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Chapter 7
International Trade, Exchange Rates,
and Macroeconomic Policy

Chapter Outline
7-1 Introduction
a. What We Learn in This Chapter
b. The “Trilemma”
7-2 The Current Account and the Balance of Payments
a. The Current Account and the Capital Account
b. The Balance of Payments Outcome
c. Foreign Borrowing and International Indebtedness
d. Why Is U.S. Income from Abroad Still Positive?
e. The International Investment Position and the U.S. Standard of Living
f. The Current Account and National Saving
7-3 Exchange Rates
a. How Exchange Rates Are Quoted
b. Changes in Exchange Rates
7-4 The Market for Foreign Exchange
a. Why People Hold Dollars and Euros
b. How Governments Can Influence the Foreign Exchange Rate
7-5 Real Exchange Rates and Purchasing Power Parity
a. Nominal and Real Exchange Rates
b. The Theory of Purchasing Power Parity
c. PPP and Inflation Differentials
d. Why PPP Breaks Down
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Chapter Overview
69
7-6 Exchange Rate Systems
a. Flexible Versus Fixed Exchange Rates
b. Workings of the Fixed Exchange Rate System
c. Characteristics of the Flexible Exchange Rate System
d. The Exchange Rate of the Dollar Since 1980
IP Box: Big Mac Meets PPP
7-7 Case Study: Asia Intervenes with Buckets to Buy Dollars and Finance the U.S. Current Account
Deficit—How Long Can This Continue?
a. How Large Are the Reserves and Which Countries Hold Them?
b. Why Do the Asians Subject Themselves to Disastrous Capital Losses?
7-8 Determinants of Net Exports
a. Net Exports and the Foreign Exchange Rate
7-9 The Real Exchange Rate and the Interest Rate
a. The Demand for Dollars and the “Fundamentals”
b. Interest Rates and Capital Mobility
c. The Two Adjustment Mechanisms: Fixed and Flexible Rates
d. Is Perfect Capital Mobility Relevant for the United States?
7-10 Effects of Monetary and Fiscal Policy with Fixed and Flexible Exchange Rates
a. The Analysis with Fixed Exchange Rates
b. The Analysis with Flexible Exchange Rates
c. How a Large Open Economy Differs from a Small Open Economy
Global Economic Crisis Focus: Is the United States Prevented from Implementing a Fiscal Policy
Stimulus by Its Flexible Exchange Rate?
7-11 Conclusion: Economic Policy in the Open Economy
a. The Trilemma, the United States, and the Euro
Summary

Chapter Overview
This chapter connects the U.S. economy with the rest of the world. It explains the concepts of
export, import, and the basics of the U.S. balance of payments, the current account, the capital
account, and international indebtedness. It also exposes student to the role of the foreign exchange
rates and the causes of their changes. It extends the analysis of macroeconomic policy in the
context of an open economy that experiences flows of goods, services, and capital to and from
other countries under fixed and flexible exchange rate regime for a small open economy as well as
a large open economy.
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Chapter 7
International Trade, Exchange Rates, and Macroeconomic Policy
In Section 7-1 he also introduces the concept of “trilemma” as a unifying concept for the chapter.
This is the inability of a country to maintain independent control of its monetary policy under
conditions of fixed exchange rates and free capital flows with other countries. Gordon explains how
the United States is affected by the trilemma over the last few decades. While the United States
adopts flexible exchange rates, some foreign nations, in particular China and Japan, have kept their
own exchange rates fixed to the U.S. dollar, preventing the dollar from appreciating.
Section 7-2 teaches students the consequences of government budget surpluses or deficits and trade
balances on national saving. Define national saving as the sum of private saving (S) and
government saving (the budget surplus T – G). Remind students that national saving is equal to
domestic and foreign investment through the “magic” equation: S + (T = G)  I + NX. In this
section, Gordon discusses the key concepts of international macroeconomics: these are current,
capital account, balance of payments, and international indebtedness. Students already know that
counterparts of the flow of goods and services counted as exports and imports are offsetting capital
flows. Problems arise when a country’s inflows of goods, services, and capital do not match
outflows. This section describes how these flows are measured in the measurement of balance of
payments. Distinguish between the current account and the capital account and explain that the
balance of payments is the sum of the balances in these two accounts. In the lecture, be sure
students understand that a credit item in these accounts is anything that leads to a flow of “money”
into the United States and that a debit is an outflow of “money.” This concept is straightforward for
the current account, where foreign purchases of domestic goods (exports) represent an inflow of
foreign currency in exchange for the domestic goods, while domestic purchases of foreign goods
(imports) represents an outflow of domestic currency in exchange for foreign goods. The current
account also includes credits and debits that arise from flows of investment income and transfer
payments into and out of a country. Thus, a current account surplus is simply the excess of credits
over debits or a positive net inflow of “currency.” However, students often get confused over the
accounting procedure of the capital account, which specifies that credits are generated when the
United States becomes indebted to foreigners. Explain that the capital account represents a transfer
of bonds or other assets (rather than goods) between countries. When the United States borrows
from foreigners by selling them securities, it results in an inflow of money into the United States
and thus a credit in the capital account. The difference is that a capital account credit results from
selling domestic securities rather than goods to foreigners. Stress the particular role of the U.S.
