Define net capital outflow (Net Foreign Investment) and trade balance. Explain how they are related.

Define net capital outflow (Net Foreign Investment) and trade balance. Explain how they are related.

5. Define the nominal exchange rate and the real exchange rate.

6. If a small open economy cuts defense spending, what happens to saving, investment, the trade balance, the interest rate, and the exchange rate?

7. If a small open economy bans the import of Japanese video game systems, what happens to saving, investment, the trade balance, the interest rate, and the exchange rate?

 8. According to the theory of purchasing-power parity, if Japan has low inflation and Mexico has high inflation, what will happen to the exchange rate between the Japanese yen and the Mexican peso?

PROBLEMS AND APPLICATIONS

1. Consider an economy described by the following equations: Y = C + I + G + NX Y = 8,000 G = 2,500 T = 2,000 C = 500 + 2/3(Y−T) I = 900−50r NX = 1,500−250? r = r∗ = 8

 a. In this economy, solve for private saving, public saving, national saving, investment, the trade balance, and the equilibrium exchange rate.

b. Suppose now that G is cut to 2,000. Solve for private saving, public saving, national saving, investment, the trade balance, and the equilibrium exchange rate. Explain what you find. c. Now suppose that the world interest rate falls from 8 to 3 percent. (G is again 2,500.) Solve for private saving, public saving, national saving, investment, the trade balance, and the equilibrium exchange rate. Explain what you find.

2. The country of Leverett is a small open economy. Suddenly, a change in world fashions makes the exports of Leverett unpopular:

a. What happens in Leverett to saving, investment, net exports, the interest rate, and the exchange rate? 1

 b. The citizens of Leverett like to travel abroad. How will this change in the exchange rate affect them?

c. The fiscal policymakers of Leverett want to adjust taxes to maintain the exchange rate at its previous level. What should they do? If they do this, what are the overall effects on saving, investment, net exports, and the interest rate?

3. What will happen to the trade balance and the real exchange rate of a small open economy when government purchases increase, such as during a war? Does your answer depend on whether this is a local war or a world war?

 4. The president is considering placing a tariff on the import of Japanese luxury cars. Using the model presented in this chapter, discuss the economics and politics of such a policy. In particular, how would the policy affect the U.S. trade deficit? How would it affect the exchange rate? Who would be hurt by such a policy? Who would benefit?

5. “Traveling in Mexico is much cheaper now than it was ten years ago,” says a friend. “Ten years ago, a dollar bought 10 pesos; this year, a dollar buys 15 pesos.” Is your friend right or wrong? Given that total inflation over this period was 25 percent in the United States and 100 percent in Mexico, has it become more or less expensive to travel in Mexico? Write your answer using a concrete example—such as an American hot dog versus a Mexican taco—that will convince your friend.

6. You read on a financial website that the nominal interest rate is 12 percent per year in Canada and 8 percent per year in the United States. Suppose that international capital flows equalize the real interest rates in the two countries and that purchasing-power parity holds.

a. Using the Fisher equation (discussed in Chapter 5), what can you infer about expected inflation in Canada and in the United States?

 b. What can you infer about the expected change in the exchange rate between the Canadian dollar and the U.S. dollar?

7. A friend proposes a get-rich-quick scheme: borrow from a U.S. bank at 8 percent, deposit the money in a Canadian bank at 12 percent, and make a 4 percent profit. What’s wrong with this scheme?

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