Topic 3

Question 1

3 assumptions about capital flows in a small open economy? What do they imply?

Answer 1

1) Domestic and foreign bonds are perfect substitutes
2) Perfect capital mobility (ie. no restrictions on trade in assets)
3) Economy can’t affect world interest rate because it’s small
1 and 2 imply r=r, and 3 implies r* is exogenous

Question 2

China X and M?

Answer 2

X=26%, M=23%

Question 3

Germany X and M?

Answer 3

X=46%, M=40%

Question 4

USA X and M?

Answer 4

X=13%, M=16%

Question 5

Net outflow of loanable funds =?

Answer 5

net purchases of foreign assets

Question 6

In a small open economy how is I, NCO and NX determined?

Answer 6

r* (exogenous) determines I, and the difference between S and I determines NCO and NX (see graph)

Question 7

How does contractionary fiscal policy affect S, I and r in a small open economy?

Answer 7

See explanation and graph

Question 8

How does expansionary fiscal policy abroad affect S, I and r in a small open economy?

Answer 8

See explanation and graph

Question 9

How does an increase in investment abroad affect S, I and r in a small open economy?

Answer 9

See explanation and graph

Question 10

Which equation explains the interaction between the current and capital account?

Answer 10

(S-I)=NX

Question 11

Balance of payments equation?

Answer 11

BP=CA-NCO

Balance of payments = current account - capital account

Question 12

3 things included in the current account?

Answer 12

Trade balance (NX)
Net factor income from abroad (NFIA)
Net unilateral transfers (NUT)
CA=NX+NFIA+NUT

Question 13

What does NFIA equal?

Answer 13

NFIA = factor income from abroad - factor payments to foreigners

Question 14

What is included in NUT?

Answer 14

Flows such as foreign aid and EU budget contributions

Question 15

Simplifying assumption regarding NUT and NFIA?

Answer 15

NUT=NFIA=0

Question 16

See:

Answer 16

big mac index slide and do calculation after

Question 17

Key point when analysing a large open economy such as the US?

Answer 17

The interest rate is no longer exogenous since a large open economy influences global financial market conditions.

Question 18

See and learn diagrams for large open economy model?

Answer 18

now

Question 19

Learn diagrams and explanations for how, in a large open economy, the following scenarios will play out:

1) Exp. FP at home
2) Increase in investment demand
3) Trade policy at home (eg. protectionism)
4) Fiscal policy abroad

Answer 19

now, also see and learn table at end of topic 3 notes that summarises it all

Question 20

What is the nominal exchange rate, e?

Answer 20

The relative price of domestic currency ITO foreign currency

Question 21

What is the real exchange rate?

Answer 21

Relative price of domestic goods ITO foreign goods

Question 22

In macroeconomics how can we view the real exchange rate? What does this then mean if there’s an increase in the exchange rate?

Answer 22

The relative price of one country’s output ITO another country’s output
This means domestic goods become relatively more expensive tf fall in X, increase in M, fall in NX

Question 23

What is the relationship between NX and real exchange rate?

Answer 23

Negative

Question 24

Why is the NCO curve vertical when plotted on a real exchange rate vs NX graph?

Answer 24

S+I don’t depend on the real exchange rate tf NCO curve is vertical

Question 25

Explain how supply and demand act in the foreign exchange market?

Answer 25

Demand: Foreigners need x’s currency to buy x’s net exports
Supply: NCO is the supply of x’s currency to be invested abroad

Question 26

Note:

Answer 26

Supply and demand of currency in foreign exchange market is not equal to demand of real money balances OR supply of money (see why in slides halfway down)

Question 27

Learn 4 experiments for a small open economy. Effects on real exchange rate vs NX graphs and explanations of:

1) FP at home
2) FP abroad
3) increase in investment demand
4) trade policy to restrict imports

Answer 27

now

Question 28

Note

Answer 28

For any given real ER, the growth rate of nominal ER is equal to the difference between foreign and domestic inflation rates

Question 29

First definition for law of purchasing power parities and reasoning behind it?

Answer 29

Goods must be sold at the same currency adjusted price in all countries; reasoning is arbitrage (ie. if not same price people would sell between countries until prices are all equal)

Question 30

Second definition for law of purchasing power parities and reasoning behind it?

Answer 30

The nominal ER will adjust to equalise the cost of a basket across countries; reasoning is Law of one price

Question 31

PPP equation?

Answer 31

e.P=P*
where:
e=nominal exchange rate
P=cost of basket of domestic goods in domestic currency
P*=cost of basket of foreign goods in foreign currency

Question 32

Note

Answer 32

Under PPP, changes in (S-I) have no impact on real or nominal ER (see why in notes)

Question 33

Evaluation: 2 reasons PPP doesn’t hold in real world?

Answer 33

1) International arbitrage not always possible (nontraded goods, transportation costs)
2) Differen’t countries’ goods are not perfect subsititutes

Question 34

Evaluation: 2 reasons PPP is still useful in analysis?

Answer 34

1) simple and intuitive

2) in real world nominal exchange rate does tend towards their PPP values in the long run