Gordon Chapter 6 International Trade, Exchange Rates, and Macroeconomic Policy

1. Gordon Chapter 6 International Trade, Exchange Rates, and Macroeconomic Policy

2. The link between domestic savings, foreign savings, and domestic investment • What are the components of domestic savings? • How does the trade deficit relate to borrowing of foreign savings? • What is the link between domestic (public and private) and foreign savings and domestic investment?

3. Already learned from chapter 5 • How may a fiscal surplus (higher domestic public savings) be offset by lower private domestic savings with no effect on domestic investment or foreign borrowings? • How can foreign borrowings be used to support domestic investment? • Why would the long-run effect of lower domestic savings result in lower domestic investment and economic growth unless the country is able to attract more foreign capital?

4. The balance of payments in an open economy • What is measured in the current account of the balance of payments? • What is the difference between the balance of trade and the balance in the current account? (Note the role of net income from foreign investment and unilateral transfer payments.) • What determines whether or not a transaction is a credit or a debit in the current account? • How does a credit affect the demand for dollars and a debit add to the supply of dollars in the international exchange market?

5. Balance of Payment (cont.) • What is meant by the capital account in the balance of payments? • How could a credit be generated in the capital account? A deficit? • Why with flexible exchange rates does the current account balance plus the capital account balance equal zero? • Why under fixed exchange rates could some of a trade deficit require financing by borrowing official reserve assets from foreign central banks?

6. Foreign Borrowing and International Indebtedness • Why does any increase in borrowing from foreign investors or foreign central banks add to the country’s indebtedness? • Why is greater international indebtedness the consequence of a deficit in a country’s current account? • Why does a persistent current account deficit results in domestic citizens paying interest and dividend income to foreigners that lowers domestic income?

7. Exchange Rates • What is meant by the exchange rate between currencies? • What does it mean when we say that there is an increase in the value of the dollar (appreciation)? • What does it mean when we say the value of the dollar is depreciating? • What is the difference between a nominal exchange rate and the real exchange rate? • Why is domestic demand affected by the real exchange rate and not by the nominal exchange rate?

8. Purchasing Power Parity • What is meant by purchasing power parity? How can this be used to determine if a currency is overvalued or undervalued relative to other currencies? • What is the Big Mac Index? http://www.economist.com/markets/bigmac/displayStory.cfm?story_id=3503641 • What factors interfere with purchasing power parity theory?

9. Exchange Rate Systems • What does it mean when we say that the problem of financing balance of payment deficits could be (1) by allowing flexible exchange rates or (2) by the use of official reserves? • How would flexible exchange rates eliminate a balance of payment deficit or surplus? • How could fixed exchange rates be managed by central banks who use official reserves to keep the exchange rate constant despite change in the demand or supply of currencies?

10. Central Bank Reserves • Why does a trade surplus add to the supply of the central bank’s reserve currencies under fixed exchange rates but a trade deficit reduces the supply of reserve currencies? • Why is the support of a currency increasingly difficult when a balance of payment deficit occurs and the central bank lacks sufficient reserve currencies? • How may the threat of domestic inflation limit the use of reserve currencies by a central bank to maintain a fixed exchange rate when a balance of payments surplus exists?

11. The Trilemma • What is the trilemma? • How was the reality of trilemma underscored in international crisis in Mexico (1994), Southeast Asia (1997), Russia and Brazil (1998), and Argentina? • How can freedom of capital flows initially lead to large inflows of capital with fixed exchange rates, shifting up the demand for domestic currency and accumulation of extra reserves by central bank?

12. How can a higher demand for a country’s assets that leads to an “asset bubble” eventually cause foreigners to run for the exits by withdrawing their funds and converting capital inflows to capital outflows? • Why can’t central banks reverse the capital outflow through the use of reserves? • Why would central banks eventually be forced to allow their currencies to float, leading to devaluation and further “panic” outflows by foreigners? • What conditions are necessary to support a more orderly foreign exchange rate?

13. Limitations of Monetary and Fiscal Policy • Why does monetary policy have no control over an economy with fixed exchange rates and perfect capital mobility? (Perfect capital mobility never exists but has a greater relative impact on smaller countries) • If monetary policy is ineffective with fixed exchange rates and perfect capital mobility, what is the appropriate fiscal policy to reverse a capital outflow? • What would be the repercussions of this fiscal policy on the domestic economy? • Is the problem, fixed or flexible exchange rates, or is it a problem of lack of control of on the free flow of capital?

14. Determinants of Net Exports • What are the influences of the following principal factors on net exports? • Higher real income • A higher real exchange rate • What is the link between the real exchange rate and real interest rate differential among countries? • How do fiscal policy and monetary policy impact on the balance of payments as they influence the goods market and the money market of an economy? • Why did the positive link between real interest rates and the real exchange rate in the U.S. break down in 1995?

15. International Perspective: Exchange Rates and Monetary Policy in U.S., Europe, and Japan • The effectiveness of expansionary monetary policy and lower interest rates to combat the U.S. 2001 recession was limited to the consumer and housing sectors of the economy. Why didn’t the dollar depreciate to encourage net exports? • The ECB responded less aggressively to the downturn compared with the Fed. Why? • What has happened to the value of the dollar versus the euro recently? Why?

16. Interest Rates and Capital Mobility • Why would complete capital mobility cause the flow of funds to removing the differential in real interest rates (adjusted for risk)? • Why would monetary expansion that temporarily lowers domestic interest rates have no permanent impact on the interest rate? • Why would fiscal policy that raises the domestic interest rate result in a huge capital inflow that would bring the interest rate back to its original level?

17. The ISLM Model in a Small Open Economy • Why is the BP schedule horizontal where the domestic interest rate equals the foreign interest rate? • Why is monetary under fixed exchange rates completely ineffective and fiscal policy even more effective in a small open economy? • Why are domestic monetary policy and fiscal policy effective under flexible exchange rates? • Why is the BP line in a large, open economy upward sloping, allowing for some change in domestic interest rates from foreign interest rates without complete capital mobility?