Economics 161
E. McDevitt
Study Questions on INTERNATIONAL ECONOMICS
1. Which of the following transactions would be considered imports from the U.S. point of view:
- U.S. wheat producers sell wheat to South Africa.
- U.S. consumers purchase jackets from producers in Mexico.
- Tourists from South Korea go to Disneyland.
- U.S. tourists stay hotels in Italy.
2. What is meant by a “trade deficit” (also referred to as a “merchandise trade deficit”)?
3. What is the interpretation of S-I? What is the definition of Foreign Lending? What is the definition of Foreign Borrowing?
4. Which of the following would considered foreign lending from the U.S. point of view:
- A U.S. firm purchases a mine in Chile.
- A U.S resident purchases a German bond.
- A Canadian resident purchases stock in a U.S. firm.
5. True or false, explain: A country that is running a trade deficit must be a net foreign borrower. Give an example to justify your answer.
6. a. Suppose domestic saving falls. Other things constant, what happens to Net Foreign Outflows (also known as Net Foreign Investment)? What happens to NX? Give a numerical example.
6.b. Suppose domestic investment increases. Other things constant, what happens to Net Foreign Outflows (Net Foreign Investment)? What happens to NX? Give a numerical example.
7. What is the relationship between the real exchange rate and the nominal exchange rate? Assume that the nominal exchange rate is £2 per dollar, P = $4 per U.S. widget, and PF = £4 per British widget. Find the real exchange rate (e).
8. What is purchasing-power-parity theory? Assume the following initial values: en = 100 Yen per dollar, P = $2 per X in U.S., and PF = 150 Yen per X in Japan. Are these the set of values you expect to see under PPP theory? If not, explain the market forces that lead to change in these values.
9.According to PPP theory, what would happen the nominal exchange rate between two countries if
the price level in each country increased by 10%?
10.What is the relationship between e and NX? Explain.
11. What is meant by the supply of dollars in the foreign exchange market?…the demand for dollars in the foreign exchange market? What is the source of supply of dollars in the foreign exchange market? ….the source of the demand for dollars in the foreign exchange market?
12. What is the supply of dollars curve in the foreign-exchange market upward slopping? What is the demand curve downward slopping? Use an example to justify your answer.
13. Using graphs of the foreign exchange market for dollars (relative to the Euro), analyze the effects on the exchange rate of each the following events. Be sure to explain any shift.
a. An increase in U.S. real income. Europe’s real income is unchanged.
b. An increase in Europe’s price level relative to the U.S. price level.
- A decrease in the U.S. real rate of interest relative to the real rate of interest in Europe.
14. Multiple Choice questions. Select the best answer.
14a. Other things constant, a decrease in the real exchange rate can be expected to cause:
a. a decrease in exports.
b. a decrease in imports.
c. a decrease in net exports.
d. all of the above.
e. none of the above.
14b. Which of the following would be considered foreign lending from the US point of view?
a. a US resident purchases land in Kenya.
b. a Korean bank purchases bonds issued by the US government.
c. a US resident takes a vacation in Mexico.
d. a British tourist vacations in the US.
e. none of the above.
14c. Suppose the nominal exchange rate changes from 1 euro per dollar to 1.1 euros per dollar over the course of a year. According to the purchasing-power-parity theory, this change can be explained by which of the following changes in the price levels of the respective countries:
a. the price level in Europe increased by 5% and the price level in the US also increased by 10%.
b. the price level in Europe remained constant, and the price level in the US increased by 10%.
c. the price level in Europe remained constant, but the price level in the US fell by 10%.
d. the price level in both Europe and the US fell by 5%.
e. the price level in both Europe and the US rose by 5%.
14d. Suppose initially that PF = 30 pesos per widget in Mexico, en = 10 pesos per dollar, and P = $2 per widget in the US. The logic of PPP theory predicts (ignore transportation costs):
a. someone can make a profit of 20 pesos by buying widgets in Mexico at a price of 30 pesos/unit and than shipping and selling them in the US.
b. someone can make a profit of 10 pesos per widget by buying widgets in Mexico at a price of 30 pesos/unit and than shipping and selling them in the US.
c. someone can make a profit of $1 per widget by buying widgets in the US at a price of $2/unit and then shipping and selling them in Mexico.
d. someone can make a profit of $10 per widget by buying widgets in the US at a price of $2/unit and then shipping and selling them in Germany.
14e. Other things constant, as U.S. exports to other countries increase, then:
a. The supply of dollars in the foreign exchange market increases.
b. The demand for foreign currency in the foreign exchange market increases.
c. The supply of dollars in the foreign exchange market decreases.
d. The demand for dollars in the foreign exchange market increases.
e. none of the above.
f. two of the above.