dollar in explaining how these accounts are “balanced.” Point out that it is simply an accounting
identity that the amount of dollars actually purchased and the amount of dollars actually sold are
equal. Also note that these accounts include the reserve and assets transactions of domestic and
foreign governments as well as private transactions. Stress that a balance-of-payments deficit or
surplus represents the net private inflow or outflow of money reflected in the current and capital
accounts. Official government transactions represent the activities of the central bank in financing a
balance-of-payments deficit. These can either take the form of (a) creating an outflow of
international reserves at the IMF or (b) increasing the dollar reserves held by foreign central banks.
To the extent that foreign central banks are willing to accumulate U.S. dollars in their official
reserve holdings, the United States need not run down its own holdings of gold or foreign exchange
to finance a deficit. Finally, stress that what matters to economic growth is not the balance-ofpayments surplus, but the current account deficit matched by a large capital account surplus. A
country’s current account balance measures the change in its net international investment position.
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Chapter Overview
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Persistent current account deficits have caused the U.S.’s position to shift from surplus to
indebtedness. The debtor position resulting from the huge foreign capital inflow implies that the
interest and dividend payments to foreigners will transfer real resources from the domestic
economy and reduce the future standard of living. Also explain the concept of “net revaluations” in
the context of international investment, because this breaks the tight link between the current
account and the change in net international investment and explains why the large current account
deficit of the United States in 2000–10 did not erode the international investment position. In
concluding Section 7-2, Gordon explains how the change from positive U.S. international
investment position in 1975–85 to the large negative position in 2000–10 did not cause net income
from abroad to be negative. But he warned that this continuous current account deficit implies a
future adverse effect on the U.S. standard of living.
Section 7-3 explains how exchange rates are quoted and reported in the financial press. Be sure that
students know that the exchange rate of, say, yen for dollars is the reciprocal of the exchange rate of
dollars for yen and understand the meaning of currency appreciation and depreciation. Tell the
students that it is conventional to report exchange rates as foreign currency for one U.S. dollar, with
two exceptions: it is always dollars per British pound and always dollars per euro.
Section 7-4 uses a simple supply-and-demand model to explain equilibrium exchange rate
determination. The exchange rate is expressed in units of foreign currency per one unit of domestic
currency. Your lecture should identify the sources of supply and demand in the foreign exchange
market and relate these to credits and debits in the balance of payments. The demand for domestic
currency springs from domestic exports and capital inflows, while the supply of domestic currency
arises from domestic imports and capital outflows. Point out that the demand curve for domestic
currency will be negatively sloped as long as foreign demand for domestic exports is not perfectly
price inelastic, while the supply curve of domestic currency will slope upward if the domestic
demand for imports is price elastic. Also stress that changes in the flows of goods, services, and
capital between countries that are not themselves caused by changes in the exchange rate will shift
the demand for and supply of domestic currency and cause the exchange rate to appreciate or
depreciate. The supply–demand analysis of Figure 7-3 can also be used when discussing fixed
exchange rates. You may also want to relate the supply-demand analysis to the balance-ofpayments account. For a balance-of-payments deficit, the U.S. government (or, for that matter, a
foreign government such as China or Japan) can only maintain the higher-than-equilibrium
exchange rate by purchasing the excess supply of dollars. The United States purchases dollars by
depleting its reserves of foreign currencies and gold. China and Japan use yuan and yen to buy U.S.
dollars. Students might find this easier to understand if you tell them that it is perfectly analogous
to the way governments can maintain agricultural price supports.
Section 7-5 presents the concepts of the nominal and the real exchange rate and the theory of
purchasing-power-parity (PPP). It begins by establishing the relation between real (e) and nominal
(e) exchange rates: e = e  P/Pf, where P = the domestic price level and P f = the foreign price
level. This relation is explained with a numerical example involving the Mexican peso/dollar
exchange rate. The main implications of PPP are that the long-run real exchange rate should be
constant and the growth rate of the nominal exchange rate should equal the inflation differential
between foreign and domestic inflation. Countries with relatively rapid rates of inflation tend to
have depreciating currencies. Nevertheless, there have been numerous examples when this PPP
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Chapter 7
International Trade, Exchange Rates, and Macroeconomic Policy
breaks down. Among the reasons that PPP has failed are rapid technological change and new
product innovation, new discoveries of natural resources, large capital movements, and government
intervention in foreign trade and the exchange markets. Another criticism of PPP is that it implies
the constancy of real exchange rates, but real exchange rates have actually been very volatile. As
students will see later in the chapter, this can contribute to aggregate demand instability.
