11: The External Sector

Question 1

An open economy interacts with other countries in three ways…

Answer 1

• It buys and sells goods and services in world product markets
• It buys and sells assets in world asset markets.
• It makes/receives transfer payments to/from other countries.

Question 2

Balance of Trade FORMULA

Answer 2

BT = X – M = NX

Question 3

Trade Surplus

Answer 3

an excess of exports over imports.

Question 4

Trade Deficit

Answer 4

an excess of imports over exports.

Question 5

Balanced Trade

Answer 5

exports and imports are equal

Question 6

Factors that influence a country’s exports, imports and net exports (5)

Answer 6

• The tastes of consumers for domestic and foreign goods.
• The prices of goods at home and abroad.
• Exchange Rates
• The policies of governments towards international trade.
• The cost of transporting goods from one country to another.

Question 7

Capital Outflow vs Capital Inflow

Answer 7

Ko: the purchase of foreign assets by domestic residents
Ki: the purchase of domestic assets by foreigners

Question 8

2 forms of foreign investment with definitions

Answer 8

• Foreign direct investment –> Australian company opens up a branch in India – high control by the Australian owner.
• Foreign portfolio investment –> Australian buys shares in an Indian corporation – less control by the Australian owner.

Question 9

Factors that influence net foreign investment (NFI) - 5

Answer 9

• The interest rates being paid on foreign financial assets and domestic financial assets.
• The relative rates of return (or dividend yields) on foreign and domestic shares
• Exchange rates
• The perceived economic and political risks and rewards of holding assets abroad.
• Government policies affecting foreign ownership of domestic assets.

Question 10

Balance of Payments FORMULA

Answer 10

total incoming payments from overseas - total outgoing payments to overseas
= total net incoming payments

Question 11

BOP’s two sub accounts

Answer 11

1. Current Account: Includes payments for goods and services and current transfers
2. Capital Account: Includes all payments relating to assets and capital transfers

Question 12

4 sources of supply curve of AUD in FEM

Answer 12

1. Imports of goods and services
2. Income payments to overseas
3. Financial capital outflow (purchase of foreign assets)
4. Central bank sales of AUD

Question 13

4 sources of demand curve of AUD in FEM

Answer 13

1. Exports of g and s
2. Income payments from overseas
3. Financial capital inflow
4. Central bank purchases of AUD

Question 14

2 exchange rate regimes

Answer 14

1. Floating or flexible system in which ER is free to vary

2. Fixed or Managed System in which ER is controlled.

Question 15

4 factors affecting exchange rates

Answer 15

1. State of World Economy
2. State of Australian Economy
3. Relative Inflation Rates
4. Interest Rate Differentials

Question 16

Rising World Income leads to…

Answer 16

Rising world income means increased demand for Australian goods and services at all levels of the ER so that the demand curve shifts right  appreciation of local currency.

Question 17

World Recession leads to…

Answer 17

demand for our export’s declines, demand for local currency declines, demand curve shifts to left, and value of the local currency falls = depreciation.

Question 18

Rising Australian Income leads to…

Answer 18

increased demand for foreign goods and services at all levels of the ER so that the supply curve shifts right  depreciation of local currency.

Question 19

Australian Recession leads to…

Answer 19

demand for foreign imports declines, supply of local currency declines, supply curve shifts to left, and value of the local currency rises = appreciation.

Question 20

What happens if our inflation rate falls?

Answer 20

• If our inflation rate falls relative to inflation in other countries, our goods and services become cheaper to them and theirs become dearer to us.
• Hence X and DAUD shifts rightwards.
• M which means SAUD shifts leftwards.