## PROBLEMS AND APPLICATIONS

1. Use the model of the small open economy to predict what would happen to the trade balance, the real exchange rate, and the nominal exchange rate in response to each of the following events.

1. A fall in consumer confidence about the future induces consumers to spend less and save more.

2. The introduction of a stylish line of Volkswagens makes some consumers prefer foreign cars over domestic cars.

3. The introduction of automatic teller machines reduces the demand for money.

2. Consider an economy described by the following equations:

Y = C + I + G + NX,

Y = 5,000,

G = 1,000,

T = 1,000,

C = 250 + 0.75(Y – T),

I = 1,000 – 50r,

NX = 500 – 500ϵ,

r = r* = 5.

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

2. Suppose now that G rises to 1,250. Solve for national saving, investment, the trade balance, and the equilibrium exchange rate. Explain what you find.

3. Now suppose that the world interest rate rises from 5 to 10 percent. (G is again 1,000.) Solve for national saving, investment, the trade balance, and the equilibrium exchange rate. Explain what you find.

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

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

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

3. 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?

4. 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?

5. In 2005, Federal Reserve Governor Ben Bernanke said in a speech: “Over the past decade a combination of diverse forces has created a significant increase in the global supply of saving—a global saving glut—which helps to explain both the increase in the U.S. current account deficit [a broad measure of the trade deficit] and the relatively low level of long-term real interest rates in the world today.” Is this statement consistent with the models you have learned? Explain.

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6. A case study in this chapter concludes that, if poor nations offered better production efficiency and legal protections, the trade balance in rich nations such as the United States would move toward surplus. Let’s consider why this might be the case.

1. If the world’s poor nations offer better production efficiency and legal protection, what would happen to the investment demand function in those countries?

2. How would the change you describe in part (a) affect the demand for loanable funds in world financial markets?

3. How would the change you describe in part (b) affect the world interest rate?

4. How would the change in the world interest rate you describe in part (c) affect the trade balance in rich nations?

7. The president of the United States is considering placing a tariff on the import of Japanese luxury cars. 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?

8. Suppose China exports television sets and uses the yuan as its currency, whereas Russia exports vodka and uses the ruble. China has a stable money supply and slow, steady technological progress in producing television sets, whereas Russia has very rapid growth in the money supply and no technological progress in vodka production. Based on this information, what would you predict for the real exchange rate (measured as bottles of vodka per television set) and the nominal exchange rate (measured as rubles per yuan)? Explain your reasoning. (Hint: For the real exchange rate, think about the link between scarcity and relative prices.)

9. Suppose that some foreign countries begin to subsidize investment by instituting an investment tax credit.

1. What happens to world investment demand as a function of the world interest rate?

2. What happens to the world interest rate?

3. What happens to investment in our small open economy?

4. What happens to our trade balance?

5. What happens to our real exchange rate?

10. “Travelling 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 about 25 percent in Canada 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 a Canadian hotdog versus a Mexican taco—that will convince your friend.

11. You read in a newspaper that the nominal interest rate is 12 percent per year in Canada and 8 percent per year in the United States. Suppose that the real interest rates are equalized in the two countries and that purchasing-power parity holds.

1. Using the Fisher equation (discussed in Chapter 4), what can you infer about expected inflation in Canada and in the United States?

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

3. 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?