Download Mankiw, Chapter 7

Mankiw, Chapter 5
Study Questions
1. (15 points) Suppose a small country is running a trade surplus. For each of the
following statements, explain whether or not the statement is consistent with this fact:
a. (5 points) Statement #1:
b. (5 points) Statement #2:
c. (5 points) Statement #3:
The world real interest rate is lower than the real
interest rate that would equate domestic loan supply
and domestic loan demand in the country.
Net foreign investment is negative.
Real GDP is greater than domestic spending.
2. (15 points) Suppose Congress has promises to take actions to reduce significantly the
budget deficit of the Federal government.
a. (8 points) If they keep this promise, what will happen to the U.S. trade deficit?
Explain.
b. (7 points) If they keep this promise, what will happen to the U.S. real exchange
rate? Explain.
3. (10 points) Suppose the republics of the former Soviet Union begin to make
significant progress in their attempts to become free-market economies. Because
these countries have capital stocks that are obsolete, this will create a large set of
profitable investment opportunities in these countries. What will happen to the trade
surplus/deficit of these countries as a result? Explain.
4. (10 points) Consider two countries, country A and country B. In country A, the
average rate of money growth has been 30% per year over the last few years, while in
country B, the average rate of money growth has been 5% per year. Over the last few
years, what has probably been happening to the nominal exchange rate between the
currency of country A and the currency of country B? Explain.
5. Suppose the world real interest rate (r*) decreases. Explain in 2 or 3 sentences the
implications of this change for the net exports (NX) of a small open economy.
6. Suppose a technological innovation increases Real GDP in the US. Explain in 2 or 3
sentences the effect of this change on U.S. net foreign investment. (You may assume
for purposes of this question that the U.S. is a "small open economy.")
7. Japan trades heavily with other east Asian countries such as Korea, Thailand,
Singapore, Hong Kong, China, and Taiwan. In the last few years Japanese net foreign
investment in these countries has decreased. What does this fact imply about the net
exports of these countries (that is, the net exports of Korea, Thailand, and Singapore)?
Explain in 2 or 3 sentences.
8. Suppose the U.S. money growth rate increases. Explain in one or two sentences each
the implications of this change for (i) the U.S. inflation rate, and (ii) the nominal
exchange rate between the dollar and other currencies such as the German
Deutschmark (DM).
NOTE: You might also want to look at the following questions from the end of Chapter
8:
- Questions for Review, p. 222: #3, #4, #5
- Problems and Applications, pp. 222-223: #1, #3, #4, #6, #7, #8
- More Problems and Applications, p. 233: #1 (hard, but try it)
SAMPLE ANSWERS
1. a. If the country is running a trade surplus, then domestic savings exceeds domestic
investment (S>I) and net foreign investment is positive. If S>I, then the world
real interest rate r* is greater than the real interest rate that would clear the
domestic loan market. This is because I depends negatively on r and S is
independent of r. Thus the statement is NOT CONSISTENT.
b. As the answer to part (a) explains, NFI must be positive with S>I. Thus the
statement is NOT CONSISTENT.
c. With a trade surplus, NX > 0. Given that Y = C+I+G+NX, NX>0 implies Y >
C+I+G, which means that Real GDP is greater than domestic spending. The
statement IS CONSISTENT.
2. a. If the government deficit is reduced, this increases national saving (S). The
vertical S line shifts right in the (S,I) graph. Given that S < I initially at r*, the
rightward shift in S will reduce the amount by which I exceeds S. Thus the US
trade deficit DECREASES.
b. If US savings (S) increases (as the answer to part a indicates), this shifts the (S-I)
curve to the right in the (NX, S-I) graph, which in turn causes the real exchange
rate () to depreciate.
3. As domestic investment opportunities increase relative to domestic savings, the I(r)
line will shift right relative to the S line in the (I,S) graph. Given r*, this rise in I
relative to S causes (C+I+G) to rise relative to S, which decreases NX. The changes
will cause lower trade surpluses or higher trade deficits.
4. Purchasing Power Parity (PPP) does a good job of explaining nominal exchange rate
changes over long periods of time, especially between a high-inflation country and a
low-inflation country. PPP says that the nominal exchange rate change is caused by
the inflation differential. Because A > B, we would expect that the currency of
country A DEPRECIATED (in nominal terms) against the currency of country B.
5. Because the domestic interest rate is equal to the world real interest rate in a small
open economy, the fall in r* means that Investment (I) increases. This in turn
decreases S-I, because savings depends on output/income (Y) and is not affected.
Thus Net Exports, NX = S-I, decreases.
6. The technological innovation will most likely increase income/output (Y). If total
savings is a constant fraction of income, then savings (S) will rise. This will tend to
increase net exports NX = S-I. On the other hand, the technological innovation might
increase investment (I) at any given real interest rate, which would decrease NX.
Whether NX rises or falls therefore depends on whether the rise in S is greater or less
than the rise in I.
