Questions for Review
1. By rewriting the national income accounts identity, we show in the text that
S – I = NX.
This form of the national income accounts identity shows the relationship between the
international flow of funds for capital accumulation, S – I, and the international flow of
goods and services, NX.
Net capital outflow refers to the (S – I) part of this identity: it is the excess of
domestic saving over domestic investment. In an open economy, domestic saving need
not equal domestic investment, because investors can borrow and lend in world financial
markets. The trade balance refers to the (NX) part of the identity: it is the difference
between what we export and what we import.
Thus, the national accounts identity shows that the international flow of funds to
finance capital accumulation and the international flow of goods and services are two
sides of the same coin.
2. The nominal exchange rate is the relative price of the currency of two countries. The
real exchange rate, sometimes called the terms of trade, is the relative price of the goods
of two countries. It tells us the rate at which we can trade the goods of one country for
the goods of another.
3. A cut in defense spending increases government saving and, hence, increases national
saving. Investment depends on the world rate and is unaffected. Hence, the increase in
saving causes the (S – I) schedule to shift to the right, as in Figure 5–1. The trade balance
rises, and the real exchange rate falls.
30
∋
∋
∋
Realexchangerate
A
B
NX
NX
Net exports
(∋)
NX2
NX1
S1
– I S2
– I
1
2
Figure 5–1
C H A P T E R 5 The Open Economy
4. If a small open economy bans the import of Japanese DVD players, then for any given
real exchange rate, imports are lower, so that net exports are higher. Hence, the net
export schedule shifts out, as in Figure 5–2.
The protectionist policy of banning DVD players does not affect saving, investment, or
the world interest rate, so the S – I schedule does not change. Because protectionist
policies do not alter either saving or investment in the model of this chapter, they cannot
alter the trade balance. Instead, a protectionist policy drives the real exchange rate
higher.
5. We can relate the real and nominal exchange rates by the expression
Nominal Real Ratio of
Exchange = Exchange × Price
Rate Rate Levels
e = × (P*/P).
Let P* be the Mexican price level and P be the Japanese price level. The nominal
exchange rate e is the number of Mexican pesos per Japanese yen (this is as if we take
Japan to be the “domestic” country). We can express this in terms of percentage
changes over time as
% Change in e = % Change in + (π* – π),
where π* is the Mexican inflation rate and π is the Japanese inflation rate. If Mexican
inflation is higher than Japanese inflation, then this equation tells us that a yen buys
an increasing amount of pesos over time: the yen rises relative to the peso.
Alternatively, viewed from the Mexican perspective, the exchange rate in terms of yen
per peso falls.
Chapter 5 The Open Economy 31
∋
∋
∋
∋
Realexchangerate
B
A
NX
NX2( )
∋NX1( )
Net exports
2
1
S - I
∋
∋
Figure 5–2
Problems and Applications
1. a. An increase in saving shifts the (S – I) schedule to the right, increasing the supply
of dollars available to be invested abroad, as in Figure 5–3. The increased supply
of dollars causes the equilibrium real exchange rate to fall from 1 to 2. Because
the dollar becomes less valuable, domestic goods become less expensive relative to
foreign goods, so exports rise and imports fall. This means that the trade balance
increases. The nominal exchange rate falls following the movement of the real
exchange rate, because prices do not change in response to this shock.
b. The introduction of a stylish line of Toyotas that makes some consumers prefer
foreign cars over domestic cars has no effect on saving or investment, but it shifts
the NX( ) schedule inward, as in Figure 5–4. The trade balance does not change,
but the real exchange rate falls from 1 to 2. Because prices are not affected, the
nominal exchange rate follows the real exchange rate.
32 Answers to Textbook Questions and Problems
Realexchangerate
NX2
NX1
(S1
– I) (S2
– I)
NX ( )
A
B
NX
Net exports
∋
∋
∋2
1
∋ ∋
∋
∋ ∋
Figure 5–3
Realexchangerate
A
B
NX
Net exports
∋
∋
∋
∋
NX2( )
∋NX1( )
2
1
(S – I) Figure 5–4
c. In the model we considered in this chapter, the introduction of ATMs has no effect
on any real variables. The amounts of capital and labor determine output Y. The
world interest rate r* determines investment I(r*). The difference between domestic
saving and domestic investment (S – I) determines net exports. Finally, the
intersection of the NX( ) schedule and the (S – I) schedule determines the real
exchange rate, as in Figure 5–5.