Section 7-6 then explains exchange rate systems. Distinguish between flexible and fixed exchange
rate regimes. Use the supply–demand model of exchange rate determination to explain and
compare the workings of each system. Contrast currency devaluation and revaluation under fixed
exchange rates with depreciation and appreciation in the flexible rate system. Also mention the role
of central bank intervention in the flexible rate system and distinguish between a “clean” and
“dirty” flexible exchange rate system.
Section 7-7 presents a case study of the Asian intervention to buy dollars and finance the U.S.
current account deficit. The United States escapes the trilemma by maintaining flexible exchange
rates with its trading partners, but it cannot force its trading partners to reciprocate. In the face of
persistent U.S. trade deficits that would lead to a depreciation of the dollar in a pure flexible
exchange rate system, The Bank of China has purchased vast quantities of dollars in an attempt to
maintain the yuan to dollar exchange rate fixed. By not allowing the yuan to appreciate, the Bank of
China hoped to keep Chinese exports high. However after 2005, they have allowed the dollar to
depreciate very slowly and by a very small amount, and as a result, the yuan to dollar exchange rate
has declined from 8.27 to 6.8 Yuan per dollar, which is much higher than the equilibrium exchange
rate. Hong Kong also tries to keep a fixed exchange rate against the American dollar by purchasing
dollars. Japan and Taiwan regularly buy dollars but do not keep their currencies fixed against the
dollar. All of these dollar purchases mean that Asian nations have been willing to finance U.S.
current account deficits. It is unclear whether this state of affairs is sustainable, or whether the U.S.
dollar will collapse at some point in the future.
Sections 7-8 through 7-10 develop the linkage between the exchange rate and income
determination and policy analysis. Section 7-8 discusses the determinants of net exports. In Figure
7-6, the net export line is plotted together with the real exchange rate. These figures support the
economic reasoning that net exports depend negatively on income (an idea introduced in Chapter 3)
and the exchange rate. Stress the reason for the latter relationship. Given U.S. and foreign prices, an
appreciating exchange rate in essence raises the price of U.S. goods relative to the price of foreign
goods, and vice versa.
Section 7-9 includes a brief discussion on what “fundamental” factors might affect the foreign
demand for dollars and U.S. supply of dollars. Stress that the interest rate of U.S. securities relative
to foreign securities has an immediate and direct impact on the foreign demand for U.S. dollars.
Therefore, the interest rate is a very important determinant of the foreign exchange rate. Figure 7-7
provides empirical support for this relationship for the time period of 1980–2010. The text
introduces capital mobility as the means by which interest rates affect exchange rates. Finally, it is
explained that the positive relationship between the real interest rate and the real exchange rate
appears to have broken down after 1995, as a result of the huge foreign capital inflows resulting
from the U.S. stock market boom. The huge foreign capital inflows pushed up the value of the
dollar without an increase in the real interest rate.
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Changes in the Twelfth Edition
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Section 7-10 develops the Mundell–Fleming version of the IS-LM model. It analyzes the case of a
small open economy under both fixed and flexible exchange-rate regimes. In both cases, monetary
and fiscal expansions are treated. In a small open economy, because of perfect capital mobility, the
domestic interest rate must equal the foreign interest rate in order to prevent unlimited capital
inflows or outflows. Gordon shows that the central bank is impotent in the small open economy.
Fiscal policy, on the other hand, is powerful, and it forces an accommodating monetary policy. The
reverse is the case under flexible exchange rates. Be sure students are clear that there are two types
of open economies that are analyzed in the text. The open economy with fixed exchange rates was
introduced in Chapter 3, although without that terminology. There, net exports consisted of an
exogenous component and an income-induced component. The induced component has the effect
of reducing the multiplier by increasing the marginal leakage rate. The “flexible exchange rate
economy” modifies the model of Chapter 3. Here, the text explicitly includes exchange rates as a
determinant of net exports. It endogenizes the exchange rate by relating it to the interest rate
through capital flows. Next, Gordon generalizes the discussion to the large open economy where
domestic interest rate may be different from foreign interest rate. But the qualitative results
concerning policy effectiveness are almost the same as for the small open economy. These are
summarized at the end of this subsection.
Section 7-11 concludes the chapter by referring once again to the problem of trilemma. The case of
the United States, whose reliance on flexible exchange rates allows it to maintain independent
control of monetary policy despite free capital flows, is contrasted with that of the euro, where
eleven European countries have agreed to give up independent control of their monetary policy in
order to maintain a fixed exchange rate. Gordon points out that the United States and the major
Asian countries, especially China and Japan, have entered into a mutually reinforcing relationship
of codependence.

Changes in the Twelfth Edition
This chapter has gone through substantial changes from the earlier edition. Actually, this chapter is
the outcome of reorganization of two chapters (5 and 6) from the 11th edition. It is created by
taking few sections of Chapter 5 and the major part of Chapter 6.
