30 Answers to Textbook Questions and Problems Problems and applications 1. a. An increase in saving shifts the(S-n) schedule to the right, increasing the supply of dollars available to be invested abroad, as in Figure 5-3. The increased supply of dollars causes the equilibrium real exchange rate to fall from e, to E2. Because the dollar becomes less valuable, domestic goods become less expensive relative to reign goods, so exports rise and imports fall. This means that the trade balar increases. The nominal exchange rate falls following the movement of the exchange rate, because prices do not change in response to this shock Net exports b. The introduction of a stylish line of Toyotas that makes some consumers prefer foreign cars over domestic cars has no effect on saving or investment, but it shift the NX(E)schedule inward, as in Figure 5-4. The trade balance does not change but the real exchange rate falls from E, to E2. Because prices are not affected, the nominal exchange rate follows the real exchange rate (S-n NX1(∈)
Problems and Applications 1. a. An increase in saving shifts the (S – I) schedule to the right, increasing the supply of dollars available to be invested abroad, as in Figure 5–3. The increased supply of dollars causes the equilibrium real exchange rate to fall from 1 to 2. Because the dollar becomes less valuable, domestic goods become less expensive relative to foreign goods, so exports rise and imports fall. This means that the trade balance increases. The nominal exchange rate falls following the movement of the real exchange rate, because prices do not change in response to this shock. b. The introduction of a stylish line of Toyotas that makes some consumers prefer foreign cars over domestic cars has no effect on saving or investment, but it shifts the NX( ) schedule inward, as in Figure 5–4. The trade balance does not change, but the real exchange rate falls from 1 to 2. Because prices are not affected, the nominal exchange rate follows the real exchange rate. 30 Answers to Textbook Questions and Problems Real exchange rate NX2 NX1 (S1 – I) (S2 – I) NX ( ) A B NX Net exports ∋ ∋ ∋ 2 1 ∋ ∋ ∋ ∋ ∋ Figure 5–3 Real exchange rate A B NX Net exports ∋ ∋ ∋ ∋ NX2( ) NX ∋ 1( ) 2 1 (S – I) Figure 5–4
Chapter 5 The Open Ec In the model we considered in this chapter, the introduction of ATMs has no effect on any real variables. The amounts of capital and labor determine output y. The world interest rate r determines investment I(r). The difference between domes tic saving and domestic investment (s-n)determines net exports. Finally, the intersection of the NX(E)schedule and the(s-n schedule determines the real exchange rate, as in Figure 5-5 NX(E) Net exports The introduction of ATMs, by reducing money demand, does affect the nomi- nal exchange rate through its effect on the domestic price level. The price level adjusts to equilibrate the demand and supply of real balances, so that M/P=(M/P) If M is fixed, then a fall in (M/P) causes an increase in the price level: this reduces the supply of real balances M/P and restores equilibrium in the money market Now recall the formula for the nominal exchange rate e=∈×(P/P. We know that the real exchange rate E remains constant, and we assume that the foreign price level P is fixed. When the domestic price level P increases, the nomi- nal exchange rate e depreciates
c. In the model we considered in this chapter, the introduction of ATMs has no effect on any real variables. The amounts of capital and labor determine output Y. The world interest rate r* determines investment I(r*). The difference between domestic saving and domestic investment (S – I) determines net exports. Finally, the intersection of the NX( ) schedule and the (S – I) schedule determines the real exchange rate, as in Figure 5–5. The introduction of ATMs, by reducing money demand, does affect the nominal exchange rate through its effect on the domestic price level. The price level adjusts to equilibrate the demand and supply of real balances, so that M/P = (M/P) d . If M is fixed, then a fall in (M/P) d causes an increase in the price level: this reduces the supply of real balances M/P and restores equilibrium in the money market. Now recall the formula for the nominal exchange rate: e = × (P*/P). We know that the real exchange rate remains constant, and we assume that the foreign price level P* is fixed. When the domestic price level P increases, the nominal exchange rate e depreciates. Chapter 5 The Open Economy 31 Real exchange rate NX Net exports ∋ ∋ ∋ NX ( ) S – I ∋ ∋ ∋ Figure 5–5
32 Answers to Textbook Questions and Problems 2. a. National saving is the amount of output that is not purchased for current con sumption by households or the government. We know output and government spending, and the consumption function allows us to solve for consumption Hence, national saving is given by S=Y-C-G =5,000-(250+0.75(5,000-1,000)-1,000 Investment depends negatively on the interest rate, which equals the world rate rof 5. Thus I=1.000-50×5 Net exports equals the difference between saving and investment. Thus, NX=S-I 750-750 Having solved for net exports, we can now find the exchange rate that clears the foreign-exchange market NX=500-500×E 0=500-500×E b. Doing the same analysis with the new value of government spending we find =5,000-(250+0.75(5,000-1,000)-1,250 I=1,000-50×5 NX=S-l =500-750 250 NX=500-500 250=500-500×E E=1.5 The increase in government spending reduces national saving, but with an unchanged world real interest rate, investment remains the same. Therefore domestic investment now exceeds domestic saving, so some of this investment must be financed by borrowing from abroad. This capital inflow is accomplished by reducing net exports, which requires that the currency appreciat