The introduction of ATMs, by reducing money demand, does affect the nominal
exchange rate through its effect on the domestic price level. The price level
adjusts to equilibrate the demand and supply of real balances, so that
M/P = (M/P)d
.
If M is fixed, then a fall in (M/P)d
causes an increase in the price level: this
reduces the supply of real balances M/P and restores equilibrium in the money
market.
Now recall the formula for the nominal exchange rate:
e = × (P*/P).
We know that the real exchange rate remains constant, and we assume that the
foreign price level P* is fixed. When the domestic price level P increases, the nominal
exchange rate e depreciates.
Chapter 5 The Open Economy 33
Realexchangerate
NX
Net exports
∋
∋
∋
NX ( )
S – I
∋
∋
∋
Figure 5–5
2. a. National saving is the amount of output that is not purchased for current consumption
by households or the government. We know output and government
spending, and the consumption function allows us to solve for consumption.
Hence, national saving is given by:
S= Y – C – G
= 5,000 – (250 + 0.75(5,000 – 1,000)) – 1,000
= 750.
Investment depends negatively on the interest rate, which equals the world rate
r* of 5. Thus,
I = 1,000 – 50 × 5
= 750.
Net exports equals the difference between saving and investment. Thus,
NX = S – I
= 750 – 750
= 0.
Having solved for net exports, we can now find the exchange rate that clears the
foreign-exchange market:
NX = 500 – 500 × ε
0 = 500 – 500 × ε
ε = 1.
b. Doing the same analysis with the new value of government spending we find:
S= Y – C – G
= 5,000 – (250 + 0.75(5,000 – 1,000)) – 1,250
= 500
I = 1,000 – 50 × 5
= 750
NX = S – I
= 500 – 750
= –250
NX = 500 – 500 × ε
–250 = 500 – 500 × ε
ε = 1.5.
The increase in government spending reduces national saving, but with an
unchanged world real interest rate, investment remains the same. Therefore,
domestic investment now exceeds domestic saving, so some of this investment
must be financed by borrowing from abroad. This capital inflow is accomplished
by reducing net exports, which requires that the currency appreciate.
34 Answers to Textbook Questions and Problems
c. Repeating the same steps with the new interest rate,
S= Y – C – G
= 5,000 – (250 + 0.75(5,000 – 1,000)) – 1,000
= 750
I = 1,000 – 50 × 10
= 500
NX = S – I
= 750 – 500
= 250
NX = 500 – 500 × ε
250 = 500 – 500 × ε
ε = 0.5.
Saving is unchanged from part (a), but the higher world interest rate lowers
investment. This capital outflow is accomplished by running a trade surplus,
which requires that the currency depreciate.
3. a. When Leverett’s exports become less popular, its domestic saving Y – C – G does
not change. This is because we assume that Y is determined by the amount of capital
and labor, consumption depends only on disposable income, and government
spending is a fixed exogenous variable. Investment also does not change, since
investment depends on the interest rate, and Leverett is a small open economy
that takes the world interest rate as given. Because neither saving nor investment
changes, net exports, which equal S – I, do not change either. This is shown in
Figure 5–6 as the unmoving S – I curve.
The decreased popularity of Leverett’s exports leads to a shift inward of the
net exports curve, as shown in Figure 5–6. At the new equilibrium, net exports are
unchanged but the currency has depreciated.
Even though Leverett’s exports are less popular, its trade balance has
remained the same. The reason for this is that the depreciated currency provides
a stimulus to net exports, which overcomes the unpopularity of its exports by
making them cheaper.
Chapter 5 The Open Economy 35
S – I
NX(ε)1
NX(ε)2
NX1 = NX2
{
NX
Net exports
ε1
ε2
ε
Realexchangerate
Figure 5–6
b. Leverett’s currency now buys less foreign currency, so traveling abroad is more
expensive. This is an example of the fact that imports (including foreign travel)
have become more expensive—as required to keep net exports unchanged in the
face of decreased demand for exports.
c. If the government reduces taxes, then disposable income and consumption rise.
