GEE - Problem set 8

Why is the Balance of Payments not considered a “theory”?

• It isn’t built on simplifying assumptions (like the AS–AD model)

• It’s an accounting identity: every transaction is recorded, ensuring that inflows equal outflows

• Memory Tip: Think “BOP = Bookkeeping” (not a theory to predict but a record of what has happened)

Which variable adjusts to balance supply and demand for foreign exchange?

• The nominal exchange rate, which continually shifts under a flexible regime

• When demand for foreign currency is high → domestic currency depreciates; (e.g., due to high imports or capital outflows),

• when supply is high → domestic currency appreciates

• Memory Tip: “Price tag on money” – it’s the price at which currencies swap

What is Net Income from Abroad?

• Definition: NIA (Net Income from Abroad) represents the balance of income a country earns from abroad minus the income paid to foreign entities.

• Components:

• Includes remittances sent by immigrants,

• profits repatriated by companies, wages, and investment income received from foreign assets.

• When NIA is Positive: If NIA > 0, it means that income inflows (e.g., profits, wages) from abroad are greater than outflows.

• When NIA is Negative: If NIA < 0, it means more income is flowing out of the country than coming in.

• Also Known As: Net Factor Payments (NFP) because it involves payments for labor and capital factors of production.

What is the Current Account Balance, and what does it include?

• Definition: The Current Account tracks a country’s transactions with the rest of the world, excluding financial transactions like investment flows.

• Formula:

  Current Account Balance=Trade Balance+Net Income from Abroad (NIA)

• Trade Balance: The difference between a country’s exports (goods and services sold to other countries) and imports (goods and services purchased from other countries).

• Net Income from Abroad (NIA): As discussed, this includes income earned by residents from abroad and income paid to foreign residents. If NIA is zero, the balance is purely based on the trade balance.

• Important: A positive Current Account means the country is earning more from exports and income than it is spending on imports. A negative balance means the opposite.

Why does a negative trade balance require net capital inflows?

• From the BOP identity: (X−M)+(Kin−Kout)=0

  • Supply (S): Exports + Capital Inflows (DEMAND FOR DOMESTIC CURRENCY)

  • S = X + Kin

  • Demand (D): Imports + Capital Outflows

  • A trade deficit (Exports – Imports < 0) must be balanced by positive net capital inflows (FDI or portfolio investments)

• Memory Tip: “If you buy more than you sell, someone must lend you money!”

Why has the U.S. current account been negative for decades?

• The U.S. has imported more than it exports (negative trade balance)

• Persistent negative trade balance is offset by steady capital inflows

• U.S. public debt is seen as a safe, attractive investment (especially for foreign portfolio investors)

• Memory Tip: Think “Deficit + Dollars = U.S. Debt Appeal”

  Safe haven status → attracts capital inflows → USD appreciates, more demand for dollars

  Makes M cheaper, X expensive → consistent trade deficit

What distinguishes Foreign Direct Investment (FDI) from Portfolio Investment (FPI)?

• FDI: Long-term, involves direct business operations (factories, facilities, real estate) (Ki):

• FPI: Shorter-term, more liquid, involves buying stocks or bonds, public debt, and tends to be more volatile

• Memory Tip: “Direct = Deep-rooted; Portfolio = Pick and Choose”

Does a high trade deficit always harm welfare?

• aggregate demand (AD) is expressed as:

  AD = C+I+G+(X-M)), where (X-M) high and negative (imports higher than exports) = lower AD

• Pros: Can indicate higher consumption without needing additional production, if the economy is at full capacity

GDP = C + I + G + (X − M). => when a country reaches its potential level of GDP, one way to increase consumption (or investment) without raising production (GDP) is through an increase in imports (M).

• Cons: A shrinking aggregate demand may hurt GDP if driven by domestic decline and overreliance on foreign goods

Under what conditions does a high trade deficit become concerning?

• When financed mainly by volatile portfolio investments, easily liquidated

• Risks include rapid capital outflows, sudden depreciation of the currency, and possible currency crises

• Memory Tip: “If your deficit is financed by quick money, be alert for a sudden drop!”

A positive financial account, primarily composed of portfolio investments, always leads to an increasing external debt.

How does the BOP framework explain crises like those in Latin America and Asia?

• Heavy reliance on portfolio investments financed trade deficits

This disparity between expensive exports and cheaper imports contributed to the trade deficit, as Mexico was importing more than it was exporting. => high trade deficit

• Political instability or loss of investor confidence can trigger massive capital outflows

• The rapid adjustment needed (via exchange rate changes) can lead to economic collapse

• Memory Tip: “When too much short-term cash funds long-term deficits, crises can follow”

1. Inflow → appreciation → export fall, import risse → deficit

2. Political risk → portfolio outflow → currency cash → economic collapse

3. Herd behavior + short-term capital = fragile situation

What is the effect on exports when the nominal exchange rate appreciates?

