Economics Chapter 5 Homework Leverett Small Open Economy That Takes The

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Questions for Review

1. By rewriting the national income accounts identity, we show in the text that

S– I= NX.

This form of the national income accounts identity shows the relationship between the

international flow of funds for capital accumulation, S– I, and the international flow of

2. The nominal exchange rate is the relative price of the currency of two countries. The

real exchange rate, sometimes called the terms of trade, is the relative price of the goods

of two countries. It tells us the rate at which we can trade the goods of one country for

the goods of another.

3. A cut in defense spending increases government saving and, hence, increases national

saving. Investment depends on the world rate and is unaffected. Hence, the increase in

saving causes the (S– I) schedule to shift to the right, as in Figure 5–1. The trade bal-

ance rises, and the real exchange rate falls.

CHAPTER 5The Open Economy

4. If a small open economy bans the import of Japanese DVD players, then for any given

real exchange rate, imports are lower, so that net exports are higher. Hence, the net

export schedule shifts out, as in Figure 5–2.

5. We can relate the real and nominal exchange rates by the expression

Nominal Real Ratio of

Exchange = Exchange ×Price

Rate Rate Levels

Chapter 5 The Open Economy 31

∋

S – I

Figure 5–2

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 1to 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 1to 2. Because prices are not affected, the

nominal exchange rate follows the real exchange rate.

32 Answers to Textbook Questions and Problems

∋

∋∋

∋

(S – I)Figure 5–4

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 domes-

tic 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.

If Mis fixed, then a fall in (M/P)dcauses 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).

Chapter 5 The Open Economy 33

∋

S – I

∋

Figure 5–5

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

= 750.

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

= 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

34 Answers to Textbook Questions and Problems

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

3. a. When Leverett’s exports become less popular, its domestic saving Y – C – G does

not change. This is because we assume that Yis 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– I, do not change either. This is shown in

Figure 5–6 as the unmoving S – I curve.

Chapter 5 The Open Economy 35

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.

4. Governor Bernanke’s statement is consistent with the models in the chapter. Suppose

we consider the United States as a small open economy, for example. The increase in

the global supply of saving pushes the global interest rate down, which encourages U.S.

investment. If we assume that this is primarily non-U.S. saving, then for the United

States, the saving curve doesn’t shift but we get a movement along the investment

curve from point A to point B in Figure 5–7. The interest rate falls, and the trade

deficit rises (

–

falls).

5. The increase in government spending decreases government saving and, thus, decreases

national saving; this shifts the saving schedule to the left, as in Figure 5–8. Given the

world interest rate r*, the decrease in domestic saving causes the trade balance to fall.

36 Answers to Textbook Questions and Problems

Figure 5–7

Figure 5–8

Chapter 5 The Open Economy 37

∋

(S2 – I)(S1 – I)

Figure 5–9

The answer to this question does depend on whether this is a local war or a world

war. A world war causes many governments to increase expenditures; this increases

the world interest rate r*. The effect on a country’s external accounts depends on the

size of the change in the world interest rate relative to the size of the decrease in sav-

ing. For example, an increase in the world interest rate could cause a country to have a

smaller trade deficit, as in Figure 5–10, or even a trade surplus, as in Figure 5–11.

38 Answers to Textbook Questions and Problems

Trade deficit

Figure 5–10

6. a. If poor nations offered better production efficiency and legal protections, then the

marginal product of capital would rise. To increase the amount of capital that they

b. Assuming that together, the poor nations account for a noticeable share of world

demand for investment, the demand for loanable funds in world financial markets

rises. For the world overall, the picture looks like Figure 5–12, which follows.

interest rate.

d. For rich countries, the increase in global interest rates reduces desired invest-

ment. Hence,

–

(

) rises, which means that the trade balance rises.

7. The tariff on luxury cars would not affect net exports because it does not affect national

saving (because it would not affect Y, C, or G) or investment. It would, however, shift

the NX curve by decreasing U.S. demand for Japanese auto imports. This shift of the

curve, shown in Figure 5–13, would raise the exchange rate. Although net exports

would not change, the volume of both imports and exports would fall by the same

amount.

Chapter 5 The Open Economy 39

Global

rFigure 5–12

There are also important compositional effects of this policy. On the production side, the

higher exchange rate increases imports and puts pressure on the sales of American com-

panies with the exception of American luxury car production, which is shielded by the

8. The real exchange rate measures the rate at which the goods of one country can be trad-

ed for the goods of the other country. In this case, the real exchange rate measures the

number of bottles of vodka that must be exchanged for one TV. If Russia is experiencing

no technological progress in vodka production, then the number of bottles produced is

fixed. Since China is experiencing positive technological progress in TV production, the

number of TVs produced will be increasing. Given that TVs are relatively more abun-

dant and vodka is relatively more scarce, we would expect the real exchange rate to

9. a. If the countries that institute an investment tax credit are large enough to shift

the world investment demand schedule, then the tax credits shift the world

investment demand schedule upward, as in Figure 5–14.

40 Answers to Textbook Questions and Problems

Figure 5–14