chapter 14 - problems

chapter 14 - problems - Chapter 14 QUICK QUIZ 2. If Country...

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Unformatted text preview: Chapter 14 QUICK QUIZ 2. If Country A experiences an economic recovery while its trading partners are in recessions, Country A will tend to experience (a) a deficit on its official settlements account. (b) a surplus on its current account. (c) a balance‐of‐payments deficit. (d) a balance‐of‐payments surplus. (e) a capital‐account deficit. (f) a movement toward a deficit on its current account. 3. The relative price of domestic versus foreign goods (R) is equal to (a) the nominal exchange rate. (b) the effective exchange rate. (c) the bilateral exchange rate. (d) the real exchange rate. (e) the ratio PIP*. (f) the forward exchange rate. 4. A depreciation of the U.S. dollar against other currencies (a) helps all U.S. firms. (b) harms all U.S. firms. (c) helps all U.S. firms that export. (d) harms all U.S. firms that export. (e) helps U.S. firms that export but don't buy imported inputs. (f) helps U.S. firms that don't export but do buy imported inputs. 5. A country's GDP and its current‐account balance (a) always move in the same direction. (b) are completely unrelated. (c) always move in opposite directions. (d) are two alternative ways of measuring the country's economic well‐being. (e) sometimes move in the same direction and sometimes move in opposite directions. (f) must, by.definition, be equal. 1 6. The spending multiplier (a) is always less than one. (b) depends positively on the marginal propensity to consume and negatively on the marginal propensity to import. (c) depends positively on the marginal propensity to consume and on the marginal propensity to import. (d) depends negatively on the marginal propensity to consume and positively on the marginal propensity to import. (e) depends negatively on the marginal propensity to consume and negatively on the marginal propensity to import. (f) is always greater than one and independent of the marginal propensities to consume and import. 7. An increase in government purchases of goods and services (a) lowers GDP and moves the current‐account toward a surplus. (b) raises GDP and moves the current‐account toward a deficit. (c) lowers GDP and moves the current‐account toward a deficit. (d) raises GDP and moves the current‐account toward a surplus. (e) lowers GDP but has no effect on the cwTent‐account balance. (f) raises GDP but has no effect on the current‐account balance. 8. A real appreciation of the domestic currency (a) lowers GDP and moves the current‐account toward a surplus. (b) raises GDP and moves the current‐account toward a deficit. (c) lowers GDP and moves the current‐account toward a deficit. (d) raises GDP and moves the current‐account toward a surplus. (e) lowers GDP'but has no effect on the current‐account balance. (f) raises GDP but has no effect on the current‐account balance. 9. The J‐curve phenomenon refers to the tendency for (a) the current‐account balance to move toward surplus immediately following a currency devaluation. (b) the official settlements balance to move toward deficit immediately following a currency devaluation. (c) the capital‐account balance to move toward deficit immediately following a currency devaluation. (d) the current‐account balance to move toward deficit in the long run following a currency devaluation. (e) the current‐account balance to move toward deficit immediately and toward surplus in the long run following a currency devaluation. . (f) the current‐account balance to move toward surplus immediately and toward deficit in the long run following a currency devaluation. 10. An increase in the domestic interest rate (a) lowers GDP and moves the current‐account toward a surplus. (b) raises GDP and moves the current‐account toward a deficit. (c) lowers GDP and moves the current‐account toward a deficit. (d) raises GDP and moves the current‐account toward a surplus. (e) lowers GDP but has no effect on the current‐account balance. (f) raises GDP but has no effect on the current‐account balance. 2 ANSWERS TO QUICK QUIZ 2. f 3. d. 4. e. 5. e. 6. b. 7. b. 8. c. 9. e. 10. a. 3 PROBLEMS AND QUESTIONS FOR REVIEW 2. In the market for domestically produced goods and services, what are the major components of aggregate demand or expenditure? What are the major determinants of each component (that is, on what variables does each depend)? 3. What is the value of the expenditure or spending multiplier in an open economy with no taxes? How does this compare with the multiplier in a closed economy (that is, one with no imports or exports), and why? 4. What is the relationship between GDP and the balance on goods and services or current account? Would you expect to see income and the current account moving in the same direction, or in opposite directions? Why? 5. A move toward a surplus on the current account typically is referred to as an "improvement" while a move toward a deficit is referred to as a "deterioration". What, if any, are the potential pitfalls of this terminology? 