Unit 6 Open Economy – International Trade and Finance

Question 1

6.1 v1: What is balance of payments (BOP) and what is it made up of?

Answer 1

An accounting system made to keep track of transactions between countries over a period of time. It is made up of two accounts, the Current account, and CFA.

Question 2

6.1 v1: What is the current account made up of?

Answer 2

• Net exports
• Money transfers
• Investment income
• Net unilateral transfers

Question 3

6.1 v1: What is the Capital and financial account made up of?

Answer 3

• The balance of payments for assets between countries
• Financial capital transfers

Question 4

6.1 v1: What are three examples of CA transactions

Answer 4

• Purchase or sale of goods between countries
• Earnings from assets owned in another country
• Sending or receiving income from another country

Question 5

6.1 v1: What is the relation ship between Net Exports, credits imports, debits, and trade balance.

Answer 5

Ca is not always balanced
Nets exports = Trade balance = Exports minus imports
Exports = credit imports = debit
Exports > Imports = trade surplus
Imports > Exports = trade deficit
When is country is in a trade deficit is does not mean the CA is in an account deficit

Question 6

6.1 v1: What are example of CFA transactions?

Answer 6

• Purchase of CD’s, Bonds, and other interest bearing assets.
• Foreign exchange market transactions.
• Purchase / sale of physical assets
• foreign direct investments

Question 7

6.1 v1: Why is CFA not always balanced?

Answer 7

Financial assets going into an economy is a surplus (Financial capital inflow)
Financial assets going out of an economy is a deficit (Financial capital outflow)

Question 8

6.1 v1: How is debit and credit payment differentiated

Answer 8

Money out (of another country) is debit, Money in (to the country) Is credit.

Question 9

6.1 v1: What should sum of all credit entries be equal too and what should the sum of all debit entries be equal too?

Answer 9

The sum of all debut entries should be equal to the sum of all credit entries.
An increase in Ca balance must be offset by a decrease in CFA balanced and vice versa.
CA + CFA = 0

Question 10

6.2 v1: What is the exchange rate?

Answer 10

The price of one currency in terms of another

Question 11

6.2 v1: What is the exchange rate in a foreign exchange market?

Answer 11

In a foreign exchange market, one currency is exchanged for another meaning the exchange rate is the price of currency.

Question 12

6.2 v1: What is currency appreciation and depreciation?

Answer 12

Appreciation: when a currency becomes more valuable in terms of other currencies.
Depreciation: when a currency becomes less valuable in terms of other currencies.

Question 13

6.2 v1: What happens to one currency when another appreciates?

Answer 13

When one currency appreciates another must depreciate and vice versa.

Question 14

6.3 v1: What is a foreign exchange market?

Answer 14

A market where buyers and sellers are exchanging the currency of one country for the currency of another

Question 15

6.3 v1: What determines the equilibrium exchange rate in the flexible exchange market and its influences.

Answer 15

The foreign exchange market determines the equilibrium exchange rate and influences the flows of goods, services, and financial capital between countries

Question 16

6.3 v1: What is the relationship between the exchange rate and the quantity demanded of a currency

Answer 16

The demand of currency in the foreign exchange market Increases when demand for the countries goods, services, and financial capital increases showing the relation ship is inverse

Question 17

6.3 v1: What is the relationship between exchange rate and the quantity supplied of a currency in the foreign exchange market.

Answer 17

The supply of a currency in the foreign exchange market increases through payments in other currencies showing the relationship is positive.

Question 18

6.3 v1: What is the goal of the foreign exchange market?

Answer 18

To reach equilibrium which is when the exchange rate has quantities of currencies demanded and supplied equal to one another.

Question 19

6.3 v1: What are shortages and surpluses (disequilibrium) in the foreign exchange market?

Answer 19

Shortages: when quantity of currency demanded is greater than currency supplied
Surpluses: when Supply of currency is greater than currency demanded.

Question 20

6.4 v1: Who are the buyers and sellers in the foreign exchange market and why do they participate?

Answer 20

1. People looking to buy goods in another country
2. People looking to earn income from another country

Question 21

6.4 v1: What are the determinants or shifters of currency demand?

Answer 21

1. Foreign demand for the country’s goods and services
2. Foreign demand for the country’s assets
3. Monetary policy
4. Fiscal policy

Question 22

6.4 v1: What are the determinants or shifters of currency supply?

Answer 22

1. Domestic demand for the country’s goods and services
2. Domestic demand for the country’s assets
3. protectionist policies (tariffs, quotas) imposed on other country’s goods and services.

