BUSI 101 - Chapter 13

(a)1 What does the small-open-economy model take as already determined, and what two variables is the model primarily trying to explain?

(a)2 Why is Canada treated as a “small” open economy with perfect capital mobility in this model?

(a)3 What are the two markets used to analyze a small open economy, and what does each market coordinate?

(a)4 What two accounting identities connect saving, investment, capital flows, and trade in the model?

(a)5 Why is net capital outflow the key variable linking the two markets?

(a)1 The model takes real GDP, the domestic price level, and the real interest rate as given. Output is determined by productive resources and technology, the price level by monetary forces, and the real interest rate by the world interest rate. The model primarily explains the trade balance and real exchange rate.

(a)2 Canada is assumed too small to materially influence world interest rates or world prices, while perfect capital mobility allows Canadian and foreign investors to move funds freely between Canadian and international financial markets.

(a)3 The loanable-funds market coordinates national saving, domestic investment, and NCO. The foreign-currency exchange market coordinates exchanges of Canadian dollars for foreign currencies and determines the real exchange rate.

(a)4 S=I+NCO and NCO=NX. Therefore, S−I=NCO=NX.

(a)5 NCO is determined in the loanable-funds market as the difference between national saving and domestic investment and then becomes the source of currency supplied in the foreign-currency exchange market.

(b)1 In an open economy, how should you interpret the identity S=I+NCO?

(b)2 At the world interest rate, national saving is $180 billion and domestic investment is $130 billion. Calculate NCO and explain what is happening to the excess saving.

(b)3 At the world interest rate, national saving is $100 billion and domestic investment is $145 billion. Calculate NCO and explain how the investment shortfall is financed.

(b)4 Why does national saving not have to equal domestic investment in a small open economy?

(b)5 How does the loanable-funds market in a small open economy differ from the closed-economy version studied earlier?

(b)1 National saving finances either domestic investment or purchases of foreign assets. Any saving not used domestically flows abroad as NCO.

(b)2 NCO=180−130=50 billion. Canadians have $50 billion of saving left after financing domestic investment, so they use it to acquire foreign assets.

(b)3 NCO=100−145=−45 billion. Domestic saving falls $45 billion short of domestic investment, so foreigners finance the difference by purchasing domestic assets.

(b)4 International capital flows allow foreign saving to finance domestic investment or domestic saving to finance investment abroad.

(b)5 In a closed economy, the domestic supply and demand for loanable funds determine the interest rate and require S=I. In the small open economy, the world interest rate is given and any difference between S and I becomes NCO.

(c)1 Why does the domestic investment curve slope downward with respect to the real interest rate, while the national-saving curve slopes upward?

(c)2 Why does the intersection of domestic saving and investment not determine Canada’s real interest rate in this model?

(c)3 If the world real interest rate is above the interest rate that would prevail in a closed Canadian economy, what happens to Canadian saving, domestic investment, and NCO?

(c)4 If the world real interest rate is below the closed-economy Canadian interest rate, what happens to saving, investment, and NCO?

(c)5 What determines Canada’s NCO once the world real interest rate is given?

(c)1 Higher interest rates make borrowing and investment more expensive, reducing investment. At the same time, higher returns make saving more attractive, increasing national saving.

(c)2 Perfect capital mobility links Canadian financial markets to world markets, forcing the Canadian real rate toward the world rate.

(c)3 Saving rises, domestic investment falls, and the excess S−I increases. Therefore NCO becomes more positive.

(c)4 Saving falls, domestic investment rises, and S−I declines. NCO becomes smaller or more negative.

(c)5 NCO=S−I, with both saving and investment evaluated at the world real interest rate.

(d)1 Why does a market for foreign-currency exchange have to exist in an open economy?

(d)2 In the foreign-currency exchange market, what generates the supply of Canadian dollars and what generates the demand for Canadian dollars?

(d)3 Why does a Canadian investor buying a foreign asset supply Canadian dollars in the foreign-exchange market?

(d)4 Why does a foreign buyer purchasing a Canadian export demand Canadian dollars?

(d)5 What price adjusts to equilibrate the supply and demand for Canadian dollars in this market?

