week 8

Question 1

closed economy is?

Answer 1

An economy that doesn’t interact with other economies in the world

Question 2

So an open economy is?

Answer 2

Economy that interacts w other economies around the world.

~ by buying and selling both goods and services and assets (stocks and bonds etc.)

Question 3

Exports + Imports are?

Answer 3

Exports:

• Goods & services that are produced domestically + sold/consumed abroad

Imports

• Goods and services that are produced abroad + bought/consumed domestically

Question 4

Net exports (NX) are?

Answer 4

value of a nation’s exports minus the value of its imports

— also called the trade balance

Question 5

factors that influence a country’s exports, imports and net exports: [6]

Answer 5

1. Tastes of consumers for domestic & foreign goods
2. Prices of goods at home and abroad
3. Exchange rates
   
   • People use domestic currency to buy foreign currencies
4. Incomes of consumers at home and abroad
5. Cost of transporting goods from country to country
6. Government policies toward international trade

Question 6

Net capital outflow (NCO) is?

Answer 6

NCO = purchase of foreign assets by domestic residents – purchase of domestic assets by foreigners

Question 7

flow of capital takes two forms, those are?

Answer 7

1. Foreign direct investment = You buy a BMW car factory
2. Foreign portfolio investment = You buy shares in BMW

Question 8

Factors that influence net capital outflow [4]

Answer 8

1. Real interest rates paid on foreign assets
2. Real interest rates paid on domestic assets
3. Perceived economic and political risks of holding assets abroad
4. Government policies that affect foreign ownership of domestic assets

Question 9

Net exports should equal…?

Answer 9

Net capital outflow

NX = NCO holds as an accounting identity

Question 10

IF NX > 0 it means there is a…?

Answer 10

TRADE SURPLUS

A Country is selling more goods and services to foreigners than it is buying from abroad.

Question 11

From net sale of goods and services the country receives ______ CURRENCY

Answer 11

FOREIGN CURRENCY

• Which is a foreign asset (adds to NCO)
• May invest this abroad (still part of NCO!)
• So NCO=NX > 0

Question 12

national accounts - open economy equations

Answer 12

• Open economy: Y = C + I + G + NX
• National saving: S = Y – C – G = I+NX

Question 13

As NX=NCO, this implies

Answer 13

S = I + NCO

National savings = Domestic Investment + Net capital outflow

Question 14

National savings = Domestic Investment + Net capital outflow means…?

Answer 14

when the UK saves a £ it can be used to accumulate capital at home or abroad

Question 15

A trade surplus is when?

Answer 15

Exports > Imports and NX > 0

Question 16

since Y = C + I + G + NX, what can we say about trade surplus?

Answer 16

S = I + NX

and **NCO = S-I > 0 **

since NX = NCO

—- Also note that I=S-NCO<S, i.e.,National Savings greater than investments

Question 17

If instead NX<0 (trade deficit), then I=

Answer 17

I=S-NCO>S

National Savings less than investments (“foreigners do part”)

Question 18

3 possible outcomes for an open economy?

Answer 18

1. Trade Deficit
   – X < M
   – NX < 0
   – Y < C + I + G
   – Saving < Investment
   – NCO < 0
2. Balanced Trade
   – X = M
   – NX = 0
   – Y = C + I + G
   – Savings = Investment
   – NCO = 0
3. Trade Surplus
   – X > M
   – NX > 0
   – Y > C + I + G
   – Savings > Investment
   – NCO > 0

Question 19

Define nominal exchange rate

Answer 19

Rate at which a person can trade currency of one country for currency of another

Question 20

define appreciation (strengthening)

Answer 20

increase in the value of a currency

(the amount of foreign currency one unit of the domestic currency can buy)

Question 21

define depreciation (weakening)

Answer 21

decrease in the value of a currency

Question 22

real exchange rate is the…?

Answer 22

the ratio at which a person can trade goods and services of one country, for goods and services of another

Question 23

Formula for real exchange rate?

Answer 23

Question 24

Real exchange rate of a Banana (example)

Answer 24

• Take a banana (UK vs US).
• Costs P pounds in the UK. Now exchange that amount of money into the foreign currency. We get e times P USD.
• Divide with the price of a banana in the US, P*, to get the number of bananas one can buy with the money.
• This is the real exchange rate: “How many US bananas is a UK banana worth”

Question 25

Formula in letters of real exchange rate?

Answer 25

Question 26

What do the letters of the formula for Real ER mean?

Answer 26

Using a price index (basket of goods):

☆ e – nominal exchange rate between the U.K. pound and foreign currencies
☆ P – price index for U.K. basket
☆ P* – price index for foreign basket

So (e × P) / P* is “the quantity of the basket of goods which a domestic unit of the basket can buy abroad”.

Question 27

depreciation (fall) in the U.K. real exchange rate means?

Answer 27

☆ U.K. goods cheaper relative to foreign goods ☆

Consumers at home and abroad buy more U.K. goods and fewer goods from other countries

- Higher exports
- Lower imports
- Higher net exports