Question 23

6.4 v2: What happens to the demand, quantity, supply, and value of two currencies if demand for one currency increases. Imagine the change on two supply supply and demand graphs.

Answer 23

Example:
If there is a increase in demand for Japanese goods in the US then more people will start wanting Yen as a currency.
Supply for dollars increases and the value decreased as there are more dollars now.
Demand for Yen increases and the value increases due to higher demand.

Question 24

6.4 v2: What happens to the demand, quantity, supply, and value of two currencies if interest rates in one country increase? Imagine the change on two supply supply and demand graphs.

Answer 24

Example:
If there is a increase in interest rates in Europe people in south Africa will see a higher rate of return in Europe.
Supply for rand (SA) increases and decreases in value because there is more rand now.
Demand for euros increases causing the exchange rate to go up causing an increase in the value of Euros.

Question 25

6.4 v2: What happens to the demand, quantity, supply, and value of two currencies if one country imposes a tariff on imported goods from the other country. Imagine the change on two supply supply and demand graphs.

Answer 25

Examples:
If Mexico imposes a trade tariff on imported goods from India there will be a reduction of trade.
Supply for Peso will decrease and demand for rupees will decrease as well because less India goods are being bought.
Peso will increase in value while Rupees will decrease in value

Question 26

6.4 v2: In paired exchange rate examples, what should be expected?

Answer 26

One currency will always appreciate in value while the another currency will always depreciate in value.

Question 27

6.5 v1: What is the relationship between currency, relative goods, and net exports?

Answer 27

Changing currency values cause a change in the relative price of goods. Changes in the relative price of goods cause a change in net exports.

Question 28

6.5 v1: If The Canadian dollar depreciates in value relative the the US dollar, what will happen to US exports?

Answer 28

US goods will be more expensive to Canadians causing US exports to fall.

Question 29

6.5 v1: If the US dollar appreciates in value relative the the Canadian dollar, what will happen to Canadian imports?

Answer 29

Canadian goods will be less expensive to Americans causing Canadian imports to America increase.

Question 30

6.5 v1: What happens to AD if the US dollar appreciates and the Canadian dollar depreciates?

Answer 30

A increase in Canadian imports and a decrease in Canadian exports will cause the Net Exports of US to fall.
NX = Exports - Imports
A fall in net exports will causing the AD curve to shift to the left.

Question 31

6.6 v1: In a open economy, what changes the relative value of foreign and domestic assets?

Answer 31

Differences in real interest rates across countries.

Question 32

6.6 v1: Where does financial capital flow and how can central banks influence it?

Answer 32

Financial capital flows toward the country with relatively higher interest rates. Central banks can influence the domestic interest rates in the short run, which in turn will affect net capital inflows.

Question 33

6.6 v1: How are capital flows reflected by shifts of the supply of loanable funds?

Answer 33

Capital inflow is reflected by a shift of supply to the right.
Capital outflow is reflected by a shift of supply to the left.

Question 34

6.6 v1: What drives change in capital flows?

Answer 34

Changes in capital flow is caused by a change in interest caused by:
Monetary policy:
-Expansionary (decrease rates and returns)
-Contractionary (increase rates and returns)
Demand for money:
-Increase (increase rates)
-Decrease (decrease rates)
Budget balances:
-Deficit (increase rates)
-Surplus (decrease rates
Household saving behavior:
-Increase (decrease rates)
-Decrease (increase rates)

Question 35

6.6 v1: What does the sentence “Financial capital will chase high interest rates” mean?

Answer 35

Investors comparing multiple financial assets in countries will gravitate towards the the highest returns signaled by high interest rates. This will cause financial capital to flow towards nations with higher interest rates.
This means capital flow is influenced by relative interest rates. The supply of loanable funds reflect these changes in capital flow

Question 36

6.6 v2: what happens to Canada capital and financial account balance if it is at 0 and Canada’s real interest rates drop from 5% to 3.5% while Mexico has a 5% real interest rate.

Answer 36

The CFA will no longer be balanced and will now be at the deficit. This occurs because the capital outflow from Canada to Mexico is recorded as debit on CFA leaving it as a deficit.

Question 37

6.6 v2: Canada capital and financial account balance is at 0 and Canada’s real interest rates drop from 5% to 3.5% while has a 5% real interest rate. How will this be represented on the graph of loanable funds market of Canada.

Answer 37

Capital outflow is represented as a leftwards shift of supply of loanable funds. As capital leaves the economy of Canada and goes to Mexico the supply of loanable fund will shift to the left. Financial capital leaving the economy will result in higher real interest rates so real interest rates in Canada will rise