(d)1 International transactions usually require payment in the seller’s currency, so buyers and investors must exchange currencies.

(d)2 NCO generates the supply of Canadian dollars, while net exports generate demand for Canadian dollars in the presentation used by the model.

(d)3 The investor must exchange Canadian dollars for the foreign currency needed to purchase the foreign asset.

(d)4 The foreign buyer must obtain Canadian dollars to pay the Canadian producer.

(d)5 The real exchange rate.

(e)1 Why does the demand curve for Canadian dollars in the foreign-currency exchange market slope downward with respect to the real exchange rate?

(e)2 Trace the effect of a real appreciation of the Canadian dollar on Canadian exports, imports, net exports, and the quantity of dollars demanded.

(e)3 Trace the opposite effects of a real depreciation of the Canadian dollar.

(e)4 Why is the supply of dollars from NCO represented as vertical in this model?

(e)5 A stronger Canadian dollar makes buying a foreign asset initially cheaper. Why does the model nevertheless assume that the real exchange rate does not change NCO?

(e)1 A higher real exchange rate makes Canadian goods relatively expensive, reducing exports and increasing imports. Net exports fall, so fewer Canadian dollars are demanded to purchase Canadian goods.

(e)2 Exports fall, imports rise, NX falls, and the quantity of Canadian dollars demanded falls.

(e)3 Canadian goods become relatively cheaper, exports rise, imports fall, NX rises, and demand for Canadian dollars rises.

(e)4 NCO is determined by saving, investment, and the real interest rate. The model therefore treats its quantity as given when analyzing the foreign-exchange market.

(e)5 A stronger dollar reduces the Canadian-dollar cost of acquiring a foreign asset but also reduces the Canadian-dollar value of the foreign currency received when the asset later pays returns. The two effects offset in the model.

(f)1 What happens if the real exchange rate is below its equilibrium level in the foreign-currency exchange market?

(f)2 What happens if the real exchange rate is above its equilibrium level?

(f)3 What condition holds at the equilibrium real exchange rate?

(f)4 Why is the classification of imports and foreign asset purchases as “supply” or “demand” for dollars partly a modelling convention?

(f)5 How can purchasing-power parity be viewed as a special case of the foreign-currency exchange model?

(f)1 Demand for Canadian dollars exceeds supply, creating a shortage that pushes the real exchange rate upward.

(f)2 Supply exceeds demand, creating a surplus of Canadian dollars that pushes the real exchange rate downward.

(f)3 The quantity of dollars supplied through NCO equals the quantity demanded through NX.

(f)4 The same international transaction can be described from different sides. The chosen convention simply makes the model easier to analyze consistently.

(f)5 PPP assumes net exports react extremely strongly to small real-exchange-rate differences. Graphically, this would make the demand curve for foreign currency horizontal at the PPP real exchange rate.

(g)1 Explain the full equilibrium mechanism connecting the world interest rate, saving, investment, NCO, net exports, and the real exchange rate.

(g)2 Suppose the world interest rate rises. Before considering exchange rates, what happens to Canadian national saving and domestic investment?

(g)3 Why does a rise in the world interest rate increase Canadian NCO?

(g)4 After NCO rises, what happens in the foreign-currency exchange market and to the Canadian real exchange rate?

(g)5 Complete the entire chain following an increase in the world interest rate: saving → investment → NCO → real exchange rate → exports/imports → net exports.

(g)1 The world interest rate determines national saving and domestic investment. Their difference determines NCO. NCO supplies Canadian dollars to the foreign-exchange market. The real exchange rate then adjusts until the resulting NX equals NCO.

(g)2 Higher interest rates encourage more saving and discourage investment.

(g)3 Both changes increase S−I, which equals NCO.

(g)4 More NCO increases the supply of Canadian dollars, shifting the foreign-exchange supply curve right and depreciating the real exchange rate.

(g)5 Saving rises → investment falls → NCO rises → the real exchange rate depreciates → exports rise and imports fall → NX rises.

(h)1 Why does an increase in the world interest rate “crowd out” Canadian domestic investment even though the increase did not originate in Canada?