Hence, saving falls so that net exports also fall. In Figure 5-6, the S – I curve
shifts to the left, lowering net exports until the exchange rate is again equal to its
initial value. This fall in net exports puts upward pressure on the exchange rate
that offsets the decreased world demand. Investment and the interest rate would
be unaffected by this policy since Leverett takes the world interest rate as given.
4. Governor Bernanke’s statement is consistent with the models in the chapter. Suppose
we consider the United States as a small open economy, for example. The increase in
the global supply of saving pushes the global interest rate down, which encourages U.S.
investment. If we assume that this is primarily non-U.S. saving, then for the United
States, the saving curve doesn’t shift but we get a movement along the investment
curve from point A to point B in Figure 5–7. The interest rate falls, and the trade
deficit rises (S-I falls).
5. The increase in government spending decreases government saving and, thus, decreases
national saving; this shifts the saving schedule to the left, as in Figure 5–8. Given the
world interest rate r*, the decrease in domestic saving causes the trade balance to fall.
36 Answers to Textbook Questions and Problems
Realinterestrate
r
I, S
Investment, Saving
I
Sr
Trade deficit
2
r1
Figure 5–7
Realinterestrate
r
I, S
Investment, Saving
I
Sr
Trade deficit
*
Figure 5–8
Figure 5–9 shows the impact of this increase in government purchases on the real
exchange rate. The decrease in national saving causes the (S – I) schedule to shift to
the left, lowering the supply of dollars to be invested abroad. The lower supply of dollars
causes the equilibrium real exchange rate to rise. As a result, domestic goods
become more expensive relative to foreign goods, which causes exports to fall and
imports to rise. In other words, as we determined in Figure 5–8, the trade balance falls.
Chapter 5 The Open Economy 37
NX
B
A
Net exports
Change in
current
account
Realexchangerate
∋
∋2
∋1
∋NX( )
(S2
– I ) (S1
– I )
NX
Net exports
NX2
NX1
Change in
the trade
balance
Figure 5–9
The answer to this question does depend on whether this is a local war or a world
war. A world war causes many governments to increase expenditures; this increases
the world interest rate r*. The effect on a country’s external accounts depends on the
size of the change in the world interest rate relative to the size of the decrease in saving.
For example, an increase in the world interest rate could cause a country to have a
smaller trade deficit, as in Figure 5–10, or even a trade surplus, as in Figure 5–11.
38 Answers to Textbook Questions and Problems
r
Realinterestrate
Investment, Saving
I, S
I(r)
r2
*
r1
*
S1S2
Trade deficit
Figure 5–10
r
Realinterestrate
I, S
Investment, Saving
I(r)
S2
S1
r2
*
r1
*
Trade
surplus
Figure 5–11
6. a. If poor nations offered better production efficiency and legal protections, then the
marginal product of capital would rise. To increase the amount of capital that they
have, firms need to increase the amount of investment. Hence, their investment
demand curve shifts out—at any given interest rate, firms have a higher level of
investment spending than they did previously.
b. Assuming that together, the poor nations account for a noticeable share of world
demand for investment, the demand for loanable funds in world financial markets
rises. For the world overall, the picture looks like Figure 5–12, which follows.
c. In global financial markets, the increase in demand for loanable funds raises the
interest rate.
d. For rich countries, the increase in global interest rates reduces desired investment.
Hence, S – I(r) rises, which means that the trade balance rises.
7. The tariff on luxury cars would not affect net exports because it does not affect national
saving (because it would not affect Y, C, or G) or investment. It would, however, shift
the NX curve by decreasing U.S. demand for Japanese auto imports. This shift of the
curve, shown in Figure 5–13, would raise the exchange rate. Although net exports
would not change, the volume of both imports and exports would fall by the same
amount.
