The open Economy

Question 1

What is the formula for imports?

Answer 1

Imports= Cd+Id+Gd

Where the f means the domestic expenditure on foreign goods and services.

Question 2

What is the formula for expenditure on domestic goods?

Answer 2

Exports= C-Cf+I-If+G-Gf+X
Where x equals exports so expenditure on domestic goods are dependent on domestic expenditure as well as foreign expenditure.

Question 3

What is the expenditure formula for an open economy?

Answer 3

Y=C+G+I+NX

Question 4

How can we link net exports to savings?

Answer 4

We know that Y=C+G+I+NX
we also know that for households income is spent in the following ways: Y=C+S+T
so: C+G+I+NX=C+S+T
rearranging to make NX the subject:
(C-C)+(S-I)+(T-G)=NX
S+(T-G)=Snat so
Snat-I=NX

Question 5

Describe the graph between Savings and Investment?

Answer 5

Savings is fixed as it is dependent on S=Y-C-G
and Y,T,G are all fixed in the long run so savings are fixed and is represented by a horizontal line. Investment is a downward sloping curve.
r is on the Y axis and I,S on the x axis

Question 6

When S is larger than I at world interest rate?

Answer 6

It is larger when there is a trade surplus and when S is smaller than I there is a trade deficit which is also accompanied by a flow of capital.

Question 7

What happens when there is a fiscal expansion ?

Answer 7

Fiscal expansion means that government expenditure increases or taxes decrease this is done to stimulate spending. An increase in G or C decreases savings which decreases the trade surplus or increases the trade deficit. This is represented by the shift to the left in the savings curve.

Question 8

What happens when there is an increase in world interest rate?

Answer 8

There is a trade surplus as at the new world interest rate savings are larger than investment. When world interest rate decreases there is a trade deficit as at this point investment is larger than savings therefore NX is negative.

Question 9

When investment increases what happens to NX?

Answer 9

The investment curve shifts to the right. This causes a trade deficit as I becomes bigger than S.

Question 10

What is the definition of net capital flow?

Answer 10

The money domestic residents lend to foreigners subtract the money we borrow from foreigners.

Question 11

What is the sign of the net capital outflow if there is a trade surplus?

Answer 11

It is positive as if there is a trade surplus, this means savings outweigh the domestic demand for loans (investment). So the remainder of the savings left is lent abroad in the form of investment.

Question 12

What is the sign of the net capital outflow if there is a trade deficit?

Answer 12

The sign will be negative as net export is negative which means investment is larger than savings. This means the demand for loans is higher than the funds available to loan. This gap is filled by foreign investment in the domestic economy by lending us money. (inflow)

Question 13

What is the relationship between net exports and capital outflow?

Answer 13

due to the rule of balance of payments Capital inflow =net exports. Therefore they offset themselves.

Question 14

In the long run are trade deficits sustainable?

Answer 14

This depends on the size of the economy of the country in question, as well as its strength.

Question 15

What is the definition of nominal exchange rates?

Answer 15

The price of domestic currency in terms of foreign currency e.g the amount of dollars a foreigner would have to part with in exchange for one British pound. This definition means an increase in foreign currency required for the pound means a strengthening in the domestic currency. E=P^f/P

Question 16

What is the definition of real exchange rates?

Answer 16

The rate at which we can trade a domestic good for a foreign good. ε=(E/P^f) For instance imagine the price of a British car is £1200 and for a similar Japanese car is 336000 yen and the exchange rate is 140Y/£
the real exchange rate is = 168000Y/336000=0.5
This means 2 British cars are required to purchase a similar Japanese car.

Question 17

What we learn from the real exchange rates?

Answer 17

It is a measure of competitiveness of domestic goods to foreign goods. the higher the exchange rate the higher the domestic prices so imports increase and exports decrease, this means net exports decrease: An increase in ε means a decrease in NX.

Question 18

Draw a graph showing the relationship between NX and S-I. Show the effects of: a. increase in savings b. Increase in world interest rates c. Increase in investments

Answer 18

S-I= is vertical because it is independent of exchange rate (y axis, NX or x axis). It represents supply of domestic currency to foreigners.
NX= function of real exchange rate and also represents demand for domestic currency. When ε is high demand is low.
a. S-I shifts to the left, lowers ε which increases NX
b. Decreases I, then continues as a does
c. S-I shifts to the right, increases ε which lowers NX

Question 19

What is the definition of arbitrage?

Answer 19

Practice of buying one good cheaply in one market and selling it in another market at a higher price for profit.

Question 20

How can we derive a theory from PPP and arbitrage?

Answer 20

Arbitage ensures that prices abroad are the same as foreign prices. This is because if prices are cheaper abroad, people will buy items and sell them in the domestic market but thre increase in demand drives foreign prices up until it is the ame price as domestic prices. This means the NX curve is relatively flat as it is very sensitive to changes in real exchange rates. This means that changes in investment and savings do not influence real exchange rate. It also means if the real exchange rate is fixed any changes in nominal exchange rates are due to changes in relative prices. However this is unlikely to hold in the long run because similar products in two different countries are not perfect substitutes, also there are some goods that can not be exported or imported such as haircuts so arbitrage cannot affect this.