(h)2 Who tends to benefit from the Canadian-dollar depreciation caused by a higher world interest rate, and who tends to be harmed?

(h)3 Why are Canadian firms planning investment projects harmed by an increase in the world interest rate?

(h)4 If the world interest rate instead falls, predict the effects on Canadian saving, domestic investment, NCO, the real exchange rate, and net exports.

(h)5 Why do movements in major foreign interest rates matter greatly to a small open economy like Canada?

(h)1 The higher world rate raises the cost of financing domestic capital projects, making fewer Canadian investments worthwhile.

(h)2 Exporters tend to benefit because Canadian goods become cheaper abroad. Importers and consumers purchasing foreign goods are harmed because imports become more expensive.

(h)3 They must finance their projects at the higher world-linked interest rate.

(h)4 Saving falls, investment rises, NCO falls, the Canadian dollar appreciates, and net exports fall.

(h)5 Perfect capital mobility ties Canadian borrowing and lending conditions closely to international financial markets.

(i)1 How does a Canadian government budget deficit initially affect national saving?

(i)2 In a small open economy, why does a larger government deficit not raise the domestic real interest rate in the basic model?

(i)3 Trace the effects of a larger government budget deficit from national saving through NCO to the real exchange rate.

(i)4 Why does the appreciation caused by a larger budget deficit reduce Canadian net exports?

(i)5 Complete the full causal chain for a larger government deficit: public saving → national saving → NCO → supply of Canadian dollars → real exchange rate → net exports.

(i)1 A deficit reduces public saving and therefore reduces national saving.

(i)2 The domestic rate remains tied to the given world rate under perfect capital mobility. Instead of the interest rate adjusting, international capital flows adjust.

(i)3 National saving falls → S−I falls → NCO falls → fewer Canadian dollars are supplied in foreign exchange → the Canadian dollar appreciates.

(i)4 Canadian goods become more expensive relative to foreign goods, so exports fall and imports rise.

(i)5 Public saving falls → national saving falls → NCO falls → supply of Canadian dollars falls → Canadian dollar appreciates → net exports fall.

(j)1 Reverse the analysis of a budget deficit: What happens to national saving, NCO, the Canadian dollar, and net exports when the government moves toward a larger budget surplus?

(j)2 Why can government fiscal policy affect the exchange rate even though it does not directly regulate currency markets?

(j)3 Why does a budget surplus tend to make Canadian exports more competitive internationally in this model?

(j)4 Compare the effect of a larger government deficit in a closed economy with its effect in a small open economy.

(j)5 Why are changes in government budget balances important to both Canadian exporters and Canadian consumers of imported goods?

(j)1 National saving rises, NCO rises, the supply of Canadian dollars in foreign exchange increases, the dollar depreciates, and net exports rise.

(j)2 Fiscal policy changes national saving. That changes international capital flows, which changes the supply of currency in foreign-exchange markets.

(j)3 The resulting depreciation makes Canadian goods cheaper relative to foreign goods.

(j)4 In a closed economy, a deficit raises the equilibrium interest rate and crowds out domestic investment. In the small open economy, the world interest rate does not change; instead NCO falls and the currency appreciates.

(j)5 Budget changes alter the exchange rate, which changes the foreign-currency price of Canadian exports and the Canadian-dollar price of imported goods.

(k)1 What are tariffs and import quotas, and what are they designed to influence directly?

(k)2 Suppose Canada imposes an import quota. At any given real exchange rate, what happens initially to imports, net exports, and demand for Canadian dollars?

(k)3 Why does the increase in demand for Canadian dollars caused by an import restriction lead to a real appreciation?

(k)4 The import quota directly reduces imports, yet the model predicts no change in overall net exports. Explain the adjustment that offsets the initial effect.

(k)5 Why does the identity NX=NCO=S−I imply that trade restrictions cannot change the overall trade balance unless they also change saving or investment?

(k)1 A tariff is a tax on imports. An import quota directly limits the amount of a foreign good that can be imported.

(k)2 Imports fall, NX initially rises, and demand for Canadian dollars shifts right.