Introduction of the chapter is completely rewritten. In Table 7-2, U.S. Balance of Payment position
has been updated with data up to the year 2010. Similarly all the figures in this chapter has been
updated with newer information up to the year 2010. In the IP Box on the Big Mac Meets PPP has
been modified substantially and the accompanying table for Cash and Carry: The Hamburger
Standard has been also modified using different set of countries and different date for the journal
“Economist.” The case study of Asian intervention in foreign exchange markets that finance the
U.S. current account deficits has been slightly modified and updated with new information about
Japanese and Chinese strategy regarding the exchange rate for Yen and Yuan. Sections 7-10 and
7-11 remain almost same as Sections 6-9 and 6-10 in the 11th edition. In Section 7-10 he has added
Global Economic Crisis Focus: Is the United States Prevented from Implementing a Fiscal Policy
Stimulus by Its Flexible Exchange Rate?
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Chapter 7
International Trade, Exchange Rates, and Macroeconomic Policy
Questions have been changed and also reorganized from two chapters of the previous edition.
Answers to New Chapter 7

Answers to Questions in Textbook
1. Any international transaction that creates a payment of money to a U.S. resident generates a credit.
Any international transaction that creates a payment of money to a foreigner by a U.S. resident is a
debit.
2. The current account includes exports and imports, receipts and payments of investment income, and
transfer payments. The capital account includes purchases of foreign assets by U.S. residents and
purchases of U.S. assets by foreigners.
3. a.
b.
c.
d.
4. a.
Credit; current account; decreases U.S. balance of payments deficit.
Debit; capital account; increases U.S. balance of payments deficit.
Credit; capital account; decreases U.S. balance of payments deficit.
Debit; current account; increases U.S. balance of payments deficit.
Net foreign investment position will improve by 100 billion dollars. Thus, it will be lower than
$600 billion.
b. The dollar appreciates; thus, U.S. foreign assets are worth less, so the net foreign investment
position will worsen, and it will be more than $600.
5. Equation 7-2 on page 195 explains how this possible. There is no change in the net international
investment position if a current account deficit is offset by increased asset valuations. The dollar
depreciation during this time period made U.S. foreign assets worth more.
6. Given that the United States’ net borrowing from the rest of the world has become an ever larger
percentage of GDP since 1990, our net investment income would be negative if the rate-of-return we
paid on what we had borrowed was the same as or less than the rate-of-return we earned on those funds
we had lent to the rest of the world. But the fact that net investment income is still positive means that
we are earning a rate-of-return on our investments abroad that is sufficiently higher than we are paying
to foreigners for the funds they have lent to us to overcome the fact that we are net borrowers from the
rest of the world.
7. National saving is the sum of the saving done by households and businesses, denoted S and called
private saving, and government saving, which is positive when there is a government surplus and
negative when there is a government deficit. Therefore a rise in the government deficit reduces
national saving.
Equation 7.5 on page 198 shows that foreign investment is the difference between domestic investment
and national saving. Since a rise in the budget deficit reduces national saving, the rise requires either a
decrease in domestic investment to match the reduction in national saving or a rise in foreign
investment if the reduction in domestic investment is less than the reduction in national saving.
8. The dollar has appreciated against a currency if the number of units of that currency a dollar can
purchase has risen over the last year. If the number of units of a currency that can be bought with a
dollar has fallen over the course of a year, then the dollar has depreciated against that currency.
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Answers to Questions in Textbook
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9. The demand for a country’s currency by foreigners (foreign exchange) is negatively sloped if the
demand for that country’s exports is negatively sloped.
10. The supply of a country’s currency to foreigners (foreign exchange) is positively sloped if the demand
by that country for imports is price elastic. For example, a depreciation of the foreign exchange rate of
the dollar relative to the euro (euro/$) will raise the dollar price of German goods. If the U.S. demand
for German goods is price elastic, then each percentage-point rise in the dollar price will be
accompanied by a greater than one percent reduction in quantity demanded of German goods. The total
expenditure in dollars will fall. Thus, a decrease in the foreign exchange rate (euro/$) is associated
with a decrease in the quantity supplied of dollars, so the supply curve of dollars will be upward
sloping. The foreign-exchange supply curve is negatively sloped if the demand for foreign goods is
price inelastic. For example, a depreciation of the foreign exchange rate of the dollar relative to the
mark (euro/$) will raise the dollar price of German goods. If the U.S. demand for German goods is
price inelastic, then each percentage-point rise in the dollar price will be accompanied by a smaller
than one percent reduction in quantity demanded of German goods. The total expenditure in dollars
will rise. Thus, a decrease in the foreign exchange rate (euro/$) is associated with an increase in the
quantity supplied of dollars, so the supply curve of dollars will be downward sloping.
11. a. The demand for the Russian currency, the ruble, rises as other nations need to buy the ruble in order
to pay for the oil that they import from Russia. This causes the ruble to be overvalued relative to its
implied purchasing-power-parity value.
b. The demand for the dollar falls as Euro zone nations import a smaller amount of U.S. produced
entertainment. This causes the value of the dollar to be undervalued relative to its implied
purchasing-power-parity value.
c. The demand for the Indian currency, the rupee, rises as funds flow into the Indian stock market
from abroad. This causes the rupee to be overvalued relative to its implied purchasing-power-parity
value.