• A stronger domestic currency means foreign buyers must spend more to purchase domestic goods, reducing exports

• Memory Tip: “Strong currency = Heavy price tag = Fewer foreign buys”

  VICE VERSA

What is the difference between the nominal and real exchange rate, and how does a higher real exchange rate impact trade balance?

• Nominal Exchange Rate: The raw price of one currency in terms of another

• Real Exchange Rate: Adjusted for price levels (Er = En × Pd/Pf) and reflects relative purchasing power => basket of goods

• When the real exchange rate increases, domestic goods become more expensive relative to foreign goods, worsening the trade balance => imports go up, exports go down => TRADE DEFICIT

• Memory Tip: “Real rates tell you the real cost – if high, exports take a dive”

  Spain: RER increase → trade deficit; RER decrease → surplus

RER < 1 = trade surplus

RER > 1 = trade deficit

effective RER = weighted average of various RER, weights determined by the volume of trade (as percentage of the total trade)

Why are imports subtracted in the GDP formula, and how can a depreciation in the real exchange rate help an economy?

• Y=C+I+G+X−M

• Imports Subtraction: GDP measures domestic production; imported goods are produced abroad => This would incorrectly inflate the country's GDP if included

• Depreciation Benefits: A cheaper real exchange rate boosts exports and reduces imports, increasing aggregate demand

• Memory Tip: “Subtract imports to see home production; a cheaper domestic price makes local goods win”

Was Spain’s shift from a major trade deficit to a surplus between 2007 and 2014 a sign of a strong economy?

• It was partly due to the 2008 economic downturn reducing domestic income (and imports) => imports also depend on domestic income

• Improvements in exports amid global recovery also played a role

• Memory Tip: “Better numbers aren’t always healthy—they might just be low demand”

  Exports rise via global recovery → helped balance

  Surplus not purely from productivity gains

What does PPP mean, and when does it hold?

• Purchasing power parity

• PPP Concept: A basket of goods should cost the same in different countries when using the proper exchange rate

• PPP Holds: When the real exchange rate equals 1 (prices adjusted for currency differences are equal) => so movements in the real exchange rate represent deviations from PPP. Empirically, we observe that, in the long run, the average real exchange rate fluctuates around one.

• Memory Tip: “PPP = Price Parity Principle: Equal prices across borders (after adjusting the exchange rate)”

What happens to the nominal exchange rate of a country with high inflation (relative to major trading partners) if PPP holds?

• High inflation reduces domestic purchasing power

• To maintain parity, the domestic currency must depreciate (lower nominal value) relative to partners

• Memory Tip: “High prices force the currency to slide”

If home inflation > foreign inflation → nominal depreciation needed to keep

PPP
After the depreciation of Country X’s currency by 5%, the new exchange rate might be something like:

• 1.05 units of Country Y's currency = 1 unit of Country X's currency.

• This depreciation ensures that Country X's goods are cheaper for people in Country Y, which helps boost exports from Country X and helps stabilize the cost of imports in Country X.

What difficulties did China face in trying to keep its real exchange rate below one?

• Massive export volumes drove up demand for the yuan, pushing appreciation

• Intervention (printing money to buy USD) led to inflation, eventually forcing the real exchange rate back toward one

• Memory Tip: “Too many exports can overheat the currency—central banks must balance carefully”

  Lesson: RER returns to 1 in the long run

Why does PPP no longer hold for Spain and how do Spain and Germany differ?

• For Spain: Joining the euro fixed nominal exchange rates, so inflation differences weren’t offset by currency changes; Spain’s higher inflation pushed its real rate above one => PIIGS, suffered huge inflation and huge trade deficits after entering

  the eurozone.=> BUT BALANCED OUT with Germany’s trade surplus

• average current account = 0

• average real exchange rate = 1

• For Germany: Lower inflation kept its real exchange rate below one, enhancing export competitiveness

• Memory Tip: “Fixing a rate can fix the problem—if inflation misbehaves, real rates diverge”

In order for this to reverse, and make the Spanish

real exchange rate return to one, domestic prices need to go down (given

that the nominal exchange rates are fixed to 1 among EMU countries), and

Germany’s should go up, so that relative prices absorb the unbalance cre-

ated by the fixing of nominal exchange rates. In fact, Germany was asked to

increase the minimum wage as a means of reaching this objective, to increase

the german inflation rate.

deflation in Spain, inflation in Germany

How do you use the Big Mac Index to calculate the actual real exchange rate between Spain and the USA, and what does it imply for the long-run nominal exchange rate?