14f. An increase in the real rate of interest in the U.S. relative to the real rate of interest in other countries will lead to all of the following EXCEPT:
a. an increase in the supply of dollars in the foreign exchange market.
b. a decrease in the demand for dollars in the foreign exchange market.
c. a decrease in the exchangerate (i.e., “dollar depreciates” since exchange rate is measured as units of foreign currency per $).
d. all of the above.
e. none of the above.
14g. A change in tastes and preference in the U.S. that leads to an increase in the demand for imported goods would:
a. increase the demand for dollars in the foreign exchange market.
b. increase the supply of dollars in the foreign exchange market.
c. lead to an increase in the exchange rate (i.e., dollar appreciates since exchange rate is measured as units of foreign currency per dollar).
d. all of the above.
e. none of the above.
ANSWERS
1. a. U.S. export. b. U.S. import. c. U.S. export. d. U.S. import.
2. Trade deficit: Imports > Exports. That is, net exports (NX) < 0.
3. The term S-I, or the excess of domestic saving over domestic investment, is referred to as Net Foreign Outflows (or as Net Foreign Investment). If S-I >0 for a given country, then that country is a net foreign lender, if S-I< 0 then that country is a net foreign borrower.
Foreign Lending (FL): the domestic purchase of foreign assets. Foreign Borrowing (FB): the foreign purchase of domestic assets. Another way of expressing Net Foreign Outflows is as NFO = FL-FB. So is NFO>0 (i.e., FL>FB) then the country is a net foreign lender and if NFO< 0 (i.e., FL<FB) the country is a net foreign borrower.
4. a. U.S. foreign lending b. U.S. foreign lending. c. U.S. foreign borrowing.
5. True. From class, we derived the following equation: NF0 = NX. From this equation can be seen that if
NX < 0, it must be that NFO < 0. When NFO is negative the country is a net foreign borrower. This can be explained with a simple example: Consider the U.S. and Mexico. Suppose that U.S. exports = $400 and U.S. imports = $500. Therefore NX for the U.S. equals -$100 (a trade deficit). What is Mexico receiving for the excess $100 worth of goods and services sold to the U.S. If it is not other goods and services, then it must be that they are acquiring ownership claims to U.S. assets (for example, U.S. financial assets or U.S. land). From the U.S. point of view, this represents foreign borrowing and so the U.S. is a net foreign borrower.
6. a. If S falls, and for a given I, then S-I must fall. For example, suppose the initial values are S=$400 and I=$600.
So S-I = 400-600 = -200. Since NF0 = NX, NX is also equal to –200. (Notice we are assuming that the country is a net foreign borrower—this a completely arbitrary assumption). If S falls to $300, then S-I = 300-600= -300.
So NF0 = NX = -300. In other words, this country’s trade deficit rises from –200 to –300 and it becomes a larger net foreign borrower.
6.b. If I rises, and for a given S, then S-I must fall. For example, suppose the initial values are again S=$400 and I=$600. So S-I = 400-600 = -200. Since NF0 = NX, NX is also equal to –200.
If I rises to $700, then S-I = 400-700= -300. So NF0 = NX = -300. In other words, this country’s trade deficit rises from –200 to –300 and it becomes a larger net foreign borrower.
7. Let e = real exchange rate, en = nominal exchange rate, P= domestic price level, and PF = foreign price level. Then, as explained in class, e = (en)(P)/ (PF). Using this formula we get:
e = (en)(P)/ (PF) = (£2 per $)($4 per US widget)/ (£4 per British widget) = 2 British widgets per US widget.
8. PPP theory claims that the real exchange rate will equal 1. That is, it claims that a good will cost the same
amount in either country expressed in a given currency. (This ignores transportation and information costs). If the real exchange rate equals 1, then PPP can be expressed as PF = (en)(P).
No, these are not the values you expect to see according to PPP because PF < (en)(P)
150 Yen per X in Japan < 200 Yen per X in US
Since good X is more highly valued in the US, Xs will be purchased in Japan, shipped and sold in US.
For example, an individual can buy one X in Japan for 150 Yen, ship it to the US, and sell it in the US for $2. The $2 can be traded for 200 Yen at the going exchange rate. That is a profit of 50 Yen for each unit of X shipped. As this process occurs, however, the increased demand for X in Japan will push up the price of X in Japan. The increased supply of X in the US will push down the price of X in the US. Finally, the increase in the number of dollars that people are trying to trade for yen will push down the exchange rate.
9. The PPP condition can be rearranged as en = (PF)/(P). Therefore, if both price levels increase by 10%,
the ratio remains the same, and therefore there is no change in the nominal exchange rate.
10. An increase in e will cause NX to fall. As e increases, domestic goods become more expensive abroad
and foreign goods become cheaper in the domestic economy. This causes exports to fall and imports to rise. In short, NX falls.
