ECON 101 Tutorial: Week 23
Shane Murphy
s.murphy5@lancaster.ac.uk
Office Hours: Monday 3:00-4:00 – LUMS C85
Outline
• Roll Call
• Problems
Chapter 28: Problem 4
How would the following transactions affect UK net capital
outflow? Also, state whether each involves direct investment
or portfolio investment:
a) A UK mobile company establishes an office in the Czech
Republic.
When a British mobile phone company establishes an office in
the Czech Republic, UK net capital outflow increases, because
the U.S. company makes a direct investment in capital in the
foreign country.
b) A US company’s pension fund buys shares in BP.
When a US company’s pension fund buys shares in BP, net
capital outflow decreases, because the US pension fund makes
a portfolio investment in the UK. (We are assuming the shares
are newly issued or purchased from a UK resident. In fact, of
course, many BP shares are already held by non-UK citizens.)
Chapter 28: Problem 4
How would the following transactions affect UK net
capital outflow? Also, state whether each involves direct
investment or portfolio investment:
c) Toyota expands its factory in Derby, UK
When Toyota expands its factory in Derby, England, UK
net capital outflow declines, because a foreign company
makes a direct investment in capital in the UK.
d) A London investment trust sells VW shares to a
French investor
When a London-based investment trust sells its
Volkswagen shares to a French investor, UK net capital
outflow declines (if the French investor pays in UK
pounds), because the UK company is reducing its
portfolio investment in a foreign country.
Chapter 28: Problem 5
Holding national saving constant, does an increase in
net capital outflow increase, decrease or have no
effect on a country’s accumulation of domestic
capital?
If national saving is constant and net capital outflow
increases, domestic investment must decrease, since
national saving equals domestic investment plus net
capital outflow. If domestic investment declines, the
country's accumulation of domestic capital declines.
Chapter 28: Problem 6c
If UK inflation exceeds EU inflation, would you
expect the UK pound to appreciate or depreciate
relative to the euro?
If UK inflation exceeds European inflation over the
next year, you would expect the pound to depreciate
relative to the euro because a pound would decline
in value (in terms of the goods and services it can
buy) more than the euro would.
Chapter 28: Problem 8
What is happening to the Swiss real exchange rate in each of
the following:
a) If the Swiss nominal exchange rate is unchanged, but prices
rise faster in Switzerland than abroad,
the real exchange rate rises.
b) If the Swiss nominal exchange rate is unchanged, but prices
rise faster abroad than in Switzerland,
the real exchange rate declines.
c) If the Swiss nominal exchange rate declines, and prices are
unchanged in Switzerland and abroad,
the real exchange rate declines.
d) If the Swiss nominal exchange rate declines, and prices rise
faster abroad than in Switzerland,
the real exchange rate declines.
Chapter 28: Problem 9
List three goes for which the law of one price is likely to hold
and three goods for which it is not.
Three goods for which the law of one price is likely to hold are
farm goods like wheat, which are nearly identical no matter
where they are produced, technological goods like computer
software, which have low shipping costs because they are
light, and clothing, which also has low shipping costs.
Three goods for which the law of one price is not likely to hold
are real estate, because you can't move land or buildings from
one country to another; goods that are mainly consumed in
one country and so are not traded, like frog’s legs that are
consumed in France but generally not elsewhere; and services
like haircuts, which cannot be arbitraged even if the price is
very different in different countries.
Chapter 29: Problem 1
Why does Germany (or Japan) generally run a trade
surplus?
Germany generally runs a trade surplus because the
Japanese saving rate is high relative to German
domestic investment. The result is high net capital
outflow, which is matched by high net exports,
resulting in a trade surplus. The other possibilities
(high foreign demand for German goods, low
Japanese demand for foreign goods, and structural
barriers against imports into Germany ) would affect
the real exchange rate, but not the trade surplus.
Chapter 29: Problem 4
Assume a rise in the trade deficit due to a rise in government
budget deficit. Assume some claim that the increased trade
deficit resulted from a decline in the quality of the country’s
products relative to foreign.
a) If relative quality did decline, how might this affect net
exports at a given exchange rate?
This would reduce net exports, reducing the demand for
dollars, thus shifting the demand curve for dollars to the left in
the market for foreign exchange
c) Does a decline in the quality of the country’s products have
any effect on standards of living for its residents?
The claim in the popular press is incorrect. A change in the
quality of US goods cannot lead to a rise in the trade deficit.
The decline in the real exchange rate means that US residents
get fewer foreign goods in exchange for their goods, so their
standard of living may decline.
Chapter 29: Problem 4
Assume a rise in the trade deficit
due to a rise in government budget
deficit. Assume some claim that the
increased trade deficit resulted
from a decline in the quality of the
country’s products relative to
foreign.
b) Use a diagram to show the effect
on real exchange rate and trade
balance.
The shift to the left of the demand
curve for dollars leads to a decline
in the real exchange rate. Since net
capital outflow is unchanged, and
net exports equals net capital
outflow, there is no change in
equilibrium in net exports or the
trade balance.
Chapter 29: Problem 6
Suppose the French develop a taste for UK wine.
a) What happens to the demand for pounds?
The demand for pounds in the foreign-currency
market increases at any given real exchange rate
b) What happens to the value of pounds?
Increased demand increases the exchange rate
c) What happens to the quantity of UK net exports?
The quantity of net exports remains unchanged
(since NCO doesn’t change as in previous figure)
Chapter 29: Problem 9
Suppose that Germans decide to increase their saving.
a) If the elasticity of German NCO with respect to the real interest
rate is high, will this increase in private saving have a large or
small effect on German domestic investment?
If the elasticity of German net capital outflow with respect to the
real interest rate is very high, the lower real interest rate that
occurs because of the increase in private saving will increase net
capital outflow a great deal, so German domestic investment will
not increase much.
b) If the elasticity of German NCO with respect to the real interest
rate is low, will this increase in private saving have a large or small
effect on the German real exchange rate?
Since an increase in private saving reduces the real interest rate,
inducing an increase in net capital outflow, the real exchange rate
will decline. If the elasticity of German exports with respect to the
real exchange rate is very low, it will take a large decline in the real
exchange rate to increase German net exports by enough to match
the increase in net capital outflow.