12. A “clean” flexible exchange rate system, in which the dollar and other currencies fluctuate freely,
becomes “dirty” when central banks intervene in foreign exchange markets to maintain a preferred
value for a currency. For example, central banks in Europe and Japan might intervene to support the
dollar, fearing that a fall in exchange rates would increase the competitiveness of U.S. exports in world
markets and reduce American demand for imports. The Fed might also intervene to support the dollar
to avoid the boost that higher import prices might give to U.S. inflation.
13. The Bank of China bought dollars during the period from 1995–2005 as needed in order to maintain an
essentially fixed exchange rate between the dollar and the yuan. It did so in an effort to maintain a low
exchange rate for the yuan so that the prices of Chinese made goods would remain low in the United
States. Those low prices enabled Chinese economic growth to stay higher than it would have been if
the yuan had risen in value relative to the dollar.
14. A country’s foreign exchange rate and its net exports are inversely related. When a country’s foreign
exchange rate appreciates, the price of its exports rises in terms of foreign currencies. Similarly, the
price of its imports falls in terms of its currency. Consequently, its firms export fewer goods and
services, and its citizens import more goods and services, causing its net exports to fall. The reverse
holds when the country’s foreign exchange rate depreciates.
15. The demand for the country’s currency rises as a result of the increase in its interest rate, since the
return on assets of that country increases, or foreigners want to hold that currency. Other things being
equal, that increase in demand results in a rise in the country’s foreign exchange rate.
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Chapter 7
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16. In order to pay for the exports, other countries need to purchase the country’s foreign exchange, which
increases the demand for the foreign exchange. The increase in demand is shown graphically by a shift
to the right of the demand curve for the foreign exchange and results in a rise of the foreign exchange
rate. If the country’s policymakers wish to prevent the rise in the foreign exchange rate, they have to
sell enough of the currency to provide an increase in the supply of the currency sufficient to match the
increase in demand.
17. If the Japanese economy had been suffering from rising inflation over the past decade, then its
government would have been taking steps to slow its growth. If that had been the case, the Japanese
government would, in all likelihood, have welcomed an appreciation of the yen versus the dollar. That
appreciation would have first, reduced the net exports of Japan, further slowing the growth of the
Japanese economy, and second, put pressure on those Japanese companies facing competition from
American firms to hold down price increases. Both effects of the yen’s appreciation would have been
desirable from the point of view of the Japanese government, given an objective of trying to reduce
inflation. Hence, it would have been far less willing to finance the United States’ current account
deficit.
Alternatively, the Japanese government would have had to sell yen in order to prevent a rise in the
value of the yen versus the dollar. But the sale of yen would have increased the money supply and
resulted in an increase in real GDP. That increase in real GDP would have added to the inflationary
pressures in the economy. As a result, it is unlikely that the Japanese government would have been
unwilling to sell yen to maintain the value of the yen against the dollar.
18. The trilemma is that it is not possible for a country to maintain independent control of its monetary
policy and fixed exchange rates and free flows of capital from other nations. The United States has
dealt with the trilemma by attempting to maintain independent monetary policy and free flows of
capital, but giving up fixed exchange rates in favor of flexible exchange rates. Ireland has dealt with
the trilemma by maintaining fixed exchange rates as a Euro zone nation and free flows of capital, but it
has given its authority over monetary policy to the European Central Bank.
19. Since the United States is a large open economy with flexible exchange rates, we know that
policymakers must use monetary policy to reduce real GDP relative to natural real GDP in an effort to
restrain a rise in inflation. In particular, monetary authorities need to reduce the real money supply,
resulting in a rise in the interest rate relative to those in the rest of the world. The higher relative
interest rate by itself will slow growth. In addition, the higher relative interest rate results in capital
inflows. The capital inflows lead to an appreciation of the dollar which causes a fall in net exports.
The fall in net exports causes an additional reduction in real GDP relative to natural real GDP.
On the other hand, Ireland has ceded control over domestic monetary policy to the European Central
Bank. Therefore, it can only use fiscal policy to reduce real GDP relative to natural real GDP. We also
know that fiscal policy is very powerful in a small open economy with fixed exchange rates.
20. A fiscal expansion increases interest rates, but, with perfect capital mobility, higher interest rates
attract capital inflows. This increased demand for the country’s currency would put upward pressure
on its foreign exchange rate. To maintain the fixed exchange rate, therefore, the central bank must
increase the money supply to bring down the interest rate and, thereby, the capital inflow. A fiscal
contraction would produce lower interest rates, a capital outflow, an increased supply of the country’s
currency on the foreign exchange market, a tendency for the country’s foreign exchange rate to fall,
and an offsetting decrease in the money supply by the country’s central bank to maintain the fixed
exchange rate. Therefore, monetary policy must accommodate fiscal policy.
