Chapter 17: Open-Market Macroeconomics

Question 1

Define ‘Balance of trade’.

Answer 1

The value of exports minus the value of imports. Also called next exports, NX.

Question 2

Define ‘Trade deficit’.

Answer 2

A negative balance of trade; a greater amount of imports than exports.

Question 3

Define ‘Trade surplus’.

Answer 3

A positive balance of trade; a greater amount of exports than imports

Question 4

Define ‘Foreign direct investment (FDI)’.

Answer 4

Investment when a firm runs part of its operation abroad or invests in another company abroad.

Question 5

Define ‘Foreign portfolio investment’.

Answer 5

Investment funded by foreign sources but operated domestically. I.e. stocks or bonds.

Question 6

Define ‘Net capital outflow’.

Answer 6

The net flow of funds invested outside of a country.

Direct investment + portfolio investment.

Question 7

Define ‘Balance-of-payments identity’.

Answer 7

An equation that shows that the value of net exports equals net capital outflow.
NX=NCO

Question 8

Define ‘Exchange rate’.

Answer 8

The value of one currency expressed in terms of another currency.

Question 9

Define ‘Exchange-rate appreciation’.

Answer 9

An increase in the value of a currency relative to the value of another currency.

Question 10

Define ‘Exchange-rate depreciation’.

Answer 10

A decrease in the value of a currency relative to other currencies.

Question 11

Define ‘Floating exchange rate’.

Answer 11

An exchange rate whose value is determined by the market.

Question 12

Define ‘Fixed exchange rate’.

Answer 12

An exchange rate that is set by the government, instead of determined by the market.
Usually set to be in relation to another stable currency.

Question 13

Define ‘Nominal exchange rate’.

Answer 13

The stated rate at which one country’s currency can be traded for another country’s currency.

Question 14

Define ‘Real exchange rate’.

Answer 14

The value of goods in one country expressed in terms of the same goods in another country.
The real XR is the nom. XR corrected for the price levels in the domestic and foreign country.
Measured in terms of goods instead of currency.

Question 15

How do net exports NX respond to the value of the exchange rate XR?

Answer 15

When the XR is high, domestic goods are expensive and foreign goods are cheap, so net exports are low. When the exchange rate is low, net exports are high.

Question 16

How are the balance of trade and net capital outflow related?

Answer 16

Through the balance-of-payments identity which states that NX=NCO. This is an accounting identity; if a country has an imbalance of trade (positive net exports), it means that it has lent money to the rest of the world (positive capital outflow) to pay for these goods.

Question 17

How are net capital outflows determined?

Answer 17

By the demand for and supply of net capital outflow.
The supply of net capital outflow is national savings less domestic investment. The demand for net capital outflow is determined by the domestic interest rate and the foreign interest rate.

Question 18

What happens when the domestic interest rate is high? The foreign interest rate?

Answer 18

When the domestic interest rate is high, net capital outflow is low, because foreign money flows into the country.
When the foreign interest rate is high, net capital outflow is high, because money flows out of the country to take advantage of high returns.

Question 19

Various events can influence the international supply and demand for loanable funds. Describe some.

Answer 19

An increase in confidence in an economy will cut net capital outflows and lower the interest rate.
A decrease in savings from an increase in the government deficit will shift the supply curve for loanable funds to the left, increasing the interest rate and decreasing net capital outflows.

Question 20

What determines the XR?

Answer 20

It is determined by demand and supply for domestic currency. Demand and supply are influence by preferences for domestic and foreign goods and services, the domestic interest rate, the foreign interest rate, and perceived riskiness of domestic and foreign investment.

Question 21

In terms of monetary policy, a fixed exchange rate necessarily means that monetary policy will …?

Answer 21

Not have any effect.

Any change to the money supply has to be counteracted by government actions on the foreign-exchange market.

Question 22

Monetary policy is possible under a ____ XR.

Answer 22

Flexible.

Question 23

If the real exchange rate is 1, then a good can be exchanges in one country directly for a good in another country. If this is the case, we say there is …?

Answer 23

PPP (purchasing power parity) between the two countries.

Question 24

Where does NCO=NX come from?

Answer 24

S=S_private + S_public
S=I+NCO
S=I+NX

Question 25

What is the equation for rXR?

Answer 25

rXR = nXR x (domestic price level / foreign price level)