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Spring Term 2008
İstanbul Bilgi University
Introduction to Economics (EC 152)
Department of Economics
Problem Sheet 9
A Macroeconomic Theory of the Open-Economy
1.
Explain why saving need not equal domestic investment in an open economy.
ANSWER: Because saving equals domestic investment plus net capital outflow. If net capital outflow is not
equal to zero, then domestic saving does not equal domestic investment.
2.
Why do higher real interest rates lead to lower net capital outflow?
ANSWER: Higher Turkish. interest rates make Turkish. assets look more attractive than foreign assets.
Investors in Turkey and other countries are likely to move funds into Turkey, reducing Turkish. net
capital outflow.
3.
Describe the sources of supply and demand in the market for loanable funds and the market for
foreign-currency exchange.
The supply of loanable funds comes from national saving; the demand for loanable
funds comes from domestic investment and net capital outflow. The supply of dollars
in the market for foreign exchange comes from net capital outflow; the demand for
dollars in the market for foreign exchange comes from net exports. The link between
the two markets is net capital outflow.
4.
In the model of the open economy developed in Mankiw Chapter 32, two markets determine two
relative prices. What are the markets? What are the two relative prices?
The two markets in the model of the open economy are the market for loanable funds
and the market for foreign-currency exchange. These markets determine two relative
prices: (1) the market for loanable funds determines the real interest rate; and (2) the
market for foreign-currency exchange determines the real exchange rate.
5.
Use the model described by graphs and discuss the movements in the relevant macroeconomic
variables. Describe the sequence of events in the model by describing the shifts in the curves in the
graph and discuss the movements in the relevant macroeconomic variables.
a. Suppose the Turkish government reduces its budget deficit.
b. Suppose the Turkish government reduces a quota on the importing of Japanese cars.
c. Suppose there is sudden inflow of capital into Turkey because we are believed to be more
politically stable than before.
Quantity of TL
a)
the increase in saving would shift the supply curve for loanable funds to the right, as
shown in Figure 1. The decline in the real interest rate increases net capital
outflow and shifts the supply of TL’s to the right in the market for foreigncurrency exchange. The result is a decline in the real exchange rate. Since the
real interest rate is lower, domestic investment increases. Since net capital
outflow increases, the trade balance also increases. Overall, saving and domestic
investment increase, the real interest rate and real exchange rate decrease, and the
trade balance increases.
A reduction in restrictions of imports would reduce net exports at any given real
exchange rate, thus shifting the demand curve for TL to the left. The shift of the demand
curve for TLs leads to a decline in the real exchange rate, which increases net exports.
Since net capital outflow is unchanged, and net exports equals net capital outflow, there
is no change in equilibrium in net exports or the trade balance. But both imports and
exports rise, so export industries benefit.
b)
Quantity of TL
c)
The flight to safety led to a desire by foreigners to buy Turkish. government
bonds, resulting in a decline in Turkish. net capital outflow, as shown in Figure 10. The
decline in net capital outflow also means a decline in the demand for loanable funds. As
the figure shows, the shift to the left in the demand curve results in a decline in the real
interest rate in Turkey. In addition, the decrease in net capital outflow decreases the
supply of TL in the foreign-exchange market, causing the TL to appreciate, shown as a
rise in the real exchange rate. The lower real interest rate causes national saving to
decline, but increases domestic investment. Since net capital outflow is lower, net
exports are lower, thus the trade balance declines.
6.
What is capital flight? When a country experiences capital flight, what is the effect on its interest rate
and exchange rate?
Capital flight is a large and sudden movement of funds out of a country. Capital
flight causes the interest rate to increase and the exchange rate to depreciate.
The increased demand for loanable funds causes the equilibrium real
interest rate to rise.
7.
Suppose the U.S. government institutes a “Buy American” campaign, in order to encourage spending
on domestic goods. What effect will this have on the U.S. trade balance?
ANSWER: Such a campaign will increase the demand for domestically produced goods and hence decrease
the demand for imports. This increases the demand for dollars in the market for foreign currency. The
real exchange rate of the U.S. dollar will appreciate, and the net effect will be no change in the trade
balance. The level of net exports ultimately depends upon domestic saving and investment, neither of
which are affected by the campaign.
TYPE: S DIFFICULTY: 2 SECTION: 19.3
8.
a) Define the Balance of payments. Why is it always in balance?
b) What are the main items of the Current Account? What is the meaning of the current
account balance
a) All transactions of the economy with the outside world is recorded in the BoP. The BoP
is always in balance and can have no deficit and surplus. Deficits or surpluses exist in its
different parts but their sum is always zero.
b) Visibles (exports, imports) , Services (tourism, transport…), Investment income, current
transfers (worker’s remittances and official transfers)
Current account of BoP includes all types of FX revenues and expenditures of the economy.
the meaning of the current account balance FX spending (imports)= FX revenues (exports