21. If actual real GDP is less than natural real GDP, then that requires that policymakers take steps to
reduce actual real GDP relative to natural real GDP in order to reduce unemployment. In the case of
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Answers to Problems in Textbook
77
fiscal policy, that would involve cutting taxes or raising spending, steps that historically this
economy’s fiscal policymakers have been unwilling to take. That means in this economy, only
monetary policymakers have the will to take actions that can permanently increase actual real GDP
relative to natural real GDP. Monetary policy is incapable of permanently raising real output under a
fixed exchange rate system in a large open economy; it can only do so under a flexible exchange rate
system in the same type of economy. Therefore, this economy would be best advised to adopt a
flexible exchange rate system so that it retains the ability to fight unemployment.
22. For a large country like United States, capital mobility is imperfect. A large country has substantial
control over the domestic interest rate. Expansionary monetary policy under a flexible exchange rate
will shift the LM curve toward right, leading to a decline in the domestic interest rate immediately.
This, in turn depreciates the domestic currency (exchange rate depreciates), leading to an increase in
net exports, thus shifting the IS curve to the right. Equilibrium income increases. This increase in
income will be larger than in the case of small economy where capital mobility is perfect. This higher
income in the new equilibrium position is accompanied by higher interest rate. This higher interest rate
may cause decline in private investment in the domestic economy in future. On the other hand,
expansionary fiscal policy is impotent in the flexible exchange rate regime just like in the case of small
country. (See pages 221–22 in the textbook.)

Answers to Problems in Textbook
1. The current account balance is the sum of net exports (40), transfer payments (20), and net investment
income (–15), or 45. The capital account balance equals the balance minus the current account, or
10 – 45 = –35.
2.
Year
1
2
3
4
Current account
balance
–500
–550
–380
–640
Change in net
int. inv. position
–360
–360
–155
–670
Change in
foreign owned
assets in U.S.
110
160
–375
0
Change in U.S.
owned assets
overseas
250
350
–150
–30
a. +140, +190, +225, –30
b. 250
c. –550
d. –155
e. 0.
3. a. The points on the demand curve are: (2,800, 0); (2,600, 1); (2,400, 2); (2,200, 3); (2,000, 4); (1,800,
5); (1,600, 6); (1,400, 7); (1,200, 8); (1,000, 9); (800, 10); (600, 11); and (400, 12). The points on
the supply curve are: (400, 0); (500, 1); (600, 2); (700, 3); (800, 4); (900, 5); (1,000, 6); (1,100, 7);
(1,200, 8); (1,300, 9); (1,400, 10); (1,500, 11); and (1,600, 12).
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Chapter 7
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b. The equilibrium value of the exchange rate is the one at which the demand for dollars and the
supply of dollars are equal. The demand for dollars and the supply of dollars both equal 1,200
billion at the exchange rate equal to 8. Therefore, 8 is the equilibrium exchange rate.
c. The demand for dollars increases when there is an increase in the demand for American exports or
capital inflows. In this case, the demand for dollars rises due to a large purchase by the Chinese of
a new American-made airplane.
The demand for dollars increases by 300 billion at each exchange rate. Therefore, the points on the
new demand curve are: (3,100, 0); (2,900, 1); (2,700, 2); (2,500, 3); (2,300, 4); (2,100, 5); (1,900,
6); (1,700, 7); (1,500, 8); (1,300, 9); (1,110, 10); (900, 11); and (700, 12).
The equilibrium value of the exchange rate is the one at which the demand for dollars and the
supply of dollars are equal. The increased demand for dollars and the supply of dollars both equal
1,300 billion at the exchange rate equal to 9. Therefore, 9 is the new equilibrium exchange rate.
d. The supply of dollars increases when Americans want to buy more imported goods than there are
capital outflows. In this case, the increase in the supply of dollars is due to a large purchase by
Americans of new lower-priced Chinese-made high-definition TVs.
The supply of dollars increases by 600 billion at each exchange rate. Therefore, the points on the
new supply curve are: (1,000, 0); (1,100, 1); (1,200, 2); (1,300, 3); (1,400, 4); (1,500, 5); (1,600, 6);
(1,700, 7); (1,800, 8); (1,900, 9); (2,000, 10); (2,100, 11); and (2,200, 12).
The equilibrium value of the exchange rate is the one at which the demand for dollars and the
supply of dollars are equal. The demand for dollars and the increased supply of dollars both equal
1,600 billion at the exchange rate equal to 6. Therefore, 6 is the new equilibrium exchange rate.
4. a. A large purchase by Americans of new lower-priced Chinese-made high-definition TVs increases
the supply of dollars. If the Chinese government wishes to maintain the value of the yuan relative to
the dollar at an exchange rate of 8, it must buy up the increased supply of dollars. It particular, it
must buy 600 billion in dollars to maintain equilibrium between the demand for dollars and the
supply of dollars at an exchange rate equal to 8.
b. A large purchase by the Chinese of a new American-made airplane increases the demand for
dollars. If the Chinese government wishes to maintain the value of the yuan relative to the dollar at
an exchange rate of 8, it must increase the supply of dollars to match that increase in demand. It
particular, it must sell 300 billion in dollars to maintain equilibrium between the demand for dollars
and the supply of dollars at an exchange rate equal to 8.