2. a. National saving is the amount of output that is not purchased for current consumption by households or the government. We know output and government spending, and the consumption function allows us to solve for consumption. Hence, national saving is given by: S= Y – C – G = 5,000 – (250 + 0.75(5,000 – 1,000)) – 1,000 = 750. Investment depends negatively on the interest rate, which equals the world rate r* of 5. Thus, I = 1,000 – 50 × 5 = 750. Net exports equals the difference between saving and investment. Thus, NX = S – I = 750 – 750 = 0. Having solved for net exports, we can now find the exchange rate that clears the foreign-exchange market: NX = 500 – 500 × ε 0 = 500 – 500 × ε ε = 1. b. Doing the same analysis with the new value of government spending we find: S= Y – C – G = 5,000 – (250 + 0.75(5,000 – 1,000)) – 1,250 = 500 I = 1,000 – 50 × 5 = 750 NX = S – I = 500 – 750 = –250 NX = 500 – 500 × ε –250 = 500 – 500 × ε ε = 1.5. The increase in government spending reduces national saving, but with an unchanged world real interest rate, investment remains the same. Therefore, domestic investment now exceeds domestic saving, so some of this investment must be financed by borrowing from abroad. This capital inflow is accomplished by reducing net exports, which requires that the currency appreciate. 32 Answers to Textbook Questions and Problems
Chapter 5 The Open Economy c. Repeating the same steps with the new interest rate S=Y-C-G =5,000-(250+0.75(5,000-1,000)-1,000 I=1.000 500 =250 250=500-500×E 0.5 Saving is unchanged from part (a), but the higher world interest rate lowers investment. This capital outflow is accomplished by running a trade surplus, urrency dep 3. a. When Leveretts exports become less popular, its domestic saving Y-C-G does not change This is because we assume that y is determined by the amount of cap- ital and labor, consumption depends only on disposable income and government spending is a fixed exogenous variable. Investment also does not change, since investment depends on the interest rate, and Leverett is a small open economy that takes the world interest rate as given. because neither saving nor investment changes, net exports, which equal S-l, do not change either. This is shown in Figure 5-6 as the unmoving S-l curve The decreased popularity of Leverett's exports leads to a shift inward of the net exports curve, as shown in Figure 5-6. At the new equilibrium, net exports are unchanged but the currency has depreciated NX(E), NX=NX, Net exports Even though Leverett,'s exports are less popular, its trade balance has emained the same. The reason for this is that the depreciated currency provides a stimulus to net exports, which overcomes the unpopularity of its exports by mak- ing them cheaper
c. Repeating the same steps with the new interest rate, S= Y – C – G = 5,000 – (250 + 0.75(5,000 – 1,000)) – 1,000 = 750 I = 1,000 – 50 × 10 = 500 NX = S – I = 750 – 500 = 250 NX = 500 – 500 × ε 250 = 500 – 500 × ε ε = 0.5. Saving is unchanged from part (a), but the higher world interest rate lowers investment. This capital outflow is accomplished by running a trade surplus, which requires that the currency depreciate. 3. a. When Leverett’s exports become less popular, its domestic saving Y – C – G does not change. This is because we assume that Y is determined by the amount of capital and labor, consumption depends only on disposable income, and government spending is a fixed exogenous variable. Investment also does not change, since investment depends on the interest rate, and Leverett is a small open economy that takes the world interest rate as given. Because neither saving nor investment changes, net exports, which equal S – I, do not change either. This is shown in Figure 5–6 as the unmoving S – I curve. The decreased popularity of Leverett’s exports leads to a shift inward of the net exports curve, as shown in Figure 5–6. At the new equilibrium, net exports are unchanged but the currency has depreciated. Even though Leverett’s exports are less popular, its trade balance has remained the same. The reason for this is that the depreciated currency provides a stimulus to net exports, which overcomes the unpopularity of its exports by making them cheaper. Chapter 5 The Open Economy 33 S – I NX(ε)1 NX(ε)2 NX1 = NX2 { NX Net exports ε1 ε2 ε Real exchange rate Figure 5–6
34 Answers to Textbook Questions and Problems expensive. This is an example of the fact that imports (including foreign travel) become more expensive-as required to keep net exp h face of decreased demand for exports c. If the government reduces taxes, then disposable income and consumption rise Hence, saving falls so that net exports also fall. This fall in net exports puts upward pressure on the exchange rate that offsets the decreased world demand Investment and the interest rate would be unaffected by this policy since Leverett takes the world interest rate as given. 4. The increase in government spending decreases government saving and, thus, decreas- es national saving; this shifts the saving schedule to the left as in Figure 5-7.Given the world interest rate r, the decrease in domestic saving causes the trade balance to fall Figure 6-7 Trade deficit I(r) Investment. Savir
b. Leverett’s currency now buys less foreign currency, so traveling abroad is more expensive. This is an example of the fact that imports (including foreign travel) have become more expensive—as required to keep net exports unchanged in the face of decreased demand for exports. c. If the government reduces taxes, then disposable income and consumption rise. Hence, saving falls so that net exports also fall. This fall in net exports puts upward pressure on the exchange rate that offsets the decreased world demand. Investment and the interest rate would be unaffected by this policy since Leverett takes the world interest rate as given. 4. The increase in government spending decreases government saving and, thus, decreases national saving; this shifts the saving schedule to the left, as in Figure 5–7. Given the world interest rate r*, the decrease in domestic saving causes the trade balance to fall. 34 Answers to Textbook Questions and Problems Real interest rate r* Current-account deficit = Capital-account surplus I, S Investment, Saving I (r) S2 S1 r Trade deficit Figure 5–7