(k)3 Higher demand for Canadian dollars bids up their real exchange value.

(k)4 Appreciation makes Canadian exports more expensive and foreign goods cheaper. Exports fall and some imports rise, offsetting the original increase in NX.

(k)5 If S and I are unchanged, S−I is unchanged. Therefore NCO and NX must also remain unchanged. The real exchange rate adjusts to enforce the identity.

(l)1 If an import quota leaves the overall trade balance unchanged, what does it actually change?

(l)2 Why might protecting one Canadian industry through an import restriction hurt another Canadian export industry?

(l)3 Suppose a quota reduces Japanese car imports into Canada. Explain how the resulting exchange-rate movement can reduce exports from an unrelated Canadian industry.

(l)4 Why are the effects of tariffs and quotas described as primarily microeconomic rather than macroeconomic in this model?

(l)5 Why do economists generally oppose trade restrictions even though they can benefit selected domestic producers?

(l)1 It changes the composition of imports and exports and redistributes gains and losses across industries, firms, and trading partners.

(l)2 Protection increases demand for the protected industry but appreciates the currency, making other Canadian exporters less competitive.

(l)3 Fewer Japanese cars initially raise NX and demand for Canadian dollars. The dollar appreciates, making unrelated Canadian exports such as trains more expensive abroad.

(l)4 They redistribute production and trade among particular goods, industries, and countries without changing aggregate NX.

(l)5 Restrictions interfere with specialization according to comparative advantage, reducing the gains from trade and overall economic welfare.

(m)1 What is capital flight?

(m)2 Why does increased political or economic risk cause lenders to demand a risk premium from borrowers in the affected country?

(m)3 Suppose the world real interest rate is 4 percent and investors now require a 3-percentage-point risk premium to hold a country’s assets. What interest rate must domestic borrowers offer?

(m)4 How does the introduction of a risk premium affect domestic investment and NCO?

(m)5 Why does capital flight increase the supply of the country’s currency in foreign-exchange markets?

(m)1 A large and sudden movement of financial capital out of a country because investors lose confidence in its economy or political stability.

(m)2 Investors require compensation for a greater probability of default or other losses.

(m)3 4%+3%=7%.

(m)4 The required domestic interest rate rises, reducing investment. With saving higher relative to investment, NCO increases.

(m)5 Investors sell domestic assets and exchange the proceeds into foreign currencies, increasing the amount of domestic currency offered for sale.

(n)1 Trace the complete effects of capital flight on the domestic interest rate, investment, NCO, exchange rate, and net exports.

(n)2 Why does the currency depreciate during capital flight?

(n)3 Why does the depreciation caused by capital flight tend to increase net exports?

(n)4 What is the most damaging long-run consequence of capital flight emphasized in the chapter?

(n)5 How can political uncertainty or concerns about government debt create capital-flight-like effects even in an otherwise developed economy such as Canada?

(n)1 Risk rises → domestic interest rate rises → domestic investment falls → NCO rises → supply of domestic currency rises → currency depreciates → exports rise and imports fall → NX rises.

(n)2 People selling domestic assets must also sell the domestic currency to acquire foreign assets, increasing its supply in foreign-exchange markets.

(n)3 Domestic goods become cheaper relative to foreign goods.

(n)4 Higher interest rates reduce domestic investment, slowing capital accumulation, productivity growth, and future economic growth.

(n)5 Political uncertainty or high government debt can raise perceived default or political risk, requiring Canadian borrowers to pay a risk premium and producing similar effects on investment and the dollar.

(o)1 What three policy goals make up the open-economy “trilemma”?

(o)2 Why can a country achieve at most two of the following simultaneously: free capital mobility, independent monetary policy, and a fixed exchange rate?

(o)3 Which two goals does a country such as Canada generally choose, and what must it therefore allow to fluctuate?

(o)4 If a country wants both a fixed exchange rate and independent monetary policy, what must it restrict?

(o)5 If countries adopt a common currency while allowing free capital movement, what monetary-policy independence must they give up?

(o)1 Free international capital mobility, independent national monetary policy, and a stable or fixed exchange rate.

