Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
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
∋
∋
B
2
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
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 (
S
-
I
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
S
r
Figure 5–7
S
r
Figure 5–8
Chapter 5 The Open Economy 37
B
A
∋
∋
2
∋
1
(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
r
r2
*
S1
S2
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,
S
–
I
(
r
) 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
S
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
S
r
Figure 5–14
