Economics of Exchange Rates and Net Exports

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Questions and Answers

How do high real exchange rates impact domestic purchasing behavior?

Increase domestic residents' demand for native goods.

Encourage vacations within the country.

Lead to a greater preference for imported goods. (correct)

Decrease demand for foreign goods.

What is the relationship between net exports and the real exchange rate?

Net exports increase as the real exchange rate increases.

Net exports decrease as the real exchange rate decreases.

Net exports decrease as the real exchange rate increases. (correct)

Net exports are independent of the real exchange rate.

Which of the following statements is true about foreign demand for U.S. goods?

It is influenced positively by a low real exchange rate. (correct)

It becomes stable regardless of domestic pricing.

It increases when domestic goods become more expensive.

It decreases when domestic goods are relatively cheap.

What is the primary reason for assuming a small open economy in economic models?

It simplifies the analysis for better understanding. Signup and view all the answers

In what scenario are U.S. net exports likely to be high?

When domestic goods are cheaper relative to foreign goods. Signup and view all the answers

What does the acronym NX represent in the context of the model discussed?

Net Exports Signup and view all the answers

What does the equation NX = NX(e) signify?

Net exports are a function of the real exchange rate. Signup and view all the answers

According to the model, what is the relationship between investment (I) and the real interest rate (r)?

Investment is negatively related to the real interest rate. Signup and view all the answers

What aspect does the model assume regarding the economy's output (Y)?

It is fixed by the factors of production and the production function. Signup and view all the answers

When would foreigners purchase fewer U.S. goods?

When the real exchange rate is high. Signup and view all the answers

Which scenario illustrates a decrease in net exports?

Increased demand for imported vehicles. Signup and view all the answers

In the context of the consumption function, what is disposable income represented as?

Y - T Signup and view all the answers

What will happen if the world interest rate increases in the context of this model?

Investment will decrease due to higher costs. Signup and view all the answers

Why might a domestic resident choose to vacation in Florida instead of Italy?

Lower relative prices of domestic destinations. Signup and view all the answers

Which part of the identity NX = S - I indicates savings in the model?

S Signup and view all the answers

Which two variables are directly compared in the accounting identity NX = (Y - C - G) - I?

Savings and total investment. Signup and view all the answers

What caused the trade deficit in the U.S. to start shrinking a few years later?

Substantial decline in housing prices Signup and view all the answers

What was the trade deficit as a percentage of GDP at its peak in 2006?

5.5 percent Signup and view all the answers

By how much did the trade deficit decrease from 2006 to 2013?

2.5 percent Signup and view all the answers

What does a positive trade balance indicate?

A trade surplus Signup and view all the answers

What relationship does the trade balance have with saving and investment?

Trade balance equals saving minus investment Signup and view all the answers

What does the history of the U.S. trade deficit suggest about interpreting this statistic?

It does not tell much about the economy by itself Signup and view all the answers

In what years does Panel (b) showcase national saving and investment as a percentage of GDP?

1960 to 2013 Signup and view all the answers

What was one of the observed consequences of lower housing prices on the economy?

Substantial decline in residential investment Signup and view all the answers

What does Robert Solow's quote about his barber illustrate regarding bilateral trade balances?

Chronic deficits with individual sectors do not necessarily impact personal financial health. Signup and view all the answers

What is the relationship between trade balance and net capital outflow in the context of saving and investment?

Trade balance equals net capital outflow, which equals saving minus investment. Signup and view all the answers

In the model of a small open economy, what assumption is made regarding the adjustment of the real interest rate?

The real interest rate remains fixed regardless of capital flows. Signup and view all the answers

What is implied by the term 'perfect capital mobility' in the context of a small open economy?

Residents can borrow or lend freely in global markets. Signup and view all the answers

What does 'small' refer to in the context of a small open economy?

The economy is a minor player in the global market. Signup and view all the answers

How does a trade deficit affect the borrowing of a small open economy?

It allows the economy to borrow from other countries. Signup and view all the answers

Which of the following statements is true regarding the model discussed?

The model uses familiar elements from previous economic chapters. Signup and view all the answers

What happens if the real interest rate does not equilibrate saving and investment?

The economy can experience either trade deficits or surpluses. Signup and view all the answers

What does the phenomenon of diminishing marginal product suggest about capital in scarce environments?

Capital is more valuable where it is scarce. Signup and view all the answers

Which factor is NOT mentioned as a reason why capital-rich countries do not lend to capital-poor countries?

Higher per worker capital accumulation in poor nations. Signup and view all the answers

In the Cobb–Douglas production function, what is indicated by a lower value of the parameter A?

Lower production output for given inputs. Signup and view all the answers

Which of the following is a reason capital might not flow into poor nations?

