Chapter 6 (The Open Economy)

Exercises from the theory book

1. Use the model of the small open economy to predict what would happen to the trade
balance, the real exchange rate, and the nominal exchange rate in response to each of the
following events: (Ex. 1 page 170)

a. A fall in consumer confidence about the future induces consumers to spend less and save
more.
b. A tax reform increases the incentive for businesses to build new factories.
c. The introduction of a stylish line of Toyotas makes some consumers prefer foreign cars
over domestic cars. (Homework).
d. The central bank doubles the money supply.
e. New regulations restricting the use of credit cards increase the demand for Money.

2. Consider an economy described by the following equations: (Ex. 2 page 170)

a. In this economy, solve for private saving, public saving, national saving, investment, the
trade balance, and the equilibrium exchange rate.
b. Suppose now that G is cut to 2,000. Solve for private saving, public saving, national
saving,
investment, the trade balance, and the equilibrium exchange rate. Explain what you find.
c. Now suppose that the world interest rate falls from 8 to 3 percent. (G is again 2,500.) Solve
for private saving, public saving, national saving, investment, the trade balance, and the
equilibrium exchange rate. Explain what you find.
c.1. Now suppose that the world interest rate falls from 8 to 3 percent. Taking into
consideration the changes in point b, show the effect on the trade balance and the equilibrium
exchange rate.

3. Albania is a small open economy. Suddenly, a change in world fashions makes the exports
of Albania unpopular. (Ex. 3 page 170)

a. What happens to saving, investment, net exports, the interest rate, and the exchange rate?
b. The citizens of Albania like to travel abroad. How will this change in the exchange rate
affect them?
c. The government of Albania wants to adjust taxes to maintain the exchange rate at its
previous level. What should they do? If they do this, what are the overall effects on saving,
investment, net exports, and the interest rate?
4. The president of United States is considering placing a tariff on the import of Japanese
luxury cars. Using the model presented in this chapter, discuss the economics and politics of
such a policy. How would the policy affect the U.S. trade deficit? How would it affect the
exchange rate? Who would be hurt by such a policy? Who would benefit? (Ex. 6 page 171)

5. You read on a financial Web site that the nominal interest rate is 12 percent per year in
Canada and 8 percent per year in the United States. Suppose that international capital flows
equalize the real interest rates in the two countries and that purchasing-power parity holds.
(Ex. 11 page 172)
a. Using the Fisher equation (discussed in Chapter 5), what can you infer about expected
inflation in Canada and in the United States?
b. What can you infer about the expected change in the exchange rate between the Canadian
dollar and the U.S. dollar?
c. A friend proposes a get-rich-quick scheme: borrow from a U.S. bank at 8 percent, deposit
the money in a Canadian bank at 12 percent, and make a 4 percent profit. What is wrong with
this scheme?

6. Consider a small open economy described by the following equations:

Y= 2500, G= 400, T = 400, C = 200+0.8 (Y-T), I=100-10r, NX=600-100, r=r*=7
a) For this economy solve private saving, public saving, national saving, investment, the
trade balance, and the equilibrium exchange rate.
b) Suppose the government reduces the taxes by 100 units and autonomous consumption
increases by 200 units.
c) How would this action affect savings and investments?
d) The world interest rate increases to 10 percent. Compute the new trade balance and
the equilibrium exchange rate.
7. Consider a small open economy described by the following equations:
Y= 2500, G= 300, T = 400, C = 200+0.5 (Y-T), I=100-10r, NX=1000-100, r=r*= 4
a) For this economy solve private saving, public saving, national saving, investment, the
trade balance, and the equilibrium exchange rate.
b) Suppose the government increases the taxes by 200 units. How would this action
affect private saving, public saving, national saving, investment, the trade balance,
and the equilibrium exchange rate.

Other exercises

1. Early in his 1993 presidency, President Clinton proposed tax increases and cuts of
government spending to reduce the trade deficit. In this case assume that tax increase is the
same as government spending cut.

a. Explain the long run implications of this policy on private, public, and national savings.
b. USA is not a closed economy. In 1993, the real interest rate was 4%. Consider USA
economy as a small, open economy, and illustrate the long-term effects of tax increases and
government spending cuts on the country's national savings, investment, real interest rate and
trade deficit.
Multiple choice:

1. If net capital outflow is positive, then:

a. S – I is negative.
b. private savings exceeds private investment.
c. NX is positive.
d. public saving exceeds public investment.
2. The price of one currency in terms of another currency, such as 100 yen for €1, is an
example of:
a. a nominal exchange rate.
b. a real exchange rate.
c. purchasing-power parity.
d. a constant world interest rate.
3. If the nominal exchange rate is €1 equals 150 Japanese yen, and a Big Mac costs €2 in the
Frankfurt and 300 yen in Tokyo, then the real exchange rate of German Big Macs for
Japanese Big Macs is:
a. 1. b. 2. c. 150. d. 300.
A U.S. Big Mac would cost $2 × (150 yen/dollar) or 300 Japanese yen. This means that you
could exchange 1 U.S. Big Mac for 1 Japanese Big Mac. The real exchange rate must be 1.
4. If a country's real exchange rate falls (depreciates), then:
a. net exports rise.
b. net exports fall.
c. exports and imports rise by the same amount.
d. exports and imports fall by the same amount.
If the real exchange rate falls, exports are relatively less expensive to foreigners and imports
are relatively more expensive to the domestic population. This means that exports will rise,
and imports will fall. Therefore, net exports will rise.
5. In the model of Chapter 6, if the government prevented the import of foreign cars, then, in
the resulting equilibrium, net exports would:
a. rise because fewer cars would be imported.
b. remain constant because saving and investment would not change.
c. fall because the real exchange rate would rise.
d. rise because the real exchange rate would fall.
Remain constant because saving and investment would not change. This policy raises the
demand for net exports and causes the real exchange rate to rise. Net exports remain constant
because saving and investment do not change.

6. With a fixed world interest rate, full employment and starting from a balanced trade
balance, an increase in taxes would cause a:

a. Trade deficit
b. Reduction in national saving
c. Negative net capital outflow
d. All the above

The increase in taxes affects the national savings. Meanwhile investments are not affected.
Public savings and therefore national savings decline causing a decline in S-I. Since savings
decrease and investment remain the same S<I and NX would be negative. So, we have trade
deficit, negative capital outflow and a reduction in national savings.

7. In a small open economy, if the demand for investments decreases, then:

a. The real exchange rate equilibrium will increase.

b. Net exports will increase.
c. National savings will increase.
d. Net capital outflows decrease.

A decrease in investment demand lowers the quantity of domestic investment and as a result,
S-I increases, because savings do not change. This means that the supply of dollars to be
exchanged into foreign currency increases. This increase in supply lowers the equilibrium
real exchange rate and as a result increases net exports.

8. Suppose foreign governments decrease their government purchases, affecting the world
interest rate. What happens in a small open economy?

If these foreign countries are a large part of the world economy, their decrease in government
purchases increases world saving. The increase in world saving causes the world interest rate
to decrease. The decrease in the world interest rate lowers the cost of borrowing and, thus,
increases investment in our small open economy.

9. In a large open economy, an increase in the government spending or a decrease in taxes

causes a:

a. An increase in the real interest rate

b. Net exports increase
c. An increase real exchange rate
d. All the above