two related? |
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| 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? |
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| 10. |
What is Purchasing Power Parity
(PPP)? |
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| 11. |
Is PPP a good description of the
short run? Of the long run? |
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| 12. |
What is the primary determinant
of long-run movements in nominal exchange rates? |
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| 13. |
Can two countries have different
long-run inflation rates under a system of fixed exchange rates? Under a system of
flexible exchange rates? |
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| 14. |
What is interest rate parity? |
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| 1. |
Shortly after the conclusion of
the Gulf War in 1991, The Wall Street Journal (July 10, 1991) reported that
"Kuwait is expected to announce plans to borrow as much as $10 billion in a
multiphase operation that will likely involve U.S. banks" and stated that this
borrowing was "the first on such a scale by the country". |
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a. |
Would this borrowing result in a capital account surplus or deficit for Kuwait? |
| b. |
Would it result in a current
account surplus or deficit? |
| c. |
What are the major determinants
of a country's overall trade balance? |
| d. |
Given your answer to part (c),
describe two reasons why the Gulf War could have caused Kuwait to borrow from the rest of
the world. |
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Answer:
| a. |
Kuwait's borrowing constitutes a
private capital inflow, i.e., a capital account surplus. |
b. |
Assuming this is not entirely offset by official intervention, it implies a current
account deficit. |
c. |
The major determinants of a country's trade balance are its domestic saving and
investment. |
d. |
Thus, the Gulf War could have affected Kuwait's borrowing (and its trade balance) by
affecting either saving or investment. The war could be expected to reduce Kuwait's saving
by causing a temporary reduction in its oil revenues. This is because consumers tend to
smooth consumption in response to temporary fluctuations in their income. (In addition,
the government's saving might have been reduced to pay for war expenses.) The war could
also be expected to increase domestic investment in Kuwait because of the need to rebuild
damaged infrastructure. |
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| 2. |
According to The Economist
of April 27, 1996, the average price of a Big Mac in the United States was $2.36. The
price in China was 9.60 yuan, and the price in Germany was 4.90 DMarks. |
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| a. |
The exchange rate between the
United States and China was 8.35 yuan/dollar. Given this exchange rate, was a Big Mac a
"better deal" in China or in the United States? What might account for this
phenomenon? |
| b. |
The exchange rate between the
United States and Germany was 1.52 DMarks/dollar. According to absolute Purchasing Power
Parity, how much should a Big Mac cost in Germany, given this nominal exchange rate and
the U.S. price of a Big Mac? |
| c. |
Suppose that Big Mac prices are
representative of the prices of goods in general (i.e., suppose that the relation
connecting U.S. Big Mac prices, German Big Mac prices, and the nominal exchange rate is
similar to the relation connecting U.S. prices of goods in general, German prices of goods
in general, and the nominal exchange rate). How are the U.S. inflation rate, the German
inflation rate, and the nominal exchange rate between the DMark and the dollar likely to
behave over the next few years? |
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Answer:
| a. |
A Big Mac is a better deal in
China. Using the market exchange rate, a Chinese Big Mac costs $1.15. This departure from
absolute PPP can be explained by the fact that a Big Mac is not readily traded
internationally. Some of the ingredients are traded, but a large part of the cost consists
of labor and the restaurant site, which are not traded. These nontraded components of the
Big Mac’s cost are lower in China. |
b. |
According to absolute PPP, a Big Mac in Germany should cost 2.36×1.52 = 3.59 marks. |
c. |
Judging by Big Mac prices, goods in Germany are more expensive than comparable goods in
the United States. Alternatively stated, the mark appears to be overvalued in real terms.
Assuming that PPP holds in the long run, this overvaluation can be expected to disappear
over time. There are two ways in which this can happen. First, the nominal exchange rate
can change, with the mark depreciating against the dollar (meaning more marks per dollar
than the current 1.52). Second, the U.S. inflation rate can exceed the German inflation
rate, raising the price of U.S. goods relative to German goods. |
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