Chapter 5 The Open Economy 39
Global
S
I, S
World investment, World saving
Worldrealinterestrate
I 1
(r)
I 2(r)
r Figure 5–12
S – I
NX(ε)2
NX(ε)1
NX1 = NX2
{
NX
Net exports
ε1
ε2
ε
Realexchangerate
Figure 5–13
There are also important compositional effects of this policy. On the production side, the
higher exchange rate increases imports and puts pressure on the sales of American companies
with the exception of American luxury car production, which is shielded by the
tariff. Also American exporters will be hurt by the higher exchange rate, which makes
their imported goods more expensive to foreign countries. Consumers of Japanese luxury
cars will be hurt by the tariffs while all other consumers will benefit from the appreciated
dollar, which allows them to purchase goods more cheaply. In sum, the policy would
shift demand to American luxury car producers at the expense of the rest of American
production and also shift consumption from Japanese luxury cars to all other imports.
8. The real exchange rate measures the rate at which the goods of one country can be traded
for the goods of the other country. In this case, the real exchange rate measures the
number of bottles of vodka that must be exchanged for one TV. If Russia is experiencing
no technological progress in vodka production, then the number of bottles produced is
fixed. Since China is experiencing positive technological progress in TV production, the
number of TVs produced will be increasing. Given that TVs are relatively more abundant
and vodka is relatively more scarce, we would expect the real exchange rate to
decrease—that is, it takes fewer bottles of vodka to buy one TV. The nominal exchange
rate (e), measured as rubles per yuan, is determined by the following equation:
where ε. measures the real exchange rate, P* measures the price level in Russia, and P
measures the price level in China. Given China has stable money growth and Russia
has rapid money growth, Russia’s price level will be increasing at a faster rate than the
price level in China. The effect on the nominal exchange rate is ambiguous. The
decline in the real exchange rate will push the nominal exchange rate down, but the
rapidly rising price level in Russia relative to China will push the nominal exchange
rate up.
9. a. If the countries that institute an investment tax credit are large enough to shift
the world investment demand schedule, then the tax credits shift the world
investment demand schedule upward, as in Figure 5–14.
b. The world interest rate increases from r*
1 to r*
2 because of the increase in world
investment demand; this is shown in Figure 5–14. (Remember that the world is a
closed economy.)
40 Answers to Textbook Questions and Problems
S
I, S
World investment, World saving
Realinterestrate
B
A
I1
(r)
I2
(r)
r2
*
r1
*
r
Figure 5–14
e
P
P
= ¥
Ê
ËÁ
ˆ
¯˜e
*
Chapter 5 The Open Economy 41
c. The increase in the world interest rate increases the required rate of return on
investments in our country. Because the investment schedule slopes downward,
we know that a higher world interest rate means lower investment, as in Figure
5–15.
d. Given that our saving has not changed, the higher world interest rate means that
our trade balance increases, as in Figure 5–16.
S
r
Realinterestrate
I, S
Investment, Saving
r2
*
I (r)
r1
*
Trade
surplus
Figure 5–16
rRealinterestrate
Investment
II1
I2
I(r)
r2
*
r1
*
Figure 5–15
e. To bring about the required increase in the trade balance, the real exchange rate
must fall. Our goods become less expensive relative to foreign goods, so that
exports increase and imports decrease, as in Figure 5–17.
10. The easiest way to tell if your friend is right or wrong is to consider an example.
Suppose that ten years ago, an American hot dog cost $1, while a Mexican taco cost 10
pesos. Since $1 bought 10 pesos ten years ago, it cost the same amount of money to buy
a hot dog as to buy a taco. Since total U.S. inflation has been 25 percent, the American
hot dog now costs $1.25. Total Mexican inflation has been 100 percent, so the Mexican
taco now costs 20 pesos. This year, $1 buys 15 pesos, so that the taco costs 20 pesos [15
pesos/dollar] = $1.33. This means that it is now more expensive to purchase a Mexican
taco than a U.S. hot dog.
Thus, your friend is simply wrong to conclude that it is cheaper to travel in
Mexico. Even though the dollar buys more pesos than it used to, the relatively rapid
inflation in Mexico means that pesos buy fewer goods than they used to—it is more
expensive now for an American to travel there.
11. a. The Fisher equation says that
i = r + πe
where
i = the nominal interest rate
r = the real interest rate (same in both countries)
πe = the expected inflation rate.