11. The supply of dollars in the foreign exchange market refers to the desire to sell dollars to acquire foreign currency and the demand for dollars refers to the desire to buy dollars with foreign currency. Source of the supply of dollars in the foreign exchange market would be imports + foreign lending. Why? Suppose a U.S. resident wants to purchase a German car (import from U.S. point of view). The German producer wants to be paid in euros and therefore the U.S. buyer must first trade dollars to get the euros that can be used to buy the car. Or, as another example, suppose a U.S. resident desires to purchase German bonds (foreign lending from U.S. point of view). The German bond seller wants to be paid in euros and therefore the U.S. buyer must first trade dollars to get the euros that can be used to buy the bonds.
The source of the demand for dollars in the foreign exchange market is exports + foreign borrowing. Why? Suppose a Japanese resident wants to purchase a U.S. car (export from U.S. point of view). The U.S. car producer wants to be paid in dollars and therefore the Japanese buyer must first trade yen to get the dollars that can be used to buy the car. As another example, suppose a Japanese resident desires to purchase U.S. bonds (foreign borrowing from U.S. point of view). The U.S. bond seller wants to be paid in dollars and therefore the Japanese buyer must first trade yen to get the dollars that can be used to buy the bonds.
12. Suppose the nominal exchange rate rises—for example, suppose it originally costs 10 pesos per dollar, but now it costs 15 pesos per dollar. Since one dollar can acquire more pesos, the dollar prices of Mexican goods and assets have decreased. For example, assume a widget in Mexico has a price of 10 pesos. From the U.S. point of view, it now costs (approximately) $0.67 to buy this widget (if $1 trades for 15 pesos, then 2/3 of dollar—about 67 cents--can be used acquire 10 pesos) instead of $1. This induces U.S. buyers to buy more goods and assets from Mexico, which means that their supply of dollars rises. Conclusion: As the exchange rate increases, the quantity of dollars supplied increases—a positively slopped supply curve.
Again assume that the nominal exchange rate rises—again, suppose it originally takes 10 pesos to buy one dollar, but now it costs 15 pesos per dollar. Since it takes more pesos to buy one dollar, the peso prices of U.S. goods and assets have risen. For example, assume one U.S. widget has a price of $1. From Mexico’s point of view, it now costs 15 pesos to buy this U.S widget (since that is how many pesos that we have to give up to get the dollar needed to buy the widget) instead of 10 pesos. This induces Mexican buyers to buy fewer U.S. goods and assets, which means that their demand for dollars falls. Conclusion: As the exchange rate increases, the quantity of dollars demanded in the foreign exchange market decreases—a negative-slopped demand curve!
13a. An increase in U.S. real income would lead to greater demand for European goods—i.e., a greater demand for imports (imports from U.S. point of view). In order to buy more foreign goods, U.S. buyers must first sell dollars to buy the foreign currency that is necessary to pay for the foreign goods. Thus, there is an increase in the supply of dollars in the foreign exchange market (rightward shift). This rightward shift will result in a drop in the exchange rate (the usual expression is “the dollar depreciates and the euro appreciates”). In other words, it will take fewer euros to buy a dollar (or equivalently it will take more dollars to buy a euro). See Figure 13a.
13b. An increase in Europe’s price level relative to the U.S. price level means that European goods and services are relatively more expensive than U.S. goods and services. Consequently, U.S. buyers will buy fewer European goods and services, which causes a decrease in the supply of dollars in the foreign exchange market (leftward shift in supply curve). Also, Europeans finding that U.S. goods and services are relatively cheaper will buy more U.S. goods and services, which causes the demand for dollars in the foreign exchange market to increase (rightward shift in the demand curve). The end result is that the exchange rate rises (“the dollar appreciates”)—it takes more euros to buy a dollar. See Figure 13b.
13c. A decrease in the U.S. real rate of interest relative to the real rate of interest in Europe makes holding U.S. assets less desirable relative to holding European assets. As a consequence, U.S. residents will desire to purchase more European assets, which causes the supply of dollars to increase (rightward shift). At the same time, European residents will desire to purchase fewer U.S. assets, which causes the demand for dollars to decrease (leftward shift).
The end result is that the exchange rate declines (“ dollar depreciates”)—it takes fewer euros to buy one dollar.
See Figure 13c.
en (euros per $) en (euros/$) en (euros/$)
13a. 13b. 13c.
S2 S1
S1
en2 S1 S2
S2 en1
en1
en2 en1
D2 en2
D D1 D2 D1
Quantity Quantity Quantity
of dollars of dollars of dollars
Answers to multiple choice questions:
14a. b. 14b. a. 14c. c. 14d. c. 14e.d. 14f. e. 14g. b.