Chapter 6 International Trade_ Exchange Rates _ and

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Chapter 6 International Trade_ Exchange Rates _ and Powered By Docstoc
					    Chapter 6: International Trade, Exchange Rates, and
                   Macroeconomic Policy

The link between domestic savings, foreign savings, and
domestic investment

  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?

Exchange Rates

  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?

The Trilemma—

  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
     domestic economy?
  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
     net exports?
        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
     recently? Why?

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
     interest rate?

  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
     open economy?

  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?


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