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381 Ch 5 - CHAPTER 5 The Open Economy Questions for Review...

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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 finan- cial markets. The trade balance refers to the ( NX ) part of the identity: it is the differ- ence 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 bal- ance rises, and the real exchange rate falls. 30 Real exchange rate A B NX NX Net exports ( ∋) NX 2 NX 1 S 1 I S 2 I 1 2 Figure 5–1 C H A P T E R 5 The Open Economy
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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 can- not 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.
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