178.200 06-8

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Open Economy

178.200 Intermediate MacroeconomicsTutorial (8)

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Short Answer Questions

1. Suppose that the NZ government passes new tax laws that provide a tax credit for those who invest in new capital. If a change in the tax laws induces more investment projects and increases the investment demand,

(1) What happens to the NZ trade balance?

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Answer:

An investment tax credit provided by the NZ government makes an outward shift in the investment schedule from I(r)1 to I(r)2 and raises the domestic interest rate to rd. As rd raises above the world interest rate rw, foreign capital flows in to obtain a claim to the future returns to domestic capital. Hence, at rw, the amount of investment correspondingly increases from I0 to I(rw).

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Answer: (continued)

Since saving S is unchanged, I(rw) is then greater than S. That is S- I(rw) < 0 which means the net capital outflow is negative. S- I(rw) < 0 ⇔ NX < 0. Therefore, an increase in investment demand leads to a trade deficit.

r

rd

rw

S

I(r)2

I(r)1

S = I0 I(rw) S,I

NX < 0

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Answer: (continued)

r

rd

rw

S

I(r)2

I(r)1

S = I0I(rw) S,I

NX > 0

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(2) What happens to the real exchange rate?Answer: An increase in investment demand shifts the

vertical S-I line to the left due to the negative net capital outflow. Meanwhile, the increase in international capital flow stimulate the demand of domestic currency and bids up the value of domestic currency.

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Answer: (continued)

Consequently, the real exchange rate raises from ε1 to ε2. The higher real exchange rate implies that the NZ goods are expensive relative to foreign goods. As a result, the net export falls from NX1 to NX2.

ε

NX

ε1

ε2

S-I(rw2) S-I(rw1)

NX2 NX1

NX(ε)

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Answer: (continued)

ε

NX

ε1

ε2

S-I(rw2)S-I(rw1)

NX2NX1

NX(ε)

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2. Suppose that the NZ government adopts a tariff by placing a tax on imports. What happens to the real exchange rate?

Answer: For any given real exchange rate, a

protectionist trade policy forces imports being lower which implies that net exports would be higher.

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Answer: (continued)

Hence, the net export schedule shifts upward from NX(ε1) to NX(ε2). In consequence, the real exchange rate raises from ε1 to ε2. The equilibrium level of net exports is unchanged because the protectionist policy does not alter either saving S or investment I.

ε

NX

ε1

ε2

S-I

NX1 = NX2

NX(ε)2

NX(ε)1

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Multiple-Choice Questions(2005 Exam Question)

(1) The false statement below is:a. net capital outflow is the excess of domestic saving over

domestic investment.b. the trade surplus and net capital outflow must both equal

zero.c. according to the national income accounts identity, net

capital outflow must equal net export.d. according to the national income accounts identity, net

capital outflow must equal the trade balance.Answer: b.

Hint: P118

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(2) If domestic investment exceeds domestic savings, one would observe:

a. Negative net capital outflow.

b. A government budget deficit.

c. A trade deficit.

d. both a and c.

Answer: d.

Hint: P118

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(3) With a constant world interest rate, full employment, and an initial trade surplus of zero, a tax cut in a small open economy will result in:

a. A trade deficit. b. A reduction in national saving. c. Negative net capital outflow. d. All of the above.Answer: d.Hint: T↓→C↑→S↓→S-I< 0 ⇔ NX< 0.

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(4) Suppose that several large foreign countries decrease government spending, leading to a decrease in the world interest rate. In a small open economy, which of the following is most likely to happen?

a. A decreasing in saving. b. A decreasing in investment. c. An increase in the trade deficit. d. An increase in net capital outflow.Answer: c.

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Hint:

I(r)

S

rw1

rw2

r

I(rw)(I(rw)>S)

S = I0 I,S

NX < 0

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(5) As the real exchange rate of the US dollar increases

a. foreign goods become cheaper to US citizens.

b. US net exports fall. c. the US trade surplus decreases. d. all of the above occur.Answer: d.

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(6) If the government of a small open economy increases personal income taxes, that country’s

a. net exports increase.

b. investment increases.

c. equilibrium real exchange rate rises.

d. consumption rises.

Answer: a.

Hint: T↑→C↓→S↑→S-I> 0 ⇔ NX> 0.

