INTERNATIONAL ECONOMICS, 7TH EDITION
Study Resources: Questions for Study & Review
Chapter 14
1. In 1995, Mexico maintained a fixed exchange rate regime relative to the U.S. dollar. In
the six months prior to the Mexican national elections in October 1995, the public debt
increased by 30 percent.
a. Use the TB/Y diagram to explain the effects of the increase in public debt. Be
specific; highlight the effect of changes in the trade balance and output.
b. Why do you think the Mexican debt increased? Use a graph.
2. From the Wall Street Journal Online News Roundup, “Foreign Exchange Section” WSJ
May 3, 2002: NEW YORK: “The dollar fell sharply in Friday trading, with dealers
clearly worried about the sustainability of the U.S. economic recovery. In midday
trading, the dollar was at ¥126.93, compared with ¥127.88 late Thursday in New York,
while the euro traded at 91.68 U.S. cents, up from 90.28 U.S. cents the previous
session. In the U.S., the closely watched monthly employment report was weaker than
expected, adding to the dollar’s woes. For April, the unemployment rate rose to 6
percent, well above the 5.8 percent economists had forecast. ‘The market’s clearly
bearish on the dollar,’ said Mitul Kotecha, head of global currency strategy at Crédit
Agricole Indosuez.”
a. If the statement that “dealers [are] clearly worried about the sustainability of the U.S.
economic recovery” means that traders are worried that consumption expenditures
in the U.S. will fall, what will be the effect on output, reserves, and the trade
balance? Use the TB/Y diagram. Assume the U.S. has a fixed exchange rate.
b. If the statement that “dealers [are] clearly worried about the sustainability of the U
economic recovery” means that traders are worried that consumption expen
in the U.S. will fall, what will be the effect on output, the exchange rate, and the
trade balance? Use the TB/Y diagram. Assume the U.S. has a flexible exchange
rate.
.S.
ditures
3. Under fixed exchange rate regimes, when countries seek to improve their trade
balance with fiscal policy, how is policy effectiveness influenced by the marginal
propensity to import? Draw graphs to explain your answer.
4. On Oct. 30, 2000 the Wall Street Journal announced that “U.S. income growth slowed
to 2.7 percent from 5.3 percent in the previous quarter. The 2.7 percent came in well
below the forecast 3.5 percent.” Assume Hong Kong and the U.S. are on a fixed
exchange rate regime, while the U.S. and Europe are on a flexible exchange rate
regime. As income growth in the U.S. decelerates, what do you expect to happen to:
a. the U.S. trade balance with Hong Kong?
b. U.S. reserves?
c. the U.S. trade balance with Europe?
d. Hong Kong output if the reduction in U.S. growth equals a reduction in U.S.
autonomous consumption?
Draw a graph to explain each answer.
5. Assume a small country is characterized by the following equations:
Consumption C = 220 + .7(Y–T)
Investment I = 200
Government spending G = 100
Tax T = 100
Imports M = 100 + .2Y
Exports X = 400
a. Calculate equilibrium income Y, the corresponding balance of trade TB, and
government saving Sg using the usual equilibrium condition Y=C+I+G+X–M.
b. Construct the equations for the SN–I line and for the X–M line and equate these two
equations to calculate equilibrium income Y (you should get the same result as in
a.).
c. Calculate the impact of a fiscal expansion (an increase in G equal to 100) under
fixed and then under flexible exchange rates using the SN–I/X–M approach.
i. Fixed exchange rate regime – G increases from 100 to 200
First construct the new equations for SN–I and X–M (if they have changed).
Calculate the new level of output, the balance of trade TB, and government saving
Sg. Illustrate your results with the SN–I/X–M graph.
ii. Flexible exchange rates – same change in G starting from the original model
What happens to the exchange rate? Construct the new equations for SN–I. What is
the value of X–M with flexible exchange rates? Equate SN–I and X–M to calculate
the resulting level of output. Illustrate your results with the SN–I/X–M graph.
iii. Compare your results under fixed and flexible exchange rates.
6. Use the model below to find the impact of a devaluation in a fixed exchange rate
regime. (Note that now the import and the export equations include the exchange
rate.) Assume the following model of the economy:
Saving S = – 80 + .2 YD
Investment I = 100 – 1000r
Exports X = 500 + 50e
Imports M = 50 + .2 Y–100e
Government spending G = 100
Tax T = 100
Disposable income YD = Y–T
Interest rate r = .05
Real exchange rate e = 1
Where Y is domestic income. The interest rate is fixed. Prices are fixed.
a. Calculate the equilibrium level of income (Ye) using the saving-investment/trade
balance equilibrium condition.
b. Calculate the corresponding trade balance. Is trade balanced or do we have a
surplus or a deficit?
c. Draw the corresponding SN–I/X–M graph and show your results (include the
intercepts on the vertical axis of the two lines).
d. Now assume that the central bank redefine e from 1 to 1.2. How do you call such
policy?
e. Calculate the new level of income and the new trade balance. What is the impact of
the devaluation on income and on the trade balance?
f. Illustrate the effect of the devaluation on the SN–I/X–M graph and report your
results.
g. Calculate the level of income consistent with balanced trade.
h. What exchange rate policy would you recommend to reach balanced trade? What
would be the impact of that policy on output?
i. Assume that the level of income calculated in Questions 5 is below full employment
income. Could you recommend a better policy to reach balanced trade, i.e. a policy
that will not impact income adversely?
INTERNATIONAL ECONOMICS, 7TH EDITION
Study Resources: Questions for Study & Review
Chapter 14: Answers
1.
a. An increase in the public debt probably corresponds to a budget deficit. As
3.
Y=C+I+G+X<minus>M and NX=Xo<minus>Mo<minus>mY
5.
a. Y=220+.7(Y<minus>T)+200+100+400<minus>100<minus>.2Y
N<minus>I
N’<minus>I