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Unformatted text preview: Economics 51D Due 16 November 2007 Problem Set 8 Answers 1. Siamese Deficit Twins? A. According to the article, it’s the Capital Account surplus that’s driving the Current Account deficit, not the Budget Deficit. In particular, the article is trying to argue that for various reasons, investment opportunities (both real and financial) are much better in the US than in many other countries. Malpass mentions that US bonds have higher returns than Japanese bonds, for example (as well as European bonds, by the way), and he also mentions the innovation taking place in the real economy is also producing high returns. Thus, both Americans and foreigners wish to buy more US assets. B. We can use several graphs to illustrate Malpass’ argument. First, we can draw a graph of the market for US assets. The demand for assets is coming from individuals and firms who wish to invest, and the supply of assets is coming from those wishing to borrow in order to fund projects. Of course, part of the supply comes from the borrowings of the US government, but according to Malpass, the story here is that the demand for US assets is surging, because of the attractive returns they offer. The demand curve, therefore, is shifting to the right, which increases the quantity of assets sold and increases the price also. Since a lot of this increase in demand for US assets comes from foreigners, this means that the demand for US dollars increases. In order to buy US assets, a purchaser must use US dollars, so the foreigners must exchange their Euro, Yen, Zlotys, Perchoopniks, Bembeni, Verminkles, and so on for US dollars. The increased demand for US assets, therefore, translates directly for an 1 increased demand for US dollars (USD). The supply curve is shifting to the left, too, because people holding dollars are less willing to sell them for foreign currency because they’d rather buy the US assets instead of foreign assets. If we use a diagram for the market for USD, where the price is given in Euro €, then the increased demand for USD increases the price of the dollar in terms of Euros. Since we quote the exchange rates in terms of USD per Euro, we can invert this price to see that the exchange rate with the Euro has fallen—the USD price of €1 has fallen. As we know, this is an appreciation of the USD against the Euro. Similarly, the USD appreciates relative to all of the currencies that are exchanged in order to buy US assets. The effect of the appreciation of the USD is to make all the products of other countries cheaper —including goods and services (and also assets, but we said above that people think the US assets are better investments). Since the prices of foreign goods have fallen, US consumers will want to buy more of them. Simultaneously, the price of US goods rises for foreign consumers, so they wish to buy fewer US goods and services. Both of these effects will increase imports into the US and decrease US exports to other countries. This, of course, lowers the Current Account balance, making any surplus smaller or any existing deficit larger....
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This note was uploaded on 03/31/2009 for the course ECON 5161 taught by Professor Fullenkampf during the Fall '07 term at Duke.
- Fall '07