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(7) If the governments of several large foreign countries raise taxes,

a. the world interest rate will rise. b. the NZ trade surplus will rise. c. the real exchange rate of the NZ dollar

will rise. d. NZ net exports will increase.Answer: c.

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Hint:

I(rw)

Sw1

rw1

rw2

rw

I(rw),Sw

Sw2

(1)

(2)

S-I(rw1)S-I(rw2)

ε1

ε2

ε

NX1NX2 NX

NX(ε)

(3)

(4)

(5)

Foreign Domestic

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(8) If investment demand decreases in a small open economy,

a. the equilibrium real exchange rate rises.

b. net exports increase.

c. national saving increases.

d. net capital outflow decreases.

Answer: b.

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(9) In the long run, if the New Zealand government places high tariffs on all imports,

a. NZ’s net exports rise.

b. NZ’s real foreign exchange rate increases.

c. net capital outflow in NZ decreases.

d. all of the above.

Answer: b.

Hint: P134

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(10) Slower growth in the Japanese money supply will lead to:

a. an increase in inflation in Japan. b. a decrease in inflation in NZ. c. a depreciation of the NZ dollar relative to

the Japanese yen. d. all of the above.Answer: c.Hint: (M/P) ↑ → e↓. P319

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(11) According to PPP, if a TV set sells for $500 in NZ and 2000 yuan in China, the nominal exchange rate, expressed in yuan per dollar, is

a. 2.5. b. 10. c. 4. d. 1.Answer: c.Hint: e = 2000/500 = 4 (yuan/NZ$).

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(12) In a small open economy with a floating exchange rate, fiscal policy will be ineffective because:

a. monetary policy will completely offset it. b. the exchange rate will remain constant. c. a fall in net exports will offset any increases in

government purchases or consumption. d. the exchange rate will rise by the same amount

as the interest rate.Answer: c.Hint: If IS↑ P318

e↑→NX↓Y↑ offset

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(13) In a small open economy with a floating exchange rate, monetary expansion does all of the following EXCEPT:

a. lower the interest rate. b. increase the equilibrium income level. c. decrease the exchange rate. d. cause net exports to rise.Answer: a.Hint: rd = rw. P315-316.

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(14) Trade restrictions have no effect on income under floating exchange rates because

a. net exports increase but investment decreases. b. the exchange rate rises to offset the initial

increase in net exports. c. the fall in imports equals the rise in exports. d. all of the above.Answer: b.Hint: NX↑→IS↑→e↑→NX↓.

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(15) If the current exchange rate ¥200/$ is above the fixed exchange rate set by the central bank (¥150/$), arbitragers can make profits by

a. buying yen in foreign exchange markets and selling them to the central bank.

b. buying yen from the central bank and selling them in foreign exchange markets.

c. buying dollars in foreign exchange markets and selling them to the central bank.

d. none of the above.Answer: a.Hint: P321

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(16) An expansionary fiscal policy under fixed exchange rates will

a. force the central bank to increase the money supply in order to prevent the exchange rate from falling.

b. increase real income. c. eventually lead the IS* and LM* curves to the

right. d. all of the above.Answer: d.Hint: P323-324

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(17) If the central bank tries to increase the money supply under fixed exchange rates,

a. national income will be unaffected. b. the initial increase in the money supply will be

offset if the central bank maintains the original fixed exchange rate.

c. the LM* curve on a Y/e graph will shift first to the right and then to the left, back to its original position.

d. all of the above.Answer: d. Hint:P324-325

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(18) The risk premium in a country’s interest rate will rise, if

a. people expect the country’s exchange rate to fall. b. fears arise that the government may not pay all

of its debt. c. the country’s foreign exchange reserves are

quickly being depleted. d. all of the above.Answer: d.Hint: P327-328

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(19) If the value of the currency is reduced via a devaluation, the

a. LM* curve shifts to the right, and both net exports and income rise.

b. LM* curve shifts to the right, net exports fall, and income rise.

c. LM* curve shifts to the left, and both net exports and income fall.

d. IS* and LM* curves both shift to the right.Answer: a.Hint: P325

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(20) A restrictive trade policy under a fixed exchange rate will

a. have the same effect as under a floating exchange rate.

b. raise the equilibrium level of national income. c. shift the IS* curve to the right and the LM*

curve to the left on a Y/e graph. d. lead to a devaluation of the currency.Answer: b.Hint:P326

178.200 06-8

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