Plugging in the values given in the question for the nominal interest rates for
each country, we find:
12 = r + πe
Can
8 = r + πe
US
This implies that
πe
Can
– πe
US
= 4.
Because we know that the real interest rate r is the same in both countries, we
conclude that expected inflation in Canada is four percentage points higher than
in the United States.
42 Answers to Textbook Questions and Problems
∋
∋
∋
Realexchangerate
A
B
NX
NX ( )
Net exports
1
∋2
NX2
(S – I)1
(S – I)2
NX1
Figure 5–17
Chapter 5 The Open Economy 43
b. As in the text, we can express the nominal exchange rate as
e = ε × (PCan/PUS),
where
ε = the real exchange rate
PCan = the price level in Canada
PUS = the price level in the United States.
The change in the nominal exchange rate can be written as:
% change in e = % change in ε + (πCan – πUS).
We know that if purchasing-power parity holds, then a dollar must have the same
purchasing power in every country. This implies that the percent change in the
real exchange rate ε is zero because purchasing-power parity implies that the real
exchange rate is fixed. Thus, changes in the nominal exchange rate result from
differences in the inflation rates in the United States and Canada. In equation
form this says
% change in e = (πCan – πUS).
Because people know that purchasing-power parity holds, they expect this relationship
to hold. In other words, the expected change in the nominal exchange
rate equals the expected inflation rate in Canada minus the expected inflation
rate in the United States. That is,
Expected % change in e = πe
Can
– πe
US
In part (a), we found that the difference in expected inflation rates is 4 percent.
Therefore, the expected change in the nominal exchange rate e is 4 percent.
c. The problem with your friend’s scheme is that it does not take into account the
change in the nominal exchange rate e between the U.S. and Canadian dollars.
Given that the real interest rate is fixed and identical in the United States and
Canada, and given purchasing-power parity, we know that the difference in nominal
interest rates accounts for the expected change in the nominal exchange rate
between U.S. and Canadian dollars. In this example, the Canadian nominal interest
rate is 12 percent, while the U.S. nominal interest rate is 8 percent. We conclude
from this that the expected change in the nominal exchange rate is 4 percent.
Therefore,
e this year = 1 C$/US$.
e next year = 1.04 C$/US$.
Assume that your friend borrows 1 U.S. dollar from an American bank at 8 percent,
exchanges it for 1 Canadian dollar, and puts it in a Canadian Bank. At the end of the
year your friend will have $1.12 in Canadian dollars. But to repay the American bank,
the Canadian dollars must be converted back into U.S. dollars. The $1.12 (Canadian)
becomes $1.08 (American), which is the amount owed to the U.S. bank. So in the end,
your friend breaks even. In fact, after paying for transaction costs, your friend loses
money.
More Problems and Applications to Chapter 5
1. a. As shown in Figure 5–18, an increase in government purchases reduces national
saving. This reduces the supply of loans and raises the equilibrium interest rate.
This causes both domestic investment and net capital outflow to fall. The fall in
net capital outflow reduces the supply of dollars to be exchanged into foreign currency,
so the exchange rate appreciates and the trade balance falls.
44 Answers to Textbook Questions and Problems
A. The Market for Loanable Funds B. Net Capital Outflow
I + CF CF(r)
Loanable funds
Realinterestrate
Realexchangerate
S
r r
C. The Market for Foreign Exchange
Net exports
NX
CF
∋
∋( )
Net capital outflow
S, I + CF CF
NX
Figure 5–18
Chapter 5 The Open Economy 45
b. As shown in Figure 5–19, the increase in demand for exports shifts the net exports
schedule outward. Since nothing has changed in the market for loanable funds, the
interest rate remains the same, which in turn implies that net capital outflow remains
the same. The shift in the net exports schedule causes the exchange rate to appreciate.
The rise in the exchange rate makes U.S. goods more expensive relative to foreign
goods, which depresses exports and stimulates imports. In the end, the increase in
demand for American goods does not affect the trade balance.
A. The Market for Loanable Funds B. Net Capital Outflow
I + CF CF(r)
Loanable funds Net capital outflow
Realinterestrate
Realexchangerate
S
r r
C. The Market for Foreign Exchange
Net exports
NX
CF
∋
∋( )
CF
NX
S, I + CF
Figure 5–19
c. As shown in Figure 5–20, the U.S. investment demand schedule shifts inward.
