Gordon Chapter 6
International Trade, Exchange
Rates, and Macroeconomic
Policy
The link between domestic
savings, foreign savings, and
domestic investment
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What are the components of domestic
savings?
How does the trade deficit relate to
borrowing of foreign savings?
What is the link between domestic
(public and private) and foreign savings
and domestic investment?
Already learned from chapter 5
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How may a fiscal surplus (higher domestic
public savings) be offset by lower private
domestic savings with no effect on domestic
investment or foreign borrowings?
How can foreign borrowings be used to
support domestic investment?
Why would the long-run effect of lower
domestic savings result in lower domestic
investment and economic growth unless the
country is able to attract more foreign capital?
The balance of payments in an
open economy
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What is measured in the current account of
the balance of payments?
What is the difference between the balance of
trade and the balance in the current account?
(Note the role of net income from foreign
investment and unilateral transfer payments.)
What determines whether or not a transaction
is a credit or a debit in the current account?
How does a credit affect the demand for
dollars and a debit add to the supply of dollars
in the international exchange market?
Balance of Payment (cont.)
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What is meant by the capital account in the
balance of payments?
How could a credit be generated in the capital
account? A deficit?
Why with flexible exchange rates does the
current account balance plus the capital
account balance equal zero?
Why under fixed exchange rates could some of
a trade deficit require financing by borrowing
official reserve assets from foreign central
banks?
Foreign Borrowing and
International Indebtedness
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Why does any increase in borrowing from
foreign investors or foreign central banks add
to the country’s indebtedness?
Why is greater international indebtedness the
consequence of a deficit in a country’s current
account?
Why does a persistent current account deficit
results in domestic citizens paying interest and
dividend income to foreigners that lowers
domestic income?
Exchange Rates
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What is meant by the exchange rate between
currencies?
What does it mean when we say that there is
an increase in the value of the dollar
(appreciation)?
What does it mean when we say the value of
the dollar is depreciating?
What is the difference between a nominal
exchange rate and the real exchange rate?
Why is domestic demand affected by the real
exchange rate and not by the nominal
exchange rate?
Purchasing Power Parity
• What is meant by purchasing power parity?
How can this be used to determine if a currency
is overvalued or undervalued relative to other
currencies?
• What is the Big Mac Index?
http://www.economist.com/markets/bigmac/d
isplayStory.cfm?story_id=3503641
• What factors interfere with purchasing power
parity theory?
Exchange Rate Systems
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What does it mean when we say that the
problem of financing balance of payment
deficits could be (1) by allowing flexible
exchange rates or (2) by the use of official
reserves?
How would flexible exchange rates eliminate a
balance of payment deficit or surplus?
How could fixed exchange rates be managed
by central banks who use official reserves to
keep the exchange rate constant despite
change in the demand or supply of currencies?
Central Bank Reserves
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Why does a trade surplus add to the supply of
the central bank’s reserve currencies under
fixed exchange rates but a trade deficit
reduces the supply of reserve currencies?
Why is the support of a currency increasingly
difficult when a balance of payment deficit
occurs and the central bank lacks sufficient
reserve currencies?
How may the threat of domestic inflation limit
the use of reserve currencies by a central bank
to maintain a fixed exchange rate when a
balance of payments surplus exists?
The Trilemma
• What is the trilemma?
• How was the reality of trilemma underscored in
international crisis in Mexico (1994), Southeast
Asia (1997), Russia and Brazil (1998), and
Argentina?
• How can freedom of capital flows initially lead to
large inflows of capital with fixed exchange
rates, shifting up the demand for domestic
currency and accumulation of extra reserves by
central bank?
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How can a higher demand for a country’s
assets that leads to an “asset bubble”
eventually cause foreigners to run for the exits
by withdrawing their funds and converting
capital inflows to capital outflows?
Why can’t central banks reverse the capital
outflow through the use of reserves?
Why would central banks eventually be forced
to allow their currencies to float, leading to
devaluation and further “panic” outflows by
foreigners?
What conditions are necessary to support a
more orderly foreign exchange rate?
Limitations of Monetary and Fiscal
Policy
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Why does monetary policy have no control
over an economy with fixed exchange rates
and perfect capital mobility? (Perfect capital
mobility never exists but has a greater relative
impact on smaller countries)
If monetary policy is ineffective with fixed
exchange rates and perfect capital mobility,
what is the appropriate fiscal policy to reverse
a capital outflow?
What would be the repercussions of this fiscal
policy on the domestic economy?
Is the problem, fixed or flexible exchange
rates, or is it a problem of lack of control of on
the free flow of capital?
Determinants of Net Exports
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What are the influences of the following principal
factors on net exports?
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Higher real income
A higher real exchange rate
What is the link between the real exchange rate and
real interest rate differential among countries?
How do fiscal policy and monetary policy impact on the
balance of payments as they influence the goods
market and the money market of an economy?
Why did the positive link between real interest rates
and the real exchange rate in the U.S. break down in
1995?
International Perspective: Exchange
Rates and Monetary Policy in U.S.,
Europe, and Japan
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The effectiveness of expansionary monetary
policy and lower interest rates to combat the
U.S. 2001 recession was limited to the
consumer and housing sectors of the
economy. Why didn’t the dollar depreciate to
encourage net exports?
The ECB responded less aggressively to the
downturn compared with the Fed. Why?
What has happened to the value of the dollar
versus the euro recently? Why?
Interest Rates and Capital
Mobility
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Why would complete capital mobility cause the
flow of funds to removing the differential in real
interest rates (adjusted for risk)?
Why would monetary expansion that
temporarily lowers domestic interest rates
have no permanent impact on the interest
rate?
Why would fiscal policy that raises the
domestic interest rate result in a huge capital
inflow that would bring the interest rate back to
its original level?
The ISLM Model in a Small Open
Economy
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Why is the BP schedule horizontal where the
domestic interest rate equals the foreign
interest rate?
Why is monetary under fixed exchange rates
completely ineffective and fiscal policy even
more effective in a small open economy?
Why are domestic monetary policy and fiscal
policy effective under flexible exchange rates?
Why is the BP line in a large, open economy
upward sloping, allowing for some change in
domestic interest rates from foreign interest
rates without complete capital mobility?