7. If Japanese NFI has fallen, then Japanese NX = NFI has also fallen. If Japanese net
exports to these countries are lower, the net exports of those countries to Japan must
be higher. Thus the countries should have had an increase in net exports (NX rises,
say, from -40 to -20, assuming Japan still runs a surplus with those countries) to
accommodate the reduced capital inflow from Japan.
8. (i) A rise in US money growth will increase US inflation. (ii) As US inflation
increase relative to the inflation rates of other countries, this will tend to make the
dollar lose value (or gain value less rapidly) against other currencies.
Questions for Review, p. 222 #3: This raises savings (S). Investment is unchanged as it
depends on the world real interest rate r*. The trade balance (NX = S-I) increases as
S rises and I is unchanged. The real interest rate r* is exogenous to the small open
economy and therefore does not change. The rise in S-I causes the real exchange rate
 to fall.
Questions for Review, p. 222 #4: This shifts the NX line to the right in the NX/(S-I)
graph. S, I, and r* are unchanged. Since (S-I) does not shift, NX is unchanged and 
rises.
Questions for Review, p. 222 #5: The Italian lira will lose value (in nominal terms)
against the German mark. High-inflation currencies lose value against low inflation
currencies.
Problems and Applications, pp. 222-223 #1: (a) This increases S, which makes NX rise.
I is unchanged because it depends on r*, which is unchanged. The increase in S-I
makes the real exchange rate fall. Given P and P*, the fall in  causes a fall in e. (b)
This is an exogenous decline in NX, so the NX line shifts left. S and I are unchanged,
so NX is unchanged. The leftward shift in the NX line makes  fall. Given P and P*,
the fall in  causes a fall in e. (c) This increases V, which increases P. S and I are
unchanged, so NX is unchanged. With dynamic PPP, the increase in P causes a fall in
e, with  unchanged.
Problems and Applications, pp. 222-223 #3: (a) This is an exogenous decline in NX. S
and I are unchanged, NX is unchanged, r = r* is unchanged, and  falls. (b) It makes
traveling abroad and purchasing foreign goods more expensive in terms of domestic
currency. (c) The should reduce government saving (increase G or decrease T). This
shifts (S-I) to the left and increases . The decrease in savings will decrease net
exports but will have no effect on the real interest rate or investment.
Problems and Applications, pp. 222-223 #4: The rise in G reduces S and therefore
decreases NX. This assume r* is unchanged, as would be the case in a local war. In a
global war, r* might change (rise, most likely, as there would be more pressure for all
governments to spend and less pressure to save). The rise in r* reduces I, increases SI and therefore increases NX.
Problems and Applications, pp. 222-223 #6: (a) I* increases at any given r* -- the world
investment curve shifts to the right. (b) r* rises. (c) I falls. (d) NX rises. (e) Since
S-I rises,  must fall.
Problems and Applications, pp. 222-223 #7: Suppose 10 years ago a cup of espresso
cost $1 in the US and L1000 (L=Lira). The $ cost of L1000 was $1. With 25%
inflation in the US and 100% inflation in Italy, the US espresso now costs $1.25,
while the Italian espresso costs L2000. The $ cost of L2000 is 2000/1500 = $1.33.
Thus by this example traveling in Italy has become MORE expensive. The real value
of the dollar () has fallen because the nominal value of the dollar has not risen
enough to compensate for the higher inflation in Italy.
Problems and Applications, pp. 222-223 #8: (a) Expected inflation is 4 percentage points
higher in Canada than in the U.S. (b) The Canadian dollar should lose 4% of its
nominal value per year against the U.S. dollar. (c) In a year, when you convert the
Canadian dollars back to US dollars, you will do so at an exchange rate the reflects
the 4% loss in the value of the Canadian dollar. Your return in US dollar terms will
still be 8%, which is the same you would have earned in the US.
More Problems and Applications, p. 233 #1:
(a) The rise in G reduces S. In a closed economy, lower S causes higher r and lower
I. In a small open economy, the fall in S causes a fall in NX and a rise in . The
average effects are therefore higher r and lower I (though not as much as in the closed
economy), and lower NX and higher  (though not as much as in the small open
economy).
(b) Exogenous rise in NX.  rises, while there is no effect on NX, S, I, or r*. See
Figure 8-22 on p. 231.
(c) Exogenous decrease in I. In a closed economy, S is unchanged, r falls and I is
unchanged. In a small open economy, S is unchanged, I falls, NX rises and 
falls. Thus in the large open economy, S is unchanged, r falls, I falls, NX rises,
and  falls.
(d) Exogenous rise in S. In a closed economy, r falls and I rises. In a small open
economy, r and I are unchanged, NX rises, and  falls. In a large open economy, r
falls, I rises, NX rises, and  falls.
(e) Exogenous increase in NX (same as (b) above). We buy fewer foreign goods and
services.
(f) Exogenous decline in I (see Figure 8-23 on p. 232).