5. a. Capital outflows result from a decline in the interest rate in the United States relative to those in the
rest of the world. That is caused by a fiscal contraction which in this case results from a fall in
defense spending. The demand for dollars decreases by 200 billion at each interest rate. Therefore,
the points on the new demand curve are: (2,600, 0); (2,400, 1); (2,200, 2); (2,000, 3); (1,800, 4);
(1,600, 5); (1,400, 6); (1,200, 7); (1,000, 8); (800, 9); (600, 10); (400, 11); and (200, 12).
The supply of dollars increases by 100 billion at each interest rate. Therefore, the points on the new
supply curve are: (500, 0); (600, 1); (700, 2); (800, 3); (900, 4); (1,000, 5); (1,100, 6); (1,200, 7);
(1,300, 8); (1,400, 9); (1,500, 10); (1,600, 11); and (1,700, 12).
The equilibrium value of the exchange rate is the one at which the demand for dollars and the
supply of dollars are equal. The decreased demand for dollars and the increased supply of dollars
both equal 1,200 billion at the exchange rate equal to 7. Therefore, 7 is the new equilibrium
exchange rate.
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Answers to Problems in Textbook
79
b. Capital inflows result from a rise in the interest rate in the United States relative to those in the rest
of the world. That is caused by contractionary monetary policy which reduces the money supply.
The demand for dollars increases by 400 billion at each interest rate. Therefore, the points on the
new demand curve are: (3,200, 0); (3,000, 1); (2,800, 2); (2,600, 3); (2,400, 4); (2,200, 5); (2,000,
6); (1,800, 7); (1,600, 8); (1,400, 9); (1,200, 10); (1,000, 11); and (800, 12).
The supply of dollars decreases by 200 billion at each interest rate. Therefore, the points on the
new supply curve are: (200, 0); (300, 1); (400, 2); (500, 3); (600, 4); (700, 5); (800, 6); (900, 7);
(1,000, 8); (1,100, 9); (1,200, 10); (1,300, 11); and (1,400, 12).
The equilibrium value of the exchange rate is the one at which the demand for dollars and the
supply of dollars are equal. The increased demand for dollars and the decreased supply of dollars
both equal 1,200 billion at the exchange rate equal to 10. Therefore, 10 is the new equilibrium
exchange rate.
6. a. 9,600 euros.
b.
c.
d.
e.
f.
g.
25.
7,500 euros
32.
$300,000.
$384,000.
The demand curve will be a negatively sloped line joining the points (e = .8euro/$, $ demanded =
300,000) and (e = .625euro/$, $ demanded = 384,000).
h. 240,000 euros.
i. 240,000 euros.
j. The supply curve will be vertical line joining the points (e = 1.60$/euro, euro supplied = 240,000)
and (e = 1.20$/euro, euro supplied = 240,000).
7. a. real exchange rate = 6.0.
b. real exchange rate = 6.6.
c. real exchange rate = 5.45.
d. nominal exchange rate = 5.45.
e. nominal exchange rate = 6.6.
Examples (a), (b), and (c) suggest that, holding the nominal exchange rate constant, the real exchange
rate rises (falls) when the domestic price level rises (falls) relative to the foreign price level. Examples
(a), (d), and (e) suggest that, holding the real exchange rate constant, the nominal exchange rate falls
(rises) when the domestic price level rises (falls) relative to the foreign price level.
8. The implied PPP exchange rate is the ratio of the coffee prices in U.S. dollars times the actual
exchange rate. For example, the implied PPP exchange rate for Javaland is (1.20/1.50)(2.35) = 1.88.
The same calculations reveal that the implied PPP exchange rates for Uppercaffina, Isle of Roast, and
Erewhon are 9.00, 2.97, and 2.61, respectively. The currencies of Uppercaffina and Isle of Roast are
overvalued in terms of PPP since their implied PPP exchange rates exceed their actual exchange rates.
The currencies of Javaland and Erewhon are undervalued in terms of PPP since their implied PPP
exchange rates are less than their actual exchange rates.
9. Nominal exchange rate e should depreciate by 1 percent for PPP to hold.
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80
Chapter 7
International Trade, Exchange Rates, and Macroeconomic Policy
10. a.
1.
2.
3.
4.
5.
6.
7.
Given the foreign exchange rate equals 2, net exports equal 870 – 0.08Y – 200(2) =
470 – 0.08Y.
In this problem, s = 0.15, t = 0.2, and nx = 0.08, so that the marginal leakage rate equals 0.15(1
– 0.2) + 0.2 + 0.08 = 0.12 + 0.2 + 0.08 = 0.4. Therefore, the multiplier k equals
1/0.4 = 2.5.
Ap = Ca – cTa + Ip + G + NXa = 200 – 8r – 0.85(200) + 1,700 – 32r + 1,800 + 470 =
4,000 – 40r.