The demand for loans falls, so the equilibrium interest rate falls. The lower interest
rate increases net capital outflow. Despite the fall in the interest rate, domestic
investment falls; we know this because I + CF does not change, and CF rises.
The rise in net capital outflow increases the supply of dollars in the market for
foreign exchange. The exchange rate depreciates, and net exports rise.
46 Answers to Textbook Questions and Problems
A. The Market for Loanable Funds B. Net Capital Outflow
I + CF CF(r)
Loanable funds Net capital outflow
Realinterestrate
Realexchangerate
S
r r
C. The Market for Foreign Exchange
Net exports
NX
CF
∋
∋( )
S, I + CF CF
NX
Figure 5–20
Chapter 5 The Open Economy 47
d. As shown in Figure 5–21, the increase in saving increases the supply of loans and
lowers the equilibrium interest rate. This causes both domestic investment and
net capital outflow to rise. The increase in net capital outflow increases the supply
of dollars to be exchanged into foreign currency, so the exchange rate depreciates
and the trade balance rises.
A. The Market for Loanable Funds B. Net Capital Outflow
I + CF CF(r)
Loanable funds Net capital outflow
Realinterestrate
Realexchangerate
S
r r
C. The Market for Foreign Exchange
Net exports
NX
CF
∋
∋( )
S, I + CF CF
NX
Figure 5–21
e. The reduction in the willingness of Americans to travel abroad reduces imports,
since foreign travel counts as an import. As shown in Figure 5–22, this shifts the
net exports schedule outward. Since nothing has changed in the market for loanable
funds, the interest rate remains the same, which in turn implies that net capital
outflow remains the same. The shift in the net exports schedule causes the
exchange rate to appreciate. The rise in the exchange rate makes U.S. goods more
expensive relative to foreign goods, which depresses exports and stimulates
imports. In the end, the fall in Americans’ desire to travel abroad does not affect
the trade balance.
48 Answers to Textbook Questions and Problems
A. The Market for Loanable Funds B. Net Capital Outflow
I + CF CF(r)
Loanable funds Net capital outflow
Realinterestrate
Realexchangerate
S
r r
C. The Market for Foreign Exchange
Net exports
NX
CF
∋
∋( )
S, I + CF CF
NX
Figure 5–22
Chapter 5 The Open Economy 49
f. As shown in Figure 5–23, the net capital outflow schedule shifts in. This reduces
demand for loans, so the equilibrium interest rate falls and investment rises. Net
capital outflow falls, despite the fall in the interest rate; we know this because
I + CF is unchanged and investment rises. The fall in net foreign investment
reduces the supply of dollars to be exchanged into foreign currency, so the
exchange rate appreciates and the trade balance falls.
A. The Market for Loanable Funds B. Net Capital Outflow
I + CF
CF(r)
Loanable funds Net capital outflow
Realinterestrate
Realexchangerate
S
r r
C. The Market for Foreign Exchange
Net exports
NX
CF∋
∋( )
S, I + CF CF
NX
Figure 5–23
2. Gingrich’s statement has no immediate effect on any of the “fundamentals” in the economy:
consumption, government purchases, taxes, and output are all unchanged.
International investors, however, will be more reluctant to invest in the American economy,
particularly to purchase U.S. government debt, because of the default risk. As
both Americans and foreigners move their money out of the United States, the CF
curve shifts outward (there is more capital outflow), as shown in Figure 5–24(B). This
raises the interest rate in order to keep I + CF equal to the unchanged S, shown in
Figure 5–24(A). The increase in CF raises the supply in the market for foreign
exchange, which lowers the equilibrium exchange rate as shown in Figure 5–24(C).
50 Answers to Textbook Questions and Problems
S
NX(ε)
Loanable funds
ε
Realinterestrate
S, I + CF
CF (r)I + CF
Net exports
Net capital outflow
rr
A. The Market for Loanable Funds B. Net Capital Outflow
C. The Market for Foreign Exchange
Realexchangerate
CF
CF
NX
Figure 5–24