6. Beginning from a position of equilibrium in the market for domestically produced goods and services and in the current account, what's the effect of a decline in government expenditure on: (a) The equilibrium level of income (b) The current account 7. Beginning from a position of equilibrium in the market for domestically produced goods and services and in the current account, what's the long‐run effect of a decrease in the relative price of domestic goods [ R = P/(eP*) ] on: (a) The equilibrium level of income (b) The current account 8. Under what circumstances will a change in the exchange rate bring about a change in the relative price of domestically produced goods and services? How were expenditure‐switching policies used during the Great Depression? Other things being equal, what groups in the economy tend to favor an appreciation of the domestic currency? A depreciation? 9. Country A devalues its currency by 20 percent on January 1 in response to a current‐account deficit. On February 1, the deficit is even larger than prior to the devaluation. You are called in as a consultant; the government officials ask you to explain "why the devaluation didn't work as economic theory suggests that it would." What would you say? What information would you like to have to back up your argument? 4 10. One obvious policy aimed at reducing a current‐account deficit is the imposition of protectionist barriers limiting imports. Briefly explain why such a policy may not be successful in actually reducing a deficit on the current account. 11. Beginning from a position of equilibrium in both the market for domestically produced goods and services and the current account, what would be the effect of a fall in the interest rate on: (a) The equilibrium level of income (b) The current account 12. Why is it impossible to draw conclusions about the balance of payments from the simple model of the market for goods and services? 14. Since the U.S. current‐account deficit became so large in the 1980s, one solution that has been suggested is to convince U.S. trading partners (particularly Germany and Japan) to pursue more expansionary macroeconomic policies designed to raise their GDPs and their demand for exports from the United States. Assume that the United States and Germany are the only two countries in the world. Beginning from a position of equilibrium in the U.S. and German markets for goods and services, suppose Germany raises government spending by 50. (a) If the German marginal propensity to consume (mpc) is 0.6 and the German marginal propensity to import is 0.1, what will happen to German income (Y*) as a result of the fiscal expansion? (b) What will happen to U.S. exports of goods and services (X) as a result of the German fiscal expansion? (c) Assume that the U.S. mpc is 0.6 and that the U.S. mpi is 0. L What happens to U.S. income (Y) as a result of the German fiscal policy? (d) What's the net effect on the U.S. current account balance, based on your answers to parts (b) and (c)? 15. During the late 1970s, the dollar depreciated against the currencies of most U.S. trading partners; and U.S. consumers complained. During the early 1980s, the dollar appreciated against the currencies of most trading partners. Producers in many industries (for example, agriculture, automobiles, footwear) complained. Explain why this is the pattern of support and opposition we'd expect to see to the exchange rates changes. 16. Evaluate the following statement: "The current‐account deficit is going from bad to worse, hindering the growth of the U.S. economy." 17. Give an example (either hypothetical or real) of a case in which a current‐account deficit might be taken as good news and a current‐account surplus as bad news about the overall state of the economy. 5 18. Why might changes in the real exchange rate (or the relative price of domestic and foreign goods and services) have a greater macroeconomic impact in a very open economy than in a relatively closed one? 19. Explain how the fact that one country's imports constitute its trading partners' exports can lead to international business cycles‐that is, to situations in which trading partners experience simultaneous economic booms or simultaneous recessions. 6 ANSWERS TO PROBLEMS AND QUESTIONS FOR REVIEW 2. The major components of total expenditure are consumption (a function of income), investment (a function of the interest rate), government purchases (a fiscal‐policy variable), and net exports (a function of domestic and foreign incomes and of R, the relative price of domestic versus foreign goods and services). 3. The expenditure or spending multiplier in an open economy with no taxes is equal to 1/(1 ‐ mpc + mpi) . The multiplier in an open economy is smaller than that in a closed economy (1/[1‐ mpc]) because a portion of any rise in income in an open economy is spent on imported goods and services. This portion leaks out of the domestic economy and isn't passed on to the next round of domestic spending. 4. The level of income affects the current account by determining import expenditures. The current account affects income because net export expenditure (exports minus imports) is one component of total expenditure on domestic goods and services. Income and the current account may move in the same direction (for example, if a fall in the relative price of domestic goods moves the current account toward a surplus and raises income) or in opposite directions (for example, if a rise in income increases imports and moves the current account toward a deficit). 