The equation of the IS curve is Y = kAp. Therefore, the equation of the IS curve is
Y = 2.5(4,000 – 40r) = 10,000 – 100r.
To obtain the equation for the LM curve, use either Equation (6) on page 118 or set the real
demand for money equal to the real supply of money to get 0.25Y – 25r = 2,250. Adding 25r to
both sides yields 0.25Y = 2,250 + 25r. Dividing both sides by 0.25 provides us with the LM
equation Y = 9,000 + 100r.
To compute the equilibrium domestic and foreign interest rates, set the equation for the IS
curve equal to the equation for the LM curve to get 10,000 – 100r = 9,000 + 100r. Adding
100r to and subtracting 9,000 from both sides yields 200r = 1,000. Dividing both sides by 200
yields the equilibrium domestic and foreign interest rates r = rf = 5.
To compute equilibrium real output, substitute the equilibrium domestic interest rate into the
equations for the IS and LM curves to get Y = 10,000 – 100(5) = 9,000 + 100(5) = 9,500.
b.
1.
2.
3.
4.
5.
To obtain the equation for the new LM curve, again use either Equation (6) on page 118 or set
the real demand for money equal to the new real supply of money to get 0.25Y – 25r = 2,200.
Adding 25r to both sides yields 0.25Y = 2,200 + 25r. Dividing both sides by 0.25 provides us
with the LM equation Y = 8,800 + 100r.
To compute the new equilibrium domestic interest rate, set the equation for the IS curve equal
to the equation for the new LM curve to get 10,000 – 100r = 8,800 + 100r. Adding 100r to and
subtracting 8,800 from both sides yields 200r = 1,200. Dividing both sides by 200 yields the
new equilibrium domestic interest rate r = 6.
To compute the new (temporary) equilibrium real output, substitute the new equilibrium
domestic interest rate into the equations for the IS and LM curves to get Y = 10,000 –
100(6) = 8,800 + 100(6) = 9,400.
In a small open economy, the domestic and foreign exchange rates must be equal. That
requires that the domestic interest rate decline to 5 percent. At a 5 percent interest rate, real
output equals 8,800 + 100(5) = 9,300, given the 50 billion decline in the real money supply.
For the commodity market to be in equilibrium at an interest rate of 5 percent and real output
equal to 9,300, there must be a 200 billion dollar shift left of the IS curve so that the equation
for the new IS curve is Y = 9,800 – 100r. Given a multiplier of 2.5, the IS curve shifts left by
200 billion dollars if there is an 80 billion dollar decrease in autonomous spending, and
therefore net exports. For net exports to decline by 80 billion, the foreign exchange rate must
rise to 2.4 from 2. (Check: if e = 2.4, NX = 870 – 0.08Y – 200(2.4) = 390 – 0.08Y, Ap = 200 –
8r – 0.85(200) + 1,700 – 32r + 1,800 + 390 = 3,920 – 40r, so that the equation of the new IS
curve is Y = 2.5(3,920 – 40r) = 9,800 – 100r.)
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Answers to Problems in Textbook
81
c.
The equation of the new autonomous planned spending is Ap = 200 – 8r – 0.85(200) +
1,700 – 32r + 1,720 + 470 = 3,920 – 40r.
2. The equation of the new IS curve is Y = 2.5(3920 – 40r) = 9,800 – 100r.
3. To compute the new equilibrium domestic interest rate, set the equation for the new IS curve
equal to the equation for the LM curve to get 9,800 – 100r = 9,000 + 100r. Adding 100r to and
subtracting 9,000 from both sides yields 200r = 800. Dividing both sides by 200 yields the
new equilibrium domestic interest rate r = 4.
4. To compute the new (temporary) equilibrium real output, substitute the new equilibrium
domestic interest rate into the equations for the IS and LM curves to get Y = 9,800 –
100(4) = 9,000 + 100(4) = 9,400.
5. In a small open economy, the domestic and foreign exchange rates must be equal. That
requires that the domestic interest rate increase to 5 percent. At a 5 percent interest rate, real
output equals 9,000 + 100(5) = 9,500, given no change in the real money supply.
6. For the commodity market to be in equilibrium at an interest rate of 5 percent and real output
equal to 9,500, the IS curve must shift right back to its original location. That requires that
autonomous spending, and therefore net exports, must rise by 80 billion, the amount of the
decrease in government spending. For net exports to increase by 80 billion, the foreign
exchange rate must fall from 2 to 1.6. (Check: if e = 1.6, NX = 870 – 0.08Y – 200(1.6) = 550 –
0.08Y, Ap = 200 – 8r – 0.85(200) + 1,700 – 32r + 1,720 + 550 = 4,000 – 40r, so that the
equation of the IS curve is Y = 2.5(4,000 – 40r) = 10,000 – 100r.)
d. Parts b and c show that monetary policy is very potent in a small open economy with a flexible
exchange rate system, whereas fiscal policy can have only a temporary impact on real output in
such an economy.
1.
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