• Step-by-Step:

  • USA Big Mac price: $5.58

  • Eurozone Big Mac price: 4.03 euros

  • Market exchange rate: 1.15 USD/EUR → Implied dollar price in Eurozone: 1.15 × 4.03 ≈ $4.64

  • Real exchange rate (Er): 1.15 × (4.03/5.58) ≈ 0.83

    • Indicates the euro is undervalued relative to PPP

  • To achieve PPP (Er = 1):

    • Set 1 = En × (4.03/5.58) → En ≈ 1.38 USD/EUR

    • Thus, in the long run, the euro should appreciate toward this level

• Memory Tip: “Big Mac tells all: Compare prices and adjust the exchange rate to see PPP in action”

If Trump Dreams in the USA earns $10,000 and Sanchez Dreams in Spain earns 8,000 euros, how do profits compare using the market exchange rate versus the PPP-implied rate, and which branch might be closed?

• Market Rate (1.15 USD/EUR):

  • Spanish branch profit = 8,000 euros × 1.15 = $9,200

  • U.S. branch appears more profitable

• PPP-Implied Rate (1.38 USD/EUR):

  • Spanish branch profit = 8,000 euros × 1.38 = $11,040

  • Spanish branch appears more profitable

• Takeaway:

  • The decision on which branch to keep depends greatly on which exchange rate measure is more relevant to long-term competitiveness and economic fundamentals

• Memory Tip: “Market vs. PPP: Different lenses can flip the profit picture!”

  Exchange rate choice changes decision → PPP matters long term

What happens when the Trade Balance is negative?

• Trade Balance is Negative: If a country imports more than it exports (i.e., negative trade balance), it has to finance the deficit by bringing money into the country.

• Capital Inflows: To balance this, the country will experience capital inflows—which means foreign investments come into the country. These could be:

  • Foreign Direct Investment (FDI): Foreign companies building businesses or factories in the country.

  • Portfolio Investment: Foreign investments in stocks, bonds, or other financial assets in the country.

• Capital Inflows help offset the negative trade balance.

What are the key equations for capital flows in the context of the trade balance?

• Supply of Foreign Exchange (demand for the domestic currency) comes from: S=X (Exports)+Kin (Capital Inflows)

• Demand for Foreign Exchange (supply of the domestic currency) comes from: D=M (Imports)+Kout (Capital Outflows)

• Key Balance Equation:

  X+Kin=M+Kout

  This equation shows that demand for foreign exchange equals supply of foreign exchange, balancing imports, exports, and capital flows.

• Simplified Formula:

  (X - M) = (Kin - Kout)(X−M)=(Kin−Kout)

  • (X - M): The Trade Balance (Exports minus Imports).

  • (Kin - Kout): Net Capital Inflows (Inflow minus Outflow of investment).

• Conclusion: A negative trade balance (more imports than exports) is balanced by capital inflows (foreign investments).

If Net Income from Abroad (NIA) is zero, what does the Current Account balance depend on?

• If NIA = 0, the Current Account depends entirely on the Trade Balance.

• Current Account Formula (with NIA = 0):

  Current Account=Trade Balance=X−M

• Explanation: When NIA = 0, the only component of the current account is the difference between a country’s exports (X) and imports (M).

• If a country is importing more than it is exporting, it has a negative trade balance, and this must be financed through capital inflows.

BOP ID

(X−M)+(Kin−Kout)=0

Trade deficit (X<M) → must be offset by capital inflows

Trade surplus (X>M) → matched by capital outflows

Definition of NOMINAL exchange rate.

1. Price of one currency in terms of another

2. Depreciation → normal rate decreases (foreign currency more expensive)

3. Appreciation → exports fall, imports rise

It is important to note that in many countries outside the eurozone, the definition of the nominal exchange rate is often presented inversely:

(e.g., the number of pesos needed to purchase one dollar).

How can a depreciation of the real exchange rate help an economy?

• Depreciation makes domestic goods cheaper for foreigners, boosting exports.

• Foreign goods become more expensive for locals, reducing imports.

• This increases aggregate demand (AD) by increasing demand for domestic goods.

• In short: Depreciation boosts exports and reduces imports, helping the economy grow.

Is the statement true or false? If the real exchange rate is smaller than one, then capital inflows are smaller than capital outflows

• False: When the real exchange rate is below 1, it means domestic goods are cheaper (exports increase).

• This leads to a positive trade balance (more exports than imports).

• In this case, capital outflows tend to be larger than capital inflows.

• Key takeaway: A lower real exchange rate typically means positive trade balance and capital outflows > inflows.

iv) if capital inflows are higher than capital outflows

then it must be the case than the nominal exchange should appreciate in the long run. Is this statement true of false?

• If a country is importing more than it’s exporting (negative trade balance), it needs more money coming in (capital inflows). This leads to a stronger currency at first.

• But in the long run, the currency will lose value (depreciate) to correct this imbalance and return to its normal exchange rate level (as PPP theory suggests). So, the exchange rate will not appreciate but depreciate in the long run.

  Higher inflows → currency appreciates short term

  But RER > 1 → needs nominal depreciation in long run → PPP restored