5. The improvement/deterioration terminology implies that current‐account surpluses are desirable and deficits undesirable. This isn't necessarily the case. For example, rapidly rising income in a growing economy may generate an increase in imports and a growing current‐account deficit. Similarly, an economy experiencing a decline in income may have a growing surplus on its current account because of the decline in imports. 6. (a) A decline in government expenditure lowers equilibrium income. (b) A decline in government expenditure moves the current account toward a surplus. 7. (a) A decrease in the relative price of domestically produced goods and services raises equilibrium income. (b) A decrease in the relative price of domestically produced goods and services moves the current account toward a surplus. 7 8. A change in the exchange rate will bring about a change in the relative price of domestically produced goods and services (R = P/eP*) if offsetting changes in P and/or P* don't occur. During the Great Depression, countries devalued their currencies (raised e) in an effort to lower the relative price of domestic goods and services and increase output at the expense of other countries. Consumer groups and producers in non‐trade oriented sectors of the economy tend to favor domestic currency appreciations, which make foreign goods relatively cheaper. Producers in export and import‐competing sectors of the economy tend to favor domestic currency depreciations, which make foreign goods relatively more expensive. 9. The depreciation immediately raises the domestic‐currency price of imports. If quantities are slow to adjust to the change in relative prices, total expenditure on imports will rise while total export receipts are unchanged. The current‐account deficit will grow in the short run (for example, the one‐month period cited in the problem); this is called the J‐curve phenomena. Estimates of the short‐run elasticities of demand for imports and exports would be helpful in establishing that the observed result is indeed a case of the J curve. 10. Protectionism by one country lowers the income of trading partners, thereby harming the first country's ability to export. If exchange rates are flexible, any reduction in imports may cause a currency appreciation which raises imports and decreases exports. Protectionism tends to lead to retaliatory measures by trading partners. By causing inefficient resource allocation, protectionism lowers the total quantity of goods and services available. 11. (a) A fall in the interest rate raises equilibrium income. (b) A fall in the interest rate moves the current account toward a deficit. 12. The balance of payments includes not only international trade in goods and services, but international financial transactions, foreign investment, and central bank intervention in currency markets as well. The market for goods and services includes only imports and exports of goods and services. 14. (a) German income (Y*) increases by the increase in G* (=50) multiplied by the German spending multiplier or 1/(1 ‐ mpc* + mpi*) = 1/(1 ‐0.6 + 0.1) = 1/0.5 = 2. Therefore, Y* increases by 50 x 2 = 100. (b) German imports rise by the increase in income multiplied by the German marginal propensity to import, or 100 x 0.1 = 10. U.S. exports equal German imports, so U.S. exports rise by 10. (c) The increase of 10 in U.S. exports raises U.S. income by 10 multiplied by the U.S. spending multiplier (1/[1‐ mpc + mpi]) = (1/[1 ‐0.6 + 0.1]) = 2. Therefore U.S. income rises by 10 ∙ 2 = 20. (d) The increase of 20 in U.S. income causes U.S. imports to rise by 20 x mpi = 20 x 0.1 = 2. Therefore, U.S. exports rise by 10 and U.S. imports rise by 2; the U.S. current account moves toward surplus by 8. 8 15. A depreciation of the dollar raises the dollar price of imported goods. Consumers of imported goods face increased costs. An appreciation of the dollar lowers the dollar price of imported goods and raises the foreign currency price of U.S. goods. U.S. consumers buy more imports, harming import‐competing domestic producers, and U.S. exporters lose sales. 16. The relationship between income and the current‐account balance is a complex, interactive one. An increased current‐account deficit might lower the growth of GDP if, for example, the deficit resulted from an increased relative price of domestic goods and services. But, an increased current‐account deficit could also result from growth in income. 17. An economy with rapidly growing income will experience an increase in imports and, often, a move toward a deficit on the current account. Conversely, an economy with shrinking income will experience a decline in imports and, often, a move toward a surplus on the current account (as in Japan during the 1990s). 18. A very open economy imports and exports large quantities of goods and services. A given change in the real exchange rate affects these large quantities of imports and exports and can, therefore, cause larger shifts in total expenditure than in a more closed economy. 19. A recession in country A reduces its demand for imports. This means country B exports less, so country B's income falls. Country B demands fewer goods from country A, deepening the recession there, and further reducing the demand for country B's exports. 9 ...
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