Chapter 6: International Trade, Exchange Rates, and
The link between domestic savings, foreign savings, and
1. What are the components of domestic savings?
2. How does the trade deficit relate to borrowing of foreign
3. What is the link between domestic (public and private) and
foreign savings and domestic investment?
Already learned from chapter 5
1. 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?
2. How can foreign borrowings be used to support domestic
3. 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
1. What is measured in the current account of the balance of
2. 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.)
3. What determines whether or not a transaction is a credit or a
debit in the current account?
4. How does a credit affect the demand for dollars and a debit
add to the supply of dollars in the international exchange
5. What is meant by the capital account in the balance of
6. How could a credit be generated in the capital account? A
7. Why with flexible exchange rates does the current account
balance plus the capital account balance equal zero?
8. 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
1. Why does any increase in borrowing from foreign investors
or foreign central banks add to the country’s indebtedness?
2. Why is greater international indebtedness the consequence of
a deficit in a country’s current account?
3. Why does a persistent current account deficit results in
domestic citizens paying interest and dividend income to
foreigners that lowers domestic income?
1. What is meant by the exchange rate between currencies?
2. What does it mean when we say that there is an increase in
the value of the dollar (appreciation)?
3. What does it mean when we say the value of the dollar is
4. What is the difference between a nominal exchange rate and
the real exchange rate?
5. 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?
6. What factors interfere with purchasing power parity theory?
Exchange Rate Systems
1. 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
2. How would flexible exchange rates eliminate a balance of
payment deficit or surplus?
3. 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?
4. Why does a trade surplus adds to the supply of the central
bank’s reserve currencies under fixed exchange rates but a
trade deficit reduces the supply of reserve currencies?
5. Why is the support of a currency increasingly difficult when
a balance of payment deficit occurs and the central bank
lacks sufficient reserve currencies?
1. What is the trilemma?
2. How was the reality of trilemma underscored in international
crisis in Mexico (1994), Southeast Asia (1997), Russia and
Brazil (1998), and Argentina?
3. 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?
4. 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?
5. Why can’t central banks reverse the capital outflow through
the use of reserves?
6. Why would central banks eventually be forced to allow their
currencies to float, leading to devaluation and further “panic”
outflows by foreigners?
7. Could the crisis have been eliminated with flexible exchange
rates in the first place? Why could this still require capital
controls under extreme asset speculation?
Limitations of Monetary and Fiscal Policy
1. 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)
2. If monetary policy is ineffective with fixed exchange rates
and perfect capital mobility, what is the appropriate fiscal
policy to reverse a capital outflow?
3. What would be the repercussions of this fiscal policy on the
4. 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
1. Why is the foreign trade surplus of deficit is best measured in
real terms (adjusted for inflation) when determining its
impact on the economy?
2. What are the influences of the following principal factors on
a. Higher real income
b. A higher real exchange rate
3. What is the link between the real exchange rate and real
interest rate differential among countries?
4. 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?
5. 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
1. 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?
2. The ECB has responded less aggressively to the downturn
compared with the Fed. Why?
3. What has happened to the value of the dollar versus the euro
Interest Rates and Capital Mobility
1. Why would complete capital mobility cause the flow of funds
to removing the differential in real interest rates (adjusted for
2. Why would monetary expansion that temporarily lowers
domestic interest rates have no permanent impact on the
3. 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
1. Why is the BP schedule horizontal where the domestic
interest rate equals the foreign interest rate?
2. Why is monetary under fixed exchange rates completely
ineffective and fiscal policy even more effective in a small
3. Why are domestic monetary policy and fiscal policy effective
under flexible exchange rates?
4. Why is the BP line in a large, open economy upward sloping,
Capital mobility and exchange rates in a large open economy,
allowing for some change in domestic interest rates from
foreign interest rates without complete capital mobility?