Fear of losing investments due to unstable conditions. Signup and view all the answers

What is a consequence of enforced property rights in a nation?

Enhanced foreign investment attraction. Signup and view all the answers

If a wealthy individual lives in a poor nation, what might they choose to do with their wealth?

Invest it in a safer country. Signup and view all the answers

What does the term 'K/L' represent in the context of capital accumulation?

Capital per worker. Signup and view all the answers

How can poor nations address the challenges posed by capital flight?

Strengthen enforcement of property rights. Signup and view all the answers

What does the flat net-exports schedule indicate about net exports and real exchange rate changes?

Net exports are highly sensitive to small changes in the real exchange rate. Signup and view all the answers

What does the law of one price state regarding international prices?

Goods should have equivalent prices when accounting for exchange rates. Signup and view all the answers

Which example demonstrates the concept of purchasing-power parity?

A Big Mac costs 8,600 pesos in Colombia when the expected exchange rate is 1,794 pesos per dollar. Signup and view all the answers

What was the predicted exchange rate for the dollar to pesos based on the Big Mac cost in Colombia?

1,794 pesos per dollar. Signup and view all the answers

How does the actual exchange rate of 1,848 pesos compare to the predicted rate?

It is higher than predicted but still within a close range. Signup and view all the answers

What conclusion can be drawn from the evidence on purchasing-power parity?

The evidence is mixed, with actual and predicted rates usually similar but not always identical. Signup and view all the answers

Which statement about net exports is most accurate based on real exchange rates?

Small fluctuations in the real exchange rate can significantly impact net exports. Signup and view all the answers

What implication does the law of one price have for exchange rates in international trade?

Exchange rates adjust to reflect differences in purchasing power. Signup and view all the answers

Study Notes

Page 1: Figure and Section 6-1

Figure 6-1 displays imports and exports as a percentage of output for various countries in 2012.
Section 6-1 discusses international capital and goods flows in open economies.
An open economy's spending doesn't necessarily equal its output.
Borrowing from or lending to other countries is possible.

Page 2: The Role of Net Exports

Expenditure in a closed economy consists of consumption (Cd), investment (Id), and government purchases (Gd).
In an open economy, exports (X) are added to the components.
Y = Cd + Id + Gd + X represents the identity of spending.
The sum of Cd, Id, and Gd is domestic spending on domestic goods and services.
The sum of domestic spending = domestic spending on domestic goods & services + domestic spending on foreign goods & services.
The identity can be re-written as Y = C + I + G + X − IM.
IM represents imports.

Page 3: International Capital Flows and the Trade Balance

In open economies, financial and goods markets are related.
National saving (S) equals the sum of private saving (Y − T − C) and public saving (T − G).
S=I+NX
NX, or net exports, is the difference between exports and imports.
The trade balance represents the difference between a country’s imports and exports of goods and services
Net capital outflow equals the difference between domestic saving and domestic investment.

Page 4: International Flows of Goods and Capital: An Example

A U.S. resident selling software to a Japanese consumer is an export.
The seller's choice of what to do with the foreign currency impacts the net capital outflow.
Net exports equal to net capital outflow form an identity, this must hold.

Page 5: The Irrelevance of Bilateral Trade Balances

A nation's overall trade balance (exports minus imports) with the rest of the world is important, not bilateral balances.
Bilateral, or country-to-country, balances may be politically relevant, but aren't significant in macro-economic sense. Exchanged goods and services from different countries do eventually balance out across all the nations.

Page 6: Saving and Investment in a Small Open Economy

A country's spending in a given year need not equal its output of goods and services in an open economy.
Countries can spend more than they produce (by borrowing abroad) or less than they produce (by lending abroad).
Net exports must equal the difference between saving and investment.

Page 7: Capital Mobility and the World Interest Rate

A small open economy has perfect access to world financial markets and the domestic interest rate equals the world interest rate.
Residents of the economy can always borrow or lend at the world rate.
The world interest rate is determined by the equilibrium of world saving and world investment.
A small open economy's effect on the world interest rate is negligible.

Page 8: The Model

Output (Y) is fixed by factors of production and the production function.
Consumption (C) is positively related to disposable income (Y-T).
Investment (I) is negatively related to the real interest rate (r).

Page 9: Saving and Investment in a Small Open Economy; How Policies Influence the Trade Balance

The trade balance depends on variables that determine national saving (S) and investment (I)
Policies affecting national saving (fiscal policy changes) will affect the trade balance.
Changes in foreign saving (fiscal policy in another country) will impact the world interest rate, which then influences domestic investment and the trade balance in a small open economy.