(o)2 With free capital mobility, interest-rate differences generate capital flows. A central bank cannot independently set an interest rate inconsistent with world rates while simultaneously preventing the exchange rate from adjusting.

(o)3 Canada generally chooses capital mobility and independent monetary policy, so it allows the exchange rate to float.

(o)4 International capital movements.

(o)5 Individual countries surrender independent national monetary policy because a common central bank sets policy for the currency area.

(p)1 What is meant by currency manipulation in the context discussed in the chapter?

(p)2 If a government deliberately purchases large quantities of foreign assets, how does this affect its NCO and the supply of its currency in foreign-exchange markets?

(p)3 Why does government-induced capital outflow tend to weaken the domestic currency and increase net exports?

(p)4 From the perspective of the country receiving those capital inflows, what happens to its currency, interest rates, investment, and trade balance?

(p)5 Why can another country’s policy of deliberately weakening its currency create both winners and losers in the country receiving the capital?

(p)1 Government action deliberately designed to influence the exchange value of its currency, such as accumulating foreign assets to encourage capital outflow and weaken the currency.

(p)2 NCO rises and more domestic currency is supplied in foreign-exchange markets.

(p)3 The increased currency supply causes depreciation. Domestic goods become relatively cheaper, increasing exports and reducing imports.

(p)4 Its currency appreciates. The capital inflow tends to reduce domestic interest rates and support investment, while the appreciation pushes its trade balance toward deficit.

(p)5 Consumers benefit from cheaper imports and borrowers may benefit from lower interest rates, while domestic firms competing with imports or trying to export may be harmed.

(q)1 Why might consumers in the capital-receiving country benefit from another nation keeping its currency weak?

(q)2 Why might domestic producers competing with imports oppose such a policy?

(q)3 How can the foreign capital inflow associated with currency manipulation stimulate domestic investment in the recipient country?

(q)4 Why might a country deliberately accumulate a large stock of foreign assets even apart from trying to promote exports?

(q)5 What broader lesson does the currency-manipulation example illustrate about judging international economic policies only by their effect on the trade balance?

(q)1 The weak foreign currency makes that country’s exports cheaper to the recipient country.

(q)2 They face stronger competition from lower-priced imported goods.

(q)3 The inflow increases the supply of funds available for domestic borrowing, reducing financing costs and supporting capital investment.

(q)4 The assets can serve as a national reserve or “rainy-day fund” that can be used during future economic emergencies.

(q)5 Policies that worsen the trade balance can simultaneously provide cheaper imports and investment financing. A trade deficit by itself therefore does not reveal the policy’s overall welfare effect.

(r)1 A small open economy experiences an increase in national saving while the world interest rate and domestic investment demand are unchanged. Predict the effects on NCO, the exchange rate, and net exports.

(r)2 A small open economy experiences an investment boom at an unchanged world interest rate while national saving is unchanged. Predict the effects on NCO, the exchange rate, and net exports.

(r)3 A government imposes a new tariff but neither national saving nor domestic investment changes. What happens to the overall trade balance, and why?

(r)4 Foreign investors suddenly become more worried about a country’s default risk. Predict the direction of change in the risk premium, domestic interest rate, investment, NCO, currency value, and net exports.

(r)5 What is the central lesson of Chapter 13 about how saving, investment, international capital flows, and exchange rates jointly determine an open economy’s trade balance?

(r)1 Higher saving raises S−I, so NCO rises. More currency is supplied in foreign exchange, causing depreciation, which raises NX.

(r)2 Higher investment reduces S−I, so NCO falls. The supply of domestic currency falls, causing appreciation, and NX falls.

(r)3 The overall trade balance remains unchanged because S−I, and therefore NCO, has not changed. The real exchange rate adjusts to offset the tariff’s direct effect on imports.

(r)4 The risk premium rises → domestic interest rate rises → investment falls → NCO rises → the currency depreciates → NX rises.

(r)5 In a small open economy, the world interest rate determines saving and investment decisions; their difference determines international capital flows; those capital flows affect the supply of domestic currency; and the real exchange rate adjusts until net exports equal net capital outflow. The central relationships are therefore S−I=NCO=NX.