Page 10: Fiscal Policy at Home; Fiscal Policy Abroad

Fiscal policy changes that affect national saving (like tax cuts) will cause a trade deficit.
Fiscal policy changes in other countries can affect the world interest rate.
Changes in the world interest rate then influence investment and, consequently, the trade balance.

Page 11:International Flows of Goods and Capital: Summary

A summary of trade surplus, balance, and deficit.
Net Exports relate to net capital outflow based on international flows.

Page 12: Evaluating Economic Policy

Whether trade deficits are problems depends on their underlying reasons.
Trade deficits might be due to low saving, high consumption.
They might reflect economic development rather than a problem.

Page 13: The U.S. Trade Deficit

U.S. trade deficits fluctuated during the 1980s, 1990s, and 2000s. This was due to changes in fiscal policy (tax cuts, government spending).
The period saw shifts from being a creditor nation to a debtor nation.
2013, the trade deficit was $497 billion or 3 percent of GDP.

Page 14: The Trade Balance, Saving, and Investment: The U.S. Experience

Figure demonstrates U.S. trade balance, saving, and investment from 1960 to 2013.

Page 15: Why Doesn't Capital Flow to Poor Countries?

Factors such as differences in technology, institutions, and property rights affect capital flows.
Capital may not flow to poorer nations even if it would yield a higher return there according to simplistic models.

Page 16: Exchange Rates

Exchange rates are prices at which one currency can be traded for another.
Nominal exchange rates describe the relative prices of the currencies.
Real exchange rates describe the relative prices of goods, considering the exchange rate

Page 17: Nominal and Real Exchange Rates

Nominal exchange rate is the relative price of the currencies of the two countries.
Example: price of 1 US Dollar in Japanese Yen.
Real exchange rate is the relative price of goods of two countries (terms of trade).
Example: comparing the price of a car in the US to the price of a similar car in Japan.

Page 18: The Real Exchange Rate and the Trade Balance

The real exchange rate determines the relative price of domestic and foreign goods, which then affect the demand for imports and exports; hence the trade balance.
The trade balance is negatively related to the real exchange rate.

Page 19: The Determinants of the Real Exchange Rate

Real exchange rate depends on net exports, saving, investment, and the world interest rate.
The real exchange rate is determined the net exports schedule and the saving minus investment schedule.

Page 20: Policies in the Large Open Economy

Fiscal policy impacts both the domestic interest rates and net exports.
Expansionary fiscal policy (tax cuts, increased government spending) reduces national saving, raises the interest rate, leads to a trade deficit, and an appreciation of the domestic currency.

Pages 21 - 22 : Effects of Trade Policies

Trade Policies (tariffs or quotas) do not directly change the trade balance, instead they alter net exports by affecting the real exchange rate.
A trade restriction increases net exports in the short run, while increasing costs in the long run for consumers

Page 23: The Determinants of the Nominal Exchange Rate

The nominal exchange rate depends on the real exchange rate and price levels in the two countries (domestic and foreign).
The formula demonstrates how changes in the real exchange rate and price levels impact the nominal exchange rate.

Page 24: Inflation and Nominal Exchange Rates

Inflation in a country causes depreciation or devaluation of that country's currency.
High inflation countries frequently have depreciating currencies.
Conversely, countries with low inflation experiences appreciating currencies.

Page 25: The Special Case of Purchasing-Power Parity

The law of one price states that the same commodity should cost the same in different markets, at the same time.
The law of one price is known as the purchasing power parity (PPP), which shows how different currency values affect a single commodity price in two different markets.

Page 26: Conclusion: The United States as a Large Open Economy

The U.S. is considered a large open economy.
Policies influence both domestic interest rates and net exports. Differences in responses between small and large open economies stem in part from the effect of policies on world interest rates.

Page 27-28: Appendix and Summary; The Large Open Economy

In large open economies, net capital outflow affects the interest rate.
The net capital outflow depends on domestic real interest rates.
Net capital outflow is a function of real interest rates (CF=CF(r)).

Pages 29-30: Appendix; The Large Open Economy

The large open economy model considers how different countries, as part of the world economy, interact in the market for loanable funds and foreign currency.

Page 31-37: Policies in the Large Open Economy

Policies can influence the equilibrium interest rate and the real exchange rate or net exports in both small and large open economies.
Policies that increase saving or decrease investment tend to cause trade surpluses.
Policies that decrease saving or increase investment tend toward trade deficits.
Trade policies affect the real exchange rate without changing the trade balance.

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Description

This quiz examines the impacts of real exchange rates on domestic purchasing behavior and explores the relationship between net exports and the real exchange rate. Additionally, it discusses factors influencing foreign demand for U.S. goods and key concepts related to small open economies. Test your understanding of these economic principles!